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Smith International, Inc. (SII)

Q2 2007 Earnings Call

July 24, 2007, 11:00 AM ET

Executives

Douglas L. Rock - Chairman, President, CEO and COO

Michael D. Pearce - President of Smith Technologies

Margaret K. Dorman - Sr. VP, Treasurer and CFO

Analysts

Kenneth Sill - Credit Suisse

Dan Pickering - Pickering Energy Partners

William Sanchez - Howard Weil

Alan Laws - Merrill Lynch

Scott Gill - Simmons & Company

Presentation

Operator

Good morning. My name is Julianne, and I will be your conference operator today. At this time, I would like to welcome everyone to the Smith International Second Quarter 2007 Investor Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]

Thank you. I would now like to turn the call over to Mr. Doug Rock. Please go ahead, sir.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Thank you, Julianne. Good morning and welcome to the Smith International second quarter 2007 investor conference call. I'm Doug Rock, Chairman and CEO of Smith. And speaking today are Mike Pearce, who's President of Smith Technologies, and Margaret Dorman, Senior Vice President and Chief Financial Officer of Smith.

This morning Margaret, Mike and I will speak for about 30 minutes, and then we'll have another half hour to answer your questions. So everyone has a chance to ask questions, please ask no more than two questions at a time. If time permits, you can re-queue and ask more questions later if the call.

Now let's turn our attention to Smith's second quarter 2007 results. Our second quarter 2007 showed continuing strong growth outside North America. Worldwide oilfield segment revenues were up 3.4% sequentially and 26.5% year-over-year. But non-North American oilfield segment revenues were up 8.3% sequentially and 32.2% year-over-year.

Operating earnings excluding last year's $0.02 per share tax gain were up 34% year-over-year. The two fastest growing oilfield segment areas were Latin America where revenues were up 18.5% sequentially and 29.7% year-over-year, and Middle East Asia were revenues were up 7.8% sequentially and 36.6% year-over-year.

Mexico, Venezuela and Brazil had year-over-year average growth rates in excess of 45%. Collectively, India, China and Australia revenues more than doubled year-over-year, and Saudi Arabia, Egypt, and Qatar averaged over 55% growth year-over-year. Year-over-year revenue growth for Europe, Africa and Russia was also up strongly at 30.7%, and Russia and West Africa averaged better than 40% growth year-over-year.

The biggest negative for the quarter was Canada, where revenues declined $98.4 million sequentially to $39.5 million year-over-year. However, our people in Canada did a great job of holding product margins and market share, and coupled with an increase in Eastern Canada offshore drilling, Smith lost just $0.06 per share sequentially in Canada, which was our forecast going into the second quarter.

However, the big question is why did the Canadian rig count hit an 8-year low in the second quarter while the US rig count hit a 23-year high in the second quarter? I don't think anyone foresaw such a radical divergence between the US and Canadian rig counts considering they're both based on primarily land-based natural gas drilling.

Some uniquely Canadian drilling issues include high wage costs, in part due to competition with oilsands projects, phase-out of the royalty trust tax structure, high inflation of oil service prices, overextended small to midsize operators, high operator debt structures, operator buybacks, and regional stranded low price gas.

But whatever the cost, Canadian drilling will return this year or next, but the current situation highlights the fragility of North American land gas drilling. For investors, the second quarter 2007 in Canada is also a good laboratory to test real-time which oil service companies' products, product mix and pricing perform well in a down market.

The second quarter 2007 is also the fifth straight year for Smith when worldwide revenue growth outside Canada more than offset the Canadian breakup revenue decline. That means we now enjoy 18 straight sequential quarters of revenue and operating earnings growth when eliminating such items as tax gains with no slowdown in sight. That's why we're increasing our earnings per share estimate for full year 2007 to between $3.15 to $3.25 per share. The second half 2007 started strongly and should continue through yearend and beyond.

