Annual Report (Form 10-K), fiscal year 1994

ITEM 1. BUSINESS
GENERAL
Smith International, Inc. ("Smith" or the "Company") is a leading worldwide supplier of products and services used in the drilling of oil and gas wells. Smith produces and markets drilling fluids and systems through its M-I Drilling Fluids Unit. Smith also manufactures and markets technologically advanced drill bits through its Smith Drill Bits Unit, and manufactures and markets drilling and completion products and services through its Smith Drilling and Completion Services Unit. Approximately 97% of services to the Company's revenues are derived from the oil and gas drilling industry with the remainder related to the mining and industrial markets.
The Company began providing drilling fluids and systems to the oil and gas drilling industry in March 1994 upon acquiring a 64% interest in M-I Drilling Fluids L.L.C. The following table sets forth the revenues attributable to continuing operations of the Company for its three business units:
RECENT ACQUISITIONS AND DIVESTITURES
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 was sold for $247.7 million. As a result, the Company recorded income in 1993 from discontinued operations of $73.6 million including the gain from the sale of the DDS business of $80.1 million. The gain included provisions for various fees, expenses and taxes related to the DDS sale. The DDS business reported revenues of approximately $36.3 million in the first three months of 1993 and $158.7 million in 1992. The DDS business reported operating losses of $6.5 million in the first three months of 1993 and $3.0 million in 1992.
The Company used a portion of the proceeds of the DDS sale to repay certain debt of the Company. For further discussion, refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Acquisitions of A-Z/Grant and Lindsey
On December 22, 1993, the Company acquired the product line assets of A-Z/Grant and Lindsey Completion Systems (A-Z/Grant and Lindsey) from MASX Energy Services Group, Inc. for $19.0 million in cash. The acquired A-Z/Grant and Lindsey operations are leading providers of downhole tools, remedial services and liner hangers to the oil and gas drilling industry. A-Z/Grant and Lindsey reported unaudited revenues of $31.6 million in 1993 and $29.0 million in 1992. The acquisition was accounted for as a purchase effective December 22, 1993. The unaudited results of A-Z/Grant and Lindsey from December 22, 1993 to December 31, 1993 were not significant to the operations of the Company.
Acquisition of M-I Drilling Fluids L.L.C.
Effective February 28, 1994, the Company acquired a 64% interest in M-I Drilling Fluids L.L.C. (M-I) from Dresser Industries, Inc. (Dresser) for $160.0 million. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. M-I is a leading provider of environmentally sensitive drilling fluids and
systems to the oil and gas drilling industry. The Company purchased the 64% interest in M-I using $80.0 million of its cash and issuing a note payable to Dresser for $80.0 million. For further discussion, refer to Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations." This acquisition was accounted for as a purchase. M-I reported unaudited revenues of $458.0 million in 1994, $405.8 million in 1993 and $382.6 million in 1992.
Acquisition of Supradiamant
On July 1, 1994, the Company acquired Supradiamant, S.A. (Supradiamant) from Societe Industrielle de Combustible Nucleaire for approximately $6.3 million in cash. Supradiamant is a leading manufacturer of ultrahard materials, polycrystalline diamonds and cubic boron nitride. This acquisition was accounted for as a purchase. Supradiamant reported unaudited revenues of $7.1 million in 1994, $7.5 million in 1993 and $6.8 million in 1992.
With the completion of the aforementioned acquisitions, the Company has established itself as a leading supplier of expendable drilling products to the oil and gas drilling industry. On an unaudited pro forma basis, the combined total revenues of all of the Company's businesses totaled $733.1 million in 1994 and $664.1 million in 1993.
Acquisition of Baker Hughes Treatment Services in 1995
Effective January 1, 1995, M-I (through its Swaco Geolograph division) acquired Baker Hughes Treatment Services (BHTS) from Baker Hughes, Inc. for approximately $5.1 million in cash. BHTS is a leading supplier of waste minimization, product recovery services, water treatment, downhole injection and reserve pit remediation services to the oilfield industry. This acquisition was accounted for as a purchase. BHTS reported unaudited revenues of approximately $10.7 million in 1994, $9.8 million in 1993 and $4.1 million in 1992.
INDUSTRY OVERVIEW
Substantially all of the Company's products and services are used in the process of drilling oil and natural gas wells. Therefore, the level of drilling activity is a useful general indicator of the demand for the products and services of the Company at any given time. The level of drilling activity is determined by a variety of factors over which the Company has no control, including the current and anticipated market price of crude oil and natural gas, the production levels of the Organization of Petroleum Exporting Countries ("OPEC") and other oil and gas producers, the regional supply and demand for oil and natural gas, the level of worldwide economic activity and the long-term effect of worldwide energy conservation measures. The worldwide average active rig count increased 3.3% from 1,713 in 1993 to 1,769 in 1994, primarily due to the 10.1% increase in the average North American rig count between 1993 and 1994.
Management anticipates that total drilling activity in 1995 will approximate 1994 activity levels. North American drilling activity is expected to decline due to the continued weakness in natural gas prices. A good portion of this decline is expected to be offset by higher drilling activity outside North America, principally in West Africa, the Far East and the North Sea. Management believes that the Company is well positioned to benefit from the increase in oil and gas drilling activity outside North America.
BUSINESS OPERATIONS
Drilling Fluids
Products and Services. Through the acquisition of M-I in March 1994, the Company provides drilling fluids systems, products, and technical services to end users engaged in drilling oil, natural gas, and geothermal wells worldwide. Drilling fluid products and systems are used to cool and lubricate the bit during drilling operations, contain formation pressures, keep rock cuttings in suspension to remove them 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
systems during the well planning phase, testing drilling fluid properties and recommending adjustments during the drilling phase, and analyzing well results after the well is completed to improve the performance of wells to be drilled in the future.
M-I offers water-based, oil-based, and synthetic-based drilling fluid systems. These are chemically complex systems, comprised of a number of products designed to ensure that the diverse functions of the fluid are met. Weighting agents, composed of high specific gravity materials such as barite and hematite are added to drilling fluid systems to increase their density. When drilling through pressurized zones, the added weight creates hydrostatic pressures that hold back formation pressures and prevent an influx of fluids from the formation into the hole. Thickening agents, or viscosifiers, produce the viscosity needed to remove the cuttings from the bit and provide adequate gel strength to suspend the cuttings when circulation is interrupted. Bentonite, a naturally occurring clay, is the most widely used viscosifier. Polymers are used to control viscosity and gel strengths and for thinning a fluid that has become too thick from formation cuttings. Loss circulation materials, such as fibers, flakes, and shells, plug pores in the formation to prevent the loss of mud. Finally, specialty products are used in certain circumstances to complement the base products, acting to reduce torque and drag, free stuck pipe, or enhance temperature stability.
Oil-based 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-based drilling fluids are used in similar drilling environments and often exceed the superior performance characteristics of oil-based drilling fluids.
M-I's geothermal/air drilling operations provides air drilling services to the geothermal, oil and gas drilling markets. These services include the rental of high-volume, high-pressure compressors and related equipment, along with expert technical support and fluid products associated with air drilling.
Through its Swaco Geolograph operations, a complete line of solids control, pressure control, and rig instrumentation products 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 dominant market positions. The solids control product line of shakers, hydroclones, and centrifuges have 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 Geolograph's rig instrumentation line features the SMART Data Acquisition System, an advanced monitoring system that measures, monitors, and displays the drilling status of a well with high speed accuracy.
With the acquisition of Baker Hughes Treatment Services (BHTS) in January 1995, Swaco Geolograph will become the world's largest supplier of waste minimization and product recovery services to the oilfield industry. BHTS also expands Swaco Geolograph's product line to include water treatment, downhole injection, and reserve pit remediation services.
Competition. The major competitors in the worldwide drilling fluids industry are Baroid Drilling Fluids (a division of Dresser), Inteq (a division of Baker-Hughes, Inc.) 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 and foreign multinational drilling fluids suppliers as well as limited product producers that market their products without technical services.
Competition within the drilling fluids industry is primarily based on the performance of the system in meeting customers' drilling objectives, the quality and experience of the field engineers, pricing, locational or other operational advantages, well planning capabilities in the design of a drilling fluids program, and the technical support of field engineers.
