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Executives

John Yearwood - Chief Executive Officer

William Restrepo - Chief Financial Officer

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

Shawn Housley - Director of Investor Relations

Analysts

Bill Sanchez - Howard Weil

Brad Handler - Credit Suisse

Bill Herbert - Simmons & Co.

Jim Crandell - Barclays

Jeff Tillery - Tudor

Geoff Kieburtz - Weeden & Co.

Ole Slorer - Morgan Stanley

Smith International Inc. (SII) Q4 2009 Earnings Call January 27, 2010 11:00 AM ET

Operator

Good morning, ladies and gentlemen and welcome to the Smith International fourth quarter 2009 earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded.

I’d now like to turn the call over to Mr. Shawn Housley, Director of Investor Relations. Mr. Housley, you may begin.

Shawn Housley

Thank you, Anthony and good morning. We appreciate you joining our conference call today I’m here today with John Yearwood, CEO of Smith International, William Restrepo, CFO of Smith International and Chris Rivers, President and CEO of M-I SWACO.

We’ll lead with some prepared remarks regarding our financial and operating results, which will be followed by a question-and-answer session. During the Q-and-A we ask that you please limit yourself to two questions so that we may have enough time to respond to all those that are in the queue.

I would like to remind you that some of today’s comments may use non-GAAP measures as well as forward-looking statements reflecting management’s outlook regarding future events and their potential effect on strategy and performance. These matters involve risks and uncertainties that could impact the company’s operations and financial results and cause our actual results to differ materially from our forward-looking statements.

These risks are more fully described in our most recent Form 10-K and other filings with the commission with the reconciliation of non-GAAP measures included in today’s press release. All these documents, as you know can be found on our website at www.smith.com. In today’s call we will use the term North America in reference to the combined operations of the United States and Canada.

Also, we will occasionally refer to Smith Oilfield segment as the Oilfield segment and the grouping of M-I SWACO segment and the Smith Oilfield segment as Oilfield or Oilfield related. Lastly, a telephone and webcast replay of this conference call will be available through February 3.

With that, I will turn the call over to John.

John Yearwood

Thank you, Shawn. Hello everyone and thank you as well for participating on today’s call. Smith consolidated fourth quarter revenues of $1.98 billion increased 6% sequentially as compared to an 8% increase in the global M-I SWACO drilling rate count.

The fourth quarter was characterized by a strong sequential increase in North American land drilling and an improvement in the global offshore rig count. North American rig activity increased sequentially by 22% primarily due to a significant increase in Canadian activity combined with a material increase in U.S. land oil targeted rigs.

Gas targeted rigs on U.S. land also increased sequentially, but at a much lower rate. The secular growth in non-vertical drilling as a percentage of total well types continued to increase during the quarter and given the improved economics from these types of wells, it is our expectation that this trend will continue for the foreseeable future.

On a consolidated basis we saw similar sequential revenue increases of both North America and the rest of the world with Canada, Latin America and Africa delivering the highest percentage growth. From a business line perspective, the fourth quarter highlighted increased customer demand for most of our products and services with environmental solutions, PathFinder drilling technologies and cased-hole wireline service leading the percentage gains.

Excluding our distribution business, Oilfield related revenues for the fourth quarter increased 5% sequentially with North America up 4% and the rest of the world up 5%. Most of the sequential Oilfield related growth in North America came from the Smith Oilfield segment while most of the drills outside of North America came from M-I SWACO, primarily in Latin America, Europe and Africa.

For M-I SWACO the offshore activity in the Gulf of Mexico was particularly soft during the fourth quarter primarily due to rig moves, contract start of delays and weather. A number of countries showed excellent sequential quarterly Oilfield related revenue growth and I would like to particularly highlight Canada, Argentina, Brazil, Angola and Algeria.

In general pricing stabilized during the fourth quarter albeit at relatively low levels, particularly in the United States. This being said, we did see a significant increase in demand in the United States at the end of the fourth quarter for unconventional reservoir drilling technologies and if this continues, it is our expectation that our PathFinder business line will be the first to benefit from improved pricing in 2010.

Year-on-year, Smith consolidated quarterly revenues, excluding the divested WH fluids businesses, declined 33%, slightly more than the 24% reduction in the global M-I SWACO drilling rig count over the same period. All geographic regions posted declines with the exception of Latin America, which posted a 5% year-on-year revenue gain inline with the 5% drilling rig count increase over the same period.

During the fourth quarter we continued to aggressively pursue our three part growth strategy, namely, delivering top quartile drilling performance with particular focus on unconventional reservoirs, strengthening our global deepwater and environmental solutions offerings and geographically expanding the footprint and product offerings of all our other business lines through the commercialization of performance driven new technologies and acquisitions.

We’ve closed three acquisitions in the fourth quarter with total transactional costs of approximately $60 million and we continue to actively pursue several additional opportunities, some of which we hope to close during the first quarter of 2010.

I will now make a few comments regarding our Smith Oilfield and Distribution segments and leave Chris to make additional comments on M-I SWACO. The Smith Oilfield segment reported revenues for the fourth quarter 2009 of $516 million, 2% higher on a sequential basis, but 41% lower year-on-year excluding the divested WH fluids businesses.

North America generated the largest component of the sequential increase driven primarily by a 29% improvement in PathFinder’s revenues and a strong 22% increase in cased-hole wireline revenues. Sequential revenue growth in the U.S. was negatively impacted by lower tubular sales and reduced more whole enlargement activity in the Gulf of Mexico.

