UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

o		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 (State or other jurisdiction of incorporation or organization)		95-3822631 (I.R.S. Employer Identification No.)
16740 East Hardy Road		77032
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 þ   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No þ

There were 201,143,019 shares of common stock outstanding, net of treasury shares held, on August 4, 2008.

 

 

INDEX

		Page
		No.
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS For the Three Months and Six Months ended June 30, 2008 and 2007			2
CONSOLIDATED CONDENSED BALANCE SHEETS As of June 30, 2008 and December 31, 2007			3
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS For the Six Months ended June 30, 2008 and 2007			4
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
Item 3. Quantitative and Qualitative Disclosures about Market Risk			21
Item 4. Controls and Procedures			21
PART II – OTHER INFORMATION
Items 1 – 1A			22
Items 2 - 4			23
Items 5 - 6			24
SIGNATURES			25
EXHIBIT INDEX			26
Restated Certificate of Incorporation
Certification of Chief Executive Officer Pursuant to Section 302
Certification of Chief Financial Officer Pursuant to Section 302
Certification Pursuant to Section 906

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

SMITH INTERNATIONAL, INC.

(In thousands, except per share data)

(Unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Revenues:
Oilfield		$	1,878,570			$	1,614,915			$	3,681,497			$	3,176,599
Distribution			615,588				499,458				1,183,659				1,045,498
Total revenues			2,494,158				2,114,373				4,865,156				4,222,097
Costs and expenses:
Cost of oilfield revenues			1,178,365				1,000,646				2,297,868				1,974,994
Cost of distribution revenues			508,341				417,181				978,352				874,592
Selling expenses			331,854				287,162				652,253				559,495
General and administrative expenses			85,831				76,935				168,109				149,439
Total costs and expenses			2,104,391				1,781,924				4,096,582				3,558,520
Operating income			389,767				332,449				768,574				663,577
Interest expense			16,244				17,605				32,545				36,139
Interest income			(752	)			(895	)			(1,648	)			(1,659	)
Income before income taxes and minority interests			374,275				315,739				737,677				629,097
Income tax provision			121,555				100,891				238,846				193,990
Minority interests			69,447				61,795				140,567				121,896
Net income		$	183,273			$	153,053			$	358,264			$	313,211
Earnings per share:
Basic		$	0.91			$	0.76			$	1.78			$	1.56
Diluted		$	0.91			$	0.76			$	1.77			$	1.55
Weighted average shares outstanding:
Basic			200,938				200,499				200,873				200,241
Diluted			202,284				202,097				202,169				201,815

The accompanying notes are an integral part of these consolidated condensed financial statements.

SMITH INTERNATIONAL, INC.

(In thousands, except par value data)

(Unaudited)

		June 30,				December 31,
		2008				2007
Assets
Current Assets:
Cash and cash equivalents		$	141,503			$	158,267
Receivables, net			1,941,289				1,750,561
Inventories, net			1,918,934				1,658,172
Deferred tax assets, net			52,070				46,220
Prepaid expenses and other			137,709				114,515
Total current assets			4,191,505				3,727,735
Property, Plant and Equipment, net			1,192,186				1,105,880
Goodwill, net			902,565				896,442
Other Intangible Assets, net			128,570				128,359
Other Assets			227,199				203,464
Total Assets		$	6,642,025			$	6,061,880
Liabilities and Stockholders’ Equity
Current Liabilities:
Short-term borrowings and current portion of long-term debt		$	121,771			$	139,481
Accounts payable			817,522				655,413
Accrued payroll costs			139,348				153,453
Income taxes payable			83,861				80,181
Other			142,749				144,772
Total current liabilities			1,305,251				1,173,300
Long-Term Debt			806,408				845,624
Deferred Tax Liabilities			168,804				160,244
Other Long-Term Liabilities			163,311				157,042
Minority Interests			1,258,674				1,130,773
Commitments and Contingencies (Note 11)
Stockholders’ Equity:
Preferred stock, $1 par value; 5,000 shares authorized; no shares issued or outstanding in 2008 or 2007			—				—
Common stock, $1 par value; 500,000 shares authorized; 218,212 shares issued in 2008 (217,586 shares issued in 2007)			218,212				217,586
Additional paid-in capital			571,456				533,429
Retained earnings			2,529,267				2,219,224
Accumulated other comprehensive income			79,067				67,840
Less – Treasury securities, at cost; 17,083 common shares in 2008 (16,825 common shares in 2007)			(458,425	)			(443,182	)
Total stockholders’ equity			2,939,577				2,594,897
Total Liabilities and Stockholders’ Equity		$	6,642,025			$	6,061,880

The accompanying notes are an integral part of these consolidated condensed financial statements.

SMITH INTERNATIONAL, INC.

