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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____ to ____
Commission file number
1-8514
SMITH INTERNATIONAL, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 95-3822631
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
411 NORTH SAM HOUSTON PARKWAY, SUITE 600 77060
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)
(281) 443-3370
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
The number of shares outstanding of the Registrant's common stock as of
November 3, 2004 was 104,877,439.
INDEX
PAGE NO.
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the Three Months and Nine Months ended September 30, 2004 and 2003............................. 1
CONSOLIDATED CONDENSED BALANCE SHEETS
As of September 30, 2004 and December 31, 2003..................................................... 2
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the Nine Months ended September 30, 2004 and 2003.............................................. 3
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS............................................... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............. 13
ITEM 3. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES............................................... 21
ITEM 4. CONTROLS AND PROCEDURES............................................................................ 21
PART II - OTHER INFORMATION
ITEMS 1-6................................................................................................... 22
SIGNATURES........................................................................................................... 24
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------------- ----------------------------------
2004 2003 2004 2003
--------------- --------------- --------------- ---------------
Revenues...................................................$ 1,119,184 $ 924,792 $ 3,201,422 $ 2,611,286
Costs and expenses:
Costs of revenues...................................... 780,201 646,390 2,221,069 1,832,631
Selling expenses....................................... 172,348 150,411 500,890 430,378
General and administrative expenses.................... 48,418 39,183 171,250 116,898
------------ ------------ ------------ ------------
Total costs and expenses........................... 1,000,967 835,984 2,893,209 2,379,907
------------ ------------ ------------ ------------
Operating income........................................... 118,217 88,808 308,213 231,379
Interest expense........................................... 9,965 10,198 28,803 31,372
Interest income............................................ (327) (534) (981) (1,636)
------------ ------------ ------------ ------------
Income before income taxes, minority interests and
cumulative effect of change in accounting principle.... 108,579 79,144 280,391 201,643
Income tax provision....................................... 35,129 25,524 90,955 64,678
Minority interests......................................... 21,557 18,616 65,216 50,346
------------ ------------ ------------ ------------
Income before cumulative effect of change in accounting
principle.............................................. 51,893 35,004 124,220 86,619
Cumulative effect of change in accounting principle,
net of tax and minority interests...................... - - - (1,154)
------------ ------------ ------------ ------------
Net income.................................................$ 51,893 $ 35,004 $ 124,220 $ 85,465
============ ============ ============ ============
Basic:
Earnings per share before cumulative effect of change
in accounting principle............................$ 0.51 $ 0.35 $ 1.23 $ 0.87
Cumulative effect of change in accounting principle.... - - - (0.01)
------------ ------------ ------------ ------------
Earnings per share.....................................$ 0.51 $ 0.35 $ 1.23 $ 0.86
============ ============ ============ ============
Diluted:
Earnings per share before cumulative effect of change
in accounting principle............................$ 0.51 $ 0.35 $ 1.21 $ 0.86
Cumulative effect of change in accounting principle.... - - - (0.01)
------------ ------------ ------------ ------------
Earnings per share.....................................$ 0.51 $ 0.35 $ 1.21 $ 0.85
============ ============ ============ ============
Weighted average shares outstanding:
Basic.................................................. 101,290 100,095 101,313 99,702
Diluted................................................ 102,424 101,093 102,545 100,774
The accompanying notes are an integral part of these
consolidated condensed financial statements.
1
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
(In thousands, except par value data)
(Unaudited)
September 30, December 31,
2004 2003
-------------- --------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents.................................................. $ 65,035 $ 51,286
Receivables, net........................................................... 910,281 801,819
Inventories, net........................................................... 834,563 739,627
Deferred tax assets, net................................................... 43,683 31,238
Prepaid expenses and other................................................. 67,303 55,826
-------------- --------------
Total current assets................................................... 1,920,865 1,679,796
-------------- --------------
Property, Plant and Equipment, net............................................. 548,845 534,871
Goodwill, net.................................................................. 711,486 690,593
Other Assets................................................................... 190,173 191,787
-------------- --------------
Total Assets................................................................... $ 3,371,369 $ 3,097,047
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current portion of long-term debt................ $ 193,605 $ 89,747
Accounts payable........................................................... 354,114 310,754
Accrued payroll costs...................................................... 74,901 73,723
Income taxes payable....................................................... 91,873 69,301
Other...................................................................... 96,294 87,399
-------------- --------------
Total current liabilities.............................................. 810,787 630,924
-------------- --------------
Long-Term Debt................................................................. 390,849 488,548
Deferred Tax Liabilities....................................................... 84,503 80,065
Other Long-Term Liabilities.................................................... 80,932 74,066
Minority Interests............................................................. 650,107 587,668
Commitments and Contingencies (See Note 14)
STOCKHOLDERS' EQUITY:
Preferred stock, $1 par value; 5,000 shares authorized; no shares
issued or outstanding in 2004 or 2003.................................. - -
Common stock, $1 par value; 150,000 shares authorized; 104,874 shares
issued in 2004 (102,720 shares issued in 2003)......................... 104,874 102,720
Additional paid-in capital................................................. 419,769 371,438
Retained earnings.......................................................... 903,343 779,123
Accumulated other comprehensive income..................................... 11,088 11,625
Less - Treasury securities, at cost; 3,529 common shares in 2004 (2,384
common shares in 2003)................................................. (84,883) (29,130)
-------------- --------------
Total stockholders' equity.......................................... 1,354,191 1,235,776
-------------- --------------
Total Liabilities and Stockholders' Equity..................................... $ 3,371,369 $ 3,097,047
============== ==============
The accompanying notes are an integral part of these consolidated
condensed financial statements.
2
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended
September 30,
----------------------------------
2004 2003
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................... $ 124,220 $ 85,465
Adjustments to reconcile net income to net cash provided by operating
activities, excluding the net effects of acquisitions:
Cumulative effect of change in accounting principle...................... - 1,154
Litigation-related charge................................................ 31,439 -
Depreciation and amortization............................................ 79,286 75,368
Minority interests....................................................... 65,216 50,346
Deferred income tax provision............................................ (3,747) 11,581
Provision for losses on receivables...................................... 3,349 1,797
Gain on disposal of property, plant and equipment........................ (7,764) (6,393)
Foreign currency translation losses...................................... 2,363 1,703
Changes in operating assets and liabilities:
Receivables.............................................................. (108,189) (119,417)
Inventories.............................................................. (93,618) (83,829)
Accounts payable......................................................... 41,956 41,017
Other current assets and liabilities..................................... (15,195) 21,508
Other non-current assets and liabilities................................. (1,835) (13,487)
------------- -------------
Net cash provided by operating activities.................................... 117,481 66,813
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired.............................. (45,762) (78,907)
Purchases of property, plant and equipment................................... (75,568) (70,057)
Proceeds from disposal of property, plant and equipment...................... 15,093 17,242
------------- -------------
Net cash used in investing activities........................................ (106,237) (131,722)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt..................................... 68,770 60,653
Principal payments of long-term debt......................................... (78,946) (58,204)
Net change in short-term borrowings.......................................... 19,126 4,400
Proceeds from exercise of stock options...................................... 48,212 15,195
Purchases of treasury stock ................................................. (54,026) -
------------- -------------
Net cash provided by financing activities.................................... 3,136 22,044
------------- -------------
Effect of exchange rate changes on cash...................................... (631) 503
------------- -------------
Increase (decrease) in cash and cash equivalents............................. 13,749 (42,362)
Cash and cash equivalents at beginning of period............................. 51,286 86,750
------------- -------------
Cash and cash equivalents at end of period................................... $ 65,035 $ 44,388
============= ==============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest....................................................... $ 35,766 $ 37,679
Cash paid for income taxes................................................... 69,779 32,204
The accompanying notes are an integral part of these consolidated
condensed financial statements.
