Earlier this morning, The Wall Street Journal reported that GE (click ticker for report: ) will acquire oil pump manufacturer Lufkin Industries (click ticker for report: ) for a whopping $3.3 billion, or $88.50 per share in cash. Paramount to any acquisition is the price paid, and we think GE paid a hefty sum to gain exposure to the US hydraulic fracturing market, paying a 20% premium to the high-end of our fair value range and a price 38% higher than Lufkin’s closing price on Friday. We understand the attractiveness of the energy business, as well as the potential synergies from incorporating the business into GE’s existing portfolio, but paying over 25x 2013 earnings for a firm that hasn’t generated free cash flow since 2009 seems hard to justify.
Nevertheless, we like the company’s decision to further invest in the energy space. Lufkin’s main service is the artificial lift—a pump that helps brings oil and gas to the surface. Naturally, this product is critical for the hydraulic fracturing (fracking) taking the US by storm. We believe drilling activity in the US will continue to grow over the next decade, and some particularly bullish observers believe the US oil market can exceed Saudi Arabia in terms of output by 2020. The US oil and gas market is among the most attractive sectors for a business to enter at this time, in our view.
Given former CEO Jack Welsh’s desire to be the number one or number two player in every market GE dealt with, we believe his protégé, Jeff Immelt, could purse a similar strategy. We’ve seen Immelt divest of GE’s non-core assets like NBCUniversal over the past few years, giving the firm a strong capital position. Lufkin could be the first of several acquisitions designed to give GE a dominant position in the energy services space. With manufacturing among GE’s core competencies, we wouldn’t be surprised to see a blockbuster acquisition like Baker Hughes (click ticker for report: ) down the road. We find it unlikely that GE acquires drilling resources since it would add substantial commodity price risk to the firm’s profit potential.
Additionally, we think this means the odds of a Joy Global (click ticker for report: ) takeover fall. Back in September 2012, the two firms were flirting with the possibility of an acquisition, but fundamentals in the materials space have deteriorated during this time, and purchasing a firm leveraged to a market facing several headwinds differs greatly from the logic behind the Lufkin acquisition. Joy Global fulfills the premise of being the number one or two player in its market, but that market could be significantly smaller in the next few years as the diversified miners have indicated less capital investment going forward.
Ultimately, we think GE may have paid a bit too much for Lufkin, but the deal remains too small to illicit a change in our fair value estimate. Shares currently trade slightly in excess of the low-end of our fair value range, and we continue to give the firm heavy consideration for the portfolio of our Dividend Growth Newsletter.