Smith International: Strong Leverage, Improved Fundamentals

Apr. 4.07 | About: Smith International (SII)

Smith International's (SII) shares have run up strongly in the recent past, reflecting the company's improved fundamentals and its strong leverage in the growing Eastern Hemisphere markets. The company's domestic operations also continue to remain strong.

Smith's diversified business mix, characterized by exposure to short-duration and relatively volatile domestic natural gas market, and a long-duration, but relatively stable offshore international markets provides it with attractive growth opportunities. We have increased our 2007 EPS estimate ($3.25 vs. $3.10) and introduced our 2008 EPS estimate at $3.79.

OVERVIEW
Houston, Texas-based Smith International, Inc., (SII) is a major oilfield services company, engaged in providing a comprehensive line of products and engineering services to the oil and gas exploration and production industry, as well as to the petrochemical and other related industries. The company provides its products and services worldwide through four business units, which are grouped into two reportable segments: Oilfield Products and Services, and Distribution. The Oilfield Products and Services segment consists of three business units: M-I SWACO, Smith Technologies, and Smith Services. The distribution segment includes the Wilson business unit, which is engaged in marketing pipe, valve, safety, and other maintenance products to the energy and other industrial markets in the U.S. and Canada. The M-I SWACO segment, which is a 60/40 joint venture with Schlumberger (NYSE:SLB), provides drilling and completion fluid system, engineering, and technical services to the oil and gas industry. Smith Technologies designs, manufactures, and sells three-cone drill bits, diamond drill bits, and turbines for use in drilling oil and gas wells. Smith Services manufactures and markets products and services used in the oil and gas industry for drilling, workover, well completion, and well re-entry.

Performance of oilfield service companies, including Smith International, is closely tied to capital expenditures by oil and gas companies on exploration and production [E&P] activities. Peak cycle commodity prices since early 2005 have significantly strengthened producers cash flows and balance sheets, enabling producers to ramp up their E&P spending gradually, particularly in the offshore markets.

Fundamentals of the natural gas market have a direct bearing on drilling activities in North America, as the predominant majority of E&P activities in this region are natural gas focused. As such, oilfield activity levels in this region (particularly the onshore areas of the U.S. and Canada) closely track the outlook for natural gas prices.

Also, projects are typically of shorter durations and simpler in complexity, giving operators the flexibility to promptly respond to changes in commodity prices. Despite the pullback in natural gas prices since early last year, natural gas focused drilling activities (as measured by regional onshore rig counts) currently remain at cyclical highs.

Over 82% of the current North American rig count is focused on natural gas finding and development activities. On the other hand, drilling activities in the international markets, particularly in the deepwater (offshore) areas, are more long-term and complex in nature and typically target crude oil. Given the relatively high costs of most of such projects, only the major oil companies and national oil companies undertake such projects as part of their long-term strategic plans. As a result, international oilfield activity levels are relatively less commodity-price sensitive and volatile compared to the North American market.

Although close to 60% of the company's 2006 consolidated revenue was generated in North America, Smith s profitability was largely dependent upon business levels in markets outside of North America. The Distribution segment, which accounts for approximately 26% of consolidated revenue and primarily supports a North American customer base, serves to distort the geographic revenue mix of the company. Excluding the impact of the Distribution segment, 55% of the company s 2006 revenue was generated from markets outside North America.

Smith, therefore, enjoys strong leverage to these markets, where activity levels are ramping up significantly. Given its geographically diversified footprint, Smith International remains well positioned to capitalize on these favorable trends. The company's revenue and margin growth thus far has mostly been driven by its North American operations. With the ongoing ramp up in international and offshore activity levels, Smith International should continue to enjoy above-average revenue and margin growth.

Geographic areas that are expected to strengthen include Europe/Africa, with the North Sea and West Africa as the main drivers. Last year, the company's revenue on a year-on-year basis grew more than 47% in this region, while revenue in the Middle East/Asia region increased approximately 43%, signifying the company s strong leverage to Eastern Hemisphere markets. Also, despite the relatively tentative near-term outlook due to weak natural gas prices, we expect North America to be strong with good performance from Canada and the U. S. offshore.

Smith International is also experiencing pricing power in many of its products, particularly in the domestic market. The price increases are in part due to increasing costs of raw materials; however, the company has been able to pass on more than just the cost increases. We expect the price increases to continue to help top-line growth throughout the year as new contracts reflect the higher prices.

Smith International has an established track record for developing and commercializing premium products and services that command higher prices and generate higher margins. The company has successfully used a combination of internal product-development efforts and acquisitions to remain technologically competitive. It is currently leading the way in developing synthetic drilling fluids and innovative drilling waste remediation systems.

We believe that Smith's focus on more profitable synthetic fluids development not only sets it apart from competition, but also positions it to take advantage of deepwater drilling opportunities. On the acquisitions front, Smith has acquired more than $400 million worth of proven products from niche industry players over the last three years. During 2006, the company completed seven acquisitions in exchange for an aggregate amount of around $227 million.

