Smith International Inc. Q2 2009 Earnings Call Transcript

| About: Smith International (SII)

Smith International Inc. (SII) Q2 2009 Earnings Call July 28, 2009 11:00 AM ET


John Yearwood – Executive Vice President, President Smith Completion and Production

Margaret K. Dorman – Chief Financial Officer and Treasurer

Chris Rivers – President and Chief Executive Officer of M-I SWACO


Daniel Boyd – Goldman Sachs

Robin Shoemaker – Citi

Dan Pickering – Tudor, Pickering, Holt & Co.

Brad Handler – Credit Suisse

Geoff Kieburtz – Weeden & Co.

Michael Urban – Deutsche Bank Securities


Welcome to the Smith International second quarter earnings conference call. Before I turn the call over to Mr. John Yearwood, Smith's Chief Executive Officer, the company would like to call your attention to the forward-looking disclosure included in today's press release.

Certain comments made on today's call may be forward-looking in nature and are intended to constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934.

These comments include, without limitation, statements regarding the company's outlook, financial projections, and business strategies and any other statements that are not historical facts. Please consult the company's annual report on Form 10-K for a discussion of additional risks and uncertainties that could impact the company's results.

Mr. Yearwood, please proceed.

John Yearwood

I will be talking today along with Margaret Dorman, our Executive Vice President and Chief Financial Officer, and Chris Rivers, President and CEO of M-I SWACO. This morning, I will start the conference call with some opening comments followed by Chris and then Margaret.

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.

Looking at the second quarter, I can say that it can be characterized as having two distinct and separate areas of focus. On the one hand, we spent a significant amount of time reducing our costs to match the [drilling] material slowdown in U.S. drilling activity combined with the seasonal break-up in Canada.

On the other hand, and simultaneously, we continue to aggressively pursue our strategy of delivering top quartile drilling optimization solutions and commercializing performance-driven new technologies. I am very pleased with the performance of all of our segments, but in particular I have to highlight M-I SWACO and Oilfield.

Despite the extreme operating conditions of lower volumes and aggressive competitive pricing, our management teams remained focused on the customer by looking for opportunities to lower overall costs through greater efficiencies, optimized solutions and fit for purpose technology.

In addition, we strengthened our balance sheet through material reductions in working capital and have put in place an organization that will deliver significant value to our shareholders. Our cost reduction measures have primarily been focused in the U.S. and Canada and in the areas of headcount, supply chain and discretionary spend.

Total annualized cost reductions to date are in the order of $400 million and we expect further cost savings, especially in the areas of supply chain and manufacturing, to be realized over the coming quarters.

Smith consolidated revenues of $1.94 billion declined 19% sequentially, out-performing the 25% reduction in the active, world-wide drilling rig count. Just over 80% of the sequential revenue decline came from the United States and Canada due to a sharp reduction in line pipe sales and overall lower sales from the distribution segment, a material decline in business volumes due to the lower rig counts and pricing adjustments across almost all product and service offerings.

Geographically, North America's second quarter revenues declined 29% sequentially comparing favorably to a 38% reduction in the drilling rig count. Outside of North America, revenues contracted 8% on a sequential quarter basis compared to a 4% reduction in the drilling rig count.

Strong sequential revenue growth in Brazil, North Africa, Russia, Kuwait, Oman, Thailand, and Australia, however, it was not enough to offset declines in Mexico, Venezuela, Argentina, West Africa, and Eastern Europe due to lower drilling activity, exceptional drilling fluid sales that we had in the prior quarter and an overall unfavorable off-shore business mix.

Year-on-year, Smith consolidated revenues declined 22%, significantly better than the 36% reduction in the drilling rig count over the same period primarily as a result of the W-H Energy acquisition in the third quarter of 2008.

Excluding the impact of the W-H Energy acquisition, excellent year-on-year revenue growth was achieved in Brazil, Kuwait, and a number of countries in the Far East. With the slowdown in North American drilling activity and the continued focus on geographic expansion of the Smith products and services, revenues generated by our oil field related businesses outside of the U.S. and Canada increased to 66% in the second quarter, up from 60% in Q1 2009. I expect this trend to continue as we expand our drilling and completions businesses combined with the continued deployment of the newly built deep water rigs.

I will now make a few comments regarding our Smith Oilfield and distributions segments and leave Chris to make the comments on M-I SWACO. The Smith Oilfield segment reported revenues for Q2 2009 of $520 million, 24% lower on a sequential basis and 12% lower year-on-year.

Approximately 90% of the sequential revenue decline came from the U.S. and Canada, primarily as a result of lower sales volumes for all services and products, as well as severe pricing pressure, particularly for our directional drilling, rental tools, and production services.