3
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION OF INTERIM FINANCIAL STATEMENTS
The accompanying unaudited consolidated condensed financial statements of Smith
International, Inc. and subsidiaries (the "Company") were prepared in
accordance with U.S. generally accepted accounting principles and applicable
rules and regulations of the Securities and Exchange Commission (the
"Commission") pertaining to interim financial information. These interim
financial statements do not include all information or footnote disclosures
required by generally accepted accounting principles for complete financial
statements and, therefore, should be read in conjunction with the audited
financial statements and accompanying notes included in the Company's 2003
Annual Report on Form 10-K and other current filings with the Commission. All
adjustments which are, in the opinion of management, of a normal and recurring
nature and are necessary for a fair presentation of the interim financial
statements have been included.
Preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities, the disclosed
amounts of contingent assets and liabilities and the reported amounts of
revenues and expenses. If the underlying estimates and assumptions, upon which
the financial statements are based, change in future periods, actual amounts
may differ from those included in the accompanying consolidated condensed
financial statements.
Management believes the consolidated condensed financial statements present
fairly the financial position, results of operations and cash flows of the
Company as of the dates indicated. The results of operations for the interim
periods presented may not be indicative of results for the fiscal year.
Certain reclassifications have been made to the prior year's financial
information to conform to the September 30, 2004 presentation.
2. DISCLOSURE RELATED TO ACCOUNTING PRONOUNCEMENTS
The cumulative effect of a change in accounting principle reflected in the
financial statements for the nine-month period ended September 30, 2003
represents the impact of the Company's adoption of Statement of Financial
Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement
Obligations."
From time to time, new accounting pronouncements are issued by the Financial
Accounting Standards Board ("FASB") which are adopted by the Company as of the
specified effective date. Unless otherwise discussed, management believes the
impact of recently issued standards, which are not yet effective, will not have
a material impact on the Company's consolidated condensed financial statements
upon adoption.
3. LITIGATION-RELATED CHARGE
During the second quarter of 2004, the Company recorded litigation-related
charges totaling $31.4 million, or $20.4 million on an after-tax basis. The
second quarter charge, which consists of an estimated loss provision, legal
fees and other directly related costs, results from a complaint which alleged
that certain of the Company's roller cone drill bit designs infringed several
of the plaintiff's U.S. patents. Approximately $28.8 million of the charges are
included in general and administrative expenses and the remainder are recorded
in costs of revenues.
4. BUSINESS COMBINATIONS AND ANNOUNCED TRANSACTIONS
During the nine months ended September 30, 2004, the Company completed four
acquisitions in exchange for aggregate cash consideration of $36.6 million. The
consideration primarily relates to the purchase of certain operating assets of
CanFish Services completed in July 2004. The CanFish operations provide
fishing, milling, casing exit, pipe recovery and related wireline services in
the Canadian and U.S. markets.
These acquisitions have been recorded using the purchase method of accounting
and, accordingly, the acquired operations have been included in the results of
operations since the date of acquisition. The excess of the purchase price over
the estimated fair value of the net assets acquired approximated $14.0 million
4
and has been recorded as goodwill in the Oilfield Products and Services segment.
The purchase price allocations related to these acquisitions are based on
preliminary information and are subject to change when additional data
concerning final asset and liability valuations is obtained; however, material
changes in the preliminary allocations are not anticipated by management. Pro
forma results of operations have not been presented because the effect of these
acquisitions was not material to the Company's consolidated condensed financial
statements.
In certain situations, the Company negotiates transaction terms, which provide
for the payment of additional consideration if various financial and/or
business objectives are met. During the nine-month period ended September 30,
2004, the Company paid $6.9 million of additional purchase consideration to the
former shareholders of IKF Services which is reflected in the accompanying
consolidated condensed balance sheet as a purchase price adjustment to
goodwill. In addition, the Company paid $2.3 million during the third quarter
of 2004 to former shareholders of acquired businesses to repay seller-financed
notes.
Additionally, in July 2004, the Company announced the signing of a non-binding
letter of intent related to the sale of Wilson Industries, Inc. ("Wilson") to
CE Franklin Ltd. Under the terms of the proposed transaction, CE Franklin would
issue common stock to the Company and remit certain amounts after closing in
exchange for the common stock of Wilson. Subsequent to the transaction, the
Company's ownership interest is expected to increase from the current 55
percent to approximately 89 percent of the outstanding shares of CE Franklin,
and accordingly, the Company would continue to consolidate the combined
distribution operations of Wilson and CE Franklin. The transaction is subject
to a number of factors, including negotiation of a definitive agreement,
approval by the minority shareholders of CE Franklin, ratification by the Board
of Directors of both companies and certain regulatory approvals. There are no
assurances as to whether this transaction ultimately will be consummated.
5. EARNINGS PER SHARE
Basic earnings per share ("EPS") is computed using the weighted average number
of common shares outstanding during the period. Diluted EPS gives effect to the
potential dilution of earnings which could have occurred if additional shares
were issued for stock option exercises under the treasury stock method. The
following schedule reconciles the income and shares used in the basic and
diluted EPS computations (in thousands, except per share data):
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------------- -------------------------------
2004 2003 2004 2003
--------------- --------------- -------------- ------------
BASIC EPS:
Income before cumulative effect of
change in accounting principle.............$ 51,893 $ 35,004 $ 124,220 $ 86,619
============== ============== ============== =============
Weighted average number of common
shares outstanding......................... 101,290 100,095 101,313 99,702
============== ============== ============== =============
Basic EPS before cumulative effect of
change in accounting principle.............$ 0.51 $ 0.35 $ 1.23 $ 0.87
============== ============== ============== =============
DILUTED EPS:
Income before cumulative effect of
change in accounting principle.............$ 51,893 $ 35,004 $ 124,220 $ 86,619
============== ============== ============== =============
Weighted average number of common
shares outstanding......................... 101,290 100,095 101,313 99,702
Dilutive effect of stock options............. 1,134 998 1,232 1,072
-------------- -------------- -------------- -------------
102,424 101,093 102,545 100,774
============== ============== ============== =============
Diluted EPS before cumulative effect of
change in accounting principle.............$ 0.51 $ 0.35 $ 1.21 $ 0.86
============== ============== ============== =============
5
6. INVENTORIES
Inventories are stated at the lower of cost or market. Cost is determined using
the average cost method for the majority of the Company's inventories; however,
certain of the Company's U.S.-based inventories are valued utilizing the
last-in, first-out ("LIFO") method. Inventory costs, consisting of materials,
labor and factory overhead, are as follows (in thousands):
September 30, December 31,
2004 2003
------------- -------------
Raw materials............................................................. $ 68,440 $ 62,631
Work-in-process........................................................... 79,595 66,151
Products purchased for resale............................................. 236,991 170,973
Finished goods............................................................ 495,581 464,151
------------- -------------
880,607 763,906
Reserves to state certain domestic inventories (cost of $329,033
and $266,328 in 2004 and 2003, respectively) on a LIFO basis............ (46,044) (24,279)
------------- -------------
$ 834,563 $ 739,627
============= =============
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following (in thousands):
September 30, December 31,
2004 2003
------------- -------------
Land...................................................................... $ 35,808 $ 38,394
Buildings................................................................. 142,644 134,568
Machinery and equipment................................................... 533,387 511,615
Rental tools.............................................................. 356,660 323,977
------------- -------------
1,068,499 1,008,554
Less-Accumulated depreciation............................................. 519,654 473,683
------------- -------------
$ 548,845 $ 534,871
============= =============
6
8. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The following table presents goodwill on a segment basis as of the dates
indicated as well as changes in the account during the period shown. Beginning
and ending goodwill balances are presented net of accumulated amortization of
$53.6 million.
