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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 OF 1934******For the Fiscal Year Ended December 31, 2005******OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934******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 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 Act.     Large Accelerated Filer þ Accelerated Filer o Non-Accelerated Filer o .     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 ofthe Act). Yes o No þ.     The aggregate market value of the voting stock held by non-affiliates on June 30, 2005 was$6,367,781,265 (199,930,338 shares at the closing price on the New York Stock Exchange of $31.85,as adjusted for the two-for-one stock split effective August 24, 2005). On June 30, 2005,212,332,278 shares of common stock were outstanding. For this purpose all shares held by officersand directors and their respective affiliates are considered to be held by affiliates, but neitherthe Registrant nor such persons concede that they are affiliates of the Registrant.     There were 213,757,655 shares of common stock outstanding on March 6, 2006.**DOCUMENTS INCORPORATED BY REFERENCE**     Portions of the Proxy Statement related to the Registrant’s 2006 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  10 Item 2. Properties  10 Item 3. Legal Proceedings  11 Item 4. Submission of Matters to a Vote of Security Holders  11          PART II           Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities  11 Item 6. Selected Financial Data  12 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations  13 Item 7A. Quantitative and Qualitative Disclosures about Market Risk  24 Item 8. Financial Statements and Supplementary Data  25 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  52 Item 9A. Controls and Procedures  52 Item 9B. Other Information  52          PART III           Item 10. Directors and Executive Officers of the Registrant  53 Item 11. Executive Compensation  53 Item 12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters  53 Item 13. Certain Relationships and Related Transactions  53 Item 14. Principal Accountant Fees and Services  53          PART IV           Item 15. Exhibits and Financial Statement Schedules  54  Form of Nonstatutory Option Agreement Form of Restricted Stock Unit Agreement Form of Performance-Based Restricted Stock Unit Agreement Amendment to Employement Agreement - Richard A. Werner Employment Agreement - Richard A. Werner 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 of Pursuant to Section 1350
 

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**PART I****Item 1.*****Business*****General**     Smith International, Inc. (“Smith” or the “Company”) is a leading worldwide supplier ofpremium products and services to the oil and gas exploration and production industry, thepetrochemical industry and other industrial markets. The Company provides a comprehensive line oftechnologically-advanced products and engineering services, including drilling and completion fluidsystems, solids-control equipment, waste-management services, production chemicals, three-cone anddiamond drill bits, turbines, fishing services, drilling tools, underreamers, casing exit andmultilateral systems, packers and liner hangers. The Company also offers supply-chain managementsolutions through an extensive North American branch network providing pipe, valves, fittings,mill, safety and 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 Products andServices and Distribution. The Oilfield Products and Services segment consists of: M-I SWACO, a 60percent-owned joint venture which provides drilling and completion fluid systems and services,solids-control and separation equipment, waste-management services and oilfield productionchemicals; Smith Technologies, which manufactures and sells three-cone drill bits, diamond drillbits and turbine products; and Smith Services, which manufactures and markets products and servicesused for drilling, workover, well completion and well re-entry operations. The Distributionsegment consists of one business unit, Wilson, which markets pipe, valves and fittings as well asmill, safety and other maintenance products 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 Note15 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 Products and Services 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 drilling fluids, which primarily are used to drill water-sensitive shales, reduce torqueand drag and are widely used in areas where stuck
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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, significantlyreducing time on location and overall drilling costs. Synthetic-base drilling fluids are used indrilling environments where oil-base fluids are environmentally prohibited and provide theperformance benefits of oil-base systems. Synthetic-base systems are particularly advantageous inthe 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 $4.7 billion in 2005, 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$0.8 billion in 2005, are Baroid Completion Fluids (a division of Halliburton), Tetra Technologies,Inc., BJ Services Company and Ambar, Inc.     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 equipment and 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, acquired in 2003.Oilfield production chemicals are used to enhance the flow of hydrocarbons from the wellbore byeliminating paraffin, scale and other byproducts encountered during the production process.Oilfield production chemicals are also used to protect piping and other equipment associated withthe 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.     *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 supply the majority of the worldwide drill bit market,which approximated $2.0
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billion in 2005, they compete with more than 20 companies. Generally,competition for sales of drill bits is based on a number of factors, including performance,quality, reliability, service, price, technological advances and breadth of products. The Companybelieves its quality, reliability and technological advances, such as diamond-enhanced inserts,provide its products with a competitive advantage.*Smith Services*     *Products and Services.*Smith Services is a leading global provider of technologicallyadvanced drilling, fishing, remedial, multilateral and completion products, services and solutionsto 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.     *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
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companies. The main competitors in the liner hanger 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 70 percent of Wilson’s 2005 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 2005 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, Europe/Africa, the Middle East, Latin America and the Far East.Approximately 55 percent, 55 percent and 56 percent of the Company’s revenues in 2005, 2004 and2003, respectively, were derived from equipment or services sold or provided outside the UnitedStates. The Company’s Distribution operations constitute a significant portion of the consolidatedrevenue base and are concentrated in North America which serves to distort the geographic revenuemix of the Company’s Oilfield segment operations. Excluding the impact of the Distributionoperations, approximately 65 percent of the Company’s revenues were generated in non-U.S. marketsfor each of the 2005, 2004 and 2003 fiscal years.     Historically, drilling activity outside the United States has been less volatile than U.S.based activity as the high cost exploration and production programs outside the United States aregenerally 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.     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 these service centers near the Company’s customers is an importantfactor in maintaining favorable customer relations.