At M-I SWACO, during the first half of 2007, we received over 60% of the contracts we bid that have been awarded to-date. That percent is both on a number of contracts and contract value basis. Also, with today's higher number of exploratory rigs operating, Smith will enjoy additional work when these rigs and fields turn to development drilling in the near future.

Looking now at second quarter results, we did have one significant operating issue. Our sale of drill pipe was $23 million under our forecast due to our supplier having a vendor delivery problem with forgings. The problem is being resolved and we'll be at full revenue levels in the fourth quarter. These sales are commission only to Smith, which is lower margin than most of our other businesses, so the shortfall was about $0.01 per share in the second quarter for Smith.

Our oilfield segment margins continue to move modestly higher, hitting 20% EBIT for the first time in 26 years. Margins should continue to prove in subsequent quarters. During the second quarter, we added 553 employees worldwide to bring our total to 18,646. We'll end 2007 with about 19,500 employees at Smith. Revenue per employee per year was $460,000 for the second quarter, up 4% year-over-year and down 3% from the first quarter due to the Canadian breakup. Revenue per employee will reaccelerate this quarter, the third quarter of 2007.

I mentioned on last quarter's investor conference call that we spent some time talking about technology on this call. After all, it's our people and technology that are driving our results. Today, Smith is approaching 4,000 active patents worldwide. New ideas are sprouting faster than ever and new products are saving our customers money as well as helping them produce more hydrocarbons faster.

Mike Pearce will speak about the improvements in the drill bit and related technologies in a little time. And with about 11% drop in the worldwide rig count from first to second quarter 2007 due to the severe Canadian breakup, Smith Technology revenues were up 2% sequentially due to our employees' efforts and new drill bit technology.

At M-I SWACO, our WARP drilling fluid solution continues to shine. WARP is a patented form of polymer-coated micronized barite. WARP allows longer horizontal drilling sections through a significant reduction in barite sag. WARP revenues more than doubled year-over-year and more than tripled sequentially. More WARP orders for critical wells were received in the second quarter and a second factory for the fluid is being built in the Eastern Hemisphere.

Next, our well bore assurance fluids, which are comprised of completion fluids, including formate, grew nearly 50% year-over year. When we had our completion tools business acquired last year, the revenue year-over-year improvement for the whole group is 75%. Revenues for our well bore assurance group should exceed $600 million this year.

Combining innovative completion tools with integrated completion fluids, this service gives M-I SWACO a leading position in the market. Additionally, M-I SWACO's environmental businesses continue their high growth rate in excess of 30% year-over-year.

Next, Smith Services has recently authored major drilling innovations, which include the RHINOReamer Borehole Enlargement system that Michael will talk about shortly. Another new product is our vertical drilling system, which is essentially a packed-hole drilling motor assembly that utilizes survey tools and full drilling system capabilities. The system has proven itself in the US and international markets and will be a major growth source for Smith Services going forward.

Smith Services is continuing development in managed pressure drilling through improvements in our Rotating Control Device, which is our new HOLD 2500 product, integration of the system with M-I SWACO's pressure control chokes and development of software and peripheral devices. Managed pressure drilling will be a major component of future worldwide drilling activity.

A new version of our Trackmaster Plus Wellbore reentry and sidetracking system accomplishes high-chrome casing alloy melting as well as tooling orientation using our on-point system. We've also seen significant growth in our drilling jars with our new HYDRA-JAR AP tools. In summary, Smith's business is looking up with our quality and our people, new and better tools, and long-term contracts, which recently are averaging more than three years in duration. We see improved results for years to come.

Now Mike Pearce has some comments.

Michael D. Pearce - President of Smith Technologies

Thanks, Doug. Appreciate the opportunity to speak to you this morning. I'm going to discuss Smith Technologies, one of four Smith's business units. We manufacture a range of high performance drilling products, including Smith drill bits, a foundation upon which Smith International was originally built and a full range of hole enlargement tools through our Smith Borehole Enlargement group.

