Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
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 May 2,
2005 was 106,146,942.
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the Three Months ended March 31, 2005 and 2004........................................ 1
CONSOLIDATED CONDENSED BALANCE SHEETS
As of March 31, 2005 and December 31, 2004................................................ 2
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the Three Months ended March 31, 2005 and 2004........................................ 3
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS...................................... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..... 12
ITEM 3. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES...................................... 20
ITEM 4. CONTROLS AND PROCEDURES................................................................... 20
PART II - OTHER INFORMATION
ITEMS 1-6.......................................................................................... 21
SIGNATURES............................................................................................... 23
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
March 31,
------------------------------
2005 2004
------------- -------------
Revenues.................................................. $ 1,288,198 $ 1,017,788
Costs and expenses:
Costs of revenues..................................... 902,786 703,786
Selling expenses...................................... 183,874 160,559
General and administrative expenses................... 53,366 45,982
------------- -------------
Total costs and expenses........................... 1,140,026 910,327
------------- -------------
Operating income.......................................... 148,172 107,461
Interest expense.......................................... 10,340 9,439
Interest income........................................... (368) (365)
------------- -------------
Income before income taxes and minority interests......... 138,200 98,387
Income tax provision...................................... 45,146 31,845
Minority interests........................................ 26,902 21,692
------------- -------------
Net income................................................ $ 66,152 $ 44,850
============= =============
Earnings per share:
Basic................................................. $ 0.65 $ 0.44
Diluted............................................... $ 0.65 $ 0.44
Weighted average shares outstanding:
Basic................................................. 101,496 101,070
Diluted............................................... 102,435 102,504
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)
March 31, December 31,
2005 2004
-------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents........................................................... $ 66,317 $ 53,596
Receivables, net.................................................................... 1,060,133 963,622
Inventories, net.................................................................... 954,802 890,462
Deferred tax assets, net............................................................ 45,751 47,083
Prepaid expenses and other.......................................................... 60,251 64,869
-------------- -------------
Total current assets............................................................ 2,187,254 2,019,632
-------------- -------------
Property, Plant and Equipment, net...................................................... 582,413 576,954
Goodwill, net........................................................................... 715,801 713,353
Other Intangible Assets, net............................................................ 66,315 68,597
Other Assets............................................................................ 141,122 128,242
-------------- -------------
Total Assets............................................................................ $ 3,692,905 $ 3,506,778
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current portion of long-term debt......................... $ 137,062 $ 211,375
Accounts payable.................................................................... 431,036 376,782
Accrued payroll costs............................................................... 65,892 89,200
Income taxes payable................................................................ 101,103 91,587
Other............................................................................... 127,012 118,413
-------------- -------------
Total current liabilities....................................................... 862,105 887,357
-------------- -------------
Long-Term Debt.......................................................................... 515,704 387,798
Deferred Tax Liabilities................................................................ 94,022 93,777
Other Long-Term Liabilities............................................................. 83,543 82,352
Minority Interests...................................................................... 679,939 654,683
Commitments and Contingencies (Note 13)
STOCKHOLDERS' EQUITY:
Preferred stock, $1 par value; 5,000 shares authorized; no shares issued or
outstanding in 2005 or 2004....................................................... - -
Common stock, $1 par value; 150,000 shares authorized; 106,126 shares issued
in 2005 (105,297 shares issued in 2004)........................................... 106,126 105,297
Additional paid-in capital......................................................... 462,249 432,395
Retained earnings.................................................................. 1,015,498 961,574
Accumulated other comprehensive income............................................. 17,625 24,404
Less - Treasury securities, at cost; 4,569 common shares in 2005 (4,222 common
shares in 2004).................................................................. (143,906) (122,859)
-------------- -------------
Total stockholders' equity...................................................... 1,457,592 1,400,811
-------------- -------------
Total Liabilities and Stockholders' Equity.............................................. $ 3,692,905 $ 3,506,778
============= =============
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)
Three Months Ended
March 31,
--------------------------
2005 2004
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.................................................................. $ 66,152 $ 44,850
Adjustments to reconcile net income to net cash provided by operating
activities, excluding the net effects of acquisitions:
Depreciation and amortization............................................ 28,362 26,494
Minority interests....................................................... 26,902 21,692
Deferred income tax provision............................................ 1,615 4,798
Provision for losses on receivables...................................... 1,160 953
Gain on disposal of property, plant and equipment........................ (2,602) (2,622)
Foreign currency translation losses (gains).............................. (587) 974
Changes in operating assets and liabilities:
Receivables.............................................................. (99,218) (33,618)
Inventories.............................................................. (65,739) (38,540)
Accounts payable......................................................... 55,122 26,340
Other current assets and liabilities..................................... (6,856) (24,416)
Other non-current assets and liabilities................................. (13,540) 1,154
---------- ----------
Net cash provided by (used in) operating activities................... (9,229) 28,059
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, net of cash acquired....................................... (3,613) (12,865)
Purchases of property, plant and equipment............................... (36,242) (22,710)
Proceeds from disposal of property, plant and equipment.................. 4,960 4,908
---------- ----------
Net cash used in investing activities................................. (34,895) (30,667)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt................................. 47,905 2,555
Principal payments of long-term debt..................................... (3,972) (55,337)
Net change in short-term borrowings...................................... 9,016 16,865
Purchases of treasury stock.............................................. (21,047) -
Proceeds from employee stock option exercises............................ 25,328 32,948
---------- ----------
Net cash provided by (used in) financing activities................... 57,230 (2,969)
---------- ----------
Effect of exchange rate changes on cash..................................... (385) (646)
---------- ----------
Increase (decrease) in cash and cash equivalents............................ 12,721 (6,223)
Cash and cash equivalents at beginning of period............................ 53,596 51,286
---------- ----------
Cash and cash equivalents at end of period.................................. $ 66,317 $ 45,063
========== ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest...................................................... $ 16,972 $ 16,349
Cash paid for income taxes.................................................. 25,090 19,267
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 2004 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 March 31, 2005 presentation.