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**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 United States. Mining explorationactivities continue worldwide to locate and evaluate ore bodies to ensure deposits are readilyavailable for production when market conditions dictate. In addition to its own production, M-ISWACO purchases the majority of its worldwide barite requirement from suppliers outside the UnitedStates, mainly the 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 $73.6 million in 2005, $67.2million in 2004 and $55.6 million in 2003. In 2005, research and engineering expendituresapproximated 1.8 percent of the Company’s Oilfield Products and Services segment revenues.     Although the Company has over 2,900 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, 2005, the Company had 14,697 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 (59)Chairman of the Board, ChiefExecutive Officer, Presidentand Chief Operating Officer Chairman ofthe Board sinceFebruary 1991, elected ChiefExecutive Officer in March1989 and served as Presidentand Chief Operating Officersince December 1987. Heldvarious positions sincejoining the Company in June1974, served as President ofthe Company’s Drilco Divisionbeginning April 1982 and wasnamed President of theCompany’s Smith Tool Divisionin July 1985.   Loren K. Carroll (62)Executive Vice President ofthe Company, President andChief Executive Officer ofM-I SWACO President and Chief ExecutiveOfficer of M-I SWACO sinceMarch 1994, Executive VicePresident since October 1992and member of the Board ofDirectors since November1987. Joined Company inDecember 1984 as VicePresident and Chief FinancialOfficer and served in thatcapacity until March 1989.Rejoined the Company inOctober 1992 as ExecutiveVice President and ChiefFinancial Officer.   Richard E. Chandler, Jr. (49)Senior Vice President, GeneralCounsel and Secretary Senior Vice President andSecretary since January 2006and served as General Counselsince August 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 (42)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 (49)President, Smith Services President, Smith Servicessince January 2006. Heldvarious positions sincejoining the Company inJanuary 1979. Named SeniorVice President World WideOperations of the Company’sSmith Tool Division in March1993 and Senior VicePresident Western HemisphereOperations of M-I SWACO inMay 1994.   John J. Kennedy (53)President and Chief ExecutiveOfficer, Wilson President and Chief ExecutiveOfficer, Wilson since June1999. Joined Company asTreasury Manager in November1986, named Treasury Director- International Operations inNovember 1987 and served asTreasurer beginning May 1991.Elected Vice President,Chief Accounting Officer andTreasurer in March 1994 andnamed Senior Vice President,Chief Financial Officer andTreasurer in April 1997.   Michael D. Pearce (58)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.   Neal S. Sutton (60)Senior Vice President — Law Senior Vice President – Lawsince January 2006. JoinedCompany as Vice President,Secretary and General Counselin January 1991, named VicePresident – Administration inMarch 1992 and Senior VicePresident – Administration,General Counsel and Secretaryin December 1994.   Malcolm W. Anderson (58)Vice President,Human Resources Vice President, HumanResources since May 2004.Vice President HumanResources of Hewlett Packardfrom January 2001 to April2004. Vice President HumanResources of WeatherfordInternational Ltd. from April1996 to December 2000.   Peter J. Pintar (47)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.   David R. Cobb (40)Vice President and Controller Vice President and Controllersince July 2002. JoinedCompany as AssistantController in October 2001.Assistant Treasurer, KentElectronics Corporation fromApril 1997 to September 2001.   Geri D. Wilde (55)Vice President, Taxes andAssistant Treasurer Vice President, Taxes sinceFebruary 1998. JoinedCompany as Manager of Taxesand Payroll of M-I SWACO inDecember 1986 and namedDirector of Taxes andAssistant Treasurer in April1997.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 Section 21E of theSecurities Exchange Act of 1934, as amended, concerning, among other things, our outlook, financialprojections and business strategies. These forward-looking statements are identified by their useof terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,”, “expected”, “project” andsimilar terms. These statements are based on certain assumptions and analyses that we believe arereasonable under the circumstances. However, our assumptions could prove to be incorrect.Furthermore, such statements are subject to risks and uncertainties, many of which are beyond thecontrol of the Company, that could cause actual results to differ materially from expected results.You should not place undue reliance on these forward-looking statements, which are based only onour current expectations. Forward-looking statements speak only as of the date they are made, andwe undertake no obligation to publicly update or revise any of them in light 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 SEC from time to time and the following important factors that couldcause our actual results to differ materially from those expressed in any forward-looking statementmade 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 impact explorationand development activity and may lead to significant changes in worldwide activity levels: **•** 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 results ofoperations.***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 economic instabilitycould adversely impact our financial condition or results of operations. Additional risks inherentin our non-North American business activities include: **•** Changes in political and economic conditions in the countries in which weoperate, 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.***We operate in a highly technical and competitive environment.***     We operate in a highly-competitive business environment. Accordingly, demand for our productsand services is largely dependent on our ability to provide leading-edge, technology-basedsolutions that reduce the operator’s overall cost of developing energy assets. If competitive orother market conditions impact our ability to continue providing superior-performing productofferings, our financial condition or results of operations could be 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 and regulationsrelating to environmental, health and safety, export control, currency exchange, labor andemployment and taxation matters. These laws and regulations are complex, change frequently andhave tended to become more stringent over time. In the event the scope of these laws andregulations expand in the future, the incremental cost of compliance could adversely impact ourfinancial condition or results of operations.
