Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Smith International Inc. (SII)

Q4 2008 Earnings Call

January 29, 2009 ET

Executives

Doug Rock - Chairman of the Board, CEO, President and COO

John Yearwood - EVP, President Smith Completion and Production

Margaret K. Dorman - EVP, CFO and Treasurer

Analysts

Jim Crandell - Lehman Brothers

Robin Shoemaker - Citigroup

Brad Handler - Credit Suisse

Dan Pickering - Tudor, Pickering, Holt & Co.

Charles Minervino - Goldman Sachs

William Herbert - Simmons & Company

Michael Urban - Deutsche Bank

Bill Sanchez - Howard Weil

Alan Laws - Banc of America

Geoff Kieburtz - Weeden & Co.

Kurt Hallead - RBC Capital Markets

Operator

Good morning ladies and gentleman, and welcome to the Smith International fourth quarter, 2008 investor relations conference call. (Operator Instructions) I will now turn the call over to Mr. John Yearwood. Mr. Yearwood, you may begin.

John Yearwood

Thank you, John. Hello everyone and welcome to the Smith International fourth quarter, 2008 investor conference call. As John said, I am John Yearwood, CEO of Smith International, and I will be talking today along with Doug Rock, Chairman of Smith, and Margaret Dorman, Executive Vice President and Chief Financial Officer.

This morning, Doug will start the conference call with some opening comments, followed by myself and then Margaret will conclude. I anticipate that we will speak for about 30 minutes and then we will have another half an hour for your questions. So that everyone has a chance to ask questions, please ask no more than two questions at one time. If time permits, you can re-queue and ask more questions later in the call.

I will now pass the call to Doug for his opening comments.

Doug Rock

Thanks, John. Please excuse my voice. Three months ago at our third quarter investor conference call, I made the statement that I’d be disappointed of Smith’s 2009 earnings were less than our 2008 results. Well clearly, I’m going to be disappointed. What I missed three months ago was the severity of the continuing decline in U.S. and global economies. This week, this includes the further slide in oil and natural gas prices to levels well below my prior expectation. With U.S. natural gas prices in the $4.50 per thousand cubic foot range, a lot less U.S. gas drilling makes financial sense, compared to just three months ago. Based on today’s oil price around $40-41.00, the same could be said for a number of Latin America and Eastern Hemisphere oil projects.

How much more will the U.S. land rate count fall? We probably won’t know the answer until mid to late second quarter 2009, when we see data for production levels, winter gas usage, and the U.S. GDP. However, I do believe the drilling drops will be short-lived compared with other downturns. As natural gas production should shrink quickly, and the world economy will stabilize in a timeframe yet to be determined.

At Smith, our significant year-on-year fourth quarter earnings and revenue growth, put us in position to take advantage of this downturn, and emerges a more efficient, broader based supplier to the worldwide energy industry. Smith’s history is one of growth through adversity.

Now I’ll turn the call back to John.

John Yearwood

Thank you, Doug.

2008 was the record year for Smith International, with revenues of 23%, and operating income from continuous operations of 22% when compared to 2007. Both the oil field and distribution segments posted 29% year-on-year revenue growth, while M-I SWACO contributed with a healthy 17% increase. Geographically, Latin America led the year-on-year revenue growth with 34%, followed by the U.S. at 28%, and Africa with 26%.

Looking our Q4 2008 results, Smith’s revenues of $3.06 billion, were up 7% sequentially, despite a 3% sequential reduction in the DHI recount over the same period. Year-on-year, the Q4 2008 revenues were up 33%, versus an average increase of only 7% in the DHI recount. A large part of this growth was driven by the inclusion of the WH companies for the entire fourth quarter of 2008. However, on a pro-form basis, the fourth quarter of ’08 revenues were up 18% year-on-year.

I will now make a few comments regarding each of our three operating segments, mainly M-I SWACO, Smith Oil Fields, and distribution. Our M-I SWACO is the majority owned joint venture operation and is managed through four divisions; drilling solutions, environmental solutions, well-work productivity and production technology. M-I SWACO Q4 2008 revenues declined $59 million sequentially, or 4%, to $1.30 billion. But increased 10% year-on-year.

This sequential decline was primarily due to the appreciation of the U.S. dollar, against the European and Canadian currencies, as well as a slow-down in land-based activity that we experienced in December in the U.S. and in Russia. This decline was only partly offset by higher sales in the Middle East, Asia and Africa. Year-on-year, all regions contributed to the increase, with the exception of Europe and FSU, which again were negatively impacted by the stronger U.S. dollar.

From a division perspective, well-bore productivity continued its impressive growth with 19% year-on-year. M-I SWACO generated 71% of its fourth quarter revenues from outside of North America, compared to 72% in the third quarter of ’08. The Far East, Middle East and Africa were the regions with the largest quarterly sequential revenue growth. The average number of deep water rigs engaged in drilling and completion operations during the fourth quarter in the U.S. market declined by one rig to 32 units. This sequential decrease was due to the mobilization of one rig outside of the Gulf of Mexico, and due to other de-mobilizations within the Gulf.

Of these 32 rigs, 75% were engaged in drilling operations, while the rest were performing work-over and completions. M-I SWACO serviced an average of 19 of these total rigs during the quarter or 58% and generated revenues of $78 million, an increase of 15% over the prior quarter and year-on-year.

Outside of North America, the deep water market averaged 80 rigs during the quarter, up three rigs sequentially. International deep water revenues were $109 million, up 3% compared to the third quarter, mainly due to improved rig market shares.

Overall, offshore revenues for M-I SWACO declined 3% on a sequential basis to $609 million, but we’re still up 5% year-on-year. The sequential reduction in revenues was primarily due to the strength of the U.S. dollar, again from North Sea currency.

New technology revenues for M-I SWACO are neither classified as technologies that have been commercialized within the last five years, grew an additional 3% to $315 million for the quarter. This sequential growth was driven primarily by the environmental solutions division, with increased sales of our new (inaudible) low profile dryer.

We anticipate no material change to the deployment of the new and upgraded deep water rigs in 2009. M-I SWACO has an excellent market position in this technology driven market, and we will continue to invest in new value creating products and services.