In addition, we provide high-speed turbo drilling services and advanced drilling engineering services, including our I-DRILL drilling simulation and analysis service. Smith Technologies saw improved performance in the second quarter, both sequentially and year-on-year, despite our strong market position in Canada, where drilling activity was particularly weak, with the rig count there declining 51% year-on-year and 74% sequentially.

Second quarter revenues for Smith technologies were $248 million, which is up 2% sequentially and 16% year-on-year. Excluding the Canadian numbers, revenues grew 9% sequentially, outpacing the quarter's 1.5% rig activity increase. The sequential quarter-to-quarter growth was driven primarily by strong PDC rentals in the US Mid-Continent and ArkLaTex region.

Pricing also contributed to the sequential quarter comparison. We realized incremental pricing not only in the US but also in Canada and in the international markets.

In North America where 90% of the diamond bits are run under rental-type arrangements, performance is key to margin expansion. We've had some very good runs on our indictment products this quarter, which helped offset the lower revenue in Canada.

Looking at the regional performance for the quarter versus results for the second quarter of last year, all geographic areas were up with the exception of Canada. Our biggest gains were in the eastern hemisphere where revenues grew 27%.

Next, looking at our gains on a product line basis, Smith Borehole Enlargement growth was particularly noteworthy, up 33% versus last year and 7.5% higher sequentially. We recently commissioned dedicated equipment for the manufacture of RHINOReamers to further enhance the growth of this product line.

On the product development front, our incorporation of i-Drill and i-Bits into the optimization of the bottom hole assembly by balancing the cutting structures in both the RHINOReamer and the drill bit have led to significant reduction in down-hole vibrations. This improvement will increase the market potential of both these tools.

Despite a continuing market shift from roller cone bits to PDC shift, Smith continues to report higher roller cone revenues. This is due to increased manufacturing capacity for large diameter bits in our Italy plant coupled with increased market penetration.

On the PDC side where we were previously experiencing capacity constraints, the addition of two new manufacturing cells at our Houston PDC bit plant and the addition of new press capacity at MegaDiamond, our PDC and diamond cutter manufacturing plant, have better positioned us to take advantage of future market opportunities.

Much of the success of Smith bits over the past few years has been the direct results of what we call our IDEAS design technology. IDEAS stands for Integrated Dynamic Engineering Analysis System, and it has helped accelerate our ability to introduce higher performing bit designs.

Our customers have directly benefitted by getting faster, longer-lasting bits and by avoiding the costly and time-consuming trial-and-error process of traditional bit design. Specific recent successes with our new IDEAS design PDC bits and other Smith Technology developments include the commercialization of our shark bit product line in the key markets of the Rockies, Mid-Continent and Ark-La-Tex regions.

It has been a technology success story. These new bits incorporated new secondary cutting row on each void, the development of VertiDrill PDC bits that use active and passive cutting zones on a single bit to provide a self-correcting bit that always seeks to drill vertically, eliminating the need for costly directional steering systems.

New high-performance bits for drilling the demanding Middle East carbonate formations, which is helping Smith establish new drilling records and increased market penetration in its key high-growth areas. The new line of PDC bits that are used with high-speed turbo drills. This introduction will complement our leading position on imprint bits, which has the advantage of expanding the market for its near-force turbo drills, a market sector where we currently hold over 90% of the worldwide market.

A new high-energy turbo drill or HEAT for short, which is about half the length of a conventional tool but still provides the same power, this new design will not only reduce certain operational costs for our customers, it will make turbo drills a more attractive opportunities to conventional motors in many applications.

The IDEAS tool has enabled us to better predict bit performance. This has improved our design process and enhances our ability to increase value and pricing with our customers. In closing, our investment in technology has positioned us well for continued success.

I'll now turn the conference call over to Margaret.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Great. Thanks, Mike. Good morning, everyone. While the quarter's results evidenced the broad business base of our operations, net income was $53 million or 76 cents per share. That's flat with operating earnings reported in the first quarter and up 34% year-over-year on an operating basis.

