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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**** ****Form 10-K****(Mark One)**   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934******For the Fiscal Year Ended December 31, 2006******OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934****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 incorporation or organization)** **(I.R.S. Employer Identification No.)** **411 North Sam Houston Parkway, Suite 600**  **Houston, Texas** **77060****(Address of principal executive offices)** **(Zip Code)****Registrant’s telephone number, including area code (281) 443-3370****Securities Registered Pursuant to Section 12(b) of the Act:**   **Title of Each Class** **Name of Each Exchange on Which Registered**   **Common Stock, $1.00 par value** **New York Stock Exchange, Inc.**  **Pacific Exchange, Inc.****Securities registered pursuant to Section 12(g) of the Act: None**     Indicate by check mark if the registrant is a well-known seasoned issuer, as definedin Rule 405 of the Securities Act. Yes þ No o .     Indicate by check mark if the registrant is not required to file reports pursuant to Section13 or Section 15(d) of the Act. Yes o No þ .     Indicate by check mark whether the registrant: (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No o .     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of RegulationS-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge,in definitive proxy or information statements incorporated by reference in Part III of this Form10-K or any amendment to this Form 10-K. o     Indicate by check mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act.Large Accelerated Filer þ       Accelerated Filero       Non-Accelerated Filer o .     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 ofthe Exchange Act). Yes o No þ .     The aggregate market value of the voting stock held by non-affiliates on June 30, 2006 was$8,819,233,034 (198,318,710 shares at the closing price on the New York Stock Exchange of $44.47).On June 30, 2006, 213,968,439 shares of common stock were outstanding. For this purpose all sharesheld by officers and directors and their respective affiliates are considered to be held byaffiliates, but neither the Registrant nor such persons concede that they are affiliates of theRegistrant.     There were 199,979,284 shares of common stock outstanding, net of shares held in Treasury, onFebruary 23, 2007.**DOCUMENTS INCORPORATED BY REFERENCE**     Portions of the Proxy Statement related to the Registrant’s 2007 Annual Meeting ofStockholders are incorporated by reference into Part III of this Form.  
 

 
**TABLE OF CONTENTS**     PART I         Item 1. Business  2 Item 1A. Risk Factors  9 Item 1B. Unresolved Staff Comments  11 Item 2. Properties  11 Item 3. Legal Proceedings  12 Item 4. Submission of Matters to a Vote of Security Holders  12      PART II         Item 5. Market for the Registrant’s Common Equity, Related StockholderMatters and Issuer Purchases of Equity Securities  12 Item 6. Selected Financial Data  13 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations  14 Item 7A. Quantitative and Qualitative Disclosures about Market Risk  25 Item 8. Financial Statements and Supplementary Data  26 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  53 Item 9A. Controls and Procedures  53 Item 9B. Other Information  53      PART III         Item 10. Directors, Executive Officers and Corporate Governance  54 Item 11. Executive Compensation  54 Item 12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters  54 Item 13. Certain Relationships and Related Transactions, and Director Independence  54 Item 14. Principal Accountant Fees and Services  54      PART IV         Item 15.Exhibits and Financial Statement Schedules  55  Second Amendment to 1989 Long-Term Incentive Compensation Plan Form of Nonstatutory Option Agreement Form of Restricted Stock Unit Agreement Form of Performance-Based Restricted Stock Unit Agreement Director Compensation Summary Amended Post-2004 Supplemental Executive Retirement Plan First Amendment to Executive Officer Annual Incentive Plan Form of Director Indemnification Agreement Consent of Independent Registered Public Accounting Firm Certification of CEO Pursuant to Rule 13a-14(a) Certification of CFO Pursuant to Rule 13a-14(a) Certification Pursuant to Section 1350
 

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**PART I****Item 1.*****Business*****General**     Smith International, Inc. (“Smith” or the “Company”) is a leading global provider of premiumproducts and services to the oil and gas exploration and production industry. The Company providesa comprehensive line of technologically-advanced products and engineering services, includingdrilling and completion fluid systems, solids-control and separation equipment, waste-managementservices, oilfield production chemicals, three-cone and diamond drill bits, turbine products,tubulars, fishing services, drilling tools, underreamers, casing exit and multilateral systems,packers and liner hangers. The Company also offers supply-chain management solutions through anextensive North American branch network providing pipe, valves and fittings as well as mill, safetyand other maintenance products.     The Company was incorporated in the state of California in January 1937 and reincorporatedunder Delaware law in May 1983. The Company’s executive offices are headquartered at 411 North SamHouston Parkway, Suite 600, Houston, Texas 77060 and its telephone number is (281) 443-3370. TheCompany’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-Kand amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934 are made available free of charge on the Company’s Internet websiteat www.smith.com as soon as reasonably practicable after the Company has electronicallyfiled such material with, or furnished it to, the Securities and Exchange Commission. TheCompany’s Corporate Governance Guidelines, Code of Business Conduct and Ethics and the charters ofthe Audit Committee, Compensation and Benefits Committee and Nominating and Corporate GovernanceCommittee are also available on the Investor Relations section of the Company’s Internet website.The Company intends to disclose on its website any amendments or waivers to its Code of BusinessConduct and Ethics that are required to be disclosed pursuant to Item 5.05 of Form 8-K. Printedcopies of these documents are available to stockholders upon request.     The Company’s operations are aggregated into two reportable segments: Oilfield andDistribution. The Oilfield segment consists of: M-I SWACO, a 60 percent-owned joint venture whichprovides drilling and completion fluid systems and services, solids-control and separationequipment, waste-management services and oilfield production chemicals; Smith Technologies, whichmanufactures and sells three-cone drill bits, diamond drill bits and turbine products; and SmithServices, which manufactures and markets products and services used for drilling, workover, wellcompletion and well re-entry operations. The Distribution segment consists of one business unit,Wilson, which markets pipe, valves and fittings as well as mill, safety and other maintenanceproducts to energy and industrial markets.     Financial information regarding reportable segments and international operations appears in“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note16 of the Notes to Consolidated Financial Statements included elsewhere in this Form 10-K.Information related to business combinations appears in Note 3 of the Notes to ConsolidatedFinancial Statements included elsewhere in this Form 10-K.**Business Operations*****Oilfield Segment****M-I SWACO*     *Fluid Products and Services.*M-I SWACO is a leading worldwide provider of drilling, reservoirdrill-in and completion fluid systems, products and engineering services to end users engaged indrilling oil and natural gas wells. Drilling fluids are used to cool and lubricate the bit duringdrilling operations, contain formation pressures, suspend and remove rock cuttings from the holeand maintain the stability of the wellbore. Engineering services are provided to ensure that thefluid products are applied effectively to optimize drilling operations. These services includerecommending products and services during the well planning phase; monitoring drilling fluidproperties; recommending adjustments during the drilling phase; and analyzing/benchmarking wellresults after completion of the project to improve the efficiencies of future wells.     M-I SWACO offers water-base, oil-base and synthetic-base drilling fluid systems. Water-basedrilling fluids are the world’s most widely utilized systems, having application in both land andoffshore environments. Typically, these systems comprise an engineered blend of weightingmaterials used to contain formation pressures, and a broad range of chemical additives, designed toyield the specific drilling performance characteristics required for a given drilling project.Oil-base
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drilling fluids, which primarily are used to drill water-sensitive shales, reduce torque and drag and arewidely used in areas where stuck pipe is likely to occur. In certain drilling areas of the world,oil-base systems exhibit comparably higher penetration rates when compared to water-base systems,significantly reducing time on location and overall drilling costs. Synthetic-base drilling fluidsare used in drilling environments where oil-base fluids are environmentally prohibited and providethe performance benefits of oil-base systems. Synthetic-base systems are particularly advantageousin the deepwater environment. M-I SWACO also provides a comprehensive line of reservoir drill-influids which combine the high performance properties of a premium drilling fluid with minimaldamaging characteristics of a brine completion fluid.     Completion fluids (clear brines) are solids-free, clear-salt solutions with high specificgravities and are non-damaging to the producing formation. Operators use these specially designedfluid systems in combination with a comprehensive range of specialty chemicals to controlbottom-hole pressures, while meeting the specific corrosion inhibition, viscosity and fluid lossrequirements necessary during the completion and workover phase of a well. These systems arespecially engineered to maximize well production by minimizing formation damage that can be causedby solids-laden systems. M-I SWACO provides a complete line of completion fluids products andservices, including low- and high-density brines, specialty chemicals, filtration and chemicaltreatment services, wellsite engineering and technical and laboratory support services.     *Fluid Competition.*The major competitors in the worldwide drilling fluids market, whichapproximated $6.0 billion in 2006, are Halliburton Energy Services (a division of HalliburtonCompany (“Halliburton”)) and Baker Hughes Drilling Fluids (a division of Baker Hughes, Inc. (“BakerHughes”)). While M-I SWACO and these companies supply a majority of the market, the drillingfluids industry is highly competitive, with a significant number of smaller, locally basedcompetitors. The major competitors in the worldwide completion fluids market, which approximated$1.2 billion in 2006, are Baroid Completion Fluids (a division of Halliburton), Tetra Technologies,Inc., and Baker Hughes.     Generally competition for sales of drilling and completions fluids is based on a number offactors, including wellsite engineering services, product quality and availability, technicalsupport, service response and price.     *M-I SWACO Drilling Waste Management.*M-I SWACO provides services, equipment and engineeringfor solids control, pressure control and waste management to the worldwide drilling market.     Solids-control equipment is used to remove drill cuttings from the fluid system, allowing thedrilling fluid to be cleaned and recirculated. Solids are normally separated from the drillingfluid using one or a combination of the following: balanced elliptical and linear-motion shaleshakers, desanders, desilters, hydroclones, mud cleaners and centrifuges. M-I SWACO designs,manufactures, sells and rents a comprehensive, proprietary line of this equipment for oil and gasdrilling processes throughout the world. The Company is also a leading manufacturer and supplierof screens used in solids-control equipment for both oilfield and certain industrial markets. M-ISWACO complements its product offering by providing engineering and technical support to operatorsand drilling contractors from the planning stages of their projects through waste removal and siteremediation.     Operators employ M-I SWACO-manufactured pressure-control equipment to drill in sour-gas andhigh-pressure zones. Well killing and high-pressure control drilling chokes, together with relatedoperating consoles, are used in the drilling process during well kicks and well clean-up andtesting operations. Degassers and mud gas separators are designed to remove and vent entrainedgases, including toxic gases such as hydrogen sulfide and corrosive oxygen, from the drilling mud.This equipment reduces the risk of dangerous and costly blowouts caused by recirculating mud thatcontains natural gas. Key products in M-I SWACO’s pressure control product line include theMud D-Gasser® and Super ChokeTM, both of which hold strong marketpositions as do the Super Mud Gas SeparatorÔ and the SuperAutochokeÔ.     With drilling operations expanding into more environmentally sensitive areas, there has beenincreased focus on the effective collection, treatment and disposal of waste produced during thedrilling of a well. M-I SWACO provides operators with solutions designed to minimize and treatdrilling waste. The Company provides a suite of waste handling, minimization and managementproducts and services, including the CleanCut® pneumatic conveyance system forcollection and transportation of drill cuttings related to offshore drilling programs. M-I SWACOalso provides rig vacuum systems for cuttings recovery, high-gravity force drying equipment forliquid/solid separation and cuttings slurification and re-injection processes for reducing haul-offwaste. In addition, through the Thermal Phase SeparationTM process, M-I SWACO providesoperators a proven technology for maximizing the recovery of drilling fluids, while minimizingwastes. M-I SWACO’s waste treatment services encompass a wide range of activities, including siteassessment, drill cuttings injection, water treatment, pit closure and remediation, bioremediation,dewatering and thermal processing. The Company has established EnviroCenters®in Norway, Germany and the United States designed specifically for recovering, treating andrecycling solid and liquid drilling wastes.