(In thousands)

(Unaudited)

		Six Months Ended
		June 30,
		2008				2007
Cash flows from operating activities:
Net income		$	358,264			$	313,211
Adjustments to reconcile net income to net cash provided by operating activities, excluding the net effects of acquisitions:
Minority interests			140,567				121,896
Depreciation and amortization			104,419				91,947
Deferred income tax provision (benefit)			(5,108	)			18,932
Increase in LIFO inventory reserves			28,909				21,777
Share-based compensation expense			20,868				16,721
Provision for losses on receivables			1,908				1,584
Foreign currency translation losses (gains)			(846	)			2,330
Gain on disposal of property, plant and equipment			(16,658	)			(11,210	)
Equity earnings, net of dividends received			(10,686	)			(5,594	)
Gain on sale of operations			—				(1,534	)
Changes in operating assets and liabilities:
Receivables			(188,565	)			(20,371	)
Inventories			(283,281	)			(121,812	)
Accounts payable			160,275				(44,371	)
Other current assets and liabilities			(38,922	)			(86,485	)
Other non-current assets and liabilities			(8,380	)			(13,163	)
Net cash provided by operating activities			262,764				283,858
Cash flows from investing activities:
Acquisitions, net of cash acquired			(27,937	)			(18,604	)
Purchases of property, plant and equipment			(163,004	)			(168,088	)
Proceeds from disposal of property, plant and equipment			26,190				23,712
Proceeds from sale of operations			—				16,655
Net cash used in investing activities			(164,751	)			(146,325	)
Cash flows from financing activities:
Proceeds from issuance of long-term debt			26,812				43,251
Principal payments of long-term debt			(67,974	)			(115,514	)
Net change in short-term borrowings			(18,130	)			24,009
Purchases of common stock under Repurchase Program			(8,647	)			(35,195	)
Payment of common stock dividends			(44,163	)			(35,984	)
Net proceeds related to long-term incentive awards			1,845				13,083
Excess tax benefit from share-based compensation			7,591				10,347
Distributions to minority interest partner			(14,747	)			(28,000	)
Net cash used in financing activities			(117,413	)			(124,003	)
Effect of exchange rate changes on cash			2,636				994
Increase (decrease) in cash and cash equivalents			(16,764	)			14,524
Cash and cash equivalents at beginning of period			158,267				80,379
Cash and cash equivalents at end of period		$	141,503			$	94,903
Supplemental disclosures of cash flow information:
Cash paid for interest		$	32,378			$	37,568
Cash paid for income taxes			228,659				163,967

The accompanying notes are an integral part of these consolidated condensed financial statements.

SMITH INTERNATIONAL, INC.

(All dollar amounts are expressed in thousands, unless otherwise noted)

(Unaudited)

1. Significant Accounting Policies

Basis of Presentation

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 2007 Annual Report on Form 10-K and other current filings with the Commission. All adjustments that 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 period presented may not be indicative of results which may be reported on a fiscal year basis.

Revenue Recognition

Revenues in the accompanying unaudited results of operations are separated into our two major business lines to provide additional information for use in analyzing the Company’s results. Generally, sales transactions are subject to contractual arrangements that specify price, general terms and conditions.

Transactions in our oilfield operations are primarily composed of rental and service revenues, but also include product and certain other revenues. Product revenues, net of applicable provisions for returns, are recognized when title and related risk of loss transfer to the customer and collectability is reasonably assured. In most cases, title and risk transfer upon product delivery; however, certain products are provided on a consigned basis with title and risk transferring when products are consumed. Rental, service and other revenues are recorded when such services are performed and collectability is reasonably assured. On a routine basis, our operating units provide multiple product and service offerings as part of a combined transaction. Service and rental revenues for these projects, which are of a short duration, are recognized when the project is complete.

Sales transactions in our distribution operations are primarily composed of product revenues. Distribution sales, net of applicable provisions for returns, are recognized when goods are delivered to the customer and collectability is reasonably assured.

Recent Accounting Pronouncements

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.

The FASB had previously issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), “Business Combinations”; SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” and SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” which have been discussed in previous filings with the Commission. The Company continues to evaluate the provisions of these standards, which are required to be adopted by the Company in the first quarter of 2009.

Management believes the impact of other recently issued standards, which are not yet effective, will not have a material impact on the Company’s consolidated condensed financial statements upon adoption.

Reclassifications

Certain reclassifications have been made to the prior years’ financial information to conform to the 2008 presentation.

2. Acquisitions and Dispositions

During the six months ended June 30, 2008, the Company completed three acquisitions in exchange for aggregate cash consideration of $27.9 million and the assumption of certain liabilities. The consideration relates to the purchase of Norwegian-based Innovar Engineering AS, a company providing wellbore completion tool technology, and Caspian Downhole Services (“CDS”), a Kazakhstan-based provider of rental tool, machine shop and inspection services.

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 net assets acquired, which is primarily associated with the CDS transaction, approximated $6.3 million and has been recorded as goodwill in the June 30, 2008 consolidated condensed balance sheet. 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.