You may recall both the periods had favorable tax benefits, 4 cents last quarter and 2 cents in the June 2006 period. We're pleased with the reported results, particularly the sequential margin expansion and incrementals posted by the oilfield segment and the operating units did an outstanding job on the cash flow front this quarter.

We generated $253 million in operating cash flow in the June period resulting from improved working capital management. And due to the limited amount of required capital investment, we saw a significant free cash flow in the quarter.

As expected, the seasonal slowdown in Canada impacted the sequential comparison. Canadian land-based revenues fell $104 million below the March period, which translated into related earnings reduction of 7 cents. The Canadian revenue and earnings decline, however, was offset by strength in other market regions, including the North Sea, Mexico and Asian markets.

Excluding the impact of our Canadian land-based operations, revenues increased 6% on a sequential quarter basis and earnings grew 11%. Consolidated revenues were flat sequentially and 22% above the prior-year levels.

Oilfield segment revenues totaled 1.61 billion, 3% above the March quarter and were 26% higher on a year-over-year basis. Compared to the March quarter, the highest growth areas for the oilfield unit were Asia, which increased 21%, driven by higher revenue intensity in the offshore development area, strong revenue gains in markets such as India, Malaysia, and China, which on a combined basis grew 61% over the March quarter, contributed to the favorable comparison.

The Latin American operations also reported very strong results. Revenues grew 19% influenced by new contract awards in Mexico and increased level of deepwater work for PEMEX and Petrobras.

And finally, our operations in the US remain solid. Revenues increased modestly, driven by the continuing strength in the US land sector, increased incremental pricing and improved deepwater fluid volumes.

I'd hit on the fastest-growing regions, however the geographic distribution for the relevant periods as well as a summary for the oilfield segment is included in schedule one that accompanies the release. With Mike covering the Smith Technologies operation, let me offer some commentary on the M-I SWACO Smith Services and Wilson results.

M-I SWACO had a very strong quarter, influenced by the continuing strength in the offshore market. M-I's revenues totaled $1.09 billion, an increase of 5% sequentially and 28% year-over-year. All of the sequential growth was organic. And after excluding revenues from last August's SPS acquisition, year-over-year base revenues grew 25%.

Sequentially, every geographic region with the exception of Canada showed revenue increases in excess of the underlying rig count with the growth seen in Latin America, Europe and Asia, which on a combined basis increased 15% over the March 2007 period, driven by continuing expansion in the offshore segment.

Offshore revenues grew 16% and deepwater business volumes increased 32% over the second quarter related to the high revenue intensity of onshore projects in the United States, India, Malaysia, Mexico and Brazil.

Continuing with the product line discussion, covering the three primary business segments; Fluids, EPS, which most of you know as SWACO; and well-bore assurance, which includes completion fluids, completion tools, and filtration services

Fluid revenues totalled $711 million for the second quarter, 3% higher on a sequential basis and 22% above the prior-year period. The sequential revenue increase was attributable to an improved business mix in the global offshore market, which resulted in a 14% increase in sales as premium Drilling Fluids, particularly the warp products Doug mentioned earlier in the call.

Our production chemical operations, which are disclosed as part of the fluids group, generated revenues of $61 million in the second quarter, 17% above the March period due in part to new contract awards in the Middle East region.

The EPS product group generated revenues of $216 million, which translates into growth of 6% and 24% over the prior quarter and the prior-year period, respectively. The waste Management business benefitted from higher fluid process equipment sales in the North Sea and Latin America and increased sales of Epcon's produced water treatment systems in the North Sea, also contributed to the sequential quarter revenue improvement.

Revenues for the well bore assurance group totalled $160 million for the second quarter, 14% and 75% higher sequentially and year-over-year respectively. The growth over the March quarter evidences the continued success of our integrated approach towards offering solutions to the completion market, with the improvement concentrated geographically in Latin America, in North Sea, and Asia.