I will now move onto our second segment; Smith Oil Field. As a reminder, the Smith Oil Field segment provide three-cone and diamond drill-bit, drilling tubules, bore hole enlargement tools, turbine motors, directional drilling, measurement while drilling, and logging while drilling services, as well as completions, coil tubing waterline and drilling related activities.

Smith Oil Field reported revenues for the fourth quarter of 2008 of $957 million. 32% higher on a sequential basis, and 65% higher year-on-year. Excluding the impact of acquired operations, bare base business revenues grew 4% sequentially and year-on-year. Sequentially, we experienced strong growth in Africa and the Middle East, while from a product line perspective; we saw a significant increase in our completions business, a record demand for pathfinders directional MWD and LWD services, and to a lesser extent for our tubules and surface production equipment.

During the fourth quarter, we implemented a new organizational structure for our engineering and support functions that is designed to ensure that we maintain a focus on the development of individual, best-in-class products within the drilling system while optimizing the interaction of these components to improve reliability and overall drilling performance.

A recent example of this occurred in the Middle East where a 9/58 inch Dina drill MX motor, running conjunction with a 22 inch smith shamau (ph) typhoon bit set an offshore performance record. The Dina Drill MX is an internally designed and manufactured motor composed of a proprietary highly reinforced rubber compound power section. This rubber increases the performance of the motor by almost 50% over a standard motor section. An additional offshore platform was awarded to Smith as a result of this successful run.

A second example was a successful combination of a Smith bit with our nacre four turbine, to provide a drilling solution for a challenging horizontal section in Freestone County, Texas. A 6.5 inch kinetic diamond impregnated bit and 4/34 inch nacre four turbo drill were used to drill 2,132 feet of a (inaudible) sand and shale in a single run. This section of hole has historically required a minimum of six cutter bits to drill the same amount of footage.

Significant cost savings were realized by reducing the number of bits, trips and days required to drill this interval. This performance based engineering solution will now be applied in the Haynesville Shale place as well as other challenging horizontal applications globally. With our proprietary ideas design software and turbine technology, we offer a value-creating solution to overcoming high temperature applications and achieving maximum rate of penetration.

Our distribution segment reported another strong quarter, with revenues of $794 million. An increase 4% sequentially and 51% year-on-year. This sequential growth was driven by our U.S. energy operation. We benefited from continued infrastructure spent by our customers, both in conventional and unconventional oil and natural gas producing regions.

We did experience a traditional slow-down in our industrial operations in the fourth quarter, plus the reduction in spending in the petro chemical sector as a result of the general slow-down in the U.S. economy. Year-on-year, distribution revenues increased across all of our divisions, as a result of the previously mentioned infrastructure spent in the energy segment. Plus, increased capital project spent and new contract roll-out in the industrial division.

Looking now at 2009 for all of Smith International, we see a year of significant uncertainty in terms of global recount levels, due to the reduction in demand for oil and gas as a result of the worldwide economic recession, and a lack of visibility regarding the depth and duration of the recession. The energy information administration short-term energy outlook of January 13th, 2009 revised its 2009 price forecast for WTI crude oil to average $43.25 per barrel and for the Henry Hub natural gas price to average $5.78 for MMBTU. At these prices, many of the unconventional oil and gas fields are just not economic to drill and develop.

In addition to the depth and duration of the economic recession, the oil price in 2009 will also be impacted by the level of compliance of the OPEC produces to the production entailment recently announced, as well as to any regional disturbances that may impact supply over the short-term.

Regarding U.S. natural gas, the success of the E&P industry to grow the year-on-year U.S. gas production by approximately 6% in 2008 was remarkable. And demonstrated the impact of applying the latest drilling and completion technologies to the vast, unconventional resource base found in the United States. These results will continue to drive the growth of horizontal drilling, and the future development of unconventional resources around the globe.

We continue to be very bullish on the long-term outlook for our products and services. The current over-supply of hydrocarbons will only last until the ever-increasing annual depletion rate combined with a lower recount to once more reduce the spread between supply and demand. Nature has given us an ample supply of hydrocarbons. It is recently mentioned in the 2008 energy report released by the international energy agency. The slump in oil prices will not last. And “Current global trends in energy supply and consumption have patiently unsustainable.” This under-investment in supply is accentuated by the rapid decline in the U.S. and Russian recounts, and will no doubt result in a faster than previously seen self-correction.

2009 will be a year of matching our resources to the activity levels, while ensuring that we maintain very close contact with our customers. We have already implemented a number of cost reduction initiatives and will continue to do so as required. We will continue to execute our plan to fill the gaps in our current offerings, expand out geographical presence and selected markets, and invest in developing complimentary technologies to broaden our portfolio.

The addition of the WH companies to the Smith Family in 2008 has strengthened our results orientated management team. And I am very confident in their ability to navigate this fast-changing landscape of 2009 while focusing on our long-term strategy.

I will now pass the call to Margaret for her comments.

Margaret K. Dorman

Thank you, John. Good morning.

Today we reported earnings from continuing operations of $2 - $219 million or a dollar per diluted share on revenues of $3.6 billion. These after-tax results exclude a $19 million non-cash loss recognized on the interest rate contract. Net of charges after-tax profitability levels grew 3% sequentially, and we’re 31% above the $167 million of earnings reported for the December 2007 quarter.

Consolidated revenues grew 7% over the third quarter and we’re 33% above the year-ago quarter. If you exclude the impact of acquired operations, revenues were slightly below the third quarter’s level, and 18% above the prior year quarter. Fourth quarter consolidated operating profit net of charges totaled $461 million or 15.1% of revenue, which compared to $448 million in the September quarter, and $356 in the December of 2007 period.

Although we typically provide guidance for the upcoming fiscal year on our fourth quarter call, with the current uncertainty surrounding the duration and severity of this downturn, it would be difficult for John or I to provide earnings guidance with any great level of confidence at this point. We will continue to monitor activity levels in the next several months with hopes of providing a full year earnings guidance in connection with our first quarter earnings announcement.

