<PAGE>   1

                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   FORM 10-K

      (MARK ONE)

         (X)      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
                  OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                       OR

         (   )    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
                  OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

                         COMMISSION FILE NUMBER 1-8514

                           SMITH INTERNATIONAL, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

      DELAWARE                                                95-3822631
(STATE OR OTHER JURISDICTION                             (I.R.S.  EMPLOYER
OF INCORPORATION OR ORGANIZATION)                         IDENTIFICATION NO.)

           16740 HARDY STREET                                      77032
             HOUSTON, TEXAS                                     (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (281) 443-3370

                SECURITIES REGISTERED PURSUANT TO SECTION 12(B)
OF THE ACT:

      COMMON STOCK                        NEW YORK STOCK EXCHANGE, INC.
                                           PACIFIC STOCK EXCHANGE, INC.
    (TITLE OF CLASS)                (NAME OF EACH EXCHANGE ON WHICH REGISTERED)

        SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE

         Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X  No 
                                             ---    ---

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-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 Form 10-K or any
amendment to this Form 10-K. [X]

         The aggregate market value of the voting stock held by non-affiliates
on March 13, 1998 was $2,099,436,360 (39,472,364 shares at the closing price on
the New York Stock Exchange of $53.19). For this purpose all shares held by
officers and directors and their respective affiliates are considered to be
held by affiliates, but neither the Registrant nor such persons concede that
they are affiliates of the Registrant.

         There were 40,333,637 shares of common stock outstanding at March 13,
1998.

                      DOCUMENTS INCORPORATED BY REFERENCE

         Portions of the Proxy Statement related to the Registrant's 1998
Annual Meeting of Shareholders are incorporated by reference into Part III of
this Form 10-K.



                                      
<PAGE>   2


                                     PART I
ITEM 1.  BUSINESS

GENERAL

         Smith International, Inc. ("Smith" or the "Company") is a leading
worldwide supplier of premium products and services to the oil and gas
exploration and production industry. The Company provides a comprehensive line
of technologically-advanced products and engineering services, including
drilling and completion fluid systems, solids control equipment, waste
management services, three-cone drill bits, diamond drill bits, fishing
services, drilling tools, underreamers, sidetracking systems and liner hangers.
The Company was incorporated in the State of California in January 1937 and
reincorporated under Delaware law in May 1983. The Company's executive offices
are headquartered at 16740 Hardy Street, Houston, Texas 77032 (telephone number
281/443-3370).

         The Company operates through five business units which provide
products and services throughout the world. The Company's business units are
(i) M-I Fluids, a division of M-I L.L.C. ("M-I"), which provides drilling and
completion fluid systems and services; (ii) M-I SWACO, a division of M-I, which
provides solids control, pressure control and rig instrumentation equipment and
waste management services; (iii) Smith Tool which manufactures and sells
three-cone drill bits for use in the oil and gas industry and in mining
operations; (iv) Smith Drilling & Completions which manufactures and markets
products and services used for drilling, workover, well completion, fishing and
well re-entry operations; and (v) Smith Diamond Technology which manufactures
and markets shear drill bits featuring cutters made of polycrystalline diamond
or natural diamond.

         For information regarding revenues of the Company's five business
units see Management's Discussion and Analysis of Financial Condition and
Results of Operations included elsewhere in this Form 10-K.

         The Company's business units supply products and provide services
primarily to the petroleum services segment. The information regarding business
segments and U.S. and non-U.S. operations appears in Note 12 of the Notes to
Consolidated Financial Statements included elsewhere in this Form 10-K.

ACQUISITIONS AND DISPOSITIONS

         On January 19, 1998, Smith signed a definitive agreement to acquire
all of the equity interests of Wilson Industries, Inc. ("Wilson") in a
transaction expected to be accounted for as a pooling of interests. A
discussion of the Wilson transaction appears in Note 14 of the Notes to
Consolidated Financial Statements included elsewhere in this Form 10-K. In
addition to the planned Wilson acquisition, the Company has acquired and
disposed of certain other operations during the prior five year period. A
description of the material transactions follows.

  Acquisitions of A-Z/Grant and Lindsey Completion Systems

         On December 22, 1993, the Company acquired the product line assets of
A-Z/Grant and Lindsey Completion Systems ("A-Z/Grant" and "Lindsey") for $19.0
million in cash. The A-Z/Grant and Lindsey operations are leading providers of
downhole tools, remedial services and liner hangers to the oil and gas
industry.

  Acquisition of M-I L.L.C.

         On February 28, 1994, the Company acquired a 64 percent interest in
M-I in exchange for cash and a note payable totaling $160.0 million. M-I is a
Houston, Texas based provider of drilling and completion fluids and systems,
solids-control equipment and waste management services to the oil and gas
drilling industry.

  Acquisition of Anchor Drilling Fluids, A.S.

     On June 11, 1996, M-I acquired the assets of Anchor Drilling Fluids, A.S.
("Anchor") in exchange for cash of approximately $105.3 million. Anchor is a
Stavanger, Norway based operation which is principally engaged in providing
drilling fluid products and services to the offshore oil and gas industry.




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<PAGE>   3



  Acquisition of The Red Baron (Oil Tools Rental)Ltd.

         On October 9, 1996, the Company acquired all of the outstanding shares
of The Red Baron (Oil Tools Rental) Ltd. ("Red Baron") in exchange for cash and
notes payable of approximately $40.3 million. Red Baron is an Aberdeen,
Scotland based supplier of fishing and other downhole remedial products and
services to the oil and gas industry.

Acquisition of Tri-Tech Fishing Services, L.L.C.

         On April 16, 1997, the Company acquired all of the equity interests in
Tri-Tech Fishing Services, L.L.C. ("Tri-Tech") in exchange for consideration
totaling approximately $20.4 million. Tri-Tech is a supplier of fishing and
other downhole remedial products and services to the U.S. Gulf Coast area.

   Acquisition of Fleming Oilfield Services, Ltd.

         On October 16, 1997, the Company acquired all of the outstanding
shares of Fleming Oilfield Services, Ltd. ("Fleming") in exchange for cash of
approximately $17.3 million. Fleming is a Calgary, Alberta based supplier of
drilling fluids products and services to the Canadian oil and gas industry.

  Sale of Directional Drilling Business

         On March 29, 1993, the Company sold its directional drilling systems
and services ("DDS") business and certain of its subsidiaries and other
affiliates to Halliburton Company ("Halliburton") for 6,857,000 shares of
Halliburton common stock. In April 1993, the Halliburton common stock obtained
in the transaction was sold for $247.7 million with the Company utilizing a
portion of these proceeds to repay certain debt. As a result of the DDS sale,
the Company recorded income in 1993 from discontinued operations of $73.6
million, which included an $80.1 million gain related to the sale of the DDS
business.

 INDUSTRY OVERVIEW

The Company's worldwide operations are largely driven by the level of
exploration and production activity in major energy producing areas and the
depth and drilling conditions of these projects. The level of worldwide
drilling activity is influenced by the prices of oil and natural gas but may
also be affected by political actions and uncertainties, environmental
concerns, capital expenditure plans of exploration and production companies and
the overall level of global economic growth and activity.

         Management anticipates that total worldwide drilling activity will
continue to increase from historical activity levels; however, the rate of
growth is expected to be lower than the 1997 growth rate. The average worldwide
rig count increased approximately 16 percent over 1996 levels due to strong
North American growth driven by higher U.S. land-based activity and record
Canadian activity levels. The 1998 worldwide rig count is expected to increase
from 1997 levels due to balanced growth across all geographic areas. The level
of commodity prices may impact the forecasted growth in worldwide drilling
activity, particularly North American land-based drilling programs which are
generally more sensitive to the price of oil and gas.

BUSINESS OPERATIONS

  M-I Fluids

         Products and Services. Through a division of its majority-owned
subsidiary, the Company is the leading worldwide provider of drilling fluids
systems, products and technical services to end users engaged in drilling oil,
natural gas and geothermal wells. Drilling fluid products and systems are used
to cool and lubricate the bit during drilling operations, contain formation
pressures, suspend and remove rock cuttings from the hole and maintain the
stability of the wellbore. Technical services are provided to ensure that the
products and systems are applied effectively to optimize drilling operations.
These services include recommending products and services during the well
planning phase; testing 



                                       2
<PAGE>   4



drilling fluid properties and recommending adjustments during the drilling
phase; and analyzing well results after the project is complete to improve the
performance of wells to be drilled in the future.

         M-I Fluids offers water-base, oil-base and synthetic-base drilling
fluid systems. Water-base drilling fluids are the most widely utilized system
around the world, having application in both land and offshore environments.
They are typically comprised of an engineered blend of weighting materials,
which are used to contain formation pressures, as well as a broad range of
chemical additives, which yield specific drilling performance features required
for a given drilling environment. Oil-base drilling fluids are used to drill
water-sensitive shales, to reduce torque and drag and to drill in areas where
stuck pipe is likely to occur. These systems are low viscosity systems that
sharply increase rates of penetration in certain drilling areas of the world.
Synthetic-base drilling fluids are used in similar drilling environments and
often exceed the superior performance characteristics of oil-base drilling
fluids.

         Completion fluids, also known as clear brine fluids, are solids-free,
clear salt solutions that have high specific gravities. Combined with a range
of specialty chemicals, these fluids are used by operators in the oil and gas
industry to control bottom-hole pressures and to meet a well's specific
corrosion, inhibition, viscosity, and fluid loss requirements during the
completion and workover phases. These systems are specially designed to
maximize well production by minimizing formation damage that can be caused by
solids-laden systems. M-I Fluids provides a complete line of completion fluids
products and services, including a full range of low- and high-density brines,
specialty chemicals, filtration and chemical treatment services used in the
reclamation of these specialized fluids and technical engineering and
laboratory support services.

         Competition. M-I Fluids competes in a number of distinct segments and
faces a number of different competitors within the oil service industry. The
major competitors in the worldwide drilling fluids industry are Baroid Drilling
Fluids (a division of Dresser Industries, Inc. ("Dresser")), INTEQ (a division
of Baker Hughes, Inc. ("Baker Hughes")) and Dowell Drilling Fluids (a division
of Schlumberger, Inc.). While these companies supply a majority of the market,
the drilling fluids industry is highly competitive, with a significant number
of smaller, locally-based competitors as well as limited product producers that
market their products without technical services. Competition is based upon
technical services provided at the wellsite, product quality and availability,
service response and price.

         M-I Completion Fluids has four main competitors in the sale of clear
brine fluids to end-use markets: Baroid Completion Fluids (a division of
Dresser), Tetra Technologies, Inc., OSCA, Inc. (a subsidiary of Great Lakes
Chemical Corporation) and Ambar, Inc. This market is highly competitive, and
competition is based primarily on product availability, technical service and
price.

M-I SWACO

         Products and Services. Through M-I's SWACO division, a complete line
of solids control, pressure control, rig instrumentation and waste management
services are offered to the worldwide drilling market on both a sale and rental
basis. Key products in the pressure control line include the D-Gasser and Super
Choke, which hold strong market positions, as well as the Super Mud Gas
Separator, which protects against the large pressure surges encountered in
underbalanced drilling operations used in horizontal wells. The solids control
product line of shakers, hydroclones and centrifuges has been designed to offer
operators the option to drill "dry locations", where drilling fluid waste is
minimized and handled in an environmentally safe manner. SWACO's rig
instrumentation line features the SMART(TM) and GEO-SMART Data Acquisition
Systems, advanced monitoring systems that measure, monitor and display the
drilling status of a well with high speed accuracy.

         Competition. SWACO competes with Brandt/EPI (a subsidiary of Tuboscope
Vetco International Corporation), Derrick Oil Services and Martin Decker Totco
(a subsidiary of Varco Industries). Additionally, there are a number of
regional suppliers that provide a limited breadth of equipment and services
tailored for their local markets. Competition is based on product availability,
equipment performance, technical support and price.



                                       3
<PAGE>   5


Smith Tool

         Products. The Smith Tool business unit is a worldwide leader in the
design, manufacture and marketing of drill bits used in drilling oil and gas
wells and in mining applications under the Smith Tool(TM) and Smith Mining(TM)
product lines. Most bits manufactured by Smith Tool are three-cone drill bits
for the petroleum industry, which range in size from 3 1/2 to 28 inches in
diameter. These three-cone bits are comprised of two major components - the
body and the cones, which contain different types of pointed structures
referred to as "cutting structures" or "teeth." The cutting structures are
either an integral part of the steel cone with a hardmetal applied surface
(referred to as "milled tooth") or made of an inserted material (referred to as
"insert") which is usually tungsten carbide. In the last few years, there has
been a significant increase in demand for drill bits in which the tungsten
carbide insert is coated with polycrystalline diamond ("PDC"). Products with
diamond enhanced inserts last longer and increase penetration rates, which
decreases overall drilling costs in certain formations. Smith Tool is the
leading provider of drill bits utilizing diamond enhanced insert technology.

         Competition. Besides the Company, Hughes Christensen (a division of
Baker Hughes), Security DBS (a division of Dresser) and Reed Tool (a division
of Camco International, Inc. ("Camco")) are the three major competitors in the
petroleum drill bit business. While the Company and Hughes Christensen maintain
the leading shares of worldwide revenues of three-cone drill bits, they compete
with over 20 other competitors. Competition for sales of petroleum drill bits
is generally based on a number of factors, including performance, quality,
reliability, service, price, technological advances and breadth of products.
Competition for sales of mining drill bits generally is based on a number of
factors, including price, performance and availability.

  Smith Drilling & Completions

         Products and Services. The Smith Drilling & Completions business unit
provides Drilling, Remedial and Completion products and services to end users
engaged in drilling oil, natural gas and geothermal wells. Approximately 80
percent of Smith Drilling & Completions' revenues are related to product
rentals and associated technical services with the remaining revenue generated
from product sales.

         Drilling products and services include the Drilco/Grant product lines
and the TIPSA, S.A. and Faster Oilfield Services operations acquired in 1997.
The product and service offerings include: rotating drilling heads for
underbalanced drilling; automatic connection torque monitoring and control
systems; downhole drilling tools; tubular drill string components (drill
collars, subs, kellys, Hevi-WateTM drill pipe); drilling tool and drill string
inspection products and services; drill string repair and rebuild services; and
production tubulars and sucker rod inspection and repair.

         Remedial products and services include the A-Z/Servco product lines,
Red Baron and Tri-Tech Fishing Services. The product and service offerings
include: remedial, re-entry, and fishing services used in specialized drilling
and workover operations; underrreaming and hole opening services to provide
additional annular space in the well bore for cementing and/or gravel packing;
coiled and thru-tubing products and services; mechanical, hydraulic, and
explosive pipe cutting to remove casing during a well or platform abandonment;
and multi-lateral installations. Products include the patented Reamaster(TM)
and Underream-While-Drilling System(TM) which allow two operations to be
performed simultaneously. The product group also includes the patented
Millmaster(TM) Performance Milling System, the patented Packstock(TM) and
Anchorstock(TM) Performance Window Cutting System and the newly developed
Trackmaster(TM).

         Completion products and services include the Lindsey Completion
Systems which offers products and services including liner hangers, cementing
products and tools, liner top packers and tie-back equipment, setting tools,
permanent and temporary packers plus the service personnel to install these
products in the well bore.

         In general, all products and services are manufactured, marketed, and
maintained by the same management, operations and sales personnel operating out
of 70 locations in 24 countries. Houston, Texas is the sales, management,
engineering, and manufacturing headquarters for this business unit.

         Competition. The Company's major competitors in the drilling,
remedial, re-entry and fishing services markets are Weatherford Enterra, Inc.,
Baker Oil Tools (a division of Baker Hughes) and numerous small local
companies. The main competitors in the completion markets are Baker Oil Tools
and TIW Corporation. Competition in the drilling and 



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completions sales, rentals and services market is primarily based on
performance, quality, reliability, service, price, response time and, in some
cases, breadth of products. Smith Drilling & Completions attributes its
competitive position to its commitment to technological advancements that add
value to the customer's programs plus the quality, performance and service of
its products and employees.

  Smith Diamond Technology

         Products. Smith Diamond Technology designs, manufactures and markets
shear drill bits featuring cutters made of polycrystalline diamond ("PDC") or
natural diamond. The Company manufactures PDC and cubic boron nitride at its
MegaDiamond and Supradiamant subsidiaries. These ultrahard materials are used
in the Company's three-cone and diamond drill bits and in other specialized
cutting tools. MegaDiamond developed and uses patented processes for applying
diamonds to a curved surface with multiple transition layers. Smith is the only
oilfield equipment manufacturer that develops, manufactures and markets its own
synthetic diamond materials, which provide the Company a cost and technological
advantage. In addition, the Company's in-house diamond research, engineering
and manufacturing capabilities enhance the Company's ability to develop the
application of diamond technology across other Smith product lines and into
several non-energy cutting tool markets. Diamond enhanced products last longer
and increase penetration rates, which decreases overall drilling costs in
certain formations. The Company believes that its ability to develop
specialized diamond inserts for specific applications has and continues to
provide new business opportunities such as Diamond Enhanced Insert roller cone
bits and Impax(TM) hammer bits as well as non-energy cutting tool applications.

         Competition. The Company's major competitors in the petroleum shear
bit business are Hycalog (a division of Camco), Hughes Christensen (a division
of Baker Hughes) and Security DBS (a division of Dresser). Competition for
sales of petroleum shear bits is generally based on a number of factors,
including performance, quality, reliability, service, price, technological
advances and breadth of products. The Company believes its quality and
reliability as well as technological advances, such as the Diamond Enhanced
Inserts, provide its products with a competitive advantage.

NON-U.S. OPERATIONS

         Sales to oil and gas exploration and production markets outside the
U.S. are a key strategic focus of Smith management. The Company markets its
products and services through subsidiaries, joint ventures and sales agents
located in virtually all petroleum producing areas of the world; including
Canada, the North Sea/Europe, the Middle East, Latin America, Asia/Pacific and
Africa. As a result, 61 percent of the Company's total revenues in 1997 were
generated from sales in non-U.S. markets.