Drill Bits
Products. The Company's Drill Bits unit designs, manufactures and markets drill bits used in drilling oil and gas wells and mining applications. The Company offers over 900 drill bits under the Smith Tooltm, Smith Diamondtm and Smith Miningtm product lines. Drill bit sizes range from 3 1/2 to 28 inches in diameter for the
petroleum industry and from 2 15/16 to 17 1/2 inches in diameter for the mining industry. Most bits manufactured by the Company are three-cone drill bits. The surfaces of the cones are comprised of different types of pointed structures that are 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.
The Company also manufactures and markets shear bits featuring cutters made of polycrystalline diamond ("PDC") or natural diamonds. The Company manufactures PDC's and cubic boron nitride at its SII Megadiamond, Inc. (Megadiamond) and Supradiamant subsidiaries. These ultrahard materials are used in the Company's 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. The Company believes that the transition layer diamond insert significantly improves the ability of diamond shear bits to drill in harder and more abrasive formations. Smith is the only oilfield equipment manufacturer that develops, manufactures and markets its own synthetic diamond materials, which provides the Company a cost and technological advantage with respect to these products. 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 into Smith drill bits, across other Smith product lines and into several non-energy cutting tool markets. Diamond enhanced products last longer, 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 will provide new business opportunities such as Diamond Enhanced Insert roller cone bits and Impaxtm hammer bits as well as non-energy cutting tool markets.
The cutting structures in mining bits are principally tungsten carbide inserts ("TCI"). Mining bits are typically utilized for shallow drilling to place explosives for blasting in open pit mining operations. Other mining bits using both tungsten carbide and diamond enhanced inserts have been designed for use with air driven percussion tools and are known as hammer bits.
Competition. Besides the Company, Hughes Christensen (a division of Baker-Hughes, Inc.), Security/DBS (a division of Dresser), and Reed/Hycalog (a division of Camco International, Inc.) 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. The Company believes its quality and reliability as well as technological advances, such as the Diamond Enhanced Inserts, specialized hardmetal applications and Spinodal bearing features in its drill bits, further enhance the Company's reputation and competitive advantage. Competition for sales of mining drill bits generally is based on a number of factors, including price, performance and availability.
Drilling and Completion Services
Products and Services. The Smith Drilling and Completion Services Unit manufactures and markets downhole drilling tools and tubular drill string components and provides related drilling and completion services for drilling oil and gas wells. These tubular products, which are manufactured with the Drilco product line, include drill collars to provide drilling weight to the bit, Hevi-Watetm drill pipe to provide stress transition between drill collars and conventional drill pipe or to provide drilling weight to the bit in horizontal drilling, connecting subs to attach drill string members of differing diameters and connections and kellys to rotate the drill string on conventional drilling rigs. The Company's downhole tools are sold or rented to the end users, and include stabilizers to centralize the drill string and reamers to maintain a uniform hole diameter.
The Company also manufactures downhole remedial tools for use in connection with the drill string for specialized drilling and workover operations within its Servco product line. These remedial tools are sold or rented to the end users, and typically include supervision services provided by the Company's employees. These remedial operations include section milling to remove a section of casing permitting the well to be re-drilled using the existing casing string, hole opening and underreaming to enlarge the wellbore for proper cementing of the casing or gravel packing, packer milling to remove production packers, conventional milling
to remove wellbore obstructions, pipe cutting to remove the casing when a well is abandoned and fishing services to remove obstructions from well bores primarily during workover operations.
The Company maintains field service centers which provide inspection and repair services for the Company's drill string components, customer owned tubular goods and for the Company's rental tools. These field service centers serve as the distribution points for all the Company's products, and are an important part of the Company's marketing efforts.
In addition to the above, the recently acquired A-Z/Grant products and services provide a further strengthening to the Servco and Drilco product lines. A-Z/Grant adds whipstock technology to Servco through its patented Packstocktm and Anchorstocktm sidetrack systems. Well abandonment services are also enhanced by the addition of the Dynacuttm Wellhead Severance system.
Grant tools adds further strengthening to Drilco through the addition of a full line of rotating drilling heads and a computerized connection torque monitoring system. The combinations of A-Z/Servco and Drilco/Grant strengthen, enhance and position both product lines as market leaders in technology and geographic presence.
Lindsey Completion Systems, a part of the A-Z/Grant acquisition offers a product line expansion for the Company. The Lindsey product line provides hanger systems and cementing equipment which are prevalent in deep wells and critical completion systems.
Competition. Competition in the drilling and completion services market is primarily based on response time, reliability and price. The Company attributes its competitive position to its commitment to quality and service which is evidenced by the Company maintaining quality equipment and trained personnel at field service centers in almost every major drilling location in the world. The markets for drilling and completion services are highly fragmented.
INTERNATIONAL OPERATIONS
Sales to the international oil drilling markets are a key strategic focus of Smith management, and the Company markets its products and services through its subsidiaries, joint ventures and sales agents in virtually all petroleum producing areas of the world, including Canada, the North Sea/Europe, the Middle East, Mexico, Central and South America, Asia/Pacific and Africa. As a result, 57% of the Company's total revenues from continuing operations in 1994 were generated from sales in the international markets, compared to 53% in 1993. Approximately 52% of the Company's revenues in 1994 are denominated in U.S. dollars as compared to 61% in 1993.
Historically, international drilling activity has been less volatile than in the U.S. due to the relatively high costs of exploration and development programs which can only be 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
The Company markets its products on a worldwide basis, employing Company sales personnel and independent sales agents. In addition, independent distributors and unconsolidated joint ventures market drilling fluid products in many locations. Sales efforts are also directed to end users in the drilling industry including independent drilling contractors, major and independent oil companies and national oil companies.
The Company's sales force is supported by field service centers worldwide. The Company considers that its worldwide sales position has been significantly enhanced by its field service centers presently maintained in every major oil and gas producing area. These field service centers serve as bases for the sales force and rental tool operations and also provide an opportunity to market a wider range of the Company's products than could be marketed by a sales office. The Company's field service centers are also important factors in maintaining good customer relations since they are designed primarily for repair and maintenance of drill string components and rental tools.
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 estimates that the Company has available manufacturing facilities to accommodate a worldwide demand level equivalent to approximately 3,000 average active drilling rigs which compares to approximately 1,700 average active drilling rigs estimated for 1995. In addition, the Company has entered into license agreements and joint ventures with worldwide manufacturers in order to increase its production capacity for drill bits.
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. Significant barite reserves are located in Nevada and the United Kingdom. Bentonite is produced from ore deposits in Wyoming and Greece. Mining exploration activities continue worldwide to locate and evaluate ore bodies to ensure deposits are ready for production when market conditions dictate their entry. In addition to its own production, M-I purchases a majority of its worldwide barite requirements from international suppliers, mainly located in the People's Republic of China, India and Morocco.
The Company purchases a variety of raw materials for its Smith Drill Bits Unit and Smith Drilling and Completion Services Unit, 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 currently purchases 80% of the tungsten carbide inserts used as cutting structures on drill bit cones, wear pads for stabilizers and hard surface materials for mills and reamers from one supplier pursuant to a supply agreement entered into in connection with the sale of a division by the Company to that supplier. In addition, the Company has also entered into a supply agreement to purchase 80% of its U.S. forging requirements from a single supplier. The Company believes that numerous alternative supply sources are available for all of such materials. The Company also produces PDC synthetic diamonds in Provo, Utah and Grenoble, France 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 M-I Drilling Fluids Unit maintains an aggressive research and development effort, reflecting the market's demands for better performance in the more hostile drilling environments and heightened concern over protecting the environment where drilling occurs. Through its research facilities in Houston, Texas, Stravanger, Norway and Aberdeen, Scotland, M-I provides basic research, testing, and technical support for its field engineers. Its environmental services group evaluates and monitors toxicity data and safe material handling procedures on all of M-I's products, enabling the customer to design a drilling program that is environmentally responsible and safe.
The M-I Drilling Fluids Unit's focus on research and development has led to the development and introduction of several new drilling fluid products and systems, most notably, FLO-PROtm, NOVADRILtm, KLA-CUREtm, and PIPE-LAX ENVtm. The FLO-PROtm system, a rheologically-engineered water-based system designed to drill the productive interval of horizontal and highly deviated wells, was introduced to the worldwide drilling and production market in 1994. NOVADRILtm is a non-toxic, synthetic-based invert emulsion drilling fluid system that offers many of the properties of conventional oil mud systems while avoiding the environmental problems associated with using diesel oil. NOVADRILtm was introduced to the U.S. Gulf of Mexico and North Sea markets in 1992 and to the Far East market in 1994. In May and June of 1994, the system set industry records for drilling performance, drilling over 7,400 feet and 8,400 feet, respectively, in a 24-hour interval.
