SMITH INTERNATIONAL INC - 10-Q Quarterly Report

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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 September 30, 2003

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 November
10, 2003 was 100,118,346.

INDEX

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

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)

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)

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 2002 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 September 30, 2003 presentation.

2. RECENT ACCOUNTING PRONOUNCEMENTS

On January 1, 2003, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations," which
addresses the financial accounting and reporting for retirement obligations and
costs associated with tangible long-lived assets. SFAS No. 143 requires that
liabilities for asset retirement obligations be recognized during the periods
incurred rather than when expended. The Company's asset retirement obligations
principally relate to the removal of leasehold improvements upon exiting certain
leased properties, primarily associated with the M-I operations. Upon adoption,
the Company recognized a charge of $2.5 million, or $1.2 million after tax and
minority interests, to reflect the cumulative amount of expense which was
required to be recognized as of January 1, 2003. This amount has been recorded
as a cumulative effect of change in accounting principle in the accompanying
consolidated condensed statement of operations. Additionally, the Company
recorded a $3.7 million long-term liability at the adoption date reflecting the
present value of projected future asset retirement obligations. The differential
of $1.2 million, which primarily represents the associated capitalized
retirement costs, will be charged to earnings over the remaining leasehold
period. Neither the amount charged to earnings in 2003 nor the pro forma effect
for the three-month and nine-month periods ended September 30, 2002 (assuming
adoption of SFAS No. 143 as of January 1, 2002) were significant to net income
or earnings per share amounts.

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 financial statements upon
adoption.

4

3. BUSINESS COMBINATIONS

During the nine months ended September 30, 2003, the Company completed two
acquisitions in exchange for cash consideration of $78.0 million. The
consideration primarily relates to the purchase of certain oilfield chemical
assets of Dynea International ("Dynea") completed in January 2003. The Dynea
operations, formerly based in Norway, provide a complete line of oilfield
specialty chemicals used to eliminate hydrocarbon flow problems encountered
during production and transportation.

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 has been recorded as
goodwill in the amount of $57.2 million. 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
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 nine-month period ended September 30, 2003, the
Company paid $0.9 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.

4. 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. Certain
outstanding employee stock options were not included in the computation of
diluted earnings per common share for the nine-month period ended September 30,
2003 and the three-month and nine-month periods ended September 30, 2002, as the
exercise price was greater than the average market price for the Company's stock
during the corresponding periods. The following schedule reconciles the income
and shares used in the basic and diluted EPS computations (in thousands, except
per share data):

5

5. 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):

6. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consist of the following (in thousands):

7. GOODWILL AND OTHER INTANGIBLE ASSETS

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.

6

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):

Amortization expense was $2.0 million and $0.8 million for the three-month
periods ended September 30, 2003 and 2002, respectively, and $5.4 million and
$2.4 million for the nine-month periods ended September 30, 2003 and 2002,
respectively. Additionally, estimated future amortization expense is expected
to range between $4.3 million and $7.5 million a year for the next five fiscal
years.

8. DEBT

The Company's $75.0 million Floating Rate Senior Notes (the "Notes"), which
matured on October 15, 2003, were repaid utilizing borrowings under the
long-term credit facility. Due to the Company's ability and intent to refinance
the Notes, the accompanying consolidated condensed balance sheet as of September
30, 2003 reflects the reclassification of these Notes to Long-Term Debt.

9. 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):

Accumulated other comprehensive income in the accompanying consolidated
condensed balance sheets consists of the following (in thousands):

7

10. STOCK-BASED COMPENSATION

The Company's Board of Directors and its stockholders have authorized an
employee stock option plan. As of September 30, 2003, 5.3 million shares were
issued and outstanding under the program and an additional 3.3 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 September
30, 2003 and 2002 and $0.3 million and $0.2 million of related expense for the
nine-month periods ended September 30, 2003 and 2002, respectively.

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 on a diluted basis would have
approximated the pro forma amounts indicated below (in thousands, except per
share data):

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
$0.2 million and $0.1 million of related expense for the three-month periods
ended September 30, 2003 and 2002, respectively, and $0.5 million and $0.4
million of related expense for the nine-month periods ended September 30, 2003
and 2002, respectively.

8

11. 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,
Smith Bits 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):

9

12. 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 the $30.5 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheets, the Company is contingently liable for
approximately $43.0 million of standby letters of credit and bid, performance
and surety bonds at September 30, 2003. Management does not expect any material
amounts to be drawn on these instruments.

