Weatherford International PLC (WFRD) 2004 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to your second-quarter 2004 Weatherford International earnings conference call. My name is Liz and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will, however, be facilitating a question-and-answer session towards the end of the conference. If at any time during the call you require assistance, please key star, followed by 0, and an operator will be happy to assist you. As a reminder, this conference is being recorded today, Thursday, July 22, 2004. I would now like to turn the presentation over to your host for today's conference, Mr. Bernard Duroc-Danner. Please go ahead, sir.

Thank you. Good morning. Lisa, why don't you get started?

Good morning. This morning we reported diluted earnings per share from continuing operations of 40 cents, excluding the gain from the sale of 3 million Universal Compression shares The 40 cents compares to 38 cents last quarter. In addition to the monitorization of 3 million shares of Universal Compression, we began the process of divesting of our Singapore-based GSI compression fabrication business, which is a non-core asset that was retained in the sale of our compression division to Universal. We reported GSI's operating reports and a related noncash impairment charge as discontinued operations. Prior period results are restated to reflect the compression fabrication business as discontinued, and have been provided in this morning's press release. I will speak further to these two compression-related transactions after reviewing the results of the quarter.

A breakdown of our sequential 2 cents earnings per share improvement can be summarized as follows. We lost 6-1/2 cents due to the -- due to 2 factors. One, a 6-cent decline due to the impact of spring break up in Canada. And then two, an incremental loss of one-half of a cent resulting from foreign currency losses, which were primarily noncash. We recouped the 6-1/2 cents and earned an additional 2 cents through the following. U.S. volume contributed 3 cents, the eastern hemisphere and Latin America regions contributed 3 cents on a combined basis, and then manufacturing and supply chain improvements provided 2-1/2 cents.

In summary, the 6-1/2 cent decline from Canada and foreign currency was offset by the U.S. and international markets, and the savings from supply chain initiatives. As a side note, the higher equity and earnings in unconsolidated affiliates was offset in full by higher corporate SG&A. The higher corporate SG&A is the result of the Sarbanes-Oxley 404 project, and stock-based compensation expense -- expenses which result from our adoption of an accounting policy to expense stock options.

On a company-wide basis, revenues increased 30 million over the prior quarter. North American revenues grew 7 million , with a 41 million increase in the U.S., more than offsetting the [inaudible - microphone being moved] declining Canadian revenue. Outside of North America, revenues improved 23 million, led by a 7% sequential improvement in the eastern hemisphere and an 8% improvement in Latin America. Eastern hemisphere continued growing in all regions. However, the North Sea was flat was first-quarter levels. That is, the North Sea seasonal recovery was essentially nonexistent. Venezuela and Mexico accounted for the growth in Latin America.

Now, turning to the divisions, drilling services. The revenues were 5% higher as compared to the prior quarter. North American revenues increased 13 million, or 7%, despite a 12 million seasonal decline in Canadian revenues. Eastern hemisphere revenues increased 8.3 million, or 4%. On a product-line basis and ranked by size, the revenues broke down as follows. Well construction, 36.6%; drilling tools, 23%; drilling methods, 21.6%; and intervention services, 18.8%. EBIT margins for this division at 25.4% were up 150 basis points sequentially, and 190 basis points year to date. The sequential improvement was a function of volume and supply chain savings, offset in part by high decrementals in Canada.

Production systems, from a geographic perspective, international markets increased by 13.4%, led by improvements in both the Middle East and Asia regions. North American revenues declined 2.8%, or $5.7 million. The 22.7 million seasonal decline in Canada was more than offset -- more than offset the 17 million increase in the United States. The first-quarter production division revenues by product line were lift, 52.1%; completion, 33.8%; and production optimization, 14.1%. EBIT margins in this division fell as a result of the decrementals associated with the steep decline in Canadian revenues. Excluding Canada, EBIT margins for this division improved 44 basis points, or had an -- in other words, had incremental operating income of 17%.

On the cost side, this quarter did surpass expectations. The implementation of initiatives to lower our manufacturing cost structure occurred ahead of schedule. This quarter we realized incremental savings of $4.2 million. The savings were primarily from well construction manufacturing that was moved out of the United States to Latin America. As I mentioned earlier, this benefited the drilling services margins. Originally the majority of these savings were expected to occur in the third quarter. Third quarter and fourth quarter revised incremental targeted savings are 2.5 million for the third quarter and 4 million for the fourth quarter.

As I mentioned earlier, there are two unrelated compression events. In June we sold 3 million shares of the Universal common stock. We received proceeds of $90 million, all of which was used to pay down short-term debt. The gain was $25.3 million, and there were no taxes associated with this gain. Therefore, the company's overall effective rate -- tax rate was only 19.8%. Our effective tax rate excluding this gain was 26.4%. We anticipate that the 26.4% will be our rate -- rate for the remaining quarters of the year.

We also have reclassified our compression fabrication business to discontinued operations. We are now only using the Singapore-based facility for our compression fabrication business, which is non-core to Weatherford. Therefore, we are in the process of disposing of the business. In this quarter we recorded a 5-cent loss from discontinued operations, which includes a noncash write-down of 5.2 million, or 4 cents per share.

In the press release this morning we provided selected balance sheet information, but I would like to point out that our days capital -- working capital decreased approximately 5 days this quarter, as compared to the first quarter. Furthermore, it has decreased 9 days, as compared to the same period last year. Capital expenditures net of lost-in-hole were approximately 67 million for the quarter, or 122 million year to date. Capital expenditures for the year will be approximately 250 million, running just below our depreciation level. During the second quarter net debt capitalization declined 230 basis points, to 34.2%.

And now I'll turn it over to Bernard.

Thank -- thank you, Lisa. Q2 was a -- was a solid quarter, excluding the gain on the sale of the UCo stock and the impairment of our small discontinued compression business, Weatherford earned 40 cents in Q2. Return on capital employed rose year-on-year on 220 basis points. [Inaudible - highly accented language] grew 2.8% sequentially to $172,650, and this is the 11th consecutive quarter of growth. The oil and gas industry is in the beginning of a multi-year expansion phase, and in this environment Weatherford intends to deliver strong financial results, coupled with increased returns, and this on the back of technology and footprint investments. The company is entirely focused on execution.