KLA-CUREtm is a water-soluble, environmentally-acceptable hydration suppressant, and is used to inhibit the dispersion and swelling of highly-reactive clays. PIPE-LAX ENVtm is a low-toxic, water dispersible spotting fluid designed to free differentially stuck drillstrings. Unlike other spotting fluids, PIPE-LAX ENVtm contains no hydrocarbons and can be incorporated into most normal drilling fluid systems to comply with most toxicity regulations.
The Smith Drill Bits and Smith Drilling and Completion Services Units maintain product development and engineering departments in rock bit, diamond bit, downhole tool and liner hanger technology whose activities are directed to developing new products and processes, improving existing product lines and designing specialized products to meet customer requirements. Experimental work in metallurgy also comprises a significant portion of the work of these departments. For example, recent new product developments include: tungsten carbide insert and milled tooth Spinodaltm bearing roller cone bits, Diamond Enhanced Insert roller cone bits, steerable motor PDC and roller cone bits; Diamond Enhanced Stabilizers; the Smith Diamond Maxidrilltm products and Diamond Enhanced Impaxtm hammer bits; the Servco Millmastertm carbide cutting structure; and the Servco Superdometm PDC underreamers and hole openers. In recent years, the Company has received special meritorious awards for engineering innovations sponsored by Petroleum Engineer International magazine. One such award was for the placement of PDC on curved surfaces for rock bit cutting structures, underreamers and hole openers while another was for the development of a new hardfacing material for use on milled tooth drill bits.
During 1991, the Company developed FDS+ Milled Tooth Rock Bits for longer life at higher rates of penetration. The Company continuously attempts to improve the quality, performance and reliability of its products in order to maintain its competitive position in the industries it serves and to develop new tools and materials to meet the evolving market needs.
The Company also maintains a drill bit data base which records the performance of substantially all drill bits used in the U.S. over the last 10 years, including those manufactured by competitors. This database gives the Company the ability to monitor, among other things, drill bit failures and performance improvements with product development. Management believes this proprietary data base gives the Company a competitive advantage in the drill bit business.
The Company has historically maintained its research and engineering expenditures at a high level to enable it to maintain its technological and performance leadership and broaden its product lines. The Company's expenditures for research and engineering activities amounted to $14.6 million in 1994, $6.6 million in 1993 and $6.2 million in 1992. In 1994, research and engineering expenditures approximated 2% of revenues.
In February 1995, the Company and its wholly owned subsidiary, SII Megadiamond, Inc., entered into a research and technology development agreement with Sandvik AB, a Swedish company, which includes joint ownership of technology and may lead to the sale of products. Should this cooperation agreement prove to be successful and should revenues reach certain hurdle rates, Sandvik has the option to purchase a minority interest in Megadiamond. In no instance does the exercise of this option include the transfer of control of Megadiamond.
Although the Company has over 650 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, 1994, the Company had approximately 4,100 full time employees throughout the world. Most of the Company's employees in the United States are not covered by collective bargaining agreements except certain domestic mining operations of M-I. The Company considers its labor relations to be satisfactory.
OTHER BACKGROUND INFORMATION
On March 7, 1986, the Company, exclusive of its subsidiaries, filed for protection under Chapter 11 of the U.S. Bankruptcy Code as a result of a judgment in the amount of $205.4 million in a patent infringement case relating to a drill bit patent that has since expired. The Company initiated the bankruptcy proceedings in order to protect its assets and operations from the judgment. On December 31, 1987, the Company's plan of reorganization became effective, and since that date it has conducted its business in the ordinary course.
During the reorganization, the Company completed an extensive restructuring of its internal operating divisions and sold certain of its operations in order to focus on its core businesses. Because the Company sustained its historical levels of research and engineering expenditures and maintained its share of industry revenues during this period, management believes that the Company was not adversely affected by the reorganization.
Industrial Equity (Pacific) Limited, a Hong Kong Corporation ("IEP") acquired 8,754,892 shares of Common Stock, 933,468 Class A Warrants and 967,133 Class B Warrants in open market purchases beginning in October 1986 and pursuant to the Company's plan of reorganization. Pursuant to a private placement in February 1988, IEP acquired preferred stock that was subsequently converted into the Company's 8.75% Convertible Preferred Stock.
In May 1989, the Board of Directors of the Company was notified by IEP that IEP wished to explore the possibility of acquiring the remaining shares of the Company that it did not own. In response to that announcement, a Special Committee of the Company's Board of Directors was formed. In July 1989, the Special Committee announced that it intended to solicit offers for the Company from third parties and "explore alternatives designed to maximize shareholder value."
The Company agreed to be acquired by Dresser pursuant to an Agreement and Plan of Merger, dated November 13, 1989. On December 28, 1989, Dresser exercised its right to terminate the Merger Agreement based upon circumstances relating to obtaining clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended.
On March 19, 1990, the Company and IEP entered into an agreement pursuant to which the Company and IEP agreed, among other things, that IEP would sell certain of the Company's securities owned by it in a public offering. The offering was successful and closed on May 30, 1990. IEP agreed that it would not acquire any securities in excess of 5% of the Company's Common Stock on a fully diluted basis for a five year period from the closing of the offering.
ITEM 2.



ITEM 2. PROPERTIES
The principal facilities and properties of the Company at December 31, 1994 are shown in the table below.
The Company considers its mines and manufacturing and processing facilities to be in good condition and adequately maintained. Due to the downturn in business in recent years, the Company's manufacturing facilities operated below capacity throughout 1994 and are continuing to operate below capacity levels. A portion of the Houston, Texas facility is currently being held for sale by the Company.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
In January 1991, the Company and several of the Company's competitors were served with a federal grand jury subpoena for documents, principally concerning the Company's sales, marketing and pricing activities for tri-cone rock bits produced and sold by the Company. In June 1992, Baker Hughes entered a plea of guilty to an Information charging it with a single count of violating Section 1 of the Sherman Act for the period March through May 11, 1989 and agreed to pay a $1.0 million fine to the U.S. government. On November 23, 1993, the Company entered a plea of guilty to a violation of Section 1 of the Sherman Act for the same period and paid a fine to the U.S. government of $0.7 million.
After it was served the subpoena by the grand jury, the Company was served with complaints in three civil proceedings. Each action alleged violations of Section 1 of the Sherman Act. The cases were consolidated for discovery purposes with four other cases filed against other tri-cone rock bit manufacturers, but not the Company, in the Southern District of Texas, which made allegations similar to those made against the Company. The consolidated case was captioned Red Eagle Resources Corporation, Inc., et al. v. Baker Hughes, Inc., Baker Hughes Production, Inc., Hughes Tool Company, Reed Tool Company, a/k/a/ Baker RTC, Inc., Camco International, Inc., Smith International, Inc., and Dresser Industries, Inc., Civil Action No. 91-H-627. In September 1992, the district court certified the case as a class action. The class consisted of direct purchasers of rock bits from defendants in the period September 1, 1986, through January 15, 1992.
On August 27, 1993, without admitting any form of liability, the Company entered into an agreement with the plaintiffs to settle all claims against the Company. The Company recorded a special charge of $19.9 million to cover the cost of the settlement of $16.8 million and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement.
Chevron USA Inc., which opted not to be part of the above mentioned class action, filed suit against the Company in the United States District Court for the Southern District of Texas, Houston Division, entitled Chevron USA Inc., acting by and through its division Chevron USA Production Company v. Baker Hughes, Inc., Reed Tool Company a/k/a Baker RTC, Inc., CAMCO International, Inc., Smith International, Inc. and Dresser Industries, Inc. Cause No. H-93-949, alleging violations of Section 1 of the Sherman Act. On July 12, 1994, without admitting any liability, the Company and Camco International, Inc. entered into an agreement with the plaintiffs to pay $0.5 million. The Company's portion of the agreed payment was $0.3 million. On July 25, 1994, the U.S. District Judge signed and entered an Agreed Order of Dismissal giving final approval to the settlement.