From time to time, the Company divests of non-core operations in the normal course of business. During the second quarter of 2007, the Company completed the disposition of certain majority-owned venture operations in exchange for cash consideration of $16.7 million. Although the transaction had a positive effect on cash flows, it did not materially impact results of operations.

Pro forma results of operations have not been presented because the effect of these transactions was not material to the Company’s consolidated condensed financial statements.

3. 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 that could have occurred if additional shares were issued for stock option and restricted stock awards under the treasury stock method. The following schedule reconciles the income and shares used in the basic and diluted EPS computations (in thousands, except per share data):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Net income		$	183,273			$	153,053			$	358,264			$	313,211
Weighted average number of common shares outstanding			200,938				200,499				200,873				200,241
Basic EPS		$	0.91			$	0.76			$	1.78			$	1.56
Net income		$	183,273			$	153,053			$	358,264			$	313,211
Weighted average number of common shares outstanding			200,938				200,499				200,873				200,241
Dilutive effect of stock options and restricted stock units			1,346				1,598				1,296				1,574
			202,284				202,097				202,169				201,815
Diluted EPS		$	0.91			$	0.76			$	1.77			$	1.55

4. 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, a significant portion 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:

		June 30,				December 31,
		2008				2007
Raw materials		$	167,885			$	139,218
Work-in-process			190,945				173,836
Finished goods			1,705,268				1,461,373
			2,064,098				1,774,427
Reserves to state certain U.S. inventories (FIFO cost of $670,927 and $611,062 in 2008 and 2007, respectively) on a LIFO basis			(145,164	)			(116,255	)
		$	1,918,934			$	1,658,172

During the first half of 2008, the Company recorded additional LIFO reserves of $28.9 million, primarily related to the higher cost of steel and alloy products purchased in the Distribution segment. To a lesser extent, modest cost inflation experienced in the oilfield manufacturing operations resulted in the revaluation of on-hand inventories to current unit cost standards during the second quarter of 2008.

5. Property, Plant and Equipment

Property, plant and equipment consist of the following:

		June 30,				December 31,
		2008				2007
Land and improvements		$	62,275			$	62,546
Buildings			245,168				235,545
Machinery and equipment			972,214				880,562
Rental tools			786,093				726,333
			2,065,750				1,904,986
Less – Accumulated depreciation			(873,564	)			(799,106	)
		$	1,192,186			$	1,105,880

6. Goodwill and Other Intangible Assets

Goodwill

The following table presents beginning and ending goodwill balances, which are presented net of accumulated amortization of $53.6 million, as well as changes in the account during the period shown. Additionally, due to the change in reportable business segments discussed in Footnote 10, the beginning goodwill balance has been recast in order to conform to the 2008 presentation.

						Smith
						Drilling and
		M-I SWACO				Evaluation				Distribution				Consolidated
Balance as of December 31, 2007		$	707,165			$	137,732			$	51,545			$	896,442
Goodwill acquired			—				6,334				—				6,334
Purchase price and other adjustments			—				247				(458	)			(211	)
Balance as of June 30, 2008		$	707,165			$	144,313			$	51,087			$	902,565

Other Intangible Assets

The Company amortizes other identifiable intangible assets on a straight-line basis over the periods expected to be benefited, ranging from two to 27 years. The components of these other intangible assets are as follows:

																										Weighted
		June 30, 2008												December 31, 2007												Average
		Gross												Gross												Amortization
		Carrying				Accumulated								Carrying				Accumulated								Period
		Amount				Amortization				Net				Amount				Amortization				Net				(years)
Patents		$	117,842			$	40,598			$	77,244			$	112,485			$	35,190			$	77,295				13.8
License agreements			32,416				15,758				16,658				31,688				14,204				17,484				10.7
Non-compete agreements and trademarks			41,626				23,501				18,125				36,704				21,032				15,672				8.6
Customer lists and contracts			37,138				20,595				16,543				34,603				16,695				17,908				9.1
		$	229,022			$	100,452			$	128,570			$	215,480			$	87,121			$	128,359				12.1

Amortization expense of other intangible assets was approximately $5.9 million and $7.7 million for the three-month periods ended June 30, 2008 and 2007, respectively, and $13.3 million and $15.2 million for the six-month periods ended June 30, 2008 and 2007, respectively. The expiration of certain licensing royalty agreements in the first quarter of 2008 contributed to the lower level of current year amortization expense as compared to the prior year periods. Amortization expense related to the existing operations is expected to approximate $24.8 million for fiscal year 2008 and is anticipated to range between $11.8 million and $20.8 million per year for the 2009 – 2012 fiscal years.