Turning to the performance of our three operating segments for the fourth quarter, which in all cases net as a non-recurring charges, and reflect no allocation of corporate costs. M-I SWACO generated $1.3 billion in revenue and $203 million in operating costs in the fourth quarter, reflecting an operating margin of 15.5%. About one-quarter M-I’s business operations were concentrated in the North Sea region, Russian and Canada, which are markets we transact as a substantial portion of the business in local currency.

As a significant strengthening of the U.S. dollar and to a lesser extent, the activity slow-down in Russia and the U.S. land market accounted for the sloopage in the M-I margins period-to-period. I might know that the M-I currency impacted reduced Smith’s consolidated earnings by 3 to $0.4 in the fourth quarter.

The Smith Oil Field segment reported revenues of $957 million and $233 million in operating profit in the fourth quarter, reflecting an operating margin of 24.3%. The legacy WH business line showed good incremental flow-through in the quarter, resulting in solid margin expansion. However, the higher waiting of the WH revenues, which carried slightly lower margins on a comparative basis. And modest pricing pressure in certain as a production related product line contributed to the sequential margin deterioration.

The distribution segment reported revenues of $794 million, an operating profit of $52 million, or 6.6% of revenues. Distribution margins in the fourth quarter were influenced by a higher mix of tubular product sales, and slightly lower tubular margin contributions associated for the most part with increased inventory costs.

A few points to mention on the rest of the income statements. First, net interest expense for the quarter total $32 million, $9 million above the third quarter of 2008, reflecting incremental bore associated with fundings, the WH energy transaction.

On the tax-front net of the charge, the effect of tax rate for the quarter was 32.6%, consistent with the level reported in the third quarter. Our tax rate as we look forward for the 2009 fiscal year should continue in the 32.5 to 33% range.

Detailed balance sheet information has been included as part of the earnings release document, so I’ll just make a few brief comments. Our balance sheet is solid and we would expect for financial condition to strengthen over the next several quarters, as we generate significant free cash flow through reduced work in capital investment, which we would utilize a good portion of to deleverage our balance sheet. Network and capital investments decline modestly in the fourth quarter, but our performance was limited by the inventory build experience and several of our business lines and geographic locations.

At year-end, our total debt stood at $2.8 billion and our leverage was just over 32%, a manageable level for a company with Smith balance sheet profile. As North American business activity levels decline, we could see the balance deleverage fairly quickly. But we are continuing to evaluate our refinancing options on the $1 billion bridge loan due later in the year. We were pleased to see some of our assembly rated peers access the debt market at the beginning of the month and give the issuances as positive.

We believe there continues to be a strong appetite for energy paper and consider a public debt issue as the strong near term possibility, although we would like to see the coupon slightly lower than the level seen in early January. We also believe there’s a good chance of terming the bridge out in the bank market at attractive rates, and believe this structure could present several advantages for us, considering the level of free cash, which should materialize over the next several quarters.

Finally, we also have the option of refinancing a portion of the bridge in the private placement market, which could be executed at favorable long-term rates. We’re seeing favorable cash flow in our business operations, and we simply need to make a determination of how much of the bridge loan we can repay out of cash flow and what requires refinancing. From a timing standpoint, I think we’ll move to address this sooner rather than later, my guess would be sometime this quarter.

Moving to net capital spending; net capital spending in the December quarter total $147 million, which is $61 million above the September quarter. As we noted on last quarter’s call, we expected higher fourth quarter spending, as we has a sizable amount of long league capital orders in the WH operation that would be received in the December period.

Additionally increased investment environmental rental equipment in MRI also contributed to the period-to-period increase. After eliminating our minority partner share in capital additions, capital expenditures, approximated $118 million for the quarter.

On a full-year basis, we reported net capital spending of $370 million, and had we included the WH operations for the entire year, Performa capital spending for 2008 would have approximated just over $490 million.

Looking forward, we believe consolidated capital spending for 2009 will be significantly lower than the fourth quarter run-rates, and the Performa 2008 net spending level. The actual number will depend on a number of factors, but our guess is that we’ll invest somewhere between $325 million, and $350 million in net capital expenditures this year. And depending on the severity of the downturn, this could turn out to be a lower number.

Depreciation in the fourth quarter of 2008 was $89.7 million, roughly $20 million above the third quarter’s level, reflecting a full-quarter impact of the WH operation and amortization of the fear value step-up of tangible and intangible assets associated.

The fourth quarter number translates into $76.4 million after considering our minority partner’s interest. We believe 2009’s spending forecast compares the full-year depreciation amortization estimate of $360 to $370 million.

So with that, I’ll hand the call back to our moderator, John for questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator’s instructions) Our first question comes from Jim Crandell from Barkley’s. Please go ahead.

Jim Crandell - Lehman Brothers

Good morning. First question is that I have sort of number of multiple or related questions about WH and I’ll just say all the questions and then you can address them all at one time. First, could you review the mix of WH now, U.S. - not only U.S. international, but also give me some idea on the percentage of business that’s coming from Gulf of Mexico, Gulf Coast? And could you also review your sort of plans for international expansion for WH? And have you revisited those? And then lastly, could you talk about the challenges of becoming a full-fledged sort of rotary steerable company and to what extent will sensor technology, at least over the next year or two be a limiting factor there?

John Yearwood

Okay Jim, so I’ll go through the questions and Margaret can add some of the numbers if I don’t have them. But for your first one, you know the mix between U.S. and international for the WH companies are still roughly around 90% for the U.S. We are seeing with the recount coming down in the U.S. and international not really coming down, I would envision it going forward that that U.S. percentage would come down and the international would go up.

Regarding Gulf of Mexico percentage, I really don’t have that number but two-thirds of their business is in the Texas, Oklahoma - so I’d say Texas, Oklahoma, Louisiana area, I would say probably two-thirds, 70%, somewhere there. The international expansion, no we’re not revisiting that at all. We had a game plan that was developed in the fourth quarter. We have submitted tenders in various international locations. We’re waiting on feedback on those tenders and we’re part of the capital spend that Margaret mentioned for ’09 is directed towards additional resources for our DDMWDLWD growth internationally. So that’s carrying on.