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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, 2005 are shownin the table below. Generally, the facilities and properties are owned by the Company.             Principal Products Processed Land Approx. Bldg.Location or Manufactured (Acres) Space(sq.ft.)*Oilfield Products and Services Segment:*        Houston, Texas Tubulars, surface and downhole tools, remedialproducts, liner hangers, diamond drill bits,turbodrills, drilling and fishing jars and fishingtool equipment  88   850,000 Houston, Texas M-I SWACO corporate headquarters and research center  18   223,000 Ponca City, Oklahoma Three-cone drill bits  15   207,000 Florence, Kentucky Separator units, mill units, parts, screens and motors  15   145,000 Aberdeen, Scotland Downhole tools and remedial products  10   132,000 Greybull, Wyoming Bentonite mine and processing  8,394   110,000 Tulsa, Oklahoma Oilfield and industrial screening products  7   95,000 Saline di Volterra, Italy Three-cone drill bits  11   92,000 Edinburgh, Scotland Wire cloth and oilfield screening products  3   91,400 Aberdeen, Scotland Downhole tools  10   91,000 Karmoy, Norway Barite and bentonite processing  5   51,000 Greystone, Nevada Barite mine and processing  268   50,000 Battle Mountain, Nevada Barite processing  23   43,000 Provo, Utah Synthetic diamond materials  4   43,000 Nisku, Canada Tubulars and drill collars  10   42,000 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   32,000 Scurelle, Italy Diamond drill bits and synthetic diamond materials  4   31,000 Amelia, Louisiana Barite processing  26   25,000 Port Fouchon, Louisiana Drilling fluid storage, processing and distribution  11   24,600 Spruce Grove, Canada Drilling fluid processing  3   24,000 Berra, Italy Solids control equipment  2   24,000 Salzweld, Germany Drilling fluid processing  2   23,000 Galveston, Texas Barite processing  6   21,000 Macon, Georgia Separator units and screens  1   18,000 Aberdeen, Scotland Barite and bentonite processing  2   12,000 Foss/Aberfeldy, Scotland Barite mine and processing  102   10,000 Grand Prairie, Canada Fishing and remedial services  2   9,000 Mountain Springs, Nevada Barite mine  900        —           *Distribution Segment:*          Houston, Texas Pipe, valves and fittings  11   198,000 Trainer, Pennsylvania Pipe, valves and fittings  3   23,000 Tampa, Florida Pipe, valves and fittings  4   16,000      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 16 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 the New York Stock Exchange and the Pacific StockExchange. The following are the high and low sale prices for the Company’s common stock asreported on the New York Stock Exchange Composite Tape for the periods indicated, and adjusted forthe two-for-one stock split effective August 24, 2005.                                   **2004 Common Stock** **2005 Common Stock**  **Q1** **Q2** **Q3** **Q4** **Q1** **Q2** **Q3** **Q4**     High $27.36  $28.88  $30.71  $31.25  $32.77  $32.06  $35.23  $39.59 Low $20.14  $24.03  $26.09  $26.99  $25.96  $27.92  $31.91  $29.61      On March 6, 2006, the Company had 1,965 common stock holders of record and the last reportedclosing price on the New York Stock Exchange Composite Tape was $38.12.*Stock Repurchases*     In October 2005, the Company completed a previously announced share repurchase program. OnOctober 20, 2005, the Board of Directors approved a new repurchase program that allows for thepurchase of up to 20 million shares of the Company’s common stock, subject to regulatory issues,market considerations and other relevant factors. During the fourth quarter of 2005, the Companyrepurchased 0.3 million shares of common stock under the programs at an aggregate cost of $9.6million. The acquired shares have been added to the Company’s treasury stock holdings and may beused in the future for acquisitions or other corporate purposes.     The following table summarizes the Company’s repurchase activity for the three months endedDecember 31, 2005:                            Total Number of       Total Number   Average   Shares Purchased as   Number of Shares that    of Shares   Price Paid   Part of Publicly   May Yet Be Purchased Period  Purchased   per Share   Announced Programs   Under the Programs October 1 – 31  225,000   $30.25   225,000   19,997,200 November 1 – 30          —          —           —   19,997,200 December 1 – 31    76,000   $36.64     76,000   19,921,200              4th Quarter 2005  301,000   $31.86   301,000   19,921,200 *Dividend Program*     On February 2, 2005, the Company’s Board of Directors approved a cash dividend program forstockholders and declared a quarterly cash dividend of $0.06 pershare, after adjusting for theAugust 2005 stock dividend. The Board of Directors declared dividends of $48.4 million anddistributed cash dividends of $36.4 million during 2005. On March 1, 2006, the Company’s Board ofDirectors approved an increase in the quarterly cash dividend to $0.08 per share, beginning withthe distribution payable April 14, 2006 to stockholders of record on March 15, 2006. The level offuture dividend payments will be at the discretion of the Board of Directors and will depend uponthe Company’s financial condition, earnings and cash flow from operations, the level of its capitalexpenditures, compliance with certain debt covenants, its future business prospects and otherfactors that the Board of Directors deems relevant.
