Sprott Inc.
Q3 2008 Earnings Call Transcript

Published: 29 Oct 2008

[Operator:]

Good morning ladies and gentlemen, and welcome to the Smith International Third Quarter 2008 Investor Relations Conference. At this time, all participants are in a listen-only mode. And later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over Mr. Doug Rock, Mr. Rock you may begin.

[Doug Rock:]

Thanks Hilda. Good day and welcome to the Smith International third quarter 2008 investor conference call. I am Doug Rock, Chairman and CEO of Smith. I'll be talking today along with John Yearwood, who is President of our Completion and Production Group, and he's also Smith's new President and CEO as of January 1, 2009; and also Margaret Dorman, our Executive Vice President and Chief Financial Officer will speak. This morning Margaret, John, and I will talk for about 30 minutes, and we'll have about a half hour for your questions. So that everyone has a chance to ask questions, please ask not more than two at a time. If time permits, you can re-queue and ask more questions later in the call. Now let's talk about Smith's third quarter 2008 results, and I'll talk a little bit about where our industry is headed over the next year. Smith's third quarter 2008 revenues up $2.85 billion were up 14% sequentially and 27% year-on-year. These revenues include our merger with W-H Energy Services for 37 days of the third quarter, but had we consolidated W-H Energy Services for the whole third quarter, Smith's revenues would have been up 37% year-on-year. September 2008 was Smith's first $1 billion plus revenue month and October looks even better. Also had Smith consolidated W-H Energy Services revenues for the entire third quarter, revenues would have been $3.71 billion. This quarterly revenue level would make Smith the third largest broad services array oil field service firm in the world. We believe Smith will improve on our third quarter revenues and earnings in the fourth quarter of 2008. Although we expect the North American rig count to contract in 2009, as of last Friday, the Smith U.S. rig count is still almost 300 rigs or 17% above this time last year and the Canadian rig count is 16% above last year. The U.S. rig count is now 1%, it's 23 year high. Therefore the financial market turmoil is yet to reach the oil patch for reasons I'll explain next. So let's look at oil service company expectations for 2009. I think the negative sentiment towards our industry is decidedly overblown for three main reasons. First, even with oils prices at $60 per barrel, that's six times the price of oil at the 1998 downturn low point. Both oil and natural gas prices today provide a reasonable profit outlook relative to finding and development costs and excepting the prior 18 months run up in energy prices, we still have one of the better profit potentials for oil and gas producers in the last few decades. Remember crude oil first hit $60 per barrel in mid 2006, and was at the lowest $34 per barrel in early 2005. Second, oil and gas supplying demand is in tight relative balance compared to the large capacity overhangs in the 1980s and 1990s. Even with slow or no demand growth for oil and gas in the next year or two, the tightness of the supply demand relationship will change substantively. There is no big bubble out there and there is none coming soon. Third, depletion rates for oil and gas production have surged in the past decade because of faster resource recovery drilling methods and lower overall quality prospects. Annual oil depletion rates have grown from about 4% annually to about 7% today. We need to find and produce an additional six million barrels of oil per day world wide just to compensate for this depletion. The natural gas depletion story is even more compelling. This is why rate count reduction shouldn't last long. Now looking at Smith's prospects, as in the past, we wont' release our annual guidance for Smith's 2009 year until the fourth quarter 2008 conference call at the end of January 2009. But I would be disappointed if our 2009 earnings didn't exceed our 2008 results. Looking at first call prediction for Smith's fourth quarter 2008 earnings, earnings per share are projected increase 30% year-on-year for Smith. That means we are going into 2009 with excellent year-on-year earnings momentum. Using First Call fourth quarter 2008 earnings in revenue estimates, Smith's earnings are projected to grow year-on-year double the average of our four primary competitors with our revenue increasing nearly double the competitors' growth rate. This brings us to our 2008 full year results. Our prior guidance for 2008 is $3.70 to $3.80 per share. Based on our third quarter 2008 results and our fourth quarter 2008 expectations, we now believe that $3.83 to $3.88 is a more reasonable estimate for 2008 full year earnings. With the W-H Energy Services merger, today Smith has over 25,000 full time employees, who are producing record revenues and profits with an expanded offering of products and services. We believe the 2009 will be another good year for Smith. Now John Yearwood has some comments.

[John Yearwood:]

Thank you Doug and hello everyone. As you have seen in our Q3 press release of this morning and as a direct result of our plan to maximize our growth through the creation of value from synergistic operations, we now manage our business within three operating segments

[Margaret K. Dorman:]