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     *M-I SWACO Drilling Waste Management Competition.*M-I SWACO competes with Brandt/Rigtech (asubsidiary of National Oilwell Varco, Inc. (“National-Oilwell Varco”)) and Derrick/Oil Tools.Additionally, there are a number of regional suppliers that provide a limited range of equipmentand services tailored for local markets. Competition is based on product availability, equipmentperformance, technical support and price.     *Oilfield Production Chemicals*. M-I SWACO provides a line of oilfield specialty chemicals andrelated technical services through its Oilfield Production Chemical division. Oilfield productionchemicals are used to enhance the flow of hydrocarbons from the wellbore by eliminating paraffin,scale and other byproducts encountered during the production process. Oilfield productionchemicals are also used to protect piping and other equipment associated with the production,transportation and processing of oil and gas.     *Production Chemical Competition.*The major competitors in the worldwide oilfield productionchemical market include Baker Petrolite (a division of Baker Hughes), Nalco Energy Services (adivision of Nalco Company) and Champion Technologies, Inc. Generally, competition is based onproduct quality, product performance, technical support and price.*Smith Technologies*     *Products and Services.*Smith Technologies is a worldwide leader in the design, manufactureand marketing of drill bits primarily used in drilling oil and natural gas wells. In addition,Smith Technologies is a leading provider of downhole turbine drilling products (referred to as“turbodrills”) and services that enhance the operating performance of petroleum drill bits incertain applications. Smith Technologies’ product offerings are designed principally for thepremium market segments where faster drilling rates and greater footage drilled provide significanteconomic benefits in reducing the total cost of a well.     Smith Technologies designs, manufactures and markets three-cone drill bits for the petroleumindustry, ranging in size from 31/2 to 32 inches in diameter. Three-cone bits work by crushing andshearing the rock formation as the bit is turned. These three-cone bits comprise two majorcomponents — the body and the cones, which contain different types of pointed structures referredto as “cutting structures” or “teeth.” The cutting structures are either an integral part of thesteel cone with a hardmetal-applied surface (referred to as “milled tooth”) or made of an insertedmaterial (referred to as “insert”), which is usually tungsten carbide. The Company also producesthree-cone drill bits in which the tungsten carbide insert is coated with polycrystalline diamond.In certain formations, bits produced with diamond-enhanced inserts last longer and increasepenetration rates, which substantially decreases overall drilling costs. Smith Technologies is aleading provider of drill bits utilizing diamond-enhanced insert technology.     In addition, Smith Technologies designs, manufactures and markets diamond drill bits. Diamondbits consist of a single body made of either a matrix powder alloy or steel. The cuttingstructures of diamond bits consist of either polycrystalline diamond cutters, which are brazed onthe bit, or natural or synthetic diamonds, which are impregnated in the bit. These bits, whichrange in size from 23/4 to 26 inches in diameter, work by shearing the rock formation with a millingaction as the bit is turned. Smith Technologies has experienced increased demand for rental ofdiamond bits as improved designs and manufacturing processes have allowed a diamond bit to be usedto drill multiple wells in certain markets.     Smith Technologies also designs, assembles and markets a comprehensive line of turbodrills andprovides related technical support. Turbodrills, which operate directly above the drill bit, usethe hydraulic energy provided by drilling fluid pumps on the rig floor to deliver torque to androtate the drill bit. These proprietary tools are designed to provide faster rates of penetration,operate in much higher temperature formations, deliver longer downhole life and produce betterwellbore quality than conventional positive displacement drilling motors. The turbine drillingmotor provides operators with cost effective solutions in demanding environments such as horizontalapplications, hard formations and high-temperature zones.     The Company manufactures polycrystalline diamond and cubic boron nitride materials that areused in the Company’s three-cone and diamond drill bits and other specialized cutting tools. TheCompany believes that it is one of the world’s largest manufacturers of polycrystalline diamond foruse in oilfield applications. Smith Technologies also develops and uses patented processes forapplying diamonds to a curved surface which optimize the performance of inserts used in drill bits.As a result, the Company believes that Smith Technologies enjoys a competitive advantage in bothmaterial cost and technical ability over other drill bit companies. In addition, the Company’sin-house diamond research, engineering and manufacturing capabilities enhance the Company’s abilityto develop the application of diamond technology across other Smith product lines and intonon-energy markets.
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     *Competition*. Hughes Christensen (a division of Baker Hughes), Security DBS (a division ofHalliburton) and ReedHycalog (a division of Grant Prideco, Inc.) are the three major competitors ofSmith Technologies in the drill bit business. While Smith Technologies and these companies supplythe majority of the worldwide drill bit market, which approximated $2.6 billion in 2006, theycompete with more than 20 companies. Generally, competition for sales of drill bits is based on anumber of factors, including performance, quality, reliability, service, price, technologicaladvances and breadth of products. The Company believes its quality, reliability and technologicaladvances provide its products with a competitive advantage.*Smith Services*     *Products and Services.*Smith Services is a leading global provider of technologicallyadvanced drilling, tubular, fishing, remedial, multilateral and completion products, services andsolutions to the oil and gas drilling industry.     Smith Services’ Drilling Products and Services business provides a broad range of downholeimpact tools for drilling applications as well as numerous other specialized downhole drillingproducts and services. Smith Services sells and rents impact drilling tools such as theHydra-Jar®Tool and the Accelerator®Tool, which are used tofree stuck drill strings during the drilling process. Additionally, Drilling on Gauge Subs andBorrox AP Reamers are some of the Company’s tools used by operators for maintaining hole gauge andquality of the wellbore. Smith Services also offers tubular drill string components, such as drillcollars, subs, stabilizers, kellys and Hevi-WateÔDrillPipe, and provides relatedinspection services, including drillstring repair and rebuild services. These components and theirplacement in the drillstring are supported by engineering and field technical services in order tooptimize bottom hole management techniques. Through state-of-the-art software, Smith Services aidsthe customer in maximizing the life of drillstring components. Rotating control devices for flowcontrol in underbalanced / managed pressure drilling applications and automatic connection torquemonitoring and control systems are designed and manufactured by Smith Services. Smith Servicesalso manufactures and markets hole openers and underreamers which are designed to create largerhole diameters in certain sections of the wellbore. The Company’s patentedRhino® Reamer, Reamaster®and simultaneous drilling andhole enlargement system are three examples of products that aid the customer in realizing lowerdrilling costs through technology. Through the use of the simultaneous drilling and holeenlargement system above the drill bit, the operator may drill the main well bore with the bit andenlarge the diameter of the hole above the drill bit in the same run.     Smith Services’ Fishing and Remedial Services business provides a comprehensive package offishing, remedial and thru-tubing services. Fishing operations clear and remove obstructions from awellbore that may arise during drilling, completion or workover activities or during a well’sproduction phase. This operation requires a wide variety of specialty tools, including fishingjars, milling tools and casing cutters, all of which are manufactured by Smith Services. Thesetools are operated by Company service personnel or sold or rented to third-party fishing companies.     Smith Services provides Wellbore DepartureTM Systems through the manufacture of proprietarycasing exit tools which are installed by trained technicians. These systems, which include thepatented Trackmaster® Plus Whipstock System, allow the operator to divertaround obstructions in the main wellbore or reach multiple production zones from the main wellbore(known as multilateral completions). In addition, Smith Services’ GeotrackTM WhipstockSystem mills the casing exit and continues to drill several hundred feet of formation in asingle trip, saving the customer time and reducing their overall drilling costs. The Company alsoprovides mechanical, hydraulic and explosive pipe-cutting services to remove casing during well orplatform abandonment.     Smith Services’ Completion Systems business specializes in providing fit-for-purpose linerhanger systems, liner cementing equipment, isolation packers, retrievable and permanent packers,and drillable bridge and frac plugs. Liner hangers allow strings of casing to be suspended withinthe wellbore without having to extend the string all the way to the surface and are also used toisolate production zones and formations. Most directional and multilateral wells include one ormore hangers due to complex casing programs and need for zonal isolation. Using Smith Services’Pocket SlipÔliner hanger system, long or heavy liners can be suspendedwith minimal casing distortion and maximum flow-by area. Packers are mechanically or hydraulicallyactuated devices which lock into place at specified depths in the well and provide a seal betweenzones through expanding-element systems. The devices therefore create isolated zones within thewellbore to permit either specific formation production or allow for certain operations, such ascementing or acidizing, to take place without damaging the reservoir. The Smith ServicesIsofracÔ packer selectively isolates multiple zones in a single trip to reducefracturing job time, while the Long ReachÔ packer facilitates successful linerdeployment in vertical and long reach horizontal wellbores without excessive work stringmanipulation. In addition, Smith Services’ top drive cementing manifold eliminates cementcontamination of top drive components by creating a flow path for cement that bypasses the drillingrig’s top drive assembly.