On a geographic basis, M-I saw a strong revenue gains in Latin America, which increased 23% over the March quarter, again, influenced by deepwater projects in Mexico and Brazil. We believe Latin America and Mexico in particular will continue to be a strong market for us. M-I has been awarded nine new contracts in Mexico during the first half of the year. These contracts, which are split between IPM work and projects directly with Pemex are over a three-year period and have a value of roughly $225 million at what we consider to be very good margins.

Turning to Smith Services, we saw a favorable product mix during the quarter, a period which has a tendency to be weak because of the seasonal decline in Canada. Revenues were $280 million for the quarter, 31% above the prior-year period and essentially flat on a sequential quarter basis. As Doug noted, we experienced temporary delays in receiving drill pipe inventory during the second quarter, which resulted in a 17% reduction in associated revenues.

Excluding this impact, revenues grew 4% over the prior quarter, with very strong sales of our drilling jars and other high-margin tools. Excluding tubular sales, the unit posted the strongest geographic revenue growth in the US, and we continue to benefit from our expansion efforts in the FSU, West Africa, and Asia.

Revenues for the distribution segment were below the March quarter, attributable to the severity of the seasonal downturn in Canada, but were 8% above amounts reported in the prior year period. Increased business volumes related to the eastern hemisphere Energy operations, including higher activity levels in the North Sea and project work in West Africa partially offset the Canadian revenue decline.

Let me make just a couple of high-level comments on the income statement, starting with operating income. Consolidated earnings before interest and taxes approximated $332 million or 15.7% of revenues. Oilfield segment margins increased to 20% in the second quarter, 10 basis points above the March period and a 180 basis points higher on a year-over-year basis.

Sequential incrementals for the oilfield segment were 22%, influenced by the loss of high-margin revenue volumes related to the Canadian onshore projects. If we exclude the impact of the Canadian land operations, we generated sequential incrementals of 32%, driven by a favorable product mix. Premium drilling fluids, high-margin drill bits, and downhole tools, as well as incremental pricing.

Distribution operating income totaled $20 million in the second quarter, which translates into 4% operating margins. One quarter of the distribution revenues were generated in Canada in the March 2007 quarter, and accordingly, the significant reduction in Canadian drilling activity impacted the reported results.

Wet weather conditions in the Central US in June and slightly higher operating costs also adversely impacted the sequential financial performance. As for the rest of the income statement, net interest expense declined $1.1 million from the March quarter, reflecting the moderate level of debt repaid during the quarter.

On the tax front, our effective rate was 32%, and after adjusting for the non-recurring tax benefit recorded in the first quarter, the rate was inline with the March rate. While changes in the geographic distribution further earnings will continue to drive increases and decreases in our quarterly rate, we believe our 2007 full-year tax rate should remain around 32%.

Detailed balance sheet information has been included as part of the earnings release document, so I'll just make a few brief comments. Our balance sheet remains very strong. At the end of June, we had outstanding debt of $1.04 billion and our debt to total capitalization declined to 24% 2.8 percentage points below the March level. Again, our operations did a great job of managing the working capital this quarter, which enabled us to reduce debt levels by $104 million.

We were successful lowering the DSOs by three days and didn't build a significant amount of inventory in the period. So we ended up with a positive net working capital inflow for the quarter. Not sure how much better receivable collections can be we're in the low 60s today. But we’ll continue to focus on the balance sheet, to see if we can generate further improvements.

In addition to the debt repayments, we funded $21 million of stock repurchases, roughly 400,000 shares at an average price of $53.32 a share, $28 million of partnered distribution and $20 million of regular dividends during the second quarter.

Net capital spending in the June quarter totaled $82 million, roughly $20 million above the first quarter amount driven by the higher level of investment and rental equipment for new contract awards. After illuminating our minority partner's interest in capital additions, capital spending approximated $64 million for the period.