The Company has also provided guarantees for loans related to certain joint
ventures accounted for by the equity method of accounting. As the net assets of
the joint ventures are available to satisfy obligations as they become due,
management believes the likelihood is remote that the Company will be required
to make payments related to these agreements. The Company's estimated maximum
exposure under these loan guarantees approximated $16.8 million as of September
30, 2003.

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 operations, which are subject
to various indemnifications from former owners.

As of September 30, 2003, the Company's environmental reserve approximated $9.5
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 September 30, 2003, 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'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
first half of 2004. In the event that i) M-I'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

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 2002 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.

Management believes the increasing complexity of drilling programs has resulted
in a shift in exploration and production spending toward value-added,
technology-based products, which reduce operators' overall drilling costs. The
Company continues to focus on investing in the development of technology-based
products that considerably improve the drilling process through increased
efficiency and rates of penetration and reduced formation damage. Management
believes the overall savings realized by the use of the Company's premium
products, such as polycrystalline diamond drill bits, diamond-enhanced
three-cone drill bits and synthetic drilling fluids, compensate for the higher
costs of these products over their non-premium counterparts.

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 spending is largely
influenced by commodity prices, 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 general
financial condition of independent E&P companies and the overall level of global
economic growth and activity. 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 over 80 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 70 percent 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 third quarter of 2003, Smith's profitability is largely
dependent upon business levels in markets outside of North America, including
Europe/Africa and Latin 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 third quarter 2003 revenues
were generated outside of North America.

11

MARKET AND INDUSTRY ACTIVITY AND OUTLOOK

The worldwide rig count is currently 15 percent above year-end 2002 levels,
driven by a strong rebound in U.S. land-based drilling. Higher U.S. drilling
activity, combined with a limited amount of storage draws, led to increased
natural gas injections during the third quarter of 2003. Accordingly, natural
gas storage in the United States, which had previously been well below the
five-year historical average, currently approximates normal seasonal levels.
Higher than anticipated natural gas storage has placed downward pressure on
prices, which are 20 percent below the average experienced in the first nine
months of 2003. Further deterioration in natural gas prices could impact North
American exploration and production spending, and have a negative effect on the
Company's financial results.

Overall, the Company's business outlook 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 financial 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, Smith Bits
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 (dollars in
thousands).

13

Oilfield Products and Services Segment

Revenues

M-I provides drilling and completion fluid systems, engineering and technical
services to the oil and gas industry through its M-I Fluids division. M-I's
SWACO division manufactures and markets equipment and services for
solids-control, separation, pressure control, rig instrumentation and
waste-management. M-I also provides a complete line of oilfield specialty
chemicals and related technical services through its Oilfield Production
Chemical division, acquired in January 2003. The M-I operations account for the
largest proportion of the Company's Oilfield segment revenues and are
significantly influenced by spending in markets outside of North America, which
contributes approximately two-thirds of the unit's revenues, and by its exposure
to the U.S. offshore market, which constitutes approximately 13 percent of the
year-to-date revenue base. U.S. offshore drilling programs, which account for
five 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's revenues totaled $479.7 million for the third quarter of
2003, 27 percent above the prior year period. Excluding the impact of
acquisitions completed over the past year, revenues increased 21 percent. The
majority of the base revenue growth was reported in the United States, which
benefited from the land-based drilling recovery as well as a favorable customer
mix in the offshore market, and Latin America, which was impacted by increased
customer spending and new contract awards. For the nine-month period, M-I
reported revenues of $1.4 billion, a 15 percent increase over the amounts
reported in the first nine months of 2002. Excluding acquisitions, which
contributed approximately one-third of the year-over-year revenue variance, base
business revenues rose ten percent. Over two-thirds of the improvement in base
revenues was reported in markets outside of North America primarily attributable
to new contract awards and increased customer spending in Europe/Africa,
including West Africa and the Former Soviet Union ("FSU"), and Latin America,
specifically Mexico.