7. 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:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Net income		$	183,273			$	153,053			$	358,264			$	313,211
Currency translation adjustments			2,637				13,045				12,052				17,618
Changes in unrealized fair value of derivatives, net			(842	)			(114	)			(801	)			149
Pension liability adjustments			—				—				(24	)			—
Comprehensive income		$	185,068			$	165,984			$	369,491			$	330,978

Accumulated other comprehensive income in the accompanying consolidated condensed balance sheet consists of the following:

		June 30, 2008				December 31, 2007
Currency translation adjustments		$	84,350			$	72,298
Unrealized fair value of derivatives			(46	)			755
Pension liability adjustments			(5,237	)			(5,213	)
Accumulated other comprehensive income		$	79,067			$	67,840

8. Employee Benefit Plans

The Company maintains various noncontributory defined benefit pension plans covering certain U.S. and non-U.S. employees. In addition, the Company and certain subsidiaries have postretirement benefit plans, which provide health care benefits to a limited number of current, and in some cases, future retirees. Net periodic benefit expense related to the pension and postretirement benefit plans, on a combined basis, approximated $1.0 million for each of the three-month periods ended June 30, 2008 and 2007, respectively, and $2.0 million for each of the six-month periods ended June 30, 2008 and 2007, respectively. Company contributions to the pension and postretirement benefit plans during 2008 are expected to be comparable with 2007 contribution levels.

9. Long-Term Incentive Compensation

As of June 30, 2008, the Company had outstanding restricted stock units and stock options granted under the Third Amended and Restated 1989 Long-Term Incentive Compensation Plan (the “Plan”). As of June 30, 2008, approximately 5,138,100 shares were authorized for future issuance pursuant to the Plan.

Restricted Stock

The restricted stock program consists of a combination of performance-based restricted stock units (“performance-based units”) and time-based restricted stock units (“time-based units”). Activity under the Company’s restricted stock program for the
six-month period ended June 30, 2008 is presented below:

		Time-based Awards								Performance-based Awards								Total
						Fair								Fair				Restricted
		No. of Units				Value(a)				No. of Units				Value(a)				Stock Units
Outstanding at December 31, 2007			796,687			$	53.06				1,280,851			$	48.55				2,077,538
Granted			4,077				56.50				—				—				4,077
Forfeited			(29,973	)			49.10				(42,073	)			40.32				(72,046	)
Vested			(500	)			27.73				(196,439	)			43.05				(196,939	)
Outstanding at June 30, 2008			770,291			$	53.25				1,042,339			$	49.92				1,812,630

Restrictions on 450,329 performance-based units and 245,441 time-based units outstanding at June 30, 2008 are expected to lapse during the 2008 fiscal year.

Stock Options

Activity under the Company’s stock option program for the six-month period ended June 30, 2008 is presented below:

						Weighted				Weighted Average				Aggregate
		Shares				Average				Remaining				Intrinsic Value
		Under Option				Exercise Price				Contractual Life				(in thousands)
Outstanding at December 31, 2007			1,547,671			$	20.04
Granted			—				—
Forfeited			(15,512	)			29.22
Exercised			(411,959	)			20.35
Outstanding at June 30, 2008			1,120,200			$	19.80				5.0			$	70,953
Exercisable at June 30, 2008			1,008,259			$	18.80				4.8			$	64,876

Share-based Compensation Expense

Share-based compensation expense, consisting of restricted stock and stock options, was $10.2 million and $8.5 million for the three-month periods ended June 30, 2008 and 2007, respectively, and $20.9 million and $16.7 million for each of the
six-month periods ended June 30, 2008 and 2007, respectively.

Moreover, the total unrecognized share-based compensation expense for awards outstanding as of June 30, 2008 approximated $70.7 million, or $42.4 million net of taxes and minority interests, which will be recognized over a weighted-average period of 2.4 years.

10. Industry Segments

The Company provides premium products and services to the oil and gas exploration and production industry, aggregating its business operations into three reportable segments: M-I SWACO, Smith Drilling and Evaluation and Distribution. The M-I SWACO segment consists of a majority-owned drilling fluid and environmental services joint venture operation. The Smith Drilling and Evaluation segment reflects two business units: Smith Technologies, a major drill bit industry participant, and Smith Services, a global provider of downhole tools, equipment, and related services. Finally, the Distribution segment consists of the Wilson distribution operations and a majority-owned interest in CE Franklin, Ltd., a publicly-traded Canadian distribution company.

Subsequent to June 30, 2008, the Company modified its segment reporting disclosure to provide investors with increased visibility into its oilfield business operations. The M-I SWACO unit has been separated from our other oilfield business operations and is being reported as a separate segment. Additionally, the Company no longer allocates corporate expenses to the various reporting segments. These changes do not affect the Company’s Consolidated Condensed Statements of Operations, Balance Sheets, or Cash Flows.

The following table, in which the prior year revenue and operating income has been recast to conform to the current year presentation, includes, financial information for each reportable segment and geographical revenues on a consolidated basis:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Revenues:
M-I SWACO		$	1,285,754			$	1,086,524			$	2,514,183			$	2,121,608
Smith Drilling and Evaluation			592,816				528,391				1,167,314				1,054,991
Distribution			615,588				499,458				1,183,659				1,045,498
		$	2,494,158			$	2,114,373			$	4,865,156			$	4,222,097
Revenues by Area:
United States		$	1,145,960			$	987,046			$	2,158,639			$	1,948,550
Canada			146,453				138,703				380,878				375,842
North America			1,292,413				1,125,749				2,539,517				2,324,392
Latin America			244,543				173,213				471,520				321,551
Europe/Africa			646,527				512,335				1,243,019				991,013
Middle East/Asia			310,675				303,076				611,100				585,141
Non-North America			1,201,745				988,624				2,325,639				1,897,705
		$	2,494,158			$	2,114,373			$	4,865,156			$	4,222,097
Operating Income:
M-I SWACO		$	208,700			$	178,982			$	412,904			$	348,097
Smith Drilling and Evaluation			162,864				150,608				325,870				298,956
Distribution			36,518				20,706				66,402				50,616
General corporate			(18,315	)			(17,847	)			(36,602	)			(34,092	)
		$	389,767			$	332,449			$	768,574			$	663,577

11. Commitments and Contingencies

Standby Letters of Credit

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 to insurance companies with respect to certain liability coverages of the Company’s insurance captive. Excluding the impact of these instruments, for which $20.7 million of related liabilities are reflected in the accompanying consolidated condensed balance sheet, the Company was contingently liable for approximately $157.2 million of standby letters of credit and bid, performance and surety bonds at June 30, 2008. Management does not expect any material amounts to be drawn on these instruments.

Litigation

The Company is a defendant in various other legal proceedings arising in the ordinary course of business. In the opinion of management, these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

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.

As of June 30, 2008, the Company’s environmental reserve totaled $6.7 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 June 30, 2008, the Company does not believe that these differences will have a material impact on the Company’s financial position, results of operations or cash flows.

12. Subsequent Event

On June 3, 2008, the Company announced that it had entered into a definitive agreement to acquire all of the outstanding shares of W-H Energy Services, Inc. (“W-H’) pursuant to an exchange offer. Under the terms of the transaction, each W-H shareholder is entitled to receive $56.10 in cash and 0.48 shares of Smith common stock in exchange for each W-H share outstanding. W-H equity holders have the option to accept the consideration mix offered or, subject to proration, elect either all-cash or all-stock consideration.

The transaction is expected to be completed in the third quarter of 2008 and is subject to the successful completion of the exchange offer, as well as customary closing conditions and regulatory approvals, including the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

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 2007 Annual Report on Form 10-K.

Company Products and Operations

The Company is a leading global provider of premium products and services to the oil and gas exploration and production industry. 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, turbines, borehole enlargement tools, tubulars, 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 North American branch network providing pipe, valves and fittings as well as mill, safety and other maintenance products.

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 E&P spending is significantly influenced by the market price of oil and natural gas, 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 financial condition of independent E&P companies and the overall level of global economic growth and activity. In addition, approximately seven percent of the Company’s consolidated revenues relate to the downstream energy sector, including petrochemical plants and refineries, whose spending is largely impacted by the general condition of the U.S. economy.

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 75 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 75 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 52 percent of the Company’s consolidated revenues were generated in North America during the first six months of 2008, Smith’s profitability was largely dependent upon business levels in markets outside of North America. The Distribution segment, which accounts for approximately one-fourth of consolidated revenues and primarily supports a North American customer base, serves to distort the geographic revenue mix of the Company’s oilfield operations. Excluding the impact of the Distribution segment, 61 percent of the Company’s revenues were generated in markets outside of North America during the first half of 2008.

Business Outlook

Near-term drilling activity will largely be influenced by the seasonal recovery in Canada, supported by a sharp rebound in the number of land-based drilling projects from the levels experienced in the second quarter of 2008. Drilling activity in markets outside of Canada should increase modestly throughout the remainder of the year as exploration and production companies develop unconventional land-based projects in the United States and benefit from the delivery of a number of newbuild deepwater drilling units in the global offshore market. However, tropical weather disturbances are typically experienced in the Gulf of Mexico during the third calendar quarter — influencing the level of planned drilling programs and, in certain circumstances, may result in the curtailment of some offshore drilling operations. Although a number of factors impact drilling activity levels, our business is highly dependent on the general economic environment in the United States and other major world economies — which ultimately influence energy consumption and the resulting demand for our products and services. A significant deterioration in the global economic environment could adversely affect worldwide drilling activity and the future financial results of the Company.