Thank you John, hello everyone. For the third quarter of 2008, Smith International generated earrings of $210 million or $1 per diluted share on revenues at $2.85 billion. The result reflects $5 million of non-occurring charges, which primarily relate to uninsured property losses sustained at our Galveston grinding [ph] plant facility as a result of Hurricane Ike. Excluding these costs, net earnings were slightly higher. We generated $212 million of after tax earnings or $1 per deluded share. Net of charges, our after tax earnings grew 16% sequentially, and we are 27% higher than the September 2007 quarter. As many of you know, we close the W-H Energy transaction nine weeks ago on August, the 25th. This is our first earnings call post closing. And for any of the W-H personnel we may have on the call, I want to pass on how pleased we are to have you as the part of those Smith family, and want to thank each of you for the contribution made to Smith's record third quarter results. While we are on the topic of the only copy could W-H let me recap the transaction. We issued 17.78 million shares of Smith and $1.64 billion of cash to the former shareholders of W-H. And we also repaid $261 million in borrowings outstanding under W-H revolving credit line. The required cash was obtained under a combination of bridge and term one borrowing arrangement; we will cover the terms of the debt in a few minutes. As Doug noted earlier, Smith's third quarter reported results included 37 days of the W-H business operations. And as we noted in the press release, we are reporting all of the former W-H operating groups as a part of the Smith Oilfield segment. W-H's revenues for the 37 days subsequent to closing were a $144 million. And when combined with the revenues for the period from July 1 through the closing date, pro forma third-quarter revenues grew 6% on a sequential quarter basis, and 30% over the prior year quarter. In the third quarter, we recognized the amortizations and depreciation related to the W-H operations of $15.5 million, which includes $4.3 million of amortizations and depreciation associated with the step up of certain of W-H's assets, the fair value of the closing day. We also experienced $1.7 million of costs during the third quarter through the gross profit line related to the step up of on-hand W-H inventory to fair value as of the closing date. The purchases price allocation is preliminary at this point. Ad although we do not expect step up the amount to change materially, we could end up adjusting some of these amounts as we complete the evaluation of the W-H's assets and liabilities over the next quarter or so. As Doug noted, the integration of the former W-H operations is on track and progressing well. We would expect to see the elimination of certain corporate overhead and public company costs over the next quarter or so. Keep in mind that W-H acquisition was more of a strategic transaction for us rather than a consolidation play. We don't see a lot of overlap between the field operations, which somewhat limits the amount of potential combination savings. Returning to the Smith consolidated results, third-quarter results net of non-recurring charges were pretty solid, consolidated revenues were $2.85 billion, up 14% from the second-quarter and up 27% year-on-year. If you exclude the impact of acquired revenues, we generated top-line growth of 8% sequentially and 21% of the prior year quarter. Consolidated operating profit net of non-recurring charges totaled $448 million or 15.7% of revenues, up 10 basis points from the second quarter's levels. This translates into consolidated incremental of 16% on both sequential and year-on-year basis. If we turned to the segment operating results for the third quarter, which in all cases are net of the aggregate $5 million of non-recurring charges and reflect no allocation of corporate costs, M-I generated $1.36 billion in revenue and $221 million in operating profit in the third quarter reflecting operating margin of 16.2%. The loss of high margin deep-water business volumes in the U.S. Gulf associated with Hurricanes Gustav and Ike accounted for the 30 basis points reduction in operating margin on a sequential quarter basis. The Smith Oilfield with segment reported revenues of $724 million and $188 million in operating profit in the third quarter reflecting an operating margin of 26%. Margins declined from the 27.5% level reported in the June 2008 quarter. Although the margins in our existing Smith operations grew just over 60 basis points on a sequential quarter basis as 7% growth experienced in the higher relative margin drill bit sales offset the impact of lower drill pipe shipments during the quarter. The addition of W-H's operations, which carries slightly lower margins on a comparative basis accounted for the margin decline. And the Distribution segment reported revenues of $761 million and operating profit of $62.5 million for the third quarter. Over the past three quarters, significant growth in revenue volume coupled with solid cost control has led to a doubling in margins from 4% to just over 8% contributing favorably to Smith's overall profitability levels. Here in the third quarter, Distribution margins improved 230 basis points influenced by higher MRO volumes associated with the growth in U.S. land based drilling projects and strong demand in improved product pricing for line pipe offerings utilized in mid-stream infrastructure projects. As for the rest of the income statement, net interest expense for the quarter totaled $23.4 million, $7.9 million above the second quarter of 2008 reflecting incremental borrowings associated with funding, the W-H Energy transactions. We financed the acquisition with $2 billion of new borrowings, a 364 day bridge loan of $1 billion and a four year term loan of $1 billion both which carrying an interest margin of 70 basis points over LIBOR. We paid all in interest rates in the mid 3% range on these borrowings related to the periods of loans, where outstanding in the third quarter. We believe the fourth quarter interest expense on the acquisition borrowing should rise approximately $12 million in the December reporting period reflecting a full quarter of outstanding debt and to a lesser extent the modest increase in short-term LIBOR rates experienced in the current quarter. You may have noticed that we filed the universal shelf registration statement in September, which may at some point we used to refinance all or a portion of the bridge loan borrowings. However, we don't see any immediate need to refinance the bridge loan, which is scheduled to mature in mid-August of 2009. On the tax front, the effective tax rate for the quarter was 32.6% in line with the level reported in the June quarter. We believe our tax rate for the 2008 fiscal year should be around 32.5%. The weighted average diluted shares outstanding of 210.2 million reflects the issuance of the additional 17.8 million shares related to the W-H acquisition for the portion of the quarter these were outstanding. We would expect the weighted average number of diluted shares in the fourth quarter to increase to approximately 220 million with the 2008 fiscal year diluted share count totaling about 209 million shares. Detailed balance sheet information has been included as part of the earnings release documents. I will make just few brief comments. Our balance sheet remains very strong. Our net working capital increased about $630 million during the third quarter, roughly $425 million of this amount relates to the addition of the acquired W-H operations. However, the Smith operations did experience higher revenue volumes, which contributed to the growth in the receivable line into a lesser extent a modest inventory built to support upcoming customer projects. At the end of September, total debt approximated $2.8 billion and debt to total capitalization stood at 32.6%, which reflects a higher leverage level than where we stood three months ago, but still a very manageable level for a company with Smith's balance sheet profile. Even with the addition of W-H, we continue to be more working capital versus CapEx intensive, so business activity should moderate going forward, which are cautioned to add we're not seeing at this time, we could see the balance sheet de-leverage fairly quickly. Net capital spending in the September quarter totaled $86 million with the increase over the June quarter attributable to the incremental investment for the W-H operations, which was a net amount of $12 million for the period post closing. After eliminating our minority partners interest in capital additions, capital spending approximated $68 million for the period. Had we acquired W-H at the beginning of the third quarter, we would have reported a $113 million of net capital spending for the reporting period. Looking forward to the fourth quarter, we believe capital spending for the Smith units will be relatively consistent with the September period, but we do anticipate having some non-recurring spending for long lead capital orders in the W-H operations in the fourth quarter and therefore would expect to report slightly higher net capital spending of about $140 million in the December quarter. This would translate into full year 2008 net spending of $360 million, which again would be capital spending net of associated proceeds reflected on our cash flow statement. Depreciation in the third quarter of 2008 was $69.3 million, which translates into $56.5 million after considering our minority partners interest. As I noted earlier, depreciation and amortization related to the W-H operations for the period subsequent to closing totaled $15.5 million, including $4.3 million associated with fair value step up of fixed assets and intangibles. We expect total consolidated depreciation and amortization to be in the range of $95 million in the fourth quarter of 2008. We believe 2008 spending forecast of $360 million compares to a full year depreciation and amortization estimate of about $270 million. So that... with that, I will hand the call back to Hilda for questions. Question And Answer