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**Item 6.*****Selected Financial Data***                       **For the Years Ended December 31,**  **2005** **2004**(a) **2003** **2002** **2001**      (In thousands, except per share data)    **Statements of Operations Data:**                    Revenues $5,579,003  $4,419,015  $3,594,828  $3,170,080  $3,551,209                      Gross profit  1,685,138   1,351,939   1,075,931   918,302   1,045,804                      Operating income  670,561   438,764   328,747   256,148   371,510                      Income before cumulativeeffect of change inaccounting principle  302,305   182,451   124,634   93,189   152,145                      Earnings per share beforecumulative effect of changein accounting principle –diluted basis(b)  1.48   0.89   0.62   0.47   0.76                      **Balance Sheet Data:**                    Total assets $4,059,914  $3,506,778  $3,097,047  $2,749,545  $2,735,828                      Long-term debt  610,857   387,798   488,548   441,967   538,842                      Total stockholders’ equity  1,578,505   1,400,811   1,235,776   1,063,535   949,159                      Cash dividends declared percommon share(c)  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 changesin the method of accounting for goodwill, business combinations completed during 2005, 2004 and2003, and unusual items, which may affect the comparability 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) On February 2, 2005, the Company’s Board of Directors approved a cash dividend program forstockholders and declared a quarterly cash dividend of $0.06 pershare, after adjusting for the August 2005 stock dividend. The Board of Directors declared dividends of $48.4 million anddistributed cash dividends of $36.4 million during 2005. On March 1, 2006, the Company’sBoard of Directors approved an increase in the quarterly cash dividend to $0.08 per share,beginning with the distribution payable April 14, 2006 to stockholders of record on March 15,2006.
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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 manufactures and markets premium products and services to the oil and gasexploration and production industry, the petrochemical industry and other industrial markets. TheCompany provides a comprehensive line of technologically-advanced products and engineeringservices, including drilling and completion fluid systems, solids-control and separation equipment,waste-management services, oilfield production chemicals, three-cone and diamond drill bits,turbine products, fishing services, drilling tools, underreamers, casing exit and multilateralsystems, packers and liner hangers. The Company also offers supply chain management solutionsthrough an extensive North American branch network providing pipe, valves and fittings as well asmill, 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 10 percent of the Company’s consolidated revenues relateto the downstream energy sector, including petrochemical plants and refineries, whose spending islargely 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 85 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 over half of the Company’s consolidated revenueswere generated in North America during 2005, Smith’s profitability was largely dependent uponbusiness levels in markets outside of North America. The Distribution segment, which accounts forapproximately 30 percent of consolidated revenues and primarily supports a North American customerbase, serves to distort the geographic revenue mix of the Company’s Oilfield segment operations.Excluding the impact of the Distribution operations, 57 percent of the Company’s 2005 revenues weregenerated in markets outside 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 2005, the average worldwide rig count grew 15 percent over theprior year period, as higher commodity prices influenced increased natural-gas focused drillingactivity. The Company expects to see modest growth in exploration and production spending in 2006,supported by commodity prices, which remain economically viable despite recent declines from the record highprices set in late 2005. Although there are a number of factors which could influence forecastedexploration and production spending, a significant decline in commodity prices, particularlynatural gas, or deterioration in the global economic environment could adversely impact worldwidedrilling activity and demand for our products and services.
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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 Products and Services segmentconsists of three business units: M-I SWACO, Smith Technologies and Smith Services. TheDistribution segment includes the Wilson business unit. The revenue discussion below has beensummarized by business unit in order to provide additional information in analyzing the Company’soperations.                           **For the Years Ended December 31,**   **2005**  **2004**  **2003** **Financial Data:***(dollars in thousands)* **Amount**  **%**  **Amount**  **%**  **Amount**  **%** **Revenues:**                        M-I SWACO $2,682,511   48  $2,231,884   50  $1,865,851   52 Smith Technologies  601,821   11   511,410   12   403,261   11 Smith Services  694,667   12   493,045   11   409,162   11                    Oilfield Products and Services  3,978,999   71   3,236,339   73   2,678,274   74 Wilson  1,600,004   29   1,182,676   27   916,554   26                    Total $5,579,003   100  $4,419,015   100  $3,594,828   100                                             **Geographic Revenues:**                        United States:                        Oilfield Products and Services $1,393,564   25  $1,128,294   26  $925,148   26 Distribution  1,127,142   20   854,173   19   667,095   18                    Total United States  2,520,706   45   1,982,467   45   1,592,243   44                    Canada:                        Oilfield