         Historically, drilling activity outside the U.S. has been less
volatile than U.S. based activity as the high cost of exploration and
production programs outside the U.S. are generally undertaken by major oil
companies, consortiums and national oil companies. These entities operate under
longer term strategic priorities than do the independent drilling operators
that are more common in the U.S. market.

SALES AND DISTRIBUTION

         Sales and service efforts are directed to end users in the drilling
and completion industry including major and independent oil companies, national
oil companies and independent drilling contractors. The Company's products and
services are primarily marketed through the direct sales force of each business
unit. In certain non-U.S. markets where direct sales efforts are not
practicable, the Company utilizes independent sales agents, distributors, or
joint ventures.

         Smith maintains field service centers, which function as repair and
maintenance facilities for rental tools, operations for remedial and completion
service and a base for the Company's global sales force, in every major oil and
gas producing area of the world. The location of these service centers near the
Company's customers is an important factor in maintaining favorable customer
relations.



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<PAGE>   7


MANUFACTURING

         The Company's manufacturing operations, along with quality control
support, are designed to ensure that all products and services marketed by the
Company will meet standards of performance and reliability consistent with the
Company's reputation in the industry.

         Management believes that it generally has sufficient internal
manufacturing capacity to meet anticipated demand for its products and
services. During periods of peak demand certain business units utilize outside
resources to provide additional manufacturing capacity.

RAW MATERIALS

         Through its company-owned mines located in the U.S. and abroad, M-I
has the capability to produce a large portion of its requirements for barite
and bentonite. Barite reserves are located in the U.S., the United Kingdom and
Morocco. Bentonite is produced from ore deposits in the U.S. and Greece. Mining
exploration activities continue worldwide to locate and evaluate ore bodies to
ensure deposits are ready for production when market conditions dictate. In
addition to its own production, M-I purchases a majority of its worldwide
barite requirements from suppliers outside the U.S., located mainly in the
People's Republic of China, India and Morocco.

         The Company purchases a variety of raw materials for its Smith Tool,
Smith Diamond Technology and Smith Drilling & Completions units, 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 or purchased components. The Company purchases a
significant amount of tungsten carbide inserts and U.S. forging requirements
from two suppliers under separate supply agreements. The Company believes that
numerous alternative supply sources are available for all such materials. The
Company produces PDC in Provo, Utah; Grenoble, France and Scurelle, Italy for
utilization in various Company products as well as direct customer sales. The
Company believes that it enjoys a competitive advantage in the manufacture of
diamond drill bits because it is the only diamond drill bit manufacturer
producing its own PDC.

PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS

         The Company's business units maintain product development and
engineering departments whose activities are focused on improving existing
products and services and developing new ones to meet customers demands for
improved drilling performance and environmental-based solutions for drilling
and completion operations. The Company's primary research facilities are
located in Houston, Texas; Stavanger, Norway and Bogota, Colombia.

         The Company also maintains a drill bit database which records the
performance of substantially all drill bits used in the U.S. over the last 15
years, including those manufactured by competitors. This database gives the
Company the ability to monitor, among other things, drill bit failures and
performance improvements related to product development. Management believes
this proprietary data base gives the Company a competitive advantage in the
drill bit business.

         The Company has historically invested significant resources in
research and engineering in order to provide customers with broader product
lines and technologically-advanced products and services. The Company's
expenditures for research and engineering activities amounted to $34.9 million
in 1997, $27.8 million in 1996 and $21.4 million in 1995.
In 1997, research and engineering expenditures approximated 2.2 percent of
revenues.

         Although the Company has over 700 patents and regards its patents and
patent applications as important in the operation of its business, it does not
believe that any significant portion of its business is materially dependent
upon any single patent or group of patents or generally upon patent protection.

EMPLOYEES

     At December 31, 1997, the Company had 7,342 full time employees throughout
the world. Most of the Company's employees in the U.S. are not covered by
collective bargaining agreements except in certain U.S. mining operations of
M-I. The Company considers its labor relations to be satisfactory. 




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ITEM 2. PROPERTIES

         The principal facilities and properties utilized by the Company at
December 31, 1997 are shown in the table below. Generally the facilities and
properties are owned by the Company with the exception of the Grenoble, France
location which is leased.

<TABLE>
<CAPTION>

                                                                                                            Approx.
                                                   Principal Products Processed            Land           Bldg. Space
Location                                                  or Manufactured                  (Acres)         (sq. ft.)
--------                                           ----------------------------            -------        -----------
<S>                                       <C>                                                 <C>           <C>  
M-I L.L.C.:
  Greybull, Wyoming...........            Bentonite mine and processing                       8,394         110,000
  Appleton, Wisconsin.........            Drilling fluid chemical products                       10          93,000
  Wharton County, Texas.......            Drilling fluid chemical products                      100          61,000
  Milos, Greece...............            Bentonite mine and processing                         124          55,000
  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
  Zelmou, Morocco.............            Barite mine                                         3,954          41,000
  Zavalla, Texas..............            Drilling fluid chemical products                       33          36,000
  Amelia, Louisiana...........            Barite processing                                      26          25,000
  Galveston, Texas............            Barite processing                                       6          21,000
  Aberdeen, Scotland..........            Barite and bentonite processing                         2          12,000
  Foss/Aberfeldy, Scotland....            Barite mine and processing                            102          10,000
  Mountain Springs, Nevada....            Barite mine                                           900             --
  Westlake, Louisiana.........            Barite processing                                       3             --

Smith Tool, Smith Drilling & Completions and Smith Diamond Technology
Units:
  Houston, Texas..............            Tubulars, surface and downhole
                                            tools, remedial products, liner
                                            hangers, diamond bits                                82         618,000
  Ponca City, Oklahoma........            Drill bits                                             15         207,000
  Grenoble, France............            Synthetic diamond materials
                                            and cubic boron nitride                              17         160,000
  Saline di Volterra, Italy...            Drill bits                                             11          92,000
  Aberdeen, Scotland..........            Downhole tools and remedial products                   10          91,000
  Nisku, Canada...............            Tubulars and drill collars                             10          42,000
  Scurelle, Italy.............            Synthetic diamond materials                             4          31,000
  Provo, Utah.................            Synthetic diamond materials                             4          30,000

</TABLE>


       The Company considers its mines and manufacturing and processing
facilities to be in good condition and adequately maintained.


ITEM 3.  LEGAL PROCEEDINGS

         Information relating to various commitments and contingencies,
including legal proceedings, is described in Note 13 of the Notes to
Consolidated Financial Statements included elsewhere in this Form 10-K.


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

         Not applicable.


                                     
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<PAGE>   9

ITEM 4A.  OFFICERS OF THE REGISTRANT

         (a) The names and ages of all officers of the Company, all positions
and offices with the Company presently held by each person named and their
business experience during the last five years are stated below. Positions,
unless otherwise specified, are with the Company.

<TABLE>
<CAPTION>

         NAME, AGE AND POSITIONS                                     PRINCIPAL OCCUPATION DURING PAST FIVE YEARS

<S>                                      <C>                                         
Douglas L. Rock (51)...........          Chairman of the Board since February 1991; Chief Executive Officer, President and
   Chairman of the Board, Chief            Chief Operating Officer since March 1989.
   Executive Officer, President
   and Chief Operating Officer

Loren K. Carroll (54)..........          President and Chief Executive Officer of M-I L.L.C. since March 1994; Executive
   Executive Vice President of the         Vice President since October 1992; Chief Financial Officer from October 1992 to
   Company; President and Chief            April 1997; member of the Board of Directors since November 1987.
   Executive Officer of M-I L.L.C.

Neal S. Sutton (52)............          Senior Vice President--Administration since December 1994; Vice
   Senior Vice President--                 President--Administration from March 1992 to December 1994; Vice President,
   Administration, General                 Secretary and General Counsel of the Company since January 1991.
   Counsel and Secretary

John J. Kennedy (45)...........          Senior Vice President, Chief Financial Officer and Treasurer since April 1997; Vice
   Senior Vice President, Chief            President, Chief Accounting Officer and Treasurer from March 1994 to April
   Financial Officer and                   1997; Treasurer from May 1991 to March 1994.
   Treasurer

D.  Barry Heppenstall (51).....          President, Smith Tool since May 1994; Vice President and General Manager--Drill Bits
   President, Smith Tool                   from March 1992 to May 1994.

Richard A. Werner (56).........          President, Smith Drilling & Completions since May 1994; Vice President and General
   President, Smith Drilling &             Manager--Smith Drilling and Completion Services from December 1993 to May 1994;
   Completions                             Vice President and General Manager--Drilco/Servco from March 1993 to December
                                           1993; Vice President and General
                                           Manager--Downhole Tools and
                                           Services from May 1991 to March
                                           1993.

Roger A. Brown (52)............          President, Smith Diamond Technology since April 1995; Vice President and General
   President, Smith Diamond                Manager, Eastern Hemisphere Operations, Reda Pump Company, Division of Camco
   Technology                              International, Inc. from November 1993 to March 1995; President, Hycalog,
                                           Division of Camco International, Inc. from November 1990 to October 1993.

Margaret K. Dorman (34)........          Vice President, Controller and Assistant Treasurer since February 1998;  Director
   Vice President, Controller and          of Financial Reporting and Planning from December 1995 to February 1998;
   Assistant Treasurer                     Various positions including Corporate Controller for Landmark Graphics
                                           Corporation from November 1992 to November 1995.


Peter D. Nicholson (41)........          Vice President, Human Resources since February 1998; Director, Human Resources from
   Vice President, Human Resources         June 1997 to February 1998; International Human Resources Manager, Eastern Hemisphere 
                                           from December 1995 to June 1997; Director of Human Resources of Baker Hughes INTEQ 
                                           in Aberdeen from February 1993 to December 1995; Eastern Region Materials Manager
                                           for Teleco Oilfield Services in Aberdeen from May 1990 to February 1993.


</TABLE>



                                      8
<PAGE>   10


<TABLE>

<S>                                      <C>
W. Lynn Perrin (43)............          Vice President, Information Technology since February 1998; Director of Information
   Vice President, Information             Technology from January 1995 to February 1998; Director of Financial and Administrative
   Technology                              Systems of Halliburton Energy Services from March 1994 to January 1995; General Manager
                                           Information Services of Halliburton Energy Services from October 1993 to March 1994; 
                                           Senior Manager of Application Systems for Halliburton Energy Services from
                                           July 1991 to October 1993.

Earl M. Springer (47)..........          Vice President, Business Development since February 1998;  Manager of Business
   Vice President, Business                Development from July 1997 to February 1998;  Manager of Technology Development
   Development                             from August 1994 to July 1997;  Senior Account Representative of M-I L.L.C. from
                                           September 1993 to July 1994; District Manager of M-I L.L.C. from November 1990 to
                                           September 1993.

Geri D. Wilde (47).............          Vice President, Taxes since February 1998; Director of Taxes from April 1997 to
   Vice President, Taxes and               February 1998;  Assistant Treasurer since April 1997; Manager of Taxes and
   Assistant Treasurer                     Payroll of M-I L.L.C. from December 1986 to April 1997.

</TABLE>


         (b) All officers of the Company are elected annually by the Board of
Directors at the meeting of the Board of Directors held immediately following
the annual meeting of shareholders. They hold office until their successors are
elected and qualified.




                                       9
<PAGE>   11





                                    PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER
        MATTERS.

         The common stock of the Company is traded on the New York Stock
Exchange and the Pacific Stock Exchange. The following are the high and low
sale prices for the Company's common stock as reported on the New York Stock
Exchange Composite Tape for the periods indicated.

<TABLE>
<CAPTION>

                                                          COMMON STOCK
                                                          ------------
                                                    HIGH                LOW
                                                    ----                ---
<S>                                              <C>                <C>      
         1996
           First Quarter...................      $  25 1/2          $  19 7/8
           Second Quarter..................         33 3/8             24 3/8
           Third Quarter...................         36 5/8             29 3/8
           Fourth Quarter..................         48                 35 1/4
         1997
           First Quarter...................         49 1/2             38 1/2
           Second Quarter..................         61 3/4             42 5/8
           Third Quarter...................         81                 60 3/4
           Fourth Quarter..................         87 7/8             53 9/16

</TABLE>

         On March 13, 1998, the Company had 2,902 common stock holders of
record and the last reported closing price on the New York Stock Exchange
Composite Tape was $53.19.

         The Company has not paid dividends on its common stock since the first
quarter of 1986. The determination of the amount of future cash dividends to be
declared and paid on the common stock, if any, will depend upon the Company's
financial condition, earnings and cash flow from operations, the level of its
capital expenditures, its future business prospects and other factors that the
Board of Directors deem relevant. In addition, the Company's debt agreements
contain covenants restricting the payment of cash dividends to the Company's
common stockholders based on net earnings and operating cash flow formulas as
defined.




                                      10
<PAGE>   12




ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>

                                                                              FOR THE YEARS ENDED DECEMBER 31,
                                               ------------------------------------------------------------------------------------
                                                     1997              1996              1995              1994(a)           1993
                                                     ----              ----              ----              ----              ----
                                                                      (IN THOUSANDS, EXCEPT PER SHARE DATA)

<S>                                             <C>               <C>              <C>               <C>              <C>         
STATEMENT OF OPERATIONS DATA:
Revenues.......................................... $  1,563,144      $  1,156,658     $    874,544    $    653,901     $    220,712
Gross profit......................................      548,532           392,062          292,540         221,274           79,963
Income from continuing operations before 
  litigation settlement, interest 
  and taxes.......................................      217,491           132,520           86,248          60,104           18,575

Income (loss) from continuing operations 
  before discontinued operations and change
  in accounting principle (b)..................... $    102,351      $     64,444     $     45,592    $     35,879     $     (3,995)
Income from discontinued operations...............                                                                           73,623
                                                            --                --               --                                --
Loss from change in accounting principle..........          --                --                                             (1,300)
                                                                                               --                                --
Net income........................................ $    102,351      $     64,444     $     45,592    $     35,879     $     68,328

DILUTED PER SHARE DATA:
Net income (loss) applicable to common stock:
  From continuing operations before 
    discontinued operations and change 
    in accounting principle....................... $       2.55      $       1.62     $       1.16    $       0.92     $      (0.13)
  From discontinued operations....................                                                                             1.95
                                                            --                --               --               --
  From change in accounting principle.............                                               
                                                            --                --               --               --            (0.03)
                                                   ------------      ------------     ------------    ------------     ------------
  Net income...................................... $       2.55      $       1.62     $       1.16    $       0.92     $       1.79
                                                   ============      ============     ============    ============     ============

BALANCE SHEET DATA:
Total assets...................................... $  1,396,033     $   1,074,582     $    702,844    $    619,780     $    348,486

Long-term debt.................................... $    306,279     $     228,443     $    117,238    $    115,000     $     46,000

Total shareholders' equity........................ $    469,457     $     368,536     $    300,886    $    253,121     $    214,466

</TABLE>

         The Notes to Consolidated Financial Statements and Management's
Discussion and Analysis of Financial Condition and Results of Operations
included elsewhere in this Form 10-K should be read in order to understand
factors such as accounting changes, business combinations, or other unusual
items which may affect the comparability of the information shown above.

(a)    On February 28, 1994, the Company acquired a 64 percent interest in M-I
       from Dresser Industries, Inc. in exchange for consideration of $160.0
       million.
(b)    In September 1993, the Company agreed to settle a class action civil
       lawsuit which alleged violations of Section 1 of the Sherman Act. This
       amount includes the impact of a $19.9 million charge related to the cost
       of settlement, related legal fees and other costs and expenses.


                                      11
<PAGE>   13

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 of Operations" is provided to assist readers in understanding the
Company's financial performance during the periods presented and significant
trends which may impact the future performance of the Company. It should be
read in conjunction with the Consolidated Financial Statements of the Company
and the related notes thereto included elsewhere in this Form 10-K.

The Company's primary business is the manufacture and sale of premium products
and services to the oil and gas industry's exploration and production sectors.
The Company's worldwide operations are largely driven by the level of
exploration and production activity in major energy producing areas and the
depth and drilling conditions of these projects. The level of worldwide
drilling activity is influenced by the prices of oil and natural gas but may
also be affected by political actions and uncertainties, environmental
concerns, capital expenditure plans of exploration and production companies and
the overall level of global economic growth and activity.

         Management anticipates that total worldwide drilling activity will
continue to increase from historical activity levels; however, the rate of
growth is expected to be lower than the 1997 growth rate. The average worldwide
rig count increased approximately 16 percent over 1996 levels due to strong
North American growth driven by higher U.S. land-based activity and record
Canadian activity levels. The 1998 worldwide rig count is expected to increase
from 1997 levels due to balanced growth across all geographic areas. The level
of commodity prices may impact the forecasted growth in worldwide drilling
activity, particularly North American land-based drilling programs which are
generally more sensitive to the price of oil and gas. Management believes that
the Company's operations are well positioned to benefit from any increase in
worldwide oil and gas drilling activity.

         Management also believes that, with the increase in offshore rig
dayrates and other fixed costs, operators are shifting exploration and
production spending toward value-added, technology-based products which reduce
the cost of their overall drilling programs. Additionally, the significant
level of extended-reach drilling programs, which often involve more difficult
drilling conditions, increases the need for efficient products and services
which reduce both drilling time and formation damage. The Company continues to
focus on investing in the development of technology-based products that
considerably improve the drilling process through increased efficiency and
rates of penetration. Management believes the overall savings realized by the
use of the Company's premium products, such as polycrystalline diamond drill
bits, diamond enhanced three-cone drill bits and synthetic drilling fluids,
compensate for the higher costs of these products over their non-premium
counterparts.