[Operator:]

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Kurt Hallead from RBC Capital Markets.

[Kurt Hallead:]

Hi good morning.

[Doug Rock:]

Hi Kurt.

[Kurt Hallead:]

Good morning. Welcome aboard, John.

[John Yearwood:]

Thank you, Kurt, thank you.

[Kurt Hallead:]

Hey Doug, your comments this morning regarding the outlook for '09 as much as it, maybe disappointed in that '09, not being above of '08. Other than the bigger picture comments that you outlined, how much of your business is backed by specific contractual obligations that kind of gives you that conviction to come out at this point especially in light of the spending touch we've been seeing?

[Doug Rock:]

Yes, about 80% of M-I SWACO's eastern hemisphere businesses contract, but it's not the contract itself that gives the faith, because it's a kind of contract, where if they don't drill, they don't need to pay us. But the real underlying thing is the contract with the rig operator. Because on the deepwater even the in the medium water stuff, 40% of the cost of the project is the rig. So even when we are seeing big declines in prior years going back as much as 30 years, we have always seen the operator drill to the end of the rig contract, because why have 40% so on cost and get nothing out of it. So that's what gave us the real confidence the contract with the rig contract give then the secondary contract with us services that provided there.

[Kurt Hallead:]

Okay. And your view point will be apples-to-apples on a pro forma basis if W-H were part of Smith for the full year?

[Doug Rock:]

I don't understand the question.

[Kurt Hallead:]

Just assuming if you look at '09, it will be above '08 that would assume on a pro forma basis that W-H were part Smith for all of '08 as well.

[Doug Rock:]

No, just the base GAAP numbers from '08 to '09.

[Margaret K. Dorman:]

On an average.

[Kurt Hallead:]

Got it, okay. All right, thanks Doug.

[Doug Rock:]

Not recast, yes.

[Kurt Hallead:]

Appreciate it.

[Doug Rock:]

You are welcome.

[Operator:]

Our next question comes from Jim Crandall [ph] from Barclays Capital.

[Unidentified Analyst:]

Good morning. Doug, congratulations on your retirement; you've certainly done a great job over the 30 years I have known you.

[Doug Rock:]

Thank you Jim.

[Unidentified Analyst:]

Doug or John, can you describe how you start up in terms of tool capability and rotary steer LWD, and as the your intention overtime to become either fully competitive or more fully competitive with the major companies in the sector?

[John Yearwood:]

Thanks Jim. Right now we are able to... we are sold out without tool capabilities both in the U.S. and in certain of our international markets. We're able to provide DDMW, DLW these services for a large number of drilling operations, where we have gaps with the larger rotary steerable tool sizes for deepwater applications. We don't have those, so we are working on them. On LWD, we have some imaging tool gaps, we've just... I talked about our iFinder, our density imaging tools 400 quarter, which is proving very successful in two countries today. But we need larger size there and we need some resistivity imaging capabilities as well.

[Unidentified Analyst:]

Would you think, John that you would have to step up CapEx and R&D spending fairly materially in those businesses over the next two years. And as a part of that question, maybe you could address the role that international expansion is going to play in the company's growth on a sort of one to two year basis?