Products and Services  313,912   6   225,629   5   171,653   5 Distribution  399,653   7   261,923   6   191,221   5                    Total Canada  713,565   13   487,552   11   362,874   10                    Non-North America:                        Oilfield Products and Services  2,271,523   41   1,882,416   43   1,581,483   44 Distribution  73,209   1   66,580   1   58,228   2                    Total Non-North America  2,344,732   42   1,948,996   44   1,639,711   46                    Total Revenue $5,579,003   100  $4,419,015   100  $3,594,828   100                                             **Operating Income:**                        Oilfield Products and Services $625,384   16  $423,648   13  $343,486   13 Distribution  64,714   4   26,513   2   (7,897)  — General Corporate  (19,537)  *   (11,397)  *   (6,842)  *                    Total $670,561   12  $438,764   10  $328,747   9                                             **Market Data:**                        **Average Worldwide Rig Count:** (1)                        United States  1,666   50   1,417   49   1,216   47 Canada  408   12   348   12   339   13 Non-North America  1,271   38   1,145   39   1,050   40                    Total  3,345   100   2,910   100   2,605   100                    Onshore  2,833   85   2,443   84   2,143   82 Offshore  512   15   467   16   462   18                    Total  3,345   100   2,910   100   2,605   100                                             **Average Commodity Prices:**                        Crude Oil ($/Bbl)(2) $56.59      $41.51      $31.06     Natural Gas ($/mcf)(3)  8.89       5.90       5.49      *(1)* *Source: M-I SWACO.* *(2)* *Average daily West Texas Intermediate (“WTI”) spot closing prices.* *(3)* *Average daily Henry Hub, Louisiana spot closing prices.* *** *not meaningful*
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*Oilfield Products and Services 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 drillingprograms, which account for approximately three percent of the worldwide rig count, are generallymore revenue-intensive than land-based projects due to the complex nature of the related drillingenvironment. For the year ended December 31, 2005, M-I SWACO reported revenues of $2.7 billion, anincrease of 20 percent over the prior year period. Over 60 percent of the business growth wasgenerated in the Eastern Hemisphere influenced by an 11 percent increase in corresponding activitylevels and the impact of new contract awards. Increased exploration and production spending in theNorth American market, driven by the significant increase in the number of land-based drillingprograms and, to a lesser extent, the impact of price increases initiated throughout 2005 alsocontributed to the year-over-year revenue improvement. M-I SWACO’s revenues totaled $2.2 billionfor the year ended December 31, 2004. The majority of the revenue increase was generated inmarkets outside of North America, where revenues grew 21 percent largely due to the underlyingactivity level increase of nine percent. Although increased investment by exploration andproduction companies in Latin America and the Middle East contributed to the improvement, newcontract awards and increased customer demand for waste management product offerings in severalmajor Europe/Africa markets also had a favorable impact. Approximately one-third of theyear-over-year revenue growth was reported in North America, as increased customer spending relatedto land-based projects more than offset the impact of reduced drilling activity in thehigher-margin U.S. offshore market.     Smith Technologies designs, manufactures and sells three-cone drill bits, diamond drill bitsand turbines for use in the oil and gas industry. Due to the nature of its product offerings,revenues for these operations typically correlate more closely to the rig count than any of theCompany’s other businesses. Moreover, Smith Technologies generally has the highest North Americanrevenue exposure of the Oilfield segment units. For the year ended December 31, 2005, SmithTechnologies reported revenues of $601.8 million, an increase of 18 percent over the prior year.The year-over-year revenue growth resulted from increased unit sales and rentals of diamond drillbits, as technological advancements in fixed cutter drill bit manufacturing and design hasinfluenced a shift from roller-cone toward diamond drill bit product offerings. To a lesserextent, the impact of higher unit pricing and continued demand for turbine products contributed tothe year-over-year revenue improvement. Smith Technologies reported revenues of $511.4 million forthe year ended December 31, 2004, a 27 percent increase over the prior year level. Approximatelythree-quarters of the revenue growth was reported in North America, as increased activity levelsimpacted demand for diamond bit rentals. Additionally, increased market penetration resulting fromnew product designs and, to a lesser extent, improved product pricing also contributed to therevenue variance.     Smith Services manufactures and markets products and services used in the oil and gas industryfor drilling, work-over, well completion and well re-entry. Smith Services’ core business volumesare more evenly distributed between North America and the international markets and are heavilyinfluenced by the complexity of drilling projects, which drive demand for a wider range of itsproduct offerings. For the year ended December 31, 2005, Smith Services reported revenues of$694.7 million, a 41 percent increase from the prior year. 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. Smith Services reported revenues of $493.0 million for theyear ended December 31, 2004, a 21 percent increase over the amount reported in 2003.Approximately three-quarters of the revenue improvement was generated in the North American market, influenced by higher activity levels, increased demand fortubular products and, to a lesser extent, incremental revenues from acquired operations.