Comments on Q2. Company-wide, the U.S. showed good top-line growth, as did the U.S. -- the eastern hemisphere, ex-North Sea. Canada predictably had a tough break-up season, with earnings per share decline Q1 on Q2 of 6 cents. The North Sea was surprisingly weak, flat from prior quarter. And the prior quarter is the seasonal low. There was no P&L benefit from U.S. pricing in the second quarter, except materials surcharges. I'll talk about pricing later on.

The drilling division had strong U.S. and eastern hemisphere top-line growth. The U.S. was driven primarily by underbalanced, which is the drilling methods segment, and well construction. The eastern hemisphere was strong in Middle East and Asia-Pac, but not the North Sea. North Sea was flat on Q1. Again, this is very unusual, as Q1 is a seasonal low. In many respects, Q1 of '04 was also a historical low, or close to historical low, and Canada was severely down on the drilling side, consistent with the region's seasonal break-up.

As Lisa mentioned, much of the 150-basis-point improvement in the drilling division's margin was earned by supply chain gains, and that's primarily in the well construction segment. It should be cementation and liner hangers.

From the divisional product line's standpoint, movements were similar to prior quarters. Drilling methods, essentially underbalanced, and well construction continued to grow quarter-on-quarter, as well as intervention services. Drilling tools, proprietary and nonproprietary, were flat. Drilling methods of 21.5% of the drilling division, up year-on-year from 18.8 in '03, is catching up in size with drilling tools, which is 23% of the division for the number 2 spot in the drilling division.

The production division also had significant top-line growth in the U.S. and eastern hemisphere. The U.S. top line benefited from what appears to be continued shares in lift. While the Middle East and Asia-Pac were up strongly, the North Sea was also unseasonably flat. Concurrently, Canada was severely down quarter-on-quarter. From a divisional part line service stand point, lift was up, quarter-on-quarter, while completion was down, essentially in Canada. Except for a company-wide procurement gain in telecommunications, the production division was not materially impacted this quarter by supply chain events.

Let me go over to the outlook. First the underlying markets. We expect the U.S. to gain another 35 rigs or so for the year, ending '04 at circa 1,250 rigs. Drilling depths in the incremental U.S. land rigs is likely to be deeper. For Canada, post break-up the year will be modestly up over 2003. Internationally, rig activity should rise about 5%, or circa 40 rigs between now and year-end.

Concurrently, we expect Weatherford's business to grow by close to 8% from now to year-end, or about roughly a 50% greater rate than the underling market. Much of the growth, if not all, will occur in the eastern hemisphere. We expect the intensity revenues for international rigs for Weatherford, or intensive revenues for well drills, either way, to rise consistently for Weatherford throughout the year. And this is consistent with our historical record, if you go back and track it. Absent the change in U.S. pricing and all movement in the Gulf of Mexico's activity, we still believe that the international markets will carry Weatherford's earnings growth in the second half of '04 and into '05.

Which brings me to the issue of the North Sea and the Gulf. Weatherford cares a great deal about the North Sea and the Gulf. For historical and product service line reasons, both offshore markets are disproportionately important to Weatherford. In late '01, the North Sea, which we define, or one defines, as U.K., Norway, Holland and Denmark, in declining order of size, and the Gulf of Mexico, represented about 25% of revenue -- Weatherford's revenues. That was, again, in '01. When the jewel declined, both markets came. Weatherford was the most exposed oil field service company. The mid-cap, large-cap space.

Since '01, both North Sea and Gulf of Mexico experienced a volume contraction of about 35% and 50%, respectively, both for rig and rig loads activity combined. Concurrently, pricing in the U.S. Gulf and Gulf Coast markets showed a severe price erosion, peak to trough, of almost 30% for us. At this point, in both our case, we are working off bottom. Volume in the North Sea remained in Q2 at the seasonal and close to second historical lows of Q1, while activity in the Gulf actually declined further from Q1 to Q2. It was marginal, but declined further. Both markets shrunk to represent today less than 16, 16% of Weatherford's revenues in Q2, while the loss in volume and pricing from peak to trough cost Weatherford close to $200 million in pre-tax income.

Prognosis appears better. It is reliable, in the case of the North Sea. It is speculative in the case of the Gulf. The North Sea, starting with the U.K. and Holland, should be substantially stronger in '05 and '06. Norway will follow with a lag, but should be equally healthy.

A combination of factors is coalescing to turn that market. Well, first you've got under -- underinvestments for years and concurrent production declines, you've got the change of operators, infrastructure which is existing and is now underutilized and therefore available on more attractive terms, and there are -- there's the business of encouraging government policies. Although some government action, to pick up the last point, has been helpful recently, that promote licenses, the [inaudible - highly accented language] initiative, both in the U.K., the lifting of restrictions on the Waden Sea in Holland, etc. Most of the prospective market lift in our minds is the function of the passing of time and the powerful effect of accelerating decline rates.

It is difficult today for us to reliably calibrate for you the volume increase in activity for '05-'06. What we do know is that it's likely to be material, broad-based and sustained. The sequence of upward moves should be the U.K. first, then Holland, and finally Norway. By next conference call in October, we should be able to provide specific guidance for '05-'06, volume increases and, of course, their financial implications. As reference, in the second quarter Weatherford's combined U.K., Norway, Holland, Denmark revenues were just about $60 million, 6-0, or 8% of total company revenues.

The Gulf, well, the Gulf of Mexico remains tough. But there are glimmers of hope. Some activity increase appears possible the next few quarters, centered around the intermediate and deep zones of the shelf. First, a significant cross-section of middle to large independents are likely to increase activity in intermediate drilling zones in the shelf over the next 18 months. They are, in increasing instances, trying to secure rigs in that area of the Gulf. Apache, Dominion [inaudible - highly accented language] are some of the operators considering incremental shelf drilling to intermediate depths.

Concurrently, smaller independents appear to us as like to to increase their '05 budgets to drill on the shallow zones of the -- of the shelf, picking up the slack for the majors and large independents. The combined effect should be a modest positive, volume-wise. But in a very weak market, marginal moves do make the difference.