2. 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. The planned adoption of Statement of Financial
Accounting Standards ("SFAS") No. 123r, "Share-Based Payment," is more fully
disclosed in Note 8. Management believes the impact of other 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. 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 March 31,
----------------------------
2005 2004
------------ -----------
BASIC EPS:
Net income................................................... $ 66,152 $ 44,850
========== ===========
Weighted average number of common shares outstanding......... 101,496 101,070
========== ===========
Basic EPS.................................................... $ 0.65 $ 0.44
========== ===========
DILUTED EPS:
Net income................................................... $ 66,152 $ 44,850
========== ===========
Weighted average number of common shares outstanding......... 101,496 101,070
Dilutive effect of stock options............................. 939 1,434
---------- -----------
102,435 102,504
========== ===========
Diluted EPS.................................................. $ 0.65 $ 0.44
========== ===========
4
4. 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):
March 31, December 31,
2005 2004
------------ -----------
Raw materials...................................................................... $ 79,331 $ 78,773
Work-in-process.................................................................... 88,230 81,002
Products purchased for resale...................................................... 285,428 252,486
Finished goods..................................................................... 570,627 530,657
------------ -----------
1,023,616 942,918
Reserves to state certain U.S. inventories (FIFO cost of $372,145 and $337,080
in 2005 and 2004,respectively) on a LIFO basis................................... (68,814) (52,456)
------------ -----------
$ 954,802 $ 890,462
============ ===========
During first quarter of 2005, the Company recorded additional LIFO reserves of
$16.4 million, primarily reflecting higher commodity prices for steel and alloy
products purchased by the Distribution segment.
5. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following (in thousands):
March 31, December 31,
2005 2004
------------- -------------
Land................................................ $ 36,051 $ 35,954
Buildings........................................... 147,188 147,442
Machinery and equipment............................. 561,536 555,469
Rental tools........................................ 386,840 376,043
------------- -------------
1,131,615 1,114,908
Less-Accumulated depreciation....................... (549,202) (537,954)
------------- -------------
$ 582,413 $ 576,954
============= =============
6. 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, 2004.................... $ 675,582 $ 37,771 $ 713,353
Goodwill acquired.................................. 2,502 - 2,502
Purchase price and other adjustments............... (54) - (54)
------------ ----------- ------------
Balance as of March 31, 2005....................... $ 678,030 $ 37,771 $ 715,801
============ =========== ============
5
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 in the accompanying consolidated
condensed balance sheets, are as follows (in thousands):
March 31, 2005 December 31, 2004
--------------------------------------- ------------------------------- Weighted
Gross Average
Gross Carrying Accumulated Carrying Accumulated Amortization
Amount Amortization Net Amount Amortization Net Period
-------------- ------------ ------- -------- ------------ ------- ------------
(years)
Patents ........................ $42,356 $15,124 $27,232 $42,353 $14,532 $27,821 15.6
License
agreements .................. 25,439 5,041 20,398 26,044 4,420 21,624 11.4
Non-compete
agreements and trademarks.... 20,899 9,643 11,256 20,772 8,899 11,873 12.8
Customer lists
and contracts .............. 9,712 2,283 7,429 9,232 1,953 7,279 16.5
------- ------- ------- ------- ------- ------- ----
$98,406 $32,091 $66,315 $98,401 $29,804 $68,597 14.0
======= ======= ======= ======= ======= ======= ====
Amortization expense of other intangible assets was $2.3 million and $2.1
million for the three-month periods ended March 31, 2005 and 2004, respectively.
Additionally, estimated future amortization expense is expected to range between
$5.1 million and $8.9 million a year for the next five fiscal years.
7. DEBT
The following summarizes the Company's outstanding debt (in thousands):
March 31, December 31,
2005 2004
------------ ------------
Current:
Short-term borrowings.................................. $ 116,712 $ 107,204
Current portion of long-term debt...................... 20,350 104,171
------------ ------------
$ 137,062 $ 211,375
============ ============
Long-Term:
Notes, net of unamortized discounts.................... $ 393,936 $ 397,213
Revolving credit facilities............................ 128,000 80,000
Term loans and other................................... 14,118 14,756
------------ ------------
536,054 491,969
Less current portion of long-term debt................. (20,350) (104,171)
------------ ------------
$ 515,704 $ 387,798
============ ============
On May 5, 2005, the Company finalized a new $400.0 million revolving credit
facility with a syndicate of nine financial institutions. The new facility
replaced a $400.0 million agreement, which was scheduled to expire in July 2005.
The revolving credit agreement (the "Agreement") allows for the election of
interest at a base rate, or a Eurodollar rate ranging from LIBOR plus 40 to 50
basis points depending on the borrowing levels drawn under the facility. The
Agreement also requires the payment of a quarterly commitment fee of 10 basis
points on the unutilized portion of the facility and compliance with certain
customary covenants, including a 40 percent debt-to-total capitalization
limitation.
Accordingly, the amounts drawn under the revolving credit facilities at March
31, 2005 have been classified as long-term in the accompanying consolidated
condensed balance sheet.