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*Operating Income*     Operating income for the Oilfield Products and Services segment was $625.4 million, or 15.7percent of revenues, for the year ended December 31, 2005. The year-over-year comparison 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 prior year level. The year-over-year operating margin expansionprimarily reflects reduced operating expenses as a percentage of revenues associated with improvedfixed cost coverage in the sales and administrative functions. Gross margins improved slightlyreflecting the impact of increased fixed cost absorption in the segment’s manufacturing operationsand higher unit pricing, partially offset by a combination of an unfavorable shift in business mixand rising commodity costs. Fiscal 2005 operating income increased $175.9 million over the prioryear, net of the litigation-related charges. The growth in operating income was attributable tothe impact of a 23 percent increase in business volumes on gross profit, partially offset by highervariable-based operating expenses, including investment in personnel and infrastructure to supportthe expanding business operations. For the year ended December 31, 2004, Oilfield operating incomewas $423.6 million, or 13.1 percent of revenues. Excluding the impact of the litigation-relatedcharge recorded during 2004, segment operating margins improved 1.3 percentage points over theprior year due to gross margin expansion and, to a lesser extent, reduced operating expenses as apercentage of revenues. The gross margin improvement largely reflects increased fixed costabsorption in the Company’s manufacturing operations and, to a lesser extent, the impact of priceincreases introduced in the drilling fluid and drill bit operations. Fiscal 2004 operating income,net of the litigation charge, increased $111.6 million over the 2003 level attributable to theimpact of higher revenue volumes on gross profit, partially offset by growth in variable-basedoperating expenses 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 95 percent of Wilson’s 2005 revenues generatedin those markets. Moreover, approximately 30 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 31,2005, Wilson reported revenues of $1.6 billion, 35 percent above the prior year. Approximatelythree-quarters of the revenue growth was generated in the upstream energy operations reflectinghigher spending by exploration and production companies associated with increased North Americandrilling and completion activity, the impact of new contract awards and strong demand for tubularproducts. Industrial and downstream sales volumes grew 17 percent, influenced by increasedspending levels for line pipe and maintenance and repair projects primarily in the engineering andconstruction and petrochemical customer base. Wilson reported revenues totaling $1.2 billion forthe year ended December 31, 2004, an increase of 29 percent from the 2003 fiscal year. Two-thirdsof the revenue improvement was reported in Wilson’s upstream energy segment, attributable to higherNorth American activity levels, increased demand for tubular products and new contract awards.*Operating Income*     Operating income for the Distribution segment was $64.7 million, or four percent of revenues,for the year ended December 31, 2005. Distribution operating results increased $38.2 million overthe amount 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. For the yearended December 31, 2004, operating income for the Distribution segment was $26.5 million, or 2.2 percent of revenues. Excluding a charge recorded in the prior year, segmentoperating income increased $29.8 million above the amount reported in 2003, equating to incrementaloperating income of 11 percent of revenues. Incremental operating income was influenced byyear-over-year improvement reported in both the energy and industrial sector operationsattributable to increased coverage of fixed sales and administrative costs and, to a lesser extent,the impact of favorable pricing driven by a competitive market for tubular products.
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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,**   **2005**  **2004**  **2003**   **Amount**  **%**  **Amount**  **%**  **Amount**  **%** Revenues $5,579,003   100  $4,419,015   100  $3,594,828   100                                             Gross profit  1,685,138   30   1,351,939   31   1,075,931   30                          Operating expenses  1,014,577   18   913,175   21   747,184   21                                             Operating income  670,561   12   438,764   10   328,747   9                          Interest expense  44,446   1   38,762   1   40,964   1 Interest income  (1,692)  —   (1,300)  —   (1,973)  —                                             Income before income taxes,minority interests and cumulativeeffect of change in accountingprinciple  627,807   11   401,302   9   289,756   8                          Income tax provision  202,743   4   129,721   3   93,334   3                          Minority interests  122,759   2   89,130   2   71,788   2                                             Income before cumulative effectof change in accountingprinciple  302,305   5   182,451   4   124,634   3                                             Cumulative effect of change inaccounting principle, net of taxand minority interests  —   —   —   —   (1,154)  —                                             Net income $302,305   5  $182,451   4  $123,480   3                    *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 the comparable prior year period. The modest declinein gross profit margins reflects an increased proportion of Distribution segment sales, whichhistorically generate lower margins than the Oilfield operations. To a lesser extent, gross profitmargin deterioration reported in the Distribution segment also contributed to the reduction inconsolidated gross profit margins. On an absolute dollar basis, gross profit was $333.2 millionabove the prior year period primarily reflecting the increased sales volumes in the Oilfieldoperations.     Operating expenses, consisting of selling, general and administrative expenses, increased$101.4 million from the amount reported in the prior year. The year-over-year operating expensevariance was impacted by litigation-related charges, including $5.6 million recorded in 2005 and $28.8 million recognized during 2004, relatedto the settlement, legal fees and other costs directly associated with a patent infringement case.Excluding the litigation-related charges, operating expenses
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increased $124.6 million on anabsolute dollar basis, but decreased two percentage points from the prior year period, as apercentage of revenues. The majority of the absolute dollar increase was attributable to variablecosts directly associated with the improved business volumes, including increased investment inpersonnel and infrastructure. To a lesser extent, increased employee profit-sharing amountsdirectly attributable to the reported profitability levels and stock-based compensation expenseassociated with restricted stock awards also contributed to the year-over-year operating expensegrowth.     Net interest expense, which represents interest expense less interest income, totaled $42.8million in 2005. Net interest expense increased $5.3 million from the prior year 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 inthe prior year, but below the U.S. statutory rate. The effective tax rate was lower than the U.S.statutory rate due to the impact of M-I SWACO’s U.S. partnership earnings for which the minoritypartner is directly responsible for its related income taxes. The Company properly consolidatesthe pretax income related to the minority partner’s share of U.S. partnership earnings but excludesthe 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 $122.8 million in 2005, a$33.6 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.*2004 versus 2003*     Consolidated revenues increased to $4.4 billion for the year ended December 31, 2004, 23percent above the prior year period. The majority of the year-over-year dollar variance wasreported in the Oilfield segment attributable to a combination of higher activity levels, increasedmarket penetration and, to a lesser extent, improved product pricing. On a geographic basis,two-thirds of the revenue improvement was reported in the Western Hemisphere as the impact ofhigher land-based drilling more than offset revenue reductions associated with activity declinesexperienced in the U.S. offshore market. Improved business volumes in the Eastern Hemispheremarket also contributed to the year-over-year revenue variance, reflecting the higher number ofexploration and production projects and the impact of new contract awards.     