The second part, which is actually more material and also more unusual. We have seen partnerships arise over the last few months in the deep zones of the shelf that you would not normally expect to see. I can tell you some, I can't tell you all. For example, Exxon has negotiated several contracts with mid to large independents, whereupon Exxon has secured the right to drill the independent well, the independent's well, sorry, to a deeper play and share in the production. Also, Shell and Chevron are negotiating agreements over certain deep-zone plays in the form of "drilling release contracts." This means, for example, an independent will drill at a specified depth and release a drilling to Chevron or Shell to take down to another specified depth. Add to this Exxon's Treasure Island play to be spotted for year end, originally a new field prospect, and BP was waiting in the wings with their own leases in the area.

This appears to be a trend with substance. It should spawn initially some volume increases, probably a 2005 event for service companies. Given the well's architecture and depth, it doesn't take a lot of incremental drilling to make an off-field volume difference. Obviously, what will matter the most is the extent of the deep shelf play, meaning how successful will the drilling be, if at all? If it is, the implications for the U.S. actually will be very significant, and disproportionately so for Weatherford.

So where does that leave us? In Gulf activity, for the first time appears likely to pick up some, driven by a mixture of incrementally more intermediate-zone drilling for the shelf and some selected deep-shelf drilling. The deep shelf clearly has quantum more potential beyond that incremental volume, albeit still uncertain in prognosis. In this regard, a word of caution. The hopeful trend is constrained by availability of equipment and people. And furthermore, it is intensely speculative, given the drilling depth pursued in the deep shelf, 1 or 2 dry wells could spell the end of the -- building thrust for deep-shelf gas. Notwithstanding the above, it's the first conference call in a very longtime where we find the -- I think, the conviction to be less pessimistic about this core market by U.S. operations.

A few words about product line segmentation. No change in product service line prognosis. I'll sort of repeat what I've said the prior conference call. The balance of the year in the drilling division, underbalanced is expected to have the highest growth rate, followed by well construction. At this point, the backlog of projects on underbalanced appears substantial enough to exceed our internal 25% brand growth rate through year-end '04 and '05. And as well as challenge our operations. Underbalanced prognosis is secure, and our focus is squarely on execution.

Well construction, which is drilling -- the drilling division's largest core segment, is also showing strength likely to outpace corporate-wide growth. Well construction regroups tubular running services, cementation and liner hangers, and that is up to 37% of the drilling division in Q2. Prospectively, the most significant story of this segment through '05 is incremental gain in deep-water market share. In the U.S. Gulf of Mexico, for example, BP has awarded Weatherford contracts mad -- on Mad Dog, Thunder Horse, as well as Atlantis, for our well construction segment. These are three of BP's crown jewels.

Add to this recent gains in liner hanger systems. Liner hangers had substantial contractual success in Q2, winning major contracts in Norway and deep-water plays in the Gulf and west Africa. These contracts have a wide -- have a range of 1 to 5-year life and will start late in '04. At this time, by our accounting we'll have the larger share of deep U.S. -- of U.S. deep-water, with 15 out of 30 deporter rigs using Weatherford liner hanger systems. We'll also have a larger share of liner systems in Norway.

Well construction, obviously, will not match underbalanced growth for the next 5 years. It's more mature. It will, though, show strong growth in high-margin applications, and that's really on the back of R&D investments. The production divisions have no change. Our production optimization is expected to have the highest growth rate, together with gradual extension of our brownfield strategy. When it comes to the geographic prognosis, no change either, with the exception of comments above on the North Sea and the Gulf of Mexico, Middle East, Caspian and Asia-Pac are the reasons -- regions with the highest expected growth rates through '05. No change change from prior assessment.

Moving over to pricing and costs, raw materials inflation is a well-advertised phenomenon. We've seen cost increases in the range of 20 to 60%, depending on materials, grade, metallurgy and shape. We have systematically canvassed and squeezed our procurement and supply chain capabilities to minimize the cost push. Notwithstanding these -- these efforts, raw materials cost push was, is unavailable -- unavoidable -- unavoidable. As a final remedy, we instituted a raw materials surcharge in early April on relevant product lines, which has passed -- phased in throughout Q2. At this time it appears that clients have recognized the reality of industrial markets, which is another way of saying the surcharge is being accepted.

Separately from this, after careful assessment, we are initiating what -- what could be summarized on average as a 6% across-the-board price increase for our entire product and service line, effective July 1, for both Canadian -- U.S. and Canadian markets. We did the same in May of last year, only to find that instead of a price increase, we experienced a pice decrease, ironically of about the same amount. Market circumstances appear different this time around. We're cautiously optimistic this price increase should prevail. We're not sure yet and we do have a long way to go.

As you may recall, Weatherford -- U.S. pricing bottomed in late November '03 at a level, on average, about 28%, 2-8, below the peak level achieved in '01, Q3 of '01 to be specific. The historical tie of Weatherford's drilling division to the Gulf of Mexico and its -- subsequent collapse in the '02-'04 period was the root cause of that pricing decline. The highest, greatest decline in Weatherford's history. Pricing in the international markets is showing a sign of strengthening in other regional markets. And it still is too early to tell how meaningful of a trend this is.

A few words about supply chain. Supply chain efficiency was assessed at $4.2 million in quarterly benefits for Q2. This was greater and earlier than anticipated. We're on track for a further $2.5 million reduction in manufacturing and supply chain costs for Q3, another 4 million for Q4. These numbers are incremental per quarter.

Numbers of actions underway. There's so much detail that I -- I'll just -- I have a quick sample, but there is much more than this. Manufacturing volume coming out of the U.S. and continental Europe to eastern Europe, South American and Asia is essentially what's going on. Specifically packers, Argentina, Brazil and India; gas lifts to Brazil and India; cementation to China; and reciprocating products to China and Romania, to name a few. There will be a further curtailment of facilities in the west while we are expanding and opening new facilities in Asia-Pac and Latin America.

The discontinued GSI facility in Singapore is another case in point. GSI is a small business, performed 2 functions, internal fabrication needs for capital goods equipment for Weatherford, and fabrication services for the compression industry in the Asian -- the Asia-Pac region. That was a small relic, actually the only relic of our compression division, the one that we merged with Universal Compression a few years ago. Effective late Q1, internal needs for fabrication that were being fulfilled by GSI were interrupted as they were being sourced out of the India and China, at what is -- amounts to about a 30% lower delivered cash cost. So at this point, the single remaining purpose of the GSI, as a business and a facility, is supporting the regional compression services needs. And that really is in core to Weatherford. Hence the continued status. The small facility business will be sold by year-end.