6
Principal payments of long-term debt for the twelve-month periods ending March
31, are as follows (in thousands):
2007.............................................................. $ 10,716
2008.............................................................. 157,040
2009.............................................................. 21
2010.............................................................. 39
Thereafter........................................................ 347,888
--------
$515,704
========
8. STOCK-BASED COMPENSATION
Stock Options
The Company's Board of Directors and its stockholders have authorized a
long-term incentive plan, which includes stock options. As of March 31, 2005,
2.8 million shares were issued and outstanding under the stock option program
and an additional 2.1 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.
Approximately 134,100 options awarded in 2001 were granted at a strike price
more than five percent below the market value on the date of issuance and, thus,
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 of $0.1 million of
related expense in the accompanying consolidated condensed statements of
operations for each of the three-month periods ended March 31, 2005, and 2004,
respectively.
Until the January 1, 2006 adoption of SFAS No. 123r, the Company will continue
to apply Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," ("APB No. 25") and related interpretations in accounting
for its stock option program. 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,
"Accounting for Stock-Based Compensation," 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 March 31,
----------------------------
2005 2004
---------- -----------
Net income, as reported........................................................................ $66,152 $44,850
Add: Stock-based compensation expense included in reported
income, net of related tax effect......................................................... 68 68
Less: Total pro forma compensation expense related to stock options determined under fair
value methods, net of related tax effect.................................................. (2,330) (2,858)
---------- -----------
Net income, pro forma.......................................................................... $63,890 $42,060
========== ===========
Earnings per share:
As reported:
Basic..................................................................................... $ 0.65 $ 0.44
Diluted................................................................................... 0.65 0.44
Pro forma:
Basic..................................................................................... $ 0.63 $ 0.42
Diluted................................................................................... 0.62 0.41
Restricted Stock
In addition to stock option awards, the Company's Board of Directors and
stockholders have approved the issuance of restricted stock and restricted stock
units under the long-term incentive plan. Restricted stock units representing
40,504 shares were issued in December 2004 with a grant date market value of
$56.26 per share. Accordingly, compensation expense related to the restricted
stock unit awards, calculated as the difference between the market value on the
date of grant and the exercise price, is being recognized ratably over the
four-year vesting period and totaled approximately $0.1 million for the
three-month period ending March 31, 2005.
7
On April 26, 2005, stockholders of the Company approved the issuance of
performance-based restricted stock units ("performance units"). Performance
units representing approximately 146,000 shares were granted on April 26, 2005;
however, the number of shares ultimately issued will be increased or decreased
dependent upon the return on equity levels achieved by the Company. In
accordance with APB No. 25, compensation expense for the performance units will
be determined during the first quarter of 2006 when the actual number of shares
issued to participants is known. Management will estimate compensation expense,
based on the stock price and projected return on equity, and recognize this
amount over the three-year vesting period. Based on the number of shares
expected to be awarded and the current stock price, compensation expense
related to these awards will approximate $3.2 million in 2005.
Recent Accounting Pronouncement Related to Stock-Based Compensation
In December 2004, the FASB issued SFAS No. 123r, which replaces SFAS No. 123 and
supersedes APB No. 25. This standard, which is effective beginning January 1,
2006, addresses the financial accounting and reporting of share-based payments
to employees, including stock options and restricted stock awards. SFAS No. 123r
requires the recognition of compensation expense, which is measured based on the
grant date fair value of equity awards, generally over the vesting period of the
related award.
The adoption of SFAS No. 123r will result in the recognition of compensation
expense related to all unvested stock options. The Company currently recognizes
compensation expense for its other share-based awards; therefore, the adoption
of SFAS No. 123r will not impact the accounting for these instruments.
Although the Company continues to evaluate the standard and related transition
matters, the adoption of SFAS No. 123r is expected to result in the recognition
of $10.2 million of additional compensation expense during the year ending
December 31, 2006. On an after-tax basis, the adoption of the new standard is
expected to reduce earnings by $7.0 million, or seven cents per share.
9. STOCKHOLDERS' EQUITY
Dividend Program
On February 2, 2005, the Company's Board of Directors approved a cash dividend
program for stockholders and declared a quarterly cash dividend of $0.12 per
share. The first dividend payment totaling $12.2 million was made on April 15,
2005 to stockholders of record on March 15, 2005. The level of future dividend
payments will be at the discretion of the Board of Directors and will depend
upon the Company's financial condition, earnings and other factors.
Common Stock Repurchases
During 2001, the Company's Board of Directors authorized a share buyback program
which allows for the repurchase of up to 5.0 million shares of common stock,
subject to regulatory issues, market considerations and other relevant factors.
During the first quarter of 2005, the Company repurchased 346,100 shares of
common stock at an aggregate cost of $21.0 million, bringing the total number of
shares acquired under the program to 3.2 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. Future repurchases under the program
may be executed from time to time in the open market or in privately negotiated
transactions.
10. 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 $0.8 million for each of the three-month
periods ended March 31, 2005 and 2004, respectively. Company contributions to
the pension and postretirement benefit plans during 2005 are expected to total
approximately $4.0 million.