                                      12
<PAGE>   14



RESULTS OF OPERATIONS

  Revenues

         The Company operates through five business units which market the
Company's products and services throughout the world. The following table
presents revenue and average rig count information for the periods shown (in
thousands, except rig count information):

<TABLE>
<CAPTION>

                                                                        FOR THE YEARS ENDED DECEMBER 31,
                                                  -----------------------------------------------------------------------
                                                           1997                     1996                    1995
                                                           ----                     ----                    ----
                                                   AMOUNT     PERCENT        AMOUNT      PERCENT        AMOUNT      PERCENT
                                                 ---------- ----------    ------------  ----------    ----------  ---------
Revenues by Business Unit:

<S>                                              <C>              <C>     <C>               <C>       <C>          <C>
  M-I Fluids...............................      $  872,290         56     $   669,583          58    $  495,135         57
  M-I SWACO................................         128,758          8          82,743           7        61,259          7
  Smith Tool...............................         248,500         16         196,691          17       167,116         19
  Smith Drilling & Completions.............         233,984         15         148,722          13       115,245         13
  Smith Diamond Technology.................          79,612          5          58,919           5        35,789          4
                                                 ---------- ----------     -----------  ----------    ----------  ---------

    Total..................................      $1,563,144        100     $ 1,156,658         100    $  874,544        100
                                                 ========== ==========     ===========  ==========    ==========  ==========


Revenues by Area:

  U.S......................................      $  611,833         39    $    451,147          39    $  358,392         41
  Export...................................          89,919          6          71,470           6        50,454          6
  Non-U.S..................................         861,392         55         634,041          55       465,698         53
                                                 ---------- ----------     -----------  ----------    ----------  ---------

    Total..................................      $1,563,144        100   $   1,156,658         100    $  874,544        100
                                                 ========== ==========     ===========  ==========    ==========  =========


Average Annual Active Rig Count:

  U.S......................................           945                          779                       724
  Canada...................................           375                          270                       231
  Non-North America........................           809                          793                       758
                                                 ----------                -----------                ----------            

    Total                                           2,129                        1,842                     1,713
                                                 ==========                ===========                ==========            

</TABLE>

M-I Fluids

         M-I Fluids, a division of M-I L.L.C. ("M-I"), provides drilling fluid
and completion fluid systems, engineering and technical services to the oil and
gas industry. M-I Fluids' 1997 revenues increased $202.7 million, or 30
percent, from 1996, and 1996 revenues increased $174.5 million, or 35 percent,
from 1995. The growth over 1996 relates to increased U.S. activity levels,
particularly in the U.S. Gulf Coast area, and the inclusion of revenues from
acquired operations. The revenue increase over 1995 was primarily attributable
to the incremental revenues associated with the Anchor Drilling Fluids A.S.
("Anchor") operations, which were acquired in June 1996, and an increased level
of deep-water drilling activity in the U.S. Gulf Coast area.




                                      13
<PAGE>   15



 M-I SWACO

         M-I SWACO, a division of M-I, manufactures and markets equipment and
services for solids control, pressure control, rig instrumentation and waste
management. M-I SWACO's 1997 revenues increased $46.0 million, or 56 percent,
from 1996, and 1996 revenues increased $21.5 million, or 35 percent, from 1995.
The revenue growth over 1996 relates to increased demand for SWACO's solids
control equipment, particularly in Latin America and the U.S., and incremental
revenues from acquisitions. The increase over 1995 was attributable to
increased market penetration in Latin America combined with higher drilling
activity in Latin America and the U.S.

  Smith Tool

         Smith Tool manufactures and sells three-cone bits for use in the oil
and gas industry and in mining applications. Smith Tool's 1997 revenues
increased $51.8 million, or 26 percent, from 1996, and 1996 revenues increased
$29.6 million, or 18 percent, from 1995. The increase over 1996 is attributable
to higher unit sales and a favorable shift in the sales mix to the MagnumTM
line of premium bits introduced in the third quarter of 1996. On a geographical
basis, higher drilling activity in North America coupled with increased market
penetration in the Eastern Hemisphere accounted for the majority of the revenue
growth. The increase over 1995 related to improved pricing, increased unit
sales and a favorable shift in the sales mix toward premium bits. The majority
of the growth was generated in the U.S.; however, the introduction of the
MagnumTM line of premium bits in the North Sea contributed to a significant
increase in Europe/Africa revenues.

  Smith Drilling & Completions

         Smith Drilling & Completions manufactures and markets products and
services used in the oil and gas industry for drilling, workover, well
completion and well re-entry. Smith Drilling & Completions' 1997 revenues
increased $85.3 million, or 57 percent, over 1996, and 1996 revenues increased
$33.5 million, or 29 percent, from 1995. Over half of the increase from 1996
relates to incremental revenues from acquisitions, with higher levels of
re-entry drilling activity in the U.S. Gulf Coast area also contributing to the
growth. The variance over fiscal 1995 was attributable to the increased level
of re-entry activity in the U.S. Gulf Coast area and the addition of The Red
Baron (Oil Tools Rental) Ltd.'s ("Red Baron") operations in October 1996.

  Smith Diamond Technology

         Smith Diamond Technology manufactures and markets shear bits featuring
cutters made of polycrystalline diamond or natural diamond at its GeoDiamond
division. Smith Diamond Technology also manufactures polycrystalline diamond
and cubic boron nitride at its MegaDiamond and Supradiamant subsidiaries. These
ultrahard materials are used in the Company's three-cone and diamond drill bits
and in other specialized cutting tools. Smith Diamond Technology's 1997
revenues increased $20.7 million, or 35 percent, over 1996, and 1996 revenues
increased $23.1 million, or 65 percent, from 1995. Higher unit sales in
Europe/Africa, the Far East and Latin America, driven by increased market
penetration and continued expansion into new markets, accounted for the
increase over 1996. The increase over 1995 was attributable to higher unit
sales, primarily in the U.S. and Latin America, driven by increased market
growth, new product introductions and expansion into markets outside the U.S.

                                      14
<PAGE>   16



         For the periods indicated, the following table summarizes the results
of the Company and presents these results as a percentage of total revenues
(dollars in thousands):

<TABLE>
<CAPTION>

                                                                        FOR THE YEARS ENDED DECEMBER 31,
                                              --------------------------------------------------------------------------------
                                                         1997                        1996                       1995
                                                         ----                        ----                       ----
                                                  AMOUNT       PERCENT       AMOUNT        PERCENT       AMOUNT       PERCENT
                                               ------------  ------------  ------------  ------------  ------------  ------------

<S>                                            <C>           <C>          <C>            <C>          <C>            <C>
Revenues...................................    $  1,563,144           100  $  1,156,658           100  $    874,544           100
                                               ------------  ------------  ------------  ------------  ------------  ------------

Gross profit...............................         548,532            35       392,062            34       292,540            33

Operating expenses.........................         331,041            21       259,542            22       206,292            23
                                               ------------  ------------  ------------  ------------  ------------  ------------

Income before interest and taxes...........         217,491            14       132,520            12        86,248            10
Interest expense, net......................          24,973             2        16,445             2        12,238             1
                                               ------------  ------------  ------------  ------------  ------------  ------------
Income before income taxes and minority
                                                    192,518            12       116,075            10        74,010             9
interests..................................
Income tax provision.......................          50,650             3        26,798             2        12,609             2
                                               ------------  ------------  ------------  ------------  ------------  ------------
Income before minority interests...........         141,868             9        89,277             8        61,401             7
Minority interests.........................          39,517             2        24,833             2        15,809             2
                                               ------------  ------------  ------------  ------------  ------------  ------------

Net income.................................    $    102,351             7  $     64,444            6$        45,592             5
                                               ============  ============  ============  ============  ============  ============

</TABLE>

1997 Versus 1996

         Total revenues for 1997 increased $406.5 million, or 35 percent, from
the prior year as the Company experienced strong growth across all business
units and geographic areas. Half of the revenue increase was reported in North
America which benefited from higher drilling activity levels and, to a lesser
extent, the impact of acquired operations. The addition of the Anchor and Red
Baron operations, which had significant operations in the Eastern Hemisphere,
and increased market penetration in Latin America also contributed to the
revenue growth. Non-U.S. revenues continue to account for a significant portion
of the Company's operations approximating 61 percent of total revenues in both
fiscal years.

         Gross profit increased $156.5 million, or 40 percent, from the 1996
fiscal year. Gross profit margins continue to improve with the Company
reporting a one percent increase in margins over the prior year. Increased
manufacturing efficiencies associated with the higher volumes, the effect of
price increases enacted during the year and the favorable impact of acquired
operations all contributed to the margin improvement.

         Operating expenses, consisting of selling expenses and general and
administrative expenses, increased $71.5 million from the prior fiscal year;
however, as a percentage of revenues, operating expenses were reduced in excess
of one percentage point. The dollar variance over the prior year relates to
increased variable costs associated with the higher level of revenues and, to a
lesser extent, costs associated with acquired operations.

         Net interest expense, which represents interest expense less interest
income, increased $8.5 million over the prior year. The increase in net
interest expense relates to the higher level of borrowings used to fund current
year acquisitions. Borrowings required to finance general working capital
needs, which increased as a result of the revenue growth experienced by the
Company, have also contributed to the higher net interest expense amounts.

                                      15
<PAGE>   17



         The effective tax rate for the year approximated 26 percent which is
higher than the prior year's effective rate and lower than the U.S. statutory
rate. The rate was higher than the prior year's effective rate as less benefit
was recorded in 1997 related to U.S. net operating loss carryforwards ("NOL
carryforwards") due to the full utilization of these amounts during the year.
The effective tax rate was lower than the statutory rate due to the impact of
NOL carryforwards and the method of recording the minority interest partner's
U.S. earnings. The effective rate is expected to remain below the statutory
rate as the Company properly consolidates the pretax income related to the
minority interest partner's share of U.S. partnership earnings but excludes the
related tax provision.

         Minority interests represent the share of M-I's profits associated
with the 36 percent minority partner's interest in those operations and, to a
lesser extent, minority interests in investments in other joint ventures held
by M-I. Minority interests increased $14.7 million from the prior year due to
the increased profitability of the M-I operations.


1996 Versus 1995

         Total revenues for 1996 increased $282.1 million, or 32 percent, from
the prior year with the Company experiencing growth across all business units
and geographic areas. The variance over the prior year is attributable to the
increased level of deep-water and re-entry drilling activity in the U.S. Gulf
Coast area and the incremental revenues associated with operations acquired
during 1996. The impact of the 1996 acquisitions, which had significant
operations in the Eastern Hemisphere, resulted in a shift in the Company's
non-U.S. revenues from 59 percent of total revenues in 1995 to 61 percent of
total revenues in 1996.

         Gross profit increased $99.5 million, or 34 percent, from the prior
year. The higher gross profit resulted in an increase in the Company's gross
profit margin from 33 percent in 1995 to 34 percent in 1996. The improvement in
margins primarily resulted from the revenue growth and related cost
efficiencies generated by the Smith Diamond Technology operations, which became
a separate business unit in 1995.

         Operating expenses, consisting of selling expenses and general and
administrative expenses, increased $53.3 million or 26 percent from the prior
year; however, as a percentage of revenues, operating expenses decreased from
23 percent in 1995 to 22 percent in 1996. The increase in absolute dollars is
due to increased variable costs associated with the higher level of revenues
and incremental costs associated with the acquired business operations for
which no amounts were included in the prior year.

         Net interest expense, which represents interest expense less interest
income, increased $4.2 million over the prior year. The increase in net
interest expense relates to the higher level of borrowings to fund the business
acquisitions. To a lesser extent, borrowings required to finance general
working capital needs, which increased as a result of the revenue growth
experienced by the Company, also contributed to the higher net interest expense
amounts.

         The effective tax rate for the year approximated 23 percent which is
higher than the prior year's effective rate and lower than the U.S. statutory
rate. The effective tax rate was higher than the prior year's rate and lower
than the statutory rate due primarily to the impact of NOL carryforwards
utilized.

         Minority interests represent the share of M-I's profits associated
with the 36 percent minority partner's interest in those operations and, to a
lesser extent, minority interests in investments in other joint ventures held
by M-I. Minority interests increased $9.0 million from the prior year due to
the increased profitability of the M-I operations.


                                      16
<PAGE>   18



LIQUIDITY AND CAPITAL RESOURCES

  General

         The Company's financial condition remained strong in 1997. Cash and
cash equivalents increased $3.4 million during the year and equaled $29.0
million at December 31, 1997. The Company's operations generated $42.5 million
of cash flows in 1997 which is a $12.4 million increase over the amounts
reported in the prior year. The improvement in cash flows from operations
resulted from the higher level of profitability, partially offset by increased
receivable levels associated with the revenue growth. Cash flows from
operations were not sufficient to fund the Company's acquisitions and capital
expenditure requirements resulting in increased borrowings of $94.4 million
under available facilities.

         In 1997, the Company invested $76.2 million in property, plant and
equipment net of cash proceeds arising from certain asset disposals. Capital
expenditures for 1998 are expected to continue at this level, which includes
routine additions of equipment used to support the Company's operations as well
as expenditures to increase productivity and efficiency. The Company believes
funds generated from operations, cash on hand and amounts available under
existing credit facilities will be sufficient to finance capital expenditures
and other working capital needs of the existing operations for the foreseeable
future.

         The Company completed $80.0 million of business acquisitions during
1997 and, subsequent to year-end, announced the signing of a definitive
agreement to acquire Wilson Industries, Inc. ("Wilson"). The Company has agreed
to issue 7.9 million shares of common stock in exchange for all of the equity
interests of Wilson and expects to account for the transaction as a pooling of
interests. Aside from the planned acquisition, management continues to evaluate
opportunities to acquire products or businesses complimentary to the Company's
operations. These acquisitions, if they arise, may involve the use of cash or,
depending upon the size and terms of the acquisition, may require debt or
equity financing.

         The Company's primary internal source of liquidity is cash flow
generated from operations. External sources of liquidity include debt and, if
needed, equity financing. The Company has various revolving line of credit
facilities in and outside the U.S. for operating and financing needs. The
Company had approximately $152 million of funds available under its long-term
revolving line of credit facilities at December 31, 1997. Additionally, the
Company had approximately $49 million of non-U.S. short-term borrowing
facilities with various banks which had available borrowing capacity of $20
million at year-end.

         The Company has been named as a potentially responsible party in
connection with three sites on the U.S. Environmental Protection Agency's
National Priorities List. At December 31, 1997, the recorded liability for
estimated future clean-up costs for the Superfund as well as other
environmental sites was $3.2 million. As more information becomes available,
the Company may be required to provide for additional environmental clean-up
costs. Management, however, believes that none of these obligations will result
in liabilities having a material adverse effect on the Company's consolidated
financial position or results of operations. See Footnote 13, "Commitments and
Contingencies" for further discussion of environmental liabilities.

         The Company believes that it has sufficient existing manufacturing
capacity to meet current demand for its products and services.

         Because of the substantial level of operations outside the U.S., the
Company is exposed to currency fluctuations and exchange risks. To mitigate the
effect of fluctuations in exchange rates on foreign currency denominated
balances, the Company utilizes a protective hedge program. The program is
designed to hedge net balance sheet positions which expose the Company to
exchange rate risk. To the extent possible, the Company matches assets and
liabilities denominated in foreign currencies and uses hedging instruments to
cover certain unmatched positions. See Footnote 6, "Financial Instruments" for
further discussion of hedging instruments.

     Inflation has not had a material effect on the Company in recent years,
and the effect is expected to be minor in the foreseeable future. In general,
the Company has been able to offset most of the effects of inflation through
productivity gains, cost reductions and price increases. 


                                      17
<PAGE>   19

NEW ACCOUNTING AND REGULATORY PRONOUNCEMENTS

         In January 1997, the Securities and Exchange Commission adopted new
rules requiring quantitative and qualitative disclosures of market risk in the
1997 financial statements of companies with market capitalizations in excess of
$2.5 billion. The Company will be required to make the necessary disclosures
under this regulation in its 1998 financial statements.

         In June 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 130 ("SFAS 130") "Reporting
Comprehensive Income" effective for fiscal years beginning after December 15,
1997. This statement establishes standards for reporting and displaying
comprehensive income and its components. Had SFAS 130 been adopted as of
December 31, 1997, the primary adjustment required to disclose net income on a
comprehensive income basis would have related to changes in the cumulative
translation adjustment amounts reported.

YEAR 2000

         The Company is currently in the process of identifying, evaluating and
implementing modifications to its business systems in order to achieve Year
2000 date conversion compliance without an effect on customers or business
operations. The Company is also communicating with suppliers, financial
institutions and others with whom it does business to address issues related to
the conversion.

         A Corporate-wide task force was established during the year to address
Year 2000 issues. The task force consists of a group of multi-disciplined
personnel assigned from various areas within the Company. The team has been
tasked with ensuring that all of the Company's enterprise business systems are
Year 2000 compliant by mid-1999, with the majority of the systems expected to
be in compliance by the end of 1998.

         The Company's business systems are comprised of a mix of off-the-shelf
and internally-developed systems that vary greatly in size, complexity and
technical architecture. The task force has defined five separate categories for
review and is in the process of identifying the critical and non-critical
components within these groups. Most of the necessary changes in computer
instructional code can be made by upgrading the off-the-shelf software in which
the application was created. In February 1998 the Company implemented Oracle
10.7, an upgrade which brought most of the Company's enterprise applications
into compliance. Except for certain applications used in international
locations, part of the Company's normal upgrade migration plans include Year
2000 compliance as a matter of course. The Company does not believe that the
necessary changes for the remaining systems will require any significant level
of external resources, or that failure to implement the proposed changes for
the remaining systems would have a material effect on the Company's
consolidated financial position or results of operations.

         The Company has not yet determined the complete status of Year 2000
compliance of its suppliers and financial institutions or what additional
costs, if any, might be required by the Company. Management believes that
non-compliance by the Company's suppliers will not have a material effect.
However, the failure of its financial institutions to become Year 2000
compliant could have a material effect on the Company's consolidated financial
position or results of operations.



                                      18
<PAGE>   20



ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Smith International, Inc.:

         We have audited the accompanying consolidated balance sheets of Smith
International, Inc. (a Delaware corporation) and subsidiaries as of December
31, 1997 and 1996, and the related consolidated statements of operations,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

         We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

         In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the financial position of Smith
International, Inc. and subsidiaries as of December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles.