[John Yearwood:]

Okay. In terms of Capital and R&D, compared to if you think compared to what W-H Energy was doing, yes, we are going to increase it, I wouldn't say materially. It's going to be focused capital spend. We have already identified the targeted countries in the international area and also in the U.S., the path finder was not playing in all of the regions of the U.S. So, we have a plan now, where we are focused on and we are building tools or ordering tools then now for those markets. So, I don't see a material increase in capital, but there will be some and R&D as well yet, there will be an increase compared to what W-H was doing. Our international growth plan is now defined and we are going forward with that in the tool ordering, the people recruiting and the training.

[Unidentified Analyst:]

Okay. And last brief question, John, do you see a lot of synergy between this business and sort of the rotary steerable LWD business? And do you see this business becoming increasingly integrated in regards to rotary steerables than literally the sensors over time being on the bit itself and the companies, who are in the bit business and in the rotaries steerable business ultimately should have an advantage in that they offer part of the system?

[John Yearwood:]

I do believe there is synergy across the entire down haul drilling assembly on the surface to the bit. It's really... it's made up of multiple elements, but it performs... and you have to have it perform as one element in terms of the drilling and well placements. So, yes there is synergy; that's we have our service, I'm sure you are familiar was called i-Drill, which looks at optimizing the type of drill bit according to the requirements of the operator, where the wells should be placed, and how, and with the drilling assembly that will be used. Clearly our strategy now is to take i-Drill and expand it from the not just optimizing the drill bit, but optimizing the entire downhaul drilling assembly. So, to answer your question, yes, there is synergy and that is our plan going forward to optimize that synergy.

[Doug Rock:]

But I might add, Jim, with us having maybe 5% of the world directional market and maybe 30% of the bit market, the customer is still going to continue to use the best elements when they go together. And just as we do other bit programs today, if the path finder system works better with a huge Christensen bit or with a National Oil Well, Reid-Colleague or with Halliburton and with Albertan [ph] we will use that fit. So we'll continue to use the best in class with whichever component we use if we get the job.

[Unidentified Analyst:]

Although, Doug, if I could just add something, many of... or certainly your competitors anyway, who are in the rotary steerable business make the comment that their bid is gone like over 90% of your job. So, it certainly seems to be the way the businesses is heading.

[Doug Rock:]

The data does not show that. And in fact if you get a hold of the SPE world record bit runs of which we have about 58%, you will find we have the world records on virtually all of our... the percentage of world records on most all of our competitors. Plus we have done research in finding out that 90% number just does not exist.

[Unidentified Analyst:]

Okay. That's enough, thank you very much.

[Doug Rock:]

You are welcome.

[Operator:]

Our next question comes from Doug Becker from Banc of America Securities.

[Douglas Becker:]

Thanks. Doug, once again Wilson did very well. I think last quarter you were mentioning you have some new contractual relationships, and just the demand for new infrastructure provides some visibility over the next two quarters. I guess with activity looking like it is going to decline in North America. I guess what's the outlook specifically there?

[Doug Rock:]

Yes, I think the good part of that is even though we believe the rig count will go down and then you've heard from other companies also that we think in some of the higher profile areas like the Haynesville and the Barnett activity... and the Haynesville along, we actually expected to go up quite a bit. There we are seeing the demand for the bulb house [ph] and the connection equipments, the mid-stream stuff very strong and actually in some of those areas will increase. So really with the rig count going down as we look at the customers as they high grade their prospects, we think the higher cost or higher value drilling areas are going to continue to either be flat or in some case improve, which is really where Wilson is getting their additional revenues and profits from. So we don't see that at all going in line with the decline of the rig count.

[Douglas Becker:]

And so just to clarify, you could see Wilson still posting better numbers over the next couple of quarters?

[Doug Rock:]

Certainly for this quarter looking into the first quarter, I don't have all the data, but just as I made my early comments, we don't see any dramatic declines here if there are some.

[Douglas Becker:]

Okay. And then as you look at your contracts with operators. How much concern do you have about potentially the late rig deliveries or I guess more specifically deep-water rig deliveries as we go forward?

[Doug Rock:]

I think in the shorter-term, probably not that much, I think the further out we get, where maybe, one statistics that sit with all the people that have ordered floaters of the big five that go from 75% to 50% market share by 2012. I think when we look out beyond 2009, those things are almost ready to be delivered or contracted. I think you get more uncertainty particularly those that are being finance from banks and not from cash flow from the rig companies.

[Douglas Becker:]

Thank you.

[Doug Rock:]

You are welcome.

[Operator:]

Our next question comes from Chuck Minervino from Goldman Sachs.

[Charles Minervino:]

Hi good morning.

[Doug Rock:]

Good morning.

[John Yearwood:]

Good morning.

[Charles Minervino:]

I was just wondering if you can give us a little update on new awards for fluids contracts associated with some of these new offshore rigs coming. Is there any update, are there some tenders out that you guys are looking to bid on and potentially win? What's the latest update there?

[Doug Rock:]

As John mentioned, we got something like $1 billion in new contracts, but the contracts are all with the operators. And for example, if I went out three years and BP was getting the rig, and I had to re-do my contracts with BP in that timeframe. I wouldn't know if I got the rating loss like at the BP work, but it's not for the rig, it's with the operator. So it's operator dependent.

[Charles Minervino:]

Okay. And then just a couple of questions on W-H one question, how much... how EPS accretive was it this quarter?

[Margaret K. Dorman:]

Chuck, it was been 4% to 5% earning accretion.