We're forecasting 2007 net capital spending of $300 million, up slightly over our previous guidance influenced by new equipment, which will be required to support some of the contract awards in Mexico and other markets. This compares to a depreciation and amortization estimate of $195 million. Depreciation in the second quarter of 2007 was $48 million, which translates into $36 million after considering our minority partner's interest.

So with that I'll hand the call back to, Julianne, for questions.

Question and Answer

Operator

[Operator Instructions]

Your first question is from the line of Ken Sill with Credit Suisse.

Kenneth Sill - Credit Suisse

Hi, good morning.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Hi, Ken.

Kenneth Sill - Credit Suisse

Looking at the results, everything seems to be doing pretty well. I guess, I'm kind of interested as you look out into next year, you've got really strong project awards, international strength is very, very good. What kind of year-over-year growth do you guys expect to see, over the next few years on the international versus North American side?

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

This is Doug. I mean, it's hard to put a number on it right now. Certainly, on the international, we talked about 32% growth non-North America on the oilfield segment. Whether it continued – we’re seeing I mean from where I sit right now compared to where we were last quarter at this time, I'm certainly more positive because of the number of... not just the number of contracts, but the duration of those contracts, as Margaret mentioned, averaging better than three years, so we feel good about that.

The unknown is how many of the new rigs come in, how many we see a lot of additional land rigs being built for the international markets, which is hard to estimate. But certainly we see going forward the kind of growth that we have right now. And it could accelerate if all those rigs go to work quickly.

Kenneth Sill - Credit Suisse

So you're not seeing any deceleration, you actually think, it's going to be maintain this growth or better as we're go forward?

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

No in fact it’s the big markets that I mentioned, some of them more than doubling they’ve really just getting started. I mean it's taken three or four years for the higher oil prices to sink in, to get a number and particularly when you go into Asia Pacific area, we're just really seeing that market heat up.

Kenneth Sill - Credit Suisse

Okay. And then kind of a housekeeping question for Margaret, that depreciation guidance for the year, I'm assuming that's $195 would be the gross number?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

That's correct, Ken.

Kenneth Sill - Credit Suisse

Okay. And did you have a net number or just assume that we're going to have about the same amount?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

I'd use about the same percentage. I can give you a net number, but, yeah, that's gross number.

Kenneth Sill - Credit Suisse

That's fine. And then, on the share repurchases, share count was actually still up a little bit. Are you guys, planning to try to keep the share count roughly flat or is there any kind of overarching strategy in the share repurchase?

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

With the number of shares still authorized to purchase, we actually hope to be reducing it. We've been doing some acquisitions and some buybacks, but if we don't do a lot of acquisitions, we'll do more buybacks. But the intention isn’t to keep it flat, it’s to reduce it.

Kenneth Sill - Credit Suisse

All right. Thanks. I'll let somebody else ask a question.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

You're welcome.

Operator

Your next question is from the line of Dan Pickering with Pickering Energy Partners. Mr. Pickering, your line is open.

Dan Pickering - Pickering Energy Partners

Good morning, sorry about that.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Yeah, morning, Dan.

Dan Pickering - Pickering Energy Partners

I don't know how to operate the mute button, I guess. Mike, since we've got you on the line here, bit pricing, we continue to hear competitors talk about efforts to push price. Can you just give us a view for what you're seeing in the marketplace from a competitive perspective, is that market remains disciplined, anybody looking for share out there?

Michael D. Pearce - President of Smith Technologies

Hi, Dan. As always, Dan, if you deliver value and performance to the customers, especially in North America where everything is on a rental basis. If you're delivering performance, they're going to allow you to charge more, you'll get more runs, more footage, and that will equate to more margin dollars. So we don't see that changing.

Dan Pickering - Pickering Energy Partners

Mike, is there any, I guess, with activity relatively flat, do you see this rental market... is it in general taking share from bit sales and is that a net positive for Smith?

Michael D. Pearce - President of Smith Technologies

Margaret?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

I think, Dan, you're just talking about the margins on a rental versus a sale.