Oilfield Distribution
Segment Segment Consolidated
-------------- ------------- --------------
(in thousands)
Balance as of December 31, 2003................. $ 652,822 $ 37,771 $ 690,593
Goodwill acquired............................... 13,993 - 13,993
Purchase price and other adjustments............ 6,900 - 6,900
-------------- ------------- --------------
Balance as of September 30, 2004................ $ 673,715 $ 37,771 $ 711,486
============== ============= ==============
Other Intangible Assets
The Company amortizes other identifiable intangible assets on a straight-line
basis over the periods expected to be benefited, ranging from three to 27
years. The components of these other intangible assets, recorded in Other
Assets in the accompanying consolidated condensed balance sheets, are as
follows (in thousands):
-------------------------------------- --------------------------------------
September 30, 2004 December 31, 2003
-------------------------------------- --------------------------------------
Weighted
Gross Gross Average
Carrying Accumulated Carrying Accumulated Amortization
Amount Amortization Net Amount Amortization Net Period
----------- ---------------- --------- ----------- --------------- ---------- -------------
(years)
Patents............. $ 42,284 $ 13,934 $ 28,350 $ 38,520 $ 12,015 $ 26,505 15.8
License
agreements........ 19,086 3,675 15,411 19,086 2,193 16,893 11.8
Non-compete
agreements and
trademarks........ 20,772 8,049 12,723 19,583 5,649 13,934 12.1
Customer lists
and contracts.... 9,232 1,671 7,561 8,724 877 7,847 16.6
-------- -------- -------- -------- -------- -------- --------
$ 91,374 $ 27,329 $ 64,045 $ 85,913 $ 20,734 $ 65,179 14.2
======== ======== ======== ======== ======== ======== =========
Amortization expense was $2.2 million and $2.0 million for the three-month
periods ended September 30, 2004 and 2003, respectively, and $6.6 million and
$5.4 million for the nine-month periods ended September 30, 2004 and 2003,
respectively. Additionally, estimated future amortization expense is expected
to range between $4.4 million and $8.4 million a year for the next five fiscal
years.
7
9. STOCK-BASED COMPENSATION
The Company's Board of Directors and its stockholders have authorized an
employee stock option plan. As of September 30, 2004, 3.9 million shares were
issued and outstanding under the program and an additional 2.3 million shares
were authorized for future issuance. Options are generally granted at the fair
market value on the date of grant, vest over a four-year period and expire ten
years after the date of grant.
Certain option awards granted on December 4, 2001 were subject to stockholder
approval which was not obtained until April 24, 2002. Accordingly, these
options were granted with a strike price more than five percent below the
market value on the date of issuance and do not meet the conditions necessary
to qualify as a non-compensatory option grant. Compensation expense related to
these grants is being recognized over the four-year vesting period and resulted
in the inclusion in the accompanying consolidated condensed statement of
operations of $0.1 million of related expense for each of the three-month
periods ended September 30, 2004 and 2003 and $0.3 million of related expense
for each of the nine-month periods ended September 30, 2004 and 2003.
The Company continues to apply Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations in
accounting for its stock option program, as allowed under SFAS No. 123,
"Accounting for Stock-Based Compensation." Therefore, for all options other
than those mentioned above, the Company elects to make pro forma disclosures
versus recognizing the related compensation expense in the accompanying
consolidated condensed financial statements. Had the Company elected to apply
the accounting standards of SFAS No. 123, the Company's net income and earnings
per share would have approximated the pro forma amounts indicated below (in
thousands, except per share data):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- -------------------------------
2004 2003 2004 2003
------------- ------------ ------------- ------------
Net income, as reported........................$ 51,893 $ 35,004 $ 124,220 $ 85,465
Add: Stock-based compensation expense
included in reported income, net of
related tax effect......................... 68 68 205 205
Less: Total stock-based compensation
expense determined under the Black-
Scholes option-pricing model, net of
related tax effect......................... (2,943) (2,683) (8,830) (8,048)
------------- ------------ ------------- ------------
Net income, pro forma..........................$ 49,018 $ 32,389 $ 115,595 $ 77,622
============= ============ ============= ============
Earnings per share:
As reported:
Basic......................................$ 0.51 $ 0.35 $ 1.23 $ 0.86
Diluted.................................... 0.51 0.35 1.21 0.85
Pro forma:
Basic......................................$ 0.48 $ 0.32 $ 1.14 $ 0.78
Diluted.................................... 0.48 0.32 1.13 0.77
In addition to the stock option program described above, the Company maintains
a stock grant program. The stock grants are issued at par value and are subject
to a four-year cliff-vesting schedule. Compensation expense, calculated as the
difference between the market value on the date of grant and the exercise
price, is being recognized ratably over the vesting period and resulted in the
inclusion in the accompanying consolidated condensed statements of operations
of $0.1 million of related expense for each of the three-month periods ended
September 30, 2004 and 2003, and $0.2 million and $0.4 million of related
expense for the nine-month periods ended September 30, 2004 and 2003,
respectively.
8
10. STOCKHOLDERS' EQUITY
During 2001, the Company's Board of Directors authorized a share buyback
program which allows for the repurchase of up to five million shares of common
stock, subject to regulatory issues, market considerations and other relevant
factors. During the second quarter of 2004, the Company repurchased 1.1 million
shares of common stock under the program at an aggregate cost of $54.0 million
bringing the total number of shares acquired under the program to 1.7 million.
The acquired shares have been added to the Company's treasury stock holdings
and may be used in the future for acquisitions or other corporate purposes.
11. EMPLOYEE BENEFIT PLANS
The Company maintains various noncontributory defined benefit pension plans
covering certain U.S. and non-U.S. employees. In addition, the Company and
certain subsidiaries have postretirement benefit plans which provide health
care benefits to a limited number of current, and in some cases, future
retirees. Net periodic benefit expense related to the pension and
postretirement benefit plans, on a combined basis, totaled $0.2 million for
each of the three-month periods ended September 30, 2004 and 2003 and $0.5
million and $0.6 million for the nine-month periods ended September 30, 2004
and 2003, respectively. Company contributions to the pension and postretirement
benefit plans during 2004 are expected to total approximately $2.0 million.
12. COMPREHENSIVE INCOME
Comprehensive income includes net income and changes in the components of
accumulated other comprehensive income during the periods presented. The
Company's comprehensive income is as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ - ------------------------------
2004 2003 2004 2003
----------- ------------ ----------- ------------
Net income....................................$ 51,893 $ 35,004 $ 124,220 $ 85,465
Changes in unrealized fair value of
derivatives, net............................. (367) (706) (2,405) 367
Currency translation adjustments............... 4,362 2,007 1,868 13,078
----------- ------------ ----------- ------------
Comprehensive income..........................$ 55,888 $ 36,305 $ 123,683 $ 98,910
=========== ============ =========== ============
As of September 30, 2004, accumulated other comprehensive income in the
accompanying consolidated condensed balance sheet consists of the following (in
thousands):
September 30, December 31,
2004 2003
----------------- ----------------
Currency translation adjustments............................................. $ 14,688 $ 12,820
Unrealized fair value of derivatives......................................... (66) 2,339
Pension liability adjustments................................................ (3,534) (3,534)
----------- -----------
Accumulated other comprehensive income....................................... $ 11,088 $ 11,625
=========== ===========
9
13. INDUSTRY SEGMENTS
The Company manufactures and markets premium products and services to the oil
and gas exploration and production industry, the petrochemical industry and
other industrial markets. The Company aggregates its operations into two
reportable segments: Oilfield Products and Services and Distribution. The
Oilfield Products and Services segment consists of three business units: M-I
SWACO, Smith Technologies and Smith Services. The Distribution segment includes
the Wilson business unit. The following table presents financial information
for each reportable segment and geographical revenues on a consolidated basis
(in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ---------------------------------
2004 2003 2004 2003
------------ ------------- -------------- --------------
Revenues:
Oilfield Products and Services............$ 816,788 $ 687,373 $ 2,360,103 $ 1,950,054
Distribution.............................. 302,396 237,419 841,319 661,232
------------ ------------- -------------- --------------
$ 1,119,184 $ 924,792 $ 3,201,422 $ 2,611,286
============ ============== ============== ==============
Revenues by Area:
United States.............................$ 510,484 $ 401,646 $ 1,444,217 $ 1,161,107
Canada.................................... 112,727 94,211 328,672 251,845
------------ ------------- -------------- --------------
North America..................... 623,211 495,857 1,772,889 1,412,952
------------ ------------- -------------- --------------
Latin America ............................ 111,088 98,554 302,194 251,721
Europe/Africa ............................ 238,680 222,625 708,153 620,881
Middle East .............................. 92,685 78,004 272,488 226,161
Far East ................................. 53,520 29,752 145,698 99,571
------------ ------------- -------------- --------------
Non-North America................. 495,973 428,935 1,428,533 1,198,334
------------ ------------- -------------- --------------
$ 1,119,184 $ 924,792 $ 3,201,422 $ 2,611,286
============ ============== ============== ==============
Operating Income:
Oilfield Products and Services............$ 112,737 $ 90,318 $ 297,251 $ 240,841
Distribution.............................. 7,388 229 16,920 (4,348)
General corporate......................... (1,908) (1,739) (5,958) (5,114)
------------ ------------- -------------- --------------
$ 118,217 $ 88,808 $ 308,213 $ 231,379
============ ============== ============== ==============
10
14. COMMITMENTS AND CONTINGENCIES
Standby Letters of Credit and Guarantees
In the normal course of business with customers, vendors and others, the
Company is contingently liable for performance under standby letters of credit
and bid, performance and surety bonds. Certain of these outstanding instruments
guarantee payment of notes issued to former shareholders of an acquired entity
as well as to insurance companies which reinsure certain liability coverages of
the Company's insurance captive. Excluding the impact of these instruments, for
which $28.9 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company is contingently liable for
approximately $40.3 million of standby letters of credit and bid, performance
and surety bonds at September 30, 2004. Management does not expect any material
amounts to be drawn on these instruments.