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     *Competition.*Smith Services’ major competitors in the drilling, remedial, re-entry andfishing services markets are Weatherford International, Inc. (“Weatherford”), Baker Oil Tools (adivision of Baker Hughes) and numerous small local companies. The main competitors in the linerhanger and packer markets are Baker Oil Tools, Weatherford and TIW Corporation. The maincompetitors in the drilling and fishing jar market and the fishing product and service market areWeatherford and National-Oilwell Varco. Competition in the drilling and completions sales, rentaland services market is primarily based on performance, quality, reliability, service, price andresponse time and, in some cases, breadth of products.***Distribution Segment****Wilson*     *Products and Services.*Wilson is a supply-chain management company which provides productsand services to the energy, refining, petrochemical, power generation and mining industries.Wilson operates an extensive network of supply branches, service centers and sales offices throughwhich it markets pipe, valves and fittings as well as mill, safety and other maintenance products,predominately in the United States and Canada. In addition, Wilson provides warehouse management,vendor integration and various surplus and inventory management services. The majority of Wilson’soperations are focused on North American distribution of maintenance, repair and operating suppliesand equipment with the remainder associated with line pipe and automated valve products (includingvalve, actuator and control packages).     Approximately 72 percent of Wilson’s 2006 revenues were generated in the energy sector, whichincludes exploration and production companies and companies with operations in the petroleumindustry’s pipeline sector. The remainder related to sales in the downstream and industrialmarket, including refineries, petrochemical and power generation plants and other energy-focusedoperations. Approximately 25 percent of Wilson’s 2006 revenues were reported in Canada,attributable to the CE Franklin Ltd. operations, a publicly-traded distribution business in whichthe Company owns the majority of the outstanding common stock.     *Competition.*Wilson’s competitors in its energy sector operations include National-OilwellVarco, Redman Pipe and Supply Company and a significant number of smaller, locally basedoperations. Wilson’s competitors in the downstream and industrial market include Hagemeyer NV,Ferguson Enterprises, Inc., McJunkin Corporation and W.W. Grainger, Inc. The distribution marketthat Wilson participates in is highly competitive. Generally, competition involves numerousfactors, including price, experience, customer service and equipment availability.**Non-U.S. Operations**     Sales to oil and gas exploration and production markets outside the United States are a keystrategic focus of Smith’s management. The Company markets its products and services throughsubsidiaries, joint ventures and sales agents located in virtually all petroleum-producing areas ofthe world, including Canada, Latin America, Europe/Africa, and Middle East/Asia. Approximately 54percent, 55 percent and 55 percent of the Company’s revenues in 2006, 2005 and 2004, respectively,were derived from equipment or services sold or provided outside the United States. The Company’sDistribution operations constitute a significant portion of the consolidated revenue base and areconcentrated in North America which serves to distort the geographic revenue mix of the Company’sOilfield segment operations. Excluding the impact of the Distribution operations, approximately 63percent, 65 percent and 65 percent of the Company’s revenues were generated in non-U.S. markets in2006, 2005 and 2004, respectively.     Historically, drilling activity outside the United States has been less volatile thanU.S.-based activity as the high cost exploration and production programs outside the United Statesare generally undertaken by major oil companies, consortiums and national oil companies. Theseentities operate under longer-term strategic priorities than do the independent drilling operatorsthat are more common in the U.S. market.**Sales and Distribution**     Sales and service efforts are directed to end users in the exploration and productionindustry, including major and independent oil companies, national oil companies and independentdrilling contractors. The Company’s products and services are primarily marketed through thedirect sales force of each business unit. In certain non-U.S. markets where direct sales effortsare not practicable, the Company utilizes independent sales agents, distributors or joint ventures.
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     Smith maintains field service centers, which function as repair and maintenance facilities forrental tools, operations for remedial and completion services and a base for the Company’s globalsales force, in all major oil and gas producing regions of the world. The location of theseservice centers near the Company’s customers is an important factor in maintaining favorablecustomer relations.**Manufacturing**     The Company’s manufacturing operations, along with quality control support, are designed toensure that all products and services marketed by the Company will meet standards of performanceand reliability consistent with the Company’s reputation in the industry.     Management believes that it generally has sufficient internal manufacturing capacity to meetanticipated demand for its products and services. During periods of peak demand, certain businessunits utilize outside resources to provide additional manufacturing capacity.**Raw Materials**     Through its company-owned mines in and outside the United States, M-I SWACO has the capabilityto produce a large portion of its requirements for barite and bentonite, which are typically addedto engineered fluid systems. Barite reserves are mined in the United States, the United Kingdomand Morocco. Bentonite is produced from ore deposits in the U.S. Mining exploration activitiescontinue worldwide to locate and evaluate ore bodies to ensure deposits are readily available forproduction when market conditions dictate. In addition to its own production, M-I SWACO purchasesthe majority of its worldwide barite requirement from suppliers outside the United States, mainlythe People’s Republic of China, India and Morocco.     The Company purchases a variety of raw materials for its Smith Technologies and Smith Servicesunits, including alloy and stainless steel bars, tungsten carbide inserts and forgings. Generally,the Company is not dependent on any single source of supply for any of its raw materials orpurchased components, and believes that numerous alternative supply sources are available for allsuch materials. The Company does not expect any interruption in supply, but there can be noassurance that there will be no price or supply issues over the long-term. The Company producespolycrystalline diamond materials in Provo, Utah and Scurelle, Italy for utilization in variousCompany products as well as direct customer sales.**Product Development, Engineering and Patents**     The Company’s business units maintain product development and engineering departments whoseactivities are focused on improving existing products and services and developing new technologiesto meet customer demands for improved drilling performance and environmental-based solutions fordrilling and completion operations. The Company’s primary research facilities are located inHouston, Texas; Stavanger, Norway; Aberdeen, Scotland; and Florence, Kentucky.     The Company also maintains a drill bit database which records the performance of drill bitsover the last 20 years, including those manufactured by competitors. This database gives theCompany the ability to monitor, among other things, drill bit failures and performance improvementsrelated to product development. The Company believes this proprietary database gives it acompetitive advantage in the drill bit business.     The Company has historically invested significant resources in research and engineering inorder to provide customers with broader product lines and technologically-advanced products andservices. The Company’s expenditures for research and engineering activities are attributable tothe Company’s Oilfield Products and Services segment and totaled $88.3 million in 2006, $73.6million in 2005 and $67.2 million in 2004. In 2006, research and engineering expendituresapproximated 1.6 percent of the Company’s Oilfield Products and Services segment revenues.     Although the Company has over 3,900 issued and pending patents and regards its patents andpatent applications as important in the operation of its business, it does not believe that anysignificant portion of its business is materially dependent upon any single patent.**Employees**     At December 31, 2006, the Company had 17,377 full-time employees throughout the world. Mostof the Company’s employees in the United States are not covered by collective bargaining agreementsexcept in certain U.S. mining operations of M-I SWACO and several distribution locations of Wilson.The Company considers its labor relations to be satisfactory.
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**Officers of the Registrant**     The names and ages of all officers of the Company, all positions and offices with the Companypresently held by each person named and their business experience are stated below. Positions,unless otherwise specified, are with the Company.   **Name, Age and Positions** **Principal Current Occupation and Other Significant Positions Held**Doug Rock (60)Chairman of the Board, ChiefExecutive Officer, Presidentand Chief Operating Officer Chairman of the Board sinceFebruary 1991, elected ChiefExecutive Officer in March1989 and served as Presidentand Chief Operating Officersince December 1987. Heldvarious positions sincejoining the Company in June1974.   Malcolm W. Anderson (59)Senior Vice President,Human Resources Senior Vice President, HumanResources since December2006. Joined Company as VicePresident, Human Resources inMay 2004. Vice PresidentHuman Resources at HewlettPackard from January 2001 toApril 2004. Vice PresidentHuman Resources atWeatherford InternationalLtd. from April 1996 toDecember 2000.   Richard E. Chandler, Jr. (50)Senior Vice President, GeneralCounsel and Secretary Senior Vice President andSecretary since January 2006and General Counsel sinceAugust 2005. Joinedpredecessor to M-I SWACO inDecember 1986 as VicePresident, General Counseland Secretary. Named SeniorVice President –Administration, GeneralCounsel and Secretary of M-ISWACO in January 2004.   Margaret K. Dorman (43)Senior Vice President, ChiefFinancial Officer and Treasurer Senior Vice President, ChiefFinancial Officer andTreasurer since June 1999.Joined Company as Director ofFinancial Reporting inDecember 1995 and named VicePresident, Controller andAssistant Treasurer inFebruary 1998.   Bryan L. Dudman (50)President, Smith Services President, Smith Servicessince January 2006. Heldvarious positions sincejoining the Company inJanuary 1979. Prior to beingnamed to current position,served as Senior VicePresident of M-I SWACO’sWestern Hemisphere Operationssince May 1994.   John J. Kennedy (54)President and Chief ExecutiveOfficer, Wilson President and Chief ExecutiveOfficer, Wilson since June1999. Held various positionssince joining the Company inNovember 1986. Elected VicePresident, Chief AccountingOfficer and Treasurer inMarch 1994 and named SeniorVice President, ChiefFinancial Officer andTreasurer in April 1997.   Donald McKenzie (57)President, M-I SWACO President of M-I SWACO sinceMay 2006. Held variouspositions since joining theCompany in 1989. NamedSenior Vice President of M-ISWACO’s Eastern HemisphereOperations of M-I SWACO inApril 1994. Appointed ChiefOperating Officer of M-ISWACO in January 2006.   Michael D. Pearce (59)President, Smith Technologies President, Smith Technologiessince May 2005. JoinedCompany as Vice PresidentSales of the Company’sGeoDiamond Division in April1995 and named Vice PresidentSales of Smith Technologiesin August 1998.   Peter J. Pintar (48)Vice President, CorporateStrategy and Development Vice President CorporateStrategy and Developmentsince September 2005. Heldvarious positions at DTEEnergy Company betweenOctober 1997 and August 2005,including Director –Corporate Development,Managing Director – VentureCapital Investments, andDirector – InvestorRelations.   Joseph S. Rinando, III (35)Vice President and Controller Vice President and Controllersince April 2006. JoinedCompany as Director ofFinancial Reporting in May2003. Served as Audit Managerfor PricewaterhouseCoopersLLP from July 2000 to June2002 and Senior Manager fromJuly 2002 to May 2003.   Geri D. Wilde (56) Vice President, Taxes andAssistant Treasurer Vice President, Taxes sinceFebruary 1998. JoinedCompany as Manager of Taxesand Payroll of predecessor toM-I SWACO in December 1986and named Director of Taxesand Assistant Treasurer inApril 1997.All officers of the Company are elected annually by the Board of Directors. They hold office untiltheir successors are elected and qualified. There are no family relationships between the officersof the Company.