And rotary steerable, we - no change there, we continue with the objective of having the smaller sized rotary steerable tools. So we have a working 12 ¼ inch, but we want to develop reliable smaller sized tools, and eventually the very large size for the deep water applications.

So, we also as you know, last year pathfinder commercialized there. Small sized 4 ¾ inch density imaging tool, we expect to come out with larger sizes this year. And continue on the track for developing the imaging resistivity tools in the future.

Jim Crandell - Lehman Brothers

Okay, thank you. And my follow up question is, could you review where M-I stands in Brazil currently in terms of a rough share of the market and how you would expect that to participate in the Brazilian business at M-I?

John Yearwood

Well M-I has a very large presence in Brazil. Much larger I would say market share today with the international operators down there, where we have a very good presence. Also with Petro-Braz, one thing in Brazil is that Petro-Braz does do a lot of their drilling fluid type operations themselves. They have historically done that, they have a very strong chemical department, a drilling fluid group. So I’m not going to say exactly what our market share, that’s a bit of competitive information, but we are strong in Brazil. And I’m very bullish long-term on M-I SWACO growing in Brazil with the development of the pre-sold reservoirs.

Jim Crandell - Lehman Brothers

Okay, thank you John.

Operator

Our next question comes from Robin Shoemaker from Citigroup. Please go ahead.

Robin Shoemaker - Citigroup

Thank you. I just had one question for Margaret on your comments about the options that you have. Banks versus private placement versus public market. How important to you is the issue of convenance that would perhaps in some cases be put in place that - versus the absolute kind of interest rate you would be paying?

Margaret K. Dorman

Robin, that’s an excellent question. I don’t see that the convenance really plays anything into the consideration. Certainly a private placement might have another covenant or two than what a bank would have, but the convenance really doesn’t play into our consideration, it’s really the long-term cost. Attractiveness of the cost.

Robin Shoemaker - Citigroup

Okay. And my follow up is then on the deep water market in Gulf of Mexico, we’ve been running at about 35 rigs, was that the level in the fourth quarter? And with the new rigs entering the market, the deliveries of new build semis and drill ships, what do you see as the growth of that market for you in 2009?

John Yearwood

Robin, what we saw in the Gulf was an average of about 32 rigs drilling in the Gulf in the fourth quarter. Down slightly, there was a rig that up-mobilized out of the Gulf, I think to Australia. And we had a couple of other rigs that went into dock to do some general repairs. So about 32 rigs from an M-I SWACO account that we track.

We see for 2009, we’re looking at 27 that we expect rigs to be deployed the quarter around the world. Of the 27, 3 are upgraded rigs and 24 are new builds. It’s our expectation that if not all of these, almost all of them will fulfill their contractual obligation, and start in 2009. It’s a high growth area for us, we have worldwide - approximately 50% of the deep water rig market share. And we expect to retain that, we did see some growth in our market share worldwide in the fourth quarter, and we don’t see any change, we have very substantial infrastructure facilities in the deep water place, and in fact, some of the $325 million is a little bit in there just to finish some facilities for some upcoming contracts that will start in ’09.

So, I don’t know if that answers your question.

Robin Shoemaker - Citigroup

Well, yes. So of the roughly 27 new builds, you’re expecting to have - basically your average historical market share of 50%.

John Yearwood

Correct.

Robin Shoemaker - Citigroup

Okay, thank you.

John Yearwood

Okay, thank you, Robin.

Operator

Our next question comes from Brad Handler from Credit Suisse. Please go ahead.

Brad Handler - Credit Suisse

Thanks, good morning. Could you please, I know you guys have moved away from doing this, I guess, to some degree anyway but – I was hoping you could give us a little more color on some of the products. Could you perhaps give us a sense of the tubular sequential change in the quarter – really the drill pipe I mean – in your oil field segment?

John Yearwood

Okay Brad we’ll look for that. Margaret, do we have that?

Margaret K. Dorman

Yes, absolutely. The question again Brad, just looking at –

Brad Handler - Credit Suisse

Just drill pipe – kind of what was the change there.

Margaret K. Dorman

Yes. I think as we talked about the drill pipe was off. That was a part of the Smith Oil Field operations. That was part of what drove the sequential revenue growth related to the drill pipe.

Brad Handler - Credit Suisse

No, I got that. I was just wondering if you could – and I recognize it’s fairly small – but if you could do the percentage change.

Margaret K. Dorman

The growth was in the $10 to $11 million revenue range – in the $10-$11 million range.

Brad Handler - Credit Suisse

Okay. That’s great.

Margaret K. Dorman

Does that help?

Brad Handler - Credit Suisse

Yes it does. Thank you. And how about for just fluids, just your traditional fluids business?

John Yearwood

You mean our drilling solutions segment – drilling fluid segment of M-I SWACO?

Brad Handler - Credit Suisse

Yes.

Margaret K. Dorman

You’re looking for the revenue growth?

Brad Handler - Credit Suisse

Yes.

Margaret K. Dorman

We can give you that. Would you just like for us to split out the numbers for you like we usually do?

Brad Handler - Credit Suisse

Yes. That would be great.

Margaret K. Dorman

We’ll do that offline. We’ve got four different segments and we’ll get you that information and split it out for you.

Brad Handler - Credit Suisse

Okay. That makes sense. We’ll do it offline. Thanks. And I guess coming back to the refinancing of the bridge loan then, could you – thank you for the discussion of the options. I certainly understand that. Can you come back to this notion of sort of free cash flow generation and then how that I think you’re stressing that that is something that you expect to see and presumably again the bank debt gives you the option to pay that down.

So how should we think about how in-fluxed this is for you? Is it really let’s see how the environment shapes up therefore how much cash we generate and therefore the option fleshes out and can you still resolve all of that within the next couple of months.

Margaret K. Dorman

Yes. I mean I think we feel very confident. Certainly you look at the balance sheet and roughly $3.6 billion of net working capital based on what we’re seeing in the North American market and in other international markets we would expect to see that working capital flow out over the next couple of quarters, but yes I think that’s really the question for us is what piece of the bridge loan requires refinancing and what piece will we pay out of cash flow. And we would expect to try to make that decision and as I said in my comments try to address that later in the quarter.