Gross profit totaled $1.4 billion, or 31 percent of revenues, one percentage point 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, a shift in the business mix toward higher-margin product offerings andimproved product pricing also had a favorable effect. On an absolute dollar basis, gross profitwas $276.0 million above the prior year period primarily reflecting the increased sales volumes inthe Oilfield operations.     Operating expenses, consisting of selling, general and administrative expenses, increased$166.0 million from the amount reported in the prior year. The operating expense growth wasimpacted by a $28.8 million litigation-related charge recognized during 2004 to reflect anestimated loss provision, legal fees and other costs directly associated with a patent infringementcase. Excluding the charge, operating expenses, as a percentage of revenues, decreased onepercentage point from the prior year period. Improved fixed cost coverage in the sales andadministrative functions accounted for the majority of the operating expense percentage decline.The majority of the absolute dollar increase was attributable to variable-related costs associatedwith the improved business volumes, including investment in personnel and infrastructure to supportthe expanding business operations. To a lesser extent, increased employee profit-sharing amountsdirectly attributable to the reported profitability levels, increased medical and casualtyinsurance program costs and legal fees associated with defending patent infringement lawsuits alsocontributed to the year-over-year operating expense growth.     Net interest expense, which represents interest expense less interest income, totaled $37.5million in 2004. Net interest expense decreased $1.5 million from the prior year reflecting loweraverage debt levels between the periods.     The effective tax rate approximated 32 percent, which was comparable to the level reported inthe prior year, but below the U.S. statutory rate. The effective tax rate was lower than the U.S.statutory rate due to the impact of M-I SWACO’s U.S. partnership earnings for which the minoritypartner is directly responsible for its related income taxes. The Company properly consolidates the pretax income related to the minority partner’s share of U.S.partnership earnings but excludes the related tax provision.
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     Minority interests reflect the portion of the results of majority-owned operations which areapplicable to the minority interest partners. Minority interests totaled $89.1 million in 2004, a$17.3 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.     The cumulative effect of change in accounting principle included for 2003 represents theimpact of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accountingfor Asset Retirement Obligations.”**Liquidity and Capital Resources***General*     At December 31, 2005, cash and cash equivalents equaled $62.5 million. During 2005, theCompany generated $219.5 million of cash flows from operations, which is $37.3 million above theamount reported in 2004. The improvement was attributable to increased profitability levelsexperienced by the Company, partially offset by higher working capital investment, particularlyreceivables, associated with the continued increase in worldwide drilling activity.     In 2005, cash flows used in investing activities totaled $212.3 million, consisting of amountsrequired to fund capital expenditures and, to a lesser extent, acquisitions. The Company invested$151.4 million in property, plant and equipment, net of cash proceeds arising from certain assetdisposals. Acquisition funding, which primarily related to thepurchase of the Tubular Technology Inc. and Nunez Oil Field PipeLtd. operations resulted in cash outflows of$81.3 million in 2005.     Projected net capital expenditures for 2006 are expected to approximate $190 million, with theyear-over-year increase driven by the inclusion of approximately $30 million of non-recurringfacility-related investment. The majority of the 2006 capital spending is expected to consist ofspending for routine additions of rental tool and manufacturing equipment to support the Company’soperations and maintenance of the Company’s capital equipment base.     Cash flows provided by financing activities totaled $2.4 million in 2005. Operating cash flowwas sufficient to fund investing activities; however, amounts required to finance repurchases underthe Company’s stock buyback program and dividend paymentsresulted in $144.7 million of incremental borrowings underexisting credit facilities.     The Company’s primary internal source of liquidity is cash flow generated from operations.Cash flow generated by operations is primarily influenced by the level of worldwide 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, 2005, the Company had $162.8 million of capacity available under itsU.S. revolving credit facilities for future operating or investing needs. The Company also hasrevolving credit facilities in place outside of the United States, which are generally used tofinance local operating needs. At year-end, the Company had available borrowing capacity of $76.9million 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 year-end, the Company was well within thecovenant compliance thresholds under its various loan indentures, as amended, providing the abilityto access available borrowing capacity. Management believes funds generated by operations, amountsavailable under existing credit facilities and external sources of liquidity will be sufficient tofinance capital expenditures and working capital needs of the existing operations for theforeseeable future.     During 2005, the Company’s Board of Directors approved a cash dividend program forstockholders. On March 1, 2006, the Company’s Board of Directors increased the quarterly cashdividend to $0.08 per share. The projected annual payout of approximately $65 million is expectedto be funded with cash flows from operations and, if necessary, amounts available under existingcredit facilities. The level of future dividend payments will be at the discretion of theCompany’s Board of Directors and will depend upon the Company’s financial condition, earnings, cash flows,compliance with certain debt covenants and other relevant factors.     In October 2005, the Company completed a previously announced share repurchase program. OnOctober 20, 2005, the Board of Directors approved a new repurchase program that allows for thepurchase of up to 20 million shares of the Company’s common stock, subject to
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regulatory issues,market considerations and other relevant factors. Future repurchasesunder the program may beexecuted from time to time in the open market or in privately negotiated transactions and will befunded with cash flows from operations or amounts available under existing credit facilities.     In February 2006,M-I SWACO acquired Norwegian-based Epcon Offshore AS for cash consideration of $46.4million. The transaction was initially funded with borrowings underan expanded local credit facility and will be refinanced with afour-year term note during the first half of 2006. Management continuesto evaluate opportunities to acquire products or businesses complementary to the Company’soperations. Additional acquisitions, if they arise, may involve the use of cash or, depending uponthe size and terms of the acquisition, may require debt or equity financing.     The Company believes that it has sufficient existing manufacturing capacity to meet currentdemand for its products and services. Additionally, although inflation has had a modest impact onthe Company’s financial results in the three most recent fiscal years, the Company experiencedsizable increases in transportation costs, as well as, petrochemical, steel and other commodityprices during 2005. These costs, however, do not comprise a significant portion of the Company’soverall cost structure and the Company has generally been able to offset most of these coststhrough 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 14, “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, 2005 (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 $744,507  $133,650  $158,234  $232,734  $219,889                      Interest on fixed ratelong-term debt  97,411   26,284   38,333   29,700   3,094                      Operating lease commitments  179,769   46,883   60,934   28,682   43,270                                      Total $1,021,687  $206,817  $257,501  $291,116  $266,253                      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 $102.1 million in 2005, 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 which reinsure certain liabilitycoverages of the Company’s insurance captive. Excluding the impact of these instruments, for which$19.5 million of related liabilities are reflected in the accompanying consolidated balance sheet,the Company was contingently liable for approximately $49.8 million of standby letters of creditand bid, performance and surety bonds at December 31, 2005. Management does not expect anymaterial amounts to be drawn on these instruments.