Notable transactions included the Epcon Offshore acquisition, a Norway-based global provider of proprietary water treatment technology designed to optimize the removal of hydrocarbons from water generated during the production process, and the Specialised Petroleum Services Group Ltd., a global provider of patented well-bore clean-up products and engineering services used to remove debris from the wellbore to facilitate improved well production.

Given its strong balance sheet (current debt-to-total capitalization is about 35%), the company continues to have the flexibility to pursue such bolt-on acquisitions. Smith also remains focused on returning capital to shareholders. It initiated a regular quarterly dividend in 2005 and raised it by 33% to the annualized run rate of $0.32 per share in March 2006.

In February of this year, the company again increased the quarterly dividend rate by 25% to the annualized run rate of $0.40 per share. The company also remains active on the share buyback front, having already re-purchased 2.7 million shares since its October 2005 buyback authorization of 20 million shares, leaving a remaining authorization of 17.3 million shares. Given the company's improved fundamentals, we expect it to generate sufficient free cash flow going forward, which will mostly be used for returning capital to shareholders.

INDUSTRY OUTLOOK

Our outlook for the oil machinery, services, and drilling industry is neutral. This view is based more on valuation than long-term fundamentals. After rising 50% and 30% in 2005 and 2004, respectively, the Oil Service Index [OSX] gave back most of the gains from the first half of 2006, finishing the year up only about 4%.

Year to date, the index is up about 5%, compared to a loss of about 2% for the broad equity markets. The index s performance mirrors crude oil and natural gas prices, which, while down from recent highs, still remain at healthy levels. While valuations are no longer stretched following the recent sell off, it will pay, in our view, to be selective.

The North American land drilling market remains strong, as confirmed by the current North American rig count that has reached prior cyclical peaks. However, given the land drilling market's natural gas exposure and the commodity's relatively weak near-term fundamentals, activity levels appear to have softened some, which has produced some signs of weakness in leading edge dayrates.

Offshore markets, both in the Gulf of Mexico as well as other international regions, remain strong. Pricing power continues to improve, particularly in the deepwater segments, as growing exploration and development outlays by oil and gas producers sustain steady demand growth. Recent newbuild announcements, while still at manageable levels, indicate that this favorable macro environment may have already started attracting new capital and additional supply. This may limit the group's long-term dayrate gains prospects.

We prefer companies with late-cycle and international exposures. We believe that national oil companies [NOC], particularly in OPEC-member countries, will significantly increase their capital budgets over the next few years. Technologies and services that promise to improve recovery from existing fields, in addition to conventional exploration and development-related products and services, will be needed. Industry players with long-standing relationships with NOCs will be key beneficiaries of this trend.

INDUSTRY POSITION
Smith International is a leading player in the highly competitive oilfield services industry. Despite its strong market share positions in each of the product categories that it competes in, Smith International faces stiff competition from other major oilfield service companies and smaller regional players. The company's technologically advanced product offerings and its global operating presence give it a competitive edge over its smaller competitors.

In bringing new products and services to the market, the company has supplemented its internal development efforts with acquisitions. In the last three years, Smith International has acquired more than $400 million worth of proven products and technologies. With a current debt-to-total-capitalization ratio of about 35%, it continues to maintain the financial flexibility to pursue acquisitions. In the global drilling fluids market, Smith International s primary competitors are Baker Hughes (NYSE:BHI) (the INTEQ division), Halliburton (NYSE:HAL) (the Baroid Drilling Fluids subsidiary), and a number of smaller, locally based competitors.

In the completion fluids market, the company's major competitors are Halliburton, Tetra Technologies (NYSE:TTI), and BJ Services (BJS). Schlumberger (SLB), a global oilfield services giant, is Smith International's 40% joint venture partner in its M-I SWACO business unit.

The key competitive factors in these two markets include wellsite engineering services, product availability, service response and price. Smith International is a recognized leader in the design, manufacturing, and marketing of drill bits used in drilling oil and gas wells.

The company's drill bit offerings are primarily geared towards the premium market segments, where faster drilling rates and greater footage drilled bring down the operator's total cost of a well. Smith International's primary competitors in this market segment include Halliburton, Baker Hughes, Grant Prideco (GRP), and more than 20 smaller players.

RECENT NEWS
Smith International will report its first quarter results on April 25. We expect the company's earnings to be approximately $0.73 per share, significantly up from the year-earlier level. We have raised our full-year EPS estimate ($3.25 vs. $3.10) and introduced our 2008 estimate $3.79.

On February 7, Smith International announced a 25% increase in quarterly cash dividend to $0.10 per share. The new dividend will be paid on April 16 to the shareholders of record on March 15, 2007. On January 30, Smith International reported modestly better than expected fourth-quarter 2006 earnings of $0.71 per share (our estimate was for $0.70 per share), compared to $0.45 per share in the yearearlier quarter.

The solid year-over-year gain was primarily driven by strong performance from the company's Eastern Hemisphere operations, which posted revenue growth of 40% over the prior-year level due to continued expansion in drilling activity in the region. Earnings for the full year of $2.47 per share were well within management s earlier guidance of $2.45 to $2.50. Revenue increased 4.4% sequentially and 30.7% year over year to $2.0 billion.