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**Item 1A.*****Risk Factors***     This document contains forward-looking statements within the meaning of the Section 21E of theSecurities Exchange Act of 1934, as amended, concerning, among other things, our outlook, financialprojections and business strategies, all of which are subject to risks, uncertainties andassumptions. These forward-looking statements are identified by their use of terms such as“anticipate,” “believe,” “could,” “estimate,” “expect,” “project” and similar terms. Thesestatements are based on certain assumptions and analyses that we believe are appropriate under thecircumstances. Such statements are subject to, among other things, general economic and businessconditions, the level of oil and natural gas exploration and development activities, globaleconomic growth and activity, political stability of oil-producing countries, finding anddevelopment costs of operations, decline and depletion rates for oil and natural gas wells,seasonal weather conditions, industry conditions, and changes in laws or regulations, many of whichare beyond the control of the Company. Should one or more of these risks or uncertaintiesmaterialize, or should the assumptions prove incorrect, actual results may differ materially fromthose expected, estimated or projected. Our management believes these forward-looking statementsare 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 thedate they are made, and we undertake no obligation to publicly update or revise any of them inlight of new information, future events or otherwise.     With this in mind, you should consider the risks discussed elsewhere in this report and otherdocuments we file with the Securities and Exchange Commission from time to time and the followingimportant factors that could cause our actual results to differ materially from those expressed inany forward-looking statement made by us or on our behalf.***We are dependent on the level of oil and natural gas exploration and development activities.***     Demand for our products and services is dependent upon the level of oil and natural gasexploration and development activities. The level of worldwide oil and natural gas developmentactivities is primarily influenced by the price of oil and natural gas, as well as priceexpectations. In addition to oil and natural gas prices, the following factors impactexploration and development activity and may lead to significant changes in worldwide activitylevels: **•** Overall level of global economic growth and activity;  **•** Actual and perceived changes in the supply and demand for oil and natural gas;  **•** Political stability and policies of oil-producing countries;  **•** Finding and development costs of operators;  **•** Decline and depletion rates for oil and natural gas wells; and  **•** Seasonal weather conditions that temporarily curtail drilling operations.     Changes in any of these factors could adversely impact our financial condition or resultsof operations.***There are certain risks associated with conducting business in markets outside of North America.***     We are a multinational oilfield service company and generate the majority of our Oilfieldsegment revenues in markets outside of North America. Changes in conditions within certaincountries that have historically experienced a high degree of political and/or economicinstability could adversely impact our financial condition or results of operations.Additional risks inherent in our non-North American business activities include: **•** Changes in political and economic conditions in the countries in whichwe operate, including civil uprisings, riots and terrorist acts;  **•** Unexpected changes in regulatory requirements;  **•** Fluctuations in currency exchange rates and the value of the U.S. dollar;  **•** Restrictions on repatriation of earnings or expropriation of property without fair compensation;  **•** Governmental actions that result in the deprivation of contract rights; and  **•** Governmental sanctions.
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***We operate in a highly technical and competitive environment.***     We operate in a highly-competitive business environment. Accordingly, demand for ourproducts and services is largely dependent on our ability to provide leading-edge,technology-based solutions that reduce the operator’s overall cost of developing energy assets.If competitive or other market conditions impact our ability to continue providingsuperior-performing product offerings, our financial condition or results of operations couldbe adversely impacted.***Our businesses are subject to a variety of governmental regulations.***     We are exposed to a variety of federal, state, local and international laws andregulations relating to matters such as environmental, health and safety, export control,currency exchange, labor and employment and taxation. These laws and regulations are complex,change frequently and have tended to become more stringent over time. In the event the scopeof these laws and regulations expand in the future, the incremental cost of compliance couldadversely impact our financial condition or results of operations.***Our industry is experiencing more litigation involving claims of infringement of intellectualproperty rights.***     Over the past few years, our industry has experienced increased litigation related to theinfringement of intellectual property rights. Although no material matters are pending orthreatened at this time, we, as well as certain of our competitors, have been named asdefendants in various intellectual property matters in the past. These types of claims aretypically costly to defend, involve monetary judgments that, in certain circumstances, aresubject to being enhanced and are often brought in venues which have proved to be favorable toplaintiffs. If we are served with an intellectual property claim which we are unsuccessful indefending, it could adversely impact our results of operations and cash flows.
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**Item 1B.*****Unresolved Staff Comments***     None.**Item 2.*****Properties***     The principal facilities and properties utilized by the Company at December 31, 2006 are shownin the table below. Generally, the facilities and properties are owned by the Company.             Principal Products Processed Land  Approx. Bldg. Space Location or Manufactured (Acres)  (sq.ft.) *Oilfield Segment:*        Houston, Texas Tubulars, surface and downhole tools, remedial          products, liner hangers, diamond drill bits,          turbodrills, drilling and fishing jars and fishing          tool equipment  88   873,600 Houston, Texas M-I SWACO corporate headquarters and research center  18   246,000 Florence, Kentucky Separator units, mill units, parts, screens and motors  6   214,000 Ponca City, Oklahoma Three-cone drill bits  15   207,000 Aberdeen, Scotland Downhole tools and remedial products  10   132,000 Greybull, Wyoming Bentonite mine and processing  8,394   110,000 Saline di Volterra, Italy Three-cone drill bits  11   99,900 Tulsa, Oklahoma Oilfield and industrial screening products  7   95,000 Edinburgh, Scotland Wire cloth and oilfield screening products  3   92,450 Aberdeen, Scotland Downhole tools  10   91,000 Provo, Utah Synthetic diamond materials  5   68,300 Karmoy, Norway Barite and bentonite processing  5   51,000 Greystone, Nevada Barite mine and processing  268   50,000 Macon, Georgia Separator units and screens  1   49,000 Battle Mountain, Nevada Barite processing  23   43,000 Zelmou, Morocco Barite mine  3,954   41,000 Zavalla, Texas Drilling fluid chemical products  33   36,000 Nivellas, Belgium Separator units, mill units, parts, screens and motors  5   35,000 Scurelle, Italy Diamond drill bits and synthetic diamond materials  4   31,000 Spruce Grove, Canada Drilling fluid processing  7   30,450 Amelia, Louisiana Barite processing  26   25,000 Berra, Italy Solids control equipment  4   24,929 Port Fouchon, Louisiana Drilling fluid storage, processing and distribution  11   24,600 Salzweld, Germany Drilling fluid processing  2   23,000 Galveston, Texas Barite processing  6   21,000 Grand Prairie, Canada Fishing and remedial services  4   13,959 Aberdeen, Scotland Barite and bentonite processing  2   12,000 Foss/Aberfeldy, Scotland Barite mine and processing  102   10,000 Mountain Springs, Nevada Barite mine  900   —            *Distribution Segment:*          Houston, Texas Pipe, valves and fittings  11   198,000 Tampa, Florida Pipe, valves and fittings  4   86,200 Trainer, Pennsylvania Pipe, valves and fittings  3   23,000      The Company considers its mines and manufacturing and processing facilities to be in goodcondition and adequately maintained. The Company also believes its facilities are suitable fortheir present and intended purposes and are generally adequate for the Company’s current andanticipated level of operations.     The Company’s Corporate headquarters is located in a leased office building in Houston, Texas.The Company leases various other administrative and sales offices, as well as warehouses andservice centers in the United States and other countries in which it conducts business. TheCompany believes that it will be able to renew and extend its property leases on terms satisfactoryto the Company or, if necessary, locate substitute facilities on acceptable terms.
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**Item 3.*****Legal Proceedings***     Information relating to various commitments and contingencies, including legal proceedings, isdescribed in Note 2 and Note 17 of the Consolidated Financial Statements included elsewhere in thisreport on Form 10-K and is incorporated herein by reference.**Item 4.*****Submission of Matters to a Vote of Security Holders***     None.**PART II****Item 5.*****Market for the Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities***     The common stock of the Company is traded on several market exchanges, including the New YorkStock Exchange, under the symbol “SII”. The following are the high and low sale prices for theCompany’s common stock as reported on the New York Stock Exchange Composite Tape for the periodsindicated, and adjusted for the two-for-one stock split effective August 24, 2005.                                   **2005 Common Stock**  **2006 Common Stock**   **Q1**  **Q2**  **Q3**  **Q4**  **Q1**  **Q2**  **Q3**  **Q4** High $32.77  $32.06  $35.23  $39.59  $44.63  $44.35  $45.79  $44.11 Low $25.96  $27.92  $31.91  $29.61  $35.66  $36.17  $36.05  $35.89      On February 23, 2007, the Company had 1,841 common stock holders of record and the lastreported closing price on the New York Stock Exchange Composite Tape was $42.10.*Stock Repurchases*     In October 2005, the Company’s Board of Directors approved a new repurchase program thatallows for the purchase of up to 20 million shares of the Company’s common stock, subject toregulatory issues, market considerations and other relevant factors. During the fourth quarter of2006, the Company repurchased 0.3 million shares of common stock in the open market at an aggregatecost, including commissions, of $13.1 million. As of December 31, 2006, the Company hasrepurchased 2.7 million shares at an average cost of $38.66 per share under the current program.The acquired shares have been added to the Company’s treasury stock holdings.     The following table summarizes the Company’s repurchase activity for the three months endedDecember 31, 2006:                           Total Number of Shares      Total Number  Average  Purchased as Part of  Number of Shares that   of Shares  Price Paid  Publicly Announced  May Yet Be Purchased Period Purchased  per Share  Program  Under the Program October 1 — 31  —  $—   —   17,581,800 November 1 — 30  —   —   —   17,581,800 December 1 — 31  317,587   41.21   317,587   17,264,213              4th  Quarter 2006  317,587  $41.21   317,587   17,264,213 *Dividend Program*     In February 2005, the Company’s Board of Directors approved a regular quarterly cash dividendprogram. The Board of Directors declared dividends of $64.0 million and $48.4 million for theyears ended December 31, 2006 and 2005, respectively.     On February 7, 2007, the Company’s Board of Directors increased the quarterly cash dividend to$0.10 per share, beginning with the distribution payable April 16, 2007 to stockholders of recordon March 15, 2007. The level of future dividend payments will be at the discretion of the Board ofDirectors and will depend upon the Company’s financial condition, earnings and cash flow fromoperations, the level of its capital expenditures, compliance with certain debt covenants, futurebusiness prospects and other factors that the Board of Directors deem relevant.