Executive Life
On March 4, 1992, the Company was served with a complaint in the U.S. District Court in the Central District of California, entitled Lynn Martin, Secretary of the U.S. Dept. of Labor v. Smith International, Inc., et al., Case No. CV92-1196. In addition, seven of its employees or former employees (the "Individual Defendants") were also served. The complaint alleges violations of the Employee Retirement Income Security Act of 1974 ("ERISA") arising out of the Company's purchase of annuities from Executive Life Insurance Company ("Executive Life"), upon the termination of its Pension Plan in August 1985. On April 11, 1991, Executive Life was placed in conservatorship in California state court by the California Insurance Commissioner. As a result of the conservatorship and reorganization, Executive Life emerged in 1993 as Aurora National Life Assurance Company, Inc. ("Aurora") from the conservatorship proceeding. Under the rehabilitation plan as ordered by the Los Angeles Superior Court judge, Aurora will honor in part Executive Life's past and continuing commitments under the annuities outstanding; however, a portion of these obligations will not be paid by Aurora (the "Shortfall").
In November 1994, the Company was dismissed from the lawsuit after obtaining summary judgment in its favor on the grounds that the Company's 1986 bankruptcy barred the Department of Labor's claim. The Individual Defendants remained in the lawsuit.
Trial of the Department of Labor's claims against the Individual Defendants and the Company's and the Individual Defendants' crossclaims was scheduled to begin on December 6, 1994. Prior to the trial, the parties agreed in principle to a settlement whereby: (i) the Department of Labor will be paid the sum of $4.07 million (which represents an actuarial estimate of the Shortfall); (ii) the Department of Labor will distribute the $4.07 million to the participants and beneficiaries of the Company's Pension Plan consistent with the goal of making the participants and beneficiaries whole to the extent possible from the $4.07 million payment only; (iii) the Company and the Department of Labor will sign a consent order which, among other things, provides that the Company neither admits nor denies the allegations of the Department of Labor's complaint; (iv) the Company will reasonably cooperate with the Department of Labor in their efforts to equitably distribute the $4.07 million; and (v) the Individual Defendants will not be required to sign the consent order and they will be dismissed with prejudice upon the payment of the $4.07 million to the Department of Labor. A substantial portion of the $4.07 million settlement will be paid by the Company's insurance carrier. The Company accrued its portion of the settlement of approximately $1.0 million in 1994.
The parties are in the process of preparing settlement documents. The Company anticipates that the settlement will be fully documented and all payments made to the Department of Labor by April 1995.
Superfund
The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (the "Superfund Act") generally addresses remedial action at sites from which there has been a "release" of "hazardous substances." Among other things, the Superfund Act authorizes the U.S. Environmental Protection Agency (the "EPA") to take any necessary response actions at these sites and, in certain circumstances, to order those parties liable for the "release" to take response actions. The EPA may seek reimbursement of expenditures of federal funds from parties potentially liable under the Superfund Act. Relevant court decisions have interpreted the Superfund Act to impose strict, joint and several liability upon all persons liable for response costs under the statute with respect to a particular site, if the harm at such site is indivisible. The Superfund Act requires the EPA to develop a National Priorities List ("NPL") of sites which are the most deserving of prompt investigation and remediation. At present, there are approximately 1,000 sites nationwide on the NPL.
The Sheridan Site. On March 31, 1987, the Sheridan Site Committee (the "Committee") filed a claim in the Company's Chapter 11 case on behalf of itself and 59 potentially responsible parties ("PRPs") at the Sheridan Disposal Services site in Hempstead, Texas, an 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 site.
On August 28, 1987, the Company reached a settlement with the Committee. The Committee agreed to withdraw its proof of claim. In return, the Company 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% of actual response costs. The Company's obligations pursuant to the settlement agreement with the Committee were not discharged or affected by confirmation of the Company's plan of reorganization.
The settlement agreement with the Committee further provides that payments by the Company will be made on the same basis and at the same time as they are made by members of the Committee whose members have recently agreed to enter into a judicial consent decree under which they will complete the remedies selected by EPA under its Record of Decision (the "ROD"), issued in December 1988 and supplemented in September 1989. Based upon the ROD, total remediation costs are estimated, on a preliminary basis, to be approximately $28.0 million. On this basis, the Company's share would be $0.8 million. On October 4, 1989, the Company entered into a Sheridan Site Trust Agreement together with 37 other PRPs, providing a mechanism for the disbursement of funds in connection with remedial action to be performed at the Sheridan Site. Remediation activities at the Sheridan Site have been suspended until the consent decree has been entered by the Federal District Court for the Southern District of Texas. The consent decree provisions for installation of a spur jetty system and the performance of an onsite Biotreatment Pilot Study have already been completed. The spur jetty system was installed before the consent decrees were lodged and the Biotreatment Pilot Study was performed under the Administrative Order. Once the consent decree is entered, remediation efforts and expenditures at the Site will likely extend over several years.
The OII Site. Under the Superfund Act, the EPA has been conducting various activities at the Operating Industries, Inc. ("OII") site, a disposal site on the NPL located in Monterey Park, California. The United States, on behalf of the EPA, filed a proof of claim in the Company's Chapter 11 case alleging that it had incurred approximately $8.0 million in response costs to date, and would continue to incur response costs in the future. Subsequently, the United States alleged that its costs had increased to over $10.0 million. In addition to the United States, 21 other PRPs for cleanup of the OII site also filed proofs of claim against the Company's estate for contribution or indemnity arising from any claims asserted against them by the United States for response costs. The Company objected to the claims of the United States and the PRPs.
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's estate (the "OII Settlement Agreement"). Under the OII Settlement Agreement, the claim of the United States was allowed as an amount (approximately $150,000) sufficient to entitle the EPA to a distribution pursuant to the Company's plan of reorganization. The Company further agreed to pay its allocable share of total future site response costs at the OII site, such share, however, to be limited to the lesser of $5.0 million or 0.65% of future site response costs.
On July 15, 1988, the District Court entered a further order withdrawing and dismissing the general unsecured claims of the 21 potentially responsible parties and their requests for payment of administrative expenses.
The EPA has issued three RODs with respect to the OII Site and remediation work under RODs I and II has commenced. The Company may be requested to make interim contributions with respect to these RODs. The EPA issued ROD III with respect to landfill gas control and landfill cover on September 30, 1990. This ROD includes net present work cost estimates for the work covering 30, 45 and 60 years of project life. The EPA has estimated the cost of this work to exceed $300.0 million. Because of the time span involved in the remedy, EPA is working with certain parties on a South West Early Action Plan ("SWEAP") designed to address landfill gas issues in the southwestern portion of the OII landfill, which is near several homes. The Company may be requested to pay its allocable share of costs incurred to stabilize and remediate the OII Site.
The cost of the final long-term remedy for the clean-up of the OII site is presently unknown and depends on the nature and extent of contamination at the site and the remedy which is ultimately selected. The EPA has released a draft Remedial Investigation, but is still preparing its final Remedial Investigation and Feasibility Study ("RI/FS") which will examine the various alternatives for a final remedy of the site. It is not known at this time when the EPA will complete the final RI/FS. Actual remediation expenditures will likely extend for a number of years after a final remedy is selected for the site, subsequent to completion of the RI/FS.
At this time, the Company is 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 the 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.
The Chemform Site. Chemform, Inc. ("Chemform"), a former wholly owned subsidiary of the Company and, subsequently, the Company itself, 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 Chemform business and assigned the lease.
The EPA has been conducting various activities at the Chemform Site under the Superfund Act and placed the Chemform Site on the NPL on October 4, 1989. In October 1989, the Company, along with three other PRPs at the Chemform Site, entered into a consent agreement with the EPA for the preparation of an RI/FS. An Amendment to that consent agreement, which became effective on April 7, 1992, specified that the RI/FS for the Chemform Site would be addressed in two operable units: Operable Unit One addresses site-related groundwater contamination, and Operable Unit Two addressed source and soil contamination.