Subsequent to September 30, 2004, the Company obtained a surety bond in the
amount of $43.5 million in connection with its appeal of the patent infringement
litigation discussed below. After taking into consideration amounts reflected in
the accompanying consolidated condensed balance sheet, the Company has a
contingent liability of up to $18.4 million associated with this instrument.
Management, however, does not expect any amounts to be drawn on this instrument.
The Company has also provided loan guarantees related to certain joint ventures
accounted for under the equity method of accounting. As the net assets and cash
flows of these entities are available to satisfy obligations as they become
due, management believes the likelihood is remote that the Company will be
required to perform under these guarantees. The Company's estimated maximum
exposure under these loan guarantees approximated $19.0 million as of September
30, 2004.
Litigation
Halliburton Energy Services, Inc. v. Smith International, Inc.
On September 6, 2002, the Company was served with a complaint in the U.S.
District Court for the Eastern District of Texas, Sherman Division entitled
Halliburton Energy Services, Inc. v. Smith International, Inc. This lawsuit is a
patent infringement claim alleging that certain roller cone drill bits made by
the Company infringe several U.S. patents owned by Halliburton.
The case was tried in the second quarter of 2004 and, on June 25, 2004, a jury
verdict was rendered against the Company awarding damages of $24.0 million and
finding the infringement willful as to certain of the claims. On August 13,
2004, the Court enhanced the damage award by $12.0 million, and awarded $5.1
million in attorneys' fees and prejudgment interest. On November 4, 2004, the
court denied the Company's post-trial motions and the Company has initiated the
appeal process. Although an appeal is underway, the Company is continuing to
pursue other options, including possible settlement. Based on the facts and
circumstances and the opinion of outside counsel, management believes that the
amounts recorded reflect the best estimate of the Company's potential loss
exposure.
Rose Dove Egle v. John M. Egle, et al.
On April 17, 1997, the Company acquired all of the equity interests in Tri-Tech
Fishing Services, L.L.C. ("Tri-Tech") in exchange for cash consideration of
approximately $20.4 million (the "Transaction").
On August 25, 1998, the Company was added as a defendant in a First Amended
Petition filed in the 15th Judicial District Court, Parish of Lafayette,
Louisiana entitled Rose Dove Egle v. John M. Egle, et al. In the amended
petition, the plaintiffs alleged that, due to an improper conveyance of
ownership interest by the Tri-Tech majority partner prior to the Transaction,
Smith purchased a portion of its equity interest from individuals who were not
legally entitled to their Tri-Tech shares. The suit was tried in the first
quarter of 2004 and, on March 30, 2004, a jury verdict of approximately $4.8
million was rendered in favor of the plaintiffs. On June 1, 2004, the court
entered the judgment and the Company's post-judgment motions were subsequently
denied by the court. The Company has initiated the appeal process and does not
anticipate a ruling from the appellate court until the first half of 2005.
Based upon the facts and circumstances and the opinion of outside legal
counsel, management believes that an unfavorable outcome on this matter is not
probable at this time. Accordingly, the Company has not recognized a loss
provision in the accompanying consolidated condensed financial statements.
Other
The Company is a defendant in various other legal proceedings arising in the
ordinary course of business. In the opinion of management, these matters will
not have a material adverse effect on the Company's consolidated financial
position or results of operations.
11
Environmental
The Company routinely establishes and reviews the adequacy of reserves for
estimated future environmental clean-up costs for properties currently or
previously operated by the Company.
In connection with most business acquisitions, the Company obtains contractual
indemnifications from the seller related to environmental matters. These
indemnifications generally provide for the reimbursement of environmental
clean-up costs incurred by the Company for events occurring or circumstances
existing prior to the purchase date, whether the event or circumstance was
known or unknown at that time. A substantial portion of the Company's total
environmental exposure is associated with its M-I SWACO operations, which are
subject to various indemnifications from former owners.
As of September 30, 2004 the Company's environmental reserve approximated $10.0
million. This amount reflects the future undiscounted estimated exposure
related to identified properties, without regard to indemnifications from
former owners. While actual future environmental costs may differ from
estimated liabilities recorded at September 30, 2004, the Company does not
believe that these differences will have a material impact on the Company's
financial position or results of operations, subject to the indemnifications in
place.
During the first quarter of 2003, the Company initiated legal action against M-I
SWACO's former owners to address issues associated with certain provisions of
the environmental indemnification provided. This matter is currently expected to
go to trial during the second quarter of 2005. In the event that i) M-I SWACO's
former owners and other parties to indemnification agreements with the Company
do not fulfill their obligations, and ii) costs incurred to remediate the
identified properties reach estimated maximum exposure limits, the Company would
be required to record an additional charge of up to $25.0 million, impacting
earnings and cash flows in future periods.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following "Management's Discussion and Analysis of Financial Condition and
Results of Operations" is provided to assist readers in understanding the
Company's financial performance during the periods presented and significant
trends which may impact the future performance of the Company. This discussion
should be read in conjunction with the consolidated condensed financial
statements of the Company and the related notes thereto included elsewhere in
this Form 10-Q and the Company's 2003 Annual Report on Form 10-K.
COMPANY PRODUCTS AND OPERATIONS
The Company manufactures and markets premium products and services to the oil
and gas exploration and production industry, the petrochemical industry and
other industrial markets. The Company provides a comprehensive line of
technologically-advanced products and engineering services, including drilling
and completion fluid systems, solids-control and separation equipment,
waste-management services, oilfield production chemicals, three-cone and
diamond drill bits, turbine products, fishing services, drilling tools,
underreamers, casing exit and multilateral systems, packers and liner hangers.
The Company also offers supply chain management solutions through an extensive
branch network providing pipe, valves, fittings and mill, safety and other
maintenance products.
The Company's operations are largely driven by the level of exploration and
production ("E&P") spending in major energy-producing regions around the world
and the depth and complexity of these projects. Although E&P spending is
significantly influenced by the market price of oil and natural gas, it may
also be affected by supply and demand fundamentals, finding and development
costs, decline and depletion rates, political actions and uncertainties,
environmental concerns, the financial condition of independent E&P companies
and the overall level of global economic growth and activity. In addition,
approximately 10 percent of the Company's consolidated revenues relate to the
downstream energy sector, including petrochemical plants and refineries, whose
spending is largely impacted by the general condition of the U.S. economy.
Capital investment by energy companies is largely divided into two markets
which vary greatly in terms of primary business drivers and associated
volatility levels. North American drilling activity is primarily influenced by
natural gas fundamentals, with approximately 85 percent of the current rig
count focused on natural gas finding and development activities. Conversely,
drilling in areas outside of North America is more dependent on crude oil
fundamentals, which influence over three-quarters of international drilling
activity. Historically, business in markets outside of North America has proved
to be less volatile as the high cost E&P programs in these regions are
generally undertaken by major oil companies, consortiums and national oil
companies as part of a longer-term strategic development plan. Although over
half of the Company's consolidated revenues were generated in North America
during the third quarter of 2004, Smith's profitability was largely dependent
upon business levels in markets outside of North America. The Distribution
segment, which accounts for approximately one-quarter of consolidated revenues
and primarily supports a North American customer base, serves to distort the
geographic revenue mix of the Company's Oilfield segment operations. Excluding
the impact of the Distribution operations, approximately 59 percent of the
Company's third quarter 2004 revenues were generated in markets outside of
North America.