[Charles Minervino:]

Okay. And then if we look out into next year, just in terms of your guidance or outlook that you don't expect EPS to be down. If we excluded W-H from that, would you still expect it to be up or at this stage, it's difficult to tell?

[Doug Rock:]

Yes, I think it's too early to make that call. We are not going to have our formal plan presented to you until January, and we'll have our Board to take a look at it in December. So I really couldn't answer that now.

[Charles Minervino:]

Okay. Thank you.

[Operator:]

Our next question comes from Brad Handler from Credit Suisse.

[Brad Handler:]

Thanks. Good morning all.

[Doug Rock:]

Good morning Brad.

[John Yearwood:]

Hi Brad.

[Brad Handler:]

Could you... couple of things, I guess. First, was there anything in the third quarter results that was a function of W-H integration costs? Maybe I missed something in the release, but I don't think I saw anything?

[Margaret K. Dorman:]

No. There is no... you are saying are there non-recurring costs that are in income statement Brad?

[Brad Handler:]

Yes.

[Margaret K. Dorman:]

The answer to that is no.

[Doug Rock:]

And the reason is they took... because we closed it three or four weeks later than we plan they took some of those costs into their second quarter and then some into the stub period prior to the acquisition. So there was really not much left.

[Brad Handler:]

Got you, okay; that's helpful. And then I guess sort of unrelated follow up though. In terms of your thinking on the fourth quarter, I know there are a number of moving parts, but I guess I am trying to reconcile the guidance a little bit, if I had backed the hurricane stuff and you get through about $1.06.

[Doug Rock:]

Although we may not all fully be back.

[Brad Handler:]

Okay. That's part of the answer; okay. Well, here is that... maybe you can help me with thinking a little bit. If I... if there is a couple of $200 million or more revenues that we're going to get, because of... which you are going to get because of W-H being on and healthy margins. Even allowing for higher interest expense and allowing for the higher share account, it seems as though that you might be talking about a nice amount of accretion relative to that $1.06 or admittedly maybe it's not a $1.06.

[Doug Rock:]

Yes, but on the other side, we're not sure with the prices of gas how much the rig count will decline between now and the end of the year. Some people think it could go 100 and150, hopefully not that much, but you've got something going the other way.

[Brad Handler:]

Is there anything...

[Doug Rock:]

Trying to make a judgment with our guidance.

[Brad Handler:]

Fair enough. Is there anything going the other way potentially outside of North America?

[Doug Rock:]

Nothing that I'm aware of. Do you think anything, John?

[John Yearwood:]

Nothing in particular that I am aware of, no Brad.

[Brad Handler:]

Okay. So it's just they are allowing for some conservatism potentially on the interest in the U.S. rig count basis stuff and Canadian as well?

[Doug Rock:]

Yes.

[Brad Handler:]

Okay. All right, thanks; appreciate it.

[Doug Rock:]

You're welcome.

[Operator:]

Our next question comes from Mike Urban from Deutsche Bank.

[Michael Urban:]

Thanks, good morning.

[Doug Rock:]

Good morning Mike.

[Michael Urban:]

The W-H businesses are... tend to have a little more operating leverage, a little more cyclicality than some of the legacies in Smith businesses especially with respect to North America. Is there anything that you are doing proactively or any adjustments you are making or thinking about making in light of the expected declines in North America?

[John Yearwood:]

No, Mike, this is John here. No, they have very executionally focused, operationally focused personnel close customer contact, highly respected in the areas that they operate. So, we are continuing as business as usual, we're sold out, turning out jobs at the moment across the entire ex-W-H product line. We are just watching the situation carefully; and if anything going forward, we'll make the necessary adjustments, but right now...

[Doug Rock:]

Yes, two things, Michaels, feel that the cyclicality won't be maybe to the extend that you are thinking. Number one, we are in the higher tech end and in the higher margin end of the... of our customers operations in North America. And secondly, with the much lower penetration internationally, we think that will offset that for some period of years as we build it up. So I think those two factors lead us to believe we won't see just your normal North American cyclicality of the W-H businesses.

[Michael Urban:]

Okay, that's helpful. So your... Doug, then in on your comments about so far so good in October pertained to, I realize as the company as a whole, but you would apply that to both the Smith and the former W-H side?

[Doug Rock:]

Definitely, yes.

[Michael Urban:]

Okay, great, that's helpful.

[Doug Rock:]

And like I said, we are 30% of the way through the quarter, so at least we've got some feel for it.

[Michael Urban:]

Okay, great. That's all for me, thank you.

[Doug Rock:]

Okay.

[Operator:]

Our next question comes from Bill Herbert from Simmons & Company.

[William Herbert:]

Thanks, good morning.

[Doug Rock:]

Yes good morning Bill.

[William Herbert:]

Doug, not your process, so I get that. But just sort of walking through a world of sort of scenario planning here for a second. In the event that you or we witness a relatively consequential decline in the U.S. rig count, call it, 500 rigs from the recent peak and the international growth rate in activity is well off the recent trend of 12% to 15% per annum to something closer to 5%. Under that scenario, do you think '09 EPS is up year-over-year?

[Doug Rock:]

I am just working on those numbers right now that I couldn't tell you under that scenario.

[William Herbert:]

Okay.

[Doug Rock:]

I mean we don't think the international probably at this point is going to be up double-digits.