Outside of North America, the overall oilfield segment revenues declined 7% sequentially. However, the drilling and evaluation division posted higher sequential quarterly sales in the Middle East, Far East region and our completions division was up 16% in Europe and Africa.

Our Smith Borehole Enlargement business line, which includes our flagship Rhino Reamer had an outstanding quarter with worldwide revenues sequentially up versus the prior quarter. During the second quarter, we continued to make progress towards our objective of being recognized as a top provider in drilling performance through the optimization of the drilling process.

On the Q1 conference call we mentioned our record drilling performance in the Haynesville shale with Comstock Resources. Today, we issued a press release explaining the latest achievement of our Pathfinder drilling organization working very closely with a Chesapeake Energies Drilling and Supervisory teams and utilizing Smith's proprietary eye-drill technology to drill the build-up curve and horizontal lateral in one run with one drilling assembly.

This significant and unprecedented achievement will open the way for further drilling efficiency gains in the highly productive Haynesville reservoir and other unconventional reservoirs around the world. We achieved another important milestone in our strategic plan during the quarter with a startup of Pathfinder operations in three new countries.

Excellent drilling performance in both hemispheres and the right technology for our customer's wells were the main reasons for this expansion and I am confident that we will continue to see additional operating countries added to the Pathfinder portfolio in the coming quarters. The recent commercialization of our new line of ONYX cutters is proving very successful in terms of increasing both the rate of penetration and total footage drilled.

The benefits are now being realized across the U.S. as well as in the North Sea where a Smith 12.25 inch bit, equipped with ONYX cutters eliminated the need for a second bit run by drilling 57% further than the median for the offset wells.

Moving on to our distribution segment, it is clear that the downturn in activity across the U.S. energy markets has had a material impact on our results. Overall distribution revenues were $411 million, a sequential decrease of $159 million or 28% and a year-on-year decrease of $205 million or 33%.

The revenue decline was most severe in the United States as revenues decrease by 32% sequentially and 40% as compared to the prior year. CE Franklin, in Canada, performed exceptionally well in a weak market, down only 18% sequentially and 2% year-on-year, when stated in U.S. dollars, as a result of new projects particularly in the oil sands.

The midstream sector suffered most of the decline, mainly as a result of 52% lower sequential line pipe sales. The industrial divisions showed the most resilience to falling customer spend with a 12% sequential decline.

Looking ahead to the rest of 2009, we believe that an oil price of greater than $60 per barrel is positive for stabilizing the non-U.S. recount at its current level and for adding oil targeted rigs to the U.S. and Canadian land markets.

As regards the overall U.S. recount, our expectation is that it is very unlikely that we will see an increase in gas targeted drilling rigs over the next six months as wellhead prices will continue to be under near term pressure due to record storage levels and relatively low industrial demand. Due to limited near-term visibility around North American drilling activity and overall softness in our distribution sector, we will not be giving guidance for the second half of 2009.

We continue, however, to be very bullish on the long-term outlook for our products and services because of the steep natural gas production decline curves experienced in North America, plus recent indications that the impact of the world stimulus packages may be starting to have an impact on industrial growth in the emerging economies.

Our strategy remains the same, to continue filling the gaps in our current offerings, expanding our geographical presence in selected markets through performance driven results, and investing and developing in the complementary technologies to broaden our portfolio.

I will now pass the call to Chris.

Chris Rivers

Thank you, John. Good morning. I am going to discuss M-I SWACO's overall performance and then comment on our segments, the deep-water market and our premium products.

Second quarter revenues for M-I SWACO were $1.13 billion, approximately 13% lower than the first quarter of 2009 and 21% lower than last year's second quarter. We were about 26% lower than our peak revenues of $1.364 billion in the third quarter of last year. Both major rig count industries declined from the first quarter, ours by 15% and Baker's by 25%.

Obviously, the decline was primarily due to North American activity where the rig count fell by 34% according to our count and 38% according to Baker's. Offshore deep-water rigs fell by 2% and shelf rigs fell by 13%, so the overwhelming demand decline was on land.

Total off shore revenues for M-I SWACO were $529 million for the second quarter. This is a decrease of nine% from the prior quarter. Off shore revenue was 52% of total revenue up from 50% in the first quarter. Seventy-eight percent of our revenues were outside North America, up 400 basis points due to the seasonal contraction in Canada and reduced land drilling in the U.S.

Now I'll cover some geographic variations. North American revenues fell by 25% sequentially and six% from last year due to the previously mentioned land and shelf rig reductions. South American revenue fell by 20% sequentially and 7% from last year primarily due to lower revenues in Venezuela and Mexico where some high value critical wells were drilled in the first quarter offset by revenue gains in Brazil.