John Yearwood

Yes, in terms of debt structure we think we’re in the driver’s seat with several attractive options. We just want to make sure we use the best option for the company and the shareholders.

Brad Handler - Credit Suisse

Okay well I appreciate it.

John Yearwood

Thanks Brad.

Operator

Our next question comes from Dan Pickering from Tudor, Pickering, Holt. Please go ahead.

John Yearwood

Dan?

Dan Pickering - Tudor, Pickering, Holt & Co.

Hi. Sorry about that I was on mute. I know that the outlook is kind of murky at this point but in terms of kind of how you plan to manage the business as things flow over the next few quarters I wonder Margaret or John if you could just comment on how decrimental margins – kind of how margin performance runs through the business as you work through a downturn – kind of maybe put it in historical context or how you see if going forward given that your MIC has changed some in the last few years.

Margaret K. Dorman

Well certainly Dan I think that’s going to determine – you know looking at the decrimentals in the business I think certainly you’ve got a good idea of the Smith businesses and how those have performed historically and I think a lot of this is going to go back to how severe is the downturn and what’s the duration.

So I think it’s difficult for us to give any guidance on the numbers for ’09 or kind of the decrimentals we would expect to see until we have some idea of how deep this may be going.

Dan Pickering - Tudor, Pickering, Holt & Co.

Yes. Maybe another way to phrase it then is if we draw it in closer. We do have a better idea of what’s going on in Q1. How are you seeing kind of the decrimentals here in the first quarter?

Margaret K. Dorman

Again, Dan, I don’t see us providing any type of guidance for first quarter earnings or 2009 earnings. I think as we get better visibility, better clarify, I think at that point when we get to that point I think we’ll be happy to provide some guidance but I think that’s difficult to do at this point.

John Yearwood

Yes, Dan with the rate count now down what 500 rigs U.S. land since the peak in the end of Q3, and continuing to fall, it’s a bit like a moving target that’s going forward. So we are – and we did reduce and take care of a lot of discretionary costs or eliminate some costs in the fourth quarter. We’re continuing to do that in line with the falling activity as we speak and will continue to do that as the recount drops in the U.S. and in other parts of the world. We’re not looking to predict where that will eventually go to but we will match our resources with the levels of activity.

Dan Pickering - Tudor, Pickering, Holt & Co.

And John if you wouldn’t mind, can you – I mean is that – are you primarily a people business in North America. Just help us understand, is this shutting down facilities to address costs, is it people? How do you manage that cost structure?

John Yearwood

Yes. Smith is primarily a people business and we’re not talking about shutting down facilities. The manufacturing we have – we do a certain amount of manufacturing as you know – drill (inaudible) and so forth. So we’ve already cut back a lot of the shift work, the hours, the overtime, maybe even reducing some shifts. We are cutting back some of the overhead structures, of course, that we have.

In addition, as the activity slows in a particular location or district what we do, of course, is with our clients we go to them and they ask for reduced pricing in return for volume or in return for longer duration of a contract. And what we push back to them is we’ll give you a break in overall costs through performance.

So we’ve been working heavily on that where we – and I quoted some examples in there – where we believe that by doing certain things with some of our products working together and services, we can drill wells more efficiently and at lower costs for our operators, which in today’s environment is extremely important for them – as you can imagine. They want to eliminate risk as much as possible.

So we do that and I don’t envision closing districts today, I just think we will adjust down the level of resources in those districts if we’re unable to sustain or maintain the levels of activity that we have.

Margaret K. Dorman

Yes, and Dan I’m going to just add that back to your initial question. Really as we look forward I don’t think this cycle is any different than historical cycles for Smith. It’s really more of the volume versus the pricing. We traditionally haven’t lost a significant amount of pricing in a downturn. It’s always been largely volume related. And we wouldn’t expect at this point for this cycle to be much different.

Now we did talk about that there was a little bit of pricing deterioration in some of our business lines in some of our markets but we don’t see this unfolding much differently than past cycles.

Dan Pickering - Tudor, Pickering, Holt & Co.

Okay, that’s helpful guidance. Thank you.

John Yearwood

You’re welcome.

Operator

Our next question comes from Charles Minervino from Goldman Sachs. Please go ahead.

Charles Minervino - Goldman Sachs

Hi. Good morning.

John Yearwood

Good morning, Charles.

Charles Minervino - Goldman Sachs

I guess a couple of questions. First, I don’t want to pin you down on any numbers in terms of rate count but a couple of your competitors have talked about their view that North America rig count could trough around mid-year. Others area in the camp of troughing more later in the year. Can you give us generally your sense which camp you’re in, in terms of how the North America drilling activity is going to progress through the course of the year?

John Yearwood

You know the Canadian one as usual has the spring break up drop and that’ll carry on. I’m not so sure how much it will recover in the third quarter, but if you look at U.S. overall, I think the offshore will be relatively flat – where we are today – especially the deep water will grow in the year.

For U.S. land, we don’t know what the absolute drop will be. I’ve heard people talk down to peak to trough 1000 rigs or 800 rigs. If we had to guess I would say you know the latter part of Q2, Q3 is probably in the trough. That’ll be the bottom somewhere there. And then how quickly that comes back depends on the decline rates, depends on the demand so that’s a question mark.

Charles Minervino - Goldman Sachs

Okay and then separately one of your competitors mentioned that most of the new build rigs – it’s maybe more like that they go towards development work rather than exploration work. Can you just give us some color on how that could potentially affect growth in your business? Is that more positive, more negative, et cetera.

John Yearwood

Definitely more positive because whenever a rig is in general doing development work versus exploration, the put of his drill is greater. You know they’re not testing the zones or coring or doing things that maybe reduce the drilling speed. So from our perspective at Smith a development always wins out over exploration.

Charles Minervino - Goldman Sachs

Are you in that same camp also that you do think that most of these new rigs will go more towards development that exploration?

