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 June 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 August
2, 2004 was 104,792,868.
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the Three Months and Six Months ended June 30, 2004 and 2003................................... 1
CONSOLIDATED CONDENSED BALANCE SHEETS
As of June 30, 2004 and December 31, 2003.......................................................... 2
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the Six Months ended June 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.............. 12
ITEM 3. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES............................................... 20
ITEM 4. CONTROLS AND PROCEDURES............................................................................ 20
PART II - OTHER INFORMATION
ITEMS 1-5................................................................................................... 21
ITEM 6...................................................................................................... 22
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 Six Months Ended
June 30, June 30,
-------------------------- ---------------------------
2004 2003 2004 2003
----------- ----------- ----------- ------------
Revenues ................................................... $ 1,064,450 $ 877,657 $ 2,082,238 $ 1,686,494
Costs and expenses:
Costs of revenues ...................................... 737,082 615,747 1,440,868 1,186,241
Selling expenses ....................................... 167,983 142,839 328,542 279,967
General and administrative expenses .................... 76,850 39,654 122,832 77,715
----------- ----------- ----------- ------------
Total costs and expenses ........................... 981,915 798,240 1,892,242 1,543,923
----------- ----------- ----------- ------------
Operating income ........................................... 82,535 79,417 189,996 142,571
Interest expense ........................................... 9,399 10,902 18,838 21,174
Interest income ............................................ (289) (522) (654) (1,102)
----------- ----------- ----------- ------------
Income before income taxes, minority interests and
cumulative effect of change in accounting principle .... 73,425 69,037 171,812 122,499
Income tax provision ....................................... 23,981 22,314 55,826 39,154
Minority interests ......................................... 21,967 16,823 43,659 31,730
----------- ----------- ----------- ------------
Income before cumulative effect of change in accounting
principle .............................................. 27,477 29,900 72,327 51,615
Cumulative effect of change in accounting principle,
net of tax and minority interests ...................... - - - (1,154)
----------- ----------- ----------- ------------
Net income ................................................. $ 27,477 $ 29,900 $ 72,327 $ 50,461
=========== =========== =========== ============
Basic:
Earnings per share before cumulative effect of change in
accounting principle ............................... $ 0.27 $ 0.30 $ 0.71 $ 0.52
Cumulative effect of change in accounting principle .... - - - (0.01)
----------- ----------- ----------- ------------
Earnings per share ..................................... $ 0.27 $ 0.30 $ 0.71 $ 0.51
=========== =========== =========== ============
Diluted:
Earnings per share before cumulative effect of change in
accounting principle ............................... $ 0.27 $ 0.30 $ 0.70 $ 0.51
Cumulative effect of change in accounting principle .... - - - (0.01)
----------- ----------- ----------- ------------
Earnings per share ..................................... $ 0.27 $ 0.30 $ 0.70 $ 0.50
=========== =========== =========== ============
Weighted average shares outstanding:
Basic .................................................. 101,580 99,736 101,325 99,501
Diluted ................................................ 102,662 100,892 102,592 100,579
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)
June 30, December 31,
2004 2003
----------- ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ............................................. $ 55,508 $ 51,286
Receivables, net ...................................................... 870,991 801,819
Inventories, net ...................................................... 789,427 739,627
Deferred tax assets, net .............................................. 37,268 31,238
Prepaid expenses and other ............................................ 63,577 55,826
----------- ------------
Total current assets .............................................. 1,816,771 1,679,796
----------- ------------
Property, Plant and Equipment, net ........................................ 538,950 534,871
Goodwill, net ............................................................. 702,496 690,593
Other Assets .............................................................. 194,924 191,787
----------- ------------
Total Assets .............................................................. $ 3,253,141 $ 3,097,047
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current portion of long-term debt ........... $ 118,209 $ 89,747
Accounts payable ...................................................... 309,393 310,754
Accrued payroll costs ................................................. 66,454 73,723
Income taxes payable .................................................. 79,692 69,301
Other ................................................................. 108,788 87,399
----------- ------------
Total current liabilities ......................................... 682,536 630,924
----------- ------------
Long-Term Debt ............................................................ 484,532 488,548
Deferred Tax Liabilities .................................................. 81,777 80,065
Other Long-Term Liabilities ............................................... 81,659 74,066
Minority Interests ........................................................ 628,145 587,668
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; 104,780 shares
issued in 2004 (102,720 shares issued in 2003) .................... 104,780 102,720
Additional paid-in capital ............................................ 416,052 371,438
Retained earnings ..................................................... 851,450 779,123
Accumulated other comprehensive income ................................ 7,093 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 ..................................... 1,294,492 1,235,776
----------- ------------
Total Liabilities and Stockholders' Equity ................................ $ 3,253,141 $ 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)
Six Months Ended
June 30,
----------------------
2004 2003
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ..................................................... $ 72,327 $ 50,461
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 .............................. 53,032 49,941
Minority interests ......................................... 43,659 31,730
Deferred income tax provision .............................. (1,841) 2,346
Provision for losses on receivables ........................ 2,546 898
Gain on disposal of property, plant and equipment .......... (5,518) (5,046)
Foreign currency translation losses ........................ 1,895 667
Changes in operating assets and liabilities:
Receivables ................................................ (73,235) (109,643)
Inventories ................................................ (52,044) (55,773)
Accounts payable ........................................... (319) 47,522
Other current assets and liabilities ....................... (19,627) 13,288
Other non-current assets and liabilities ................... 1,460 (9,820)
--------- ---------
Net cash provided by operating activities ...................... 53,774 17,725
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired ................ (26,022) (78,007)
Purchases of property, plant and equipment ..................... (48,735) (45,871)
Proceeds from disposal of property, plant and equipment ........ 10,584 12,072
--------- ---------
Net cash used in investing activities .......................... (64,173) (111,806)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt ....................... 64,111 58,855
Principal payments of long-term debt ........................... (62,040) (30,722)
Net change in short-term borrowings ............................ 22,375 8,182
Proceeds from exercise of stock options ........................ 45,048 14,616
Purchases of treasury stock .................................... (54,026) -
--------- ---------
Net cash provided by financing activities ...................... 15,468 50,931
--------- ---------
Effect of exchange rate changes on cash ........................ (847) 241
--------- ---------
Increase (decrease) in cash and cash equivalents ............... 4,222 (42,909)
Cash and cash equivalents at beginning of period ............... 51,286 86,750
--------- ---------
Cash and cash equivalents at end of period ..................... $ 55,508 $ 43,841
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest ......................................... $ 18,810 $ 21,046
Cash paid for income taxes ..................................... 46,823 23,812
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 June 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 six-month period ended June 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
In 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 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. The case went to trial during the second quarter of 2004, and the
jury awarded specified damages to the plaintiff.
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
During the six months ended June 30, 2004, the Company completed three
acquisitions in exchange for aggregate cash consideration of $19.1 million. The
consideration primarily relates to the purchase of certain specialty chemical
assets of Fortum Oil and Gas OY completed in January 2004. The Fortum
operations, formerly based in Finland, manufacture and market specialty chemical
products which improve hydrocarbon flow rates.
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 $4.7 million
and has been recorded as goodwill. 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
4
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 six-month period ended June 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.
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 Six Months Ended
June 30, June 30,
-------- -------- -------- --------
2004 2003 2004 2003
-------- -------- -------- --------
BASIC EPS:
Income before cumulative effect of
change in accounting principle ...... $ 27,477 $ 29,900 $ 72,327 $ 51,615
======== ======== ======== ========
Weighted average number of common
shares outstanding .................. 101,580 99,736 101,325 99,501
======== ======== ======== ========
Basic EPS before cumulative effect of
change in accounting principle ...... $ 0.27 $ 0.30 $ 0.71 $ 0.52
======== ======== ======== ========
DILUTED EPS:
Income before cumulative effect of
change in accounting principle ...... $ 27,477 $ 29,900 $ 72,327 $ 51,615
======== ======== ======== ========
Weighted average number of common
shares outstanding .................. 101,580 99,736 101,325 99,501
Dilutive effect of stock options ...... 1,082 1,156 1,267 1,078
-------- -------- -------- --------
102,662 100,892 102,592 100,579
======== ======== ======== ========
Diluted EPS before cumulative effect of
change in accounting principle ...... $ 0.27 $ 0.30 $ 0.70 $ 0.51
======== ======== ======== ========
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):
June 30, December 31,
2004 2003
--------- ------------
Raw materials................................................... $ 64,797 $ 62,631
Work-in-process................................................. 75,840 66,151
Products purchased for resale................................... 210,442 170,973
Finished goods.................................................. 476,492 464,151
--------- ------------
827,571 763,906
Reserves to state certain domestic inventories (cost of $303,734
and $266,328 in 2004 and 2003, respectively) on a LIFO basis.. (38,144) (24,279)
--------- ------------
$ 789,427 $ 739,627
========= ============
5
7. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following (in thousands):
June 30, December 31,
2004 2003
---------- ------------
Land ................................... $ 38,335 $ 38,394
Buildings .............................. 138,393 134,568
Machinery and equipment ................ 523,091 511,615
Rental tools ........................... 338,159 323,977
---------- ------------
1,037,978 1,008,554
Less-Accumulated depreciation .......... 499,028 473,683
---------- ------------
$ 538,950 $ 534,871
========== ============
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 ........................... 4,703 - 4,703
Purchase price and other adjustments ........ 7,200 - 7,200
------------ ------------ ------------
Balance as of June 30, 2004 ................. $ 664,725 $ 37,771 $ 702,496
============ ============ ============
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):
June 30, 2004 December 31, 2003
------------------------------------------ ------------------------------------------
Weighted
Gross Gross Average
Carrying Accumulated Carrying Accumulated Amortization
Amount Amortization Net Amount Amortization Net Period
------------ ------------ ------------ ------------ ------------ ------------ ------------
(years)
Patents ................. $ 41,420 $ 13,327 $ 28,093 $ 38,520 $ 12,015 $ 26,505 15.9
License
agreements ............ 19,086 3,178 15,908 19,086 2,193 16,893 11.7
Non-compete
agreements and
trademarks ............ 20,772 7,234 13,538 19,583 5,649 13,934 11.7
Customer lists
and contracts ........ 9,232 1,389 7,843 8,724 877 7,847 16.3
------------ ------------ ------------ ------------ ------------ ------------ ----
$ 90,510 $ 25,128 $ 65,382 $ 85,913 $ 20,734 $ 65,179 14.0
============ ============ ============ ============ ============ ============ ====
Amortization expense was $2.3 million and $1.9 million for the three-month
periods ended June 30, 2004 and 2003, respectively, and $4.4 million and $3.4
million for the six-month periods ended June 30, 2004 and 2003, respectively.
Additionally, estimated future amortization expense is expected to range between
$4.5 million and $8.4 million a year for the next five fiscal years.
6
9. STOCK-BASED COMPENSATION
The Company's Board of Directors and its stockholders have authorized an
employee stock option plan. As of June 30, 2004, 4.0 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 June 30,
2004 and 2003 and $0.2 million of related expense for each of the six month
periods ended June 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 Six Months Ended
June 30, June 30,
------------------------ ------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income, as reported ................ $ 27,477 $ 29,900 $ 72,327 $ 50,461
Add: Stock-based compensation expense
included in reported income, net
of related tax effect .............. 68 68 137 137
Less: Total stock-based compensation
expense determined under the Black-
Scholes option-pricing model, net of
related tax effect ................. (2,943) (2,683) (5,887) (5,366)
---------- ---------- ---------- ----------
Net income, pro forma .................. $ 24,602 $ 27,285 $ 66,577 $ 45,232
========== ========== ========== ==========
Earnings per share:
As reported:
Basic .............................. $ 0.27 $ 0.30 $ 0.71 $ 0.51
Diluted ............................ 0.27 0.30 0.70 0.50
Pro forma:
Basic .............................. $ 0.24 $ 0.27 $ 0.66 $ 0.45
Diluted ............................ 0.24 0.27 0.65 0.45
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 June
30, 2004 and 2003, and $0.1 million and $0.2 million of related expense for the
six-month periods ended June 30, 2004 and 2003, respectively.
7
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 June 30, 2004 and 2003 and $0.3 million and $0.4 million for the
six-month periods ended June 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 Six Months Ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Net income ........................ $ 27,477 $ 29,900 $ 72,327 $ 50,461
Changes in unrealized fair value of
derivatives, net ................ (889) 667 (2,038) 1,073
Currency translation adjustments .. (1,475) 7,108 (2,494) 11,071
-------- -------- -------- --------
Comprehensive income .............. $ 25,113 $ 37,675 $ 67,795 $ 62,605
======== ======== ======== ========
As of June 30, 2004, accumulated other comprehensive income in the accompanying
consolidated condensed balance sheet consists of the following (in thousands):
June 30, December 31,
2004 2003
------------ ------------
Currency translation adjustments ............ $ 10,326 $ 12,820
Unrealized fair value of derivatives ........ 301 2,339
Pension liability adjustments ............... (3,534) (3,534)
------------ ------------
Accumulated other comprehensive income ...... $ 7,093 $ 11,625
============ ============
8
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 Six Months Ended
June 30, June 30,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenues:
Oilfield Products and Services .... $ 787,825 $ 659,121 $ 1,543,315 $ 1,262,681
Distribution ...................... 276,625 218,536 538,923 423,813
------------ ------------ ------------ ------------
$ 1,064,450 $ 877,657 $ 2,082,238 $ 1,686,494
============ ============ ============ ============
Revenues by Area:
United States ..................... $ 491,572 $ 392,146 $ 933,733 $ 759,461
Canada ............................ 88,396 71,353 215,945 157,634
------------ ------------ ------------ ------------
North America ............. 579,968 463,499 1,149,678 917,095
------------ ------------ ------------ ------------
Latin America ..................... 98,633 85,946 191,106 153,167
Europe/Africa ..................... 245,497 211,208 469,473 398,256
Middle East ....................... 94,542 80,709 179,803 148,157
Far East .......................... 45,810 36,295 92,178 69,819
------------ ------------ ------------ ------------
Non-North America ......... 484,482 414,158 932,560 769,399
------------ ------------ ------------ ------------
$ 1,064,450 $ 877,657 $ 2,082,238 $ 1,686,494
============ ============ ============ ============
Operating Income:
Oilfield Products and Services .... $ 78,102 $ 81,590 $ 184,514 $ 150,523
Distribution ...................... 6,466 (478) 9,532 (4,577)
General corporate ................. (2,033) (1,695) (4,050) (3,375)
------------ ------------ ------------ ------------
$ 82,535 $ 79,417 $ 189,996 $ 142,571
============ ============ ============ ============
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 $30.1 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company is contingently liable for
approximately $47.3 million of standby letters of credit and bid, performance
and surety bonds at June 30, 2004. Management does not expect any material
amounts to be drawn on these instruments.
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 $18.8 million as of June 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
9
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. Due to the willful
finding by the jury, the court may increase the damages up to three times the
amount of the award. Once the judgment is entered by the court, the Company
plans to pursue all available options, including possible settlement, file
appropriate motions and, if necessary, appeal the verdict. Based on the facts
and circumstances and the opinion of outside counsel, management believes that
the recorded charge is the best estimate within the range of probable loss.
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 June 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 June 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 expected to go to
trial during the fourth quarter of 2004. 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 establish additional environmental reserves of up to $25.0 million,
impacting earnings and cash flows in future periods.
10
15. SUBSEQUENT EVENT
On July 8, 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
approximately 67 million shares of 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 90 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
expected to close on or around September 30, 2004 and is subject to a number of
factors, including satisfactory completion of due diligence, 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.
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 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 second 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, 60 percent of the Company's second quarter 2004
revenues were generated in markets outside of North America.
MARKET OUTLOOK
Near-term activity levels will likely be influenced by the seasonal drilling
recovery in Canada, which, depending on weather and other factors, is expected
to result in an increase in the number of land-based drilling programs. Even
without the effect of the seasonal recovery in Canada, the Company believes
activity levels will increase modestly throughout the second half of the year as
operators seek to address declining production levels stemming from a period of
underinvestment in their upstream operations. Tropical weather disturbances are,
however, typically experienced in the U.S. Gulf of Mexico during the third
calendar quarter which influences the level of planned drilling programs and, in
certain circumstances, may result in the curtailment of some offshore drilling
operations. In addition to the aforementioned, there are several other factors
that could influence forecasted E&P spending. The Company's 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. Changes in the global economic
environment could impact worldwide drilling activity and future results of the
Company.
12
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 June 30, Six Months Ended June 30,
----------------------------------------- ------------------------------------------
2004 2003 2004 2003
------------------- ------------------- ------------------- --------------------
Amount % Amount % Amount % Amount %
------------ --- ------------ --- ------------ --- ------------- ---
FINANCIAL DATA: (dollars in thousands)
REVENUES:
M-I SWACO........................ $ 550,257 52 $ 460,386 52 $ 1,069,342 51 $ 876,675 52
Smith Technologies............... 121,184 11 96,506 11 246,525 12 188,745 11
Smith Services................... 116,384 11 102,229 12 227,448 11 197,261 12
------------ --- ------------ --- ------------ --- ------------- ---
Oilfield Products and Services. 787,825 74 659,121 75 1,543,315 74 1,262,681 75
Wilson........................... 276,625 26 218,536 25 538,923 26 423,813 25
------------ --- ------------ --- ------------ --- ------------- ---
Total....................... $ 1,064,450 100 $ 877,657 100 $ 2,082,238 100 $ 1,686,494 100
============ === ============ === ============ === ============= ===
GEOGRAPHIC REVENUES:
United States:
Oilfield Products and Services... $ 277,518 26 $ 225,369 26 $ 540,527 26 $ 441,697 26
Distribution..................... 214,054 20 166,777 19 393,206 19 317,764 19
------------ --- ------------ --- ------------ --- ------------- ---
Total United States......... 491,572 46 392,146 45 933,733 45 759,461 45
------------ --- ------------ --- ------------ --- ------------- ---
Canada:
Oilfield Products and Services... 40,296 4 30,424 3 99,114 5 73,875 4
Distribution..................... 48,100 4 40,929 5 116,831 5 83,759 5
------------ --- ------------ --- ------------ --- ------------- ---
Total Canada................ 88,396 8 71,353 8 215,945 10 157,634 9
------------ --- ------------ --- ------------ --- ------------- ---
Non-North America:
Oilfield Products and Services... 470,011 44 403,328 46 903,674 44 747,109 44
Distribution..................... 14,471 2 10,830 1 28,886 1 22,290 2
------------ --- ------------ --- ------------ --- ------------- ---
Total Non-North America..... 484,482 46 414,158 47 932,560 45 769,399 46
------------ --- ------------ --- ------------ --- ------------- ---
Total Revenue............ $ 1,064,450 100 $ 877,657 100 $ 2,082,238 100 $ 1,686,494 100
============ === ============ === ============ === ============= ===
OPERATING INCOME:
Oilfield Products and Services... $ 78,102 10 $ 81,590 12 $ 184,514 12 $ 150,523 12
Distribution..................... 6,466 2 (478) * 9,532 2 (4,577) *
General Corporate................ (2,033) * (1,695) * (4,050) * (3,375) *
------------ --- ------------ --- ------------ --- ------------- ---
Total.................... $ 82,535 8 $ 79,417 9 $ 189,996 9 $ 142,571 8
============ === ============ === ============ === ============= ===
MARKET DATA:
AVERAGE WORLDWIDE RIG COUNT: (1)
United States.................... 1,387 51 1,223 50 1,347 48 1,138 46
Canada........................... 198 7 189 8 336 12 322 13
Non-North America................ 1,120 42 1,047 42 1,114 40 1,027 41
------------ --- ------------ --- ------------ --- ------------- ---
Total.................... 2,705 100 2,459 100 2,797 100 2,487 100
============ === ============ === ============ === ============= ===
AVERAGE COMMODITY PRICES:
Crude Oil ($/Bbl) (2)............ $ 38.12 $ 28.95 $ 36.63 $ 31.48
Natural Gas ($/mcf) (3).......... $ 5.91 $ 5.37 $ 5.66 $ 5.75
(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
13
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
almost two-thirds of the unit's revenues, and by its exposure to the U.S.
offshore market, which constitutes approximately 12 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 $550.3 million for the second quarter of 2004, an increase of 20 percent
above the prior year period. Revenue growth in both North American and non-North
American markets exceeded the underlying change in rig count. Approximately
two-thirds of the overall revenue improvement was generated in international
markets largely influenced by new contract awards and increased customer
spending in Europe/Africa, including the former Soviet Union ("FSU") and the
U.K. sector of the North Sea, and in certain Middle East markets. North American
business volumes benefited from increased customer spending in land-based
markets and, to a lesser extent, the impact of the Alpine Mud Products
operations acquired in October 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 30 percent
above the prior year level, also contributed to the improvement. For the
six-month period, M-I SWACO reported revenues of approximately $1.1 billion, a
22 percent increase over the amount reported in the first half of 2003. The
majority of the revenue growth was reported in markets outside North America,
specifically the FSU, Latin America and the Middle East region, 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 driven, in part, by the significance of its Canadian
operations. Accordingly, the duration and severity of the seasonal drilling
decline in Canada adversely effects the unit's financial performance in the
second quarter. Smith Technologies reported revenues of $121.2 million for the
quarter ended June 30, 2004, an increase of 26 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 second quarter of 2003.
Excluding the effect of these export sales, revenues were approximately 32
percent above the level reported in the prior year quarter, influenced by the
increase in worldwide activity levels. Approximately three-quarters of the
year-over-year revenue growth was reported in North America, where sales volumes
grew at more than three times the rate of the underlying change in rig count.
The North American revenue increase was attributable to a combination of higher
land-based drilling activity, increased market penetration, influenced in part
by product introductions and, to a lesser extent, higher unit pricing. Revenues
generated in markets outside North America grew in-line with activity levels as
increased demand for diamond bits and continued market penetration of the
turbodrilling product line were partially offset by the lower level of
international export orders in the current quarter. For the six-month period,
Smith Technologies reported revenues of $246.5 million, a 31 percent increase
over the comparable period of 2003. The majority of the revenue growth was
generated in North America, benefiting from increased market penetration and, to
a lesser extent, the higher level of land-based drilling activity.
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 June 30, 2004, Smith Services' revenues totaled $116.4 million, 14
percent above the prior year period. The year-over-year revenue comparison was
impacted by a 37 percent reduction in drill pipe orders, which partially offset
higher sales generated across all core product lines. Excluding drill pipe
sales, which are not highly correlated to drilling activity, revenues grew 17
percent largely associated with the general increase in global E&P spending.
Over two-thirds of the core business growth was reported in the United States,
primarily reflecting increased customer demand for remedial and drilling-related
products and service lines. To a lesser extent, the introduction of new remedial
and completion product offerings also contributed to the revenue improvement.
For the first half of 2004, Smith Services reported revenues of $227.4 million,
a 15 percent increase from the comparable prior year period. Excluding the
impact of lower drill pipe sales volumes, revenues were 19 percent above the
14
first half of 2003, reflecting the increase in worldwide activity levels. The
majority of the revenue growth was reported in the United States and Latin
America, specifically Venezuela, influenced by strong demand for remedial
products and completion systems.
Operating Income
Operating income for the Oilfield Products and Services segment was $78.1
million, or 10 percent of revenues, for the three months ended June 30, 2004.
Excluding the impact of a litigation-related charge recorded in the second
quarter of 2004, operating income was $109.5 million, or 14 percent of revenues.
Oilfield operating income, net of the charge, increased $28.0 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,
excluding the charge, increased 1.5 percentage points above the prior year
quarter primarily related to gross margin expansion. The gross margin
improvement reflects the impact of price increases implemented during the fourth
quarter of 2003 and early 2004. Although such price increases should lead to
margin expansion in future periods, there is no assurance that these increases
will ultimately be realized. To a lesser extent, gross profit margins were
influenced by the effect of higher sales volumes on fixed cost coverage,
increased absorption in the Company's manufacturing operations and a favorable
shift in the revenue mix towards higher-margin products and services. For the
six-month period, Oilfield operating margins, exclusive of the second quarter
litigation-related charge, improved 2.1 percentage points reflecting gross
margin expansion and, to a lesser extent, reduced operating expenses as a
percentage of revenues. On an absolute dollar basis, six-month operating income
exclusive of the second quarter charge was $65.4 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 $276.6
million for the second quarter of 2004, 27 percent above the comparable prior
year period. The year-over-year revenue variance was reported in both the energy
and industrial operations influenced by increased demand for tubular products,
sales of which were approximately 70 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, petrochemical and engineering and construction
markets. In the first six months of 2004, Wilson reported revenues totaling
$538.9 million, an increase of 27 percent from the first half 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 $6.5 million, or two percent
of revenues, for the three months ended June 30, 2004. Segment operating income
increased $6.9 million from the loss reported in the second quarter of 2003,
equating to incremental operating income of approximately 12 percent of
revenues. The incrementals were above those historically reported in the
segment, attributable to increased tubular sales volumes and related pricing
and, to a lesser extent, coverage of fixed sales and administrative costs. On a
year-to-date basis, segment operating income rose $14.1 million from the amount
reported in the first six 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.
15
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 June 30, Six Months Ended June 30,
------------------------------------------ -----------------------------------------
2004 2003 2004 2003
------------------- ------------------- ------------------- -------------------
Amount % Amount % Amount % Amount %
------------- --- ------------- --- ------------ --- ------------- ---
Revenues.......................... $ 1,064,450 100 $ 877,657 100 $ 2,082,238 100 $ 1,686,494 100
------------- --- ------------- --- ------------- --- ------------- ---
Gross profit...................... 327,368 31 261,910 30 641,370 31 500,253 30
Operating expenses................ 244,833 23 182,493 21 451,374 22 357,682 21
------------- --- ------------- --- ------------- --- ------------- ---
Operating income.................. 82,535 8 79,417 9 189,996 9 142,571 9
Interest expense.................. 9,399 1 10,902 1 18,838 1 21,174 1
Interest income................... (289) - (522) - (654) - (1,102) -
------------- --- ------------- --- ------------- --- ------------- ---
Income before income taxes,
minority interests and
cumulative effect of change in
accounting principle............ 73,425 7 69,037 8 171,812 8 122,499 8
Income tax provision.............. 23,981 2 22,314 3 55,826 3 39,154 3
Minority interests................ 21,967 2 16,823 2 43,659 2 31,730 2
------------- --- ------------- --- ------------- --- ------------- ---
Income before cumulative
effect of change in accounting
principle....................... 27,477 3 29,900 3 72,327 3 51,615 3
Cumulative effect of change in
accounting principle, net of
tax and minority interests...... - - - - - - (1,154) -
------------- --- ------------- --- ------------- --- ------------- ---
Net income........................ $ 27,477 3 $ 29,900 3 $ 72,327 3 $ 50,461 3
============= === ============== === ============= === ============= ===
Consolidated revenues were $1.1 billion for the second quarter of 2004, 21
percent above the prior year period, primarily attributable to increased demand
for Oilfield segment product offerings. Oilfield segment revenues grew 20
percent year-over-year with the increase balanced between North American and
non-North American markets. The revenue variance reflects higher global activity
levels, new contract awards and increased customer spending. 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 half of 2004,
consolidated revenues were $2.1 billion, 23 percent above the comparable 2003
period, predominantly reflecting increased Oilfield segment business volumes.
Oilfield segment revenues rose 22 percent over amounts reported in the prior
year period, largely benefiting from the 17 percent increase in North American
land-based activity levels and, to a lesser extent, the impact of new contract
awards and additional customer spending in Europe/Africa and certain Middle East
markets.
Gross profit totaled $327.4 million for the second quarter of 2004, 25 percent
above the prior year period. Gross profit increased $65.5 million over the prior
year quarter reflecting higher sales volumes associated with improved worldwide
activity levels, specifically in the Western Hemisphere. Gross profit margins
for the second quarter of 2004 were 31 percent of revenues and compared to
margins of 30 percent reported in the prior year period. The gross margin
expansion was influenced by a combination of improved pricing in both the
Oilfield and Distribution segments and the effect of increased sales volumes on
fixed manufacturing and service infrastructure. For the six-month period, gross
profit totaled $641.4 million, or 31 percent of revenues, one percentage point
above the gross profit margins reported in the comparable prior year period. The
gross profit margin improvement for the six-month comparison was, again,
influenced by a combination of favorable pricing and increased fixed cost
coverage. On an absolute dollar basis, gross profit was $141.1 million above the
prior year period primarily reflecting the increased sales volumes in the
Oilfield operations.
16
Operating expenses, consisting of selling, general and administrative expenses,
increased $62.3 million and $93.7 million from the prior year quarter and first
six months of 2003, respectively. Second quarter 2004 operating expenses include
a $28.8 million charge recognized primarily for an estimated loss provision,
legal fees and other costs directly associated with a patent infringement case.
Excluding the charge, operating expenses increased on an absolute dollar basis;
however, as a percentage of revenues, decreased one percentage point from both
prior year comparable periods. 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 contributed to the period-to-period variance.
Net interest expense, which represents interest expense less interest income,
equaled $9.1 million in the second quarter of 2004. Net interest expense
decreased $1.3 million and $1.9 million from the prior year quarter and first
six months of 2003, respectively, with the decrease for both periods primarily
reflecting lower average debt levels.
The effective tax rate for the second quarter and first six months of 2004
approximated 33 percent, which was above the 32 percent effective rate reported
in the comparable 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. The effective tax rate
increased above the level reported in the prior year periods, attributable to an
unfavorable shift in the geographic mix of pretax income towards higher tax rate
jurisdictions and the expiration of a foreign tax relief program.
Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests was $5.1 million and $11.9 million above amounts reported in the prior
year quarter and the first half of 2003, respectively, due primarily to the
increased profitability of the M-I SWACO joint venture.
The cumulative effect of change in accounting principle included for the six
months ended June 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 June 30, 2004, cash and cash equivalents equaled $55.5 million. During the
first six months of 2004, the Company generated $53.8 million of cash flows from
operations as compared to the $17.7 million generated in the comparable prior
year period. The improvement in cash generated from operations was attributable
to increased profitability levels.
During the first six months of 2004, cash flows used in investing activities
totaled $64.2 million, consisting of amounts required to fund capital
expenditures and, to a lesser extent, acquisitions. The Company invested $38.2
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 specialty chemical assets from Fortum Oil and Gas OY,
resulted in cash outflows of $26.0 million in the first six months of 2004. Cash
used for investing activities during the first half of 2004 was less than the
$111.8 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 $15.5 million for the first
half 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 $24.4 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. The Company
has various revolving credit facilities in the United States. As of
17
June 30, 2004, the Company had $295.8 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 June 30,
2004, the Company had available borrowing capacity of $65.5 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 June 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.
Subsequent to June 30, 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., a publicly-traded entity in which the Company currently owns 55
percent of the outstanding common stock. The potential transaction, which is
currently expected to close on or around September 30, 2004, 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 in the second
quarter of 2005. In the event the transaction is ultimately consummated, no
material book gain or loss would be realized on the sale; however, the Company
would recognize an immaterial amount of transaction-related costs, primarily
professional fees. 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 second 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 $30.1 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheet, the Company is contingently liable for
approximately $47.3 million of standby letters of credit and bid, performance
and surety bonds at June 30, 2004. Management does not expect any material
amounts to be drawn on these instruments.
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 $18.8 million as of June 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.
18
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. Due to the willful
finding by the jury, the court may increase the damages up to three times the
amount of the award. Once the judgment is entered by the court, the Company
plans to pursue all available options, including possible settlement, file
appropriate motions and, if necessary, appeal the verdict. Based on the facts
and circumstances and the opinion of outside counsel, management believes that
the recorded charge is the best estimate within the range of probable loss.
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 June 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 June 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 expected to go to
trial during the fourth quarter of 2004. 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 establish additional environmental reserves of up to $25.0 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 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.
20
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 June
30, 2004 is as follows:
Total Total Number of
Number of Average Shares Purchased as Number of Shares that
Shares Price Paid Part of Publicly May Yet Be Purchased
Period Purchased per Share Announced Program Under the Program
------------------ ----------- -------------- ------------------- ---------------------
April 1 - April 30 0 $ 0.00 0 4,463,800
May 1 - May 31 1,114,000 $ 48.50 1,114,000 3,349,800
June 1 - June 30 0 $ 0.00 0 3,349,800
--------- -------------- --------- ---------
2nd Quarter 2004 1,114,000 $ 48.50 1,114,000 3,349,800
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Stockholders on April 20, 2004, stockholders of
the Company elected all nominated directors and approved Deloitte & Touche LLP
as auditors for 2004 by the votes shown below.
For Withheld
----------- ----------
Election of Directors:
James R. Gibbs ............................. 88,960,831 5,768,336
Jerry W. Neely.............................. 68,087,618 26,641,549
For Against Abstain
----------- ---------- -------
Approval of Deloitte & Touche LLP as
auditors for the Company for 2004........... 94,217,144 486,985 25,038
ITEM 5. OTHER INFORMATION
None.
21
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.
(c) Reports on Form 8-K
The Registrant furnished two reports on Form 8-K during the quarterly
period ended June 30, 2004.
1. Form 8-K dated April 23, 2004 relating to a press release
announcing the Company's results for the quarter ended March 31,
2004. 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 June 25, 2004 relating to a press release
announcing the outcome of a certain legal proceeding. The
document was reported under "Item 5. Other Events."
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: August 9, 2004 By: /s/ DOUG ROCK
---------------------
Doug Rock
Chairman of the Board, Chief Executive Officer,
President and Chief Operating Officer
Date: August 9, 2004 By: /s/ MARGARET K. DORMAN
----------------------
Margaret K. Dorman
Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Accounting Officer)
23
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.
24