Technology. We stand by our commitment to raise the technology content of our products and services. By our assessment, Weatherford spends more in R&D, obviously on intensity of revenue dollar basis, than any of our peers, save Slumberzhay [ph]. Our purpose has been and remains two-fold, advancing our core technology beyond the present generation of tools. Core product and service lines account for two-thirds of R&D spending. And the second objective, develop, nurture and commercialize changed technologies that are natural fits, an extension of our core.

A few updates on R&D on what we're working on. Each one is deserving of a whole topic of itself. Fiber optic R&D, focusing on sub-sea applications, work is progressing on drilling with casing third-generation systems, prototype testing on -- steering systems for underbalanced applications, software enhancements ongoing for underbalanced reservoir selection. On the expandable side, R&D is focused -- focus has shifted squarely back to solids, away from expandable sand screens. Solids -- solid expandables, in our minds, is a competency technology that is consistent with our core, and is deemed strategic. Expandables, ESS, expandable sand screens, has seen its backlog of work rise gradually throughout the quarter . We hope to have recovered this product's 2002 volume as we enter '05.

On a related note, we've signed exclusive agreement for Slumberzhay [ph] to use and market Weatherford's ESS worldwide. In many respects, Slumberzhay [ph] is optimally equipped to utilize and commercialize this technology. Weatherford will continue to market and install ESS concurrently with Slumberzhay [ph]. ESS has made its mark as the first application of revolutionary expandables technology and, such such, deservedly got a disproportionate amount of attention. Slumberzhay [ph] is the industry's premiere sand control company, so it's a good fit and we -- we're hopeful that a combined effort will bear fruit.

Which brings me to my concluding comments. The outlook for oil field service is strong. This isn't the first time market prognosis for oil field services is being constructive. What is different this time, and we felt -- felt this way for the past two years, is how gradual and sustainable the rise in activity is. We interpret this as a corollary to a tug-of-war between capital discipline and the growing difficulty with which our clients can secure desired -- desired rates of production growth. It's the reservoir which is the cause of all this. This isn't the [inaudible - highly accented language] issue. Reservoir productivity difficulties will get worse in '06 and beyond.

Let's address the following. The U.S. markets will peak by year-end '04, at around 1,250 recount levels. It should fluctuate up or down around that level in '05-'06. We do not expect any further improvements beyond 1,250 rigs. Within the U.S., regional rotation is possible, even likely. Canada will stay stable at or around present levels of activity, adjusting for seasonality. Changes to the upside will be minor. Earnings and returns in North America from '05 thereon will be earned by pricing, share, technology and supply chain efficiency.

The international markets will blossom in '05-'06, as our clients make a push to secure production growth rates. Within the international market, the North Sea will be materially stronger than anticipated in '05-'06. The Gulf of Mexico remains a wild card. There are reasons to be more constructive for '05, albeit they are speculative. The technologies and improved reservoir productivity will do increasingly well as '05-'06 unfolds. For the next several years we -- Weatherford will see strong organic growth top line, coupled with increased returns on the back of the technology and footprint investments already made. And to close the way we opened, we're intensely focused on execution.

With that, Operator, I'll turn it back to you to start the question-and-answer period.

Ladies and gentlemen, at this time if you wish to ask a question or make a comment on today's presentation, please key star, followed by 1 on your touch-tone telephone. If your question has been answered and you wish to withdraw your registration, please key star, followed by 2. Your first question comes from the line of Jim Crandell of Lehman Brothers. Please go ahead, sir.

Good morning, Bernard and Lisa.

Good morning.

Good morning.

I have a question on expandables and a question -- let me just start on expandables. First of all, can you define exclusive in your exclusive arrangement with Slumberzhay [ph]? Do you expect that Slumberzhay [ph] is going to work on a competing system? And then maybe wrapping up, can you talk about how you see revenues coming from expandables in the completion tool area, and when you see revenues kicking in on the solid side?

Hi. I'll -- the relationship with Slumberzhay [ph] on ESS is straightforward, in that they have the exclusive rights to sell ESS as part of their offering. And no one else has that right. We have the right to, obviously, but no one else will have that right, by agreement. We -- the installation and the service side of the business will continue to be done by Weatherford, because we've got, you know, we've got the crews that are trained there and it's not a -- it's not a simple matter to train people to do this. And with -- insofar as their system is concerned, my understanding is that the -- the work they were doing on expandable sand screen has been discontinued as a result of this agreement. Does that answer your question?

It answers the first part, Bernard. Then can you comment on when and how significant you see revenue unfolding from your work in expandables in the completion area and then the -- how you see it coming along in the solids area?

Jim, I'm going to be very cautious on that, and if you wonder why, you'll probably look or think about it and you'll see that I have no reason to be anything but cautious. I think -- first of all, I think the agreement with Slumberzhay [ph] is very helpful from the top-line standpoints, helpful to them, helpful to us, it's a good fit. And before I get to completion and solids, I'll also add that, you know, expandable sand screen is a sand control technology. If you think about it, it isn't really our business. We're not a sand control company. It is ours because it's the first by-product of the expandable technology. Really our business is solid side. This is where we belong. It doesn't mean that we're turning our back on ESS, it just means having someone who's in sand control, and probably the very best in the industry. And using a technology which is a sand control technology is actually very reasonable and helpful. How much money does it mean? I don't know, and if I know, I probably wouldn't tell you, out of caution. With respect to completion and solids, I'm sorry, Jim, I'm going to also be a wet blanket, just to say that I think it is progressing. I wouldn't bake anything in solids or completion in any numbers until we tell to you do so, if only because I'd rather be safe than sorry.

Okay. Fair enough. And my other question has to do with underbalanced, based on past conversations with you. I had the sense that you had expected a material pick-up in the Middle East beginning in the second half of this year, and since such a large percentage of those wells would be drilled underbalanced, you expected really a substantial step-up in your Middle East underbalanced business. Can you comment on that, and maybe even break it down a little bit by country or area?