Dan Pickering - Pickering Energy Partners

Correct.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

And again, I think as Mike pointed out, with some of the runs, I think, if you look at the quarter's results, I was very pleased with the amount of pricing that we received, not only on the sale side, but also the footage basis for the rentals. So we'd tell you the margins are very good in both the sale as well as the rental business.

Dan Pickering - Pickering Energy Partners

Okay. That's helpful. And then Margaret, while I've got you, you were helpful in terms of helping us understand the incrementals ex the Canadian business. I guess, if we looked on a year-over-year basis now, I'm thinking about incrementals, and the oil patch for you guys has been very consistent, running right around 27%, 28%.

As you look out into '08, is there any reason to think that that number would pick up with an international mix increase or do we hold steady kind of right here at this level?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

I mean you're right, Dan. And if you look at the oilfields, the incrementals year-over-year, we're talking around 27% and they've been in that high 20 range. It's really going to be dependent on the business and the mix of the business.

I think we had a very good, as we pointed out in our commentary, we had a very good mix this quarter and it's all going to be dependent on where you see the business, you’re adding thing done.

Michael D. Pearce - President of Smith Technologies

Yeah. Just with Canada being so very high in margins particularly embeds to some other tools, its back-up to the mid-300 kind of rigs, which will help. But if we can get that up into the 400 to 500 range, that certainly helps our margins. That's why we tend to have flatter margins from first to second quarter every year, because we lose a lot of that high Canadian margin business.

Dan Pickering - Pickering Energy Partners

Okay. Great. So we should see some pickup there as we move into the second half of the year.

Michael D. Pearce - President of Smith Technologies

Yeah. We help above with Canada picking up, yeah Canada is still running 30% year-over-year under where it was, so you're not going to see the strength in pickup. At least for right now, that you saw on prior years, so for the $ 0.06 that we lost, which includes the offshore penny that we gained in Canada first to second, and you may see a couple cent pickup, but typically, we were talking $0.03or $0.04 in the past when the rate count would get back up to 500-550 quickly in the third or fourth quarter little bit moderated.

Dan Pickering - Pickering Energy Partners

Okay. Thank you.

Michael D. Pearce - President of Smith Technologies

You’re welcome.

Operator

[Operator Instructions]

Your next question is from the line of Bill Sanchez with Howard Weil.

William Sanchez - Howard Weil

Good morning.

Michael D. Pearce - President of Smith Technologies

Yeah. Good morning, Bill.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Good morning, Bill.

William Sanchez - Howard Weil

Margaret, I was hoping perhaps you could update us, just as it relates to kind of the overall oilfield EBIT margin outlook for the balance of the year. I think in earlier comments, you had expressed maybe as much as 200 to 300 basis points of margin improvement in oilfield on a year-over-year basis.

Just curious and certainly I appreciate the high decrementals in Canada, but given the continued mix shift we see certainly the impressive offshore revenue growth we saw on the quarter, which is also a high margin. Can you give us a feel of kind of how overall EBIT margins you’re thinking about over the year?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Yeah. I think what we have traditionally talked about, Bill is, our expectation, we've targeted 200 to 300 basis point growth in our year-over-year oilfield margin, so this year, year-over-year, the second quarter, we saw just under that, 180 basis points. So with what we see in the business, I think we were pretty pleased with the reported margin expansion.

We've seen good pricing, we've seen a good mix. Our expectation is still going to try to put those margins 200, 300 basis points year-over-year, but we're focused on doing as well as we can with the business growth that we see. And I think we're going to continue to try to get the best margins... margin expansion that we can.

Michael D. Pearce - President of Smith Technologies

I would comment that with the rollout of all of our new contracts, we are training record numbers of people and there is always a slight depression getting ready for those contracts. If we ever hit a steady state point, which I'm not predicting over the next couple years, there certainly would be a natural increase in margins. In fact, we just graduated some... the whole class full of field bit technology people and they're training with us six months each. So I mean these are quite costly things.