Smith Bits 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 Smith Bits correlate more closely to the rig
count than any of the Company's other operations. Smith Bits reported revenues
of $104.5 million for the third quarter of 2003, an increase of 33 percent over
the comparable prior-year period. Excluding incremental revenues from
acquisitions, base revenues were 29 percent above the third quarter of 2002 and
compared to a 23 percent increase in worldwide drilling activity. The
year-over-year base revenue growth was predominantly reported in North America
reflecting the effect of the recovery in land-based drilling on sales of
petroleum three-cone bits. For the nine-month period, Smith Bits reported
revenues of $293.3 million, a 19 percent increase over the comparable period of
2002. Excluding the effect of acquisitions, base revenues were approximately 13
percent above the first nine months of 2002 due to higher North American
drilling activity.

Smith Services manufactures and markets products and services used in the oil
and gas industry for drilling, workover, 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 September 30, 2003, Smith Services' revenues totaled $103.1
million, two percent above the prior year quarter. The current year quarter was
impacted by a 70 percent reduction in U.S. drill pipe product sales, which are
not highly correlated to drilling activity. Excluding the effect of drill pipe
orders, Smith Services revenues increased eight percent over the prior year
quarter primarily reflecting the impact of the increase in exploration and
production spending in the United States and, to a lesser extent, the timing of
customer orders in certain Middle East markets. On a product basis, the majority
of the eight percent revenue growth from the prior year quarter was influenced
by increased demand for remedial product and service lines, including the
recently introduced RHINO(R)Reamer. For the first nine months of 2003, Smith
Services reported revenues of $300.4 million, a four percent decrease from the
comparable prior year period. The nine-month revenue variance was also impacted
by a reduction in U.S. drill pipe product sales, which were approximately 60
percent less than the amount reported in the prior year period. Excluding the
impact of drill pipe sales, revenues were two percent higher than the first nine
months of 2002, primarily influenced by the effect of higher North American
activity levels and increased customer activity in the Middle East.

14

Operating Income

Operating income for the Oilfield Products and Services segment was $90.3
million or 13.1 percent of revenues in the third quarter of 2003. Segment
operating margins increased 2.8 percentage points from the prior year quarter
reflecting a favorable shift in the revenue mix towards sales of higher-margin
products, including drill bits and synthetic drilling fluids. To a lesser
extent, improved coverage of fixed manufacturing costs and favorable drill bit
pricing has contributed to the comparison. On an absolute dollar basis,
operating income was $33.1 million above the prior year quarter reflecting the
effect of higher revenue volumes on the segment's gross profit, partially offset
by growth in variable-based operating expenses. For the nine-month period,
Oilfield operating margins improved 30 basis points as the favorable product mix
discussed above was partially offset by a higher operating expense ratio
associated with increased investment in people and infrastructure to support
business expansion.

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 over 90 percent of Wilson's third quarter 2003 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. Wilson
reported revenues of $237.4 million for the third quarter of 2003, approximately
eight percent above the prior year quarter driven by higher energy branch sales
and, to a lesser extent, shipments related to a downstream engineering and
construction project in the FSU region. Revenues in Wilson's energy sector rose
19 percent over the third quarter of 2002 associated with improved North
American drilling and completion activity. The overall revenue growth was
impacted by lower U.S. industrial sales volumes primarily related to reduced
maintenance and repair spending in the refining and petrochemical customer base.
In the first nine months of 2003, Wilson reported revenues totaling $661.2
million, a decline of two percent from the first nine months of 2002. The
revenue variance from the comparable prior year period reflects lower spending
in the industrial sector, primarily by refining, engineering and construction
and petrochemical customers. The industrial revenue decline more than offset a
seven percent increase in Wilson's energy sector sales.

Operating Income

Operating income for the Distribution segment increased $0.9 million from the
amount reported in the prior year quarter with segment operating income of
approximately $0.2 million in the third quarter of 2003. The operating income
variance reflects the effect of higher sales volumes on the segment's gross
profit partially offset by higher variable-based operating expenses. On a
year-to-date basis, segment operating income declined $2.8 million from the
amount reported in the first nine months of 2002, impacted by lower gross profit
related to the reduction in industrial distribution revenues. As a percentage of
revenues, operating margins were one-half of a percentage point below the first
nine months of the prior year attributable to the effect of lower revenues on
coverage of fixed sales and administrative expenses in the current year-to-date
period.

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):

Consolidated revenues were $924.8 million for the third quarter of 2003, 19
percent above the prior year period. Excluding the impact of acquisitions
completed during the prior 12-month period, revenues increased 16 percent as
higher drilling activity influenced Oilfield segment business volumes. Over
three-quarters of the base revenue growth was reported in the Western
Hemisphere, reflecting a combination of higher drilling activity and a favorable
customer and product mix. Increased customer spending and new contract awards in
certain Eastern Hemisphere markets, including the FSU and West Africa, also
contributed to the year-over-year revenue variance. For the first nine months of
2003, consolidated revenues were $2.6 billion, nine percent above the comparable
2002 period. Excluding incremental revenues from acquisitions, base revenues
were five percent higher than the prior year period reflecting increased demand
for Oilfield segment product offerings. Base Oilfield revenues grew eight
percent over amounts reported for the September 2002 nine-month period, with
approximately two-thirds of the variance associated with the significant
increase in Western Hemisphere land-based exploration and production spending.

16

Gross profit totaled $278.4 million for the third quarter of 2003, 28 percent
above the prior year period. The increase in gross profit reflects the higher
sales volumes associated with improved worldwide activity levels, specifically
in the Western Hemisphere. Gross profit margins for the third quarter of 2003
were 30 percent of revenues and compared to margins of 28 percent reported in
the prior year quarter. The margin improvement primarily reflects an increased
proportion of revenues in the Oilfield segment, which traditionally generate
higher gross profit margins than the Distribution operations. To a lesser
extent, a favorable shift in the product mix towards higher-margin products,
including drill bits and synthetic drilling fluids, contributed to the reported
margin expansion. For the nine-month period, gross profit totaled $778.7
million, or 30 percent of revenues, one percentage point above the gross profit
margins reported in the comparable period of the prior year. The gross profit
margin improvement for the nine-month period comparison was, again, influenced
by a combination of a higher proportion of Oilfield segment sales and a
favorable product mix. On an absolute dollar basis, gross profit was $83.2
million above the prior year period reflecting the increased sales volumes in
the Oilfield operations.

Operating expenses, consisting of selling, general and administrative expenses,
increased on an absolute dollar basis; however, as a percentage of revenues,
were comparable with the prior year periods. The majority of the absolute dollar
increase related to higher variable costs directly associated with the improved
business volumes, as well as increased investment in personnel and
infrastructure to support the expanding business base. To a lesser extent,
incremental expenses associated with acquired operations and increased employee
profit-sharing amounts also contributed to the period-to-period variance.

Net interest expense, which represents interest expense less interest income,
equaled $9.7 million in the third quarter of 2003. Net interest expense
increased $0.4 million and $0.5 million from the prior year quarter and the
first nine months of 2003, respectively. The increase for both periods primarily
reflects a shift in the debt mix associated with the Dynea acquisition completed
in January 2003. The transaction was primarily financed with Norwegian
Kroner-based term loans, which carry a higher comparable interest rate, in order
to hedge the underlying foreign currency exposure.

The effective tax rate for the third quarter approximated 32.3 percent, which is
lower than the U.S. statutory rate due to the impact of M-I's U.S. partnership
earnings for which the minority partner is directly responsible for their
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 40 basis
points above the third quarter of 2002, reflecting an unfavorable shift in the
geographic mix of pretax income towards higher rate jurisdictions. The effective
tax rate for the nine-month period was 32.1 percent, one percentage point above
the level reported in the comparable prior year period. The higher current year
rate primarily reflects the lower proportion of M-I's U.S. partnership earnings.

Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests was $7.3 million and $5.2 million above amounts reported in the prior
year quarter and the first nine months of 2002, respectively. The variance in
both periods primarily relates to the higher profitability reported in the M-I
operations.

The cumulative effect of change in accounting principle included for the nine
months ended September 30, 2003 represents the impact of the adoption of
Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for
Asset Retirement Obligations."

17

LIQUIDITY AND CAPITAL RESOURCES

General

At September 30, 2003, cash and cash equivalents equaled $44.4 million.

Cash flow provided by operating activities was $66.8 million for the first nine
months of 2003 as compared to the $210.4 million generated by the Company's
operations in the prior year period. The increased level of exploration and
production spending in 2003 has driven higher working capital investment,
particularly accounts receivable and inventories, in contrast to the prior year
period when declining business levels contributed to positive cash flow from
working capital accounts.