No, it's -- it is -- it is -- there's a lot of startups in Q3 in the Middle East and a lot of startups in Q3 also in the -- in the region, which would be somewhere in the Middle East and Asia-Pac. So that is happening. It's -- it'll happen in Q3 and in Q4 and in Q1. There's a lot of pipeline of work to be increased. The -- you know, what I try to convey in my comments is that at this point in time, the volume of business that we seem to have, I hate the word locked up, we would seem to have contractually committed, suggests that we are less hungry for more volume. We're more hungry for better execution right now. Because I think we have what we expected to have. And in terms of breaking it down by country, Jim, I can maybe do that with you off line. I wouldn't want to do that on the phone, I really would not, for competitive reasons. But you can assume that it is very widespread geographically. It's not one country at all. I can think, just offhand,about 10 countries, if that gives you an idea. And the volumes for us are there. I am not saying we're satiated. I am saying that we are very focused now on not taking on too much. As --, you know, it would be great to report that, well, instead of 25 or 30% it will be x percent more, and then 2 quarters later we have to report that, well, the margin declined by XYZ because we had operating problems.

Okay. One final question, Bernard, just on the underbalanced side. Do you -- do you think the competitive position of Precision and Halliburton has increased over the past 6 months in this business, stayed about the same, or just don't see them?

Oh, no, no, no. We do see them and we welcome them. First, to give back to Caesar what is Caesar's due, I think Precision was a pioneer in the business. And I think we were a follower, and we just grew faster. We committed more time and energy to it, that's all. But they were a pioneer in the business and remain excellent. We welcome Halliburton in the business, not because we're in the habit of welcoming competitors, really because the business is so young. And having a good company and very credible, dedicating time and energy to it, is excellent. I mean, the issue here is not one of, you know, I want a bigger slice of that pie because the pie is staying the way it is. The pie is growing so fast. The issue is let's help the pie grow effectively so that the clients are happy with it. In 5 years or 10 years, you can start arguing about market shares and things like that. So, no, I would say we see them. They are very active. No doubt, you know, given the fact that we are sort of -- we seem to be happy with what we have, they may get some good business of their own, and we wish them well in this particular side of our business. Because, again, I think to a degree we're partners in crime. That's just the way we perceive it. They may perceive it differently. We perceive it this way.

Okay. Thanks, Bernard.

And your next question comes from the line of Bill Herbert of Simmons & Company. Please go ahead.

Thanks. Good morning.

Good morning.

Good morning.

Could you refresh us and update us with respect to underbalanced margins relative to the drilling services segment margins? Higher, flat, lower?

Lisa, do you want to do that?

Well, they run about 30% on an EBITDA basis.

Okay.

That's, you know, basically right in line.

Got it.

We've got -- got two comments. One is the amount of startup costs that are embedded in it, which tends to depress it. The other side of the coin is maybe our inability so far to extract some performance pricing out of the client, which is a reflection of how young it is.

Right.

Maybe it doesn't -- doesn't -- maybe that doesn't go on forever.

Okay. Secondly, you mentioned that we're at 21.5% of the segment revenues. We're number 2 relative to drilling tools.

Number 3, actually.

Number 3.

We -- we're catching up to number 2, is the point I made.

Number 3. Great. At what point do you expect underbalanced -- do you think underbalanced is ever going to be the most significant division within the segment?

Oh, good God. Will we catch up with the well construction. Yeah, on a -- on a -- on a -- if you talk to me sort of late in the evening I would say probably yes. But on a more reasonable basis, meaning I would get romantic about it. But I am not in a very romantic mood right now and I would say that it would take many years, because just work through the math. The well construction is growing also at much lower rate. It is growing faster than the overall rate, so it would take many years.

North America in terms of pricing, we're instituting the 6% pricing increase. Where do you expect to get the most pricing opportunity and the most pricing resistance?

I see you -- I think it's -- I think the -- ha, ha, ha. I don't know. I don't know. I think -- I -- I -- first of all, we made a complex situation simpler. Meaning that there isn't a -- there isn't a -- just a -- a sort of button I press on and, bingo, everything goes up by 6%. It's a blended -- it's a meaningful number, but it's a blended number of a lot of different products and service lines. That's the first thing. It is quite -- quite complex. I would say, Bill, that with our psychology, although we will fight tooth-and-nails for it, we were reporting this, we're not saying you should -- we would actually urge you not to take it to the bank yet. We'd rather tell you now and then in October if we do already very well, we'll tell you, well it worked and so forth, or we'll tell you it didn't work. But at least we'll have told you we're trying. We -- and -- and what our expectations typically in -- before the event of last year, which obviously shocked us a lot, meaning price increase and actually we got a price decrease, we're not alone in this, but still it shocked us a lot. I think normally we'd say, Bill, that two-thirds of it would be what we'd hope to bring back to the bank.

Okay.

But then I'd be cautious not to bake it in the numbers yet, because we actually don't know.

Okay, and --

We waited -- we did first took care of the raw materials surcharge, that was the most urgent, because we have a higher product content, if you will, than some of the pure service players out. there. So people like us that are half products, half services, the materials issue is material, as opposed to if you are a seller's player, it is less material because it goes through your business via the CapEx line, not the income statement line, and so it takes much longer to have an impact. So if we are to address it first, we did address it thoroughly. It got addressed very well. It impressed us. We didn't make any money out of it, but also we didn't lose any money from it. And they were very happy about that and they gave us, I think, the backbone to go out and adjust our pricing further, which is the next step.

Okay.

No, we'd like to -- like to report to you in 3 months that it worked and then, if it worked, maybe, maybe things change. Numbers change and -- and whatnot. But we really struggle with reporting this because we -- it's better to report it after you do it and it's successful, than beforehand.

Two more quick ones. International pricing, any opportunities on that front?

Yes, there is. It's just not as -- it's not as monolithic as in the U.S., where you have [inaudible - highly accented language]. The U.S. has many regional markets, but it still is -- it still is a more consistent market, whereas internationally -- first, it's contractually led, so it's lumpy. Second, there are often differences country by country. But, yes, there are opportunities. And you see -- we see opportunities to move pricing in the U.S., but internationally between 5 and 10% is what I've seen in a number of instances.

But --

Yes, Lisa?

But -- but it's -- but it's not all at once.

It's not all at once.

They -- they -- they -- they bleed into the P&L very slowly.

Okay.

But -- but -- but it has happened.

Last question. Norway, any concern about the strike or any exposure? Just sort of refresh us --

Let -- certainly -- first of all I would point out that, as a matter of historical relevance, the Norwegians always go on strike in the summer.

Okay.

You think about it for a second.