In the fourth quarter we experienced material growth in our, i-DRILL drilling optimization services especially in the unconventional reservoirs and we are now providing this service for multiple clients. During the first quarter of 2010 we will enter the execution phase on several additional projects in Texas and Oklahoma as well as with a major national oil company.

Our, i-DRILL teams continue to focus on adding resources due to customer demand. This demand is spurred by our differentiating philosophy of fully simulating the optimal drilling process while recommending the right technology for the specific application, irrespective of whether it is a Smith product or not. This philosophy has proven successful in the rollout of these services and we expect that this important alignment of objectives will continue to gain traction with our customers.

We achieved another important milestone during the fourth quarter with a 21% sequential increase in our global PathFinder directional drilling measurement well drilling and logging well drilling revenues. Excellent cost effective drilling performance in both hemispheres as a result of improved tool reliability and increased customer demand for our services were the main reasons for this growth.

Based on our current January job count combined with a startup of many new contract awards, I would expect continued strong growth rate for these services in the first quarter of 2010. The recent acquisition of the San Antonio Directional Drilling business combined with the multiyear contract award with Petrobras will provide the platform of delivering our full suite of drilling optimization technologies to one of our major clients.

I mentioned on our last conference call the success of our new line of ONYX cutters in terms of increasing both the rate of penetration and total footage drilled. During the fourth quarter we continued to set industry benchmarks with several record PDC drill bit runs in East Texas, Louisiana and the Middle East. This success was achieved by our ability to simulate bit performance based on actual rock properties.

Thus optimizing the design for a variety of formations and developing proprietary cutter technology matched to the designs. Of particular note is a recent 16 inch bit run in Kuwait where a major customer was able to significantly improve their drilling program as a result of our ability to drill the 16 inch section with two bit runs instead of three. These runs were significant records in terms of the footage drilled while maintaining competitive rates of penetration and we are consistently maintaining this record performance with our new bit technology.

Additionally, we are also seeing record results with this new technology on horizontal drilling applications and have added new customers as a result of the recent success. One of these customers in this horizontal application is saving on average 10 days per well as a result of these new drill bits. As part of our expansion into new markets, our diamond drill power section and motor component division opened a motor manufacturing and service center in Dubai during the fourth quarter.

This state of the art facility now allows us to better service our customers throughout the Middle East and the eastern hemisphere. Our Production Services Division posted positive sequential revenue gains of 12% primarily due to increased activity in Texas combined with geographic expansion into Canada and the eastern hemisphere. Partly offset by slow activity on the Gulf of Mexico shelf and weather delays.

Moving on to our Distribution segment, it is clear that we are seeing signs of improved customer activity and demand in the energy sector, particularly in the midstream markets. Distribution revenues were $410 million for the three months ending December 31, 2009, an increase of $32 million or 8% on a sequential quarter basis.

The majority of the sequential improvement was in the Energy segment as customer activity primarily in the unconventional oil and gas plays and to a lesser extent in the traditional oil producing areas, generated higher revenues. Industrial revenues also increased sequentially as a result of higher project activity and new contract awards.

Despite a quarterly operating income loss for our Distribution business we did see month-on-month improvements during the quarter as we work through the higher cost inventory items, particularly our line pipe. We continue to effectively manage our Distribution inventories and believe that we are now appropriately positioned as we move into 2010.

Looking ahead to 2010, we continue to believe that a sustained oil price of $70 per barrel is positive for an increased rig count outside of North America and for adding oil targeted rigs to the U.S. and Canadian land markets. As regards the U.S. gas rig count, we are cautious as to the full year level of activity given relatively low industrial demand and uncertainty regarding the timing as to when we will see the impact of the expected steep gas production declines.

Given the situation we will not be giving full year EPS guidance. However, given the recent increase in North American drilling and the expectation that the margin impact on our Distribution business resulting from higher last in first out inventory costing is largely behind us, we do expect our first quarter revenues to sequentially increase and believe that our earnings per share using the new share count and excluding non-reoccurring items will be generally inline with current market consensus estimates.

Despite the uncertainty regarding the overall level of North American activity, we continue to be optimistic about our growth opportunities due to the following key drivers. First, the continued success of M-I SWACO as regards contract awards. Second, the expected increased utilization and deployment of additional deported rigs.

Third the continued geographical expansion of our PathFinder and completions businesses, fourth, the strong customer demand for our i-DRILL drilling optimization offering and fifth, the expected commercialization of differentiating new technologies from both our M-I SWACO and Smith Oilfield segments.

I will now pass the call to Chris.

Chris Rivers

Thank you, John. Good morning. I will discuss M-I SWACO’s fourth quarter performance. Fourth quarter revenues for M-I SWACO were approximately $1.1 billion, approximately 6% higher than the third quarter of 2009, but 19% lower than last year’s fourth quarter. In the fourth quarter 77% of M-I SWACO revenues were outside of North America.

The M-I SWACO rig count increased by 8% from the third quarter, the recovery continues to be driven primarily by gains in North America where the U.S. rig count increased 172 rigs or 16% sequentially. The worldwide offshore rig count improved by 17 rigs. Revenues for our offshore business were $523 million for the fourth quarter. This was an increase of 5% from the prior quarter inline with the sequential increase in offshore rig activity.