8
11. 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 March 31,
----------------------------
2005 2004
------------- -----------
Net income.................................................................. $ 66,152 $ 44,850
Changes in unrealized fair value of derivatives, net........................ (186) (1,149)
Pension liability adjustments............................................... (476) -
Currency translation adjustments............................................ (6,117) (1,019)
---------- --------
Comprehensive income........................................................ $ 59,373 $ 42,682
========== ========
Accumulated other comprehensive income in the accompanying consolidated
condensed balance sheet consists of the following (in thousands):
March 31, December 31,
2005 2004
----------- -------------
Currency translation adjustments............................................ $ 21,666 $ 27,783
Unrealized fair value of derivatives........................................ (318) (132)
Pension liability adjustments............................................... (3,723) (3,247)
---------- ------------
Accumulated other comprehensive income...................................... $ 17,625 $ 24,404
========== ============
12. 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 March 31,
----------------------------
2005 2004
------------ -----------
Revenues:
Oilfield Products and Services.................... $ 910,161 $ 755,490
Distribution...................................... 378,037 262,298
------------ -----------
$ 1,288,198 $ 1,017,788
============ ===========
Revenues by Area:
United States..................................... $ 570,962 $ 442,161
Canada............................................ 191,658 127,549
------------ -----------
North America............................. 762,620 569,710
------------ -----------
Latin America .................................... 114,234 92,473
Europe/Africa .................................... 258,665 223,976
Middle East ...................................... 103,440 85,261
Far East ......................................... 49,239 46,368
------------ -----------
Non-North America......................... 525,578 448,078
------------ -----------
$ 1,288,198 $ 1,017,788
============ ===========
Operating Income (Loss):
Oilfield Products and Services.................... $ 137,856 $ 106,412
Distribution...................................... 13,517 3,066
General corporate................................. (3,201) (2,017)
------------ -----------
$ 148,172 $ 107,461
============ ===========
9
13. 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 to insurance companies which reinsure certain liability coverages of the
Company's insurance captive. Excluding the impact of these instruments, for
which $16.5 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company was contingently liable for
approximately $54.3 million of standby letters of credit and bid, performance
and surety bonds at March 31, 2005. Management does not expect any material
amounts to be drawn on these instruments.
During the fourth quarter of 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 $17.9 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 $18.1 million as of March 31, 2005.
Litigation
Halliburton Energy Services, Inc. v. Smith International, Inc.
In September 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.
This case was tried in the second quarter of 2004 and the plaintiff was
ultimately awarded $41.1 million, which includes the original jury assessment of
$24.0 million, a subsequent award enhancement, attorney's fees and prejudgment
interest. The Company filed a notice of appeal in the fourth quarter of 2004,
and a ruling from the appellate court is not anticipated until the first quarter
of 2006.
Although an appeal of this ruling is currently underway, the Company is
continuing to pursue other options, including possible settlement of related
claims outstanding. Based on the facts and circumstances and the opinion of
outside counsel, management believes that the amounts recognized by the Company
reflect the best estimate of its potential loss exposure. In the event the
appeal is unsuccessful on all grounds, which management currently believes is
unlikely, the Company would be required to record an additional $16.3 million of
litigation-related costs associated with this matter.
Prior to the trial of the U.S. case, various infringement actions and revocation
proceedings in the U.K. were consolidated in the Patents Court of the High Court
of Justice of England and Wales. This consolidated proceeding is essentially a
U.K. counterpart to the U.S. patent action mentioned above and, as such, the
Company is defending the allegations and seeking to invalidate the patents
involved. The U.K. case went to trial in January 2005, and a ruling from the
court is anticipated during the second quarter of 2005.
Outside counsel has advised the Company that any damages that could potentially
be shown by the plaintiff in the U.K. case, other than their legal costs, have
already been satisfied in the U.S. patent action mentioned above. Accordingly,
the Company has not recognized a loss provision in the accompanying consolidated
condensed financial statements.
Rose Dove Egle v. John M. Egle, et al.
In April 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").
In August 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 a
jury verdict of approximately $4.8 million was rendered in favor of the
plaintiffs. The Company has initiated the appeal process and does not anticipate
a ruling from the appellate court until the first quarter of 2006. 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.
10
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 March 31, 2005, the Company's environmental reserve totaled $9.1 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 March 31, 2005, 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 2003, the Company took legal action against M-I SWACO's former owners to
clarify certain contractual provisions of the environmental indemnification upon
which approximately $8.3 million of remediation costs properly incurred under
the indemnification remains unpaid. This matter is expected to go to trial
during the fourth 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 $24.0 million, impacting
earnings and cash flows in future periods.
14. SUBSEQUENT EVENT
On April 4, 2005, the Company and CE Franklin Ltd., a publicly-traded entity in
which the Company owns 55 percent of the outstanding common stock, announced
that they terminated negotiations relating to CE Franklin's previously announced
proposal to acquire Wilson International, Inc.
11
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 2004 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 North
American branch network providing pipe, valves and fittings as well as 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 first quarter of 2005,
Smith's profitability was largely dependent upon business levels in markets
outside of North America. The Distribution segment, which accounts for
approximately 30 percent 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, 56 percent of the Company's first quarter 2005 revenues were
generated in markets outside of North America.
BUSINESS OUTLOOK
Near-term activity levels will likely be influenced by the annual spring
break-up in Canada, which limits land-based drilling activity during the second
quarter. As a result, the Canadian rig count currently approximates one-third of
first quarter 2005 levels, which will likely contribute to a temporary decline
in average drilling activity for the second quarter. Excluding the seasonal
decline in Canada, the Company believes activity levels will increase modestly
throughout the remainder of the year as exploration and production companies
focus on higher-reserve projects in the U.S. Gulf of Mexico, Europe/Africa and
the Middle East markets. In addition to the anticipated increase in drilling
activity and the more favorable product mix which could result from a recovery
in the U.S. deepwater market, recently announced price increases in our Oilfield
segment businesses could also influence near-term financial results. Although a
number of factors impact drilling activity levels, our business is highly
dependent on the general economic environment in the United States and other
major world economies - which ultimately impact energy consumption and the
resulting demand for our products and services. A significant deterioration in
the global economic environment could adversely impact worldwide drilling
activity and the future financial results of the Company.