[William Herbert:]

Yes.

[Doug Rock:]

Maybe not at the single-highs, and we don't think North America will be down as much as some people think. But we think it will be down under that basis. But using your, I mean even when you say that 400 to 500 rigs, does that occur by March or does that occur by next December. Timing is so critical, and that's what we are trying to lay out right now.

[William Herbert:]

Okay. And in the event that a contraction in U.S. activity is relatively sharp and severe and quick. Do you think we get back to '01, '02 margins, or is that too penal?

[Doug Rock:]

It just depends. If you look at where we were in '02 with the 37% rig count contraction, we actually lost about 100 basis points on pricing. The margins were really sense of volume.

[William Herbert:]

Right.

[Doug Rock:]

But really our margins were higher than they were in other downturns. So we had higher highs and higher lows. I mean I think to get to that point with that kind of size of downturn, you need 700 to 800 rig decline when you are talking close top 40%.

[William Herbert:]

Yes, Got you.

[Doug Rock:]

So I mean, it's still penal just from your description.

[William Herbert:]

Okay. Last one for you; walk me through how... well, simply stated the integration of WH. How does that formulation change in terms of you plans in the event you see a pretty significant contraction in the U.S. rig count in 2009?

[John Yearwood:]

Bill, this is John. I will try to answer that.

[William Herbert:]

Sure.

[John Yearwood:]

W-H company is their one of the key growth services they have product of course is pathfinder DMW, LWD. And they are performing on as I have mentioned those high value added wells horizontal place in the unconventional gas.

[William Herbert:]

Right.

[John Yearwood:]

And they are also in certain other international markets high value.

[William Herbert:]

Yes.

[John Yearwood:]

Our plan is to continue to grow that business line.

[William Herbert:]

Yes.

[John Yearwood:]

Without they can perform.

[William Herbert:]

Yes.

[John Yearwood:]

Into the high end plays. We see those high end plays continuing as the margins for the operators are generally better. And we will continue to fund the R&D and the capital to grow our market share.

[William Herbert:]

In the U.S., are you guys still adding to a headcount with regard to W-H business and to Smith overall or are you taking away to see approach?

[John Yearwood:]

We are headcounts up, there were 4,000 great team members coming in from the W-H organizations that joined us the third quarter. We are adding people, we are adding engineers for our MWD, LWD.

[William Herbert:]

Got you. Okay.

[Doug Rock:]

And good quality direction drillers.

[William Herbert:]

All right

[Doug Rock:]

As the past, Bill, when we had reference parts, we continue with the research and the product development. So under any case I wouldn't see any reductions in those areas. It could be field people if a particular area went down and we couldn't... we didn't have a way to higher cost structure, but the product development research definitely goes on.

[William Herbert:]

Okay, great. Thanks for your insights.

[Doug Rock:]

Yes, you're welcome.

[John Yearwood:]

Thanks Bill.

[Operator:]

Our next question comes from Geoff Kieburtz from Weeden.

[Geoff Kieburtz:]

Good morning.

[Doug Rock:]

Yes, hi Geoff.

[Geoff Kieburtz:]

Maybe a little bit out of sorts of questions, but we have seen a lot of financial strengths across the industry, potentially I guess. Having just completed this large merger W-H, do you feel like Smith is still in a position to take advantage of opportunities over the next 12 months that might arise because other financial difficulty?

[Doug Rock:]

Yes, definitely. I mean essentially if you look at a year ago, our debt to capital is 23%, now it's 32.6%. So we are just mildly increased our leverage, but I think we have substantially increased our cash flows, so I mean we paid down over a period of one year or less time, I think 700 basis points debt to cap. So we've got the huge cash flow coming out of the company. So if there is some opportunities there, whether it's acquisitions or whatever, we still plan to take advantage of them.

[Geoff Kieburtz:]

And when you look at the portfolio businesses within Smith, post the W-H combination, do you see obvious places, where acquisitions might be the better past to fill out that portfolio rather than just organic growth?

[Doug Rock:]

Yes, essentially W-H added four additional areas of growth on top of the four that we had in some areas of higher potential growth, certainly.

[Geoff Kieburtz:]

Okay. Any thoughts you are willing to share in terms of your where acquisitions might be the most effective path?

[Doug Rock:]

Really in any of those areas, I mean just as in the past, we wanted to buy a diamond bit company, we couldn't find one. So we built it ourselves. We wanted to buy a completion fluids company, we couldn't find one at the right value, so we built it ourselves. It's just a matter of value and timing. And we are looking at alternatives on both sides of that right now.

[Geoff Kieburtz:]

Okay, great, thank you.

[Doug Rock:]

You are welcome.

[Operator:]

Our next question comes from Dan Pickering from Tudor Pickering.

[Dan Pickering:]

Good morning guys.

[Doug Rock:]

Good morning Dan.

[Dan Pickering:]

If we look at cash spend for next year at this point assuming virtues to simply add W-H full year, directionally guys, I mean what's the budget looks like, you talked a little bit about Q4 spending for tools et cetera. Do we spend more in '09 versus '08 pro forma?