On September 22, 1992, the EPA issued the ROD for Operable Unit One at the Site. The ROD selected a "No Action with Monitoring" alternative, under which groundwater would be monitored quarterly for at least one year. On July 13, 1993, the Company, along with two other PRPs and the EPA, executed an Administrative Order on Consent ("AOC") and Scope of Work ("SOW") to govern the implementation of the ROD for Operable Unit One at the Chemform Site. Under the terms of the AOC and SOW, the Company, along with two other PRPs, agreed to undertake the groundwater monitoring work specified in the AOC and SOW. Four quarters of groundwater monitoring have now been completed in accordance with the terms of the AOC and SOW. The State of Florida, as represented by the Florida Department of Environmental Protection ("Florida DEP"), has requested that additional monitoring work be performed. The Company and two other PRPs are presently conducting discussions with the EPA and the Florida DEP regarding whether additional monitoring work will be required and, if so, what the scope of such work will be. The final scale of the 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 Operable Unit Two at the Chemform Site, which addresses site-related soil contamination. The ROD determined that no further Superfund 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 have performed the soil removal requested, but it is unknown whether the Florida DEP will require any additional soil removal work. As the EPA still retains jurisdiction over the Chemform Site, it is possible that additional issues may arise which would require further resolution. The Company believes that the EPA will demand reimbursement of certain oversight expenses that the EPA allegedly has incurred in administering the Chemform site. The Company intends to scrutinize and, if necessary, vigorously contest any such claims made by the EPA.
In 1994, 1993 and 1992, the Company paid for various clean-up activities and recorded additional provisions charged to continuing operations of $0.3 million, $0.5 million and $0.4 million, respectively, and also charged a provision of $1.5 million to the gain on sale of DDS operations based on annually revised estimates of required future clean-up costs. In addition, estimated liabilities of approximately $2.5 million were recorded in the 1994 consolidated balance sheet in connection with the Company's 1994 business acquisitions.
At December 31, 1994, 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 $6.1 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.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
(a) The names and ages of all executive 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.
(b) All officers of the Company are elected annually by the Board of Directors at the meeting of the Board of Directors regularly held immediately following the annual meeting of shareholders. They hold office until their successors are elected and qualified.
PART II
ITEM 5.

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.
On March 3, 1995, the Company had approximately 5,040 Common Stock holders of record and the last reported closing price on the New York Stock Exchange Composite Tape was $13.625.
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.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
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(a) Effective February 28, 1994, the Company acquired a 64% interest in M-I Drilling Fluids L.L.C. (M-I) from Dresser Industries, Inc. (Dresser) for $160.0 million. M-I is a leading provider of drilling fluids and systems to the oil and gas drilling industry. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. As a result, the financial data for 1994 includes the results of M-I for the period subsequent to the acquisition date. The Company purchased the 64% interest in M-I using $80.0 million of its cash and issuing a note payable to Dresser for $80.0 million. See Notes 2 and 4 of Notes to Consolidated Financial Statements.
(b) In March 1993, the Company sold its DDS business to Halliburton resulting in income from discontinued operations of $73.6 million. This amount includes the gain from the sale of the DDS business of $80.1 million. As a result, the financial data for the periods 1990 through 1992 has been restated to report the results of the DDS business as discontinued operations. The Company used a portion of the proceeds from the DDS sale to repay its bank debt and $49.0 million of notes payable to insurance companies. The Company's remaining debt, totaling $46.0 million, was presented as long-term debt at December 31, 1993 and 1992. See Notes 2 and 4 of Notes to Consolidated Financial Statements. (Notes continued on following page)
(c) In September 1993, the Company agreed to settle a class action civil lawsuit which alleged violations of Section 1 of the Sherman Act. As a result, the Company recorded a special charge of $19.9 million to cover the cost of the settlement and related legal fees and other costs and expenses. See Note 14 of Notes to Consolidated Financial Statements.
(d) During the first quarter of 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." As a result of adopting SFAS No. 106, the Company recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the Consolidated Statements of Operations. See Note 9 of Notes to Consolidated Financial Statements.
(e) In 1991, the Company recorded $22.2 million of non-recurring charges related primarily to the restructuring of its worldwide operations in response to a decline in U.S. drilling activity. The non-recurring charges consisted of $21.2 million of charges related to the restructuring and an additional $1.0 million tax provision to reflect expected tax settlements of prior year foreign tax liabilities of certain of the Company's subsidiaries. The amount of restructuring charges related to the continuing operations of the Company of $18.4 million in 1991 was charged to income (loss) from continuing operations before interest and taxes. The amount of restructuring charges related to the DDS business of $2.8 million is recorded in the results of discontinued operations in 1991.
(f) In 1991, the Company paid off its Series B Notes totaling $44.7 million from the $50.0 million proceeds of its temporary warrant reduction offers and its issuance of 992,000 shares of additional common stock.
(g) In accordance with APB No. 11, the Company recognized an extraordinary tax credit of $7.5 million in 1990 resulting from utilization of operating loss carryforwards of which approximately $5.2 million related to continuing operations.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Smith International, Inc. manufactures and markets a wide range of products and services used in the drilling of oil and gas wells. The Company historically has provided technologically advanced drill bits and drilling and completion products and services to the oil and gas industry. The Company began providing drilling fluids and systems to the oil and gas drilling industry in March 1994 upon acquiring a 64% interest in M-I Drilling Fluids L.L.C. (M-I).
The decline in worldwide oil and gas drilling activity which occurred in 1992 caused the Company to reassess its future strategy from both a business portfolio and financial flexibility standpoint. Management concluded that the sale of the Company's directional drilling systems and services (DDS) business was in the best long-term interest of the Company's shareholders. This conclusion resulted in the sale of the DDS business to Halliburton Company in March 1993 for $247.7 million in cash.
The proceeds of the DDS sale have enabled the Company to pursue its strategic growth objective and reduce its debt burden. The Company used $102.6 million of the cash proceeds to repay debt of the Company. In addition several key acquisitions have been accomplished as part of the Company's strategic program. On December 22, 1993, the Company purchased the product line assets of A-Z/Grant and Lindsey Completion Systems (A-Z/Grant and Lindsey). On February 28, 1994, the Company acquired a 64% majority interest in M-I an acknowledged world leader in drilling fluid systems, from Dresser Industries, Inc. On July 1, 1994, the Company acquired Supradiamant, S.A. (Supradiamant), a leading manufacturer of ultrahard materials, polycrystalline diamonds and cubic boron nitride, to strengthen the Company's Megadiamond product line. Effective January 1, 1995, M-I (through its Swaco Geolograph division) acquired Baker Hughes Treatment Services (BHTS), a leading supplier of waste minimization, product recovery services, water treatment, downhole injection and reserve pit remediation services to the oilfield industry from Baker-Hughes, Inc. These acquisitions were all accounted for as purchase transactions and the acquired operations are included in the Company's Consolidated Statements of Operations from the dates of each acquisition. The Company believes that these acquisitions complement the Company's existing core products in forming one of the more complete packages of expendable products to the oil and gas drilling and production industry.
Management anticipates that total drilling activity in 1995 will approximate 1994 activity levels. North American drilling activity is expected to decline due to the continued weakness in natural gas prices. A good portion of this decline is expected to be offset by higher drilling activity internationally outside North America, principally in West Africa, the Far East and the North Sea. Management believes that the Company is well positioned to benefit from the increase in international oil and gas drilling activity outside North America.
RESULTS OF OPERATIONS
Revenues
The products manufactured and the services provided by the Company fall into three product and service business units that are marketed throughout the world. The following table sets forth the amounts and percentages of revenues by business units and by area, as well as average rig count data:
Drilling Fluids
Drilling Fluids revenues represents ten months operations related to the M-I Drilling Fluids Unit acquired on February 28, 1994. Drilling Fluids revenues increased approximately $40.1 million or 11.7% over the same period in 1993 (prior to the Company's acquisition of M-I Drilling Fluids) due primarily to increased revenues in North America due to increased drilling activity, and increased volumes in Norway, Latin America and Germany.
Drill Bits
Drill Bits revenues are generated from the sale of petroleum drill bits and mining bits. Petroleum drill bit revenues increased $16.3 million or 11.2% from $145.8 million in 1993 to $162.1 million in 1994 due primarily to increased sales in Canada resulting from the increase in drilling activity, the acquisition of Supradiamant and increased sales in Latin America and the U.S. These increases were partially offset by reduced sales in Europe due to lower drilling activity. Petroleum drill bit revenues increased $18.3 million or 14.4% from $127.5 million in 1992 to $145.8 million in 1993 due primarily to higher sales and improved pricing in the United States and Canada resulting from the increase in North American drilling activity and increased sales into the former Soviet Union. These increases were partially offset by reduced sales in the North Sea area due to lower drilling activity and reduced volume in Mexico and Italy.
Mining drill bit sales increased $0.6 million or 3.6% from $16.5 million in 1993 to $17.1 million in 1994 due to higher sales in Australia and increased sales to Canadian iron ore producers. Mining drill bit sales decreased $1.5 million or 8.3% from $18.0 million in 1992 to $16.5 million in 1993 due to reduced sales to Canadian iron ore producers.