Uh-huh.

They never go on strike in the winter. And if you go back in history, you'll find that's true. Second, it certainly didn't help Q2, because it disrupted our June.

Okay.

A third, in what we have assumed, you know -- our outlook for the North Sea was certainly more subdued than it is becoming. So in that regard, I think what we have assumed for the North Sea included in Norway which is less than -- less than -- less than strong. So, we're fine.

Okay. Thank you.

Are we happy about disruptions in Norway? No. Again, I would -- I will suggest to you that as the cold weather comes back, some of the union pressures may go away. And I'm -- I am actually quite serious.

Okay. Thank you, Bernard.

Operator, do we have another question?

Yes, I apologize. Your next question comes from the line of Rob Mackenzie of Friedman, Billings and Ramsey. Please go ahead, sir.

Good morning, all.

Good morning.

I wanted to drill down into the price increase question a little bit deeper here. Specifically, you know, you said on average, Bernard, a 6% increase in the U.S. and Canadian markets. Could you break that out for us, how much -- what percent you might be instituting on land in the U.S. versus offshore Gulf of Mexico?

It's really, Rob -- it's pretty much the same and it is because we -- because we have a -- we have a broad offering, it -- it -- there would be some variations. Some places as low as 2 and other places as high as 8 or 10. It does vary. And for competitive reasons I would like to, you know, keep -- plus, it's too complicated to do on a conference call. Second of all, for competitive reasons I'd like to remain quiet on it. But it's fair to say that it is a -- an attempt which is about equal land or offshore throughout the United States and Canada, and 6 is the average. It's very close to being -- to be -- I mean, it's mathematically almost perfectly correct.

Okay, fair enough.

And now -- and now also -- same thing I answered to your peer, Bill Herbert, a few minutes ago, we would be -- would be very happy if we brought to the bank two-thirds of it, which is 4 out of 6, and I cannot guarantee you that it does work. What I can guarantee you is the raw materials surcharge did work, because it's a fact.

Fair enough. In terms of the international, could you comment on which markets specifically you are starting to see some of the pricing power and with that -- and tied in with that, where you see capacity utilization for many of your products and services, market by market?

The two markets that come to mind would be Caspian in the Middle East, on pricing, and we see capacity constraints in the Caspian, in the Middle East, in north Africa. Not as much in Asia-Pac. We're also -- interestingly enough, there's a lot of equipment and people that have left the North Sea. The North Sea has not done well. We know this. But, I mean, even recently it has not done well. One of the things that's intriguing about the much-improved prognosis of the North Sea is that you will have capacity constraints in the North Sea very quickly that I don't think the clients are anticipating quite yet, but they will. So that will be a market which one ought to watch in '05, because you'll have volume and you may actually have pricing. But I can't say any more than that now, because that's -- that's just an educated guess.

How about west Africa? We've seen a number of signs of that picking up recently.

Yes. No, Very much so. Very much so. And you do well to remind me. Yes, west Africa and land Africa, also. Markets like Chad are also very significant in terms of delta. But you're absolutely right. And I -- we've have had some very good contractual success in west Africa, particularly on the well construction sites. You do well to remind me. Yes. My omission, my mistake.

Okay, fine. Lisa, this is a question for you, and perhaps we can get it offline again, is if you could provide a -- a table of the second-quarter stock option expense again?

It approximated 1 cent impact to the second quarter. And I -- I can help you out with that offline.

Great. Okay. Thanks, I'll turn it back.

Thank you.

And your next question comes from the line of Grant Borbridge of Prudential Equity Group. Please go ahead, sir.

Thank you. First, a question about the impact of the weather on your operations. We've had some pretty wet weather in Canada during July, as well as some still wet weather in the southern parts of Texas, and I was wondering if you're expecting any impact from the weather on your next quarter results?

Well, I think -- well, let me just answer the weather and I'll get to the quarter. You're right. July has been -- I mean, until about a week ago -- so, July was impressingly wet. Impressively wet, I'm sorry, impressively wet in Canada, no doubt. And south Texas is of lesser -- lesser --it's not as material. And it is also true that as a result of that, activity has been held back in July in Canada. It's true. We find ourselves in the odd situation, which I think is shared by many of our peers, of having a bundle of work in Canada, which is there like a coiled spring and waiting for the weather to permit it to proceed. Okay. So is that a -- is that a good thing? No, it's not. Does it pinch you on the Canadian earnings of Q2? Yes, it does. Do we calibrate our numbers so that everything needs to -- all the moons have to be aligned and the sun has to shine and everything else? No. Because if we did, we would get in trouble. The answer is, I think we should be fine. But you are absolutely right. It has not been helpful. But there's always something. If it isn't the rain, it's a strike, if it's not a strike, it's a natural disaster or political upheaval. In our business there is always something, and you have to adjust for it.

Sure. Second question for you. You sound awfully positive about the developments in the Gulf of Mexico deep shelf. What happens, though, in that market, in your opinion, if Exxon, for example, doesn't have success on the well that they commence drilling probably before the end of this year? Does that bring a quick end to the optimism you have, or do you think there are enough other --

Well, I am very distraught to hear that I sounded very optimistic on the Gulf. I try not to be. I -- I -- I honestly try not to be. I's actually far more -- it's far more reliable -- I'm far more encouraged about the North Sea. But then again, I don't hear myself. So maybe I did sound -- no, I -- I -- I am -- I view the Gulf of Mexico events on the shelf into two different buckets. A little bucket and a big bucket. The little bucket is the intermediate zone. It's true there seems to be a little bit of delta coming from independents, large independents on intermediate zones. I call intermediate zones are 10 to 12,000 feet. That's true. That's a good thing. Is this going to make us all rich? No. And, concurrently, the -- some of the small independents some to be picking up slack in the shallow zones of the deep shelf. I mean, you have to be very specific. There's too many shallow and deep words being used. The real -- obviously the real elephant in the room, if there is an elephant in the room, is the deep shelf. Okay. And I really did not want to sound too optimistic, because that would be irresponsible. I just conveyed what I heard and what I know. If Exxon finds -- if Exxon or anyone else finds a bunch of dry wells -- I think I've tried to mention it in my comments so you can take a look at them. If there's a couple of dry wells, this will go back in the closets of history until someone else decides to open the door. It will be a nonevent. There is no doubt. That's why it's so speculative. That's why I would not, other than reporting it for the sake of providing information, I -- I -- I certainly as a businessman don't think about it in any financial way or form. I do not. For me, the Gulf remains a very weak market, whether it appears to be a small glimmer -- small, with respect to intermediate zones on the shelf. And that small glimmer becomes relevant simply because we know when business is bad, in terms of volume, a little bit more makes a difference, but that's it. Clearly the deep shelf is something worth being excited about if there is, you know, oil and gas down, gas in particular. And I don't know. And you don't know either, that's why we have to be careful. And so thank you for asking me the question, because I do not want to come across as optimistic. I am not.