John Yearwood

I’m not that convinced about that. I still believe that a lot of the operators – the big ones who have the contracts with these deep water rigs, they still want to prove up some of these reserves. You know they have had some issues accessing reserves over the last few years and I would believe that it would still carry on with those projects. I would be surprised if any of the big guys changed that much. There may be some movement but I don’t really see a big swing in the deep water rigs myself.

Charles Minervino - Goldman Sachs

Okay. That’s very helpful. Thanks.

John Yearwood

You’re welcome.

Operator

Our next question comes from Bill Herbert from Simmons & Company. Please go ahead.

William Herbert - Simmons & Company

Thanks. Good morning. John and Margaret getting back to sort of the Q4 to Q1 bridge if you will recognizing that you don’t want to give specific guidance – I can hardly blame you on that front – but with regard to just conceptually here, I mean clearly the negatives, North America, Russia, UK, North Sea – walk us through above and beyond those three markets. So the seasonal issues and sort of high level positive and negatives Q4 to Q1?

John Yearwood

Well high level positives and negatives – you know those three markets you mentioned, those clearly are the negatives, drop in rate count. For the deep water market segment, that will grow materially Q1 over Q4, maybe not that much of an impact but that’ll be fine.

The other markets, you know there are certain places whether they are countries in the Middle East or other countries that are talking about at least continuing or if not increasing slightly their capital spend so there will be some growth. For us also, you know we have a relatively small market share in LDD, MWD LWD business.

William Herbert - Simmons & Company

Yes.

John Yearwood

If we pick up a couple of these contracts that we tended for in Q4 and Q1 you’ll see some pick up there.

William Herbert - Simmons & Company

Tendering for where? Internationally?

John Yearwood

Internationally, yes.

William Herbert - Simmons & Company

Got it. Yes.

John Yearwood

Yes. And our completions business as well – you know it’s hard to see too much of a needle moving positive I would say in Q1. It’s really a volume decrimentals in those three markets that are going to drive the Q1 numbers I think.

William Herbert - Simmons & Company

Right. Margaret, I think I heard you say that thus far you have seen very modest pricing erosion and expect that to be the case going forward. Is that correct?

Margaret K. Dorman

Yes. That’s our sense that in the fourth quarter you saw some modest erosion and our guess is you’ll see some modest erosion in the first quarter but I’d say nothing material at this point.

John Yearwood

Yes, it can be a little bit product specific and regional specific and overall I agree with Margaret worldwide, but there will be certain basins and certain products that for whatever reason if the operator is not so convinced on a performance-related solution then they ask for a discount. So in those markets we’ll see some of that.

William Herbert - Simmons & Company

I’m just curious here with regard to your MI business and with this onslaught of new builds coming to the market in the offshore arena. Paint for me the competitive environment there. Is there decent pricing acquiescence on that front or is it focused not on pricing at all – more on solutions. Walk me through the dynamic there in terms of the give and take.

John Yearwood

Our deep water – first of all the rigs are contracted to the operator wherever they may be and we have contracts with the operators. In general my experience is that the deep water operators given the costs of these wells and the risk profile they’re not that focused on, especially from a Smith prospective, M-I SWACO perspective, that much focused on beating down cost.

What’s critical for them are logistical support, environmental solution support, you know waste management, cuttings management – they want to see that because that makes a materially large difference to their successful development of a deep water play. So yes you will get some who will say hey you know – and some of this stuff is indexed.

As you know our base oils are indexed so you’ll get a reduction there as oil prices are down. There’s a reduction indexation in pricing. But I don’t see anything really out of hand in terms of deep water pricing going forward. It’s more defined on the ability of the service provider to deliver what the operator wants.

William Herbert - Simmons & Company

Okay. Thanks very much.

John Yearwood

You’re welcome, Bill.

Operator

Our next question comes from Michael Urban from Deutsche Bank. Please go ahead.

Michael Urban - Deutsche Bank

Thanks. Good morning.

Margaret K. Dorman

Good morning, Mike.

Michael Urban - Deutsche Bank

You talked a little bit about your expectations on pricing and would generally agree you guys haven’t experienced a lot of pricing pressure in the past. I guess the big difference now would be the addition of the WH businesses, which having covered them those guys tend to have a little bit more actually in some cases a lot more pricing leverage both to the upside and the downside. What are your expectations there or are some of the markets where you’ve seen some pricing pressure are those in some of those North American, WH business lines?

John Yearwood

Yes. I would say that’s where we are seeing it today. And again it’s regionally specific and operator specific. Where we again we go back – we stay close to our customers and we go back to them on a constant basis when they ask for pricing concessions to change the discussion more to performance-related, whether it’s drilling the well quicker and cheaper using a better solution with a particular type of Smith bit or optimizing the overall drilling program with our I-drill.

So we have seen pricing there come down and it’s mainly I would say in the areas of the U.S. where there’s been greater rig count drop – level of activity drop.

Michael Urban - Deutsche Bank

Okay. And –

Margaret K. Dorman

And Mike, I would add that that’s probably where we see the risk or more risk, but I’d also point out that the WH operations constitute 10-12% of the overall Smith business volume, so just put it in perspective.

Michael Urban - Deutsche Bank

Oh yes, I’m aware of the size. I was just trying to understand where things might shape up a little differently this time. And then internationally you mentioned earlier you are going to push forward with moving some of the WH products onto the international platform. How much do you have to do in terms of service locations?

And I guess maybe a better way to put it is how much of the CapEx is going to go to the WH build out internationally?

John Yearwood

Well for ’09 in terms of facilities, infrastructure – very little, minimum because we already have those facilities there from our Smith services offering, so very little in terms of that. We’re probably what 40%, 50%, 30%.

Margaret K. Dorman

Yes, 35% to 40%. Yes.

John Yearwood

How far our CapEx will go would be on tools – new tools to be able to work in those different markets around the world. That’s where the spend is, and we’ll continue to do that. And it’s not just on the Hoffbinder (ph) product offering. We’re also expecting to grow our completions business.

We have a relatively good presence here in the U.S. but we’re not in all the countries where we think we should be with that business and in ’09 you will be seeing that over the fortress our expectation is to enter those markets.

Again you don’t need facilities – they’re there. Its more adding some people and some of our newer technology to those locations.