Offshore revenue was 49% of total revenue unchanged from the third quarter and with regards to the deep water market, the total number of deepwater rigs operating around the world during the fourth quarter was 113. Our share was approximately 45% excluding those that were unavailable in Brazil.

The average number of rigs operating in the U.S. deepwater market improved to 31 rigs from 29 rigs in the prior quarter. We serviced an average of 11 rigs and generated revenues of $42 million, a decline from the third quarter due to rigs going into completion mode, rigs inactivated and contract delays. The international deepwater market averaged 82 rigs during the quarter, down one rig from the third quarter.

Our international deepwater revenues were $119 million, up 11% compared to our third quarter mainly due to increased activity in South America, North Africa, India and Angola offset by lower activity in Australia and Nigeria. In 2009, 25 new deepwater rigs were added worldwide. We expect another 33 to be added in 2010. Of those rigs that were contracted in 2009 we have to work on 50% of them and this is holding true for the rigs that have contracts for 2010 as well and I should add, M-I SWACO won 75% of the 2009 deepwater awards based on tender value.

New technology revenues which are generated from technology that is less than five years old were $283 million for the quarter. That’s a sequential increase of 7%, but down 10% from last year. As a percentage of our total revenues they were 27% compared to 24% in 2008. On a geographic basis, all of our business unit revenues improved from the third quarter, although our Gulf of Mexico revenues were below our expectations because contracts awarded to us earlier in the year did not start as anticipated.

North America posted revenue growth of 3%. South America was the big star on the quarter. Overall revenues improved by 17% with all regions growing, but southern South America grew by 38%. Brazil revenues for the quarter set a record. Our largest unit, the eastern hemisphere, posted 5% growth with Europe, which includes Russia and Africa leading the way. Our environmental solution business warrants special mention.

While our overall revenues were up 6% sequentially, the technologies that make up our environmental solutions Oilfield segment were up 10%. This performance underscores our customers’ long term commitment to conducting their E&P operations in an environmentally responsible manner and the amplified need for our services. The increase in North America drilling activity and the bottoming of international rig activity during the fourth quarter was as we expected.

Our outlook for 2010 remains positive and dependent upon the recovery rate for the general economy. While we will see increases in oil related drilling activity in North America throughout the year, we remain cautious on the outlook for natural gas drilling activity until there’s a real and material return of industrial demand. Oil prices should remain at levels that support steady international growth. Beyond 2010 we believe that operators around the world will need to increase their E&P spending to maintain current production rates.

During fourth quarter we closed two acquisitions. We purchased Precision Gas Well Testing and Cyclotest. Over the next few months we will integrate the capabilities and technologies of both companies to optimize our ability to offer unique solutions to our customers and grow the business. We will continue to pursue acquisitions that fit and build upon our technology suite and we are reviewing many candidates currently. Our deepwater leadership, technology portfolio and international franchise have us well positioned for future growth.

Now, I will hand over to William.

William Restrepo

Thank you, Chris. Good morning. The fourth quarter of 2009 confirms some of the trends we identified in the third quarter and that we covered during our last conference call. Activity continued to pickup after a slow point during the month of August, particularly in the US in terms of job count and revenue levels.

The offerings benefiting the most were directional drilling, PDC bits, production services and the distribution segment. Prices did not fall below the levels we saw during the middle of the third quarter, but at this point pricing has not yet recovered in the U.S. for the majority of our product lines. The increased U.S. activity was based on a 16% increase in rig count and on our customers’ increased willingness to spend on infrastructure. These increases in U.S. activity were stronger than what we had anticipated at the end of the third quarter.

As disclosed in this morning’s release, for the fourth quarter of 2009 we reported earnings of $20 million or $0.09 per diluted share on revenue of $2 billion. This compares to our third quarter results of $15 million excluding charges or $0.07 per diluted share on revenue of $1.9 billion.

Consolidated revenue was 6% above the level reported in the September quarter. Revenue for our Oilfield related operations increased 5% sequentially after three straight quarters of sequential declines. Both M-I SWACO and Smith Oilfield improved in North America with revenue growth of 3% and 5% respectively, whereas outside the North American market, M-I SWACO grew by 7%, while Smith Oilfield was essentially unchanged as compared to the third quarter.

The North American focus Distribution business had the strongest rebound of our segments during the fourth quarter grown by 8% and reversing a similar reduction during the third quarter. Operating income totaled $123 million, up $9 million from the prior quarter, after excluding $13 million in restructuring and other charges in the third quarter. There were no material charges in the fourth quarter.

Strong revenue growth in Europe, Africa, Latin America and Canada were the primary drivers of the sequential increase in operating income. Increased activity in the United States, particularly for distribution and for many of our oilfields land based services resulted in significantly higher revenues, but with a more limited impact on our operating income reflecting the depressed level of prices in this market.

Weakness in the U.S. offshore market, some of it weather related, affected our sales of high margin product and service offerings. For the company as a whole the unfavorable revenue mix and low prices in the United States contributed to consolidated margin increases of only 10 basis points translating into incrementals of 8%.

From an earnings standpoint consolidated earnings per diluted share increased by $0.02 on an operating basis. Our oilfield related businesses, together with 100% of our unallocated corporate costs, delivered $0.15 per diluted share. The distribution segment lost $0.06 per share largely due to our LIFO accounting.