12
FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995 concerning, among other things,
the Company's outlook, financial projections and business strategies, all of
which are subject to risks, uncertainties and assumptions. These forward-looking
statements are identified by their use of terms such as "anticipate," "believe,"
"could," "estimate," "expect," "project" and similar terms. These statements are
based on certain assumptions and analyses made by the Company that it believes
are appropriate under the circumstances. Such statements are subject to, among
other things, general economic and business conditions, the level of oil and
natural gas exploration and development activities, global economic growth and
activity, political stability of oil-producing countries, finding and
development costs of operations, decline and depletion rates for oil and natural
gas wells, industry conditions, changes in laws or regulations and other risk
factors outlined in the Company's Form 10-K for the fiscal year ended December
31, 2004, many of which are beyond the control of the Company. Should one or
more of these risks or uncertainties materialize, or should the assumptions
prove incorrect, actual results may vary materially from those expected,
estimated or projected. Other than as required under securities laws, the
Company does not assume a duty to update these forward-looking statements.
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 March 31,
-----------------------------------------------------
2005 2004
----------------------- -----------------------
Amount % Amount %
------------- --- ------------- ---
FINANCIAL DATA: (dollars in thousands)
REVENUES:
M-I SWACO................................... $ 618,546 48 $ 519,085 51
Smith Technologies.......................... 142,224 11 125,341 12
Smith Services.............................. 149,391 12 111,064 11
------------- --- ------------- ---
Oilfield Products and Services............ 910,161 71 755,490 74
Wilson...................................... 378,037 29 262,298 26
------------- --- ------------- ---
Total................................... $ 1,288,198 100 $ 1,017,788 100
============= === ============= ===
GEOGRAPHIC REVENUES:
United States:
Oilfield Products and Services............ $ 317,055 24 $ 263,009 25
Distribution.............................. 253,907 20 179,152 18
------------- --- ------------- ---
Total United States..................... 570,962 44 442,161 43
------------- --- ------------- ---
Canada:
Oilfield Products and Services............ 87,131 7 58,818 6
Distribution.............................. 104,527 8 68,731 7
------------- --- ------------- ---
Total Canada............................ 191,658 15 127,549 13
------------- --- ------------- ---
Non-North America:
Oilfield Products and Services............ 505,975 39 433,663 43
Distribution.............................. 19,603 2 14,415 1
------------- --- ------------- ---
Total Non-North America................. 525,578 41 448,078 44
------------- --- ------------- ---
Total Revenue....................... $ 1,288,198 100 $ 1,017,788 100
============= === ============= ===
OPERATING INCOME:
Oilfield Products and Services.............. $ 137,856 15 $ 106,412 14
Distribution................................ 13,517 4 3,066 1
General Corporate........................... (3,201) * (2,017) *
------------- --- ------------- ---
Total................................... $ 148,172 12 $ 107,461 11
============= === ============= ===
MARKET DATA:
AVERAGE WORLDWIDE RIG COUNT: (1)
United States............................... 1,549 48 1,307 45
Canada...................................... 494 15 474 17
Non-North America........................... 1,215 37 1,107 38
------------- --- ------------- ---
Total................................... 3,258 100 2,888 100
============= === ============= ===
Onshore..................................... 2,780 85 2,420 84
Offshore.................................... 478 15 468 16
------------- --- ------------- ---
Total................................... 3,258 100 2,888 100
============= === ============= ===
AVERAGE COMMODITY PRICES:
Crude Oil ($/Bbl) (2)....................... $ 49.71 $ 35.13
Natural Gas ($/mcf) (3)..................... 6.28 5.41
(1) Source: M-I SWACO.
(2) Average weekly 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, particle separation, pressure
control, rig instrumentation and waste-management. M-I SWACO is significantly
influenced by spending in markets outside of North America, which contributes
approximately 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 approximately 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 $618.5 million for the first quarter of 2005, an
increase of 19 percent above the prior year period. The majority of the revenue
increase was generated in markets outside of North America, where revenues grew
17 percent largely due to the underlying activity level increase of 10 percent.
The year-over-year improvement in non-North American revenues also reflects
increased investment by exploration and production companies in offshore
drilling projects and the impact of new contract awards for drilling fluids and
waste management product offerings in Europe/Africa, including the North Sea and
West Africa markets. North American revenues, which accounted for over one-third
of the improvement, grew 22 percent driven by increased customer spending
related to land-based drilling programs as revenues and corresponding activity
levels in the U.S. offshore market were relatively comparable period-to-period.
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 typically
correlate more closely to the rig count than any of the Company's other
businesses. Moreover, Smith Technologies generally has the highest North
American revenue exposure of the Oilfield segment units driven, in part, by the
significance of its Canadian operations. Accordingly, depending on the duration
and severity of the annual seasonal drilling decline in Canada, this factor
could have an adverse effect on the unit's second quarter financial performance.
Smith Technologies reported revenues of $142.2 million for the quarter ended
March 31, 2005, an increase of 13 percent over the comparable prior year period.
The year-over-year revenue growth primarily relates to the increase in worldwide
rig count; however, the comparison was also impacted by the inclusion of
several, large Eastern Hemisphere export orders in the prior year period.