Eastern hemisphere revenues declined 5% sequentially, mainly due to lower activity levels in Africa and Asia Pacific on shelf base rigs. Our revenue base outside North America contracted 8% on a sequential quarter basis. Much of our business is tied to off shore drilling programs, which tend to be uneven from quarter-to-quarter due to the timing of work and the type of activity taking place, which influenced the period-to-period revenue comparison.

In addition to the lower level of off shore drilling activity in the second quarter, our off shore business mix in several key markets, specifically in Mexico and West Africa, was lower relative to the March quarter.

I will now address our product segments. Drilling solutions revenues were $659 million down 14% sequentially and down 18% compared to 2008. Environmental solutions revenues were $207 million, down 7% sequentially and 24% compared to last year where we had significant capital sales in the Eastern Hemisphere. Wellbore productivity revenues were 147 million, down 13% sequentially and 28% compared to last year, many due to activity shifts from completions to drilling.

Now some comments on the deep-water market. The average number of deep-water rigs operating around the world was 119 during the second quarter. The M-I SWACO's share of these was about 50%. Adjusting the count for petro based rigs that are serviced internally raises our share to about 55% globally. The average number of rigs operating in the U.S. deep-water market declined to 30 rigs from 32 rigs in the prior quarter.

M-I SWACO serviced an average of 15 rigs, a reduction of 4 rigs as compared to the first quarter and generated revenues of $66 million, down 16% from the first quarter. From this point to December, we expect three more rigs to enter the Gulf of Mexico market.

The international deep-water market averaged 88 rigs during the quarter, up three rigs from the first quarter. Our international deep-water revenues were $128 million, up 2% compared to our first quarter mainly due to improved activity in Brazil, West Africa and Australia. Our market outlook includes another 15 rigs to be delivered during the remainder of 2009.

Premium fluids revenues, which include all of our high-performance synthetic and water-based fluids, were $124 million for the quarter, which is a decrease of 12% from the first quarter of 2009. Total synthetic revenues for the quarter were $90 million, down 13% from the first quarter and up 9% from last year. Decreases in the U.S., deep-water Mexico and Australia were offset by increased activity in Brazil.

New Technology revenues, which are generated from technology that is less than five years old, were $281 million for the quarter. That is slightly down by 7% sequentially, but up 4% from last year. As a percentage of our total revenues, they were 28% compared to 21% this time last year. During the quarter M-I SWACO was again recognized for its technology innovation.

At OTC, M-I SWACO was presented with a special meritorious award for engineering excellence in drilling fluids by Hart's E&P magazine for our innovative suite of products and services called IBOS. IBOS, which stands for Integrated Borehole Strengthening Solution is a unique solution's toolkit specifically designed to stabilize wellbores while drilling and enable the construction of wellbores that significantly reduce drilling costs. We will continue to invest in technology development that delivers more cost-effective solutions for our customers and higher yielding returns for M-I SWACO.

The first half of 2009 saw most of the majors rebid or renegotiate their contracts. That process is largely complete. Obviously, their intent was to reduce their costs of drilling from every source including those products and service lines that we provide.

We have re-priced some of our work and have aggressively pursued work that was open to bid. As is our practice and discipline, we bid based on getting positive returns from each and every contract and we understand completely the cost environment everywhere that we operate.

Overall, I am pleased that we have added to our revenue base, and as a result we will see the benefit of the incremental ads starting in the fourth quarter. Since we do not announce our Tundra Awards because it is a repetitive exercise, I would like to mention that we continue to build upon our leading position in all major basins around the world, especially in critical segments such as deep water that employ premium technologies.

To this point in the year, we have continued as the incumbent, or won as new awards, deep-water contracts worth 1.7 billion, for example. Most of the net margin impacted the re-pricing and the awards have been absorbed in this quarter.

At the same time, our procurements and logistics personnel were charged to find every dollar of cost reductions possible. I am pleased with their results and as the year proceeds we will continue to proactively reduce our costs where necessary and aggressively secure further savings in our supply chain operations.

We don't expect much change in activity during the rest of this year. We are on bottom and are expecting gradual improvement from here. Now I will hand over to Margaret.

Margaret K. Dorman

Thank you, Chris. Good morning, everyone. We appreciate your taking time to join us for the call today. Starting off, I think the results for the quarter are fairly straightforward. As outlined in this morning's release, we reported earnings of $24 million on revenues of $1.9 billion for the second quarter 2009.

