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Executives

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

Don McKenzie - President and CEO of M-I SWACO

Margaret Dorman - SVP and CFO

Analysts

Ken Sill - Credit Suisse

Rob Mackenzie - SBR

Scott Gill - Simmons & Company

Dan Pickering - Tudor Pickering

Robin Shoemaker - Bear Stearns

Kurt Hallead - RBC Capital Markets

Jim Crandell - Lehman Brothers

Alan Laws - Merrill Lynch

Geoff Kieburtz - Citigroup

Brad Handler - Wachovia Capital

Smith International Inc. (SII) Q3 2007 Earnings Call October 23, 2007 11:00 AM ET

Operator

Good morning ladies and gentlemen, and welcome to the SmithInternational Third Quarter 2007 Investor Conference Call. At this time, allparticipants are in a listen-only mode. Later we will conduct aquestion-and-answer session. Please note that this conference is beingrecorded.

I will now turn the call over to Mr. Doug Rock. Mr. Rock,you may begin.

Doug Rock

Thank you, Tatiana. Good morning, and welcome to the SmithInternational Third Quarter 2007 Investor Conference Call. I am Doug Rock,Chairman and CEO of Smith; and speaking today are Don McKenzie, who isPresident and CEO of M-I SWACO, and Margaret Dorman, our Senior Vice Presidentand Chief Financial Officer. This morning, Margaret, Don and I will talk forabout 30 minutes and then we'll have another half hour to answer yourquestions. So that everyone has a chance to ask questions, please ask no morethan two questions at one time. If time permits, you can re-queue and ask morequestions later in the call.

Now let's talk about Smith's third quarter 2007. Overall,Smith third quarter 2007 revenues increased 17.3% year-on-year, and 6.2%sequential quarters. But once again the story is all about growth in the Eastern Hemisphere and Latin American markets.Year-on-year, our oil field segment revenues grew 19.3%, but Eastern Hemisphereand Latin American combined revenues grew 30% with a corresponding rig countgrowth of 8.4%.

Our products and services are more suited to complex anddeep drilling, and completions along with high-temperature, high-pressureoperations. That's why our revenues expand much faster on a smaller rig countgains in the Eastern Hemisphere and Latin America.Most North American drilling rigs are land based, and drill on average, shallowless cost of the wells.

Year-on-year for the quarter, the North American rig countwas down 3.4% and revenues were up 7.8%. That's not bad considering theCanadian rig count was down about 30% year-on-year for the quarter.

Margins held steady force in North America, as our product mix has not been affected by theoversupply of products or services with high capital cost content.

We did see some softness in the deep U.S. Gulf market duringthe quarter, but one should see recovery in that market over the next twoquarters as five deepwater rigs are added, bringing the U.S. Gulf deepwater rigcount to 42 rigs, which will tie an all time high. Our market shares in thedeep Gulf are also at a historic high.

The two hurricanes that threatened the Gulf coast cost usabout $10 million in third quarter revenue, about $0.01 per share in profits.Our top performing geographic market for the third quarter was again Latin America, which grew revenues of 20% sequentiallyand 49% year-on-year.

Latin America trailed Eastern Hemisphere growth over the past two years, but it’s now catchingup. Growth in Mexico, Brazil, Argentinaand Columbia led the way, and Venezuelawasn't far behind.

Year-on-year, in both Europe and Africa, and the MiddleEast/Far East areas, revenues grew 27%,although sequentially, the Middle East/Far East revenues were slightly down.That's because we have some softness in the region after many quarters of highgrowth. We sold the business in Omanwhich accounted for 12.5 million revenue quarter reduction. Sequentially,Middle East/Far East comparison would be more favorable this quarter.

The highest growth areas in countries in the EasternHemisphere included all areas of West Africa, the former Soviet Union, Egypt, Qatar, Indiaand Australia, New Zealand. Malaysia, Indonesiaand Saudi Arabia, and bothmajor sectors of the North Sea also showedsolid growth.

Our Drill Pipe business, which was impaired last quarter bysupplier manufacturing firms returned to a pre-second quarter revenue levelsand were $16 million higher in revenues last quarter.

Turning to profitability, Oilfield segment earnings were up8% sequentially and 28% year-on-year. The primary detractor from higher margingrowth was mixed, as worldwide offshore revenues declined and land rig revenuesgrew. Again, this situation has reversed itself in the fourth quarter. Don andMargaret will give you more specifics concerning this issue.

Revenue per employee for the quarter was $474,000 per year,an increase of 3% from last quarter. We added 600 people in the quarter and nowhave 19,250 full-time employees at Smith.

Last week, we announced the purchase of a minority interestin At Balance, which is the Shell Technology Venture Company. At Balance is atechnology leader in the Managed Pressure Drilling business and combined withSmith's capabilities and well pressure control, drilling chokes and softwareand rotating pressure control devices make Smith/At Balance have a highcapability to be a force in the Managed Pressure Drilling business, which weare in today and it's expanding fast.

Now turning to our business units: Smith Services againshowed the best revenue gains, with 13% sequential and 31% year-on-year growth,strong revenue increases for completion equipment, pressure control, drillingdevices, tubulars, both rentals and sales, drilling jars, stabilizers andreamers all contributed to the growth.

M-I SWACO's sequential revenue gain of 2.2% was dampened byweaker offshore drilling, which will recover this quarter, but M-I SWACO'syear-on-year growth was a credible 18%.

Year-on-year WARP, a micronized barite fluid, had sales morethan doubled, and Production Chemical's waste management and specializedcompletion tools all gained considerable volumes.

Smith Technologies had solid sequential and year-on-yeargrowth in revenues with the highest growth rates coming from diamond bits andborehole enlargement systems, and finally Wilson,a good sequential and year-on-year growth despite the 30% decrease in Canadianrig count. Wilson's year-on-year growth for theEastern Hemisphere and Latin America exceeded 85% and now accounts for 6.5% of Wilson's revenues.