Excluding export sales, revenues grew 19 percent with both North American and
non-North American revenue growth outpacing the corresponding activity levels.
The majority of the revenue improvement was reported in North America
attributable to higher land-based drilling activity, increased demand for
diamond drill bits specifically designed for the rental market and, to a lesser
extent, improved unit pricing. Approximately one-third of the non-export revenue
growth was generated outside North America, with increased customer spending in
the Middle East and Latin America accounting for the majority of the revenue
variance.
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 March 31, 2005, Smith Services' revenues totaled $149.4 million,
35 percent above the prior year period. The year-over-year revenue growth was
influenced by a higher level of tubular product orders in the current period and
incremental revenues from acquisitions, primarily the CanFish operations
acquired in July 2004. Excluding the impact of acquisitions and tubular sales,
which are not highly correlated to drilling activity, base business revenues
were approximately 22 percent above the prior year period largely driven by the
increase in worldwide E&P spending levels. Over three-quarters of the core
business growth was reported in the Western Hemisphere markets, primarily
attributable to higher customer demand for remedial and completion product and
service lines due, in part, to recent product introductions.
Operating Income
Operating income for the Oilfield Products and Services segment was $137.9
million, or 15.1 percent of revenues, for the three months ended March 31, 2005.
Segment operating margins were one percentage point above the prior year period
due to reduced operating expenses as a percentage of revenues and, to a lesser
extent, a slight improvement in gross margins. The gross margin improvement
reflects increased fixed cost absorption in the Company's manufacturing
operations and the impact of higher product pricing. Although the Company has
announced recent price increases, which should lead to margin expansion in
future periods, there is no assurance that these increases will ultimately be
realized. First quarter 2005 operating income increased $31.4 million over the
prior year period attributable to the impact of higher revenue volumes on gross
profit, partially offset by growth in variable-based operating expenses
associated with the expanding business base, including additional field
engineering support personnel.
15
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 approximately 95 percent of Wilson's first quarter 2005 revenues
generated in those markets. Moreover, approximately one-third of Wilson's
revenues relate to sales to the industrial and 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 $378.0 million for the first quarter of
2005, 44 percent above the comparable prior year period. The revenue improvement
was impacted by increased demand for tubular products, sales of which were
approximately 80 percent above the amount reported in the prior year quarter.
Over three-quarters of the year-over-year revenue growth was reported by the
energy sector operations, largely influenced by increased North American
activity levels. Industrial and downstream revenues grew 30 percent above the
prior year level, benefiting from additional line pipe projects in the
engineering and construction market and maintenance and repair spending in the
petrochemical customer base.
Operating Income
Operating income for the Distribution segment was $13.5 million, or 3.6 percent
of revenues, for the quarter ended March 31, 2005. Segment operating income
increased $10.5 million above the amount reported in the prior year period,
equating to incremental operating income of nine percent of revenues.
Incremental operating income was influenced by year-over-year improvement
reported in both the energy and industrial sector operations attributable to
increased coverage of fixed sales and administrative costs. The significant
improvement in the expense ratio more than offset deterioration in gross profit
margins associated with a combination of higher tubular product costs and an
increased proportion of lower-margin project business.
Consolidated Results
For the periods indicated, the following table summarizes the results of
operations of the Company and presents these results as a percentage of total
revenues (dollars in thousands):
Three Months Ended March 31,
--------------------------------------------------
2005 2004
----------------------- ----------------------
Amount % Amount %
-------------- --- -------------- ---
Revenues................................................ $ 1,288,198 100 $ 1,017,788 100
-------------- --- -------------- ---
Gross profit............................................ 385,412 30 314,002 31
Operating expenses...................................... 237,240 18 206,541 20
-------------- --- -------------- ---
Operating income........................................ 148,172 12 107,461 11
Interest expense........................................ 10,340 1 9,439 1
Interest income......................................... (368) - (365) -
-------------- --- -------------- ---
Income before income taxes and minority interests....... 138,200 11 98,387 10
Income tax provision.................................... 45,146 4 31,845 3
Minority interests...................................... 26,902 2 21,692 2
-------------- --- -------------- ---
Net income.............................................. $ 66,152 5 $ 44,850 5
============== === ============== ===
Consolidated revenues were $1.3 billion for the first quarter of 2005, 27
percent above the prior year period, primarily attributable to increased demand
for Oilfield segment product offerings. Over two-thirds of the revenue growth
was reported in North America influenced by a combination of higher activity
levels, strong demand for tubular products and increased market penetration. The
year-over-year revenue variance was also impacted by improved business volumes
outside North America, reflecting increased exploration and production
investment, primarily in Latin America and the Middle East, and customer
specific spending and new contract awards in Europe/Africa, including the
North Sea, FSU and West Africa markets.
16
Gross profit totaled $385.4 million, or 30 percent of revenues, one percentage
point below the gross profit margins generated in the comparable prior year
period. Gross margin improvement in the Oilfield segment was more than offset by
an increased proportion of Distribution segment sales, which traditionally
generate lower gross profit margins than the Oilfield operations. On an absolute
dollar basis, gross profit was $71.4 million above the prior year period
reflecting increased sales volumes associated with improved worldwide activity
levels.
Operating expenses, consisting of selling, general and administrative expenses,
increased $30.7 million on an absolute dollar basis; however, as a percentage of
revenues, decreased two percentage points from the prior year period. Improved
fixed cost coverage in the sales and administrative functions accounted for the
operating expense percentage decline. The majority of the absolute dollar
increase was attributable to variable-related costs associated with the improved
business volumes, including investment in personnel and infrastructure to
support the expanding business operations. To a lesser extent, increased medical
and casualty insurance program costs and legal fees associated with defending
patent infringement lawsuits also contributed to the year-over-year operating
expense growth.