After adjusting for $13 million in severance costs, second quarter operating earnings totaled $0.15 per diluted share. Consolidated revenues fell 19% from the levels reported in the March quarter. Revenues for our oilfield related operations decline 17% sequentially, sustained by the high relative international and offshore exposure of the M-I business while the North American focus distribution operations experience a 28% revenue reduction.

Operating profit fell sharply due to the substantial decline in North American business volumes driven by the lower U.S. natural gas recount and the seasonal breakup in Canada. Increased competitive pricing pressure in a number of the Smith Oilfield product lines also placed downward pressure on earnings.

Considering the magnitude of the revenue loss, operating margins for our oilfield-related businesses held up reasonably well. After excluding the impact of charges reported in the June, as well as the March- quarter, sequential decremental margins for Smith's oilfield related operations were 34%.

In the distribution operations we lost $0.16 of EBIT on every revenue dollar, reflecting volume reductions, softness in line pipe product pricing and higher inventory costs largely associated with LFIO inventory evaluation.

The majority of the normalized EBIT and margin compression, reflected volume and to a lesser extent pricing reductions in the U.S. and the seasonal drilling downturn in Canada, which as most of you know is a higher margin product and service market.

The U.S. was much more competitive from a pricing standpoint in the June quarter with pricing contributing roughly one third of the 370 basis point normalized margin compression in our oilfield-related operations.

We saw a larger impact in the Smith Oilfield business lines and although I sense every service company with U.S. operations has lowered prices over the past several quarters, I know our drill bit and fluid lines have fared much better on the pricing front than the coil tubing, wire line tubular and directional offerings.

Internationally, the pricing environment seems to be much better, but we may have a minimal level of pricing exposure in the back half of 2009. From an earnings standpoint, the majority of the $0.37 sequential profitability reduction on an operating basis came out of the U.S. market.

The spring break up in Canada impacted the sequential results by roughly $0.04 and with the lower offshore drilling volumes earnings in Latin America and West Africa are also impacted. With that said, in the June quarter our M-I SWACO and our Smith Oilfield segments generated positive EBIT in both Canada and the U.S. markets.

In response to the continuing deterioration in the U.S., we were required to undertake additional cost control actions in the June quarter. We've reduced another 10% of our domestic workforce since the end of the first quarter, which brings the total downsizing in the U.S. employee base this year to 23%.

We expect to see a benefit from our cost reduction initiatives, whether it stems from headcount reductions, vendor pricing renegotiations, facility shutdowns, etc. However, in some cases the savings impact may not be immediate.

For instance, we won't realize some of the lower inventory costs until we actually start restocking our operations and lower manufacturing personnel simply helped reduce the plant overhead variances, which were realized over an inventory turn at several quarters.

With the U.S. recovery likely a couple of quarters away, we'll continue to focus on ways to cut costs in an effort to influence our margins. Touching briefly on the performance of our three operating segments for the second quarter, which in all cases are net of charges and corporate cost allocations, M-I SWACO generated 1.01 billion in revenue and 124 million in operating profit in the second quarter, reflecting an operating margin 12.3%.

We're pleased with M-I's results for the second quarter. Revenues fell 13% and margins slipped 210 basis points, translating in decrementals of 29%. Most of the revenue decline was associated with the North American land-based operations, but our off shore business contributed just over 0.33 of the sequential revenue decline. The off shore business base contracted 9% from the first quarter's level reflecting significant weakness in the U.S. Gulf and the timing of off shore projects and related business mix in international markets.

A decline in completion activity in the U.S. gulf and lower demand for fluid offerings and other markets was partially offset by continued growth in our offshore waste management business mostly in the North Sea and in Asia.

The Smith Oil Field segment reported revenues of $520 million and $56 million in operating profit in the second quarter reflecting an operating margin of 10.8%. Margins declined 650 basis points from the March quarter translating into decremental margins of 38%.

The 24% decline in sequential revenues was almost exclusively concentrated in North America. However, international revenues fell 7% sequentially, albeit off of a relatively small base reflecting the timing of Eastern Hemisphere tender sales and activity declines in Argentina and Venezuela.

While the decremental flow-throughs were significantly better than the 50% levels reported in the March quarter, the level of EBIT decline per revenue dollar was influenced by the loss of higher relative margin drill bit volumes, as well as lower demand for tubulars, directional drilling, wire line, and cold tubing services, all of which have a significant fixed cost component.

Lastly, competitive pricing pressure was more severe in the Smith Oil Field operations, which contributed a significant portion of the margin compression. The distribution segment reported revenues of $411 million and an operating loss of $8.5 million. The distribution operations were particularly hard hit this quarter, influenced by fundamentals in the line pipe business.