All right.

I just am intrigued.

Fair enough. One last question. With the improvements that you've seen in your business, is there a temptation on your part to increase R&D and/or CapEx spending going forward?

R&D, no. R&D, no. You know, we spend so much on R&D. I -- we made the point that I don't know of any other company except for Slumberzhay [ph] that spends as much as we do on an intense -- you know, percentage of revenue or whatever basis on you want to use, and we are very focused on getting a return on that. And, of course, you know, a third of it is in step-change type technologies, which take a long time to deliver. There's no doubt about it. Although in the case of underbalanced, they started to deliver. So very focused on getting a return on that, and I certainly don't know. The answer on R&D answer is squarely no. I don't think we could manage it if we wanted to. In fact, I -- it may be wishful thinking, but I keep on thinking it's going to come down. It's not going up, but it will come down by a least a couple million dollars a quarter, sooner or later. But not up. CapEx is a little bit different. CapEx only if the volume of business not only comes our way, but more importantly, we can manage it. Yes, then CapEx will go up. But you will be told. It won't be sort of an event. And presumably you would want that to happen, because if it did happen it would suggest that the company's organic -- organic growth rate is moving up at a higher plane. And it's possible. In fact, it's desirable. Possible and desirable. Not R&D, though.

Okay. Great. That does it for me. Thank you.

Thank you.

And your next question comes from the line of Dan Pickering of Pickering Energy Partners. Please go ahead, sir.

Good morning, guys.

Good morning, Dan.

I want to look at the production systems business for just a second. Bernard, you spent a fair amount of time talking about the North Sea as clearly a mixed issue that has affected the business as we've looked over the past year. As you look forward in the production systems business, kind of how do you think about incremental margins or absolute margins? Which -- we probably anniversaried a lot of that North Sea issue, correct?

Not really. First of all, North Sea is not really a mixed business, Dan. It's just basically -- North Sea has seen about a large third of its volume go away in the past two years, and stayed down. And it is more of a drilling issue than a production issue. It's true there are -- there are some production sales also in the North Sea, but it is predominantly -- I mean, of the $60 million, Lisa, how much is drilling versus production? Is it 50 versus 10, or something like that?

Yeah.

So you see, Dan, it's really -- it's $60 million and that number is correct. It's U.K., Holland -- well, U.K., Holland, Norway, Denmark.

Yep.

I don't know if it -- I don't know if it's 50 drilling, 10 production, but I'm probably not far off, and Lisa can --

No, you're -- you're very close.

And 60's a good number. So, first of all, do realize that North Sea, the issue is the drilling side and not the production side. Now, I wish production had more sales in the North Sea, but it is what it is.

Yep.

Second, it's not a mix issue in the North Sea, since the business has not been good in the North Sea for anyone for the past two years. And it's been long in turning and as the seeds of a -- what appears to be a strong turn are there for '05-'06. And that's actually the topic, probably, of a different conference call altogether, because it's a long discussion.

Sure.

Let's stick to the margins on production, and I'm going to turn to Lisa and maybe she can -- as opposed to --

I -- really what you see in this quarter was the impact of extremely high decrementals in Canada, which --

Yep.

I mean, obviously it resulted from the drop-off. They had lower absorption in the manufacturing plant sale, so did more maintenance and operating expenses. If you take back out the impact of Canada, the incremental operating margin -- margin was 17%.

Okay.

Now that's a little bit lower than we would like to see. And I didn't really want to go into any more detail past that because it was a number of -- number of factors that had that be low our target, which is about -- 25% is what we shoot for in incremental margins out of production.

Okay. So 25% is how you're thinking about the go-forward number, ex the Canadian seasonal affects?

Yes.

Okay. And -- and so I would assume the number with Canada picking back up next quarter should theoretically be higher.

Yes, you're right

That's correct, that's correct, Dan. That's correct, Dan.

Yes.

Okay. Last quarter I think Lisa or Bernard, I'm not sure who did it, but one of the things you did was talk about the guidance for the forward quarter. Are - do you guys want to do that again this quarter in terms of talking about third quarter?

I mean, we're comfortable with FirstCall consensus.

Okay.

And -- and the -- like we said, we're not baking in any of the pricing that we talked about at this point, so there are some variables out there that, you know, if it starts coming in towards the end of the quarter we would put out a release and let people know if there is any changes. But at this point, I see FirstCall consensus very reasonable.

Okay. Thank you. Last question. Your U.S. results second quarter up 17% on the revenue line. Activity was up 4%. Bernard, you indicated that you were not getting any net pricing, but did the surcharge help in terms of the revenue line? Obviously there is a cost line there, too, but --

Yeah. No, that's a very good point. I think there are -- there are -- there are sort of two different things. One, obviously, the surcharge was somewhere around 8%, 10%. Not on everything, on what -- on what, you know, where relevant This is -- this is not something we just decide on, you know, because it feels good. We document it for our clients. So, and wherever necessary.

Right.

Okay. So there's that aspect. It doesn't cover everything we do. Think in terms of roughly half what we do is products, half is service. Actually, what is it, Lisa? Is it more 40, 60 maybe?

That's right.

Okay, 40% of what we do is product, 60 is services. So think on 40% of what we do, we slapped on a 10% surcharge. I didn't run the numbers that way, but it's maybe not quite 10, 8 to 10% raw materials surcharge. So that's one thing. And that obviously moves the numbers a certain way.

Yep.

Internationally it's a bit different, because internationally it gets contractually dealt with, so it's more phased in. And it happened before we acted in North America and it is happening after. So that's the difference in --

Uh, huh. I guess --

And also internationally I think our business tends to be more service and less product, come to think of it also.

Right.