[Margaret K. Dorman:]

Dan, my expectation is we'll be able to give clear guidance on that on the fourth quarter call. But I think directionally, John mentioned, you are going to see the spending up marginally. We gave you a 140 run rate for the fourth quarter, but I also talked about the fact that there is non-recurring spend in there. But yes, I think directionally, you'll see the full year '09 number somewhat over the full year as reported '08 number. But I think that's marginal, and I think we'll be able to give you a better guidance on the fourth quarter call.

[Doug Rock:]

That field is now is similar.

[Dan Pickering:]

Okay. So even with W-H added queue added, it would only be flattish to slightly up.

[Doug Rock:]

Yes, there is some areas that may go down and some that will go up. So we've got out... Margaret says, we've got to look at each one and balance it out.

[Dan Pickering:]

Right. Margaret, while we've got you talking, as you look at the balance sheet and the debt sort of world out there right now, how do you... how would you characterize your ability to go out and swap out the billion in the short term line, I mean is it there right now, and how do you monitor those...

[Margaret K. Dorman:]

I mean it's... I mean we are an investment grade company, and it's there just a question of the price that you would pay, but as I noted in my comments, the bridge loan is it matures in mid-August of '09, so we don't see that as a near time event. But certainly there is a shelf registration out there when it gets to a range that we like the price, then we'll consider it.

[Dan Pickering:]

Fair enough. Thank you.

[Doug Rock:]

Thanks.

[Operator:]

Our next question comes from Michael LaMotte from JPMorgan.

[Michael LaMotte:]

Thanks. Good morning.

[Doug Rock:]

Good morning Mike.

[Michael LaMotte:]

John, first of all, if I may to you on the notion of efficiency at the drill string, it strikes me their optimization of it. There is a lot of low hanging fruit now that you have got essentially all the parts in there and the underlying system of, i-Drill. Can you talk us through that a little bit in terms of what it looks like and what potentially the benefits are?

[John Yearwood:]

Yes, Michael, yes. You used the word low hanging fruit. But I would say that there are great growth opportunities. The ability of i-Drill to do what it does today in optimizing the selection and type of drill bit for the whole is going to be drilled, it's recognized by our customers around the world as being best-in-class. We are growing that and we are looking to optimize it with the addition of another proprietary piece of software that we have so that in the near future and starting very quickly, we will be looking to optimize the entire drilling assembly. We know today that the many, many rigs are drilling in sub optimal conditions in terms of excessive vibration or excessive torque, they are taking too long to drill these wells. And we believe that in a very short period of time with the in-house capabilities that we now have across the entire drilling assembly. And with the proprietary i-Drill software, we can make a difference to our customers drilling performance. And that's something that does not require any more CapEx or equipment than what we have today. It's basically taking what we have and optimizing it.

[Michael LaMotte:]

If I think about the opportunity to package is the priority going to be on, sorry to use the word bundling, but on bundling the components of the bottom whole assembly or do you envision Smith ultimately bundling everything including... everything that you do including fluids et cetera.

[John Yearwood:]

No, no, I don't see it as bundling. I see it as the our, client the operators saying look, I need to place the well at a certain depth at certain angle, certain direction, x amount of feet horizontal. And tell me how is the best way to drill that well into safest and most... shortest period of time. So, we will do the work, do the software analysis, do the simulation, design the well before even committing to anything and in many cases in today as Doug has mentioned, we will use competitor element within that drilling assembly. We will make sure that what we are offering to our clients is the best in class available technologies to achieve the well construction and well work placement in the way that they want it to happen. So, no I am not talking about bundling our services at all, I am talking about knowing what is best to create the optimum well as per our clients requirements and then using the bits and pieces that we have if they are the best in class to make that happen.

[Doug Rock:]

Essentially, Mike, it's performance based drilling, where really the direction of drilling component with the LWD is the lead in.

[Michael LaMotte:]

I think that's such clear clarification on strategy relative to others out there, I just wanted to make sure that point, got me?

[Doug Rock:]

Yes.

[John Yearwood:]

Yes, it's very clear for us, so where we are going now. By having this knowledge of with what works best where and when and how. Of course that provides a loop mechanism back into our research and engineering department, so that we are constantly able to know what tools are going to be required going forward.

[Michael LaMotte:]

Thank you. Margaret or Doug, if I can ask you a question on the change in the bit market over the last five or so years it's gone a lot more rental versus consumable, and I am curious as to your thoughts in terms of how that impacts that the capital cycle for Smith particularly as we enter into a period, where there is a lot of uncertainty on drilling activity.

[John Yearwood:]

Actually it's usually the diamond bits that are more on the rental side, and that's... mainly North America was probably 95% plus. But part of the North Sea certainly does it. It's not a high amount of capital just because you depreciate the most of it on your first run. So, we haven't seen a big capital increase at all by doing it that way. And that's only because in the past what we did is we built on dollar, which meant we didn't... even if somebody brought the bit, we didn't build until after they used it. So, essentially we haven't changed the cash flow model to any extent.

[Michael LaMotte:]

Okay, that's very helpful.

[Doug Rock:]

Sort of an order deal this business, but that's how it works.

[Michael LaMotte:]

Okay, great. And then last thing Margaret, if I can on Wilson, was there any inventory gain in terms of impact on the margin here in the second quarter, just trying to look senses sustainability?

[Margaret K. Dorman:]

No. Not, we didn't pull LIFO through if that is the question.

[Michael LaMotte:]

Yes, okay. Great, thanks.

