We are maintaining our Hold recommendation on global heavyweights in drilling services Smith International Inc. (SII) shares following its acquisition of W-H Energy Services, Inc. (WHQ) in a $3.2 billion stock-and-cash deal. We view the transaction as a good strategic fit in terms of mix of products and services.
n particular, the acquisition provides Smith an entry into additional product lines with favorable growth prospects like logging-while-drilling, measurement while-drilling, rotary steerable systems, directional drilling and downhole motors. However, we believe that SII's premium valuation relative to the peer group already reflects the strategic value of its WHQ acquisition and the late-cycle leverage.
Smith management expects this acquisition to be immediately accretive to earnings and cash flow per share. Risks include increased leverage and integration problems associated with the transaction. The company is expected to report second-quarter results on July 24. We are keeping our 2008 EPS estimate unchanged at $3.77 and reducing our 2009 estimate ($4.69 vs. $4.92).
Our continued Hold recommendation on Smith International shares primarily reflects valuation concerns though we continue to like the company for its late-cycle leverage. Based on most conventional valuation metrics, the stock is trading at a significant valuation premium relative to the peer group.
We believe that the stock's positive risk-return fundamentals are already reflected in current valuation, leaving little room for upside from current levels. In fact, the stock may be vulnerable to a sentiment shift in the likely event of a temporary commodity-price weakness.