Touching on the fourth quarter performance of our three operating segments, which in all cases is net of charges and corporate costs allocations, M-I SWACO generated $1.06 billion in revenue and $129 million in operating profit in the fourth quarter, translating to an operating margin of 12.2%. M-I’s operating margin for the fourth quarter was essentially unchanged compared to the third quarter and 62% of the revenue increase was on land, which normally brings lower margins than the offshore activity.

Revenue increased sequentially by 6% providing incremental operating margins of 13%. The Smith Oilfield segment reported revenues of $516 million and $39 million in operating profit in the fourth quarter representing an operating margin of 7.6%. The 2% sequential increase in revenue was primarily concentrated in North America, which grew by 5%, whereas revenue outside North America was flat falling large completion tender sales in the Middle East during the third quarter. Excluding the tender sale the market outside North America would have grown had it paid similar to that experience in North America.

Operating margins declined by 55 basis points from the September quarter as the additional land based revenue in the United States came with relatively low prices. In addition, sales of our higher margin products and services, particularly offshore, fell as compared to the third quarter.

The Distribution segment reported revenue of $410 million and an operating loss of $18.7 million. Despite the significantly higher revenue, the Distribution segment delivered only 5% sequential incrementals during the quarter with a negative margins improving by 80 basis points.

Our fourth quarter margins for this segment were affected by the consumption of the remainder of the high cost 2008 LIFO inventory layer, by low volumes as compared to historical trends and by prices that, despite reaching bottom, have not yet started to recover.

On the positive side our Distribution business continued to deliver operating cash flow, contributing $61 million during the fourth quarter as we continue to drive down our inventories. Despite the low prices and thin margins for many of our products, we expect the Distribution segment to improve significantly, during the first quarter given the improvement in our LIFO inventory costs, corporate expense of $26.7 million for the fourth quarter decreased by $0.7 million net of the third quarter charges.

A few other points to mention on the rest of the income statement, first, net interest expense for the quarter totaled $38.6 million, $1.3 million below third quarter’s level, reflecting primarily the debt retired during the quarter. Assuming further debt retirements of $525 million in the first quarter, we would expect to see interest expense continue to fall.

Moving onto taxes, the effective tax rate for the quarter was 27.5%, 1.8 percentage points below the level reported in the third quarter. Our tax rate for the 2010 fiscal year, while dependent on the distribution of earnings between regions, should be in the low 30% range.

Our balance sheet continued to improve as we reduce our total debt to $2.2 billion, on our net debt to $1.2 billion at the end of the fourth quarter, which translates into a net debt to capital ratio of 14.8%. Operating cash flows, less CapEx in fourth quarter totaled $256 million, somewhat higher than our expectations as we reduced inventories by another $127 million during the quarter and customer receivables by $30 million. For the full year period, we generated operating cash flow less CapEx of $1 billion.

Our liquidity position remains strong with $1 billion in cash and $1.4 billion in undrawn credit facilities, which were increased by an additional $600 million before the end of last year. We are confident that our current liquidity, our internal cash flow generation and our credit facilities will allow us to comfortably manage our plan to repay $525 million in debt, address our acquisitions pipeline during the first quarter and meet working capital needs to fund the anticipated growth in activity, as well as any distributions to shareholders and minority interest partners.

Our consolidated DSO fell by six days during the quarter as collections improved worldwide with particularly healthy customer payments in Latin America. As a result, our customer receivable balance fell an additional $30 million despite the $105 million sequential growth in quarterly revenue.

Net capital spending in the December quarter totaled $93 million. For the full year 2009 net capital spending reached $294 million, $24 million higher than our previous expectation, with most of our increase coming in our PathFinder operations, as we accelerated investments inline with new expansion opportunities.

For 2010, we now forecast $320 million in net capital expenditures, about $40 million below our forecast D&A for the year. This number could vary depending on the activity level and the opportunities to expand our international operations during 2010.

I would like to make some comments on the Venezuelan Bolivar devaluation. On the 8 of January the government modified the official rate from 2.15 Bolivars per dollar to a dual rate system of 2.6 and 4.3 Bolivars per dollar with the two rates being applied depending on the type of transaction. Currency devaluation will result in the re-measurement of our Bolivar denominated assets and liabilities at the new exchange rate resulting in a onetime charge to earnings during the first quarter of 2010.

At this point the Venezuelan regulatory authorities have not provided sufficient clarity on the exchange rates to be applied to specific Bolivar and US dollar positions of our Venezuelan entities. Until more information becomes available we will be unable to calculate with a reasonable amount of precision the impact of the devaluation on the quarterly results.

So with that, I’ll hand the call back to Anthony for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Bill Sanchez - Howard Weil.

Bill Sanchez - Howard Weil

My question involves the progression from fourth quarter, first quarter and the guidance given, or at least the comfort with consensus numbers. John, you said that PathFinder and cased-hole revenues it sounded like it grew higher than what the rig count did either in the U.S. quarter-to-quarter or North America.

Can you talk about kind of first quarter revenues and Smith Oilfield’s expectations as a whole? We heard some positive commentary on bids, just your thoughts on coal tubing and then perhaps, what kind of incremental margins we could expect in the North American segment?

John Yearwood

A lot of parts to that question, Bill, revenue, I’ll start with that for the Smith Oilfield segment. We ended the fourth quarter slightly higher North American rig activities than we were expecting, I would say back at the end of October, very positive, and at the beginning of the year in January, we’re seeing continued rig additions in Canada and U.S. land primarily.