Line pipe demand in the U.S. fell dramatically and tubular pricing also weakened during the quarter driving two thirds of the sequential revenue loss. These factors combined with the 16% reduction and non tubular sales volumes in the March quarter had a significant impact on fixed cost coverage.

Unfortunately, it's difficult to see the tubular business and the related Wilson results improving until we experience some recovery in energy and industrial sector line pipe demand.

In corporate net of charges in both the first and second quarter increased $1 million reflecting the amortization of debt issuance cost associated with first quarter refinancing and foreign exchange movements offset by lower incentive and other reserve requirements.

A few points to mention on the rest of the income statement, first net interest expense for the quarter totaled $42 million, $15 million above the first quarter's level reflecting the $1 billion debt refinancing completed in mid-March of this year. Assuming further debt retirements in current short-term market rates, we would expect to see interest expense drop modestly in the third quarter.

Moving on to taxes, after excluding the impact of the charge the effective rate for the quarter was 31%, 1.5 points below the level reported in the first quarter. Period-to-period decline was influenced by the shift in pre-tax earnings toward M-I SWACO Operations, which due to the partnership structure in the U.S. reports a slightly lower effective rate.

Our tax rate for the back half of the 2009 fiscal year should continue to be in the low 30% range. Detailed balance sheet information has been included as part of the earnings release documents, so I'll make just a few brief comments.

We think the balance sheet is in good shape. We have roughly $2.2 billion of outstanding net debt, which translates into a 27% net debt to total capitalization ratio with a 65/35 fixed versus floating mix. Free cash generated in the second quarter, most of which was utilized to repay outstanding indebtedness totaled just above $300 million, dropping our leverage ratio by almost three percentage points in the quarter.

Through the first half of 2009, we've generated free cash of $412 million, a number that is net of $130 million of capital spending, $53 million of dividend, and $64 million of partner distributions. We would expect to see a further contraction of working capital in the back half of the year resulting in incremental cash flow.

This most likely will result in continued deleveraging of the balance sheet, but acquisition and share repurchases aren't out of the question either. When questioned in the fourth quarter conference call, I commented we thought we would be able to release somewhere around $900 million of cash out of balance sheet in 2009.

Although the sharply lower profitability levels have had an impact on our expected cash flow performance, we'd like to be able to take another $350 million to $400 million of cash out of the business in the back half of the year. So we're in a solid position from a liquidity standpoint to take advantage of any opportunities that arise. Currently our cash, combined with availability under credit facilities, totals just over $1 billion.

Our consolidated DSO held flat in the quarter as improved collection efforts were offset by the increased mix of business outside North America which carried higher relative collection days. We showed sequential core improvement in every region with the exception of Latin America in the second quarter, and with Latin American collections, specifically Venezuela, picking up subsequent to the end of June, we would expect DSOs to show further improvement in the third quarter.

Net capital spending in the June quarter totaled $56 million with each business division reporting lower sequential CapEx investment. On a year to date basis net spending totals $131 million, more than 40% below the pro forma spending for the first half of fiscal 2008.

After considering our minority partner's interest in capital additions, capital spending approximated $47 million for the June quarter. With the U.S. downturn we've eliminated nonessential spending and believe that 2009 capital spending will now approximate $240 million to $250 million, about $125 million under our forecasted DD&A and significantly below the levels required across our peer group.

Depreciation in the second quarter of 2009 was $92 million and after considering our non-controlling partner's interest in depreciation, depreciation totaled $79 million. We believe the 2009 spending forecast compares to full year depreciation and amortization estimate of about $365 million to $370 million.

So with that I'll hand the call back to [Loraine] for questions.

Question-and-Answer Session


(Operator Instructions). Our first question comes from Daniel Boyd – Goldman Sachs.

Daniel Boyd – Goldman Sachs

Thanks. Margaret, I'd like to focus on North American margins, what you said actually were in the positive this quarter, what are your expectations going forward given your cost reduction so far, your continuing to make cost reductions and then your comment that you think pricing is stabilized?

Margaret K. Dorman

Yes, I think, Dan, that's an excellent question. I think that as we look forward we do feel like that we've realized most of the pricing impact in the North American market, so our expectation as we go forward is that you'll see those positive margins in that realm.

Daniel Boyd – Goldman Sachs

Can you help us with some type of magnitude? We've seen margins anywhere from 1% to 6.5% from some competitors in North America, are they in the middle of that range, higher end or lower end?

Margaret K. Dorman

Yes, I think as you know we run the business from a product versus a geographic perspective, but based on the financial performance as you noted of some of our peers in North America we thought it was important to highlight our North American results.

I would put those margins in the high single digits. Keep in mind we have one of the leading drill bit franchises which generates very good margins and returns, and this really helped contribute to the solid North American results this quarter.