ARTHUR ANDERSEN LLP

Houston, Texas
January 30, 1998

                                      19
<PAGE>   21
                           SMITH INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>


                                                          
                                                          
                                                          
<CAPTION>

                                                                               FOR THE YEARS ENDED DECEMBER 31,
                                                               ----------------------------------------------------------------
                                                                        1997                1996                  1995
                                                                    -----------          -----------          -----------
                                                                             (IN THOUSANDS, EXCEPT PER SHARE DATA)

<S>                                                                  <C>                  <C>                    <C>     
Revenues..................................................           $1,563,144           $1,156,658             $874,544

Costs and expenses:
  Costs of revenues.......................................            1,014,612              764,596              582,004
  Selling expenses........................................              251,278              194,875              158,300
  General and administrative expenses.....................               79,763               64,667               47,992
                                                                    -----------          -----------          -----------
     Total costs and expenses.............................            1,345,653            1,024,138              788,296
                                                                    -----------          -----------          -----------

Income before interest and taxes..........................              217,491              132,520               86,248

Interest expense..........................................               26,854               18,654               14,101
Interest income...........................................               (1,881)              (2,209)              (1,863)
                                                                    -----------          -----------          -----------

Income before income taxes and minority interests.........              192,518              116,075               74,010
Income tax provision......................................               50,650               26,798               12,609
                                                                    -----------          -----------          -----------

Income before minority interests..........................              141,868               89,277               61,401

Minority interests........................................               39,517               24,833               15,809
                                                                    -----------          -----------          -----------

Net income................................................            $ 102,351              $64,444              $45,592
                                                                    ===========          ===========          ===========

Earnings per share:
  Basic...................................................            $    2.58             $   1.64             $   1.17
                                                                    ===========          ===========          ===========
  Diluted.................................................            $    2.55             $   1.62             $   1.16
                                                                    ===========          ===========          ===========

Weighted average shares outstanding:
  Basic...................................................               39,604               39,352               39,043
                                                                    ===========          ===========          ===========
  Diluted.................................................               40,183               39,880               39,383
                                                                    ===========          ===========          ===========
</TABLE>

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

                                      20
<PAGE>   22



                           SMITH INTERNATIONAL, INC.

                          CONSOLIDATED BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>

                                                                                                 DECEMBER 31,
                                                                                -----------------------------------------------
                                                                                         1997                    1996
                                                                                         ----                    ----
                                                                                                (IN THOUSANDS)

CURRENT ASSETS:

<S>                                                                                    <C>                      <C>        
     Cash and cash equivalents................................................         $  28,971              $    25,540
     Receivables, less allowance for doubtful accounts of $5,804 and
       $6,424  in 1997 and 1996, respectively................................            409,765                  309,062
     Inventories..............................................................           358,361                  295,041
     Deferred tax assets, net.................................................            25,254                    8,979
     Prepaid expenses and other...............................................            28,620                   26,655
                                                                                       ---------                ---------

       Total current assets...................................................           850,971                  665,277
                                                                                       ---------                ---------

PROPERTY, PLANT AND EQUIPMENT:

     Land.....................................................................            22,226                   17,880
     Buildings................................................................            46,046                   40,170
     Machinery and equipment..................................................           387,016                  305,491
                                                                                       ---------                ---------

                                                                                         455,288                  363,541

     Less - accumulated depreciation..........................................           184,347                  158,290
                                                                                       ---------                ---------

     Net property, plant and equipment........................................           270,941                  205,251
                                                                                       ---------                ---------

  OTHER ASSETS, including assets held for sale of
     $1,831 and $3,173 in 1997 and 1996, respectively.........................            64,786                   43,257

  GOODWILL,   net  of   accumulated   amortization   of  $11,451   and  $6,043
     in 1997 and 1996, respectively...........................................           209,335                  160,797
                                                                                        --------                 --------

  TOTAL ASSETS................................................................        $1,396,033               $1,074,582
                                                                                      ==========               ==========

</TABLE>

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

                                      21
<PAGE>   23



                           SMITH INTERNATIONAL, INC.

                          CONSOLIDATED BALANCE SHEETS

                      LIABILITIES AND SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>

                                                                                                      DECEMBER 31,
                                                                                      ----------------------------------------
                                                                                             1997                      1996
                                                                                             ----                      ----
                                                                                         (IN THOUSANDS, EXCEPT PAR VALUE DATA)

CURRENT LIABILITIES:

  <S>                                                                                   <C>                        <C>        
  Short-term borrowings and current portion of long-term debt..............             $    91,523                $    74,983
  Accounts payable..............................................................            119,353                    106,962
  Accrued payroll costs.........................................................             54,620                     42,836
  Income taxes payable..........................................................             25,796                     19,706
  Other.........................................................................             81,635                     56,014
                                                                                           --------                   --------

    Total current liabilities...................................................            372,927                    300,501
                                                                                           --------                   --------

LONG-TERM DEBT..................................................................            306,279                    228,443

DEFERRED TAX LIABILITIES........................................................             16,578                      2,059

OTHER LONG-TERM LIABILITIES.....................................................             24,087                     20,302

MINORITY INTERESTS..............................................................            206,705                    154,741

COMMITMENTS AND CONTINGENCIES (Note 13).........................................                 --                         --

SHAREHOLDERS' EQUITY:

  Preferred stock, $1 par value; 5,000 shares authorized; no shares issued
    or outstanding in 1997 or 1996..............................................                 --                         --
  Common stock, $1 par value; 60,000 shares authorized; 40,316 shares
    issued and outstanding in 1997 (40,157 in 1996).............................             40,316                     40,157
  Additional paid-in capital....................................................            282,772                    278,955
  Retained earnings.............................................................            164,833                     62,482
  Cumulative translation adjustments............................................            (10,762)                    (5,356)
  Less - treasury securities, at cost; 656 common shares in 1997 and 1996.......             (7,702)                    (7,702)
                                                                                           --------                   --------

    Total shareholders' equity..................................................            469,457                    368,536
                                                                                           --------                   --------

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY......................................         $1,396,033                 $1,074,582
                                                                                         ==========                 ==========

</TABLE>

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

                                      22
<PAGE>   24



                           SMITH INTERNATIONAL, INC.

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
                 (IN THOUSANDS, EXCEPT SHARE AND WARRANT DATA)

<TABLE>
<CAPTION>


                                                                                                                               
                                                                                                                               
                                                                  COMMON STOCK          COMMON STOCK WARRANTS        
                                                          ---------------------------  ----------------------      ADDITIONAL
                                                              NUMBER                      NUMBER                     PAID-IN 
                                                            OF SHARES       AMOUNT      OF WARRANTS    AMOUNT        CAPITAL
                                                          -------------  ------------  ------------  ----------    ---------- 

<S>                                                          <C>          <C>           <C>          <C>           <C>         
Balance, December 31, 1994                                   39,432,833   $   39,433    2,525,191    $    7,278    $  272,483  
Exercise of stock options and stock grants                      230,940          230         --            --           1,908  
Exercise of common stock warrants                               143,572          144     (143,572)         --           1,041  
Expiration of common stock warrants                                --           --     (1,930,262)         --            --    
Net income                                                         --           --           --            --            --    
Translation adjustment for the period                              --           --           --            --            --    
                                                             ----------   ----------   ----------    ----------    ----------  
Balance, December 31, 1995                                   39,807,345   $   39,807      451,357    $    7,278    $  275,432  
Exercise of stock options and stock grants                      349,233          350         --           --           3,523   
Expiration of common stock warrants                                --           --       (451,357)       (7,278)         --    
Purchases of treasury stock                                        --           --           --            --            --    
Net income                                                         --           --           --            --            --    
Translation adjustment for the period                              --           --           --            --            --    
                                                             ----------   ----------   ----------    ----------    ----------  
                                                                                                                               
Balance, December 31, 1996                                   40,156,578   $   40,157         --      $     --      $  278,955  
Exercise of stock options                                       159,021          159         --            --           3,817  
Net income                                                         --           --           --            --            --    
Translation adjustment for the period                              --           --           --            --            --    
                                                             ----------   ----------   ----------    ----------    ----------  
Balance, December 31, 1997                                   40,315,599   $   40,316         --      $     --      $  282,772  
                                                             ==========   ==========   ==========    ==========    ==========  

</TABLE>

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

<TABLE>
<CAPTION>


                                                                                                 TREASURY SECURITIES   
                                                                              ----------------------------------------------------
                                                     RETAINED                       COMMON STOCK                  WARRANTS
                                                     EARNINGS     CUMULATIVE  ----------------------      ------------------------
                                                   (ACCUMULATED   TRANSLATION   NUMBER OF                 NUMBER OF             
                                                     DEFICIT)     ADJUSTMENTS   SHARES      AMOUNT        WARRANTS         AMOUNT
                                                   ------------  -----------  -----------  ---------      ---------      ---------
                                                                                                                                   
<S>                                                <C>           <C>             <C>       <C>            <C>            <C>       
Balance, December 31, 1994                         $  (47,554)   $   (4,605)     (628,583) $  (6,636)     (451,357)      $  (7,278)
Exercise of stock options and stock grants               --            --            --          --           --              --   
Exercise of common stock warrants                        --            --            --          --           --              --   
Expiration of common stock warrants                      --            --            --          --           --              --   
Net income                                             45,592          --            --          --           --              --   
Translation adjustment for the period                    --          (1,150)         --          --           --              --   
                                                   ----------    ----------    ----------  ---------      --------       --------- 
Balance, December 31, 1995                         $   (1,962)   $   (5,755)     (628,583) $  (6,636)     (451,357)      $  (7,278)
Exercise of stock options and stock grants               --           --            --          --            --              --   
Expiration of common stock warrants                      --            --            --         --         451,357           7,278 
Purchases of treasury stock                              --            --         (27,271)    (1,066)         --              --   
Net income                                             64,444          --            --         --            --              --   
Translation adjustment for the period                    --             399          --         --            --              --   
                                                   ----------    ----------    ----------  ---------      --------       --------- 
Balance, December 31, 1996                         $   62,482    $   (5,356)     (655,854) $  (7,702)         --         $    --   
Exercise of stock options                                --            --            --          --           --              --   
Net income                                            102,351          --            --          --           --              --   
Translation adjustment for the period                    --          (5,406)         --          --           --              --   
                                                   ----------    ----------    ----------  ---------      --------       --------- 
Balance, December 31, 1997                         $  164,833    $  (10,762)     (655,854) $  (7,702)         --         $    --   
                                                   ==========    ==========    ==========  =========      ========       ========= 
</TABLE>


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

                                      23
<PAGE>   25



                           SMITH INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>

                                                                                FOR THE YEARS ENDED DECEMBER 31,
                                                                        -----------------------------------------------
                                                                               1997              1996             1995
                                                                               ----              ----             ----
                                                                                          (IN THOUSANDS)

<S>                                                                          <C>               <C>              <C>  
Cash flows from operating activities:
  Net income...............................................................  $102,351          $64,444          $45,592
  Adjustments to reconcile net income to net cash
    provided by operating activities, excluding the
    net effects of acquisitions:
      Depreciation and amortization........................................    46,704           31,601           25,540
      Minority interests...................................................    39,517           24,833           15,809
      Provision for losses on receivables..................................     1,612            1,490            1,024
      Provision for LIFO inventory reserves................................     2,992            1,282            2,956
      Gain on disposal of property, plant and equipment....................    (2,225)          (4,100)          (4,198)
      Foreign currency translation losses..................................       138               62            1,112
  Changes in operating assets and liabilities:
    Receivables............................................................   (95,605)         (37,756)         (29,847)
    Inventories, net.......................................................   (58,250)         (54,273)         (22,917)
    Accounts payable.......................................................    10,172           18,712            3,448
    Other current assets and liabilities...................................   (18,057)            (945)             (72)
    Other non-current assets and liabilities...............................    13,183          (15,254)         (11,259)
                                                                             --------         --------          -------
        Net cash provided by operating activities..........................    42,532           30,096           27,188
                                                                             --------         --------           ------

Cash flows from investing activities:
  Acquisition of businesses, net of cash acquired..........................   (80,036)        (104,683)          (6,131)
  Purchases of property, plant and equipment...............................   (82,787)         (72,958)         (35,126)
  Proceeds from disposal of property, plant and equipment..................     6,540           11,711           10,042
                                                                             --------         --------           ------
        Net cash used in investing activities..............................  (156,283)        (165,930)         (31,215)
                                                                             --------         --------          -------

Cash flows from financing activities:
  Proceeds from issuance of long-term debt.................................   276,548          124,641           12,238
  Principal payments of long-term debt.....................................  (193,602)         (14,910)         (10,401)
  Net increase in short-term borrowings....................................    16,653           34,121            8,038
  Proceeds from exercise of stock options and warrants.....................     1,794            3,873            3,323
  Purchases of treasury stock..............................................       --            (1,066)             --
  Contributions from (distributions to) minority interest partner..........    16,092              --            (2,520)
                                                                             --------         --------
        Net cash provided by financing activities..........................   117,485          146,659           10,678
                                                                             --------         --------          -------
Effect of exchange rate changes on cash....................................      (303)            (130)              49
                                                                             --------         --------          -------
Increase in cash and cash equivalents......................................     3,431           10,695            6,700
Cash and cash equivalents at beginning of year.............................    25,540           14,845            8,145
                                                                             --------         --------          -------
Cash and cash equivalents at end of year...................................   $28,971          $25,540          $14,845
                                                                             ========         ========          =======
</TABLE>

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





                                      24

<PAGE>   26



                           SMITH INTERNATIONAL, INC.

                        NOTES TO CONSOLIDATED FINANCIAL
                STATEMENTS (ALL DOLLAR AMOUNTS ARE EXPRESSED IN
                       THOUSANDS, UNLESS OTHERWISE NOTED)

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Basis of Presentation

         Smith International, Inc. (the "Company") is engaged in the
manufacture and sale of premium products and services to customers in the oil
and gas industry. The consolidated financial statements include the accounts of
the Company and all wholly and majority-owned subsidiaries. Investments in
affiliates in which ownership interest ranges from 20 to 50 percent, and the
Company exercises significant influence over operating and financial policies,
are accounted for on the equity method. All other investments are carried at
cost, which does not exceed the estimated net realizable value of such
investments. All significant intercompany accounts and transactions have been
eliminated.

  Significant Risks and Uncertainties

         Preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosed amounts of contingent assets and liabilities and the reported amounts
of revenues and expenses. Actual results could differ from those estimates.

  Cash and Cash Equivalents

         The Company considers all highly liquid financial instruments
purchased with an original maturity of three months or less to be cash
equivalents.

  Fixed Assets

         Fixed assets, consisting of rental equipment and property, plant and
equipment, are stated at cost. The Company computes depreciation on fixed
assets using principally the straight-line method. The estimated useful lives
used in computing depreciation generally range from 20 to 40 years for
buildings, 3 to 25 years for machinery and equipment, and 5 to 7 years for
rental equipment. Leasehold improvements are amortized over the lives of the
leases or the estimated useful lives of the improvements, whichever is shorter.
For income tax purposes, accelerated methods of depreciation are used.

         Cost of major renewals and betterments are capitalized as fixed
assets. Expenditures for maintenance, repairs and minor improvements are
charged to expense when incurred. When fixed assets are sold or retired, the
remaining cost and related reserves are removed from the accounts and the
resulting gain or loss is included in the Consolidated Statements of
Operations.

  Valuation of Inventories

     Inventories are stated at the lower of cost or market. Cost is determined
by the last-in, first-out ("LIFO") method for certain U.S. inventories and the
first-in, first-out ("FIFO") method for all other inventories. Inventory costs
consist of materials, labor and factory overhead.

                                      25
<PAGE>   27



                           SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

   Goodwill

         Goodwill, which represents the excess of costs over the fair value of
net assets acquired, is amortized on a straight-line basis over 40 years. The
Company continually evaluates whether subsequent events or circumstances have
occurred that indicate the remaining useful life of goodwill may warrant
revision or that the remaining balance of goodwill may not be recoverable.
Management believes that there have been no events or circumstances which
warrant revision to the remaining useful life or which affect the
recoverability of goodwill.

  Foreign Currency Translation and Transactions

         Gains and losses resulting from balance sheet translation of
operations outside the U.S. where the applicable foreign currency is the
functional currency are included as a separate component of shareholders'
equity. Gains and losses resulting from balance sheet translation of operations
outside the U.S. where the U.S. dollar is the functional currency are included
in the Consolidated Statements of Operations.

         All foreign currency transaction gains and losses are recognized
currently in the Consolidated Statements of Operations.

  Financial Instruments

         The Company enters into various instruments, including derivatives, to
manage interest rate and foreign exchange risks. Derivatives are limited in use
and are not entered into for speculative purposes.

         The Company enters into interest rate swaps to manage interest rate
risk on a portion of its long-term borrowings. The differential to be received
or paid is accrued, as interest rates change, and recognized over the life of
the agreement.

         The Company enters into foreign exchange contracts to hedge foreign
currency denominated assets or liabilities and currency commitments. Gains and
losses on foreign exchange contracts are recognized currently and are generally
offset by gains or losses on the related assets or liabilities. If the
transaction qualifies as a hedge, the resulting gains and losses are deferred.

  Environmental Obligations

         Expenditures for environmental obligations that relate to current
operations are expensed or capitalized, as appropriate. Expenditures that
relate to an existing condition caused by past operations and which do not
contribute to current or future revenue generation are expensed. Liabilities
are recorded when remedial efforts are probable and the costs can be reasonably
estimated.

  Income Taxes

         The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes".
This standard requires an asset and liability approach for financial accounting
and income tax reporting based on enacted tax rates.

  Revenue Recognition

         The Company's revenues are composed of product sales and rental,
service and other revenues. The Company recognizes product sales revenues upon
delivery to the customer. Rental, service and other revenues are recorded when
such services are performed.