So we have good momentum coming to the quarter as you said and I noted our PathFinder job count especially in North America is strong, as strong as it was back in when we first made the acquisition at the end of 2008. Now, what will the revenue growth be for the whole Oilfield segment?

Outside of North America, we’re not seeing anything other than the PathFinder growth that we’re seeing in some new countries and new contract startup awards. I would expect outside North America not to change very much sequentially. I don’t see any main drivers for the Oilfield segment, but North America should continue to pickup. So I don’t want to put a percentage on it, but it will increase.

Now the cased-hole wireline was very good and I think that could be a reflection of maybe some of the wells that were drilled and not completed. I think we all believe that it was some extra completions that happened in the fourth quarter and I think that drove the slightly higher cased-hole, especially the perforating plug setting business. We didn’t see it across the Board. Quite sure, we didn’t grow at that same rate especially because the Gulf of Mexico was so slow.

Margins, Oilfield segment going forward Q1, sequentially I would expect some slight improvement, again nothing that material because pricing to be honest even though we are tendering everything that comes in, we’re sending back with some price adjustments and increases whether or not a day rate, but maybe some additional charge, not everything is sticking and I don’t think we’ll get much incremental due to pricing in the first quarter. Hopefully if the activity continues on its current growth rate, we may see something in the second quarter or in the second half of the year.

Bill Sanchez - Howard Weil

John, as a follow-up, I know you don’t report your geomarkets operating income numbers, but I guess as we think about international margins all of your peers have suggested that first quarter margin’s down versus fourth quarter. What specifically do you think for Smith as a whole first quarter versus fourth quarter there?

John Yearwood

I’ll let William take that one, Bill.

William Restrepo

Thanks for giving me the future margins, John. Well, we don’t expect a lot of growth in Oilfield internationally. Of course M-I will, but at Smith Oilfield and we don’t see any pricing traction as well. So we’ll see again the same thing that we saw in the fourth quarter, stable margins with some improvements in some places like Latin America, but we don’t expect a tremendous progression in the margin percentage in the first quarter outside North America.

Operator

Your next question comes from Brad Handler - Credit Suisse.

Brad Handler - Credit Suisse

I guess I’ll take the other side of that. Will, you just mentioned you just made a passing comment to M-I, but noting some of the strength in there Latin America where it seemed there was a good mix of drilling versus completion activity. What is your sense for M-I revenues in the first quarter? Is there some sort of again seasonal get back either out of Africa or the Latin American markets?

William Restrepo

What was the second part of the question?

Brad Handler - Credit Suisse

Just noting the strength in Latin America, noting and Africa, was some of that perhaps a little bit, if not non-recurring, perhaps was it just seasonally or did it wind up being strong and is there perhaps a little bit of there for give back in Q1?

Chris Rivers

No. I don’t believe so. I think John used the right word in terms of momentum with regard to M-I SWACO. I think we do have lots of momentum internationally going through the fourth quarter that will carry over into 2010, not just the first quarter as specifically in Latin America and Africa and North Africa and West Africa. I’m expecting to be strong throughout 2010. So I don’t expect any give backs. I expect us to continue the performance that we’re turning in.

Brad Handler - Credit Suisse

A different question, then, just unrelated follow-up. I just want to clarify the commentary around reducing debt. Fair enough you have the cash balances in hand, but maybe William, can you talk to us about free cash flow generation expectations in the first half of 2010, just sort of along the lines of your commentary about paying back the debt?

William Restrepo

We believe that in the first part of the year and, of course it will depend on the increase in activity, but we’re planning for significant growth in our working capital and we’re ready for that. So we think that with the cash on hand and our facilities will be in good shape to meet some of our desire to reduce our debt and get rid of some of the debt in the balance sheet, while at the same time being able to grow our working capital significantly. We think that’s going to happen during the first half of the year.

Brad Handler - Credit Suisse

Presumably, you need to rebuild inventories?

William Restrepo

Correct. That’s absolutely right. I mean end customer receivables, but the reduction in revenue versus last year that John highlighted, was reflected also in the cash generation and the reduction of those balance sheet items during the year. We believe that we’ll see a reversal of that in the first half of next year and obviously we feel that by year end as that impact is digested we will still generate significant cash flow by year end somewhere in range of what we did this year.

John Yearwood

Brad, just to add on the inventories, we did take my hat off to our teams around the world. They did a fantastic job in 2009 of reducing our inventory levels. We set aggressive targets back in January of ‘09 and most of, if not everywhere, achieved or exceeded those targets. So hats off. We have implemented a very structured manufacturing and supply chain initiative.

We call it smart source and my expectation is that even though activity hopefully will continue to increase during 2010. We don’t know for sure, but if it does and William talks about building working capital, the intent is to not build backup inventory levels like we have done in the historical past as the activity comes back. We think we have stronger processes in place, better procurement initiatives and the idea of receivables will build as you build the revenue, but we don’t want to build inventories like we did historically.

Brad Handler - Credit Suisse

If I could just follow, I want to make sure I heard you right and then I’ll drop off. Will, I heard that you say you think you can generate as much free cash in ‘10 as you did in ‘09?

John Yearwood

Before acquisitions. We are assuming a better year in 2010.