Michael Urban - Deutsche Bank

And last question is what do you think your maintenance CapEx is now globally for the whole company?

Margaret K. Dorman

I’d put that probably in the $50 to $60 million range, Mike.

Michael Urban - Deutsche Bank

Great. That’s all for me. Thank you.

John Yearwood

You’re welcome. Thank you.

Operator

Our next question comes from Bill Sanchez from Howard Weil. Please go ahead.

Bill Sanchez – Howard Weil

Good morning.

Margaret K. Dorman

Good morning, Bill.

Bill Sanchez – Howard Weil

The question is a bit of a follow up to the kind of the fourth quarter to first quarter bridge. Margaret, typically Smith doesn’t have much if anything as it relates to export sales in the fourth quarter. Is that correct?

Margaret K. Dorman

That’s correct.

Bill Sanchez – Howard Weil

Okay. So therefore we shouldn’t expect really any revenue drop off in first quarter as a result of that issue?

Margaret K. Dorman

Yes. I tend to agree.

Bill Sanchez – Howard Weil

Can you remind us Russia was a culprit in the fourth quarter – can you remind us just how much of total revenue for Smith comes from Russia.

Margaret K. Dorman

Okay. If you look at the FSU region, that would be about 6% of our revenue – of our oil field revenues MI and the Smith oil field business.

Bill Sanchez – Howard Weil

Six percent of oil field revenue?

Margaret K. Dorman

Yes.

John Yearwood

M-I plus two segments – M-I charcoal plus oil field segment.

Bill Sanchez – Howard Weil

But my guess is that M-I would be the majority of that or no?

Margaret K. Dorman

That is correct.

Bill Sanchez – Howard Weil

Okay. All right. That was it for me. Thank you.

Margaret K. Dorman

Thank you.

John Yearwood

Thank you, Bill.

Operator

Our next question comes from Alan Laws from Banc of America. Please go ahead.

Alan Laws – Banc of America

Good morning.

Margaret K. Dorman

Hi, Alan.

John Yearwood

Hi.

Alan Laws – Banc of America

Hey. Let’s see I’ve got a couple left here. One of them the topic of the day – Venezuela receivables – any exposure there?

Margaret K. Dorman

Certainly we do business in Venezuela. It’s a couple of percent of our oil field business and we’ve seen some slowing in payment but not a significant slowing in payment in Venezuela.

Alan Laws – Banc of America

Are there other areas that you’re more worried about, like Independence in the North Sea or something like that?

Margaret K. Dorman

No. I think the business operations have done a really good job of trying to keep the DSOs in line. We say no slippage in the fourth quarter and as we go forward certainly that’s a real focus area for us. But certainly we’re looking at things a little more closer than we have and going to try to keep that in a management level as we go forward.

Alan Laws – Banc of America

Sounds good. Another balance sheet question I guess here for you Margaret. When we look at your free cash flow and the potential working capital claw backs, it looks the less like you could take out most of the bridge and even with the 138 maturity in 2Q. So I guess three things around this. Is that the case from your look or are we kind of in left field?

And second, I guess how much working capital could you see freed up in the first half given what you talked about there on the size of the working capital employed?

And then what is a decision in to term out actually pay out using cash flows here on the bridge loan.

Margaret K. Dorman

Yes. Both excellent questions. I think that you guys are probably in the ballpark on estimates.

When I look forward roughly $3.6 billion is unnoted net working capital investment. I’d be disappointed if we didn’t see you know a quarter of that come out. And the question is really going to be timing.

I mean I would expect that we’ll start seeing it come out later in the first quarter and into the second and third. So I think you’re thoughts that we could repay the majority of that bridge loan with cash flow out of operations is kind of what we’re thinking as well. And as we go forward like I said in my prepared comments, that’s the determination we’re going to need to make – how much comes out of free cash.

How much of that do we want to refinance? And certainly there will be a lot of questions around that, as to what are the best uses of that cash flow and I think that we’ll try to make those determinations as we go forward. Do you want to add anything John?

John Yearwood

No. I agree with you.

Alan Laws – Banc of America

Is the determination or the decision depending or is it hinging at all on potential acquisitions or having the available cash to do that?

Margaret K. Dorman

Certainly I think we’ve got the balance sheet to do that and the free cash we see coming in does give us that option. And I think that’s why we’re going to have to take a number of factors in to consideration – whether it’s acquisitions, whether it’s buy backs, whether its repaying the lines – a 32% debt to cap for a company with the cash flow profile is – I think we’re very comfortable with that.

Alan Laws – Banc of America

Yes. It seems very reasonable to us too. Last question then would be given the move into international – I know you’ve been asked before about running into a competitor’s a big part of your core business joint venture. Could you remind us a little bit about how the joint venture stand still agreement works and whether that is a consideration in the long-term to take that out?

John Yearwood

You know the joint venture has run independently basically from Smith and it has its own day- to day management. Our international growth for Smith is in no way linked to M-ISWACO. M-I SWCO has their plan for growth and they execute it. For the Smith Oil Field, the pot finder growth or the completions growth that’s the handle through the Smith Facilities in those countries.

In terms of the joint venture its being around you for nine almost 10 years – 1999, created a lot of value for Smith and I hope also for Schlumbershea (ph). We feel it’s working well and we’ve always been interested in the 40%, but we’re happy also with our partner.

Alan Laws – Banc of America

Okay. And how does it work if you were interested in the 40%. Is it a shotgun situation where you make and offer and then they can counter offer at the same price or how does that work. Technically there is that in the agreement you know. You make an offer and then the other one can counteroffer.

However, the relationship that we have over the years, you know I personally believe it’s very strong. I think Liberty from the Smith side, Schlumbershea has always been very transparent and supportive and the same I hope they consider of Smith. So I think if wither party wanted to get out or Schlumbershea (ph) wanted to get out I think it would be more of a discussion type mechanism.

Alan Laws – Banc of America

Perfect. Thanks. That’s all I’ve got and I appreciate the answers.

John Yearwood

Thank you very much.

Operator

Our next question comes from Geoff Kieburtz from Weeden & Co. Please go ahead.