John Yearwood

And those were our oil field-related segments.

Daniel Boyd – Goldman Sachs

Yes, and I guess in a very similar way to follow up for Chris on SWACO, given that we should see a positive mix going forward in terms of more deepwater, you also said that you've taken the hit on much of the re-pricing already in the second quarter. Should we also see margin improvement in SWACO?

Chris Rivers

Well, I think we'll see it gradually as we go forward, yes.


Our next question comes from Robin Shoemaker – Citi.

Robin Shoemaker – Citi

Yes. Just continuing on that theme, Chris, you described the international tendering is very competitive. You went after some new business and I think won some of that. A lot of it was deepwater. So when you say that you're kind of roughly current 12% margins would not decline further from here based on the business that you booked here in the first half of '09.

Chris Rivers

That's my expectation. Yes.

Robin Shoemaker – Citigroup

My follow-up question then would be related to distribution. Is there a prospect or plan in place for that business to reach a breakeven level even if line pipe sales don't pick up or are we looking at negative operating income for a while in that arena?

John Yearwood

Robin, unlike the oil field related activities where we have seen some stabilization of pricing and utilization in North America on the distribution side it is still fairly soft. There are actually a record number of tenders that our team are addressing in the June and July period as we speak. But it's still fairly soft, so I think our expectations are that probably it's going to continue in a fairly depressed mode for the time being.


Our next question comes from Dan Pickering – Tudor, Pickering, Holt & Co.

Dan Pickering – Tudor, Pickering, Holt & Co.

Good morning. John, could you give us an update generally on the progress of growing the W-H businesses out into the international marketplace. I know that's been a goal. Has the softer market slowed that down? Where do you stand relative to your initial game plan?

John Yearwood

Dan, yes, it is our goal. It's a key part of our strategy, not only for Pathfinder, but as you know for our completion product lines as well where we have a fairly relatively low market share. In terms of the W-H, we are now in three new countries since in Q2 with our Pathfinder offerings and it's going fine. We had all of those countries we got on board through – we did a field trial in one of them. It performed exceptionally well. And in the other ones it's through performance. It's having the right focus of operationally strong people with the right technology offering for their particular application.

So the Pathfinder's on track, and I'm very happy with what the team is doing. We have a strong group in Aberdeen that's really performing exceptionally in a tough North Sea market. But they're also supporting the future growth that you're going to see in the coming quarters in the Eastern hemisphere.

With the other W-H companies, we are also – I haven't mentioned it. I'll mention it probably in the third quarter call. We will be probably in a couple of new countries with some of those services on the production side, and we're being a bit more, I'd say, cautious on that. We will go into the countries similar to Pathfinder, but in the case of cold tubing wire line, we'll go in where we can clearly see value added for our shareholders.

They are countries that have a need for what we can offer. We're operationally extremely strong in both land, and in the case of cold tubing, in the deep water market in the Gulf of Mexico. So we are hand picking those countries that we go in. So overall, Dan, expect to see continued strong expansion of our Pathfinder business. And on the production services side, it'll be a little bit slower than the Pathfinder in terms international expansion, but the plan is to make it happen.

Dan Pickering – Tudor, Pickering, Holt & Co.

Okay. Is the net impact of that growth, John and Margaret, is that a net benefit to margins? I mean are there start up costs that make it a net drag to margins or is it essentially neutral?

John Yearwood

Well, I would say that, of course, there are some. We've been investing the last six months in those countries by having people go there, transferring people in. We have the facilities already, but we've had people costs, and travel, and expenses and shipping costs of course. So we've been absorbing that as we go along.

But our expectation is that once we are in country, like we are in these three new countries, and have X number of rigs, however many we get assigned in the next few months in addition to what we are on now, that we will have positive margins definitely going forward. You know the DDM, WDL, WB business, as you know well Dan, it generates very good margins and we have the tools and the assets and the people as we speak.

Margaret K. Dorman

Absolutely. We'd expect that to be incremental to earnings.

John Yearwood


Dan Pickering – Tudor, Pickering, Holt & Co.

All right. I understand it's incremental to earnings but I just didn't know if it was help or a drag to margins this quarter. It sounds like it's like that.

Margaret K. Dorman

Not with the margins and –

John Yearwood

For Q2, of course, we have had some expenses. So you could say it was a drag to Q2 but going forward, it shouldn't be.

Dan Pickering – Tudor, Pickering, Holt & Co.

Right. And then my non-related follow-up would be just around the recovery in Canada. If we look outside the distribution business, how meaningful should the Canada bounce back be? I understand you're saying you think margins in North America generally have bottomed. Was Canada a pretty big chunk of your decline quarter-to-quarter from Q1 to Q2? And should it therefore help us bounce back in Q3?