Drilling and Completion Services
Drilling and Completion Services revenues increased $33.7 million or 57.7% from $58.4 million in 1993 to $92.1 million in 1994. The increase in revenues was primarily due to the acquisition of the A-Z/Grant and Lindsey product lines and higher sales volume in North America and Colombia. Drilling and Completion Services revenues decreased $6.8 million or 10.4% from $65.2 million in 1992 to $58.4 million in 1993 due to lower international drilling activity primarily in the Europe/Africa region, the Middle East and Mexico. These declines were partially offset by increased sales in Canada.
For the periods indicated, the following table summarizes the results of continuing operations of the Company and presents results as a percentage of total revenues of the continuing operations:
1994 Versus 1993
Total revenues for 1994 increased by $433.2 million from $220.7 million in 1993 to $653.9 million in 1994. The increase was primarily due to the acquisitions of M-I, A-Z/Grant and Lindsey and Supradiamant. In addition, the revenue increase reflected the higher North American drilling activity, increased drill bit sales in Latin America and increased drilling and completion services volume in the United States and Colombia.
Gross profit, computed as revenues less cost of revenues, increased by $141.3 million from $80.0 million in 1993 to $221.3 million in 1994. The increase was due to the acquisitions of M-I, A-Z/Grant and Lindsey and Supradiamant and higher volumes in Canada and the United States. In addition, the increase in gross profit reflected increased drill bit volumes in Latin America and lower drilling and completion services operating costs in Europe/Africa.
Operating expenses, comprised of selling expenses and general and administrative expenses, increased by $99.8 million from $61.4 in 1993 to $161.2 in 1994. The increase was due primarily to the additional expenses associated with the newly acquired companies and increased variable costs related to the higher level of revenues partially offset by lower legal expenses as a result of the settlement of the drill bit litigation suit in 1993. Operating expenses as a percentage of revenues decreased from 27.8% in 1993 to 24.7% in 1994.
Interest expense increased by $4.0 million from $6.0 million in 1993 to $10.0 million in 1994 due primarily to the additional $80.0 million of debt incurred to acquire M-I and higher variable interest rates. Interest income decreased by $2.4 million from $3.8 million in 1993 to $1.4 million in 1994 as a result of reduced short-term investments as these funds were used in the acquisition of A-Z/Grant and Lindsey in December 1993, and M-I and Supradiamant in 1994.
The Company provides for U.S. taxes at the statutory rate offset by tax benefits related to the net operating loss carryforwards, available to the Company as well as foreign taxes. The tax provision increased $6.3 million from $0.5 million in 1993 to $6.8 million in 1994. The tax provision primarily reflects foreign taxes on income principally related to the additional earnings of M-I.
Minority interests represents the share of M-I profits associated with the 36% minority interest in the earnings of M-I partially offset by credits associated with other minority interests from investments in other joint ventures held by M-I.
1993 Versus 1992
Revenues for 1993 increased $10.0 million or 4.7% from $210.7 in 1992 to $220.7 in 1993. Revenues in the United States and Canada increased due primarily to increased drilling activity. These increases were partially offset by lower revenues outside of North America due to lower drilling activity. Domestic revenues increased $16.2 million, or 18.4%, from $88.2 million in 1992 to $104.4 million in 1993 due to a 5.0% increase in the average U.S. rig count and improved pricing. International revenues decreased by $6.2 million or 5.1% from $122.5 million in 1992 to $116.3 million in 1993 due to the 9.7% decline in international drilling activity which was partially offset by revenues in Canada and the former Soviet Union.
Gross profit, computed as revenues less cost of revenues, increased $8.4 million or 11.7% from $71.6 million in 1992 to $80.0 million in 1993. Gross profit increased due to higher sales and improved pricing in the United States and Canada.
Operating expenses, comprised of selling expenses and general and administrative expenses, increased by $0.1 million or 0.2% from $61.3 million in 1992 to $61.4 million in 1993. The increase was due primarily to higher variable selling expenses relating to the higher North American revenues and increased legal expenses associated with the drill bit litigation. These increases were reduced by lower personnel levels due to cost reduction actions and lower foreign currency translation losses. Operating expenses as a percentage of revenues decreased from 29.1% in 1992 to 27.8% in 1993.
On August 27, 1993, without admitting any form of liability, the Company entered into an agreement to settle a class action civil lawsuit pending in the federal district court in Houston. The lawsuit alleged that the Company and other defendants violated Section 1 of the Sherman Act. The Company recorded a special charge of $19.9 million to cover the cost of the settlement and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement.
Interest expense decreased $4.6 million or 43.4% from $10.6 million in 1992 to $6.0 million in 1993 due to the refinancing of long-term debt in the fourth quarter of 1992 and the repayment of debt from the proceeds of the DDS sale. Interest income increased by $3.3 million from $0.5 million in 1992 to $3.8 million in 1993 due to a higher level of short-term investments resulting from the investment of the proceeds of the DDS sale.
The tax provision of $0.5 million for 1993 consists primarily of foreign taxes on income. The tax benefit of $1.0 million in 1992 relates primarily to a $2.5 million benefit related to the settlement of a U.S. tax claim with the IRS. The Company provides for U.S. taxes at the statutory rate offset by tax benefits related to the U.S. net operating loss (NOL) carryforwards, available to the Company as well as foreign taxes. During 1993, the Company adopted Statement of Financial Accounting Standard No. 109 for accounting for income taxes. The adoption did not materially affect the 1993 results.
LIQUIDITY AND CAPITAL RESOURCES
General
The Company's cash position at December 31, 1994 totaled $8.1 million or a decrease of $93.4 million from the Company's cash position at December 31, 1993. The Company's current ratio decreased to 2.57 to 1 at December 31, 1994 from 3.28 to 1 at December 31, 1993. The decrease in cash and the current ratio was due primarily to the acquisition of the 64% interest in M-I for $160.0 million using $80.0 million of cash and the issuance of a note payable to Dresser for $80.0 million and the acquisition of Supradiamant for approximately $6.3 million in cash.
The Company refinanced the Dresser note payable in March 1994 with a $40.0 million term loan from two of its insurance company lenders, and a $65.0 million revolving line of credit from a bank group. The term loan bears interest at a rate of 6.02 percent and is payable over a four year period ending in January 1998. The revolving line of credit expires in March 1997 and bears interest at a rate ranging from LIBOR + 3/4 percent to LIBOR + 1 1/2 percent based upon debt-to-total capitalization ratios. The Company had borrowing capacity under its domestic line of credit at December 31, 1994 of approximately $26.0 million.
In June 1994, the Company established a $20.0 million revolving line of credit for M-I with its existing bank lenders. This revolving line of credit expires in February 1996 and bears interest at the rate of LIBOR + 3/4 percent. M-I had borrowing capacity under this revolving line of credit at December 31, 1994 of $20.0 million. The Company has guaranteed its proportional 64% interest of the revolving line of credit or approximately $12.8 million.
The Company also had various international borrowing facilities with various foreign banks totaling approximately $15.7 million. At December 31, 1994, the Company had borrowing capacity under its' international credit facilities of approximately $10.1 million.
The Company has annual interest requirements of approximately $6.3 million under its existing long-term fixed rate debt agreements. In addition, the Company will incur interest expense under the $65.0 million and $20.0 million revolving lines of credit referred to above. The amount of such interest expense will be determined by the amounts of the lines which are utilized and the variable interest rates in effect. 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. The Company has not paid dividends on its Common Stock since the first quarter of 1986. In addition to complying with the covenants of the indentures, 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.
The Company believes that it has sufficient existing manufacturing capacity to meet current demand for its products and services. Projected capital expenditures in 1995 will approximate $28.0 million. The Company currently expects to be able to meet its ongoing working capital and capital expenditure requirements from existing cash on hand, operating cash flow and existing credit facilities.
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, 1994, the remaining recorded liability for estimated future clean-up costs for Superfund sites as well as properties currently or previously owned or leased by the Company was $6.1 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs. 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. See Item 3. "Legal Proceedings" for discussion of Superfund matters and other significant litigation.
Because of its substantial foreign operations, the Company is exposed to currency fluctuations and exchange risks. The Company tries to limit these risks by matching, to the extent possible, assets and liabilities denominated in foreign currencies and using hedging instruments to cover certain unmatched positions.