Finally, as we look towards the fourth quarter 2007, 2008,we have several opportunities and challenges. Clearly the growth rate in NorthAmerica experienced over the last five years had decelerated and will needhigher sustained gas prices, probably $8 per MCF range till we accelerate to North America.

The proposed Alberta Royalty increases for oil, gas and oilsands productions causes uncertainties for our customers going into 2008. EdStelmach, the premier of Alberta will address this issue in a speech thisThursday, but a more in-depth government response will likely come several dayslater from the both the Premier Stelmach and Energy Minister Mel Knight.

With that said, worldwide fourth quarter 2007 activity looksbetter to us than the third quarter. The worldwide drilling outside of North America will be better in 2008 than 2007. ForSmith, our full year 2007 earnings per share results should come in near thetop of our previous guidance of $3.15 to $3.25 per share. Our guidance hasalways is GAAP and it includes the $0.04 per share tax gain in the firstquarter of 2007.

In summary, Eastern Hemisphereand Latin American growth looks to be assured over at least the next severalyears, but North American activity should remain static until natural gasprices improve and the uncertainty of the Alberta Royalty issue is resolved inan industry favorable manner.

Now, Don McKenzie has some comments.

Don McKenzie

Thank you Doug, good morning. I am going to discuss M-ISWACO. First, I will make some overall comments, then address the deepwatermarket, new technologies and individual business segments. Third quarter revenuesfor M-I SWACO were $1.115 billion, approximately 2% higher than the secondquarter of 2007, and 18% higher than the third quarter of 2006. This is ourthird billion-dollar quarter, and revenues have now increased in 20 consecutivequarters.

Rig activity as measured by the M-I SWACO global rig countincreased 9% for the second quarter to average 4398 rigs. The worldwide rigcount increased 6% in Q3 as compared to the third quarter of 2006.

Eastern Hemisphere grew2.8% sequentially and now accounts for 56.9% of total M-I SWACO revenue. LatinAmerican revenues grew 19.8% sequentially, and accounts for 14% of total M-ISWACO revenues.

North American revenue fell by 5.5% in the quarter and NorthAmerican revenue now accounts for 29.2%.

Total offshore revenue for M-I SWACO was $534.8 million inthe third quarter. This is a decline of 10.1% from the prior quarter. This$60.4 million decline is comprised of 13 days of revenue losses due toprecautionary shutdowns in the Gulf of Mexico because of storms, as well as, alower active deepwater rig count due to repairs in rig move and delays tointernational contract starts where we are the incumbent. The offshore rigreduction was offset by $84.4 million in land-based revenue increase.

Now, let's look at the deepwater market. The average numberof rigs operating in the deepwater market declined 10% in the third quarter.The rig count engaged in drilling and completion of operations averaged 33.8units. The reduction of 3.3 rigs from the second quarter was primarily due torig repairs and the impact of weather in the quarter. Of the 33.8 rigs, 27.9were engaged in drilling operations, while 5.9 were engaged in workover andcompletion operations.

M-I SWACO's service averaged 17.7 of the 33.8 rigs ascompared to 21.9 rigs in the second quarter and generated revenues of $53.9million. This is a decrease of $29.6 million from our US deepwaterrevenues in Q2, or 35.4%, due to the previously mentioned storm impact and rigrepair. We expect the USdeepwater rig count that is active in drilling or completions to improve in thefourth quarter by 5 rigs, and M-I SWACO will benefit from this increasedactivity.

The international deepwater market averaged 66 rigs duringthe quarter, representing an increase of 6% or 4 rigs from the second quarter. Brazil and West Africaaccounted for essentially all of the increase. Our international deepwaterrevenues were $104.6 million, up 17% compared to the second quarter results.

Now, I'll review M-I SWACO's new technology revenue. Premiumfluids include all other high performance synthetic and water-based fluids.Premium fluid revenues for the quarter were $109 million, which represents adecrease of $6.7 million from the second quarter and entirely attributable tothe deepwater Gulf of Mexico.

Total synthetic revenue for the quarter was $67.3 million,down $16.5 million, or 20% from the second quarter. U.S. synthetic revenue hasaccounted for $8.7 million of this decrease. This decrease in synthetic revenuewas offset by increased sales of WARP and ultra drill. The acceptance of WARPtechnology is accelerating with operators around the world.

New technology revenues, which are generated fromtechnologies that are less than five year old, were $260.6 million for thequarter. That is up 8.1% from the second quarter, and up 39.4% from a year ago.

I will now discuss our product segment. Our fluid segment,revenue which includes drilling fluids, Federal Wholesale and productchemicals, was $747.2 million for the third quarter of 2007. Third quarterrevenue increased to approximately $36.7 million or 5.2% from the secondquarter and $112.3 million or 17.7% from a year ago. Western Canada and Mexico accounted for almost 100% of the growthin the sequential quarter with gains in the North Sea in Europe offsetting thedecrease in U.S.offshore.

Compared to the third quarter of 2006, the majority of ourrevenue growth came from international operations. The Environmental M-I SWACOsolution segment which includes drilling waste management, solid controlequipment, pressure control and produced water continue to grow during thequarter. Third quarter revenue grew 4.6% to $226.3 million as compared to thesecond quarter of 2007. Major growth areas included South America and Africa. Compared to the third quarter of 2006, revenuegrew 24%, or approximately $43 million. All of the growth occurred in theEastern Hemisphere and South America.

Our Wellbore productivity segment includes reservoirdrilling fluids, completion fluids, specialized tools and filtrationpreparation equipment and services. Revenues were $137 million for the quarter.That is down 14.1% versus the second quarter of 2007. Lower rig activity in theGulf of Mexico was responsible for themajority of the change.

In the coming quarters we expect to see continued growth atM-I SWACO. The outlook for the Eastern Hemisphere and deepwater Gulf of Mexicojust continues to be strong, and based upon recent contract awards, ourbusiness in Mexicowill be growing.

I will now turn the call over to Margaret.