The sequential revenue improvement is primarily attributable to a 9.8% increase in Eastern Hemisphere business volumes that was favorably impacted by growth in West Africa, the Middle East, and the Former Soviet Union. All six of Smith's geographic markets grew on a sequential as well as on year-over-year basis. Revenue generated from the company's North American operations increased 1.5% sequentially and 25.6% year over year to $1.14 billion.

Non-North American revenue registered 8.7% sequential and 38% year over year increases to $855 million. With respect to business segments, M-I SWACO s fourth quarter revenue totaled $980 million, up 4% sequentially and 34.8% year over year, driven by continued momentum in the Eastern Hemisphere, especially higher offshore revenue from West Africa and the Middle East.

To a lesser extent, increased demand for environmental waste management services in the former Soviet Union, the inclusion of a full quarter of revenue associated with the Specialized Petroleum Services acquisition, and incremental product pricing also contributed to the increase. After excluding the impact of acquisitions, base revenue grew 3% sequentially and 31% year over year. Smith Technologies reported fourth quarter revenue of $218.3 million, up 6.2% sequentially and 30.3% year over year, primarily reflecting increased diamond and three-cone product penetration in Europe/Africa, higher offshore activity in Asia, and the inclusion of a number of large export orders.

Excluding the impact of export sales, revenue was up 2% sequentially and 31% year over year. Smith Services revenue was up 8.7% sequentially and 47.5% year over year. Approximately 80% of the sequential revenue growth was reported in North America, driven by higher sales of drill pipe and other tubular products and services. Wilson reported fourth quarter revenue of $512.9 million, up 2.3% sequentially and 16.3% year over year.

The improved performance reflects higher business volumes in the energy sector operations related to new contract awards, partially offset by reduced downstream and industrial sales related to the timing of project spending in the engineering and construction sector. Overall oilfield operating margin increased 310 basis points from the year-earlier level and 30 basis points from the prior-quarter level to 19.5%.

On the call, management indicated that they expect first quarter 2007 revenue to increase more than 20% year over year. Management also expects that based on recent price increases initiated at both Smith Technologies and Smith Services and new contracts with higher price at M-I SWACO, momentum of margin expansion will continue into 2007. At the end of the year, the company had $80 million in cash and $1089 million in debt (including short-term borrowings of $288 million). The year-end total debt-to-capitalization ratio stood at 35.4%

On September 28, Smith International was added to the S&P 500, replacing Golden West Financial, which was acquired by Wachovia. Inclusion in this key index will enable the stock to attract index-fund money, which should support valuation.

VALUATION

We believe that the company remains well positioned to capitalize on the current cycle through its diversified base of operations and value added product and service offerings. We project steady margins gains going forward on the back of already announced and expected price hikes. We have raised our price objective as we believe that despite the stock s recent run up, there is further space for upside.

Our new target price $52, up from $48, reflects 2007 EV/EBITDA and P/E multiples of 7.0x and 16.8x, respectively, within historical trading ranges.

RISKS

  • Oilfield services stocks are highly volatile and their movements exhibit more correlation with shortterm commodity price fluctuations than underlying long-term performance potential. A sustained pullback in commodity prices would severely impact the current oilfield cycle.
  • The oilfield services industry in extremely competitive, which could negatively impact margins and the company's ability to increase prices. Recent acceleration in dayrates in certain areas may cause operators to delay or forgo projects.
  • A deceleration in U.S. rig count could impact Smith International's outlook. Demand for the company's products and services is largely dependent on its ability to provide leading-edge, technology-based solutions that reduce the operator's overall cost.
  • Competitive or other market conditions may impact the company's ability to continue providing superior-performing product offerings, and accordingly financial condition or results of operations could be adversely impacted.

  • INSIDER TRADING AND OWNERSHIP

    Institutional shareholders own approximately 89% of the company s outstanding shares. Fidelity Management and Research Company (owns 10.6% of the total outstanding shares), Price Associates (9.1%), and Capital Research & Management Company (7.8%) are the company's top three institutional owners.

    Institutional shareholders have been net sellers of the stock in the recent past. Insiders have a stake of about 5% in the company, and have been net sellers. Short interest at approximately 5 days is relatively on the higher side.

    KEY POINTS

  • While near-term commodity-price weakness will weigh on the stock price, the company s long-term
    prospects remain positive, given its leverage to continued strength in oilfield activity levels in the international and North American markets.
  • We expect continued improvement in the company's revenue and margins over the next few
    quarters, driven by price increases and demand growth.
  • The company's strong balance sheet gives it the flexibility to continue making acquisitions.
    We believe that the initiation of a quarterly dividend and a 20 million buyback authorization in 2005 are indicative of management s optimistic view of the future.
  • Smith International's addition to the S&P 500 provides useful valuation support in the current
    relatively weak macro backdrop.
  • SII 1-yr chart: