Wednesday, November 18, 2009

Smith International (NYSE:SII): Upgraded to Buy at Citigroup, RBC buys the deal

Smith International (NYSE:SII) is getting some interesting comments following yesterday's sell-off on the announced secondary:

- Citigroup is upgrading SII to a Buy from Hold while raising their price target to $35 (prev. $29).

Smith shares plunged nearly 13% as the company tried to place a 28 million common share offering that no one expected and that seemed to be poorly timed. Citi notes they have lowered their EPS estimates slightly to reflect the dilution from the share offering. Their EPS estimate for 2010 is revised to $1.05 from $1.10 and their EPS estimate for 2011 is revised to $1.60 from $1.65. They believe that Smith is a company with high quality products and services and a premier brand name in oilfield services. That Smith is the one of the poorest performers among the major oil service stocks in 2009 makes this stock worth of a second look (especially following the stock’s brutal sell-off).

Smith Pays a Price to Remain Investment Grade While Pursuing Growth
Smith surprised analysts and investors by announcing a 28 million share stock offering, with proceeds to be used for debt repayment and to fund potential acquisitions and new growth initiatives. The company (which is determined to preserve its investment grade credit rating) realized that issuing new debt for acquisitions or growth would have resulted in a ratings downgrade.

Citi Believes SII Shares Are Oversold and Could Bounce in 2010
They have raised their rating on Smith to Buy from Hold. While Smith has been one of the worst performing oil service stocks in 2009, its poor operating results and its need for new equity capital are reflected in its current share price. Citigroup believes the stock has upside to around $35 in 2010.

They Believe Smith is a High Value M&A Target
Two M&A deals in oilfield services in 2009 have apparently kicked off another round of industry consolidation. While Smith’s stock offering clearly signals its desire to move forward on its own in the next phase of the business cycle, we see Smith as an ideal M&A target based on its longstanding global leadership in drilling fluids and bits.

Citi believes that Smith is a logical fit for several companies that have clearly signaled to the market that they want to make acquisitions. The most likely buyer of Smith, in firm's view, would be National Oilwell Varco (NOV.N; US$46.13; 1H). Clearly the operations and technological strengths of the two companies are well aligned. Other candidates to acquire Smith could be Schlumberger (SLB.N; US$67.09; 1M) and Weatherford (WFT.N; US$18.56; 1H)(in that order of probability).

If Smith Stumbles Next Year, Pressures to Merge Could Build Quickly
In 2010 Smith will face continuing challenges in the form of start-up costs in new international markets and pricing pressures in domestic markets. Smith’s PathFinder suite of drilling services is trailing expectations with respect to its pace of international expansion. If the company were to stumble amid these challenges, pressures to merge with a larger competitor could intensify quickly.

- RBC Capital is out with a call titled "Buy the Deal". Firm is reiterating their Outperform rating and $35 price target (unch).

They would buy the deal. Here's why:

1. Deal will help accelerate the expansion of SII's Directional Drilling product line and the growth of its international footprint.

2. SII remains the most consumable (razor blade) intensive company.

3. SII is the only pure play service specific company for mid cap ($2-10bn)

Highlights from chat with company last night:
1. Company has ~30 deals in various stage of discussions, and they typically close 10%. The M&A pipeline has heated up recently, as such, we would expect some deal flow within the next 3-6 months.

2. The sizes range between $6mn-$200mn. This indicates to us that most, if not all, potential deals will be private.

3. Company noted that any acquisition won't be pressure pumping and this equity deal is not related to SLB's put option on the M-I joint venture with SII.

Clients are still questioning execution.
RBC notes they would be concerned about execution if it coincided with status quo. This is not however the case. John Yearwood has been CEO since Jan 1, 2009. He has recently hired a new CFO and established an IR effort, SII's first ever. The CFO is an upgrade, in RBC's opinion, and the IR role shows a commitment to improving its communication effort with both investors and the sell-side.

From an operational standpoint, they have expanded the Pathfinder product line into 6 new countries in 2H09 and are targeting 1-2 new Eastern Hemisphere countries per qtr through 2010.

In RBC's view, the investment decision on SII is simple:
You either buy into John Yearwood, a successful geographic expansion, roll-out of the Pathfinder product line into new countries, successful execution on M&A and an improvement in investor communication or you don't.

Notablecalls: So, there you have it. Two firms are telling you buy SII down 4pts from the $31 level. The thing priced $26.50 last night.

Could trade towards $28 level if the market plays ball.

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