Margaret Dorman

Great Don, thank you. Good morning everyone. Just to quicklyrecap this morning's release, third quarter earnings totaled a $167 million or$0.83 per share. This represents a 9% profitability improvement over the Junequarter and year-on-year earnings growth of 26%.

One of the largest factors that impacted the quarter was thedecline in offshore revenues. As Don mentioned M-I offshore operations reportedrevenues, which were $60 million or 10% below the levels experienced in the secondquarter. The softness in the offshore market, however was more than offset bythe Canadian drilling recovery that started several recent onshore fluidcontracts in Mexico, astrong quarter for premium tubular products and drill pipe in the U.S. market,and an increased demand for environmental equipment and service in theEurope/Africa region.

The profitability improvement over the June quarter wasdriven by several factors including seasonal pickup in Canada forSmith, which recovered roughly half of the Canadian earnings declineexperienced in the June quarter. Higher business volumes in the U.S. marketwhere margins held, even with the weakness in offshore business. And furtherexpansion of our operations and markets outside North America in areas such as Mexico, Continental Europe and the North Sea region.

Consolidated revenues for the quarter totaled $2.25 billion,representing 19% year-over-year growth in our Oilfield segment operations, anda 12% gain in our distribution segment.

On a sequential quarter basis, consolidated revenues grew6%, largely concentrated in the Western Hemispheremarkets. Our onshore business volumes in Mexico, which grew a 146% over theJune quarter as we began work on several of the new contracts awarded earlierin the year, combined with increased land-based business volumes in the US andCanada, contributed to the revenue growth over the June quarter.

Revenues for the Middle East/Asia operations declined $13million or 4% on a sequential quarter basis. As Doug mentioned, second quartersales from Omani joint venture operations combined with the timing of offshoreprojects in the Asian markets impacted the reported revenues. Excluding thesefactors, revenues for the Middle East/Asia region grew 5%.

I've touched on several of the regions, however, thegeographic revenue distribution for the relevant period, as well as, thesummary for the Oilfield segment is included in Schedule 1 that accompanies therelease.

Since Don has covered M-I SWACO, I'll offer some brief commentaryon Smith Technologies, Smith Services and Wilson. We experienced solid growthacross the Smith Technologies operations. Revenues for the quarter were $259million, 4% above the June quarter and 13% higher year-on-year. Revenues forthe combined drill bit product lines grew 8% over the second quarter's levels,influenced by the Canadian recovery and increased business volumes in Latin America, where we experienced 17% growth rate overthe second quarter of 2007.

Smith Services posted extremely strong results for thequarter; revenues were $316 million, 13% above the second quarter’s levels and31% higher year-on-year. Again, the second quarter sales of Smith Servicesinterest in Middle East joint-ventureinfluenced the sequential comparison. Excluding this impact, revenues grew 18%on a sequential quarter basis and 38% over the September 2006 period. Thesequential revenue improvement related to higher drill pipe volumes and premiumtubular product sales in the US market, and to a lesser extent, increaseddemand for fishing and drilling products and services in markets outside ofNorth America, including the Middle East/Asia region, which grew nearly 30% ona sequential quarter basis.

We noted last quarter we had experienced temporary delays inreceiving drill pipe inventory during the June period, that is, she was for themost part was off during the September quarter.

And finally, the distribution segment posted one of thehighest sequential revenue improvements of the Smith company unit, reporting bothyear-over-year and sequential growth of 12%. Revenue increase of the Junequarter reflects strong results in the upstream energy branch operations drivenby the seasonal recovery in Canadaand higher line pipe sales volumes to support a number of upstream andmidstream customer projects.

Let me make just a couple of high-level comments on theincome statement, starting with the operating income. Consolidated earningsbefore interest and taxes approximated $350 million or 15.6% of revenues,although there was no margin deterioration reported for the oil field or thedistribution segment. The higher mix of distribution revenues drove a slightreduction in the overall margins from the prior quarter level.

Oil field segment margins were 20% comparable with the Junequarter and 80 basis points above the prior year period. The unfavorablereduction in offshore business mix, and a resulting impact on M-I was offset bya shift towards sales of higher comparable margin product and service offeringsincluding premium tubulars and drill bits.

Net pricing for the oil field units remains marginally abovethe second quarter's level. The operations have been able to achieve priceincreases, which exceed the rate of growth in our internal cost, which hascontributed to an expansion and also gross profit margin.

M-I SWACO contributed the majority of the net pricinggenerated during the quarter influenced by improved Eastern Hemisphere contractpricing, although higher petroleum base chemical cost and the rising cost forcertain commodity needs partially offset the amount of net pricing realized.

Distribution operating income totaled $25 million in thethird quarter. Operating margins were 4.4%, 40 basis points improvement overthe June quarter. Sequential incremental operating margins were 8%, influencedin part by a higher mix of project work reported in the energy branchoperations.

As for the rest of the income statement. Net interestexpense declined modestly from the June quarter reflecting the reduction inaverage debt levels outstanding during the quarter. Late in the third quarter,we repaid a $150 million of public notes utilizing lower cost borrowings. So weshould see this trend continue in the fourth quarter as well.

On the tax front our effective rate was 32% comparable withthe second quarter's rate and matching the guidance provided on last quarter'scall. While changes in the geographic distribution and earnings will continueto drive increases and decreases in our quarterly rate, we believe our tax ratefor the fourth quarter should remain around 32%.

Detailed balance sheet information has been included as partof the earnings release stock and so I’ll just make a few brief comments. Ourbalance sheet remains very strong. At the end of September we had outstandingdebt of $1.1 billion and our debt to total capital ratio remains just below24%, a 14 basis points reduction from the June level.

Net working capital increased about $200 million in theSeptember quarter influenced by higher business volumes there was quitedeterioration and receivable collection base. We have seen extremely strongcash collection at the start of fourth quarter and expect to report improvedworking capital performance in the December period.

During the quarter we funded $44 million of stockrepurchases, 743,000 shares of stock at an average price of $58.75 a share, $12million of partner distributions and $20 million of regular dividends duringthe third quarter.

Net capital spending in the September quarter totaled $70million, roughly $12 million below the second quarter amount, driven by thetiming of the drill tool additions in the Smith Services operations. Aftereliminating our minority partner's interest and capital additions, capitalspending approximated $52 million for the September quarter.

We believe net capital spending will total around $300million for the year. This compares to a depreciation and amortization estimateof roughly a $195 million. Depreciation in the third quarter of 2007 was $50million, which translates into $38 million after considering that minoritypartner's interest.

So with that, let me hand the call back to Tatiana forquestions.

Question-and-AnswerSession

(Operator Instructions) Our first question comes from KenSill from Credit Suisse, please go ahead.

Ken Sill - CreditSuisse

Yeah. Good morning, guys. Nice results considering whathappened in the Gulf of Mexico.

Doug Rock

Thank you.

Ken Sill - CreditSuisse

One of your competitors yesterday mentioned that they werestarting to see a little bit of price erosion in commodity fluids in distant North America. They kind of indicated it wasn’t a bigdeal yet, but are you guys seeing any of that leaking in the North America after the supplies of the some of the other product linesfor other people?

Don McKenzie

Excuse me, in the third quarter our margins in the Rockiesand in USland were actually up. We haven’t seen a lot of pricing erosion. We are themarket leader; we're going to be the market leader in pricing. We have seenwhere some of the cost of some of our commodities like Ferrite have increased,but to a great extent we have been able to pass some of that increase on andso, we're pretty bullish on North American land, stay at reasonable levels asit is now.

But if we take a look at, Doug said in his earlier commentsthat, we're not affected quite as much by high CapEx items like pressurepumping where there is an oversupply and then you get kind of a double factorthere with utilization and price. We’re basically, the resources and the assetsare in place such as liquid mud flaps and what not and so, we see US land as avery important market and we will continue to be. We are continuing to monitorexactly what's happening there. And like I said, we’re going to be the pricingleader in that market like we are elsewhere around the world. And like I said,we haven’t seen any erosion to date.

Doug Rock

And also Ken, we are not on the high end of thetechnologies. I mean, we don't sell bits and certain basins in the U.S.and other locations. We don’t operate where there is very low cost commoditytype business, so that really helps insulators from that quite a bit.

Ken Sill - CreditSuisse

And then just one follow- on, on that, how much of yourcontracts in North America internationally areup for renewal, I guess, in the fourth quarter year?

Don McKenzie

In the fourth quarter in the Eastern Hemisphere and South America there are very, very few contracts that areup for renewal. In North America, we have three or four that are up forrenewal, and we have a portion of basically every one of those contracts now,and that we are looking at what we are going to do from a pricing standpoint,and I hate to disclose what we are going to do because I am sure that some ofour competitors are listening.

Doug Rock

But most of the big ones are really that have been passedoff, so they’ve really been continued in some cases without bidding duringabout and as early this year.

Don McKenzie

That's right.

Ken Sill - CreditSuisse

Okay. Thank you.

Don McKenzie

Welcome. Thank you.

Operator

Thank you. Our next question comes from Rob Mackenzie fromSBR. Please go ahead.

Rob Mackenzie – SBR

Hello.

Don McKenzie

Yeah, hi Rob.

Rob Mackenzie - SBR

Hi, sorry I had my phone on mute. Pardon me for that. Iwanted to talk with you guys a little more about something, not one of theother companies said on their call and that's the ability to find people again,I know this has been a long-time topic but when Schlumberger just startstalking about having problems, staffing up and finding people to me that couldbe a material impediment to grow.

Can you talk to us about how, how you are dealing with thatpeople and do you think that will be a meaningful bottleneck in 2008 and 2009?

Don McKenzie

I don't think people will be meaningful, but if I couldcontrast the kind of people we hire versus say Schlumberger, Halliburton andBaker, maybe it's Exxon and Weatherford. Our key technologies are in mechanics,they are in materials, they are in chemistry, they're in logistics, hydraulicsand we are not the people that really evaluate the reservoir. So thegeophysicist system, the geologist, the GMG guys, the petroleum engineers, thereservoir people particularly, we have those people, but those aren't our mainpeople. So when you hear about shortages, typically in those geologicallyrelated functions, but with the 600 that we've hired pretty much average perquarter for the last three years, mostly outside the U.S. there's been a very littleproblem at all.

Doug Rock

And from an M-I SWACO standpoint, we will train about 500engineers, fluid engineers this year. And for example, when we had the downturnin the Canadian activity we were able to place a lot of the Canadian engineerselsewhere in the Eastern Hemisphere where weare actually growing and so we are able to move some of the people arounddepending on what is happening in the geographic area. But we are continuing tomonitor, North America. And if there is anyactivity, a change or whatsoever we will take those people and move themelsewhere around the world.

Rob Mackenzie - SBR

Okay Don, my follow-up was actually for you as well. Justtrying to get a feel for how much of the reduction in Gulf of Mexico, deepwater activity from storms you've gotten back and if there is any otherinfluences there, rigs moving into market, out of market that would be movingfactors in Q4?

Don McKenzie

Well, what happened in Q3, it was kind of a double whammy ifyou will. First was the disruption because of the hurricanes and that was 13days and then a couple of other rigs actually went into a repair mode and so weexpect, like we've said in the call five additional rigs to come into the Gulfof Mexico in the fourth quarter and in our share that is going to be fairly significant.

Rob Mackenzie - SBR

Great, thank you very much.

Operator

Thank you. Our next question comes from Scott Gill from Simmons& Company. Please go ahead.

Scott Gill - Simmons& Company

Yes. Good morning.

Don McKenzie

Good morning.

Scott Gill - Simmons& Company

Don and Margaret I heard you talk a lot about the Mexico contributions here in the third quarterand the Latin America revenue growth 49%, veryimpressive. I am wondering as we look into 2008, if you could kind of give ussome sort of guidance as to what that Latin Americagrowth number could look like? I know you still ramping Mexico. So I would expected it tobe pretty big, but if you could just provide some color that would be great?

Don McKenzie

I am not going to give you a number, but I will give yousome color, I mean, Brazil'sgot another 8 or 9 offshore rigs. It will becoming in over the next 18 months,so we see significant growth there. We actually see significant growth in Venezuela coming along, and we've been surprisedsomewhat about the pickup that we've seen in Columbia. So, you'll see a very stronggrowth, we think at the level that we see in the eastern hemisphere and clearlywe've been running in the upper 20% to 30% range that actually on an average isa little over 30% for the last couple of years. But we think the Latin America area would be similar to eastern hemispheregrowth, at least for 2008.

Scott Gill - Simmons& Company

Okay, and as a follow-up Doug you highlighted the revenueper rig numbers that you've seen in the eastern hemisphere. Clearly, we aregoing to get very similar type of numbers of out of Latin America. At what point does that revenue per rigorous start tonormalize in other words, are they kind of grows more with the rig count, howfar are we away from that?

Doug Rock

Well, I think, that there if you look at the 130 or 140offshore rigs that are coming in, I guess they are booking them now and thetail end of 2010. We'd certainly be looking at accelerated revenue per rig asthese come in over 2008, 2009 at least the first half of 2010 has a lot offloaters not as many jack-ups in that period, and then I think the schedulesshowing out through the end of 2010. So we are looking at that to continue forthe next two to three years at least.

Doug Rock

We believe that in 2008, we are going to see 14 deepwaterrigs come back -- comes into the around the world, in 2009, 21 and 2010, 14. Sothere is a total of 50 rigs that are coming into deepwater and from a M-I SWACOstandpoint deepwater rigs, we are 10 land rigs, so that kind of multiple.

Scott Gill - Simmons& Company

Okay. Thank you.

Doug Rock

You're welcome.

Operator

Thank you. Our next question comes from Dan Pickering from TudorPickering. Please go ahead.

Dan Pickering - TudorPickering

Good morning, guys.

Don McKenzie

Good morning, Dan.

Dan Pickering - TudorPickering

I would like to follow-up a little bit on the comment aroundthe deepwater rig additions and, bare with me, I want to check some numbers.Don, I think you said that the Gulf of Mexico deepwater was down about 30million or so sequentially in revenue, and I think I heard you say, you wereworking on about 17.7 rigs versus 21.9 rigs last quarter, is that right?

Don McKenzie

That is correct.

Dan Pickering - TudorPickering

Okay, and so guess what I am grappling with here is, is yourreported revenue is about $3 million a rig there, and the delta was about $7million a rig. And so, I am trying to understand that the rigs that went downwere sort of a ultra high end, you were getting a lot of revenues there and aswe step forward the rigs that are being added, do they look more like theaverage Gulf of Mexico rig or the incremental?

Don McKenzie

I think the missing piece is Doug was the that we lostacross a number of rigs with the delta that turned as a result of the twohurricanes that were coming in. You’ve got to put that in and that reduces the7 million numbers significantly.

Dan Pickering - TudorPickering

Okay. So the delta was really the hurricane impact? Okay.And, I guess, my other question then would be, as we look at Canada Doug, Iknow there are a lot of uncertainties, do we think at this point kind of bestchance is Canada has a seasonal recovery, but still down the lineyear-over-year do we run a risk that Canada doesn’t do anything from here andkind of pulls to 2001 when it was pretty flattish Q3 to Q4, how do you see thatmarket playing out?

Doug Rock

For planning purposes we’ve really planned on pretty much aflat North America going into 2008. I thinkthe question is if Canadareduces significantly and if they go with the full royalty proposal of theroyalty panel it could reduce, but then I think the deliveries to the US will -- natural gas will go down quickly andwe’ll actually see a short move up in the US. So it’s a tough one to figure,but for planning purposes we are looking at reasonably flat, but we are goingto be looking real carefully over the next couple of weeks with what happenswith the royalty proposal as an indicator of how 2008 will look in Canada.

Dan Pickering - TudorPickering

Okay. And just remind us your biggest business in Canadais best of services at this point, on a percentage basis?

Don McKenzie

On a percentage basis, yeah.

Doug Rock

Yeah, on a percentage basis it’s more bets then, but MI hasgot a very sizeable business as their services and as those in CE Franklin.

Dan Pickering - TudorPickering

Great. Thank you

Doug Rock

Yeah.

Don McKenzie

You are welcome.

Operator

Thank you. Our next question comes from Robin Shoemaker fromBear Stearns. Please go ahead.

Robin Shoemaker -Bear Stearns

Yes. Thank you. I just wanted to follow-up on this deepwaterfleet, our rig additions to the fleet just for background purposes,approximately how far in advance of a start up of a new deepwater rig is thedrilling fluid contract negotiated in, what is sort of the timing of that andhow much incremental business do you expect from new rig deliveries in '08. Imean we can see what the delivery schedule is, but are those contract alreadyawarded or in process?

Doug Rock

Well, typically what will happen is that if a deeper rigcomes in and we have a contract for that particular operator, then we will getit. So, it's not a rig by rig basis, its more in line with where is thedistribution going to, what operator, and in some cases you may bid it out, butprobably in 70% of the cases, its going to go into the blanket agreement thatyou already have in place.

Don McKenzie

But when we give you the numbers looking forward like thefive rigs, we know month-by-month actually by a week, which rigs are going tobe drilling and which aren't. So, these are specific rigs, specific timeframesthat tie down to really within a week or two of starting up. So, we'reconfident about these numbers.

Doug Rock

And for that like in 2008, we know there is five rigs cominginto the U.S.gulf and another nine will be delivered internationally. And we know kind ofwhere those are going because they were committed in the shipyard and we have apretty good idea as to, if that revenue stream is going to [flow transferred]to somebody else.

Don McKenzie

And the further you are out 2009, 2010, where they operatorscontract may or may not turn over, that we don't know, because its going to dependon who the operator is or whether we have contract with that operator.

Robin Shoemaker -Bear Stearns

Got it, okay. So, just on that same subject, your marketshare I believe you given this in the past, the domestic and international ondeep water rigs. Do you have that kind of broken out domestic, internationallyyour market share?

Doug Rock

Well, what we typically have done is told you the numbers ofrigs that we're on, not necessarily the value of the market share and if youtake a look at in the third quarter we were on 17.7 or 33.8 of rigs and if wecompare that to the previous one its 21.9 and I now think Margaret's got somemore data for you.

Margaret Dorman

That’s the U.S.number?

Doug Rock

That's the U.S.number.

Margaret Dorman

Yeah.

Doug Rock

Okay.

Robin Shoemaker -Bear Stearns

Is there a comparable international number or…?

Doug Rock

We don't typically give that out…

Robin Shoemaker -Bear Stearns

Okay.

Doug Rock

For obvious reasons and what we said is our international sharesare similar and world wide it's over 50%.

Don McKenzie

That's right.

Robin Shoemaker -Bear Stearns

Okay. All right, thank you.

Doug Rock

And thank you.

Robin Shoemaker -Bear Stearns

Great. Thank you.

Operator

Thank you. Your next question comes from Kurt Hallead fromRBC Capital Markets. Please go ahead.

Kurt Hallead - RBCCapital Markets

Hey, good morning.

Doug Rock

Good morning, Kurt.

Margaret Dorman

Good morning, Kurt.

Kurt Hallead - RBCCapital Markets

Just, I want to circle back around Doug you referenced theback that the Eastern hemisphere growth of North 30% in the last couple ofyears. Any reason to think if that adds at all in 2008 or do you think it'smaybe that a constant or accelerate. Can you give some color on that?

Doug Rock

Right now, I mean it seems to be going near we have beenrunning in that 27%, 29% range over the last couple of quarters I don't seethat slowing down with the number of rigs that are coming in right now. But asDon mentioned there is some contracts we may do better, we may do worse say,but I don't see anything substantially changing, particularly with all the newrigs coming in and the opening up of some additional areas in the former SovietUnion and also with the rig activity going in to West Africa plus I thinkBrazil, acceleration in Saudi Arabia and a couple of other areas.

Kurt Hallead - RBCCapital Markets

Okay and then Schlumberger referenced to prospects for someproject delays they mentioned in Nigeria, the Caspian and a coupleof regions and have a kind follow on impact or flow through impact on yourprospects?

Doug Rock

That's part of our business project delays. We've alwayssaid if all the countries in West Africadrilled simultaneously, we might not have enough capability to service themall. There are always delays. So we haven't seen a delays that are abnormal oroutside of what we've seen in the past neither in a higher percentage ofprojects.

You know, some projects we've got ready drilling had to waittwo years, and this is just the nature of the funding, particularly ournational oil companies where the funding has to come from the political side.So, we don't see it to be an abnormal slowdown as a result of delays at thispoint.

Kurt Hallead - RBCCapital Markets

Okay. And then you referenced specifically in Latin America,Venezuela, despite I guess a lot of the headline, noise and the impact it mayhave on oil company ownership issues, can you give us some color as to whythings are looking so positive…?

Doug Rock

Our relationships with Petrobras and the other companies in Venezuelahave been very solid. There are some of the -- they pay us on time, they liveup to their contracts. So, Don, you might want to comment, you have a majorityof business there?

Don McKenzie

Well, Venezuela,of course, it's difficult to say what you'll have there slightly tomorrow, but Petrobrasis stepping in to fill in the void of some of the IOCs that were in there andso there is opportunity in Venezuela.I think it's what we are talking about here, Kurt.

Kurt Hallead - RBCCapital Markets

And then, just kind of to give your perspective on what's --how would you handicap the prospects for the Canadian tax issue?

Dough Rock

How will I handicap? I believe there will be some form ofcompromise, but Premier Stelmach, he replaced Ralph Klein and hasn't go throughan election. He has got election next year and the polls, some place between78% and 88% of the people want to see higher taxes. So something is going tohappen. It's a question, is it going to be in line, you know, if you kick theRoyalty rates on the Oil Sands up 17% which is the proposal, and then 5% eachon gas and oil with no grandfathering, which again is the panel’s proposal,that’s pretty draconian, but still the take for the Canadian is not excessivecompared to the percent take of, of other countries in the world, if you lookat that information. So my guesses will be some form of compromise, and wherethat compromise winds up or whether that satisfies the EnCanas, the Talismansand Petrocas, I am not sure, but I think there will be a compromise.

Kurt Hallead - RBCCapital Markets

And the bulkier stuff in Canada, if I understand correctly,it's still natural gas, right?

Doug Rock

A lot of that drilling is natural gas, correct, but if yougo to offshore, Eastern Canadawhich is -- and the oil stock, it’s still about 30% of rigs drilling for oil.

Kurt Hallead - RBCCapital Markets

Got it. Thanks.

Doug Rock

You’re welcome.

Operator

Thank you. Our next question comes from Jim Crandell from LehmanBrothers. Please go ahead.

Jim Crandell - LehmanBrothers

Good morning.

Doug Rock

Good morning, Jim.

Don McKenzie

Good morning.

Jim Crandell - LehmanBrothers

Doug, you and I've talked about this before, but more and moreof the drilling that takes place is horizontal, more of it uses rotarysteerable and two of the three large providers of rotary steerable do on theirown big companies, and they seem to be doing everything humanly possible tomake sure that their bits are used with their own rotary steerables, andapparently meeting with increased success. I realized that Schlumberger,Weatherford don't have big companies, and you strive to be the premium supplierof drill bits and, but it just seems you are up against a very powerful sort offorce here. Could you talk about this issue?