                                      26
<PAGE>   28

                           SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

   Minority Interests

         The Company records minority interests expense which primarily
represents the portion of the earnings of M-I L.L.C. ("M-I") applicable to the
36 percent minority interest partner. In addition, minority interests includes
income and expense associated with the minority interest ownership positions in
other joint ventures.

   Employee Benefits

         The Company accounts for postretirement benefits in accordance with
SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than
Pensions". This standard requires the cost of postretirement benefits to be
recognized over the employee service periods.

         The provisions of SFAS No. 87, "Employers' Accounting for Pensions",
require an additional minimum liability to be recognized for a defined benefit
plan to the extent that the accumulated pension benefit obligation exceeds the
fair value of pension plan assets and any accrued pension liabilities. An
offsetting intangible asset is recorded in the amount of the additional minimum
liability, not to exceed the amount of any unrecognized prior service costs and
any unrecognized transition obligation. Amounts exceeding the unrecognized
prior service costs and unrecognized transition obligation are reflected in
other current liabilities in the Consolidated Balance Sheets.

   New Accounting Pronouncements

         In June 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 130 ("SFAS 130") "Reporting
Comprehensive Income" effective for fiscal years beginning after December 15,
1997. This statement establishes standards for reporting and displaying
comprehensive income and its components. Had SFAS 130 been adopted as of
December 31, 1997, the primary adjustment required to disclose net income on a
comprehensive income basis would have related to changes in the cumulative
translation adjustment amounts reported.

   Reclassifications

         Certain prior year amounts have been reclassified to conform to
current year presentation.

2.  ACQUISITIONS

  Acquisition of Anchor Drilling Fluids, A.S.

         On June 11, 1996, M-I acquired the assets of Anchor Drilling Fluids,
A.S. ("Anchor") in exchange for cash of approximately $105.3 million. Anchor is
a Stavanger, Norway based operation which is principally engaged in providing
drilling fluid products and services to the offshore oil and gas industry. The
Company utilized $73.4 million of borrowings under new loan agreements to
finance their portion of the purchase price and retire certain debt assumed in
the acquisition. The minority partner contributed $41.3 million to fund their
portion of the purchase price and retire certain debt, which is included in
Minority Interests in the accompanying Consolidated Balance Sheets.

   Acquisition of The Red Baron (Oil Tools Rental) Ltd.

         On October 9, 1996, the Company acquired all of the outstanding shares
of The Red Baron (Oil Tools Rental) Ltd. ("Red Baron") in exchange for cash and
notes payable of approximately $40.3 million. Red Baron is an Aberdeen,
Scotland based supplier of fishing and other downhole remedial products and
services to the oil and gas industry.

   Acquisition of Tri-Tech Fishing Services, L.L.C.

         On April 16, 1997, the Company acquired all of the equity interests in
Tri-Tech Fishing Services, L.L.C. ("Tri-Tech") in exchange for consideration
totaling approximately $20.4 million. Tri-Tech is a supplier of fishing and
other downhole remedial products and services to the U.S. Gulf Coast area.

                                      27
<PAGE>   29

                           SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

   Acquisition of Fleming Oilfield Services, Ltd.

         On October 16, 1997, the Company acquired all of the outstanding
shares of Fleming Oilfield Services, Ltd. ("Fleming") in exchange for cash of
approximately $17.3 million. Fleming is a Calgary, Alberta based supplier of
drilling fluids products and services to the Canadian oil and gas industry.

      Other Acquisitions

         In 1997, the Company has completed the acquisitions of seven other
operations for an aggregate purchase price of $42.3 million. Additionally,
several other acquisitions were completed in 1996 and 1995 in exchange for
consideration of $6.2 million and $7.8 million, respectively. These
acquisitions have generally been financed with cash, new term loans or
borrowings against available lines of credit.

         The above acquisitions have been recorded using the purchase method of
accounting and, accordingly, the acquired operations have been included in the
results of operations since their respective acquisition dates. The purchase
price was allocated to the net assets acquired based upon their estimated fair
market values at the dates of acquisition. The excess of the purchase price
over the estimated fair value of the net assets acquired amounted to
approximately $53.9 million in 1997 and $119.6 million in 1996, which has been
recorded as goodwill.

         The balances included in the Consolidated Balance Sheets related to
the current year acquisitions are based upon preliminary information and are
subject to change when additional information concerning final asset and
liability valuations is obtained. Material changes in the preliminary
allocations are not anticipated by management.

         The following unaudited pro forma supplemental information presents
consolidated results of operations as if the Company's current and prior year
acquisitions had occurred on January 1, 1996 (in thousands, except per share
amounts):

<TABLE>
<CAPTION>

                                                                                    1997                    1996
                                                                                    ----                    ----
                                                                                            (UNAUDITED)
<S>                                                                           <C>                       <C>       
Revenues...............................................................       $ 1,611,796               $1,293,623
Net income.............................................................       $   105,904               $   65,678
Earnings per share :
      Basic............................................................       $      2.67               $     1.67
      Diluted..........................................................       $      2.64               $     1.65

</TABLE>

         The unaudited pro forma supplemental information is based on
historical information and does not include estimated cost savings; therefore,
it does not purport to be indicative of the results of operations had the
combinations been in effect at the dates indicated or of future results for the
combined entities.

     The following schedule summarizes investing activities related to current
year acquisitions included in the Consolidated Statements of Cash Flows:

<TABLE>

<S>                                                                         <C>    
Fair value of assets, net of cash acquired of $1,957.................       $55,142
Goodwill recorded....................................................        53,946
Less:  Total liabilities assumed.....................................       (29,052)
                                                                            -------
Cash paid for acquisition of businesses, net of cash acquired........       $80,036
                                                                            =======
</TABLE>


                                      28
<PAGE>   30

                           SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)



3.  EARNINGS PER COMMON SHARE

         During 1997, the Company adopted SFAS No. 128 "Earnings per Share".
The Statement is effective for financial statements for both interim and fiscal
periods ending after December 15, 1997 and requires restatement of all
prior-period earnings per share ("EPS") data. SFAS No. 128, which conforms the
U.S. method of computing EPS with international accounting standards, requires
dual presentation of basic and diluted EPS data. Basic EPS is computed using
the weighted average number of common shares outstanding during the period.
Diluted EPS gives effect to the potential dilution of earnings which could have
occurred if additional shares were issued for stock option exercises under the
treasury stock method. The following schedule reconciles the income and shares
used in the basic and diluted EPS computations (in thousands, except per share
data):

<TABLE>
<CAPTION>

                                                        1997              1996              1995
                                                        ----              ----              ----
        BASIC EPS
<S>                                                   <C>                <C>              <C>    
        Net income................................    $102,351           $64,444          $45,592
                                                      ========           =======          =======

        Weighted average number of common
          shares outstanding......................      39,604            39,352           39,043
                                                        ------            ------           ------

        Basic EPS.................................      $ 2.58           $ 1.64            $ 1.17
                                                        ======           =======           ======

</TABLE>


<TABLE>
<CAPTION>

                                                        1997              1996              1995
                                                        ----              ----              ----
        DILUTED EPS
<S>                                                   <C>                <C>              <C>    
        Net income................................    $102,351           $64,444          $45,592
                                                      ========           =======          =======

        Weighted average number of common
          shares outstanding......................      39,604            39,352           39,043
        Dilutive effect of stock options..........         579               528              340
                                                      --------         ---------         --------
                                                        40,183            39,880           39,383
                                                        ------            ------           ------

        Diluted EPS...............................      $ 2.55           $ 1.62             $1.16
                                                        ======           =======            =====
</TABLE>


4.  INVENTORIES

         Inventories consist of the following at December 31:
<TABLE>
<CAPTION>

                                                       1997                  1996
                                                       ----                  ----

<S>                                                 <C>                   <C>     
    Raw materials...............................    $  35,206              $ 30,614
    Work-in-process.............................       72,233                45,985
    Finished goods..............................      268,611               233,139
                                                    ---------             ---------
                                                      376,050               309,738


    Reserves to state certain U.S. inventories
      ($146,431 in 1997 and $117,360 in 1996)
      on a LIFO basis...........................      (17,689)              (14,697)
                                                     --------              --------
                                                     $358,361              $295,041
                                                     ========              ========


</TABLE>


                                      29
<PAGE>   31


                           SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)



5. DEBT


<TABLE>
<CAPTION>
         The following summarizes the Company's outstanding debt at 
December 31:

                                                                                     1997               1996
                                                                                  ---------           ---------

     CURRENT:
<S>                                                                              <C>                 <C>    
       Short-term borrowings.................................................     $  61,010           $  49,178
       Current portion of long-term debt.....................................        30,513              25,805
                                                                                  ---------           ---------
         Short-term borrowings and current portion of long-term debt.........        91,523              74,983
                                                                                  ---------           ---------

     LONG-TERM:

       Notes:
       7% Senior Notes maturing September 2007 with an effective interest 
       rate of 7.07%.  Interest payable semi-annually (presented net of
       unamortized discount of $1,009).......................................       148,991                  --

       Notes payable to insurance companies maturing between  1998 and 2006.
       Interest payable quarterly or semi-annually at rates ranging
       from 6.02% to 9.83% ..................................................       100,889             116,000

       Bank revolvers payable:
       $120.0 million revolving note expiring December 2002. Interest payable
       quarterly at base rate (8.50% at December 31, 1997) or adjusted
       Eurodollar interbank rate, as defined (6.24% at December
       31, 1997) and described below.........................................        10,600              55,000

       M-I L.L.C. $80.0 million revolving note expiring December
       2002.  Interest payable quarterly at base rate (8.50% at December
       31, 1997) or adjusted Eurodollar interbank rate, as defined (6.20%
       at December 31, 1997) and described below.............................        37,000              37,200

       Term Loans:
       320.0 million Norwegian Krone term loan facility with a bank group.
       Principal due in semi-annual installments of 32.0 million Krone through
       December 2000, remainder due March 2001. Interest payable semi-annually
       at a Eurokrone rate (4.55% at
       December 31, 1997), ranging from NIBOR + 3/8 to NIBOR + 3/4...........        30,498              44,626

       Other                                                                          8,814               1,422
                                                                                  ---------           ---------
                                                                                    336,792             254,248
       Less current portion of long-term debt................................       (30,513)            (25,805)
                                                                                  ---------           ---------
       Long-term debt........................................................     $ 306,279           $ 228,443
                                                                                  =========           =========

         Principal payments of long-term debt for years subsequent to 1998 are
as follows:

         1999...............................................................      $  20,942
         2000...............................................................         20,942
         2001...............................................................         49,884
         2002...............................................................         51,702
         Thereafter.........................................................        162,809
                                                                                  ---------  
                                                                                  $ 306,279
                                                                                  =========

</TABLE>
                                      30
<PAGE>   32
                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


         The Company's short-term borrowings consist of amounts outstanding
under short-term lines of credit and a short-term loan. Certain subsidiaries of
the Company have unsecured short-term line of credit facilities with banks
aggregating approximately $49 million. At December 31, 1997, approximately $20
million of additional borrowing capacity was available under these facilities.
These lines of credit had a weighted average interest rate of 11 percent and 12
percent at December 31, 1997 and 1996, respectively. The remainder of the
balance relates to a short-term loan with a bank which carries interest at 7.5
percent and is scheduled to mature on March 31, 1998.

         Additionally, the Company has $200.0 million of unsecured revolving
credit agreements at December 31, 1997. These agreements provide for the
election of interest at a base rate or a Eurodollar rate ranging from LIBOR +
1/4 to LIBOR + 5/8 and require the payment of a quarterly commitment fee ranging
from .09 percent to .20 percent of the unutilized credit facility. The interest
and commitment fee percentages are determined based upon the senior debt rating
of the Company, as defined. As of December 31, 1997 the borrowing capacity under
these lines of credit approximated $152 million.

         During 1997 the Company completed a public debt offering for $150.0
million of unsecured 7% Senior Notes. The Notes are redeemable by the Company,
in whole or in part, at any time prior to maturity at a redemption price equal
to accrued interest plus the greater of the principal amount or the present
value of the remaining principal and interest payments.

         The Company was in compliance with all of its loan covenants under the
various loan indentures at December 31, 1997 and 1996. The indentures relating
to its long-term debt contain certain covenants restricting the payment of cash
dividends to the Company's common shareholders based on net income and operating
cash flow formulas, as defined. The Company has not paid dividends on its Common
Stock since the first quarter of 1986.

         Interest paid during the years ended December 31, 1997, 1996 and 1995
amounted to $24.9 million, $17.5 million and $14.3 million, respectively.

6.  FINANCIAL INSTRUMENTS

  Interest Rate Contracts

         From time to time the Company enters into interest rate swaps with the
intent of managing the exposure to interest rate risk. Interest rate swaps are
contractual agreements between two parties for the exchange of interest payments
on a notional principal amount and agreed upon fixed or floating rates, for
defined time periods.

         At December 31, 1997 and 1996, the Company had notional principal
amounts of interest rate swaps on outstanding debt of $80.5 million and $90.6
million, respectively. Gains and losses from interest rate swaps are recognized
currently in the Consolidated Statements of Operations. All swap agreements,
which are hedges against certain debt obligations, are classified as for
"purposes other than trading" under the provisions of SFAS No. 119.

         In the unlikely event that the counterparty fails to perform under the
contract, the Company bears the credit risk that payments due to the Company may
not be made.

  Foreign Currency Contracts and Options

         From time to time, the Company enters into spot and forward contracts
as a hedge against foreign currency denominated assets and liabilities and
currency commitments. Market value gains and losses on such forward contracts
are recognized currently, and the resulting amounts generally offset foreign
exchange gains or losses on the related accounts. Gains or losses on contracts
are deferred if the transaction qualifies as a hedge. At December 31, 1997 and
1996, foreign exchange contracts outstanding totaled $20.9 million and $17.3
million, respectively.




                                       31
<PAGE>   33
                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)



         The Company also purchases foreign exchange option contracts to hedge
certain operating exposures. Premiums paid under these contracts are expensed
over the life of the option contract. Gains arising on these options are
recognized at the time the options are exercised. The Company had $12.0 million
and $12.3 million of foreign exchange option contracts outstanding at December
31, 1997 and 1996, respectively.

  Fair Value

<TABLE>
<CAPTION>
                                                              1997                             1996
                                                  ---------------------------      -----------------------------
                                                   Recorded           Fair          Recorded             Fair
                                                     Value           Value            Value             Value
                                                  ----------       ----------       ----------        ----------

<S>                                               <C>             <C>              <C>              <C>
    Long-term debt .......................        $ 336,792        $ 338,787         $ 254,248        $ 257,259
    Interest rate swaps ..................             --             (1,239)             --               (482)
  </TABLE>

         The fair value of the remaining financial instruments, including cash
and cash equivalents, receivables, payables, short-term debt and foreign
currency contracts, approximates the carrying value due to the short-term nature
of these instruments.

7.  INCOME TAXES

         The geographical sources of income before income taxes and minority
interests for the three years ended December 31, 1997, were as follows:

<TABLE>
<CAPTION>
                                                                               1997            1996            1995
                                                                               ----            ----            ----
<S>                                                                          <C>             <C>             <C>     
     Income before income taxes and minority interests:
       U.S ..........................................................        $117,836        $ 68,564        $ 54,896
       Non-U.S ......................................................          74,682          47,511          19,114
                                                                             --------        --------        --------
       Total ........................................................        $192,518        $116,075        $ 74,010
                                                                             ========        ========        ========
</TABLE>


         The income tax provision is summarized as follows:

<TABLE>
<CAPTION>
                                                                             1997             1996             1995
                                                                             ----             ----             ----
<S>                                                                        <C>              <C>              <C>     
       Current -
         U.S ......................................................        $ 20,599         $  9,159         $  1,605
         Non-U.S ..................................................          26,784           17,808           10,700
         State ....................................................           1,655            1,319            1,245
                                                                           --------         --------         --------
                                                                             49,038           28,286           13,550
                                                                           --------         --------         --------
       Deferred -
         U.S ......................................................          (2,775)          (1,940)               7
         Non-U.S ..................................................           4,387              452             (948)
                                                                           --------         --------         --------
                                                                              1,612           (1,488)            (941)
                                                                           --------         --------         --------
       Income tax provision .......................................        $ 50,650         $ 26,798         $ 12,609
                                                                           ========         ========         ========
</TABLE>

         Deferred taxes are principally attributable to timing differences
related to depreciation expense and net operating loss ("NOL") and tax credit
carryforwards. In 1997, 1996 and 1995, the Company reported the tax benefit of
operating loss carryforwards as a reduction in the provision for income taxes in
accordance with SFAS No. 109.