And the second part of your question, though, is was there a business volume also gained above -- and the answer is yes. And you see it in three places. You see it, since you asked about production, in lift.

Yeah.

It continued to do very well in terms of gaining share. I'm not, you know -- I -- it's wide -- it is a wide -- it's across the product -- the product line so I can't even say it's that form of lift or this form of lift.

Yeah.

The second thing is that underbalanced does -- does very well internationally, but did extremely well in the U.S., to be fair.

Okay.

And much of the gains volume-wise in the U.S. above and beyond market rate was underbalanced. In fact, I'll leave it at that, because I think that's probably the fairest way I can describe it.

Production and lift and underbalanced were kind of our rig list growth areas?

That is absolutely correct. That would be a very fair statement.

That's good.

There were a few other ones, too, but this is essentially correct, yes.

Thank you.

And your next question comes from the line of James Stone of UBS. Please go ahead, sir.

I'm going to pass. The rest of my questions have been answered and time is running late.

Thank you, Jamie.

And your -- I'm -- I'm sorry.

Which brings up the fact that maybe it is running late, so maybe we should have another question maybe, or --

Is there one more question?

Yes there is. Yes there is. Your next question comes from the line of Kevin Simpson of Miller Tabak. Please go ahead, sir.

And I'm not going to pass. Good morning.

Good morning.

Good morning.

Sorry about that. A couple quick questions. Just -- just on underbalanced, was the growth in the U.S. -- couple questions there. One, was the growth in the U.S. primarily tight sands-related and, you know, is there more upside there, or was it maybe less sophisticated work? And then second, it almost seemed to me like you sound like, in terms of the large contracts you picked up that will be coming into effect as we go through this year and into next, that your near-term plate is full. Is that a -- is -- is that too, you know, cautious an assessment? Plate is full in terms of what you think your capability is for the near term.

Well, I think that the answer to tight -- tight sands is, yes.

More upside?

Yes. And its sophisticated applications, yes. As opposed to the more simple drilling type of business. And the second thing is, I didn't think of it in those terms, but yes, you actually are -- you actually sound -- you're actually right. I think there is a -- there is a sense that we have enough on our plate. That is correct. One never has enough, but I will mind you the opening and the closing statement was just focused on execution. It is not there for aesthetic reasons, it's that we mean it. And we don't want to take -- we want to do what we have and do it well. We'd rather than work on the margin side. We have enough growth, that is, I think, seems -- seems available. I -- I don't think that's going to be the short fall at Weatherford. It has to be execution. So, I think your -- I didn't think of it in those terms, but you're correct.

Okay. Second, on ESS, I don't want to -- maybe -- maybe I'm reading too much into this, but you've had a lot of problems with the ex -- you know, the performance of the product. Where it almost sounded frustrated 3 to 6 months ago. Does the Slumberzhay [ph] agreement and, you know, maybe it sounds a little more positive outlook from you, say that you think that, you know, the --the bulk of the problems are behind and you that somebody like a Slumberzhay [ph] is kind of -- blesses the, you know, the -- the technical competence of the product, or is that reading too much into it?

Well, I think technology is hard. If I sounded frustrated 3 to 6 months ago -- because I was even -- mostly frustrated with myself, more than ESS. Insofar as, I think, the mistake that was made really was more of a communication mistake than an execution mistake. I think that too much was -- too much was -- too much love if any -- for lack of a better word, was thrown onto ESS, which was just the very first application of something that is profound but difficult, from a technological standpoint. I think the problems are -- the technical problems and engineering problems of ESS were actually minor, and they were solved a year ago. But our industry is such that when you pull a product or service line out of the market, particularly in new technology, which is a very responsible, if expensive, thing to do, then it takes a fair amount of time, and about the same amount of time to go back in the market. So really if you read frustration, and I guess I -- the way I do, I communicate, I show emotions probably more than I should, was here with myself, not ESS. In ESS, you will also have to bear in mind, it -- it is -- it is very important symbolically for the world of expandables. It is really not what the future will be for us. We would not be in expandables if it wasn't for ESS. It's just not -- not a business, but not without sand control people. We are expandables people, and we'll -- we'll -- our future is the solid side. Probably the frustrations, as I think it through, had more to do with the fact that I wasted time on the solid side, than anything else. With respect to Slumberzhay [ph], well, I don't think we needed their blessing to know that it was working. I think the blessing of our clients is far more important. However, I have -- obviously I'd be -- I'm not blind. I can see that in the realm of sand control, they are -- they are, you know, extremely, extremely good, probably the best. So I suppose that it -- it -- it's nice to know that they acknowledge that it was -- it's good technology. But it's more and more a commercial issue than a sort of religious issue, which is they -- they're going to pray at our church. It's just the money. They need it and it's good for our business. That's really all it is. It's not much more than that.

Okay. So I'm probably making more of it than -- than --

It's just money. It's just money, really. I mean, it's just hard to -- I mean, I -- the expandables technology that Weatherford has is a little bit more than our fears insofar as it's successively compliant. I don't want to get into the technical aspects of it, but it -- but it does makes a difference, a big difference, and they know this. It's sort of hard to emulate what we have. Why would they bother? I mean, so it is just money for them, money for us. More than sort of, you know -- sort of a -- you get -- you get a good grade here. I mean, it's just money. And really for us, though, the future is solids, but, you know Kevin, it'll take -- solids is not something you should think about, because it would take too long for it to make any difference to you.

Right. I got that message. One last question, for either you or Lisa, Bernard, and that is, I've heard some rumblings on potential changes now that may be moving along in -- for inverted companies, and just wanted an update there, if there is any.

I think probably the phone calls I think that Lisa got had to do with the fact that the treaty -- tax treaty between the country of Barbados and the United States has been renegotiated and is going to go through the -- I think it has gone through the Senate or is going through the Senate for final approval.

It hasn't been ratified yet.

It's irrelevant to us.

It doesn't matter.

So that's the short answer. But it may be relevant to others. So the -- And what did -- what did that treaty mean? It had to do with earnings stripping, I think?

Yeah, income stripping.

Yeah, yeah. Something like that. Irrelevant to us, Kevin.

Great. Thank you very much.

You're more than welcome.

Thank you.

Which, I think, probably concludes our conference call. Thank you very much.

Ladies and gentlemen, that concludes your presentation for today. We thank you for your participation, and have a great day.