Forward-Looking Statements

This document contains forward-looking statements within the meaning of the Section 21E of the Securities Exchange Act of 1934, as amended, concerning, among other things, our outlook, financial projections and business strategies, all of which are subject to risks, uncertainties and assumptions. These forward-looking statements are identified by their use of terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “project” and similar terms. These statements are based on certain assumptions and analyses that we believe are appropriate under the circumstances. Such statements are subject to, among other things, general economic and business conditions, the level of oil and natural gas exploration and development activities, global economic growth and activity, political stability of oil-producing countries, finding and development costs of operations, decline and depletion rates for oil and natural gas wells, seasonal weather conditions, industry conditions, changes in laws or regulations and other risk factors outlined in the Company’s Form 10-K for the fiscal year ended December 31, 2007, many of which are beyond the control of the Company. Should one or more of these risks or uncertainties materialize, or should the assumptions prove incorrect, actual results may differ materially from those expected, estimated or projected. Management believes these forward-looking statements are reasonable. However, you should not place undue reliance on these forward-looking statements, which are based only on our current expectations. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to publicly update or revise any of them in light of new information, future events or otherwise.

Results of Operations

Segment Discussion

The Company markets its products and services throughout the world through four business units which are aggregated into three reportable segments: M-I SWACO, Smith Drilling and Evaluation and Distribution. The M-I SWACO segment consists of a majority-owned drilling fluid and environmental services joint venture operation. The Smith Drilling and Evaluation segment reflects two business units: Smith Technologies, a major drill bit industry participant, and Smith Services, a global provider of downhole tools, equipment, and related services. Finally, the Distribution segment consists of the Wilson distribution operations and a majority-owned interest in CE Franklin, Ltd., a publicly-traded Canadian distribution company.

The accompanying revenue information and discussion has been presented by business unit in order to provide additional information in analyzing the Company’s operations. Additionally, due to the change in reportable business segments discussed in Footnote 10, the Company has recast prior year geographic revenue and operating income information in order to conform to the 2008 presentation.

		Three Months Ended June 30,																Six Months Ended June 30,
		2008								2007								2008								2007
		Amount				%				Amount				%				Amount				%				Amount				%
Financial Data: (dollars in thousands)
Revenues:
M-I SWACO		$	1,285,754				52			$	1,086,524				51			$	2,514,183				52			$	2,121,608				50
Smith Technologies			281,317				11				248,294				12				556,042				11				492,385				12
Smith Services			311,499				12				280,097				13				611,272				13				562,606				13
Oilfield operations			1,878,570				75				1,614,915				76				3,681,497				76				3,176,599				75
Distribution operations			615,588				25				499,458				24				1,183,659				24				1,045,498				25
Total		$	2,494,158				100			$	2,114,373				100			$	4,865,156				100			$	4,222,097				100
Geographic Revenues:
United States:
M-I SWACO		$	327,121				13			$	307,212				15			$	633,386				13			$	603,985				14
Smith Drilling and Evaluation			330,444				13				292,689				14				639,506				13				570,841				14
Distribution			488,395				20				387,145				18				885,747				18				773,724				18
Total United States			1,145,960				46				987,046				47				2,158,639				44				1,948,550				46
Canada:
M-I SWACO			26,663				1				34,664				2				73,025				2				91,759				2
Smith Drilling and Evaluation			24,579				1				27,368				1				72,173				1				76,928				2
Distribution			95,211				4				76,671				3				235,680				5				207,155				5
Total Canada			146,453				6				138,703				6				380,878				8				375,842				9
Non-North America:
M-I SWACO			931,970				37				744,648				35				1,807,772				37				1,425,864				34
Smith Drilling and Evaluation			237,793				10				208,334				10				455,635				10				407,222				10
Distribution			31,982				1				35,642				2				62,232				1				64,619				1
Total Non-North America			1,201,745				48				988,624				47				2,325,639				48				1,897,705				45
Total Revenue		$	2,494,158				100			$	2,114,373				100			$	4,865,156				100			$	4,222,097				100
Operating Income:
M-I SWACO		$	208,700				16			$	178,982				16			$	412,904				16			$	348,097				16
Smith Drilling and Evaluation			162,864				27				150,608				29				325,870				28				298,956				28
Distribution			36,518				6				20,706				4				66,402				6				50,616				5
General Corporate			(18,315	)			*				(17,847	)			*				(36,602	)			*				(34,092	)			*
Total		$	389,767				16			$	332,449				16			$	768,574				16			$	663,577				16

		Three Months Ended June 30,																Six Months Ended June 30,
		2008								2007								2008								2007
		Amount				%				Amount				%				Amount				%				Amount				%
Market Data:
Average Worldwide Rig Count: (1)
United States			2,081				47				1,934				48				2,045				45				1,917				46
Canada			144				3				126				3				295				7				305				7
Non-North America			2,205				50				1,960				49				2,174				48				1,924				47
Total			4,430				100				4,020				100				4,514				100				4,146				100
Onshore			3,849				87				3,456				86				3,937				87				3,595				87
Offshore			581				13				564				14				577				13				551				13
Total			4,430				100				4,020				100				4,514				100				4,146				100
Average Commodity Prices:
Crude Oil ($/Bbl) (2)		$	123.80							$	65.02							$	111.12							$	61.67
Natural Gas ($/mcf) (3)			11.47								7.66								10.14								7.42