MARKET OUTLOOK
The Company's business is highly dependent on the general economic environment
in the United States and other major world economies, which impact energy
consumption and the resulting demand for our products and services. Current
supply and demand fundamentals are some of the tightest experienced in a number
of years, which should support modestly higher exploration and production
spending. However, crude oil prices have increased over 40 percent during the
past year and recently reached an all-time record high price - largely due to
market instability in certain geographic regions. A significant increase in
commodity prices could adversely affect global economic expansion efforts as
well as the level of worldwide drilling activity that drives demand for our
products and services.
13
RESULTS OF OPERATIONS
Segment Discussion
The Company markets its products and services throughout the world through four
business units which are aggregated into two reportable segments. The Oilfield
Products and Services segment consists of three business units: M-I SWACO,
Smith Technologies and Smith Services. The Distribution segment includes the
Wilson business unit. The revenue discussion below has been summarized by
business unit in order to provide additional information in analyzing the
Company's operations.
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------------------ -----------------------------------------
2004 2003 2004 2003
------------------- ------------------- ------------------ -------------------
Amount % Amount % Amount % Amount %
------------ ----- ------------ ----- ------------ ---- ------------- ----
FINANCIAL DATA: (dollars in thousands)
REVENUES:
M-I SWACO........................ $ 565,366 51 $ 479,724 52 $ 1,634,708 51 $ 1,356,399 52
Smith Technologies............... 126,805 11 104,505 11 373,330 12 293,250 11
Smith Services................... 124,617 11 103,144 11 352,065 11 300,405 12
------------- ----- ------------ ----- -------------- ----- ------------- -----
Oilfield Products and Services. 816,788 73 687,373 74 2,360,103 74 1,950,054 75
Wilson........................... 302,396 27 237,419 26 841,319 26 661,232 25
------------ ----- ------------ ----- -------------- ----- ------------- -----
Total....................... $ 1,119,184 100 $ 924,792 100 $ 3,201,422 100 $ 2,611,286 100
============= ===== ============ ===== ============== ===== ============= =====
GEOGRAPHIC REVENUES:
United States:
Oilfield Products and Services... $ 285,523 26 $ 231,436 25 $ 826,050 26 $ 673,133 26
Distribution..................... 224,961 20 170,210 18 618,167 19 487,974 18
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total United States......... 510,484 46 401,646 43 1,444,217 45 1,161,107 44
------------- ----- ------------ ----- -------------- ----- ------------- -----
Canada:
Oilfield Products and Services... 53,084 5 43,827 5 152,198 5 117,702 5
Distribution..................... 59,643 5 50,384 5 176,474 5 134,143 5
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total Canada................ 112,727 10 94,211 10 328,672 10 251,845 10
------------- ----- ------------ ----- -------------- ----- ------------- -----
Non-North America:
Oilfield Products and Services... 478,181 43 412,110 45 1,381,855 43 1,159,219 44
Distribution..................... 17,792 1 16,825 2 46,678 2 39,115 2
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total Non-North America..... 495,973 44 428,935 47 1,428,533 45 1,198,334 46
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total Revenue............ $ 1,119,184 100 $ 924,792 100 $ 3,201,422 100 $ 2,611,286 100
============= ===== ============ ===== ============== ===== ============= =====
OPERATING INCOME:
Oilfield Products and Services... $ 112,737 14 $ 90,318 13 $ 297,251 13 $ 240,841 12
Distribution..................... 7,388 2 229 - 16,920 2 (4,348) *
General Corporate................ (1,908) * (1,739) * (5,958) * (5,114) *
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total.................... $ 118,217 11 $ 88,808 10 $ 308,213 10 $ 231,379 9
============= ===== ============ ===== ============== ===== ============= =====
MARKET DATA:
AVERAGE WORLDWIDE RIG COUNT: (1)
United States.................... 1,475 50 1,280 48 1,390 49 1,185 46
Canada........................... 311 11 340 13 328 11 328 13
Non-North America................ 1,146 39 1,059 39 1,124 40 1,038 41
------------- ----- ------------ ----- -------------- ----- ------------- -----
Total.................... 2,932 100 2,679 100 2,842 100 2,551 100
============= ===== ============ ===== ============== ===== ============= =====
AVERAGE COMMODITY PRICES:
Crude Oil ($/Bbl) (2)............ $ 43.83 $ 30.19 $ 39.03 $ 31.05
Natural Gas ($/mcf) (3).......... $ 5.32 $ 4.74 $ 5.55 $ 5.41
(1) Source: M-I SWACO.
(2) Average West Texas Intermediate ("WTI") spot closing prices.
(3) Average weekly composite spot U.S. wellhead prices.
* not meaningful
14
Oilfield Products and Services Segment
Revenues
M-I SWACO primarily provides drilling and completion fluid systems, engineering
and technical services to the oil and gas industry. Additionally, these
operations provide oilfield production chemicals and manufacture and market
equipment and services used for solids-control, pressure control, rig
instrumentation and waste-management. M-I SWACO is significantly influenced by
spending in markets outside of North America, which contributes almost
two-thirds of the unit's revenues, and by its exposure to the U.S. offshore
market, which constitutes approximately 10 percent of the revenue base. U.S.
offshore drilling programs, which account for four percent of the worldwide rig
count, are generally more revenue-intensive than land-based projects due to the
complex nature of the related drilling environment. M-I SWACO's revenues
totaled $565.4 million for the third quarter of 2004, an increase of 18 percent
above the prior year period. Revenue growth in both North American and
non-North American markets exceeded the underlying change in rig count for the
corresponding period. Approximately two-thirds of the overall revenue
improvement was generated in markets outside of North America, largely
influenced by new contract awards and increased customer spending in the former
Soviet Union ("FSU"), the Middle East and the Far East markets. North American
revenues rose from the prior year level, despite a 19 percent reduction in
offshore business volumes that primarily resulted from adverse drilling
conditions in the U.S. Gulf. Revenues reported in the United States and Canada
benefited from increased spending levels by independent oil companies on
land-based projects and, to a lesser extent, incremental sales from operations
acquired in the fourth quarter of 2003. While the majority of the overall
revenue increase on a product basis reflects higher sales of drilling fluid
products and services, revenues related to waste management offerings, which
were 33 percent above the prior year level, also contributed to the
improvement. For the nine-month period, M-I SWACO reported revenues of
approximately $1.6 billion, a 20 percent increase over the amount reported in
the first nine months of 2003. The majority of the revenue growth was reported
in markets outside North America, specifically the FSU and Middle East regions,
reflecting new contract awards and increased investment by major and
international exploration and production companies.
Smith Technologies designs, manufactures and sells three-cone drill bits,
diamond drill bits and turbines for use in the oil and gas industry. Due to the
nature of its product offerings, revenues for these operations correlate more
closely to the rig count than any of the Company's other businesses. Moreover,
Smith Technologies has the highest North American revenue exposure of the
Oilfield segment units. Smith Technologies reported revenues of $126.8 million
for the quarter ended September 30, 2004, an increase of 21 percent over the
comparable prior year period. The year-over-year comparison was impacted by the
inclusion of several large international export orders in the third quarter of
2003. Excluding export orders, revenues were approximately 25 percent above the
level reported in the prior year quarter, influenced by the increase in
worldwide activity levels. Approximately two-thirds of the year-over-year
revenue growth was reported in North America, where sales volumes grew at more
than twice the rate of the underlying change in rig count. The revenue increase
in the United States and Canada was attributable to a combination of higher
land-based drilling activity, increased demand for diamond bit products
specifically designed for the North American rental market and, to a lesser
extent, higher unit pricing. Revenues generated in markets outside North
America exceeded the corresponding change in activity levels as increased
demand for drilling bits, primarily in the Far East and Latin America,
more than offset a reduction in international export orders. For the nine-month
period, Smith Technologies reported revenues of $373.3 million, a 27 percent
increase over the comparable period of 2003. Approximately 70 percent of the
revenue growth was generated in North America, benefiting from a combination of
increased market penetration, higher land-based drilling activity and, to a
lesser extent, improved pricing.