Geoff Kieburtz - Weeden & Co

Thanks very much. Good morning.

Margaret K. Dorman

Hi Geoff.

John Yearwood

Good morning Geoff.

Geoff Kieburtz - Weeden & Co

John you mentioned a couple of times on the call here this concept of responding to customer pricing pressure with efficiency solutions, either down hole technology or logistics related. How are those discussions going? I mean have you had enough of them to be able to characterize how customers are responding to your pitch?

John Yearwood

We have had enough of them in the U.S. land market over the last month that I believe there’s genuine traction there. What’s interesting is that the operators seem much more willing to discuss a performance type drilling risk mitigation solution than they were in the boom days over the last few years because they have limited capital spend or reduced capital spend and they don’t want uncertainty. They don’t want their AFPs being blown by 10% or 15% on a regular basis.

So, yes, we have had traction in the low 48 and we’ve organized ourselves in the fourth quarter as I mentioned in my comments to be able to address this, to be able to look at what the operator is doing, bring the pieces together that we think are best in class that makes sense, use our propriety simulation software to optimize the drilling performance and we will be doing those. We’ve already done some and we will be doing some more and I think it has a good chance of definitely growing.

Geoff Kieburtz - Weeden & Co

And it sounds like – well not sounds like you just said it – I mean it’s a risk mitigation on the part of the customer so that presumably its somewhat greater risk being borne by Smith. Is that correct?

John Yearwood

Well not really because in the end when things are very busy and your supply service companies are running around and you know you’re just trying to get services to your rigs as quick as you can – I’m speaking from an operator perspective. So I think they were inherently some inefficiencies in the system that were built up over ’06, ’07, ’08, so by going to certain customers – the ones that we’re closer with – the ones that were drilling and doing activities with today we have kind of seen some of those inefficiencies and we designed what we considered together with our client a better drilling solution and then we executed.

So, yes, you could say there’s on paper there could be more risk but in practice I don’t see that as the case.

Geoff Kieburtz - Weeden & Co

And kind of globally, how much of your business do you think is say this concept is applicable to? I mean is this something you could roll out on a major scale across the world?

John Yearwood

If we were ready to, absolutely. We’re just not ready to roll it out to that extent right now. It’s clearly intent over time, but we want to walk before we run and also Rome wasn’t built in a day. It was definitely built but not in a day, so we will plan it, we will execute, we will deliver and then move forward.

Geoff Kieburtz - Weeden & Co

Okay and in this environment is there something that you see as a margin preservation effect or do you think that you could actually with successful execution improve margins?

John Yearwood

We see it as in some cases both – sometimes proper preservation, sometimes improvement. It’s also a market share preservation or growth. It’s both. And it’s also a bit of a mind set as well, cultural change for some parts of our organization where we’re looking more at the bigger picture of drilling optimization while still having a large majority of our organization focused on best in class products and services. So it’s kind of bringing about three or four different things behind it.

Geoff Kieburtz - Weeden & Co

Okay and if I could just a couple of quick ones. Have you actually made head count reductions? Have you had layoffs already?

John Yearwood

In Q4 there were relatively small amount but that’s something that as I said we are matching resources with levels of activity so that’s something that yes is happening.

Geoff Kieburtz - Weeden & Co

Okay. And just to clarify Margaret, on the working capital release you said that you hoped to – I think the disappointing comment was maybe not a skim and stuck comment earlier – but you’re looking at something like 25% of that working capital or $900 million possibly being released over the third quarter.

Margaret K. Dorman

I think that’s a decent estimate for us to use at this point. Again that will depend on how deep, how severe, what the time frame, is this a V-shape, is it a U-shape – I mean I think there are a lot of factors but we would expect to see a significant amount of free cash generated out of the operation.

And keep in mind a lot of this cash flow is in M-I, so $1 of working capital in M-I is equal to $0.60 to Smith but yes I think the point is we expect to generate and we will focus on generating significant cash in 2009 and then we’ll see what that number turns out to be.

Geoff Kieburtz - Weeden & Co

And just to clarify in your earlier conversation about the options, even if you were pretty comfortable with the outlook of generating $900 million of cash flow from working capital over that time period, you’re still evaluating refinancing the bridge loan?

Margaret K. Dorman

We are evaluating all options at this point.

Geoff Kieburtz - Weeden & Co

Okay. All right. Thank you.

Margaret K. Dorman

Thank you.

John Yearwood

Thank you. John, I think we probably have to come to a close or do you have one question lined up there?

Operator

We do have one final question from Kurt Hallead from RBC Capital Markets. Please go ahead.

Kurt Hallead - RBC Capital Markets

I made the cut. How about that? Thank you very much.

John Yearwood

You’re welcome Kurt.

Kurt Hallead - RBC Capital Markets

All right. Just real quick and then we’ll break off – can you give us some general sense as to the percentage of your business that is driven by completion and production versus drilling and evaluation and how you may see that morphing as 2009 evolves?

John Yearwood

Well as 2009 evolves we’re focusing on growing our completion business, which we have relatively small market share. We’re going to be focusing on growing our drilling and evaluation services as well. So I don’t see much relative change between the two in 2009. In terms of a percentage …

Kurt Hallead - RBC Capital Markets

Yes, in terms of your overall – exclude distribution from it right – If you look at M-I, you look at your oil field, roughly speaking right I know it’s not going to be exact but are you 50/50 between completion production and drilling and evaluation or is it more heavily skewed one way?

Margaret K. Dorman

It’s more 90% on the drilling evaluation, 10%-ish on the completion production when you split the businesses apart.

Kurt Hallead - RBC Capital Markets

Okay. And then last before we close on M-I what percentage of M-I’s business is deep water?

Margaret K. Dorman

In the 10%-ish range.

John Yearwood

Right.

Kurt Hallead - RBC Capital Markets

Thanks. I’ll take some others offline. I appreciate it. Thank you.

John Yearwood

All right Kurt you’re welcome. Okay well thank you all very much for participating on this fourth quarter 2008 conference call and thank you for the questions.

Operator

Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may all disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Smith International Inc. Q4 2008 Earnings Call Transcript
This Transcript
All Transcripts