Inflation has not had a material effect on the Company in the last few years, and the effect is expected to be minor in the near future. In general, the Company has been able to offset most of the effects of inflation through productivity gains, cost reductions, and price increases.
Net Operating Loss Carryforwards
As of December 31, 1994, for U.S. tax reporting purposes, the Company had net operating loss ("NOL") carryforwards of approximately $84.4 million, expiring between 2002 and 2007, which should be available to offset future U.S. taxable income. Upon certain changes in equity ownership of the Company, however, the Company's ability to utilize its NOL carryforwards may become subject to limitation under Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"). Management believes that the application of Section 382 will not materially limit the availability of the NOL carryforwards.
ITEM 8.


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, 1994 and 1993, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1994. These consolidated financial statements and schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule 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 financial statements referred to above present fairly, in all material respects, the financial position of Smith International, Inc. and subsidiaries as of December 31, 1994 and 1993, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the accompanying index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit 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.
As discussed in Note 1 to the Notes to Consolidated Financial Statements, the Company adopted, effective January 1, 1993, Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes" and SFAS No. 106 "Employers Accounting for Postretirement Benefits other than Pensions".
ARTHUR ANDERSEN LLP
Houston, Texas February 8, 1995
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1994, 1993 AND 1992
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ALL DOLLAR AMOUNTS IN THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE EXPRESSED IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND WHERE STATED IN MILLIONS)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and all of its wholly-owned and majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in affiliates of at least a 20% interest but not more than a 50% interest are accounted for using the equity method; all other investments are carried at cost, which does not exceed the estimated net realizable value of such investments.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, the Company considers all highly liquid financial instruments purchased with an original maturity of three months or less to be cash equivalents.
Property, Plant and Equipment
Property, plant and equipment, which includes rental equipment, are stated at cost. The Company computes depreciation on plant and equipment using principally the straight-line method. The estimated useful lives used in computing depreciation range from 3 to 40 years for buildings, 3 to 20 years for machinery and equipment, and 3 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. Expenditures for maintenance, repairs and minor improvements are charged to expense when incurred. When property, plant and equipment 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 results 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 most of the domestic inventories of the Smith Drill Bit Division and the Smith Drilling and Completion Services Division and by the first-in, first-out ("FIFO") method for all other inventories. Inventory costs consist of materials, labor and factory overhead.
Amortization
Goodwill is being amortized over 40 years using the straight-line method. 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.
Translation of Foreign Currencies
For the majority of the Company's international operations, the functional currency is the United States dollar. As a result, the accounts of these international operations are translated to United States dollars as follows: cash, receivables and related allowances, current liabilities and long-term debt are translated at year-end exchange rates; income and expense accounts, except for cost of inventory sold and depreciation and amortization are translated at average exchange rates during the year and all other accounts are translated at
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
historical rates. All translation adjustments resulting from the translation of these financial statements to United States dollars are charged or credited to income currently.
For the remaining international operations of the Company, the functional currency is the applicable local currencies. The accounts of the these operations are translated to United States dollars as follows: all asset and liability accounts are translated at year-end exchange rates, and income and expense items are translated at the average exchange rates during the year. Cumulative translation adjustments resulting from the translation of the financial statements of these operations to United States dollars are recorded as a separate component of shareholders' equity.
All foreign currency transaction gains and losses are credited or charged to income currently.
Foreign Exchange Contracts
From time to time, the Company enters into spot and forward contracts under foreign exchange lines as a hedge against accounts payable in foreign currencies. Market value gains and losses on such forward contracts are recognized on a monthly basis, and the resulting amounts offset foreign exchange gains or losses on the related accounts payable as payments are made.
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.
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 Statement of Financial Accounting Standards with ("SFAS") No. 109 "Accounting for Income Taxes" which was adopted in the first quarter of 1993. This standard superseded SFAS No. 96, "Accounting for Income Taxes" and requires an asset and liability approach for financial accounting and income tax reporting based on enacted tax rates. In connection with the adoption of SFAS No. 109, the Company elected not to restate prior years' consolidated financial statements and has determined that the cumulative effect of the change in accounting for income taxes was insignificant.
Revenue Recognition
The Company's revenues are composed of product sales and rental, service and other revenues. The Company records product sales when the goods are sold to a customer. Rental, service and other revenues are recorded as the rentals and services are performed.
Minority Interests
The Company records minority interests expense which primarily represents the portion of the earnings of M-I applicable to the 36% minority interest in M-I.
Earnings Per Common Share
Earnings per common share are computed on the basis of the weighted average number of common shares and equivalent shares outstanding during each year after deducting preferred dividends in 1993 and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1992. Earnings per common share assuming full dilution, is substantially the same as primary earnings per common share as presented for each of the three years ended December 31, 1994. As the Company incurred a net loss for the year ended December 31, 1992, the equivalent shares were antidilutive; therefore, the equivalent shares were not included in the average number of common shares outstanding when calculating the loss per common share in 1992.
Income (loss) per common share from discontinued operations was $1.95 and $(.08), respectively, for the years ended December 31, 1993 and 1992. The loss per common share attributable to the change in accounting principle was $(.03) for the year ended December 31, 1993.
Employee Benefits
During the first quarter of 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This standard changed the criteria for recognizing the cost of postretirement benefits from the cash basis to the recognition of such benefits over the employee service periods. As a result of adopting this standard, the Company recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the 1993 consolidated statement of operations.
Reclassifications
Certain reclassifications have been made to the 1993 and 1992 consolidated financial statements and notes in order to conform with the current year presentation.
2. ACQUISITIONS AND DIVESTITURES
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 was sold for $247.7 million. As a result, the Company recorded income from discontinued operations of $73.6 million including the gain from the sale of the DDS business of $80.1 million. The gain includes provisions for various fees, expenses and taxes related to the DDS sale.
The consolidated statements of operations report the net results of the DDS operations as income (loss) from discontinued operations. The DDS business reported revenues of $36.3 million in the first three months of 1993 and $158.7 million in 1992. In determining the income (loss) from discontinued operations, interest expense of $1.3 million in 1993 and $5.6 million in 1992 has been allocated to the discontinued DDS operations based on the ratio of the estimated net assets sold in relation to the sum of the Company's shareholders' equity and the aggregate of outstanding debt at the end of each period.
Acquisitions of A-Z/Grant and Lindsey
On December 22, 1993, the Company acquired the product line assets of A-Z/Grant and Lindsey Completion Systems (A-Z/Grant and Lindsey) from MASX Energy Services Group, Inc. for $19.0 million in cash. A-Z/Grant and Lindsey are a leading provider of downhole tools, remedial services and liner hangers to the oil and gas industry. A-Z/Grant and Lindsey reported unaudited revenues of $31.6 million in 1993 and $29.0 million in 1992. This acquisition was accounted for as a purchase effective December 22, 1993. The unaudited results of A-Z/Grant and Lindsey from December 22, 1993 to December 31, 1993, were not significant to the operations of the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The historical balance sheet of the Company at December 31, 1993 included the historical accounts of A-Z/Grant and Lindsey on an estimated basis. During the third quarter of 1994, the Company revised its valuation of the tangible assets acquired and other costs related to the purchase of A-Z/Grant and Lindsey. The Company has restated its December 31, 1993 balance sheet for such revisions by increasing inventories by $6.7 million, other assets by $0.8 million and other liabilities by $0.1 million and decreasing property, plant and equipment, net by $7.4 million.
Acquisition of M-I Drilling Fluids L.L.C.
Effective February 28, 1994, the Company acquired a 64% interest in M-I Drilling Fluids L.L.C. (M-I) from Dresser Industries, Inc. (Dresser) for $160.0 million. M-I was owned 64% by Dresser and 36% by Halliburton prior to the acquisition. M-I is a leading provider of drilling fluids and systems to the oil and gas drilling industry. The Company purchased the 64% interest in M-I using $80.0 million of its cash and issuing a note payable to Dresser for $80.0 million due on August 28, 1994 (See Note 4 for discussion of the refinancing of this note). This acquisition was accounted for as a purchase. The Company recorded approximately $37.3 million of goodwill upon purchase of the 64% interest in M-I. M-I reported unaudited revenues of $75.4 million for the two months ended February 28, 1994, $405.8 million in 1993 and $382.6 million in 1992.