Brad Handler - Credit Suisse

I just expected more cash flow being squeezed in ‘09 as you said through your processes. I’m pleasantly surprised by that comment.

Operator

Your next question comes from Bill Herbert - Simmons & Co.

Bill Herbert - Simmons & Co.

Getting back to Oilfield here for a sec, directional up little strong; quarter-on-quarter up 29% in North America at least, case hole up 22%. What did drill bits do in the quarter?

William Restrepo

Drill bits I believe were high single digits, in the U.S.?

Bill Herbert - Simmons & Co.

Yes.

William Restrepo

Yes. Well, mid-to-high.

Bill Herbert - Simmons & Co.

So, again relative to a rig count that was up 16%, why the lag?

John Yearwood

Well a lot of the rigs were in areas that, well, maybe West Texas or parts of the oil targeted rigs that with the rental business we have there was not necessarily that much of an up tick for us, not so much service intensity. We’re very happy with our performance in the unconventional plays with the bits, with the record runs. I mentioned ONYX cutters. We’ve seen across the board record performance in fourth quarter 2009 with these cutters. So, Bill, I think you’re going to see maybe a bit of a lag. I think we’ll start to get maybe some improved overall margins from our new cutters as we go forward because of the better performance.

Bill Herbert - Simmons & Co.

So the utilization on your bit plant today is roughly where plants rather?

John Yearwood

Well, today if you take right now, over the last five to six weeks it’s ramped up significantly.

Bill Herbert - Simmons & Co.

I would assume that means it’s higher than 50%.

John Yearwood

Well, let me just say one of the plants is still closed. We have what, one, two, three, four, five, four bit plants that I’m aware of, two here, five and we still have one that’s closed. So if you discount that one, it’s especially on the bit side where we have significant growth in our PDC demand over the last five or six weeks that we’re well above 50% at the moment.

Bill Herbert - Simmons & Co.

With regard to the tubular headwind that you encountered in the fourth quarter, I assume that meant that tubulars were actually down quarter-on-quarter in terms of revenues in the fourth quarter.

John Yearwood

Correct.

Bill Herbert - Simmons & Co.

Is there any reason to assume, John that tubulars are going to continue to decline in the first given what’s happened with regard to the rig count?

John Yearwood

There’s so much inventory out there of heavyweight collars, heavyweight drill pipe. I don’t know when that cannibalization of stacked rigs will finish. Revenue was down sequentially. We have started to build, manufacture some tough different sizes and types of heavyweight because the inventory has come down, but I’d be very surprised if we see an up tick in Q1.

Bill Herbert - Simmons & Co.

Yes. I’m not necessarily inquiring about an up tick. I’m inquiring about a continuation of the decline in the first quarter. That’s my question given the fact that the rig count’s doing what it is, you’re drawing down some inventory. Do you expect to see another significant down tick in Q1?

John Yearwood

Conventional wisdom or logic would probably indicate no, but it’s too early, I think if its best case scenario for me would be to hold flat.

Bill Herbert - Simmons & Co.

Long way of coming around to actually what the nub of my question is and that is getting back to the margin expectations for the first quarter, given the fact that your manufacturing plant with regard to drill bit, the asset employment there is considerably higher, PathFinder just doing really well. Case to hole water line continuing to do its thing, drill bits turning to again getting it back to that doing quite well.

You’re going to have an easier comp with regard to that completion sale. That was a tough comp in the third quarter. I’m just curious as to why we think the margin recovery, given the fact that your cost absorption should so be much better in the first quarter, I’m just curious as to why we’re expecting a relatively lethargic improvement in margins. I get that pricing is not improving, but on cost absorption alone your margins should be showing more vigor.

John Yearwood

I think you have to look back at also you could argue why is Q4 not up versus on the Smith Oilfield segment versus Q3., and what’s happening is that we’re starting up or we’ve won contracts for PathFinder business in a number of countries around the world. We invested in that and what we invested in a number of startup countries for new contract awards in the fourth quarter.

Actually we’re now in as I speak now we’re performing in two new countries this first quarter and the third one we expect next month and there’s a country where we’ve just taken over a significant part of the entire market for directional drilling. So these startup costs impacted us to a certain extent in the fourth quarter.

You saw that with our CapEx that came in a little bit higher in the fourth quarter than what we thought it would be doing at the end of October and that was to fuel some of these startup contracts that are now happening in the first quarter. So how much impact do these startup costs have on the operation? It’s heavy, but we don’t break it out. We take it as part of our normal.

Bill Herbert - Simmons & Co.

That’s helpful because that’s something that I missed.

William Restrepo

Let me add something to that, Bill, because, a lot of focus on the U.S. where it should be, the size of the business here, but you mentioned that the absorption and you’re right, the under absorption is going to be much lower now in terms of overhead. Remember that that is really smoothed out over several months. So you don’t see big jumps in profitability just because we have a bit better absorption.

It just goes into the different types of inventories that are, and those under absorptions are amortized over the turns of those inventories, right? So you’re not going to see an immediate jump in one quarter, because of the way we do our accounting. The second thing that I think you should consider for the first quarter is that, impacting the fourth for U.S. employee population, we had furloughs and salary reductions and that was in the month of December effective the 1 of December. We went back to the old salaries and took off some of the furloughs.

So that was one month impact and we’re going to have a full three month impact in the first quarter. Now, you’re right. You’re giving some of the positives, but it’s not all positive, right? So I think all that will balance out in the end.