Doug Rock

Yeah, sure if you read, I am sure you did, the Richard'sprevious report on market shares recently you find out that we are doing verywell for several years, and obviously with our relationship with Schlumbergerwho has gained significant share in the in the directional, in the drilling andmeasurement business. That's a very helpful to us. So, I'd say with thecombination of new products, with our both sequential and year-over-yearrevenue growth for the last couple years, all I can say is that Smith has beena successful one in those areas. So we are very pleased with where we aregoing.

Jim Crandell - LehmanBrothers

What do you think the Company's drill bit share and I am notlooking for any specific number here, but just a sense is, with Schlumberger integratedproject management contract?

Doug Rock

That's so hard when I, I mean….

Jim Crandell - LehmanBrothers

I mean is it very high?

Doug Rock

I don’t know the answer to that. I haven't asked in thatnumber.

Jim Crandell - LehmanBrothers

Okay. My second question here for both Doug and Don here is,do you see at all some of your competitors namely Halliburton, and Baker tryingto package fluid that's with a number of their other items for "a loweroverall cost to the customer", and that because they offer the broaderproduct line than you were, that provides -- that's competitive issue for youand them there in the field.

Doug Rock

Yes, we don’t see Baker doing as much. We do see Halliburtonoffering a package and this comes around from time-to-time. We saw it in theearly 90s and then the operators turned out with a package, maybe they weren'tgetting all the leading technology. So their efficiency wasn't as good. But ithasn't been a large trend, though of course with our relationships with Schlumberger,where they are doing integrated their project management, we are involved inmost, if not all of those project. But that tends to be in more remote areas.Not areas were operators can get a hold of variety of technologies andservices. If I answer your question I have seen Halliburton do more and reallyBaker very little.

Jim Crandell - LehmanBrothers

Okay. Thank you Doug

Doug Rock

You are welcome.

Operator

Thank you. Your next question comes from Alan Laws from MerrillLynch. Please go ahead.

Alan Laws - MerrillLynch

Good morning.

Doug Rock

Good morning Alan

Alan Laws - MerrillLynch

See what I have here. I have many questions here. You'vecontinually been pretty successful of completing and you're adding earningsvalue, via tuck-in acquisitions and the recent At Balance like acquisition atoe hold I guess, it looks pretty interesting. How do the M&A pipelinelook? I know we ask you this question pretty much every quarter but I just wantto know the expectation gaps are really wide out there it. Is there a lot moreopportunities there?

Doug Rock

We are review that very frequently and there we have a longlist of companies we are interested in, we are talking to. That's not for us topredict how many we close, but mostly in the Eastern Hemisphere and Latin America the areas where we are growing, Don you'vegot the numbers those we are looking at?

Don McKenzie

I can answer you, but our list is about -- on average withwhat we've done in the last or what we've looked at in the last three or fouryears. I think we are probably, notprobably, we are looking at seven to-date. Whether they are closed or not is, Idon't know but we are actively looking at ways that we grow our business ortake a niche technology and use our infrastructure around the world anddistribute it around the world. So we are continuing. Certainly the multiplesmay be a little bit higher today, but if you can find the right thing and useyour footprint around the world to improve the overall revenues and earnings ofthat particularly company then it’s something we are looking at.

Alan Laws - MerrillLynch

All right. Just as a regional comment. Canada being so weak and so deepdown, is there anything in that market that has looked attractive to you?

Doug Rock

Well, essentially as Don mentioned, we're looking more fortechnologies. I am not saying that if we had a good value asset play, where wecould buy something at discount. Assets, we wouldn’t do it, but at this pointthere is maybe Canadian company or two there. But nothing has come up as aresult of this downturn because they are primarily looking for new technologyplayers.

Alan Laws - MerrillLynch

Okay. So, your second question have us on SmithTechnologies, I know this is kind of coming up in the next few months. I waswondering if you had any internal or western surround, you had a margin impactor earnings sensitivity from the six-cutter royalties you begin to play in January.

Don McKenzie

Actually there will be, it’s not January but our deal with GrantPrideco is that we prepaid royalties for six quarters, and actually when we hitthe second quarter of next year, because of the percentage use of the beds, itwill actually go down.

Alan Laws - MerrillLynch

Okay.

Don McKenzie

So, there will no margin, and there will be no marginreduction and potentially a margin increase.

Alan Laws - MerrillLynch

Okay. Thank you.

Don McKenzie

You are welcome.

Operator

Thank you. Our next question comes from Geoff Kieburtz fromCitigroup, please go ahead.

Geoff Kieburtz -Citigroup

Good morning.

Don McKenzie

Good morning, Geoff.

Doug Rock

Good morning, Geoff.

Geoff Kieburtz -Citigroup

The oil field margins were flat sequentially, is that a faircharacterization for each of the three pieces of oil field?

Margaret Dorman

I think what I've said Geoff is that, certainly theonshore/offshore mix in your mind, you would expect replacing onshore revenuesto with offshore reductions. You would expect that to have an adverse impact onthe EMI margins. What I had talked about is that, that really that was morethan compensated by the shift to the higher comparable margin quarters in SmithServices and Smith Technology. So, to answer your question, I don’t think thatwould be an accurate representation as each of the unit was flat.

Geoff Kieburtz -Citigroup

Got you. We talked a little bit about the impact to the newrigs, and I think someone was trying to get a handle on it, let me make a stab,that you are getting something in the order of $4 to $5 million in a quarterfrom a deep water rig, is that a fair estimate?

Margaret Dorman

Yeah, I mean I think what we’ve talked about, Geoff issomewhere a deepwater would be, you know, one to one and half a month, so $3million or $4 million a quarter.

Geoff Kieburtz -Citigroup

3 to 4,okay.

Margaret Dorman

Yeah, depending on the depth of that rig.

Don McKenzie

If we put it in downhole tools, and that's depending on therig, it could go up somewhat.

Geoff Kieburtz -Citigroup

Okay. And as these new rigs come into the fleet, would youexpect them, I mean, obviously there is a variable, we don't know how many ofthose you will be contracted on, but is would -- should we expect that, thatrevenue run rate should be generated from the very beginning or will there besome kind of ramp up?