                                       32
<PAGE>   34

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


           The consolidated effective tax rate (as a percentage of income before
income taxes and minority interests) is reconciled to the U.S. Federal Statutory
rate as follows:

<TABLE>
<CAPTION>
                                                                             1997          1996          1995
                                                                             ----          ----          ----

<S>                                                                          <C>           <C>           <C>  
  U.S. Federal statutory tax rate .................................          35.0%         35.0%         35.0%
  Utilization of U.S. net operating
    loss and credit carryforwards .................................          (5.7)         (9.2)        (18.4)
  Minority interest's share of U.S. partnership earnings ..........          (6.2)         (5.6)         (7.2)
  Permanent differences ...........................................           2.2           1.8           2.3
  State taxes, net ................................................           1.1           1.2           1.7
  Non-U.S. tax provisions which vary from the
    U.S. rate/non-U.S. losses with no
    tax benefit realized ..........................................           0.2           0.9           4.2
  Other items, net ................................................          (0.3)         (1.0)         (0.6)
                                                                             ----          ----          ---- 
    Effective tax rate ............................................          26.3%         23.1%         17.0%
                                                                             ====          ====          ==== 
</TABLE>


         The components of deferred taxes at December 31 are as follows:

<TABLE>
<CAPTION>
                                                                                                                NET
                                                                             1997             1996            CHANGE
                                                                             ----             ----            ------
<S>                                                                        <C>              <C>              <C>      
  Deferred tax liabilities attributed 
    to the excess of net book basis 
    over remaining tax basis 
    (principally depreciation):
      U.S .........................................................        $(12,035)        $(11,037)        $   (998)
      Non-U.S .....................................................         (11,124)          (9,789)          (1,335)
                                                                           --------         --------         --------
    Total deferred tax liabilities ................................         (23,159)         (20,826)          (2,333)
                                                                           --------         --------         --------

  Deferred tax assets attributed to
    net operating loss and tax credit
    carryforwards:
      U.S .........................................................          10,265           23,986          (13,721)
      Non-U.S .....................................................          27,095           27,860             (765)

  Other deferred tax assets (principally accrued
    liabilities not deductible until paid):
      U.S .........................................................          21,401           16,125            5,276
      Non-U.S .....................................................           5,899            7,910           (2,011)
                                                                           --------         --------         --------
        Subtotal ..................................................          64,660           75,881          (11,221)

  Valuation allowance .............................................         (33,332)         (46,725)          13,393
                                                                           --------         --------         --------

    Subtotal deferred tax assets ..................................          31,328           29,156            2,172
                                                                           --------         --------         --------

    Net deferred tax assets .......................................        $  8,169         $  8,330         $   (161)
                                                                           ========         ========         ========

  Balance sheet presentation:

    Deferred tax assets, net ......................................        $ 25,254         $  8,979
    Other assets ..................................................            --              1,410
    Other current liabilities .....................................            (507)            --
    Deferred tax liabilities ......................................         (16,578)          (2,059)
                                                                           --------         --------
       Net deferred tax assets ....................................        $  8,169         $  8,330
                                                                           ========         ========
  </TABLE>



                                       33
<PAGE>   35

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


         For U.S. tax reporting purposes, the Company utilized all cumulative
NOL and investment and other business credits available during 1997. At December
31, 1997, alternative minimum tax credits of $10.3 million, with no expiration,
are available to reduce future U.S. income taxes.

         Income taxes paid during the years ended December 31, 1997, 1996 and
1995 amounted to $41.3 million, $17.4 million and $3.8 million, respectively.

         The Company has provided additional taxes for the anticipated
repatriation of certain earnings of its non-U.S. subsidiaries. Undistributed
earnings above the amounts upon which additional taxes have been provided, which
approximated $26.6 million at December 31, 1997, are intended to be permanently
invested by the Company. It is not practicable to determine the amount of
applicable taxes that would be incurred if any of such earnings were
repatriated.

8.  CAPITAL STOCK

  Common stock warrants

         All outstanding common stock warrants, which allowed for conversion
into shares of the Company's common stock, were exercised or expired during 1995
and 1996. In 1995, approximately $1.2 million was received upon the exercise of
143,572 warrants into an equivalent number of common shares. No common stock
warrants were outstanding at December 31, 1997 or 1996.

9.  STOCKHOLDERS' RIGHTS PLAN

         During 1990, the Company adopted a Stockholders' Rights Plan ("Rights
Plan"). As part of the Rights Plan, the Company's Board of Directors declared a
dividend of one preferred stock purchase right ("Right") for each share of the
Company's common stock outstanding on June 29, 1990. The Board also authorized
the issuance of one such Right for each share of the Company's common stock
issued after June 29, 1990 until the occurrence of certain events.

         Each Right entitles the holder thereof (except an Acquiring Person) to
purchase, at an exercise price of $50, shares of the Company's common stock
having a market value of twice the Right's exercise price. The Rights are
exercisable upon the occurrence of certain events related to a person acquiring
or announcing the intention to acquire beneficial ownership of 20 percent or
more of the Company's common stock. The Rights are not exercisable in the event
the Company's common stock is acquired pursuant to a Qualifying Offer, as
defined in the Rights Plan. In addition, if the Company is involved in a merger
or other business combination transaction, or sells 50 percent or more of its
assets or earning power to another entity, each Right will entitle its holder to
purchase, at the Right's then current exercise price, shares of common stock of
such other entity having a value of twice the Right's exercise price.

         The Rights are subject to redemption at the option of the Board of
Directors at a price of $0.01 per Right until the occurrence of certain events.
The Rights currently trade with the Company's common stock, have no voting or
dividend rights and expire on June 19, 2000.


                                       34
<PAGE>   36

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


10.  EMPLOYEE STOCK OPTIONS

         As of December 31, 1997, the Company had outstanding stock options
granted under the 1989 Long-Term Incentive Compensation Plan ("1989 Plan").
Options are generally granted at fair market values on the date of grant with
matters such as vesting periods and expiration of options determined on a
grant-by-grant basis. The options, exercisable at various dates through December
2007, are conditioned upon continued employment.

         During 1997, all options remaining under the 1982 Stock Option Plan
were exercised or forfeited. No further options may be granted under this Plan.

         The Company has adopted the reporting standards of SFAS No. 123 ("SFAS
123") "Accounting for Stock-Based Compensation". SFAS 123, which was effective
for fiscal years beginning after December 15, 1995, established financial
accounting and reporting standards for stock-based employee compensation plans
and for transactions in which equity instruments are issued to non-employees for
the acquisition of goods and services. SFAS No. 123 required, among other
things, that compensation cost be calculated for fixed stock options at the
grant date by determining fair value using an option-pricing model. The Company
has the option of recognizing the compensation cost over the vesting period as
an expense in the Consolidated Statements of Operations or making pro forma
disclosures in the notes to the financial statements.

         The Company continues to apply APB Opinion 25 and related
Interpretations in accounting for the plan. Accordingly, no compensation cost
has been recognized in the accompanying consolidated financial statements for
its stock option plan. Had the Company elected to apply the accounting standards
of SFAS 123, the Company's net income and earnings per share would have
approximated the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                                  1997                  1996                 1995
                                                                  ----                  ----                 ----
<S>                               <C>                          <C>                    <C>                  <C>     
         Net income               As reported                  $ 102,351              $ 64,444             $ 45,592
                                  Pro forma                    $ 101,062              $ 63,958             $ 45,495

         Earnings per share       As reported:
                                       Basic                   $    2.58              $   1.64             $   1.17
                                       Diluted                 $    2.55              $   1.62             $   1.16

                                  Pro forma:
                                       Basic                   $    2.55              $   1.63             $   1.17
                                       Diluted                 $    2.52              $   1.60             $   1.16
</TABLE>

         The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model which resulted in a
weighted-average fair value of $18.68, $12.37 and $7.50 for grants made during
the years ended December 31, 1997, 1996 and 1995, respectively. The following
assumptions were used for option grants in 1997, 1996 and 1995, respectively;
dividend yield of 1.5 percent, 1.6 percent and 1.0 percent; expected volatility
of 19 percent, 23 percent and 38 percent, risk-free interest rates of 5.7
percent, 6.2 percent and 6.9 percent and an expected life of six years. The
compensation expense included in the above pro forma net income may not be
indicative of amounts to be included in future periods as the fair value of
options granted prior to 1995 was not determined.



                                       35
<PAGE>   37

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)



         A summary of the Company's stock option plans as of December 31, 1997,
1996 and 1995, and changes during those years is presented below:

<TABLE>
<CAPTION>
                                                                           Weighted-Average
                                                             Shares            Exercise
                                                          Under Option           Price
                                                        ----------------   ----------------
<S>                                                        <C>               <C>      
Outstanding at December 31, 1994 .................         1,377,075         $   11.22

Options granted ..................................           225,485             16.82
Options forfeited ................................           (13,574)            11.62
Options exercised ................................          (228,940)             9.35
                                                           ---------

Outstanding at December 31, 1995 .................         1,360,046             12.43

Options granted ..................................           252,670             40.79
Options forfeited ................................            (1,290)            17.88
Options exercised ................................          (348,408)            11.13
                                                           ---------

Outstanding at December 31, 1996 .................         1,263,018             18.46

Options granted ..................................           284,500             69.06
Options forfeited ................................           (19,335)            18.03
Options exercised ................................          (159,021)            11.39
                                                           ---------

Outstanding at December 31, 1997 .................         1,369,162         $   29.79
</TABLE>

         The number of outstanding fixed stock options exercisable at December
31, 1996 and 1995 was 481,606 and 494,889, respectively. These options had a
weighted average exercise price of $12.13 and $11.56 at December 31, 1996 and
1995, respectively. The following summarizes information about fixed stock
options outstanding at December 31, 1997:

<TABLE>
<CAPTION>
                                    Options Outstanding                      Options Exercisable
                     --------------------------------------------------  -----------------------------
                                         Weighted             Weighted                       Weighted
                                          Average              Average                         Average
   Range of               Number         Remaining            Exercise        Number         Exercise
Exercise Prices        Outstanding    Contractual Life         Price        Exercisable        Price
---------------        -----------    ----------------        --------      -----------      ---------

<S>                       <C>               <C>                <C>             <C>            <C>    
$ 8.38 - $10.31           183,335           5.4                $  9.21         183,335        $  9.21
$12.56 - $17.88           655,412           6.5                  14.36         424,858          14.11
$22.50 - $41.13           245,915           8.9                  40.83          62,314          40.53
$69.06                    284,500           9.9                  69.06            --             --
                        ---------           ---                 ------         -------         ------
                        1,369,162           7.3                 $29.79         670,507         $15.22
                        =========           ===                 ======         =======         ======
</TABLE>

         At December 31, 1997, there were 173,916 shares of common stock
reserved under the 1989 Plan for the future granting of stock options, awarding
of additional restricted stock options and/or awarding of additional Stock
Appreciation Rights.


                                       36
<PAGE>   38
                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


11.  EMPLOYEE BENEFITS

  Pension Plans

         The Company has pension plans in the U.S. and the United Kingdom
("U.K."). Benefit accruals under the Company's U.S. pension plan, which have
been frozen since 1987, covered substantially all the U.S. employees of the
Company at that date. Due to the freezing of U.S. pension benefits and fully
funding those benefits in 1987, no material contributions were made to the Plan
in 1997, 1996 or 1995. Most of the employees of M-I are not covered by a pension
plan.

         During 1997, a decision was made to terminate the U.K. pension plan and
replace it with a defined contribution plan. All current and future obligations
to plan participants are expected to be settled in 1998.

         The following tables detail the components of pension expense for the
three years ended December 31, 1997, the funded status of the plans and major
assumptions used to determine these amounts:

<TABLE>
<CAPTION>
                                                        1997            1996           1995
                                                        ----            ----           ----

<S>                                                  <C>             <C>             <C>    
Service cost ................................        $   323         $   311         $   286
Interest cost ...............................          1,129           1,020             942
Actual return on plan assets ................         (1,298)         (1,771)           (796)
Prior service cost ..........................              6               6               8
Net amortization and deferral
  and other .................................            (38)            685            (199)
                                                     -------         -------         -------
Net periodic pension cost ...................        $   122         $   251         $   241
                                                     =======         =======         =======
</TABLE>

Reconciliation of Funded Status of the Plan:

<TABLE>
<CAPTION>
                                                                          1997              1996              1995
                                                                          ----              ----              ----
<S>                                                                     <C>               <C>               <C>     
Actuarial present value of benefit obligations:

  Vested benefit obligation ........................................    $ 17,158          $ 13,252          $ 11,672
                                                                        ========          ========          ========

  Accumulated benefit obligation ...................................    $ 17,329          $ 13,375          $ 11,834
                                                                        ========          ========          ========

  Projected benefit obligation .....................................    $ 18,522          $ 14,481          $ 12,700
  Plan assets at fair value ........................................      18,626            15,804            12,926
                                                                        --------          --------          --------

  Projected benefit obligation less than Plan assets ...............    $    104          $  1,323          $    226
  Unrecognized prior service cost ..................................          43                28                34
  Unrecognized net loss (gain) .....................................         432              (759)              211
  Additional minimum liability .....................................      (1,283)             (480)             (880)
                                                                        --------          --------          --------

  Pension asset (liability)recognized in the Balance Sheet .........    $   (704)         $    112          $   (409)
                                                                        ========          ========          ========

Weighted-average assumed discount rate .............................  7.0% - 8.0%       7.8% - 9.0%       7.0% - 9.0%

Rate of compensation increases in the U.K. (none in the U.S.
due to freezing of benefits) .......................................         6.5%              7.0%              7.5%

Weighted-average expected long-term rate of return on Plan
assets .............................................................  8.0% - 9.0%       8.5% - 9.0%       8.5% - 9.0%
</TABLE>

         The Company has several other pension plans covering certain U.S. and
non-U.S. employees as well as a pension plan covering directors. Pension
expense, total accumulated plan benefits and net assets available for benefits
for these plans were not material at December 31, 1997, 1996 or 1995.


                                       37
<PAGE>   39

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


Retirement Plans

         The Company established the Smith International, Inc. 401(k) Retirement
Plan (the "Plan") for the benefit of all eligible employees. Employees may
voluntarily contribute up to 12 percent of compensation, as defined, to the
Plan. The Company makes retirement, matching and, in certain cases,
discretionary matching contributions to each participant's account under the
Plan. Participants receive a full match of the first 1 1/2 percent of their
contributions along with a retirement contribution ranging from 2 percent to 6
percent of their qualified compensation. In addition, the Company may provide
discretionary matching contributions to participants who are employed by the
Company on December 31. The Company's contributions to the Plan totaled
approximately $6.9 million, $4.9 million and $3.9 million in 1997, 1996 and
1995, respectively.

         M-I has a Company Profit-Sharing and Savings Plan (the "M-I Plan")
under which participating employees may defer up to 12 percent of their
compensation, as defined. Under the terms of the M-I Plan, qualified employees
are eligible to receive basic, matching and profit-sharing contributions with
the approval of the Employee Benefits Committee, and in certain instances, the
Board of Directors. Participants are eligible to receive a basic contribution
equal to 3 percent of qualified compensation, and a full match of the first 1
1/2 percent of their contributions. Further, effective January 1, 1996, the
Board of Directors approved an additional profit-sharing match of up to 2 1/2
percent of participant's voluntary contributions. Total contributions under the
M-I Plan approximated $5.0 million in 1997, $4.2 million in 1996 and $2.2
million in 1995.

Postretirement Benefit Plans

         The Company and its subsidiaries provide certain health care benefits
for retired employees. Many of the employees who retire from the Company are
eligible for these benefits.

         The Smith International, Inc. Retiree Medical Plan ("Smith Medical
Plan") provides postretirement medical benefits to retirees and their spouses.
The retiree medical plan has an annual limitation (a "cap") on the dollar amount
of the Company's portion of the cost of benefits incurred by retirees under the
Plan. The remaining cost of benefits in excess of the cap is the responsibility
of the participants. The cap will be adjusted annually for inflation, which is
currently assumed to be 4 percent.

         M-I provides retiree medical coverage to eligible retirees and their
dependents under the M-I Drilling Fluids Retiree Medical Plan ("M-I Medical
Plan"). Eligibility for inclusion in that plan; however, was closed as of
January 1, 1994, to the majority of M-I's employees. M-I contributes to the cost
of the benefits under this plan; however, these costs are reviewed annually for
inflation, and limited to a maximum 5 percent increase in M-I's contribution per
year. Any costs in excess of M-I's maximum contribution are the responsibility
of the retiree or their dependents.


                                       38
<PAGE>   40


                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


         The following table sets forth the plans' unfunded status reconciled
with the amount shown in the Company's Consolidated Balance Sheets at December
31:

<TABLE>
<CAPTION>
                                                             1997             1996             1995
                                                             ----             ----             ----
<S>                                                       <C>              <C>              <C>      
Accumulated postretirement benefit obligation:
    Retirees .....................................        $ (7,199)        $ (5,538)        $ (5,105)
    Actives ......................................          (4,690)          (3,773)          (3,543)
Plan assets at fair value ........................            --               --               --
                                                          --------         --------         --------
Accumulated postretirement
  benefit obligation in excess of
  plan assets ....................................         (11,889)          (9,311)          (8,648)
Unrecognized net loss (gain) and
  prior service cost .............................             866           (1,487)          (1,832)
                                                          --------         --------         --------
Accrued postretirement
  benefit obligation .............................        $(11,023)        $(10,798)        $(10,480)
                                                          ========         ========         ========
</TABLE>

         Postretirement benefit expense recognized in the Consolidated
Statements of Operations for the three years ended December 31, 1997, is
summarized as follows:

<TABLE>
<CAPTION>
                                                             1997             1996             1995
                                                             ----             ----             ----

<S>                                                          <C>              <C>              <C>  
Service cost .....................................           $ 109            $ 103            $  83
Interest cost on accumulated
  postretirement benefit obligation
  and other ......................................             723              704              686
Net amortization .................................             (46)            (116)            (170)
                                                             -----             -----           -----
Postretirement benefit expense ...................           $ 786             $ 691           $ 599
                                                             =====             =====           =====
</TABLE>

         The health care cost trend rate assumption can have a significant
effect on the amounts reported. For measurement purposes, the Smith Medical Plan
assumes an 8 percent, 9 percent and 10 percent annual rate of increase in the
per capita cost of covered health care benefits for 1997, 1996 and 1995,
respectively; and the M-I Medical Plan assumes a 5 percent increase for the
periods presented. The Smith Medical Plan rate was assumed to gradually decrease
to 5 percent for 2000 and to remain at that level thereafter. An increase of one
percentage point in the health care cost trend rate would increase the
accumulated postretirement benefit obligation and the aggregate of the service
and interest cost components of the postretirement benefits expense by $1.3
million and $0.1 million, respectively.

         The weighted-average discount rates used in determining the accumulated
postretirement benefit obligation for 1997, 1996 and 1995 were 7.0 percent, 8.0
percent and 8.4 percent, respectively.


                                       39
<PAGE>   41
                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


12.  INDUSTRY SEGMENTS AND INTERNATIONAL OPERATIONS

         The Company operates primarily in one industry segment, the petroleum
services segment. The products and services of the petroleum services segment
are primarily used in the drilling of oil and gas wells. No single customer
represented in excess of 10 percent of total revenues during any of the years
presented.