M-I SWACO Segment

Revenues

M-I SWACO primarily provides drilling and completion fluid systems, engineering and technical services to the oil and gas industry. Additionally, these operations provide oilfield production chemicals and manufacture and market equipment and services used for solids-control, particle separation, pressure control, rig instrumentation and waste-management. M-I SWACO is significantly influenced by its exposure to the global offshore market, which constitutes approximately 50 percent of the revenue base, and to exploration and production spending for land-based projects outside of North America, which contributes just over 30 percent of the unit’s revenues. Offshore drilling programs, which accounted for 13 percent of the worldwide rig count during the first six months of 2008, are generally more revenue-intensive than land-based projects due to the complex nature of the related drilling environment. M-I SWACO’s revenues totaled $1.3 billion for the second quarter of 2008, an increase of 18 percent above the prior year period. Approximately 80 percent of the revenue improvement over the prior year period was attributable to an 11 percent growth in the average number of active land-based drilling rigs which favorably impacted business volumes in the Former Soviet Union (“FSU”), Latin America and other major drilling markets, including the United States. The unit’s onshore revenues grew 32 percent over the prior year quarter, evidencing increased demand for drilling fluids and, to a lesser extent, fluid processing and other environmental equipment rentals. Increased customer spending for completion fluids and produced water separation equipment in the North Sea market accounted for the period-to-period growth in the global offshore business. For the six-month period, M-I SWACO reported revenues of $2.5 billion, a 19 percent increase over the amounts reported in the first half of 2007. The revenue increase was reported in markets outside North America — primarily attributable to higher land-based drilling activity levels that favorably impacted business volumes in the FSU, Mexico and North Africa. Approximately one-third of the year-to-date revenue growth reflects improved offshore results, largely reflecting a favorable customer mix and new contract awards in the North Sea market.

Operating Income

Operating income for the M-I SWACO segment was $208.7 million for the three months ended June 30, 2008. M-I SWACO segment margins were 16.2 percent for the second quarter of 2008, reflecting a 30 basis point decline from the year-ago period. Several factors contributed to the operating margin performance, including a shift in the business mix towards lower-relative margin land-based programs, higher transportation and raw material input costs and, to a lesser extent, incremental project costs associated with new contracts in Latin America. On an absolute dollar basis, second quarter 2008 operating income increased $29.7 million over the prior year quarter, reflecting the impact of a 18 percent increase in business volumes on gross profit, partially offset by growth in variable-based operating expenses associated with the expanding global business infrastructure. On a year-to-date basis, M-I SWACO operating margins were comparable with the prior year period as lower gross margins were offset by improved fixed cost coverage. On an absolute dollar basis, six-month operating income was $64.8 million above the first half of 2007 level, largely attributable to the impact of higher revenue volumes on the segment’s reported gross profit, partially offset by growth in variable-based operating expenses associated with the expanding business base.

Smith Drilling and Evaluation Segment

Revenues

Smith Technologies designs and manufactures three-cone and diamond drill bits, turbines and borehole enlargement tools for use in the oil and gas industry. Due to the nature of its product offerings, revenues for these operations typically correlate more closely to the rig count than any of the Company’s other businesses. Moreover, Smith Technologies has a high level of North American revenue exposure driven, in part, by the significance of its Canadian operations. Accordingly, the seasonal Canadian drilling decline, which occurs in the second quarter, adversely impacts the unit’s financial performance. Smith Technologies reported revenues of $281.3 million for the quarter ended June 30, 2008, an increase of 13 percent over the comparable prior year period. The majority of the year-on-year revenue growth was reported in the Western Hemisphere operations, influenced by increased unconventional drilling projects in the U.S. land-based market and, to a lesser extent, improved drill bit market penetration in key Latin American markets and pricing realization. Outside the United States, the improved business volumes reflect higher activity levels as well as strong demand for diamond drill bit products. For the six-month period, Smith Technologies reported revenues of $556.0 million, a 13 percent improvement over the comparable prior year period. Two-thirds of the revenue growth was reported in the United States, driven by improved three-cone drill bit market penetration and the impact of price increases introduced during the past 12-month period. Increased demand for diamond and three-cone drill bit products in Latin America also contributed to the favorable comparison to the prior year period.