Smith Services manufactures and markets products and services used in the oil
and gas industry for drilling, work-over, well completion and well re-entry.
Revenues for Smith Services are evenly distributed between North America and
the international markets and are heavily influenced by the complexity of
drilling projects, which drive demand for a wider range of its product
offerings. For the quarter ended September 30, 2004, Smith Services' revenues
totaled $124.6 million, 21 percent above the prior year period. The
year-over-year revenue comparison was impacted by a higher level of tubular
product orders in the current period and incremental revenues from the CanFish
acquisition completed during the quarter. Excluding the impact of the CanFish
acquisition and tubular sales, which are not highly correlated to drilling
activity, base business revenues grew approximately 12 percent largely
associated with the general increase in global E&P spending. Three-quarters of
the core business growth was reported in the United States, primarily
reflecting increased customer demand for remedial and drilling-related product
and service lines. For the first nine months of 2004, Smith Services reported
revenues of $352.1 million, a 17 percent increase from the comparable prior
year period. The favorable revenue comparison reflects higher sales across all
core product lines, driven by the general increase in global exploration and
production spending levels. Two-thirds of the revenue growth was reported in the
United States, influenced by strong demand for drilling-related and remedial
product and service lines due, in part, to new product introductions.
15
Operating Income
Operating income for the Oilfield Products and Services segment was $112.7
million, or 14 percent of revenues, for the three months ended September 30,
2004. Oilfield operating income increased $22.4 million over the amount
reported in the prior year quarter reflecting the effect of higher revenue
volumes on the segment's reported gross profit, partially offset by growth in
variable-based operating expenses. Segment operating margins increased one
percentage point above the prior year quarter primarily related to reduced
operating expenses as a percentage of revenues and, to a lesser extent, gross
margin expansion. Oilfield gross margin improvement reflects the effect of
higher sales volumes on fixed cost coverage and increased absorption in the
Company's manufacturing operations. To a lesser extent, price increases
implemented during the fourth quarter of 2003 and early 2004 had a favorable
impact on reported margins. Although the Company has announced price increases
in 2004, which should lead to margin expansion in future periods, the amount of
net pricing realized has been and will continue to be impacted by rising costs,
and there is no assurance that the expected benefits of the price increases
will ultimately be realized. For the nine-month period, Oilfield operating
margins, exclusive of the second quarter litigation-related charge of $31.4
million, improved 1.5 percentage points reflecting gross margin expansion and,
to a lesser extent, reduced operating expenses as a percentage of revenues. On
an absolute dollar basis, nine-month operating income exclusive of the second
quarter charge was $87.8 million above the comparable prior year period
attributable to the impact of higher revenue volumes on the segment's reported
gross profit, partially offset by growth in variable-based operating expenses
associated with the expanding business base.
Distribution Segment
Revenues
Wilson markets pipe, valves, fittings and mill, safety and other maintenance
products to energy and industrial markets, primarily through an extensive
network of supply branches in the United States and Canada. The segment has the
most significant North American revenue exposure of any of the Company's
operations with 95 percent of Wilson's 2004 revenues generated in those
markets. Moreover, approximately one-third of Wilson's revenues relate to sales
to the downstream energy sector, including petrochemical plants and refineries,
whose spending is largely influenced by the general state of the U.S. economic
environment. Additionally, certain customers in this sector utilize petroleum
products as a base material and, accordingly, are adversely impacted by
increases in crude oil and natural gas prices. Distribution revenues were
$302.4 million for the third quarter of 2004, 27 percent above the comparable
prior year period. The year-over-year revenue growth was relatively balanced
between the energy and industrial operations influenced by increased demand for
tubular products, sales of which were approximately 60 percent above the amount
reported in the prior year quarter. Distribution revenues were also impacted by
the higher level of North American drilling and completion activity on the
energy sector operations and the implementation of new contract awards and
increased project spending in the refining and petrochemical markets. In the
first nine months of 2004, Wilson reported revenues totaling $841.3 million, an
increase of 27 percent from the first nine months of 2003. The majority of the
revenue variance from the prior year period was generated by the energy
operations, reflecting higher North American activity levels, the impact of new
contract awards and, to a lesser extent, strong demand for tubular products.
Operating Income
Operating income for the Distribution segment was $7.4 million, or two percent
of revenues, for the three months ended September 30, 2004. Segment operating
income increased $7.2 million from the near breakeven amount reported in the
third quarter of 2003, equating to incremental operating income of
approximately 11 percent of revenues. The incrementals, which were influenced
by improvement in the energy and industrial sectors, were above those
historically reported in the segment, attributable to a combination of
increased tubular sales volumes and related pricing and improved coverage of
fixed sales and administrative costs. On a year-to-date basis, Distribution
operating margins improved 2.7 percentage points reflecting the impact of lower
operating expenses as a percentage of revenues. On an absolute dollar basis,
segment operating income was $21.3 million above the amount reported in the
first nine months of 2003. The operating income variance reflects the impact of
higher revenue volumes and improved tubular product pricing on the segment's
reported gross profit, partially offset by growth in variable-based operating
expenses.
16
Consolidated Results
For the periods indicated, the following table summarizes the results of the
Company and presents these results as a percentage of total revenues (dollars
in thousands):
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------------------- ------------------------------------------
2004 2003 2004 2003
-------------------- -------------------- -------------------- --------------------
Amount % Amount % Amount % Amount %
------------- ----- ------------- ----- ------------- ----- ------------- -----
Revenues..........................$ 1,119,184 100 $ 924,792 100 $ 3,201,422 100 $ 2,611,286 100
------------- ----- ------------- ----- ------------- ----- ------------- -----
Gross profit....................... 338,983 30 278,402 30 980,353 31 778,655 30
Operating expenses................. 220,766 19 189,594 20 672,140 21 547,276 21
------------- ----- ------------- ----- ------------- ----- ------------- -----
Operating income................... 118,217 11 88,808 10 308,213 10 231,379 9
Interest expense................... 9,965 1 10,198 1 28,803 1 31,372 1
Interest income.................... (327) - (534) - (981) - (1,636) -
------------- ----- ------------- ----- ------------- ----- ------------- -----
Income before income taxes,
minority interests and
cumulative effect of change
in accounting principle.......... 108,579 10 79,144 9 280,391 9 201,643 8
Income tax provision............... 35,129 3 25,524 3 90,955 3 64,678 3
Minority interests................. 21,557 2 18,616 2 65,216 2 50,346 2
------------- ----- ------------- ----- ------------- ----- ------------- -----
Income before cumulative
effect of change in accounting
principle........................ 51,893 5 35,004 4 124,220 4 86,619 3
Cumulative effect of change in
accounting principle, net of
tax and minority interests....... - - - - - - (1,154) -
------------- ----- ------------- ----- ------------- ----- ------------- -----
Net income........................$ 51,893 5 $ 35,004 4 $ 124,220 4 $ 85,465 3
============= ===== ============= ===== ============= ===== ============== =====
Consolidated revenues were $1.1 billion for the third quarter of 2004, 21
percent above the prior year period, primarily attributable to increased demand
for Oilfield segment product offerings. Oilfield segment revenues grew 19
percent year-over-year with the increase balanced between North American and
non-North American markets. The revenue variance reflects higher global
activity levels as well as new contract awards and increased customer spending,
primarily in international markets. The Distribution operations, influenced by
strong demand for tubular products and new contract awards, reported a 27
percent increase from the prior year quarter and also contributed to the
consolidated revenue improvement. For the first nine months of 2004,
consolidated revenues were $3.2 billion, 23 percent above the comparable 2003
period. Two-thirds of the consolidated revenue growth reflects higher Oilfield
segment revenues, which rose 20 percent over amounts reported in the prior year
period. Oilfield business volumes benefited from the 20 percent increase in
U.S. land-based drilling activity and, to a lesser extent, the impact of new
contract awards and additional customer spending in certain Eastern Hemisphere
markets.