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**Item 6.*****Selected Financial Data***                       **For the Years Ended December 31,**   **2006**  **2005**  **2004**(a)  **2003**  **2002**       (In thousands, except per share data)     **Statements of Operations Data:**                    Revenues $7,333,559  $5,579,003  $4,419,015  $3,594,828  $3,170,080                      Gross profit  2,344,271   1,685,138   1,351,939   1,075,931   918,302                      Operating income  1,080,081   670,561   438,764   328,747   256,148                      Income before cumulativeeffect of change inaccounting principle  502,006   302,305   182,451   124,634   93,189                      Diluted earnings per sharebefore cumulative effect ofchange in accountingprinciple(b)   2.49   1.48   0.89   0.62   0.47                      **Balance Sheet Data:**                    Total assets $5,335,475  $4,059,914  $3,506,778  $3,097,047  $2,749,545                      Long-term debt  800,928   610,857   387,798   488,548   441,967                      Total stockholders’ equity  1,986,937   1,578,505   1,400,811   1,235,776   1,063,535                      Cash dividends declared percommon share(c)   0.32   0.24   —   —   —      The Selected Financial Data above should be read together with the Notes to ConsolidatedFinancial Statements and Management’s Discussion and Analysis of Financial Condition and Results ofOperations included elsewhere in this Form 10-K in order to understand factors, such as businesscombinations completed during 2006, 2005 and 2004, and unusual items, which may affect thecomparability of the Selected Financial Data. (a) In 2004, the Company recognized a $31.4 million, or $0.10 per share, patentlitigation-related charge. (b) All fiscal years prior to 2005 have been restated for the impact of a two-for-one stockdividend distributed on August 24, 2005. (c) In February 2005, the Company’s Board of Directors approved a regular quarterly cash dividendprogram. For additional information regarding the Company’s dividend program, see Part II,Item 5. “Market for the Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities” to this Form 10-K.
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**Item 7.*****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 ofOperations” is provided to assist readers in understanding the Company’s financial performanceduring the periods presented and significant trends which may impact the future performance of theCompany. This discussion should be read in conjunction with the Consolidated Financial Statementsof the Company and the related notes thereto included elsewhere in this Form 10-K. This discussionincludes forward-looking statements that are subject to risks and uncertainties. Actual resultsmay differ materially from the statements we make in this section due to a number of factors thatare discussed beginning on page 9.**Company Products and Operations**     The Company is a leading global provider of premium products and services to the oil and gasexploration and production industry. The Company provides a comprehensive line oftechnologically-advanced products and engineering services, including drilling and completion fluidsystems, solids-control and separation equipment, waste-management services, oilfield productionchemicals, three-cone and diamond drill bits, turbine products, tubulars, fishing services,drilling tools, underreamers, casing exit and multilateral systems, packers and liner hangers. TheCompany also offers supply chain management solutions through an extensive North American branchnetwork 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 theseprojects. Although E&P spending is significantly influenced by the market price of oil and naturalgas, it may also be affected by supply and demand fundamentals, finding and development costs,decline and depletion rates, political actions and uncertainties, environmental concerns, thefinancial condition of independent E&P companies and the overall level of global economic growthand activity. In addition, approximately eight percent of the Company’s consolidated revenuesrelate to the downstream energy sector, including petrochemical plants and refineries, whosespending 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 greatlyin terms of primary business drivers and associated volatility levels. North American drillingactivity is primarily influenced by natural gas fundamentals, with approximately 82 percent of thecurrent rig count focused on natural gas finding and development activities. Conversely, drillingin areas outside of North America is more dependent on crude oil fundamentals, which influence overthree-quarters of international drilling activity. Historically, business in markets outside ofNorth America has proved to be less volatile as the high cost E&P programs in these regions aregenerally undertaken by major oil companies, consortiums and national oil companies as part of alonger-term strategic development plan. Although close to 60 percent of the Company’s consolidatedrevenues were generated in North America during 2006, Smith’s profitability was largely dependentupon business levels in markets outside of North America. The Distribution segment, which accountsfor approximately 26 percent of consolidated revenues and primarily supports a North Americancustomer base, serves to distort the geographic revenue mix of the Company. Excluding the impactof the Distribution segment, 55 percent of the Company’s 2006 revenues were generated in marketsoutside of North America.**Business Outlook**     The Company’s business is highly dependent on the general economic environment in the UnitedStates and other major world economies, which impact energy consumption and the resulting demandfor our products and services. In 2006, the average worldwide rig count grew 13 percent over theprior year period influenced, in part, by higher commodity prices which resulted in increasedinvestment in oil-focused drilling projects in markets outside of North America.     The Company anticipates modest growth in exploration and production spending in 2007 which isexpected to be concentrated in the Eastern Hemisphere regions and, to a lesser extent, in the U.S.offshore market. Although the long-term outlook for North American land-based drilling activityis favorable based upon expected growth in worldwide energy consumption, an adverse change innear-term market fundamentals could cause activity reductions for marginal land-based projects.     There are a number of factors which influence forecasted exploration and production spending.Ultimately, any significant deterioration in the global economic environment or prolonged weaknessin commodity prices could affect worldwide drilling activity and demand for our products andservices.
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**Results of Operations***Segment Discussion*     The Company markets its products and services throughout the world through four business unitswhich are aggregated into two reportable segments. The Oilfield segment consists of three businessunits: M-I SWACO, Smith Technologies and Smith Services. The Distribution segment includes theWilson business unit. The revenue discussion below has been summarized by business unit in orderto provide additional information in analyzing the Company’s operations.                           **For the Years Ended December 31,**   **2006**  **2005**  **2004**   **Amount**  **%**  **Amount**  **%**  **Amount**  **%** ***Financial Data:****(dollars in thousands)*                        **Revenues:**                        M-I SWACO $3,573,395   49  $2,682,511   48  $2,231,884   50 Smith Technologies  790,131   11   601,821   11   511,410   12 Smith Services  1,024,212   14   694,667   12   493,045   11                    Oilfield  5,387,738   74   3,978,999   71   3,236,339   73 Wilson  1,945,821   26   1,600,004   29   1,182,676   27                    Total $7,333,559   100  $5,579,003   100  $4,419,015   100                                             **Geographic Revenues:**                        United States:                        Oilfield $2,009,997   27  $1,393,564   25  $1,128,294   26 Distribution  1,374,732   19   1,127,142   20   854,173   19                    Total United States  3,384,729   46   2,520,706   45   1,982,467   45                    Canada:                        Oilfield  404,121   6   313,912   6   225,629   5 Distribution  487,167   6   399,653   7   261,923   6                    Total Canada  891,288   12   713,565   13   487,552   11                    Non-North America:                        Oilfield  2,973,620   41   2,271,523   41   1,882,416   43 Distribution  83,922   1   73,209   1   66,580   1                    Total Non-North America  3,057,542   42   2,344,732   42   1,948,996   44                    Total Revenue $7,333,559   100  $5,579,003   100  $4,419,015   100                                             **Operating Income:**                        Oilfield $1,012,295   19  $625,384   16  $423,648   13 Distribution  101,830   5   64,714   4   26,513   2 General Corporate  (34,044)  *   (19,537)  *   (11,397)  *                    Total $1,080,081   15  $670,561   12  $438,764   10                                             ***Market Data:***                        **Average Worldwide Rig Count:**(1)                         United States  1,901   47   1,666   47   1,417   45 Canada  413   10   408   11   348   11 Non-North America  1,747   43   1,517   42   1,377   44                    Total  4,061   100   3,591   100   3,142   100                    Onshore  3,523   87   3,069   85   2,667   85 Offshore  538   13   522   15   475   15                    Total  4,061   100   3,591   100   3,142   100                                             **Average Commodity Prices:**                        Crude Oil ($/Bbl)(2)  $66.25      $56.71      $41.47     Natural Gas ($/mcf)(3)   6.98       9.01       6.18      (1)  Source: M-I SWACO. (2) Average daily West Texas Intermediate (“WTI”) spot closing prices, as quoted by NYMEX. (3) Average daily Henry Hub, Louisiana spot closing prices, as quoted by NYMEX. * not meaningful
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*Oilfield Segment**Revenues*     M-I SWACO primarily provides drilling and completion fluid systems, engineering and technicalservices to the oil and gas industry. Additionally, these operations provide oilfield productionchemicals and manufacture and market equipment and services used for solids-control, particleseparation, pressure control, rig instrumentation and waste-management. M-I SWACO is significantlyinfluenced by exploration and production spending in markets outside of North America, whichcontributes approximately two-thirds of the unit’s revenues, and by its exposure to the U.S.offshore market, which constitutes nine percent of the revenue base. U.S. offshore drillingaccounts for approximately three percent of the worldwide rig count and generally is morerevenue-intensive than land-based projects due to the complex nature of the related drillingenvironment. For the year ended December 31, 2006, M-I SWACO reported revenues of $3.6 billion, anincrease of 33 percent over the prior year period. Excluding the impact of acquired operations,revenues grew 31 percent over the prior year. Approximately two-thirds of the base revenueincrease was generated in markets outside of North America, primarily reflecting new contractawards and increased customer activity in the Europe/Africa and Middle East offshore markets.North American base revenues grew 33 percent above the prior year level, largely attributable toincreased investment by exploration and production companies in land-based drilling projects andthe impact of price increases implemented in late 2005. M-I SWACO’s revenues totaled $2.7 billionfor the year ended December 31, 2005, an increase of 20 percent over the prior year period. Over60 percent of the business growth was generated in the Eastern Hemisphere influenced by an 11percent increase in corresponding activity levels and the impact of new contract awards. Increasedexploration and production spending in the North American market, driven by the significantincrease in the number of land-based drilling programs and, to a lesser extent, the impact of priceincreases initiated throughout 2005 also contributed to the year-over-year revenue improvement.     Smith Technologies designs and manufactures three-cone drill bits, diamond drill bits andturbines for use in the oil and gas industry. Due to the nature of its product offerings, revenuesfor these operations typically correlate more closely to the rig count than any of the Company’sother businesses. For the year ended December 31, 2006, Smith Technologies reported revenues of$790.1 million, an increase of 31 percent over the prior year period. The majority of the revenueincrease was reported by the Western Hemisphere operations, influenced by higher U.S. land-baseddrilling activity, improved pricing and, to a lesser extent, strong demand for turbine products inthe Latin America market. Revenues generated in the Eastern Hemisphere region increased 30percent, contributing one-third of the revenue improvement over the prior year period. Theyear-over-year increase reflects growth in the Middle East, Former Soviet Union (“FSU”) and theNorth Sea area, attributable to new contract awards and improved market penetration. SmithTechnologies reported revenues of $601.8 million for the year ended December 31, 2005, an 18percent increase over the prior year level. The year-over-year revenue growth resulted fromincreased unit sales and rentals of diamond drill bits, as technological advancements in fixedcutter drill bit manufacturing and design has influenced a shift from roller-cone toward diamonddrill bit product offerings. To a lesser extent, the impact of higher unit pricing and continueddemand for turbine products contributed to the year-over-year revenue improvement.     Smith Services manufactures and markets products and services used in the oil and gas industryfor drilling, work-over, well completion and well re-entry. Revenues for Smith Services arerelatively balanced between North America and the international markets and are heavily influencedby the complexity of drilling projects, which drive demand for a wider range of its productofferings. For the year ended December 31, 2006, Smith Services reported revenues of $1.0 billion,47 percent above the prior year period. The year-over-year revenue growth was significantlyinfluenced by increased demand for tubular products in the U.S. market. Excluding the impact oftubular product sales, which are not highly correlated to drilling activity, business volumesincreased 29 percent above the prior year period. Two-thirds of the core business growth wasreported in North America, reflecting increased customer demand for premium remedial product andservice lines. The revenue growth in markets outside of North America was, again, driven byincreased demand for remedial product offerings, primarily in the Middle East, North Sea and FSUregions. Smith Services reported revenues of $694.7 million for the year ended December 31, 2005,a 41 percent increase over the amount reported in 2004. Excluding the effect of acquiredoperations, revenues increased 34 percent influenced by higher worldwide exploration and productionspending levels. The majority of the base revenue growth was generated in North America, asincreased activity levels impacted tubular product sales, which were twice the level reported inthe prior year. Approximately one-third of the year-over-year base revenue growth was reported inmarkets outside of North America, driven by strong demand for remedial product and service lines inthe Middle East and North Sea markets.