Smith Services manufactures and markets products and services used in the oil and gas industry for drilling, work-over, well completion and well re-entry. Smith Services’ revenues are heavily influenced by the complexity of drilling projects, which drive demand for a wider range of its product offerings. In recent years, growth in the number of U.S. land-based drilling programs has resulted in strong demand for additional rigs and related drilling equipment, including the Company’s premium tubular products and drill pipe. Excluding the impact of tubular sales volumes, which are not highly correlated to drilling activity levels, revenues for Smith Services are relatively balanced between North America and the international markets. Smith Services’ revenues for the three months ended June 30, 2008 totaled $311.5 million, 11 percent above the prior year period. The year-over-year revenue growth was evenly distributed between the North American and international operations. Business volumes in the North American market was influenced by increased demand for premium tubular product and service offerings, attributable to higher onshore activity levels in the U.S. market, whereas new contract awards impacted revenue growth in the international markets. For the first half of 2008, Smith Services reported revenues of $611.3 million, a nine percent increase from the comparable prior year period. The comparison to the 2007 period is influenced by lower drill pipe sales associated with a decline in customer rig construction projects. Excluding drill pipe, revenues grew 15 percent above the first half of 2007 attributable to activity-driven demand for premium tubular products and services in the United States and Latin America. To a lesser extent, increased demand for Hydra-Jar^® drilling services and high-performance completion products in Europe/Africa also contributed to the revenue growth.

Operating Income

Operating income for the Smith Drilling and Evaluation segment was $162.9 million for the three months ended June 30, 2008. Operating margins were 27.5 percent for the second quarter of 2008, reflecting a one percentage point decline from the year-ago period. The margin decline was experienced in the Smith Services operations, influenced by the prior-year sale of a majority-owned joint venture operation and higher raw material input costs. Improved business volumes and incremental pricing in the Smith Technologies unit, which generates higher-relative profitability levels, partially offset the reduction in Smith Services’ margins. On an absolute dollar basis, second quarter 2008 operating income increased $12.3 million over the prior year quarter, reflecting the impact of higher business volumes on gross profit, partially offset by growth in variable-based operating expenses associated with the expansion of Smith Services’ manufacturing, sales and service base in the Eastern Hemisphere market. On a year-to-date basis, Smith Drilling and Evaluation operating margins declined 40 basis points, as improved gross profit margins were more than offset by the financial impact of the prior-year joint venture sale and, to a lesser extent, higher relative operating costs. On an absolute dollar basis, six-month operating income was $26.9 million above the first half of 2007 level, as increased revenue volumes and incremental pricing offset the offset the growth in variable-based operating expenses associated with the expanding business base.

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 95 percent of Wilson’s second quarter 2008 revenues generated in those markets. Moreover, approximately one-fourth 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. Distribution revenues were $615.6 million for the second quarter of 2008, 23 percent above the comparable prior year period. The majority of the period-to-period revenue growth was attributable to increased demand for line pipe and other operating supplies associated with unconventional onshore drilling projects in the United States. Additionally, higher capital project activity in the downstream and industrial sector of the business contributed to a 31 percent improvement in sales volumes, favorably impacting the period-to-period comparison. For the first six months of 2008, the Distribution operations reported revenues of $1.2 billion, a 13 percent improvement over the comparable prior year period. The business growth was largely influenced by the U.S. operations, reflecting higher onshore drilling and completion activity and related demand.

Operating Income

Operating income for the Distribution segment was $36.5 million, or 5.9 percent of revenues, for the three months ended June 30, 2008. Segment operating margins were 1.8 percentage points above the prior year quarter, translating into 14 percent incremental operating income as a percentage of revenues. The year-over year margin improvement was influenced by higher revenue volumes, which had a favorable impact on fixed-cost coverage, and improved product pricing. On an absolute dollar basis, operating income increased $15.8 million over the year-ago period reflecting the impact of a 23 percent increase in business volumes on gross profit, partially offset by growth in variable-based operating expenses. On a year-to-date basis, Distribution operating margins improved 80 basis points, reflecting improved business volumes and product pricing related to line pipe expansion projects in the energy sector. On an absolute dollar basis, operating income was $15.8 million above the amount reported in the first half of 2007. The operating income variance reflects the impact of higher revenue volumes and improved gross profit levels, partially offset by growth in variable-based operating expenses.

Consolidated Results

For the periods indicated, the following table summarizes the results of operations of the Company and presents these results as a percentage of total revenues:

		Three Months Ended June 30,																Six Months Ended June 30,
		2008								2007								2008								2007
		Amount				%				Amount				%				Amount				%				Amount				%
Revenues		$	2,494,158				100			$	2,114,373				100			$	4,865,156				100			$	4,222,097				100
Gross profit			807,452				33				696,546				33				1,588,936				33				1,372,511				33
Operating expenses			417,685				17				364,097				17				820,362				17				708,934				17
Operating income			389,767				16				332,449				16				768,574				16				663,577				16
Interest expense			16,244				1				17,605				1				32,545				1				36,139				1
Interest income			(752	)			—				(895	)			—				(1,648	)			—				(1,659	)			—
Income before income taxes and minority interests			374,275				15				315,739				15				737,677				15				629,097				15
Income tax provision			121,555				5				100,891				5				238,846				5				193,990				5
Minority interests			69,447				3				61,795				3				140,567				3				121,896				3
Net income		$	183,273				7			$	153,053				7			$	358,264				7			$	313,211				7