John Yearwood

Well I'll start and then Margaret can add anything on the margins. Overall we were quite very satisfied with the performance of Canada Q2 to Q1, typical margin decline in business decline. I was just in Canada week. I spent almost the entire week up there to get a very good feel for what's going on, and we've cut back our cost structure there, but we're very focused on certain plays that we believe will be active even in a depressed natural gas price, namely some other plays that are there. And we're working closer as an organization to bring our drilling optimization and completion products to the offering.

So Canada won't have a boom year of course. We know that because of the gas pricing, and tax issues, and so forth, but I can tell you that I'm very impressed with our team there. I'm very impressed. I take off my hat to how CE Franklin and the Smith organization, M-I SWACO, handled the Q2 breakup. It was a tough, tough breakup. But they handled it. Margins are positive, and I think activity won't bounce back a tremendous amount, but we're well positioned to capture whatever does come back.


Our next question comes from Brad Handler – Credit Suisse.

Brad Handler – Credit Suisse

Could you please a little bit more on, I guess, the M-I side to the issue of contract success? You highlight the $1.7 billion of incremental or incumbent renewal. And I guess maybe you could focus your comments a little on what we think we see in press releases a sense that you're saying you're growing in Brazil. How does that work with, based on what we think we've seen from not working for Petrobras as part of the normal frame agreement, maybe that's one example.

And then if I could ask you also to comment on StatoilHydro and the renewal there. I'm sorry this is growing into a long question, but I guess what I'm trying to get at is you're sustaining your share; maybe you're growing it a little bit. Are there rigs and contracts that are being swapped around among the major fluids providers now and you just think you're gaining your more fair share of what is sort of open for you to win?

Chris Rivers

Okay. Well let me start with the StatoilHydro question first because obviously our competitor has announced something. I mean we share that work with them and the same renewal will occur, although that has not been completed yet. But that would be, if I could characterize that as a normal contract extension, so there's no difference there, if you like.

With regard to the Brazilian market, there are several facets to that which I'm not going to go into in detail but there's obviously a Petrobras market and an IOC market that we participate very well in. But I think the bottom line is is what we see as quarter-to-quarter share differences due to activity fluctuations are fairly normal.

I mean we don't announce our awards. People don't announce their losses either. But we do have the best intelligence in the market in my opinion, and we have every reason to believe that our share is steady if not slightly improved in the long term. I think we all recognize the values on contracts awards are vastly overstated. I mean, they rarely perform based on what they've asked you to bid on. And as the incumbent generally, I think we see a more real view, a more real future view of the market than some others.

That being said though, I think that it's important for everyone to note that we run the business and focus on our returns. It's our remit to be the most profitable company in our segments. So we do on occasion walk away from work that's not profitable, and so if that answers your question, I hope it does.

Brad Handler – Credit Suisse

Actually it does and I appreciate that you waded through mine to answer it, so that's very helpful. Just as I guess as a related follow-up, maybe Margaret, can you help us think about the proportion of operating income that is likely to be shared with your minority interest partners in the second half of the year?

So the percentage was somewhat lower than we were looking for in this quarter, I know there are various facets that go in there, but can you help us at all recognizing this is quasi-guidance I suppose but can you help us at all with kind of what proportion, is it the 65% that we saw this quarter, is that a pretty good run rate for the second half?

Margaret K. Dorman

I would think that that's probably a decent run rate for the second half of the business. But I think what you'll have to determine is which side of the business do you think you're going to see more growth? Is it M-I? Is it Smith Oilfield, is it CE Franklin? But I think with that said, that's probably a decent run rate to use for the second half of the year at this point.


Our next question comes from Jeff Kieburtz – Weeden & Company.

Jeff Kieburtz – Weeden & Company

Good morning. It sounds like in the oil field and M-I businesses, both you feel as if the pricing effects have been fully impacted in the second quarter and that margins should stabilize to move somewhat higher in the second half of the year. Did I kind of get that all right?

John Yearwood

Margins I would say yes, they're stabilized. How much higher in the second half, well it's volume drives a lot of that. And business mix depending on a particular activity in a country with a couple of deepwater rigs, it can have a big impact. But yes in principle I would say yes, we agree with what you said.

Jeff Kieburtz – Weeden & Company

Okay and you are expecting I think as Chris went through, some meaningful increases in both the Gulf of Mexico and international deepwater markets as rigs arrive in the second half of the year. So that's at least some indicator of activity. I understand your reluctance to give guidance, but what are the scenarios in which you make less money per quarter in the second half than you made in the second quarter?