Bill Herbert - Simmons & Co.

Last one from me, William, with regard to the high costs LIFO layer for line pipe, is that completely behind us now and do we expect to generate positive EBIT for Wilson in Q1?

William Restrepo

I won’t give you a number because, there’s too many moving parts including volume and pricing, right? So I can’t really tell you a number at this point. It’s too early in the quarter and it’s a lot of things in transition, but what I can tell you is the fact that yes, the 2008 layer that we’ve been talking about at Nauseum for the last three quarters or so is behind us.

So that will immediately have just an accounting from the accounting point of view a very positive healthy impact on our margins and I think it will drive us towards break even. I’d be very pleasantly surprised if I’d see a positive number, though, Bill.

Operator

Your next question comes from Jim Crandell - Barclays.

Jim Crandell - Barclays

John, what percentage of the offshore exploration market is you capable of serving now with PathFinder given its sensor capabilities?

John Yearwood

Jim, no. For PathFinder that’s not a focus area for us. We focus on the majority of the directional horizontal drilling activities around the world, which we believe 90% of that’s on land or on shallow water applications. So no, we’re not focused at least for the next few years on taking the PathFinder offering to deepwater exploration activities.

Jim Crandell - Barclays

Or shallow water?

John Yearwood

As I said, we believe about 90% of the deviated wells horizontal drilled around the world are on land, the vast majority, or in shallow water. So we’ll focus on shallow water type activities, which tend to be not the same tool sizes that are required or they don’t require the same types of LWD technology that focus on replacing open hole wireline logs.

Jim Crandell - Barclays

Let me ask it the same way. How about what percentage of the land market do you feel you can compete on today given your sensor capabilities?

John Yearwood

Today right now, I would put 70%, somewhere in that basis, and by within the next couple of months it will go up, because we’ll be commercializing our slim hole rotary terrible tool within the next few months and then we have our, as it moves to debriding resitivity tool testing by the end of the year.

So if I had to put a number down and it’s a guess, Jim, but I would say 70% today and our target is to get up to for land operations by the end of the year, early next year to be able to address 90%.

Jim Crandell - Barclays

Chris, just a couple of quick questions for you, I think you mentioned 2009, how well you did in deep water awards. I think there are about 30 new deep water rigs coming on this year. How many of those today have selected vendors for offshore fluids approximately and how are you doing in those awards?

Chris Rivers

There are about 12 that have contracts and we have 50% of those.

Jim Crandell - Barclays

Is it at all a concern of yours, Chris that National Oil Wells is getting into the fluids business and seems to have a strategy of making it global, that Weatherford is in the fluids business? It seems bigger companies are making strategic commitments to get into fluids.

Chris Rivers

It’s not a concern. I’m interested to understand their strategy, which I don’t at the moment. They need to have a different footprint in their acquiring and there’s a big technology component that they don’t have. So I’m just interested watching, but I’m not concerned about it.

Jim Crandell - Barclays

One other question for you, how important a market is Iraq to you? It seems like it could be a multi-billion dollar market for oil service companies, yet most of the big jobs seem like they’re going to go the IPM route, which would seemingly prohibit you doing business with Halliburton, Baker and Weatherford.

Chris Rivers

We currently are working in Iraq in both the north and south, so as an emerging market, it has a high focus with our management. So 2010 plan is quite optimistic for that region. I’m looking for good growth there. I don’t really see any impediment in terms of what we’re doing and who we’re working for at the moment.

John Yearwood

That’s the same, Jim, for the Smith Oilfield segment. We’ve been answering a number of tenders. We’re providing a number of services. We’re already discrete products and services in north and the south and now we’re happy being the provider of performance driven technologies. That’s where we think the better returns are going to come.

Jim Crandell - Barclays

In the drill bit business I think Baker Hughes just said on their call that they believe they had meaningful market share gains in drill bits here recently. NOV has been talking about market share gains over the past few months in drill bits and just given what you said about your drill bit revenues are lagging the rig count, do you think you’ve lost any market share in bits overall?

John Yearwood

No. I don’t think. So I’m not sure what numbers they’re using for that to come to that assumption. No, what I do see is that we seem to be dramatically ahead of our peers in terms of drilling performance, and in terms of world records. I think there’s going to be a new publication third-party coming out in the near future. That’s going to confirm that. So no, I believe, Jim, that our customers are focused on performance and if a bit doesn’t deliver better rate of penetration or longer penetration footage, than they’re not going to use it irrespective if you discount it or not. So no, I don’t think so.

Operator

Your next question comes from Jeff Tillery - Tudor.

Jeff Tillery - Tudor

Just a follow-up on some of the earlier questions on the Smith Oilfield business, looking at kind of the U.S. progression there sequentially revenues up in aggregate and it looks to me something like 3%. So with PathFinder and wireline and bits growing much higher rates than that, was the tubular drop off sequentially a big number? I’m just trying to get a feel for what was down, tubulars in Gulf of Mexico, I would think, but were those pretty sizable sequential declines?

William Restrepo

It was not just tubulars and yes, it was pretty with big. Double digit, but the other component that has also dropped both in revenue and even more so affecting our margin was the borehole enlargement.

John Yearwood

Gulf of Mexico as Chris had mentioned, a lot of rigs are on completion phase or moving and we just didn’t see the same level of borehole enlargement activities in fourth quarter. We expect that to come back and just as a seasonal thing.