         The following table presents financial information about non-U.S. and
U.S. operations and export sales:

<TABLE>
<CAPTION>
                                                        1997              1996              1995
                                                        ----              ----              ----
<S>                                                  <C>               <C>               <C>       
Revenues:
United States:
  Domestic ..................................        $  611,833        $  451,147        $  358,392
  Export ....................................            89,919            71,470            50,454
North Sea/Europe ............................           285,655           242,828           168,135
Latin America ...............................           210,409           153,540           112,587
Other .......................................           365,328           237,673           184,976
                                                     ----------        ----------        ----------
                                                     $1,563,144        $1,156,658        $  874,544
                                                     ==========        ==========        ==========

Income before interest and taxes:
  United States .............................        $   84,175        $   56,387        $   37,115
  North Sea/Europe ..........................            45,427            29,289            15,129
  Latin America .............................            37,515            22,296            21,307
  Other .....................................            64,338            36,337            23,083
                                                     ----------        ----------        ----------
                                                     $  231,455        $  144,309        $   96,634
                                                     ==========        ==========        ==========

Identifiable assets:
  United States .............................        $  642,365        $  466,711        $  418,588
  North Sea/Europe ..........................           311,780           309,791            94,648
  Latin America .............................           166,030           138,988            87,322
  Other .....................................           275,858           159,092           102,286
                                                     ----------        ----------        ----------
                                                     $1,396,033        $1,074,582        $  702,844
                                                     ==========        ==========        ==========
</TABLE>

         General corporate expenses have been excluded from income before
interest and taxes in the table above. Results of operations as reported in the
accompanying consolidated financial statements include general corporate
expenses of $14.0 million in 1997, $11.8 million in 1996 and $10.4 million in
1995.

         Transfers between geographic areas, which are eliminated upon
consolidation, are excluded from the above presentation. These transfers are
recorded by the Company and its subsidiaries based on their various intercompany
pricing agreements. U.S. sales to affiliates amounted to $210.8 million, $169.5
million and $126.1 million in 1997, 1996 and 1995, respectively. Non-U.S. sales
to affiliates approximated $136.5 million, $93.0 million and $58.2 million in
1997, 1996 and 1995, respectively.

         The Company's revenues are derived principally from uncollateralized
sales to customers in the oil and gas industry. This industry concentration has
the potential to impact the Company's exposure to credit risk, either positively
or negatively, because customers may be similarly affected by changes in
economic or other conditions. The creditworthiness of this customer base is
strong, and the Company has not experienced significant credit losses on such
receivables.


                                       40

<PAGE>   42

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


13.   COMMITMENTS AND CONTINGENCIES

  Leases

         The Company routinely enters into operating and capital leases for
certain of its facilities and equipment. Amounts related to assets under capital
lease were immaterial for the periods presented. Rent expense totaled $17.9
million, $13.8 million and $12.9 million in 1997, 1996 and 1995, respectively.

         Future minimum payments under all non-cancelable operating leases
having initial terms of one year or more are as follows:

<TABLE>
<CAPTION>
         YEARS ENDING
         DECEMBER 31,                                 AMOUNT
         ------------                                 ------

<S>                                                 <C>    
             1998                                     $15,771
             1999                                      13,017
             2000                                       8,384
             2001                                       6,618
             2002                                       5,384
          Thereafter                                   31,664
                                                      -------
                                                      $80,838
                                                      =======
</TABLE>

   Year 2000

         The Company is currently in the process of identifying, evaluating and
implementing modifications to its business systems in order to achieve Year 2000
date conversion compliance without an effect on customers or business
operations. The Company expects that all of its enterprise business systems will
be Year 2000 compliant by mid-1999, with the majority of the systems expected to
be in compliance by the end of 1998. Most of the necessary changes in computer
instructional code can be made by upgrading the off-the-shelf software in which
the application was created. Subsequent to year end, the Company's systems were
upgraded to Oracle version 10.7 which brought most of the Company's enterprise
applications into compliance. The Company does not believe that the necessary
changes for the remaining systems will require any significant level of external
resources, or that failure to implement the proposed changes for the remaining
systems would have a material effect on the Company's consolidated financial
position or results of operations.

         The Company has not yet determined the complete status of Year 2000
compliance of its suppliers and financial institutions or what additional costs,
if any, might be required by the Company. Management believes that
non-compliance by the Company's suppliers will not have a material effect.
However, the failure of its financial institutions to become Year 2000 compliant
could have a material effect on the Company's consolidated financial position or
results of operations.

  Litigation

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

         The Company is involved in several actions relating to alleged
liability in connection with the U.S. Environmental Protection Agency's ("EPA")
National Priorities List ("NPL") sites:

         Sheridan. On March 31, 1987, the Sheridan Site Committee (the
"Committee") filed a claim on behalf of itself and 59 potentially responsible
parties ("PRPs") at the Sheridan Disposal Services site in Hempstead, Texas, a
NPL site. The claim was based on the Company's alleged liability to the
claimants for "contribution and potential cost recovery for administrative and
remedial work" expenses incurred and to be incurred by them in connection with
the Sheridan Disposal 



                                       41
<PAGE>   43
                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


site. On August 28, 1987, the Company reached a settlement
and agreed to pay its allocable share of response costs incurred by the
Committee, such share to be limited to the lesser of $3.0 million or 2.93
percent of actual response costs. Based upon an EPA Record of Decision ("ROD"),
total remediation costs are estimated to be approximately $28 million. On this
basis, the Company's share would be $0.8 million.

         Operating Industries. Under the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 (the "Superfund Act"), the EPA has been
conducting various activities at the Operating Industries, Inc. ("OII") site, an
NPL disposal site located in Monterey Park, California. On June 14, 1988, the
United States District Court entered an order approving a Stipulation and
Agreement to Compromise and Settle EPA's claim against the Company (the "OII
Settlement Agreement"). Under the OII Settlement Agreement, the Company agreed
to pay its allocable share of total future site response costs at the OII site,
which is limited to the lesser of $5.0 million or 0.65 percent of future site
response costs.

         Actual remediation of the OII Site is likely to extend for a number of
years after a final remedy is selected for the site. The EPA issued the ROD with
respect to the OII Site, estimating remediation costs of $300 million. The
Company is presently unable to determine the amount it may ultimately have to
contribute to the OII site pursuant to the OII Settlement Agreement. This amount
will range from approximately $150,000 that the Company has already paid to the
$5.0 million at which the Company's liability is capped under the OII Settlement
Agreement.

         Chemform. The Company operated a business and held a leasehold interest
in property located in Pompano Beach, Florida (the "Chemform Site") between May
14, 1976 and March 16, 1979, at which time the Company sold the business and
assigned the lease. The EPA placed the Chemform Site on the NPL on October 4,
1989. On September 22, 1992, the EPA issued the ROD for a portion of the
Chemform Site. The ROD selected a "No Action with Monitoring" alternative,
requiring groundwater to be monitored quarterly for at least one year. Although
the Company and two other PRPs completed four quarters of groundwater
monitoring, the Florida Department of Environmental Protection ("Florida DEP")
requested additional monitoring. The Company and two other PRPs performed the
additional monitoring and are presently conducting discussions with the EPA and
the Florida DEP regarding what, if any, additional monitoring work will be
required. The final scale of any monitoring work is not yet known. It is also
not yet known whether any groundwater remediation work will thereafter be
required.

         On September 16, 1993, the EPA issued the ROD for the remainder of the
Chemform Site, which addressed site-related soil contamination. The ROD
determined that no further action was necessary to address Operable Unit Two at
the site; however, the Florida DEP requested that additional soil be removed at
the Chemform Site. The Company and the two other PRPs performed the soil removal
requested under the oversight of the Florida DEP and has provided a Technical
Memorandum summarizing this action to the EPA and the Florida DEP. The Company
has not received any written response from either the EPA or the Florida DEP. In
April 1996, the Company and the other PRPs received a letter from the EPA
demanding approximately $0.8 million in response and oversight costs. The
Company and the other PRP's are contesting this claim and are requesting
additional information. As the EPA still retains jurisdiction over the Chemform
Site, it is possible that additional issues may arise which would require
further resolution, including the claim by the EPA for payment of past oversight
or response costs incurred. The Company intends to scrutinize and, if necessary,
vigorously contest any such claims made by the EPA.

         At December 31, 1997, the remaining recorded liability for estimated
future clean-up costs for the sites discussed above as well as properties
currently or previously owned or leased by the Company was $3.2 million. As
additional information becomes available, the Company may be required to provide
for additional environmental clean-up costs for Superfund sites and for
properties currently or previously owned or leased by the Company. However, the
Company believes that none of its clean-up obligations will result in
liabilities having a material adverse effect on the Company's consolidated
financial position or results of operations.


                                       42
<PAGE>   44

                            SMITH INTERNATIONAL, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)


14.  SUBSEQUENT EVENT

         On January 20, 1998, the Company announced the signing of a definitive
agreement to acquire Wilson Industries, Inc. ("Wilson") in a transaction
expected to be accounted for as a pooling of interest. Wilson, which operates
through Wilson Supply and Houston Engineers, is a privately-held company based
in Houston, Texas. Wilson Supply is a U.S.-based stocking distributor of
materials for drilling, production, refining and petrochemical plants and
pipeline operations. Houston Engineers provides drilling and fishing tools and
directional drilling services worldwide to the exploration and production
industry. The Company expects to issue 7.9 million shares of common stock in
exchange for all of the equity interests of Wilson.

         The transaction is subject to, among other conditions, approval by the
Wilson shareholders and various U.S. governmental entities. There are no
assurances as to whether this transaction will be ultimately consummated.

15.   QUARTERLY INFORMATION (UNAUDITED)

<TABLE>
<CAPTION>
1997                                            FIRST             SECOND            THIRD           FOURTH           YEAR
                                                -----             ------            -----           ------           ----

<S>                                          <C>               <C>               <C>              <C>             <C>       
Revenues ...............................     $     357,484     $     383,163     $    396,629     $   425,868     $1,563,144
                                             =============     =============     ============     ===========     ==========
Gross profit ...........................     $     121,265     $     133,194     $    140,040     $   154,033     $  548,532
                                             =============     =============     ============     ===========     ==========
Net income .............................     $      21,113     $      23,929     $     27,264     $    30,045     $  102,351
                                             =============     =============     ============     ===========     ==========
Basic earnings per share ...............     $        0.53     $        0.60     $       0.69     $      0.76     $     2.58
                                             =============     =============     ============     ===========     ==========
Diluted earnings per share .............     $        0.53     $        0.60     $       0.68     $      0.75     $     2.55
                                             =============     =============     ============     ===========     ==========
<CAPTION>
1996                                            FIRST             SECOND            THIRD           FOURTH           YEAR
                                                -----             ------            -----           ------           ----

<S>                                          <C>               <C>               <C>              <C>             <C>       
Revenues ...............................     $     238,820     $     270,272     $    310,657     $   336,909     $1,156,658
                                             =============     =============     ============     ===========     ==========
Gross profit ...........................     $      80,909     $      90,323     $    103,398     $   117,432     $  392,062
                                             =============     =============     ============     ===========     ==========
Net income .............................     $      12,948     $      14,981     $     16,604     $    19,911     $   64,444
                                             =============     =============     ============     ===========     ==========
Basic earnings per share ...............     $        0.33     $        0.38     $       0.42     $      0.51     $     1.64
                                             =============     =============     ============     ===========     ==========
Diluted earnings per share .............     $        0.33     $        0.38     $       0.42     $      0.50     $     1.62
                                             =============     =============     ============     ===========     ==========
</TABLE>


                                       43
<PAGE>   45


ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

         None.

                                    PART III

ITEM  10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         For information concerning directors of the Registrant, see the
information set forth following the caption "ELECTION OF DIRECTORS" in the
Company's definitive proxy statement to be filed no later than 120 days after
the end of the fiscal year covered by this Form 10-K (the "Proxy Statement"),
which information is incorporated herein by reference. For information
concerning executive officers of the Registrant, see Item 4A appearing in Part I
of this Form 10-K.

ITEM  11.  EXECUTIVE COMPENSATION

         The information set forth following the caption "EXECUTIVE
COMPENSATION" in the Company's Proxy Statement is incorporated herein by
reference.

ITEM  12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information set forth following the captions "ELECTION OF
DIRECTORS" and "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" in the
Company's Proxy Statement is incorporated herein by reference.

ITEM  13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information set forth following the captions "ELECTION OF
DIRECTORS" and "EXECUTIVE COMPENSATION" in the Company's Proxy Statement is
incorporated herein by reference.

                                     PART IV

ITEM  14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A)  FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                                                 PAGE
                                                                                                               REFERENCE
                                                                                                               ---------
<S>      <C>                                                                                                  <C>
(1)      Financial statements included in this report:
         Report of Independent Public Accountants...........................................................       19
         Consolidated Statements of Operations for the years ended
           December 31, 1997, 1996 and 1995.................................................................       20
         Consolidated Balance Sheets at December 31, 1997 and 1996..........................................      21-22
         Consolidated Statements of Shareholders' Equity for the years
           ended December 31, 1997, 1996 and 1995...........................................................       23
         Consolidated Statements of Cash Flows for the years ended
           December 31, 1997, 1996 and 1995.................................................................       24
         Notes to Consolidated Financial Statements.........................................................      25-43

(2)      Financial statement schedule for the years ended December 31, 1997,
           1996 and 1995:
         Report of Independent Public Accountants on Financial Statement Schedule...........................       49
         Schedule II-Valuation and Qualifying Accounts and Reserves.........................................       50
</TABLE>


                                       44
<PAGE>   46
         All other schedules have been omitted since the required information is
not present or not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the Consolidated
Financial Statements or notes thereto.

         (3)   EXHIBITS AND INDEX TO EXHIBITS

                  3.l     -- Restated Certificate of Incorporation of the
                             Company as amended to date. Filed as Exhibit 3.1 to
                             the Company's report on Form 10-K for the year
                             ended December 31, 1993 and incorporated herein by
                             reference.

                  3.2     -- Bylaws of the Company as amended to date. Filed
                             as Exhibit 3.2 to the Company's report on Form 10-K
                             for the year ended December 31, 1993 and
                             incorporated herein by reference.

                  4.1     -- Rights Agreement, dated as of June 19, 1990,
                             between the Company and First Chicago Trust Company
                             of New York.

                  4.2     -- Form of Indenture between the Company and The
                             Bank of New York, as Trustee. Filed as Exhibit 4.1
                             to the Company's Registration Statement on Form S-3
                             dated August 22, 1997 and incorporated herein by
                             reference.

                  4.3     -- Form of Note. Filed as Exhibit 4.2 to Amendment
                             No. 1 to the Company's Registration Statement on
                             Form S-3 dated September 9, 1997 and incorporated
                             herein by reference.

                  9.      -- Not applicable.

                  10.1    -- Smith International, Inc. Supplemental Pension
                             Plan as amended to date. Filed as Exhibit 10.1 to
                             the Company's report on Form 10-K for the year
                             ended December 31, 1995 and incorporated herein by
                             reference.

                  10.2    -- Smith International, Inc. 1982 Stock Option
                             Plan. Filed as Exhibit 10.2 to the Company's report
                             on Form 10-K for the year ended December 31, 1995
                             and incorporated herein by reference.

                  10.3    -- Smith International, Inc. 1989 Long Term
                             Incentive Compensation Plan, as amended to date.
                             Filed as Exhibit 10.3 to the Company's report on
                             Form 10-K for the year ended December 31, 1994 and
                             incorporated herein by reference.

                  10.4    -- Smith International, Inc. Directors' Retirement
                             Plan as amended to date. Filed as Exhibit 10.4 to
                             the Company's report on Form 10-K for the year
                             ended December 31, 1995 and incorporated herein by
                             reference.

                  10.5    -- Smith International, Inc. Supplemental Executive
                             Retirement Plan, as amended. Filed as Exhibit 10.5
                             to the Company's report on Form 10-K for the year
                             ended December 31, 1993 and incorporated herein by
                             reference.

                  10.6    -- Supply Agreement dated April 2, 1987 between the
                             Company and TCM Holding Corporation and Rogers Tool
                             Works, Inc. for the supply of tungsten carbide
                             products. Filed as Exhibit 10.6 to the Company's
                             report on Form 10-K for the year ended December 31,
                             1995 and incorporated herein by reference.


                                       45
<PAGE>   47

                  10.7    -- Amendment to Supply Agreement dated January 22,
                             1993 between the Company and Rogers Tool Works,
                             Inc. Filed as Exhibit 10.7 to the Company's report
                             on Form 10-K for the year ended December 31, 1995
                             and incorporated herein by reference.

                  10.8    -- Supply Agreement dated October 1, 1989 between
                             the Company and Amforge-Smith Forge Company for the
                             supply of forgings. Filed as Exhibit 10.8 to the
                             Company's report on Form 10-K for the year ended
                             December 31, 1995 and incorporated herein by
                             reference.

                  10.9    -- Employment Agreement dated December 10, 1987
                             between the Company and Douglas L. Rock. Filed as
                             Exhibit 10.11 to the Company's report on Form 10-K
                             for the year ended December 31, 1993 and
                             incorporated herein by reference.

                  10.10   -- Employment Agreement dated December 10, 1987
                             between the Company and D. Barry Heppenstall. Filed
                             as Exhibit 10.12 to the Company's report on Form
                             10-K for the year ended December 31, 1993 and
                             incorporated herein by reference.

                  10.11   -- Employment Agreement dated January 2, 1991
                             between the Company and Neal S. Sutton. Filed as
                             Exhibit 10.11 to the Company's report on Form 10-K
                             for the year ended December 31, 1996 and
                             incorporated herein by reference.

                  10.12   -- Employment Agreement dated May 1, 1991 between
                             the Company and Richard A. Werner. Filed as Exhibit
                             10.12 to the Company's report on Form 10-K for the
                             year ended December 31, 1996 and incorporated
                             herein by reference.

                  10.13   -- Employment Agreement dated April 3, 1995 between
                             the Company and Roger A. Brown. Filed as Exhibit
                             10.13 to the Company's report on Form 10-K for the
                             year ended December 31, 1995 and incorporated
                             herein by reference.