John Yearwood

The natural gas price in the U.S. is still fairly depressed and storage is filling up. One scenario could be that if the natural gas price drops further or significantly below where it is today and drilling slows down in the unconventional place, which we really haven't seen too much of yet or not compared to the nonconventional.

So we're cautious because to be honest, there are no – we don't see any reason for gas drilling to increase in North America over the rest of this year. There could be reasons for it to decrease.

Jeff Kieburtz – Weeden & Company

Okay, so that's the primary downside scenario driver as you see it today.

John Yearwood


Jeff Kieburtz – Weeden & Company

And then with that in mind, you've highlighted several times both the effort going in and the success coming out of the performance drilling initiatives that you've been pressing. Do you feel like the traction that you're getting in that business is and the scale of it is enough to, let's say, grow earnings if activity is otherwise flat or maybe hold earnings if activity does take a downtick?

John Yearwood

Activity taking a downtick, volume always has a bigger impact over our results than anything else. So I don't want to talk about that one. But to be in activity flat scenario, yes definitely, there's tremendous customer uptake about our drilling optimization offering, tremendous.

Our issue is being able to focus it in terms of where we get our best returns and also to be able to execute multiple, I'm talking lots of these projects simultaneously in different parts of the world. We're far away from that so far, but we are progressing.

Now, we won't be giving releases for every success we have, we've had a number of others that we have not come out with, but we came out with this one today because it was so significant, being able to do the entire curve and horizontal lateral with one assembly.

So our customer, Chesapeake Energy, we're very excited about that and we felt it was justified. But we will continue to in a flat market, yes, I believe we gained share in the second quarter because we're in these new countries, where in some of those countries rig count is actually flat or gone down, and I think as we execute more of these projects Jeff, that it will have an impact of course on our – a positive impact on our margins.

Jeff Kieburtz – Weeden & Company

And what today is the principal bottleneck in or limiting factor in terms of expanding that business?

John Yearwood

It's really having a process whereby we're able to do the pre-planning of the job and then monitor the job in almost – in real time to make sure that everything that we simulated is happening and taking those decisions as we go along in case something is not as we predicted.

So we have a certain number of people. We were structured for a certain volume of activity and as we're ramping this up, it really is adding a few more experts in the right area and fine tuning the process of pre-planning, execution, post execution evaluation, learning from that and repeating the cycle. So its people and process improvements that we need to continue to add to what we have today.


Our next question comes from Mike Urban – Deutsche Bank Securities.

Michael Urban – Deutsche Bank Securities

Thanks, good morning. Wanted to follow up a little bit on those last couple of questions internationally and rolling out the new product. Sounds like you've made a good bit of progress and had some nice success on the drilling side, taking maybe a little more cautious approach on the completion and production side.

Are you seeing customers asking for more on that side or is there something in particular that you need and that you look to add and would that be an organic add or do you have to potentially acquire something to fill those holes?

John Yearwood

Let me just correct something you said, you said more cautious on the completions and production. On completions, no, we're not being cautious at all. We're having very good buy-in on our completion products, whether it's our new liner hanger system or our new bridge plugs or our new quick flow testing assembly. So completions is full steam ahead and we're going to continue to be adding to that portfolio, both organically in-house as well as looking for nice acquisitions to add to our completions offering.

In the case of production services, that's – and I'm talking a really wireline, cased-hole wireline and coiled tubing, we are being a little bit more cautious because those businesses, I'm very familiar with those businesses and they – to really create incremental or accretive margins in new countries, you have to come in with something that's a little bit – you have some differentiation with local providers.

There are a number of competitors in those activity lines and we are making sure that when we go into a country, and as I said, we're looking at a couple as we speak, that we're offering something that local competitors do not have and where we can differentiate and then command higher margins for our services.

The plan is not just to spread cased-hole wireline and coiled tubing units around the world and suffer decrementals. That's not the plan. It's a very competitive business line and we want to strategically enter markets where we can generate decent margins for our shareholders.

Michael Urban – Deutsche Bank Securities

And you feel like you're developing those solutions in-house or is that something where you might have to look outside?

John Yearwood

Combination, we believe for where we've targeted so far, we do have very nice synergistic offering between our completions and production lines. And we will – we're always looking to maybe add some acquisitions to that portfolio, yes, combination of both.

Well I think we're – for a ten o'clock, almost ten o'clock, sorry 11 o'clock here in Houston, [Loraine], so if there are no more questions, I'd like to thank everyone of participating on the call and look forward to our future discussions. Thank you.


Thank you. And thank you ladies and gentlemen. This concludes today's teleconference. Thank you for participating. You may now disconnect.

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