Jeff Tillery - Tudor

Then just on M-I margins seemed to, on a percentage basis, really found a floor over the last couple of quarters has been essentially, perfectly flat. Any reason to think margins on percentage terms would feel pressure in the first part of 2010?

Chris Rivers

No. I don’t think so. I’m looking for obviously improved activity in the Gulf of Mexico, which is going to help slightly, but our continued good performance in South America and solid performance in the Eastern Hemisphere, I see absolutely no reason for our margins to decrease.

Operator

Your next question comes from Geoff Kieburtz - Weeden & Co.

Geoff Kieburtz - Weeden & Co

Just wanted to follow-up on the comment in the press release about the revenue per rig increase in Latin America and Africa, what’s behind that? Is this a trend or is it just a fluctuation that occurred in the quarter?

John Yearwood

That really primarily came from M-I. M-I SWACO had a very good growth in drilling fluids and other related business lines in both Latin America and Africa. You want to add to that, Chris? I think you kind of answered earlier. That wasn’t exceptional and you kind of expect that to continue.

Chris Rivers

Right.

Geoff Kieburtz - Weeden & Co

Maybe, Chris, you could elaborate on your outlook for the Gulf of Mexico in 2010, you do expect it to get better. Can you give us a little more color on what you think is going to happen there?

Chris Rivers

I’m completely frustrated with the Gulf of Mexico in the third and fourth quarters because we have contracts, new contracts, with operators that are just getting delayed started. So the business that we’ve had traditionally has been fine with the exception of one operator that inactivated a couple of rigs in the quarter.

So we didn’t get that offset from new work, which I expect to start in the first quarter even though it hasn’t started to this point. So once that work gets started, we should be back to where we were, if not better than we were in the early part of 2009 in terms of revenue levels. So we’re still very optimistic, but just frustrated that it hasn’t started yet.

Geoff Kieburtz - Weeden & Co

Any senses to the reasons behind the delays?

Chris Rivers

No. I think it’s just poor planning by the operator. There have been some distractions on their side and a couple of changes in plans. It’s nothing that would affect the contract; I think it’s just typical poor planning.

Operator

Your final question comes from Ole Slorer - Morgan Stanley.

Ole Slorer - Morgan Stanley

Chris, just want to discuss the potential margin recovery in M-I SWACO. Was that’s to take it back to old levels as the rig count expands? What component is going to come from pricing and to what extent does fixed cost infrastructure leverage higher activity across your existing infrastructure play a role?

Chris Rivers

Obviously if we get our volumes back, that will have a big role. We won’t have costs back to the same extent. Basically, we’re going to rely on the fact that we have more new technology products than anybody else to rollout to improve our margins in the short term and longer term.

We will address pricing, remembering that we’ve just gone through the most extensive repricing exercise that really anybody’s ever undertaken in the industry. So I mean we all have new prices and a new playing field and we will adjust that based on new technology and negotiations as we go forward.

Ole Slorer - Morgan Stanley

How booked are you at the moment if activity in deepwater let’s say continues to expand, if there is a new play in deep formation on the shelf, if you implement price increases today, what will be the earliest time that you’ll realize those based on your current bookings?

Chris Rivers

I’m not sure there’s much opportunity. You’re talking about if there were a new tender?

Ole Slorer - Morgan Stanley

Yes. I’m talking about if how booked you are at the moment, what the lag in your division when it comes to let’s say if you’re in an up cycle, which I think most people believe, if you have a gentle recovery in drilling global, if market continues to tighten, I’m looking at the estimated margins for your division in consensus looking into 2012, 2011 and I think most people have margins flat, which sort of means that there is an assumption that there is a very limited ability to realize the effect of pricing increases whenever they might come.

Chris Rivers

I see, okay. Well, I think I would be just as conservative as everybody else. It’s a very competitive marketplace, but if we were looking to push prices, it would be later in 2010 that you’d see any impact.

John Yearwood

Chris would be it fair to add that the main mechanism we have to push prices is new technology and product substitution.

Chris Rivers

That’s right, yes.

John Yearwood

So you can actually change the day rate for an engineer or for way right but you look to come with a new system that provides an enhanced value for the operator and for ourselves.

Chris Rivers

We do have new systems for deepwater, for example, that will be start to be rolled out in the second quarter that will probably have an impact, as I say, in the fourth quarter.

Ole Slorer - Morgan Stanley

So really 2011 will be a mix and activity driven margin expansion if at all?

Chris Rivers

Yes.

John Yearwood

Given the tendering cycles it takes some time to bring those prices up. The only exception in I would say we’ll see an immediate increase in margins is ironically in Venezuela. In evaluations you’ll see the margins going up.

Ole Slorer - Morgan Stanley

I have no problem with projections for this year. I’m just puzzled about the kind of flattish expectations in fluids relative to every other segment out there.

Chris Rivers

Yes.

Shawn Housley

Alright, Anthony, I think we’re ready to end the call. But just before we break, here are the final housekeeping items. We expect to release our first quarter results on Thursday, April 29. We look forward to speaking with you then. I’m available today and tomorrow if you have further follow up questions. Thanks for joining the call.

John Yearwood

Thank you, everyone.

Operator

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

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Source: Smith International Inc. Q4 2009 Earnings Call Transcript
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