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*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.*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 2006. 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.     In connection with most business acquisitions, the Company obtains contractualindemnifications from the seller related to environmental matters. These indemnificationsgenerally provide for the reimbursement of environmental clean-up costs incurred by the Company forevents occurring or circumstances existing prior to the purchase date, whether the event orcircumstance was known or unknown at that time. A substantial portion of the Company’s totalenvironmental exposure is associated with its M-I SWACO operations, which are subject to variousindemnifications from former owners.     As of December 31, 2005, the Company’s environmental reserve totaled $9.6 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, 2005, the Company does not believe that these differences will have a material impact on the Company’sfinancial position or results of operations, subject to the indemnifications in place.     During 2003, the Company took legal action against M-I SWACO’s former owners to clarifycertain contractual provisions of the environmental indemnification. Subsequent to December 31,2005, the two parties reached an agreement in principle whereby M-I SWACO’s formerowners agreed to pay an outstanding receivable owed to the Company,assume all environmental liabilities associated with two identifiedsites and reimburse the Company for certain future environmentalremediation costs.
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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 activity levels 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, $37.9 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**     On January 1, 2003, the Company adopted SFAS No. 143, “Accounting for Asset RetirementObligations,” which addresses the financial accounting and reporting for retirement obligations andcosts associated with tangible long-lived assets. Upon adoption, the Company recognized a chargeof $2.5 million, or $1.2 million after tax and minority interests, to reflect the cumulative amountof expense that was required to be recognized as of January 1, 2003. This amount has been recordedas a cumulative effect of change in accounting principle in the accompanying statement ofoperations. The amounts charged to earnings in 2005, 2004 and 2003 were not significant to netincome or earnings per share amounts.     In 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004),“Share-Based Payment” (“SFAS No. 123r”), which addresses the financial accounting and reporting ofshare-based payments to employees, including stock option awards. SFAS No. 123r, which wasrequired to be adopted by the Company on January 1, 2006, provides for the inclusion of share-basedcompensation expense in the consolidated financial statements. Share-based compensation, which isdetermined based upon the fair value of the award as of the date of grant, is generally required tobe expensed over the service period of the related award. Based on stock options outstanding as ofDecember 31, 2005, the adoption of SFAS 123r is expected to result in the recognition of $14.4million of future compensation expense, of which $8.9 million is expected to be recorded during the2006 fiscal year.     From time to time, new accounting pronouncements are issued by the FASB that are adopted bythe Company as of the specified effective date. Unless otherwise discussed, management believesthe impact of recently issued standards, which are not yet effective, will not have a materialimpact on the Company’s consolidated financial statements upon adoption.
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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 9, “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, 2005 and 2004. At December 31, 2005, 38 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, 2005, the notional amounts of fairvalue hedge contracts and cash flow hedge contracts outstanding were $99.8 million and $40.4million, respectively, and the fair value was less than the notional amount of these contracts by$1.7 million. As of December 31, 2004, the notional amount of fair value hedge contractsoutstanding was $99.6 million, approximating the fair value of these contracts. In some areas,where hedging is not cost effective, the Company addresses foreign currency exposure utilizingworking capital 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, 2005.Management’s assessment of the effectiveness of internal control over financial reporting as ofDecember 31, 2005 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 26 of this Annual Report on Form 10-K.     /s/ Doug Rock /s/ Loren K. Carroll /s/ Margaret K. Dorman     Doug Rock Loren K. Carroll Margaret K. DormanChairman of the Board and Executive Vice President 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, 2005,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, 2005, 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 of December 31,2005, based on the criteria established in *Internal Control—Integrated Framework*issued by theCommittee 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, 2005 of the Company and ourreport dated March 13, 2006expressed an unqualified opinion on those financial statements and financial statement schedule andincluded an explanatory paragraph regarding the Company’s adoption of the provisions of Statementof Financial Accounting Standard No. 143, “Accounting for Asset Retirement Obligations” in 2003.DELOITTE & TOUCHE LLPHouston, Texas