Schlumberger (NYSE: SLB) announced an $11.3 billion all-stock offer to acquire rival oil-services firm Smith International (NYSE: SII). On Friday rumors abounded that such a deal was imminent, and the two sides formally announced over the deal over the weekend. Shareholders will receive 0.6966 shares of Schlumberger for each share of Smith International.

Although we did not hold Smith International in the model Portfolios, I did highlight the stock as a likely takeover target in a lengthy Flash Alert issued Dec. 17, 2009, Ten Takeover Plays. In particular, that report focused on Smith International’s key MI-SWACO drilling fluids unit, noting that the company would likely either buy out Schlumberger’s 40 percent stake in the unit or be acquired:

By far the biggest and most important business on this list is MI-SWACO, a joint venture that’s 40 percent owned by Schlumberger (NYSE: SLB) and 60 percent by Smith. MI-SWACO is a leader in drilling fluids and related systems.

In modern drilling operations, producers use what’s known as a circulating mud system. When drilling for oil or gas, drillers pump a substance known as drilling mud into the well. Originally, drilling fluids were made quite literally of mud; the story goes that early operators in Texas had cattle walk through puddles to produce the mud they needed.

Nowadays, fluids are far more complex. Drilling mud offsets the natural underground pressure of the hydrocarbons in the reservoir. In other words, the pressure of the mud in the well helps prevent oil from rushing into the well and gushing out the top of the well bore. In addition, drilling mud picks up debris and rock shavings that are generated while drilling and lubricate and cool the drill bit. Mud literally circulates, moving down the drill pipe, through the drill bit, and back to the surface.

The mud circulating system pumps the mud under pressure down the well and then processes and removes impurities from the mud so that it can be recycled down the well.

Although this sounds like a rather simple operation on paper, it’s a far more complex proposition in offshore and deepwater fields where pressures and temperatures are far higher than in traditional onshore operations. Obtaining the proper weight and composition of the drilling mud is important–miscalculations can impact the productivity of the well and the speed and efficiency of the drilling operation. And when you consider that it can cost an operator over $600,000 per day to rent a rig to drill a deepwater well, time savings equals real money in the bank.

MI-SWACO dominates this business and in 2009 was awarded 77 percent of all contracts for deepwater fluids.  Given its leadership in the premium offshore fluids business and the coming expansion in deepwater drilling activity over the next few years, Smith International’s fluids business has significant growth potential.

The firm’s other two business units are solid, though less compelling than MI-SWACO. The company’s oilfield segment sells drill bits, assorted drilling tools and tubular products used in well construction. A drop-off in North American gas drilling activity hit the division’s revenues over the past year, though the international side of the operation appears to be stabilizing and, perhaps, turning positive again.

The distribution business involves selling basic drilling products via a network of supply branches across North America. More than 95 percent of revenues are from North America, so this segment was the hardest hit by the slowdown in US and Canadian drilling activity. A pick-up in activity is likely, as gas prices recover in 2010; solid growth in unconventional gas drilling should help stabilize this business.

Companies never get as much credit for joint ventures as they do for owning a key business outright; Smith’s shares would likely receive a significant boost if it purchased the minority stake in the MI-SWACO joint venture from Schlumberger. In addition, outright ownership of MI-SWACO would make Smith a far more attractive takeover candidate.

With a total enterprise value of just $8 billion, Smith is a second-tier services companies that isn’t in the same league as Schlumberger, Halliburton (NYSE: HAL) or even Weatherford International (NYSE: WFT). However, MI-SWACO would be a valuable business line for almost any of the other services companies; owning the premier offshore fluids business would give a services firm a leg up in bidding on offshore contracts.

Smith’s shares were punished recently when the company announced a secondary offering of 28 million new shares priced at $26.50 per share. Management stated the proceeds were earmarked for debt repayment and acquisition opportunities. In addition to that $750 million cash raise, Smith also arranged a new $1 billion credit facility this month.

It certainly appears that Smith is taking advantage of strong capital markets to build a war chest of cash and unused debt facilities. I suspect that the company is trying to put together a deal to buy out MI-SWACO.

Although I didn’t add Smith International to the model Portfolios, I have heard from a few subscribers who purchased the stock based on that recommendation and want to know what their next move should be. My advice would be to sell Smith, as its shares trade just under 5 percent below its value under the terms of the deal. And because we already recommend Schlumberger, owning both stocks is the equivalent of being double overweight. Investors who bought Smith International on Dec. 17, 2009, are up 47 percent. 

Meanwhile, shares of Schlumberger have traded sharply lower over the past two days, a typical reaction to all-stock deals; Schlumberger is effectively issuing new stock to complete the transaction, diluting existing shareholders’ stake.

Nonetheless, I regard this knee-jerk reaction as completely overdone. Schlumberger is arguably the leading services firm when it comes to deepwater developments, one of the industry’s most attractive growth markets. By owning the dominant MI-SWACO unit outright, Schlumberger is solidifying its position in the deepwater market. Smith Internationals’ drill bits unit is also valuable in that regard.

Although few would argue with the value of the fluids and drill bits units, some question whether Schlumberger is overpaying for Smith International. Others fret over the potential for the US Dept of Justice (DOJ) to force the companies to divest assets before approving the deal.

As to the first point, Schlumberger may be paying full price, but investors should remember that Smith’s shares have underperformed by a significant margin over the past five years: Based on closing prices at the end of January, the Philadelphia Oil Services Index is up 53.6 percent over the past five years; shares of Smith International are up just 7.79. Smith has valuable assets, but was undervalued mainly because the market perceived it as too small to compete on its own.

As for the DOJ, Schlumberger can always back out of the deal if required divestitures are too onerous. That being said, it’s unlikely the DOJ would require Schlumberger to sell off Smith’s most valuable businesses. And any divestitures that do occur could be a boon for our other services recommendations, Weatherford International (NYSE: WFT) and Baker Hughes (NYSE: BHI).

Finally, investors should put their trust in Schlumberger’s CEO Andrew Gould and the rest of the oil service giant’s management team. Schlumberger has proven its ability to generate value for investors over the years, nearly doubling the performance of the Oil Services Index over the past five years alone. I am not inclined to bet against that track record. Buy Schlumberger under 85.