William Sanchez - Howard Weil

Understand. Mark, can you update us, has there been any change as it relates to your market share on the deepwater fluid side? I believe in the first quarter you had seen that share going to 55% up from 50% in the fourth quarter, was there any noticeable shift in the second quarter results on the deepwater fluids?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

No. And you're talking about the US?

William Sanchez - Howard Weil

No. I'm just talking about overall just deepwater as a whole.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

US, I think at the end of June, we were on 22 out of 38 deepwater rigs. So that's about 58%, and I think, you know, on a worldwide basis, we're still, you know, right over half of the market.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Yeah. That was a US gulf number. So it's about the same.

William Sanchez - Howard Weil

Okay. Thank you.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

You're welcome.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

You're welcome.

Operator

Your next question is from the line of Alan Laws with Merrill Lynch.

Alan Laws - Merrill Lynch

Good morning.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Good morning, Alan.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Good morning, Alan.

Alan Laws - Merrill Lynch

It's kind of a maybe a little different question, but a few years back you were trying to consolidate the distribution business with your interest in CE Franklin there, you had a deal on the table that didn't quite work out, but now that the Canadian market has sort of gone into a little bit of a dive here, and valuations are lower, perhaps, for than in other periods of time, like even two years ago, is it maybe time to look at that again, and Is there any strategy around that? Have you thought about that?

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Yeah. I always thought. I mean, I can't talk about specific thing. But certainly, we believe that consolidation is the way to go and we're continuing to talk to other parties and there's still an opportunity there. I can't talk about one versus the other. But that opportunity is still there, and we're continuing to pursue it.

Alan Laws - Merrill Lynch

Okay. That's all I had. Thanks.

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Thank you.

Operator

Your next question is from the line of Scott Gill with Simmons & Company.

Scott Gill - Simmons & Company

Margaret, on the... when you talk about the M-I business, you mentioned five contracts awarded during the first half of 2007 from Mexico. I guess, I'm wondering, what's kind of the outlook for the back half of the year, are there still more contracts being evaluated for award, number one, and number two, if you can talk about how your other product lines either fit into those contracts or, you know, what the prospects are outside of those contracts?

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Scott, let me clarify. M-I was awarded nine.

Scott Gill - Simmons & Company

Right.

Margaret K. Dorman - Senior Vice President, Treasurer and Chief Financial Officer

Nine new contracts in the first half of the year. Again, a mix of half-and-half IPM and directly with PEMEX. I want to say that seven of those started during the quarter. We see a couple more that began in the third quarter, but I think the outlook for the year is very strong. Mike, do you want to add on what you're seeing on the SBE front?

Michael D. Pearce - President of Smith Technologies

Yeah. Both SBE and bit sales should be enhanced with these contracts, both with IPM and D&M contracts.

Scott Gill - Simmons & Company

And Mike, just for you, on your... when we talk about the North America business model moving more and more towards rentals as opposed to sales, is that model going to unfold for the international market as well, do you think?

Michael D. Pearce - President of Smith Technologies

Probably not. In that model in the US is... it's there. I mean we're at probably 90% rental right now. And the problems you have internationally is, you've got customs and taxes associated with the importation of a lot of these bits, so it's really not set up to accommodate a rental-type scenario. Plus, you need a rental repair facility.

Scott Gill - Simmons & Company

Would you say that that is a more ideal business model for the bit business or, which one is kind of the ideal from a profitability standpoint?

Michael D. Pearce - President of Smith Technologies

They are both very profitable.

Scott Gill - Simmons & Company

Okay. All right. Thank you.

Operator

There are no further questions at this time. Mr. Rock, are there any closing remarks?

Douglas L. Rock - Chairman, President, Chief Executive Officer and Chief Operating Officer

Yeah. Thank you for joining us for our second quarter conference call, and we look forward to speaking with you in about three months at our third quarter call. Thanks again.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Smith International Q2 2007 Earnings Call Transcript
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