During the first nine months of 2003, cash flows used in investing activities
totaled $131.7 million, consisting of amounts required to fund acquisitions and,
to a lesser extent, capital expenditures. Acquisition funding, which primarily
related to the purchase of the oilfield production chemical operations of Dynea
International, resulted in cash outflows of $78.9 million during the first nine
months of 2003. The Company also invested $52.8 million in property, plant and
equipment, net of cash proceeds arising from certain asset disposals. Cash used
for investing activities in 2003 was in excess of the $83.9 million required in
the prior year period, with the variance related to the higher level of
acquisition investment during the current year.

Cash flow provided by financing activities totaled $22.0 million for the period
ended September 30, 2003. Operating cash flow was not sufficient to fully fund
current year acquisitions, requiring incremental borrowings of $6.8 million
during the reporting period. Stock option exercises, which resulted in cash
proceeds of $15.2 million during the first nine months of 2003, also had a
positive effect on reported cash flow.

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. On October
15, 2003, $75.0 million of the Company's Floating Rate Notes (the "Notes")
matured and were repaid with borrowings under a long-term credit facility. After
taking into consideration the subsequent refinancing of the Notes, the Company
had $289.1 million of funds available under U.S. revolving credit facilities as
of quarter-end to fund future operating or investing needs of its worldwide
operations. The Company also has revolving credit facilities in place outside
the United States, which are generally used to finance local operating needs. At
September 30, 2003, borrowing capacity of $66.6 million was available under the
non-U.S. borrowing facilities.

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 September 30, 2003, the Company was within the covenant
compliance thresholds under its various loan indentures, as amended, providing
the ability to access available borrowing capacity. Management believes funds
generated from 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. These
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.

18

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 the $30.5 million of related liabilities are reflected in the accompanying
consolidated condensed balance sheets, the Company is contingently liable for
approximately $43.0 million of standby letters of credit and bid, performance
and surety bonds at September 30, 2003. Management does not expect any material
amounts to be drawn on these instruments.

The Company has also provided guarantees for loans related to certain joint
ventures accounted for by the equity method of accounting. As the net assets of
the joint ventures are available to satisfy obligations as they become due,
management believes the likelihood is remote that the Company will be required
to make payments related to these agreements. The Company's estimated maximum
exposure under these loan guarantees approximated $16.8 million as of September
30, 2003.

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 operations, which are subject
to various indemnifications from former owners.

As of September 30, 2003, the Company's environmental reserve approximated $9.5
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 September 30, 2003, 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'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
first half of 2004. In the event that i) M-I'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.

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 2002
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.

19

Recent Accounting Pronouncements

On January 1, 2003, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations," which
addresses the financial accounting and reporting for retirement obligations and
costs associated with tangible long-lived assets. SFAS No. 143 requires that
liabilities for asset retirement obligations be recognized during the periods
incurred rather than when expended. The Company's asset retirement obligations
principally relate to the removal of leasehold improvements upon exiting certain
leased properties, primarily associated with the M-I operations. Upon adoption,
the Company recognized a charge of $2.5 million, or $1.2 million after tax and
minority interests, to reflect the cumulative amount of expense which was
required to be recognized as of January 1, 2003. This amount has been recorded
as a cumulative effect of change in accounting principle in the accompanying
consolidated condensed statement of operations. Additionally, the Company
recorded a $3.7 million long-term liability at the adoption date reflecting the
present value of projected future asset retirement obligations. The differential
of $1.2 million, which primarily represents the associated capitalized
retirement costs, will be charged to earnings over the remaining leasehold
period. Neither the amount charged to earnings in 2003 nor the pro forma effect
for the three-month and nine-month periods ended September 30, 2002 (assuming
adoption of SFAS No. 143 as of January 1, 2002) were significant to net income
or earnings per share amounts.

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 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 2002 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

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS AND REPORT 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) Report on Form 8-K

The Registrant furnished a report on Form 8-K during the
quarterly period ended September 30, 2003. The document was
reported under "Item 9. Regulation FD Disclosure" and
disclosed the following:

1. Form 8-K dated July 21, 2003 relating to a press
release announcing the Company's results for the
quarter ended June 30, 2003.

21

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: November 14, 2003 By: /s/ DOUG ROCK
-------------------------------------------
Doug Rock
Chairman of the Board, Chief Executive Officer,
President and Chief Operating Officer

Date: November 14, 2003 By: /s/ MARGARET K. DORMAN
-------------------------------------------
Margaret K. Dorman
Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Accounting Officer)

22

EXHIBIT INDEX