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*Operating Income*     Operating income for the Oilfield segment was $1.0 billion, or 18.8 percent of revenues, forthe 2006 fiscal year period. The segment operating margins were 3.1 percentage points above theprior year level with incremental operating income approximating 28 percent of revenues. Theoperating margin growth was predominantly driven by increased business volumes, but was also favorably impacted by an improved businessmix and pricing initiatives. To a lesser extent, the margin improvement wasinfluenced by improved general and administrative cost coverage. On an absolute dollar basis,fiscal 2006 operating income increased $386.9 million over the prior year, largely attributable tothe impact of a 35 percent increase in business volumes on gross profit, mitigated by highervariable-based operating expenses, including investment in personnel and infrastructure to supportthe expanding business operations. For the year ended December 31, 2005, Oilfield operating incomewas $625.4 million, or 15.7 percent of revenues. The year-over-year comparison to 2004 wasimpacted by litigation-related charges, including $5.6 million and $31.4 million in 2005 and 2004,respectively. Excluding the impact of these charges, segment operating margins increased 1.8percentage points above the 2004 level. The year-over-year operating margin expansion primarilyreflects reduced operating expenses as a percentage of revenues associated with improved fixed costcoverage in the sales and administrative functions. Gross margins improved slightly reflecting theimpact of increased fixed cost absorption in the segment’s manufacturing operations and higher unitpricing, partially offset by a combination of an unfavorable shift in business mix and risingcommodity costs. Fiscal 2005 operating income increased $175.9 million over the 2004 period, netof the litigation-related charges. The growth in operating income was attributable to the impactof higher business volumes on gross profit, partially offset by higher variable-based operatingexpenses associated with the expanding business base.*Distribution Segment**Revenues*     Wilson markets pipe, valves, fittings and mill, safety and other maintenance products toenergy and industrial markets, primarily through an extensive network of supply branches in theUnited States and Canada. The segment has the most significant North American revenue exposure ofany of the Company’s operations with approximately 96 percent of Wilson’s 2006 revenues generatedin those markets. Moreover, approximately 28 percent of Wilson’s revenues relate to sales to thedownstream energy sector, including petrochemical plants and refineries, whose spending is largelyinfluenced by the general state of the U.S. economic environment. Additionally, certain customersin this sector utilize petroleum products as a base material and, accordingly, are adverselyimpacted by increases in crude oil and natural gas prices. For the year ended December 31, 2006,Wilson reported revenues of $1.9 billion, 22 percent above the prior year. Two-thirds of therevenue growth was generated by the upstream energy operations, reflecting higher spending byexploration and production companies associated with increased North American drilling andcompletion activity and the impact of new contract awards. Industrial and downstream sales volumesgrew 13 percent, influenced by increased customer spending related to line pipe projects. Wilsonreported revenues totaling $1.6 billion for the year ended December 31, 2005, an increase of 35percent from the 2004 fiscal year. Approximately three-quarters of the revenue growth wasgenerated in the upstream energy operations reflecting higher spending by exploration andproduction companies associated with increased North American drilling and completion activity, theimpact of new contract awards and strong demand for tubular products. Industrial and downstreamsales volumes grew 17 percent above 2004 levels, influenced by increased spending levels for linepipe and maintenance and repair projects primarily in the engineering and construction andpetrochemical customer base.*Operating Income*     Operating income for the Distribution segment in fiscal 2006 was $101.8 million, or 5.2percent of revenues. The operating margin improvement of 1.2 percentage points reflects loweroperating expenses as a percentage of revenues and, to a lesser extent, gross margin expansion.Incremental operating income was 11 percent of revenues, with the majority of the growthattributable to the energy sector operations, influenced by increased coverage of fixed sales andadministrative costs. On an absolute dollar basis, segment operating income was $37.1 millionabove the amount reported in 2005, impacted by a 22 percent increase in revenue volumes on thesegment’s reported gross profit, partially offset by higher variable-based operating expenses. Forthe year ended December 31, 2005, operating income for the Distribution segment was $64.7 million,or four percent of revenues. Distribution operating results increased $38.2 million over theamount reported in 2004, equating to incremental operating income of nine percent of revenues.Incremental operating income was driven by the energy sector operations reflecting increasedcoverage of fixed sales and administrative costs. The lower expense ratio more than offsetdeterioration in gross profit margins associated with increased tubular product costs and a highermix of project and export orders, which typically generate lower comparable margins.
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*Consolidated Discussion*     For the periods indicated, the following table summarizes the consolidated results ofoperations of the Company and presents these results as a percentage of total revenues (dollars inthousands):                           **For the Years Ended December 31,**   **2006**  **2005**  **2004**   **Amount**  **%**  **Amount**  **%**  **Amount**  **%** Revenues $7,333,559   100  $5,579,003   100  $4,419,015   100                                             Gross profit  2,344,271   32   1,685,138   30   1,351,939   31                          Operating expenses  1,264,190   17   1,014,577   18   913,175   21                                             Operating income  1,080,081   15   670,561   12   438,764   10                          Interest expense  62,967   1   44,446   1   38,762   1                          Interest income  (2,982)  —   (1,692)  —   (1,300)  —                                             Income before income taxes andminority interests  1,020,096   14   627,807   11   401,302   9                          Income tax provision  326,674   4   202,743   4   129,721   3                          Minority interests  191,416   3   122,759   2   89,130   2                                             Net income $502,006   7  $302,305   5  $182,451   4                    *2006 versus 2005*     Consolidated revenues increased to $7.3 billion for the year ended December 31, 2006, 31percent above the prior year period. The majority of the year-over-year revenue growth wasreported in the Oilfield segment attributable to a combination of higher worldwide drillingactivity, a favorable product and business mix and, to a lesser extent, improved pricing.On a geographic basis, two-thirds of the revenue improvement was generated in the WesternHemisphere market, which accounted for the majority of theyear-over-year increase in drilling activity levels.The year-over-year revenue growth was also driven bythe strength in the Company’s international operations which reporteda 33 percent increase in revenues.     Gross profit totaled $2.3 billion, or 32 percent of revenues, two percentage points above thegross profit margins generated in the comparable prior year period. Although the margin expansionwas largely driven by the impact of increased sales volumes on fixed manufacturing and serviceinfrastructure costs, an improved business mix and product pricing also had a favorable effect. Onan absolute dollar basis, gross profit was $659.1 million above the prior year period primarilyreflecting the increased sales volumes in the Oilfield operations.     Operating expenses, consisting of selling, general and administrative expenses increased$249.6 million from the amount reported in the prior year; however, as a percentage of revenuesdecreased 95 basis points. Improved fixed cost average in the sales and administrative functionsaccounted for the operating expense percentage decline. The majority of the absolute dollarincrease was attributable to variable costs directly associated with the improved business volumes,including increased investment in personnel and infrastructure. To a lesser extent, increasedemployee profit-sharing amounts directly attributable to the reported profitability levels,incremental operating expenses of acquired operations and stock-based compensation expense alsocontributed to the year-over-year operating expense growth.     Net interest expense, which represents interest expense less interest income, totaled $60.0million in 2006. Net interest expense increased $17.2 million from the prior year reflectinghigher average debt levels in 2006 due to borrowings related to the financing of severalacquisitions and, to a lesser extent, an increase in variable interest rates.