Gross profit totaled $339.0 million for the third quarter of 2004, 22 percent
above the prior year period. Gross profit increased $60.6 million over the
prior year quarter reflecting higher sales volumes associated with improved
worldwide activity levels, predominantly in the United States. Gross profit
margins for the third quarter of 2004 were 30 percent of revenues, comparable
to the level reported in the prior year period. For the nine-month period,
gross profit totaled $980.4 million, or 31 percent of revenues, one percentage
point above the gross profit margins reported in the comparable prior year
period. The gross margin expansion was influenced by a combination of favorable
pricing and the effect of increased sales volumes on fixed manufacturing and
17
service infrastructure. On an absolute dollar basis, gross profit was $201.7
million above the nine-month period ended September 30, 2003 primarily
reflecting the increased sales volumes in the Oilfield operations.
Operating expenses, consisting of selling, general and administrative expenses,
increased $31.2 million on an absolute dollar basis; however, as a percentage
of revenues, decreased one percentage point from the prior year quarter. The
majority of the absolute dollar increase related to variable costs directly
associated with the improved business volumes, as well as increased investment
in personnel and infrastructure to support the expanding business base,
including engineering support costs. To a lesser extent, increased employee
profit-sharing amounts directly attributable to the higher profitability levels
and increased costs associated with U.S. casualty and medical insurance
programs contributed to the period-to-period variance. Operating expenses
increased $124.9 million from the first nine months of 2003 due to
variable-related costs attributable to the improved business volumes and, to a
lesser extent, a $28.8 million charge recognized during the second quarter
primarily for an estimated loss provision, legal fees and costs directly
associated with a patent infringement case. Excluding the charge, operating
expenses as a percentage of revenues decreased one percentage point from the
nine-month period ended September 30, 2003.
Net interest expense, which represents interest expense less interest income,
equaled $9.6 million in the third quarter of 2004. Net interest expense was
comparable to the prior year quarter but decreased $1.9 million from the first
nine months of 2003, with the variance primarily reflecting lower average debt
levels.
The effective tax rate for the third quarter and first nine months of 2004
approximated 32 percent, which was comparable to the level reported in the
prior year periods, but below the U.S. statutory rate. The effective tax rate
was lower than the U.S. statutory rate due to the impact of M-I SWACO's U.S.
partnership earnings for which the minority partner is directly responsible for
its related income taxes. The Company properly consolidates the pretax income
related to the minority partner's share of U.S. partnership earnings but
excludes the related tax provision.
Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests was $2.9 million and $14.9 million above amounts reported in the
prior year quarter and the first nine months of 2003, respectively, due
primarily to the increased profitability of the M-I SWACO joint venture and, to
a lesser extent, improved earnings reported by CE Franklin Ltd.
The cumulative effect of change in accounting principle included for the nine
months ended September 30, 2003 represents the impact of the adoption of
Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for
Asset Retirement Obligations."
LIQUIDITY AND CAPITAL RESOURCES
General
At September 30, 2004, cash and cash equivalents equaled $65.0 million. During
the first nine months of 2004, the Company generated $117.5 million of cash
flows from operations as compared to the $66.8 million generated in the
comparable prior year period. The improvement in cash generated from operations
was attributable to increased profitability levels.
During the first nine months of 2004, cash flows used in investing activities
totaled $106.2 million, consisting of amounts required to fund capital
expenditures and, to a lesser extent, acquisitions. The Company invested $60.5
million in property, plant and equipment, net of cash proceeds arising from
certain asset disposals. Acquisition funding, which primarily related to the
purchase of certain operating assets from CanFish Services, resulted in cash
outflows of $45.8 million in the first nine months of 2004. Cash used for
investing activities during the first nine months of 2004 was less than the
$131.7 million required in the prior year period primarily due to the size of
acquisitions and related funding levels.
Cash flows provided by financing activities totaled $3.1 million for the first
nine months of 2004. Operating cash flow and cash proceeds associated with the
exercise of employee stock options were not sufficient in the aggregate to
fully fund investing activities and share purchases under a stock buyback
program, requiring incremental borrowings of $9.0 million.
The Company's primary internal source of liquidity is cash flow generated from
operations. Cash flow generated by operations is primarily influenced by the
level of worldwide drilling activity, which affects profitability levels and
working capital requirements. Capacity under revolving credit agreements is
18
also available, if necessary, to fund operating or investing activities. The
Company has various revolving credit facilities in the United States. As of
September 30, 2004, the Company had $297.0 million of capacity available under
these facilities for future operating or investing needs of its worldwide
operations. The Company also has revolving credit facilities in place outside of
the United States, which are generally used to finance local operating needs. At
September 30, 2004, the Company had available borrowing capacity of $64.6
million under the non-U.S. borrowing facilities.
The Company's external sources of liquidity include debt and equity financing
in the public capital markets, if needed. The Company carries an
investment-grade credit rating with recognized rating agencies, generally
providing the Company with access to debt markets. The Company's overall
borrowing capacity is, in part, dependent on maintaining compliance with
financial covenants under the various credit agreements. As of September 30,
2004, the Company was well within the covenant compliance thresholds under its
various loan indentures, as amended, providing the ability to access available
borrowing capacity. Management believes funds generated by operations, amounts
available under existing credit facilities and external sources of liquidity
will be sufficient to finance capital expenditures and working capital needs of
the existing operations for the foreseeable future.
Management continues to evaluate opportunities to acquire products or
businesses complementary to the Company's operations. Additional acquisitions,
if they arise, may involve the use of cash or, depending upon the size and
terms of the acquisition, may require debt or equity financing.
The Company has previously announced the signing of a non-binding letter of
intent related to the sale of Wilson Industries, Inc. ("Wilson") to CE Franklin
Ltd., a publicly-traded entity in which the Company currently owns 55 percent of
the outstanding common stock. The potential transaction is structured as a sale
of shares of Wilson in exchange for additional shares of CE Franklin.
Accordingly, the transaction would not be expected to have an impact on the
Company's liquidity before certain stock sale restrictions lapse, which is
currently anticipated in the second half of 2005. In the event the transaction
is ultimately consummated, no material book gain or loss is expected to be
realized on the sale. The Company, however, has agreed to fund certain
transaction-related costs, primarily professional fees, which are expected to be
immaterial. And, depending on the final terms of the transaction, the Company
may be required to record a tax provision on the sale which could be material in
relation to the third quarter 2004 tax provision, negatively impacting the
recorded provision and effective tax rate in the period the transaction is
consummated.
Commitments and Contingencies
Standby Letters of Credit and Guarantees
In the normal course of business with customers, vendors and others, the
Company is contingently liable for performance under standby letters of credit
and bid, performance and surety bonds. Certain of these outstanding instruments
guarantee payment of notes issued to former shareholders of an acquired entity
as well as to insurance companies which reinsure certain liability coverages of
the Company's insurance captive. Excluding the impact of these instruments, for
which $28.9 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company is contingently liable for
approximately $40.3 million of standby letters of credit and bid, performance
and surety bonds at September 30, 2004. Management does not expect any material
amounts to be drawn on these instruments.
Subsequent to September 30, 2004, the Company obtained a surety bond in the
amount of $43.5 million in connection with its appeal of the patent infringement
litigation discussed below. After taking into consideration amounts
reflected in the accompanying consolidated condensed balance sheet, the Company
has a contingent liability of up to $18.4 million associated with this
instrument. Management, however, does not expect any amounts to be drawn on
this instrument.
The Company has also provided loan guarantees related to certain joint ventures
accounted for under the equity method of accounting. As the net assets and cash
flows of these entities are available to satisfy obligations as they become
due, management believes the likelihood is remote that the Company will be
required to perform under these guarantees. The Company's estimated maximum
exposure under these loan guarantees approximated $19.0 million as of September
30, 2004.
Litigation
Halliburton Energy Services, Inc. v. Smith International, Inc.
On September 6, 2002, the Company was served with a complaint in the U.S.