                  10.14   -- Amendment to Employment Agreement dated October
                             16, 1989 between the Company and Douglas L. Rock.
                             Filed as Exhibit 10.14 to the Company's report on
                             Form 10-K for the year ended December 31, 1995 and
                             incorporated herein by reference.

                  10.15   -- Amendment to Employment Agreement dated October
                             16, 1989 between the Company and D. Barry
                             Heppenstall. Filed as Exhibit 10.15 to the
                             Company's report on Form 10-K for the year ended
                             December 31, 1995 and incorporated herein by
                             reference.

                  10.16   -- Amendment to Employment Agreement dated January
                             2, 1991 between the Company and Neal S. Sutton.
                             Filed as Exhibit 10.16 to the Company's report on
                             Form 10-K for the year ended December 31, 1996 and
                             incorporated herein by reference.

                  10.17   -- Amendment to Employment Agreement dated May 1,
                             1991 between the Company and Richard A. Werner.
                             Filed as Exhibit 10.17 to the Company's report on
                             Form 10-K for the year ended December 31, 1996 and
                             incorporated herein by reference.

                  10.18   -- First Amendment to Amendment to Employment
                             Agreement dated November 12, 1992 between the
                             Company and Doug Rock. Filed as Exhibit 10.18 to
                             the Company's report on Form 10-K for the year
                             ended December 31, 1995 and incorporated herein by
                             reference.


                                       46
<PAGE>   48
                  10.19   -- First Amendment to Amendment to Employment
                             Agreement dated November 12, 1992 between the
                             Company and Barry Heppenstall. Filed as Exhibit
                             10.19 to the Company's report on Form 10-K for the
                             year ended December 31, 1995 and incorporated
                             herein by reference. 

                  10.20 --   First Amendment to Amendment to Employment
                             Agreement dated November 12, 1992 between the
                             Company and Neal S. Sutton. Filed as Exhibit 10.20
                             to the Company's report on Form 10-K for the year
                             ended December 31, 1995 and incorporated herein by
                             reference.

                  10.21   -- First Amendment to Amendment to Employment
                             Agreement dated November 12, 1992 between the
                             Company and Dick Werner. Filed as Exhibit 10.21 to
                             the Company's report on Form 10-K for the year
                             ended December 31, 1995 and incorporated herein by
                             reference.

                  10.22   -- Note Agreement, dated as of May 21, 1996,
                             between the Company and Principal Mutual Life
                             Insurance Company, John Hancock Mutual Life
                             Insurance Company, John Hancock Variable Life
                             Insurance Company, IDS Certificate Company, Mellon
                             Bank, N.A., as Trustee for AT&T Master Pension
                             Trust and The Maritime Life Assurance Company.
                             Filed as Exhibit 10.3 to the Company's report on
                             Form 10-Q for the quarter ended June 30, 1996 and
                             incorporated herein by reference.

                  10.23   -- Loan Agreement dated as of April 4, 1996, by and
                             among the Company and Texas Commerce Bank National
                             Association, a national banking association,
                             individually and as Agent, and the other financial
                             institutions parties thereto. Filed as Exhibit 10.1
                             to the Company's report on Form 10-Q for the
                             quarter ended June 30, 1996 and incorporated herein
                             by reference.

                  10.24   -- Loan Agreement dated as of April 4, 1996, by and
                             among M-I Drilling Fluids Company, L.L.C., Texas
                             Commerce Bank National Association, individually
                             and as Agent, and the other financial institutions
                             parties thereto. Filed as Exhibit 10.2 to the
                             Company's report on Form 10-Q for the quarter ended
                             June 30, 1996 and incorporated herein by reference.

                  10.25   -- First Amendment to Loan Agreement dated April 8,
                             1997, by and among the Company and Texas Commerce
                             Bank National Association, a national banking
                             association, individually and as Agent, and the
                             other financial institutions parties thereto. Filed
                             as Exhibit 10.1 to the Company's report on Form
                             10-Q for the quarter ended June 30, 1997 and
                             incorporated herein by reference.

                  10.26   -- First Amendment to Loan Agreement dated April 8,
                             1997, by and among M-I Drilling Fluids, L.L.C.,
                             Texas Commerce Bank National Association, a
                             national banking association, individually and as
                             Agent, and the other financial institutions parties
                             thereto. Filed as Exhibit 10.2 to the Company's
                             report on Form 10-Q for the quarter ended June 30,
                             1997 and incorporated herein by reference.

                  10.27   -- Second Amendment to Loan Agreement dated
                             December 23, 1997, by and among the Company and
                             Texas Commerce Bank National Association, a
                             national banking association, individually and as
                             Agent, and the other financial institutions parties
                             thereto.


                                       47
<PAGE>   49

                  10.28   -- Second Amendment to Loan Agreement dated
                             December 23, 1997, by and among M-I Drilling
                             Fluids, L.L.C., Texas Commerce Bank National
                             Association, a national banking association,
                             individually and as Agent, and the other financial
                             institutions parties thereto.

                  11.     -- Not applicable.

                  12.     -- Not applicable.

                  13.     -- Not applicable.

                  18.     -- Not applicable.

                  19.     -- Not applicable.

                  21.1    -- Subsidiaries of the Company

                  23.1    -- Consent of Independent Public Accountants.

                  27.1    -- Financial Data Schedule

(B) REPORTS ON FORM 8-K.

         No reports on Form 8-K were filed during the last quarter of the period
covered by this report.


                                       48
<PAGE>   50


    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE

To Smith International, Inc.:

         We have audited, in accordance with generally accepted auditing
standards, the consolidated balance sheets of Smith International, Inc. and
subsidiaries as of December 31, 1997 and 1996, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
three years in the period ended December 31, 1997, included in this Form 10-K,
and have issued our report thereon dated January 30, 1998. Our audits were made
for the purpose of forming an opinion on the basic consolidated financial
statements taken as a whole. The financial statement schedule listed in Part IV,
Item 14(A)(2) for Smith International, Inc. and subsidiaries is the
responsibility of the Company's management and is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not part of
the basic financial statements. This financial statement schedule has been
subjected to the auditing procedures applied in the audits of the basic
financial statements and, in our opinion, fairly states in all material respects
the financial data required to be set forth therein in relation to the basic
financial statements taken as a whole.



ARTHUR ANDERSEN LLP

Houston, Texas
January 30, 1998




                                       49
<PAGE>   51

                                                                     SCHEDULE II


                            SMITH INTERNATIONAL, INC.

                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                              ADDITIONS
                                                 BALANCE AT    CHARGED                                BALANCE
                                                 BEGINNING        TO                                   AT END
                                                  OF YEAR      EXPENSE   WRITE-OFFS      OTHER        OF YEAR
                                                  -------      -------   ----------      -----        -------
<S>                                               <C>         <C>         <C>          <C>            <C>    
Allowance for Doubtful Accounts:
  Year Ended--December 31,
    1997 ....................................     $ 6,424     $ 1,612     $(2,257)     $    25(a)     $ 5,804
 Year Ended--December 31,
    1996 ....................................     $ 6,838     $ 1,490     $(2,338)     $   434(a)     $ 6,424
 Year Ended--December 31,
    1995 ....................................     $ 8,679     $ 1,024     $(2,865)        --          $ 6,838
</TABLE>

(a) Amounts represent accounts receivable reserves related to acquisitions made
by the Company during the years presented.




                                       50
<PAGE>   52

                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                      SMITH INTERNATIONAL, INC.

                                      By:      /s/ DOUGLAS L. ROCK
                                          -------------------------------------
                                                   Douglas L. Rock
                                               Chief Executive Officer,
                                          President and Chief Operating Officer

March 23, 1998

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities on the date indicated:

<TABLE>

<S>                                        <C>                                                  <C>
/s/ DOUGLAS L. ROCK                         Chairman of the Board, Chief
----------------------------                 Executive Officer, President and
(Douglas L. Rock)                            Chief Operating Officer                            March 23, 1998


/s/ LOREN K. CARROLL                        Executive Vice President                            March 23, 1998
----------------------------
(Loren K. Carroll)


/s/ JOHN J. KENNEDY                         Senior Vice President, Chief Financial
----------------------------                 Officer and Treasurer                              March 23, 1998
(John J. Kennedy)


/s/ BENJAMIN F. BAILAR                      Director                                            March 23, 1998
----------------------------
(Benjamin F. Bailar)


/s/ G. CLYDE BUCK                           Director                                            March 23, 1998
----------------------------
(G.  Clyde Buck)


/s/ JAMES R. GIBBS                          Director                                            March 23, 1998
----------------------------
(James R. Gibbs)


/s/ JERRY W. NEELY                          Director                                            March 23, 1998
----------------------------
(Jerry W. Neely)


/s/ H. MOAK ROLLINS                         Director                                            March 23, 1998
----------------------------
(H. Moak Rollins)
</TABLE>


                                       51
<PAGE>   53

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                    DESCRIPTION
-------                   ------------

<S>        <C>
   3.l     -- Restated Certificate of Incorporation of the Company as amended
              to date. Filed as Exhibit 3.1 to the Company's report on Form 10-K
              for the year ended December 31, 1993 and incorporated herein by
              reference.

   3.2     -- Bylaws of the Company as amended to date. Filed as Exhibit 3.2
              to the Company's report on Form 10-K for the year ended December
              31, 1993 and incorporated herein by reference.

   4.1     -- Rights Agreement, dated as of June 19, 1990, between the
              Company and First Chicago Trust Company of New York.

   4.2     -- Form of Indenture between the Company and The Bank of New York,
              as Trustee. Filed as Exhibit 4.1 to the Company's Registration
              Statement on Form S-3 dated August 22, 1997 and incorporated
              herein by reference.

   4.3     -- Form of Note. Filed as Exhibit 4.2 to Amendment No. 1 to the
              Company's Registration Statement on Form S-3 dated September 9,
              1997 and incorporated herein by reference.

   9.      -- Not applicable.

   10.1    -- Smith International, Inc. Supplemental Pension Plan as amended
              to date. Filed as Exhibit 10.1 to the Company's report on Form
              10-K for the year ended December 31, 1995 and incorporated herein
              by reference.

   10.2    -- Smith International, Inc. 1982 Stock Option Plan. Filed as
              Exhibit 10.2 to the Company's report on Form 10-K for the year
              ended December 31, 1995 and incorporated herein by reference.

   10.3    -- Smith International, Inc. 1989 Long Term Incentive Compensation
              Plan, as amended to date. Filed as Exhibit 10.3 to the Company's
              report on Form 10-K for the year ended December 31, 1994 and
              incorporated herein by reference.

   10.4    -- Smith International, Inc. Directors' Retirement Plan as amended
              to date. Filed as Exhibit 10.4 to the Company's report on Form
              10-K for the year ended December 31, 1995 and incorporated herein
              by reference.

   10.5    -- Smith International, Inc. Supplemental Executive Retirement
              Plan, as amended. Filed as Exhibit 10.5 to the Company's report on
              Form 10-K for the year ended December 31, 1993 and incorporated
              herein by reference.

   10.6    -- Supply Agreement dated April 2, 1987 between the Company and
              TCM Holding Corporation and Rogers Tool Works, Inc. for the supply
              of tungsten carbide products. Filed as Exhibit 10.6 to the
              Company's report on Form 10-K for the year ended December 31, 1995
              and incorporated herein by reference.
</TABLE>


<PAGE>   54

<TABLE>
<S>        <C>
   10.7    -- Amendment to Supply Agreement dated January 22, 1993 between
              the Company and Rogers Tool Works, Inc. Filed as Exhibit 10.7 to
              the Company's report on Form 10-K for the year ended December 31,
              1995 and incorporated herein by reference.

   10.8    -- Supply Agreement dated October 1, 1989 between the Company and
              Amforge-Smith Forge Company for the supply of forgings. Filed as
              Exhibit 10.8 to the Company's report on Form 10-K for the year
              ended December 31, 1995 and incorporated herein by reference.

   10.9    -- Employment Agreement dated December 10, 1987 between the
              Company and Douglas L. Rock. Filed as Exhibit 10.11 to the
              Company's report on Form 10-K for the year ended December 31, 1993
              and incorporated herein by reference.

   10.10   -- Employment Agreement dated December 10, 1987 between the
              Company and D. Barry Heppenstall. Filed as Exhibit 10.12 to the
              Company's report on Form 10-K for the year ended December 31, 1993
              and incorporated herein by reference.

   10.11   -- Employment Agreement dated January 2, 1991 between the Company
              and Neal S. Sutton. Filed as Exhibit 10.11 to the Company's report
              on Form 10-K for the year ended December 31, 1996 and incorporated
              herein by reference.

   10.12   -- Employment Agreement dated May 1, 1991 between the Company and
              Richard A. Werner. Filed as Exhibit 10.12 to the Company's report
              on Form 10-K for the year ended December 31, 1996 and incorporated
              herein by reference.

   10.13   -- Employment Agreement dated April 3, 1995 between the Company
              and Roger A. Brown. Filed as Exhibit 10.13 to the Company's report
              on Form 10-K for the year ended December 31, 1995 and incorporated
              herein by reference.

   10.14   -- Amendment to Employment Agreement dated October 16, 1989
              between the Company and Douglas L. Rock. Filed as Exhibit 10.14 to
              the Company's report on Form 10-K for the year ended December 31,
              1995 and incorporated herein by reference.

   10.15   -- Amendment to Employment Agreement dated October 16, 1989
              between the Company and D. Barry Heppenstall. Filed as Exhibit
              10.15 to the Company's report on Form 10-K for the year ended
              December 31, 1995 and incorporated herein by reference.

   10.16   -- Amendment to Employment Agreement dated January 2, 1991 between
              the Company and Neal S. Sutton. Filed as Exhibit 10.16 to the
              Company's report on Form 10-K for the year ended December 31, 1996
              and incorporated herein by reference.

   10.17   -- Amendment to Employment Agreement dated May 1, 1991 between the
              Company and Richard A. Werner. Filed as Exhibit 10.17 to the
              Company's report on Form 10-K for the year ended December 31, 1996
              and incorporated herein by reference.

   10.18   -- First Amendment to Amendment to Employment Agreement dated
              November 12, 1992 between the Company and Doug Rock. Filed as
              Exhibit 10.18 to the Company's report on Form 10-K for the year
              ended December 31, 1995 and incorporated herein by reference.
</TABLE>


<PAGE>   55

<TABLE>
<S>        <C>
   10.19   -- First Amendment to Amendment to Employment Agreement dated
              November 12, 1992 between the Company and Barry Heppenstall. Filed
              as Exhibit 10.19 to the Company's report on Form 10-K for the year
              ended December 31, 1995 and incorporated herein by reference.
             
   10.20   -- First Amendment to Amendment to Employment Agreement
              dated November 12, 1992 between the Company and Neal S. Sutton.
              Filed as Exhibit 10.20 to the Company's report on Form 10-K for
              the year ended December 31, 1995 and incorporated herein by
              reference.

   10.21   -- First Amendment to Amendment to Employment Agreement dated
              November 12, 1992 between the Company and Dick Werner. Filed as
              Exhibit 10.21 to the Company's report on Form 10-K for the year
              ended December 31, 1995 and incorporated herein by reference.

   10.22   -- Note Agreement, dated as of May 21, 1996, between the Company
              and Principal Mutual Life Insurance Company, John Hancock Mutual
              Life Insurance Company, John Hancock Variable Life Insurance
              Company, IDS Certificate Company, Mellon Bank, N.A., as Trustee
              for AT&T Master Pension Trust and The Maritime Life Assurance
              Company. Filed as Exhibit 10.3 to the Company's report on Form
              10-Q for the quarter ended June 30, 1996 and incorporated herein
              by reference.

   10.23   -- Loan Agreement dated as of April 4, 1996, by and among the
              Company and Texas Commerce Bank National Association, a national
              banking association, individually and as Agent, and the other
              financial institutions parties thereto. Filed as Exhibit 10.1 to
              the Company's report on Form 10-Q for the quarter ended June 30,
              1996 and incorporated herein by reference.

   10.24   -- Loan Agreement dated as of April 4, 1996, by and among M-I
              Drilling Fluids Company, L.L.C., Texas Commerce Bank National
              Association, individually and as Agent, and the other financial
              institutions parties thereto. Filed as Exhibit 10.2 to the
              Company's report on Form 10-Q for the quarter ended June 30, 1996
              and incorporated herein by reference.

   10.25   -- First Amendment to Loan Agreement dated April 8, 1997, by and
              among the Company and Texas Commerce Bank National Association, a
              national banking association, individually and as Agent, and the
              other financial institutions parties thereto. Filed as Exhibit
              10.1 to the Company's report on Form 10-Q for the quarter ended
              June 30, 1997 and incorporated herein by reference.

   10.26   -- First Amendment to Loan Agreement dated April 8, 1997, by and
              among M-I Drilling Fluids, L.L.C., Texas Commerce Bank National
              Association, a national banking association, individually and as
              Agent, and the other financial institutions parties thereto. Filed
              as Exhibit 10.2 to the Company's report on Form 10-Q for the
              quarter ended June 30, 1997 and incorporated herein by reference.

   10.27   -- Second Amendment to Loan Agreement dated December 23, 1997, by
              and among the Company and Texas Commerce Bank National
              Association, a national banking association, individually and as
              Agent, and the other financial institutions parties thereto.
</TABLE>

<PAGE>   56

<TABLE>
<S>        <C>
   10.28   -- Second Amendment to Loan Agreement dated December 23, 1997, by
              and among M-I Drilling Fluids, L.L.C., Texas Commerce Bank
              National Association, a national banking association, individually
              and as Agent, and the other financial institutions parties
              thereto.

   11.     -- Not applicable.

   12.     -- Not applicable.

   13.     -- Not applicable.

   18.     -- Not applicable.

   19.     -- Not applicable.

   21.1    -- Subsidiaries of the Company

   23.1    -- Consent of Independent Public Accountants.

   27.1    -- Financial Data Schedule
</TABLE>