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     The effective tax rate approximated 32 percent, partially impacted by the settlement of a U.S.tax audit that resulted in the release of certain deferred tax reserves during the second quarterof 2006. Excluding the tax settlement, the effective rate was comparable to the level reported inthe prior year, but below the U.S. statutory rate due to the impact of M-I SWACO’s U.S. partnershipearnings for which the minority partner is directly responsible for its related income taxes. TheCompany properly consolidates the pretax income related to the minority partner’s share of U.S.partnership earnings but excludes the related tax provision.     Minority interests reflect the portion of the results of majority-owned operations which areapplicable to the minority interest partners. Minority interests totaled $191.4 million in 2006, a$68.7 million increase from the prior year. The year-over-year increase primarily reflects thehigher profitability of the M-I SWACO joint venture and, to a lesser extent, improved earningsreported by CE Franklin Ltd.*2005 versus 2004*     Consolidated revenues increased to $5.6 billion for the year ended December 31, 2005, 26percent above the prior year period. The majority of the year-over-year dollar variance wasreported in the Oilfield segment primarily attributable to higher worldwide drilling activity. Ona geographic basis, two-thirds of the revenue improvement was generated in North America impactedby a combination of increased land-based drilling activity, strong demand for tubular products andimproved pricing. Increased business volumes in markets outside North America also contributed tothe year-over-year revenue variance, reflecting higher customer spending levels and the impact ofnew contract awards.     Gross profit totaled $1.7 billion, or 30 percent of revenues, less than one percentage pointbelow the gross profit margins generated in 2004. The modest decline in gross profit marginsreflects an increased proportion of Distribution segment sales, which historically generate lowermargins than the Oilfield operations. To a lesser extent, gross profit margin deteriorationreported in the Distribution segment also contributed to the reduction in consolidated gross profitmargins. On an absolute dollar basis, gross profit was $333.2 million above the prior year periodprimarily reflecting the increased sales volumes in the Oilfield operations.     Operating expenses, consisting of selling, general and administrative expenses, increased$101.4 million from the amount reported in the 2004 fiscal year. The year-over-year operatingexpense variance was impacted by litigation-related charges, including $5.6 million recorded in2005 and $28.8 million recognized during 2004, related to the settlement, legal fees and othercosts directly associated with a patent infringement case. Excluding the litigation-relatedcharges, operating expenses increased $124.6 million on an absolute dollar basis, but decreased twopercentage points from the prior year period, as a percentage of revenues. The majority of theabsolute dollar increase was attributable to variable costs directly associated with the improvedbusiness volumes, including increased investment in personnel and infrastructure. To a lesserextent, increased employee profit-sharing amounts directly attributable to the reportedprofitability levels and stock-based compensation expense associated with restricted stock awardsalso contributed to the year-over-year operating expense growth.     Net interest expense, which represents interest expense less interest income, totaled $42.8million in 2005. Net interest expense increased $5.3 million from the 2004 level reflecting higheraverage debt levels between the periods and, to a lesser extent, an increase in variable interestrates.     The effective tax rate approximated 32 percent, which was comparable to the level reported in2004, but below the U.S. statutory rate. The effective tax rate was lower than the U.S. statutoryrate due to the impact of M-I SWACO’s U.S. partnership earnings for which the minority partner isdirectly responsible for its related income taxes. The Company properly consolidates the pretaxincome related to the minority partner’s share of U.S. partnership earnings but excludes therelated tax provision.     Minority interests reflect the portion of the results of majority-owned operations which areapplicable to the minority interest partners. Minority interests totaled $122.8 million in 2005, a$33.6 million increase from 2004. The year-over-year increase primarily reflects the higherprofitability of the M-I SWACO joint venture and, to a lesser extent, improved earnings reported byCE Franklin Ltd.
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**Liquidity and Capital Resources***General*     At December 31, 2006, cash and cash equivalents equaled $80.4 million. During 2006, theCompany generated $287.2 million of cash flows from operations, which is $67.8 million above theamount reported in 2005. Increased profitability levels experienced by the Company were offset byhigher working capital investment required to support the significant increase in business volumes.     In 2006, cash flows used in investing activities totaled $470.9 million, primarily consistingof amounts required to fund capital expenditures and acquisitions. The Company invested $257.7million in property, plant and equipment, net of cash proceeds associated with certain assetdisposals, as well as, funds received related to property insurance claims. Acquisition funding,which primarily related to the purchase of Specialised Petroleum Services Group Limited and EpconOffshore AS, resulted in cash outflows of $226.7 million in 2006.     Projectednet capital expenditures for 2007 are expected to approximate $285 million. Themodest increase in planned investment year-over-year is associated with growth in spending for the rental equipment fleet to support marketexpansion efforts in the United States and certain key international regions. The majority of the 2007 capital spendingconsists of investment for routine additions of rental tool and manufacturing equipment to supportthe Company’s operations and maintenance of the Company’s capital equipment base.     Cash flows provided by financing activities totaled $199.5 million in 2006. Due to the higherbusiness volumes, which impacted the required investment in working capital, cash flows fromoperations were not sufficient to fund investing activities, repurchases under the Company’s stockbuyback program and dividend payments. This resulted in incremental borrowings of $346.8 millionfinanced by the issuance of publicly-traded debt instruments and, to a lesser extent, thenegotiation of foreign-currency denominated term loans with two financial institutions.     The Company’s primary internal source of liquidity is cash flow generated from operations.Cash flow generated from operations is primarily influenced by the level of worldwide drillingactivity, which affects profitability levels and working capital requirements. Capacity underrevolving credit agreements is also available, if necessary, to fund operating or investingactivities. As of December 31, 2006, the Company had $235.0 million of capacity available under itsU.S. revolving credit facilities for future operating, investing or financing needs. The Companyalso has revolving credit facilities in place outside of the United States, which are generallyused to fund local operating needs. At the end of fiscal 2006, the Company had available borrowingcapacity of $112.7 million under the non-U.S. borrowing facilities.     The Company’s external sources of liquidity include debt and equity financing in the publiccapital markets, if needed. The Company carries an investment-grade credit rating with recognizedrating agencies, generally providing the Company with access to debt markets. The Company’soverall borrowing capacity is, in part, dependent on maintaining compliance with financialcovenants under the various credit agreements. As of December 31, 2006, the Company was wellwithin the covenant compliance thresholds under its various loan indentures, as amended, providingthe ability to access available borrowing capacity. Management believes funds generated byoperations, amounts available under existing credit facilities and external sources of liquiditywill be sufficient to finance capital expenditures and working capital needs of the existingoperations for the foreseeable future.     Management continues to evaluate opportunities to acquire products or businesses complementaryto the Company’s operations. Additional acquisitions, if they arise, may involve the use of cashor, depending upon the size and terms of the acquisition, may require debt or equity financing.     During 2005, the Company’s Board of Directors approved a quarterly cash dividend program. OnFebruary 7, 2007, the Company’s Board of Directors increased the quarterly cash dividend to $0.10per share. The current annualized payout of approximately $80 million is expected to be fundedwith cash flows from operations and, if necessary, amounts available under existing creditfacilities. The level of future dividend payments will be at the discretion of the Company’s Boardof Directors and will depend upon the Company’s financial condition, earnings, cash flows,compliance with certain debt covenants and other relevant factors.
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     In October 2005, the Company’s Board of Directors authorized a share repurchase program thatallows for the purchase of up to 20 million shares of the Company’s common stock, subject toregulatory issues, market considerations and other relevant factors. As of December 31, 2006, theCompany had 17.3 million shares remaining under the current authorizations. Future repurchasesunder the program may be executed from time to time in the open market or in privately negotiatedtransactions and will be funded with cash flows from operations or amounts available under existingcredit facilities.     The Company believes that it has sufficient existing manufacturing capacity to meet currentdemand for its products and services. Additionally, inflation has had a modest impact on theCompany’s financial results in the three most recent fiscal years, with the Company experiencing aslight escalation in wages, transportation costs, as well as, petrochemical, steel and othercommodity prices during 2006. The Company expects to be able to continue to offset the impact ofcost inflation going forward through productivity gains and price increases.     The Company has not engaged in off-balance sheet financing arrangements through specialpurpose entities, and the consolidation of the Company’s minority ownership positions would notresult in an increase in reported leverage ratios. The Company has no contractual arrangements inplace that could result in the issuance of additional shares of the Company’s common stock at afuture date other than the Company’s stock-based compensation program, which is discussed in Note1, “Summary of Significant Accounting Policies,” and Note 15, “Long-Term Incentive Compensation.”**Contractual Obligations, Commitments and Contingencies***Contractual Obligations*     The following table summarizes the Company’s debt maturities, estimated interest on fixed ratelong-term debt and future minimum payments under non-cancelable operating leases having initialterms in excess of one year as of December 31, 2006 (in thousands):                           Amount of Commitment Expiration per Period      Less than  1-3  3-5  More than   Total  1 year  years  years  5 years                      Debt maturities $1,088,632  $287,704  $67,801  $432,311  $300,816                      Interest on fixed ratelong-term debt  245,065   39,983   62,700   50,944   91,438                      Operating lease commitments  191,862   54,524   68,396   32,178   36,764                                      Total $1,525,559  $382,211  $198,897  $515,433  $429,018                      In the normal course of business, the Company enters into lease agreements with cancellationprovisions as well as agreements with initial terms of less than one year. The costs related tothese leases have been reflected in rent expense, which totaled $127.1 million in 2006, but havebeen appropriately excluded from the future minimum payments presented in the table above. Amountsrelated to commitments under capital lease agreements, as well as pension and other postretirementobligations, were immaterial for the periods presented.*Standby Letters of Credit*     In the normal course of business with customers, vendors and others, the Company iscontingently liable for performance under standby letters of credit and bid, performance and suretybonds. Certain of these outstanding instruments guarantee payment to insurance companies whichreinsure certain liability coverages of the Company’s insurance captive. Excluding the impact ofthese instruments, for which $19.4 million of related liabilities are reflected in the accompanyingconsolidated balance sheet, the Company was contingently liable for approximately $78.3 million ofstandby letters of credit and bid, performance and surety bonds at December 31, 2006. Managementdoes not expect any material amounts to be drawn on these instruments.*Insurance*     The Company maintains insurance coverage for various aspects of its business and operations.The Company has elected to retain a portion of losses that occur through the use of deductibles andretentions under its insurance programs. Amounts in excess of the self-insured retention levelsare fully insured to limits believed appropriate for the Company’s operations. Self-insuranceaccruals are based on claims filed and an estimate for claims incurred but not reported. Whilemanagement believes that amounts accrued in the accompanying consolidated financial statements areadequate for expected liabilities arising from the Company’s portion of losses, estimates of theseliabilities may change as circumstances develop.
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*Litigation**Rose Dove Egle v. John M. Egle, et al.*     In April 1997, the Company acquired all of the equity interests in Tri-Tech Fishing Services,L.L.C. (“Tri-Tech”) in exchange for cash consideration of approximately $20.4 million (the“Transaction”).     In August 1998, the Company was added as a defendant in a First Amended Petition filed in the15th  Judicial District Court, Parish of Lafayette, Louisiana entitled Rose Dove Egle v.John M. Egle, et al. In the amended petition, the plaintiffs alleged that, due to an improperconveyance of ownership interest by the Tri-Tech majority partner prior to the Transaction, Smithpurchased a portion of its equity interest from individuals who were not legally entitled to theirTri-Tech shares. The suit was tried in the first quarter of 2004, and a jury verdict ofapproximately $4.8 million was rendered in favor of the plaintiffs. The Company has appealed theverdict and does not anticipate a ruling until the third quarter of 2007. Based upon the facts andcircumstances and the opinion of outside legal counsel, management believes that an unfavorableoutcome on this matter is not probable at this time. Accordingly, the Company has not recognized aloss provision in the accompanying consolidated financial statements.*Other*     The Company is a defendant in various other legal proceedings arising in the ordinary courseof business. In the opinion of management, these matters will not have a material adverse effecton the Company’s consolidated financial position or results of operations.*Environmental*     The Company routinely establishes and reviews the adequacy of reserves for estimated futureenvironmental clean-up costs for properties currently or previously operated by the Company.     As of December 31, 2006, the Company’s environmental reserve totaled $8.4 million. Thisamount reflects the future undiscounted estimated exposure related to identified properties,without regard to indemnifications from former owners. While actual future environmental costs maydiffer from estimated liabilities recorded at December 31, 2006, the Company does not believe thatthese differences will have a material impact on the Company’s financial position or results ofoperations.