Net interest expense, which represents interest expense less interest income,
equaled $10.0 million in the first quarter of 2005. Net interest expense
increased $0.9 million from the prior year quarter primarily reflecting higher
average debt levels between the periods.
The effective tax rate for the first quarter approximated 33 percent, which was
above the 32 percent effective rate reported in the prior year period, 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. The effective rate increased 30 basis points above the first quarter
of 2004, attributable to a lower proportion of M-I SWACO's U.S. partnership
earnings.
Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests totaled $26.9 million in the first quarter of 2005, a $5.2 million
increase from the prior year period. The year-over-year increase primarily
reflects the higher profitability of the M-I SWACO joint venture and, to a
lesser extent, improved earnings reported by CE Franklin Ltd.
LIQUIDITY AND CAPITAL RESOURCES
General
At March 31, 2005, cash and cash equivalents equaled $66.3 million. During the
first quarter, the Company's operations utilized $9.2 million of cash flow,
which compared to the $28.1 million generated in the prior year period. The
continued improvement in worldwide drilling activity has resulted in higher
working capital levels, particularly the required investment in accounts
receivable and inventories, and more than offset the impact of increased
profitability levels in the first quarter of 2005.
During the first quarter of 2005, cash flows used in investing activities
totaled $34.9 million, consisting of amounts required to fund capital
expenditures and, to a lesser extent, acquisitions. The Company invested $31.3
million in property, plant and equipment, net of cash proceeds arising from
certain asset disposals. Cash used for investing activities during the first
three months of 2005 exceeded the $30.7 million required in the prior year
period primarily due to the level of capital spending, particularly the
investment in manufacturing and rental tool equipment, associated with the
higher drilling activity.
Cash flows provided by financing activities totaled $57.2 million for the first
quarter of 2005. Cash flows from operations 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, resulting in incremental borrowings of $52.9 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 also
available, if necessary, to fund operating or investing activities. As of March
31, 2005, the Company had $267.5 million of capacity available under its U.S
revolving credit facilities for future operating or investing needs. The U.S.
revolving credit facilities in place at March 31, 2005, have been extended and
are available through May 2010. The Company also has revolving credit facilities
in place outside of the United States, which are generally used to finance local
operating needs. At March 31, 2005, the Company had available borrowing capacity
of $56.2 million under the non-U.S. borrowing facilities.
17
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 March 31, 2005, 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.
On February 2, 2005, the Company's Board of Directors approved a cash dividend
program for stockholders and declared a quarterly cash dividend of $0.12 per
share which, was paid on April 15, 2005. The projected annual payout of
approximately $49 million is expected to be funded with cash flows from
operations and, if necessary, amounts available under existing credit
facilities. The level of future dividend payments will be at the discretion of
the Company's Board of Directors and will depend upon the Company's financial
condition, earnings, cash flows, compliance with certain debt covenants and
other relevant factors.
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.
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 to insurance companies which reinsure certain liability coverages of the
Company's insurance captive. Excluding the impact of these instruments, for
which $16.5 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company is contingently liable for
approximately $54.3 million of standby letters of credit and bid, performance
and surety bonds at March 31, 2005. Management does not expect any material
amounts to be drawn on these instruments.
During the fourth quarter of 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 $17.9 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 $18.1 million as of March 31, 2005.
Litigation
Halliburton Energy Services, Inc. v. Smith International, Inc.
In September 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.
This case was tried in the second quarter of 2004 and the plaintiff was
ultimately awarded $41.1 million, which includes the original jury assessment of
$24.0 million, a subsequent award enhancement, attorney's fees and prejudgment
interest. The Company filed a notice of appeal in the fourth quarter of 2004,
and a ruling from the appellate court is not anticipated until the first quarter
of 2006.
Although an appeal of this ruling is currently underway, the Company is
continuing to pursue other options, including possible settlement of related
claims outstanding. Based on the facts and circumstances and the opinion of
outside counsel, management believes that the amounts recognized by the Company
reflect the best estimate of its potential loss exposure. In the event the
appeal is unsuccessful on all grounds, which management currently believes is
unlikely, the Company would be required to record an additional $16.3 million of
litigation-related costs associated with this matter.
Prior to the trial of the U.S. case, various infringement actions and
revocation proceedings in the U.K. were consolidated in the Patents Court of the
High Court of Justice of England and Wales. This consolidated proceeding is
essentially a U.K. counterpart to the U.S. patent action mentioned above and, as
such, the Company is defending the allegations and seeking to invalidate the
patents involved. The U.K. case went to trial in January 2005, and a ruling
from the court is anticipated during the second quarter of 2005.
Outside counsel has advised the Company that any damages that could potentially
be shown by the plaintiff in the U.K. case, other than their legal costs, have
already been satisfied in the U.S. patent action mentioned above. Accordingly,
the Company has not recognized a loss provision in the accompanying consolidated
condensed financial statements.
18
Rose Dove Egle v. John M. Egle, et al.
In April 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").
In August 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 a
jury verdict of approximately $4.8 million was rendered in favor of the
plaintiffs. The Company has initiated the appeal process and does not anticipate
a ruling from the appellate court until the first quarter of 2006. 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 March 31, 2005, the Company's environmental reserve totaled $9.1 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 March 31, 2005, 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 2003, the Company took legal action against M-I SWACO's former owners to
clarify certain contractual provisions of the environmental indemnification upon
which approximately $8.3 million of remediation costs properly incurred under
the indemnification remains unpaid. This matter is expected to go to trial
during the fourth 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 $24.0 million, impacting
earnings and cash flows in future periods.