Don McKenzie

It's an oddity. Usually when they come to spud we providethem with some lower cost spud mud. So you see some higher revenues in the beginning,and usually lower margins. And then once they get into the deeper drilling andcertainly get into the reservoirs or the extended reach you’ll see the highermargin stuff being used.

So, typically if they come in you might see a jump in volumewith lower margins and then you see the margins pick up once they are into theoperations.

Geoff Kieburtz -Citigroup

Okay, but --

Don McKenzie

It’s the drilling multiple wells only from a single cord, sowe used to get a spud and then added 26 or 36 inch hole then only do themultiples coming up the bottom there, they extend in the region of a high valuework type and ultra deal fluid.

Geoff Kieburtz -Citigroup

Got you. So it's really like a well -- really trying to getout as you probably heard Schlumberger’s comments about the efficiency of thesenew rigs as they come in to the fleet from the shipyard and their expectationthat they would not be generating service revenue at a seasoned rig, kind ofrate for, I think, they said as much as two years and I wondered how thatmight…

Doug Rock

I didn't hear the comment.

Geoff Kieburtz -Citigroup

Okay.

Don McKenzie

I didn't hear the comment neither, but if you look at itGeoff, without a doubt when it comes from the shipyard and goes to the seatrials and goes on its first well there is some bugs that have to be workedout. But typically I would think we took two years, but nonetheless, when theycome in we would start generating revenue once its spud.

Doug Rock

And what's more important there is whether it's exploratoryor development drilling, development drilling generating much higher revenues.

Geoff Kieburtz -Citigroup

And similar margins or higher margins as well?

Don McKenzie

For similar margins.

Doug Rock

Similar, yeah.

Geoff Kieburtz -Citigroup

Okay. And a question lastly for you Don, you called out thedollar amount of new technology revenue at M-I. I guess a two part question;one is, it seems like its running in just under 25% of M-I revenue now. Wheredo you see that going and the other part of the question is, is that heavily ordisproportionately in any one of the three segments of M-I that you've alsogiven us detail on?

Don McKenzie

Well, I would think that our new technology revenue willimprove overtime. We've invested a lot of money in research and development inour M-I new products system. We will also be looking at as we talked aboutearlier acquisitions that provide a component of new technologies.

When you are talking about the segments, certainly the fluidsegment is important in the environmental process and solutions. That has ahigher component of new technologies and fluids by about 10% and so as thatgrows we would expect the margins to improve accordingly.

Geoff Kieburtz -Citigroup

Okay. And just to clarify on the first part of your answer,do you expect new technology as a percentage of M-I revenue to go up?

Don McKenzie

Yes, we do.

Geoff Kieburtz -Citigroup

Any kind of target?

Don McKenzie

Well, if you take a look at, this is a new technology wedefine as any technology that is less than five year old. So at the end ofevery year, our field operations are somewhat concerned because we drop thingsoff and as we drop off, so yes, it would improve, but even though you dropthings off, you wouldn’t necessarily expect the margin to erode just becauseyou dropped it off.

Geoff Kieburtz -Citigroup

Got you.

Don McKenzie

If we take a look at for example, [sprinkler] technology andI don't know that actually dropped off. But it is a very interesting technology,it is, in terms of rig efficiency and what it can do for operators throughoutthe world, is an improvement over any other method, and so, consequentlymargins for that would stay.

Geoff Kieburtz -Citigroup

Great, thank you.

Don McKenzie

Thank you.

Operator

Thank you. Your next question comes from Brad Handler fromWachovia Capital, please go ahead.

Brad Handler -Wachovia Capital

Thanks, good morning.

Doug Rock

Good morning, Brad.

Margaret Dorman

Hi, Brad.

Brad Handler -Wachovia Capital

I guess I just have one question last, overtime, you guyshave spoken to the idea of getting 200 to 300 basis points of margin throughthe course of an extended cycle. I never mean to suggest that was necessarily atarget, but it does seem, that was your representation on how it worked. Itlooks as though, if we're looking at your guidance, 2007 is going to shape upthat way. And I guess I was curious for whether or not if composition of yourbusiness has changed a little. For example, a bit more kind of an internationalland as you penetrate there. If there was something that changes about the[tenure] of your ability to move margins over the next couple of years?

Doug Rock

Yeah, I think, you are exactly right, that's what we saidwith average-over-cycle, in fact, in this cycle that’s what we are averaging,but we've also the cycles who have periods where there are a little bit flatter,and really it's been a deceleration of North American growth that has -- therest of the world is growing at a rate much higher than I would have thoughtcouple of years ago, because I didn'tthink that oil prices would be this high, and were 85% or so of US drilling is gas;85% of rest of the world's drilling outside of Canada is oil.

So, moving there, but again with a flat North American, thatwas the piece that was creating the other 100 basis point to get us up about200. That said deceleration. North American gas drilling will accelerate, Ijust can't tell you whether it's going to be 2008 or 2009 or 2010, but deliverabilityis going to be down. Consumption is not coming off and they still not kicks in,I think, you'll see rates above that range.

Brad Handler -Wachovia Capital

Okay. So, just to clarify at the -- your sense of theopportunities again in whether it’s international land or just broadlyinternational new different from a year-on-year opportunity to raise margin?

Don McKenzie

No, and particularly I think with the this quarter wasmainly, throughout the world, we actually saw a little bit less offshore indeep growing, and I think that was just a factor of the third quarter which werig by rig would see most of that or much of it coming back in the fourthquarter.

Brad Handler -Wachovia Capital

Sure. Makes sense. Okay, that’s helpful. Thanks.

Don McKenzie

Yeah, you are welcome.

Operator

We have no further questions at this time.

Doug Rock

Well, thank you for joining us for our third quarter call,and we look forward to speaking with you and answering your questions in thefourth quarter. Good bye.

Operator

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

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Source: Smith International Q3 2007 Earnings Call Transcript

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