[Margaret K. Dorman:]

And there is no anomalies in those numbers, just had a very good quarter.

[Michael LaMotte:]

Very good quarter.

[Doug Rock:]

We just did really, really well.

[Michael LaMotte:]

Really well. Okay, thanks guys.

[John Yearwood:]

Thank you Michael.

[Operator:]

Our next question comes from Robin Shoemaker from Citigroup.

[Robin Shoemaker:]

Thank you, good morning.

[Doug Rock:]

Hi Rob.

[Robin Shoemaker:]

Just a one question; Doug, on the last call, you referenced some cost pressures that Smith was experiencing in transportation in other areas. Could you just generally comment on what you see as the cost environment going forward? And are there areas, where you are looking at potentially lower costs in any category of costs that Smith has?

[Doug Rock:]

Yes.

[Robin Shoemaker:]

That could benefit us going forward?

[Doug Rock:]

Yes, the transportation and the petroleum based fluids pressures are actually coming off right now as the price of the petroleum products goes down, surcharges come off to the extent those to go back or index back to the customers in a number of cases they are, but it certainly takes the short-term pressure often from that stand point.

[Robin Shoemaker:]

Okay, and in terms of W-H and Smith sort of just wage kind of rates or equalization or whatever is, is there any say reduced pressure on labor costs impacting you going forward?

[Doug Rock:]

No, not really. I think the wages as we look that in for both of groups were similar than they both of them paid recently well around the world and we'd see a normal increase in the wages this year some place in the 4% range, so no change really at all.

[Robin Shoemaker:]

Okay. Finally just a quick one

[Margaret K. Dorman:]

Well, certainly, that's why I made the comment that if we see the activity levels moderate, we could generate more cash flow and that could limit how much we needed to tap the public market for us. So certainly we'll look at as we go forward. But that's our mindset is to generate positive free cash and that might limit the amount of rigs that you had to refinance, Robin.

[Robin Shoemaker:]

Yes, okay.

[Doug Rock:]

Yes, still two-thirds of our tangible network is working capital, so less growth we have, the more cash that comes out.

[Robin Shoemaker:]

Yes, thank you.

[Operator:]

Our next questions comes from David Anderson from UBS.

[J. David Anderson:]

Thank you. I was just wondering if you could expand a little bit on the comment about drill pipes, so it was down 61% quarter-to-quarter, primarily because you are looking at more spot sales. I don't quite understand how that works out to 61% down. I know we had some pretty good numbers in drill pipe and overall I thought the market was pretty tight.

[Doug Rock:]

Yes, we actually only act as a representative, we don't manufacture the drill pipe itself. So typically it's a big order type of business, and we just didn't see those big orders coming in from the quarter. So we are just selling as John mentioned more on the spot, which is higher margins for us. It's not a primary business. We don't manufacture, we just do it as a pass through.

[J. David Anderson:]

And roughly how much in revenue is that on an annual basis, pipe?

[Doug Rock:]

It goes up and down.

[J. David Anderson:]

But a couple of $100 million or so?

[Doug Rock:]

It was... it's certainly a lot. No, I don't think it ever reach that much, but it may have for the prior year.

[J. David Anderson:]

Okay, fair enough. One last...

[Doug Rock:]

Main productive, but that's very low margins for us.

[J. David Anderson:]

Okay. Just one last question, recognizing that your secondary sales on the contracts with the offshore rigs, just wonder if you could talk a little bit about pricing. How does pricing work with the contracts? Is that kind of fix, is there a flexibility, how do you see that playing out?

[Doug Rock:]

Yes, there is nothing fixed about it. What we do is we give our project managers the responsibility to improve margins through new products, and we also escalate prices based on costs. We index most on the flat soil gram in terms of petroleum feed stocks or transportation costs. So typical contracts by the time we are complete with them, we actually have somewhat higher margins on where we start.

[Doug Rock:]

Okay. Thank you very much.

[Margaret K. Dorman:]

David, the question on drill pipe, I think the year-to-date number is around $110 million.

[J. David Anderson:]

Okay. Thank you, Margaret.

[Margaret K. Dorman:]

Thank you.

[Doug Rock:]

Yes.

[Margaret K. Dorman:]

And Hilda, I think we've exceeded our time allotment for the call. Why don't we take one more question?

[Operator:]

Our next question is from Rob Mackenzie from FBR Capital Markets.

[Robert Mackenzie:]

Good morning folks. One last follow up for you. I just wanted to get some guidance on how we should think about potential inventory destalking in the distribution business in the light of a contraction of several hundred... 400, 500 rigs in the U.S. and perhaps the severe break up in Canada in next spring?

[Doug Rock:]

Certainly most of the inventory there is very high turn rate typically 30 to 60 days. So clearly if you just work on the turn ratios, but we don't see... as I mentioned, so much of this is going into your higher end areas. We don't see a huge decline in that business. But I think if you model the revenue inventory relationship, we get that in the line of very quickly.

[Robert Mackenzie:]

Okay. Thanks.

[Doug Rock:]

You're welcome. Well again, thank you very much for joining us for the third quarter call, and we look forward to talking you in late January for the year-end results. Good bye.

[Operator:]

Thank you. Ladies and gentlemen, this concludes your conference call. We thank you for participating. You may now disconnect. .