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**Critical Accounting Policies and Estimates**          The discussion and analysis of financial condition and results of operations are based uponthe Company’s consolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparation of these financialstatements requires management to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure of contingent assets andliabilities. The Company evaluates its estimates on an on-going basis, based on historicalexperience and on various other assumptions that are believed to be reasonable under thecircumstances. Actual results may differ from these estimates under different assumptions orconditions.          The Company believes the following describes significant judgments and estimates used in thepreparation of its consolidated financial statements:*Allowance for doubtful accounts.*The Company extends credit to customers and other parties inthe normal course of business. Management regularly reviews outstanding receivables and providesfor estimated losses through an allowance for doubtful accounts. In evaluating the level ofestablished reserves, management makes judgments regarding the parties’ ability to make requiredpayments, economic events and other factors. As the financial condition of these parties change,circumstances develop or additional information becomes available, adjustments to the allowancefor doubtful accounts may be required.*Inventory reserves.*The Company has made significant investments in inventory to service itscustomers around the world. On a routine basis, the Company uses judgments in determining thelevel of reserves required to state inventory at the lower of cost or market. Management’sestimates are primarily influenced by technological innovations, market fundamentals and thephysical condition of products. Changes in these or other factors may result in adjustments tothe carrying value of inventory.*Goodwill*. The Company has acquired a number of operations during the past decade, which hasresulted in the recording of a material amount of goodwill. Under SFAS No. 142, “Goodwill andOther Intangible Assets,” the Company is required to perform an annual goodwill impairmentevaluation, which is largely influenced by future cash flow projections. Estimating future cashflows of the Company’s operations requires management to make judgments about future operatingresults and working capital requirements. Although the majority of the goodwill relates to theCompany’s Oilfield operations, $40.7 million of goodwill relates to Distribution transactions.Changes in cash flow assumptions or other factors that negatively impact the fair value of theoperations would influence the evaluation and may result in the determination that a portion ofthe goodwill is impaired when the annual analysis is performed.*Self-Insurance*. The Company maintains insurance coverage for various aspects of its business andoperations. The Company retains a portion of losses that occur through the use of deductiblesand retentions under self-insurance programs. Management regularly reviews estimates of reportedand unreported claims and provides for losses through insurance reserves. As claims develop andadditional information becomes available, adjustments to loss reserves may be required.*Income taxes*. Deferred tax assets and liabilities are recognized for differences between thebook basis and tax basis of the net assets of the Company. In providing for deferred taxes,management considers current tax regulations, estimates of future taxable income and availabletax planning strategies. In certain cases, management has established reserves to reducedeferred tax assets to estimated realizable value. If tax regulations, operating results or theability to implement tax planning strategies vary, adjustments to the carrying value of deferredtax assets and liabilities may be required.*Environmental Obligations*. The Company records liabilities for environmental obligations whenremedial efforts are probable and the costs can be reasonably estimated. Management’s estimatesare based on currently enacted laws and regulations. As more information becomes available orenvironmental laws and regulations change, such liabilities may be required to be adjusted.Additionally, in connection with acquisitions, the Company generally obtains indemnificationsfrom the seller related to environmental matters. If the indemnifying parties do not fulfilltheir obligations, adjustments of recorded amounts may be required.
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**Recent Accounting Pronouncements**     From time to time, new accounting pronouncements are issued by the Financial AccountingStandards Board (“FASB”) that are adopted by the Company as of the specified effective date.     In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accountingand disclosure requirements for uncertainty in tax positions. FIN 48 requires a two-step approachto evaluate tax positions and determine if they should be recognized in the financial statements.This approach involves recognizing any tax positions that are “more likely than not” to occur andthen measuring those positions to determine if they are recognizable in the financial statements.The provisions of FIN 48 are effective and the Company will adopt the interpretation in the firstquarter of 2007. Based on our evaluation as of December 31, 2006, we do not expect the adoption ofFIN 48 to have a material impact on our consolidated financial statements.     In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No.158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — anamendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). Effective December 31,2006, SFAS 158 requires recognition of the funded status of an entity’s defined benefit pension andother postretirement benefit plans as an asset or liability in the Company’s consolidated balancesheet. Subsequent changes to the funded status are to be recognized through stockholders’ equityas a component of comprehensive income. In addition, for fiscal years ending after December 15,2008, SFAS 158 requires the adoption of certain provisions related to the measurement date ofobligations and assets used to calculate the funded status. The December 31, 2006 adoption of therecognition provisions of SFAS 158 did not have a material impact on the Company’s consolidatedfinancial position or results of operations. We do not expect the remaining elements of theStatement to have a material impact on our consolidated financial statements.     Management believes the impact of other recently issued standards, which are not yeteffective, will not have a material impact on the Company’s consolidated financial statements uponadoption.
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**Item 7A. Quantitative and Qualitative Disclosures about Market Risk**     The Company is exposed to market risks from changes in interest rates and foreign exchangerates and enters into various hedging transactions to mitigate these risks. The Company does notuse financial instruments for trading or speculative purposes. See Note 10, “FinancialInstruments,” to the Consolidated Financial Statements for additional discussion of hedginginstruments.     The Company’s exposure to interest rate changes is managed through the use of a combination offixed and floating rate debt and by entering into interest rate contracts, from time to time, on aportion of its long-term borrowings. The Company had no interest rate contracts outstanding as ofDecember 31, 2006 and 2005. At December 31, 2006, 35 percent of the Company’s long-term debtcarried a variable interest rate. Management believes that significant interest rate changes willnot have a material near-term impact on the Company’s future earnings or cash flows.     The Company’s exposure to changes in foreign exchange rates is managed primarily through theuse of forward exchange contracts. These contracts increase or decrease in value as foreignexchange rates change, to protect the value of the underlying transactions denominated in foreigncurrencies. All currency contracts are components of the Company’s hedging program and are enteredinto for the sole purpose of hedging an existing or anticipated currency exposure. The gains andlosses on these contracts offset changes in the value of the related exposures. The terms of thesecontracts generally do not exceed two years. As of December 31, 2006, the notional amounts of fairvalue hedge contracts and cash flow hedge contracts outstanding were $126.9 million and $20.8million, respectively, and the fair value was less than the notional amount of these contracts by$0.2 million. As of December 31, 2005, the notional amount of fair value hedge contracts and cashflow hedge contracts outstanding were $99.8 million and $40.4 million, respectively, and the fairvalue was less than the notional amount of these contracts by $1.7 million. In some areas, wherehedging is not cost effective, the Company addresses foreign currency exposure utilizing workingcapital management.     The Company utilizes a “Value-at-Risk” (“VAR”) model to determine the maximum potentialone-day loss in the fair value of its foreign exchange sensitive financial instruments. The VARmodel estimates were made assuming normal market conditions and a 95 percent confidence level. TheCompany’s VAR computations are based on the historical price movements in various currencies (a“historical” simulation) during the year. The model includes all of the Company’s foreign exchangederivative contracts. Anticipated transactions, firm commitments and assets and liabilitiesdenominated in foreign currencies, which certain of these instruments are intended to hedge, wereexcluded from the model. The VAR model is a risk analysis tool and does not purport to representactual losses in fair value that will be incurred by the Company, nor does it consider thepotential effect of favorable changes in market factors. The estimated maximum potential one-dayloss in fair value of currency sensitive instruments, calculated using the VAR model, was notmaterial to the Company’s financial position or results of operations.
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**Item 8. Financial Statements and Supplementary Data****Management’s Report on Internal Control Over Financial Reporting**Management of the Company is responsible for establishing and maintaining effective internalcontrol over financial reporting as defined in Rule 13a — 15(f) under the Securities Exchange Actof 1934. The Company’s internal control over financial reporting is designed to providereasonable, not absolute, assurance to the Company’s management and board of directors regardingthe preparation and fair presentation of published financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent ordetect misstatements. Therefore, even those systems determined to be effective can provide onlyreasonable, not absolute, assurance with respect to financial statement preparation andpresentation.The Company’s management assessed the effectiveness of the Company’s internal control overfinancial reporting based on criteria established in Internal Control—Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment,management believes that the Company’s internal control over financial reporting was effective asof December 31, 2006.Management’s assessment of the effectiveness of internal control over financial reporting as ofDecember 31, 2006 has been audited by Deloitte & Touche LLP, the independent registered publicaccounting firm who also audited the Company’s consolidated financial statements. The Deloitte &Touche LLP attestation report on management’s assessment of the Company’s internal control overfinancial reporting appears on page 27 of this Annual Report on Form 10-K.     /s/ Doug Rock /s/ Margaret K. Dorman   Doug Rock  Margaret K. Dorman  Chairman of the Board and Senior Vice President,  Chief Executive Officer Chief Financial Officer and Treasurer  
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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**To the Board of Directors and Stockholders of Smith International, Inc.:We have audited management’s assessment, included in the accompanying Management’s Report onInternal Control Over Financial Reporting, that Smith International, Inc. and subsidiaries (the“Company”) maintained effective internal control over financial reporting as of December 31, 2006,based on criteria established in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission. The Company’s management is responsible formaintaining effective internal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit.We conducted our audit in accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides a reasonable basisfor our opinions.A company’s internal control over financial reporting is a process designed by, or under thesupervision of, the company’s principal executive and principal financial officers, or personsperforming similar functions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of the assets of thecompany; (2) provide reasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally accepted accounting principles,and that receipts and expenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.Because of the inherent limitations of internal control over financial reporting, including thepossibility of collusion or improper management override of controls, material misstatements due toerror or fraud may not be prevented or detected on a timely basis. Also, projections of anyevaluation of the effectiveness of the internal control over financial reporting to future periodsare subject to the risk that the controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures may deteriorate.In our opinion, management’s assessment that the Company maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in all material respects, based onthe criteria established in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained,in all material respects, effective internal control over financial reporting as ofDecember 31, 2006, based on the criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.We have also audited, in accordance with the standards of the Public Company Accounting OversightBoard (United States), the consolidated financial statements and financial statement schedule as ofand for the year ended December 31, 2006 of the Company and our report dated February 28, 2007expressed an unqualified opinion on those financial statements and financial statement schedule andincluded an explanatory paragraph regarding the Company’s adoption of new accounting standards.DELOITTE & TOUCHE LLPHouston, Texas