19
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 2004
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
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 123r, "Share-Based
Payment" ("SFAS No. 123r"), which replaces SFAS No. 123 "Accounting for
Stock-Based Compensation," and supersedes Accounting Principles Board Opinion
No. 25 "Accounting for Stock Issued to Employees." This standard, which is
effective beginning January 1, 2006, addresses the financial accounting and
reporting of share-based payments to employees, including stock options and
restricted stock awards. SFAS No. 123r requires the recognition of compensation
expense, which is measured based on the grant date fair value of equity awards,
generally over the vesting period of the related award.
The adoption of SFAS No. 123r will result in the recognition of compensation
expense related to all unvested stock options. The Company currently recognizes
compensation expense for its other share-based awards; therefore, the adoption
of SFAS No. 123r will not impact the accounting for these instruments.
Although the Company continues to evaluate the standard and related transition
matters, the adoption of SFAS No. 123r is expected to result in the recognition
of $10.2 million of additional compensation expense during the year ending
December 31, 2006. On an after-tax basis, the adoption of the new standard is
expected to reduce earnings by $7.0 million, or seven cents per share.
From time to time, new accounting pronouncements are issued by the 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 2004 Annual Report on Form
10-K.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures designed to provide
reasonable assurances 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 has been no change in the Company's internal control over financial
reporting during the quarter ended March 31, 2005 that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
20
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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 first quarter of 2005, the Company repurchased 0.3 million
shares of common stock under the program at an aggregate cost of $21.0 million
bringing the total number of shares acquired under the program to 3.2 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
March 31, 2005 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
- ---------------- ------------ ------------ ------------------- ----------------------
January 1 - 31 - $ - - 2,120,000
February 1 - 28 - - - 2,120,000
March 1 - 31 346,100 - 346,100 1,773,900
------- ------------ ------- ---------
1st Quarter 2005 346,100 $ - 346,100 1,773,900
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
On May 5, 2005, the Company and M-I L.L.C. entered into a new five-year,
$400.0 million revolving credit agreement with a syndicate of nine financial
institutions, as further disclosed in Note 7 to the Company's consolidated
condensed financial statements. The new facility, which will be used for general
corporate purposes, is available through May 5, 2010 and replaces a revolving
credit facility which was scheduled to expire on July 10, 2005.
The Agreement is filed as an exhibit to this Form 10-Q.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits filed as part of this report:
10.1 Credit Agreement dated as of May 5, 2005 among the Company and
M-I L.L.C., the Lenders From Time to Time Party Thereto and
Comerica Bank, as Administrative Agent, ABN AMRO Bank N.V., as
Syndication Agent, Den Norske Bank ASA, as Documentation
Agent, and Calyon New York Branch and RBS Securities
Corporation, as Co-Lead Arrangers and Joint Bookrunners.
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.
21
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.
(c) Reports on Form 8-K
The Registrant furnished five reports on Form 8-K during the
quarterly period ended March 31, 2005.
1. Form 8-K dated March 14, 2005 relating to stock option grants,
base salaries and bonuses awarded to the Named Executive
Officers, as well as the Company's Non-qualified Stock Option
Agreement form as amended to date. The document was reported
under "Item 1.01. Entry into a Material Definitive Agreement"
and "Item 9.01. Financial Statements and Exhibits."
2. Form 8-K dated March 3, 2005 relating to an employment
agreement between Smith and a principal operating officer of
the Company, as well as the announcement of a new President of
Smith Technologies. The document was reported under "Item
1.01. Entry into a Material Definitive Agreement", "Item 5.02.
Departure of Directors or Principal Officers, Election of
Directors; Appointment of Principal Officers" and "Item 9.01.
Financial Statements and Exhibits."
3. Form 8-K dated February 28, 2005 relating to the approval and
adoption of the Smith International, Inc. Post-2004
Supplemental Executive Retirement Plan. The document was
reported under "Item 1.01. Entry into a Material Definitive
Agreement" and "Item 9.01. Financial Statements and Exhibits."
4. Form 8-K dated February 8, 2005 relating to a press release
announcing a cash dividend program. The document was reported
under "Item 8.01. Other Events."
5. Form 8-K dated January 28, 2005 relating to a press release
announcing the Company's results for the quarter and year
ended December 31, 2004. The document was reported under "Item
2.02. Results of Operations and Financial Condition" and "Item
9.01. Financial Statements and Exhibits."
22
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: May 10, 2005 By: /s/ Doug Rock
----------------------------------
Doug Rock
Chairman of the Board, Chief
Executive Officer,
President and Chief Operating
Officer
(principal executive officer)
Date: May 10, 2005 By: /s/ Margaret K. Dorman
----------------------------------
Margaret K. Dorman
Senior Vice President,
Chief Financial Officer and Treasurer
(principal financial and accounting
officer)
23
EXHIBIT INDEX
Exhibit
Number Description
10.1 Credit Agreement dated as of May 5, 2005 among the Company and M-I L.L.C., the Lenders From Time
to Time Party Thereto and Comerica Bank, as Administrative Agent, ABN AMRO Bank N.V., as
Syndication Agent, Den Norske Bank ASA, as Documentation Agent, and Calyon New York Branch and
RBS Securities Corporation, as Co-Lead Arrangers and Joint Bookrunners.
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.
24