District Court for the Eastern District of Texas, Sherman Division entitled
Halliburton Energy Services, Inc. v. Smith International, Inc. This lawsuit is a
patent infringement claim alleging that certain roller cone drill bits made by
the Company infringe several U.S. patents owned by Halliburton.
19
The case was tried in the second quarter of 2004 and, on June 25, 2004, a jury
verdict was rendered against the Company awarding damages of $24.0 million and
finding the infringement willful as to certain of the claims. On August 13,
2004, the Court enhanced the damage award by $12.0 million, and awarded $5.1
million in attorneys' fees and prejudgment interest. On November 4, 2004, the
court denied the Company's post-trial motions and the Company has initiated the
appeal process. Although an appeal is underway, the Company is continuing to
pursue other options, including possible settlement. Based on the facts and
circumstances and the opinion of outside counsel, management believes that the
amounts recorded reflect the best estimate of the Company's potential loss
exposure.
Rose Dove Egle v. John M. Egle, et al.
On April 17, 1997, the Company acquired all of the equity interests in Tri-Tech
Fishing Services, L.L.C. ("Tri-Tech") in exchange for cash consideration of
approximately $20.4 million (the "Transaction").
On August 25, 1998, the Company was added as a defendant in a First Amended
Petition filed in the 15th Judicial District Court, Parish of Lafayette,
Louisiana entitled Rose Dove Egle v. John M. Egle, et al. In the amended
petition, the plaintiffs alleged that, due to an improper conveyance of
ownership interest by the Tri-Tech majority partner prior to the Transaction,
Smith purchased a portion of its equity interest from individuals who were not
legally entitled to their Tri-Tech shares. The suit was tried in the first
quarter of 2004 and, on March 30, 2004, a jury verdict of approximately $4.8
million was rendered in favor of the plaintiffs. On June 1, 2004, the court
entered the judgment and the Company's post-judgment motions were subsequently
denied by the court. The Company has initiated the appeal process and does not
anticipate a ruling from the appellate court until the first half of 2005.
Based upon the facts and circumstances and the opinion of outside legal
counsel, management believes that an unfavorable outcome on this matter is not
probable at this time. Accordingly, the Company has not recognized a loss
provision in the accompanying consolidated condensed financial statements.
Other
The Company is a defendant in various other legal proceedings arising in the
ordinary course of business. In the opinion of management, these matters will
not have a material adverse effect on the Company's consolidated financial
position or results of operations.
Environmental
The Company routinely establishes and reviews the adequacy of reserves for
estimated future environmental clean-up costs for properties currently or
previously operated by the Company.
In connection with most business acquisitions, the Company obtains contractual
indemnifications from the seller related to environmental matters. These
indemnifications generally provide for the reimbursement of environmental
clean-up costs incurred by the Company for events occurring or circumstances
existing prior to the purchase date, whether the event or circumstance was
known or unknown at that time. A substantial portion of the Company's total
environmental exposure is associated with its M-I SWACO operations, which are
subject to various indemnifications from former owners.
As of September 30, 2004 the Company's environmental reserve approximated $10.0
million. This amount reflects the future undiscounted estimated exposure
related to identified properties, without regard to indemnifications from
former owners. While actual future environmental costs may differ from
estimated liabilities recorded at September 30, 2004, the Company does not
believe that these differences will have a material impact on the Company's
financial position or results of operations, subject to the indemnifications in
place.
During the first quarter of 2003, the Company initiated legal action against M-I
SWACO's former owners to address issues associated with certain provisions of
the environmental indemnification provided. This matter is currently expected to
go to trial during the second quarter of 2005. In the event that i) M-I SWACO's
former owners and other parties to indemnification agreements with the Company
do not fulfill their obligations, and ii) costs incurred to remediate the
identified properties reach estimated maximum exposure limits, the Company would
be required to record an additional charge of up to $25.0 million, impacting
earnings and cash flows in future periods.
20
Critical Accounting Policies and Estimates
The discussion and analysis of financial condition and results of operations
are based upon the Company's consolidated condensed financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires
the Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. The Company evaluates its estimates on an
ongoing basis, based on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances. Actual results may
differ from these estimates under different assumptions or conditions. In its
2003 Annual Report on Form 10-K, the Company has described the critical
accounting policies that require management's most significant judgments and
estimates. There have been no material changes in these critical accounting
policies.
Recent Accounting Pronouncements
From time to time, new accounting pronouncements are issued by the Financial
Accounting Standards Board ("FASB") which are adopted by the Company as of the
specified effective date. Unless otherwise discussed, management believes the
impact of recently issued standards, which are not yet effective, will not have
a material impact on the Company's consolidated condensed financial statements
upon adoption.
ITEM 3. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES
The Company is exposed to certain market risks arising from transactions that
are entered into in the normal course of business which are primarily related
to interest rate changes and fluctuations in foreign exchange rates. During the
reporting period, no events or transactions have occurred which would
materially change the information disclosed in the Company's 2003 Annual Report
on Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures and internal controls
designed to ensure that information required to be disclosed in our filings
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported within the time frame specified in the Commission's rules and
regulations. Our principal executive and financial officers have evaluated our
disclosure controls and procedures and have determined that such disclosure
controls and procedures are effective as of the end of the period covered by
this report. There were no significant changes in the Company's internal
controls or in other factors that could significantly affect those controls
subsequent to the evaluation date.
21
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
EQUITY SECURITIES
During 2001, the Company's Board of Directors authorized a share
buyback program which allows for the repurchase of up to five million shares of
common stock, subject to regulatory issues, market considerations and other
relevant factors. During the second quarter of 2004, the Company repurchased
1.1 million shares of common stock under the program at an aggregate cost of
$54.0 million bringing the total number of shares acquired under the program to
1.7 million. The acquired shares have been added to the Company's treasury
stock holdings and may be used in the future for acquisitions or other
corporate purposes.
A summary of the Company's repurchase activity for the three months ended
September 30, 2004 is as follows:
Total Number of
Total Number Average Shares Purchased as Number of Shares that
of Shares Price Paid Part of Publicly May Yet Be Purchased
Period Purchased per Share Announced Program Under the Program
- ---------------------- ------------ ------------ ---------------------- ---------------------
July 1 - 31 - $ - - 3,349,800
August 1 - 31 - $ - - 3,349,800
September 1 - 30 - $ - - 3,349,800
------------ ------------ ---------------------- ---------------------
3rd Quarter 2004 - $ - - 3,349,800
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits filed as part of this report:
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14 or 15d-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14 or 15d-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
(b) Exhibit furnished with this report:
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
22
(c) Reports on Form 8-K
The Registrant furnished four reports on Form 8-K during the quarterly
period ended September 30, 2004.
1. Form 8-K dated July 9, 2004 relating to a press release announcing the
Company's earnings release and conference call information for the quarter
ended June 30, 2004 and comments on second quarter litigation charges. The
document was reported under "Item 7. Financial Statements and Exhibits"
and "Item 12. Disclosure of Results of Operations and Financial
Condition."
2. Form 8-K dated July 22, 2004 relating to a press release announcing the
Company's results for the quarter ended June 30, 2004. The document was
reported under "Item 7. Financial Statements and Exhibits" and "Item 12.
Disclosure of Results of Operations and Financial Condition."
3. Form 8-K dated August 18, 2004 relating to a press release updating the
status of certain legal proceedings. The document was reported under "Item
5. Other Events."
4. Form 8-K dated September 8, 2004 relating to a press release updating the
status of the transaction regarding the potential purchase of the Wilson
distribution operations by C.E. Franklin, Ltd. The document was reported
under "Item 8.01. Other Events."
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SMITH INTERNATIONAL, INC.
Registrant
Date: November 9, 2004 By: /s/ DOUG ROCK
-------------------------------------
Doug Rock
Chairman of the Board,
Chief Executive Officer,
President and Chief Operating Officer
Date: November 9, 2004 By: /s/ MARGARET K. DORMAN
-------------------------------------
Margaret K. Dorman
Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Accounting Officer)
24
EXHIBIT INDEX
Exhibit Number Description
- -------------- -----------
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14 or 15d-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14 or 15d-14 of the Securities Exchange Act of 1934, as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
25