Acquisition of Supradiamant
On July 1, 1994, the Company acquired Supradiamant, S.A. (Supradiamant) from Societe Industrielle de Combustible Nucleaire for approximately $6.3 million in cash. Supradiamant is a leading manufacturer of ultrahard materials, polycrystalline diamonds and cubic boron nitride. This acquisition was accounted for as a purchase. Supradiamant reported unaudited revenues of $3.9 million for the first six months of 1994, $7.5 million in 1993 and $6.8 million in 1992. Summarized unaudited pro forma results from continuing operations of Supradiamant for the years ended December 31, 1994 and 1993 are not significant to the Company.
The historical balance sheet of the Company at December 31, 1994 includes the historical accounts of Supradiamant and certain purchase accounting adjustments on an estimated basis. Management has not fully evaluated all of the consequences of the acquisition of Supradiamant including assessing the fair market value of the tangible assets acquired and the total amount of costs that may be necessary to reorganize their operations. Upon completion of these evaluations during 1995, any additional adjustments will be recorded and the excess purchase price over net tangible assets acquired, if any, will be recorded as goodwill in accordance with purchase accounting rules and principles.
The unaudited pro forma revenues and income from continuing operations for the years ended December 31, 1994 and 1993 assuming the acquisitions of A-Z/Grant and Lindsey, M-I and Supradiamant had been made on January 1, 1993 are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Unaudited Subsequent Event-Acquisition of Baker Hughes Treatment Services
Effective January 1, 1995, M-I (through its Swaco Geolograph division) acquired Baker Hughes Treatment Services (BHTS) from Baker-Hughes, Inc. for approximately $5.1 million in cash. BHTS is a leading supplier of waste minimization, product recovery services, water treatment, downhole injection and reserve pit remediation services to the oilfield industry. This acquisition will be accounted for as a purchase. BHTS reported unaudited revenues of approximately $10.7 million in 1994, $9.8 million in 1993 and $4.1 million in 1992.
3. INVENTORIES
Inventories consist of the following:
4. DEBT
The following summarizes the Company's outstanding debt:
In March 1994, the Company refinanced the $80.0 million note payable to Dresser issued to purchase its investment in M-I with a $40.0 million term loan from two of its insurance company lenders and a $65.0 million revolving line of credit from a bank group. The term loan is payable over a period ending in January 1998. The revolving line of credit expires in March 1997 and bears interest at a rate ranging from LIBOR + 3/4 percent to LIBOR + 1 1/2 percent based upon the debt-to-total capitalization of the Company. The revolving line of credit carries a commitment fee of 3/8 percent of the unutilized credit facility.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In June 1994, the Company established a $20.0 million revolving line of credit for M-I with its existing bank lenders. This revolving line of credit expires in February 1996 and bears interest at the rate of LIBOR + 3/4 percent. At December 31, 1994, M-I has borrowing capacity under this revolving line of credit of $20.0 million. The Company has guaranteed its proportional 64% interest of the revolving line of credit or approximately $12.8 million. This revolving line of credit carries a commitment fee of 1/4 percent of the unutilized credit facility.
In connection with the DDS sale, the Company was required to repay its bank debt. The Company also granted options which expired on July 23, 1993 to its insurance company lenders for early repayment of their debt at a reduced make whole premium. On April 12, 1993, the Company used a portion of the proceeds of the DDS sale to retire its domestic credit facility totaling $37.2 million, its domestic bank term loan totaling $16.4 million and $39.0 million of notes payable with insurance companies. On July 23, 1993, the Company repaid an additional $10.0 million of notes payable with insurance companies. The Company's remaining debt totaling $46.0 million at December 31, 1993 was classified as long-term. The Company renegotiated its loan agreements with the insurance companies to amend certain financial covenants as well as to release the collateral under the loan indenture. The Company was in compliance with its loan covenants under the amended loan indenture at December 31, 1994 and 1993, respectively.
Certain of the Company's foreign subsidiaries have short-term lines of credit with various foreign banks totaling approximately $15.7 million. At December 31, 1994, borrowings of $5.6 million were outstanding under these lines. The majority of these lines are unsecured.
The Company's indentures relating to its long-term debt 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. The Company has not paid dividends on its Common Stock since the first quarter of 1986. In addition to complying with the covenants of the indentures, 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.
The Company had average short-term borrowings of $9.1 million in 1994 and $13.9 million in 1993. The average interest rate related to these short-term borrowings were 13% and 7%, respectively.
Payment requirements on long-term debt for the next five years are as follows: $10.0 million in 1995; $10.0 million in 1996; $59.2 million in 1997; $20.2 million in 1998; $10.2 million in 1999; and $15.4 million thereafter.
Interest paid during the years ended December 31, 1994, 1993, and 1992 amounted to $7.0 million, $9.2 million, and $15.7 million, respectively.
5. FINANCIAL INSTRUMENTS
The carrying values of cash and cash equivalents, receivables, accounts payable and short-term debt approximate the fair market values due to the short-term maturities of these instruments. Management believes that the carrying amount of long-term debt is not materially different from the fair value using rates currently available for debt of similar terms and maturity.
The Company is a party to financial instruments described below with off balance sheet risks which it utilizes in the normal course of business to manage its exposure to fluctuations in interest rates and foreign currency exchange rates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Foreign Currency Forward Contracts and Options
At December 31, 1994, the Company had outstanding foreign exchange contracts as a hedge against foreign accounts totaling $17.5 million maturing at various dates during 1995. There were no significant unrecorded gains or losses on these contracts as of December 31, 1994. The Company had outstanding foreign currency option contracts of $14.8 million at December 31, 1994 which expire at various dates in 1995. The Company has no loss exposure under these contracts.
Interest Rate Contracts
In July 1993, the Company entered into an interest rate swap agreement which expires on October 1, 1997 with a financial institution in order to balance the portfolio of fixed rate and floating rate instruments of the Company. Under this agreement, the Company receives a fixed rate of 4.86% and pays a floating rate based on 6 month LIBOR on $46.0 million in borrowings. Management estimates that the fair market value of the swap agreement at December 31, 1994 was approximately ($1.7 million). The fair market value was estimated by discounting the expected cash flows using current market rates over the life of the swap agreement. The estimation determined above may not be indicative of the amounts which the Company would pay in a current market exchange or ultimately pay over the life of the swap agreement. Management believes that the swap will not have a material effect on the consolidated financial position or results of the Company over the remaining term of the swap agreement.
6. INCOME TAXES
The consolidated income tax provision (benefit) relating to continuing operations are summarized as follows:
Deferred taxes are principally attributable to timing differences related to depreciation expense and net operating loss (NOL) and tax credit carryforwards. Deferred taxes also include, in 1992, the net benefit resulting from a settlement of various outstanding issues with the Internal Revenue Service related to prior year audits and offsetting claims for refunds of prior year taxes. In 1994 and 1993, 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.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The income tax provision (benefit) computed by applying the U.S. Federal statutory rate to income (loss) from continuing operations before income taxes and after minority interest are reconciled to the actual tax provision (benefit) as follows:
The components of the net deferred tax asset (liability) are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The net change in deferred taxes of $11.1 million is primarily attributed to the acquisition of M-I as discussed in Note 2.
For U.S. tax reporting purposes, the Company has cumulative NOL carryforwards in the amount of approximately $84.4 million. These losses were generated in 1987, 1988 and 1992 in the amounts of $39.9 million, $42.3 million and $2.2 million, respectively. Losses in 1987, 1988 and 1992 are available to reduce future U.S. taxable income that may be generated through the years 2002, 2003 and 2007, respectively. On certain changes in equity ownership of the Company, the ability to utilize NOL carryforwards becomes subject to limitation under Section 382 of the Internal Revenue Code of 1986, as amended. In the opinion of management, the application of Section 382 will not materially limit the availability of net tax loss carryforwards.
Also available to reduce future U.S. income taxes are unused alternative minimum tax credits of $3.8 million and investment tax credits of $7.3 million. The investment tax credits expire as follows: $2.8 million in 1997, $1.8 million in 1998, $1.6 million in 1999 and $1.1 million in 2000. Income taxes paid during the years ended December 31, 1994, 1993 and 1992 amounted to $7.0 million, $0.9 million, and $4.4 million respectively.
The Company's foreign subsidiaries currently have undistributed earnings of $18.0 million which if repatriated would be generally sheltered from U.S. tax by NOL carryforwards and various foreign tax credits.
7. CAPITAL STOCK
Preferred Stock
In 1988, the Company authorized the issuance of 5,000,000 shares of 8.75% convertible preferred stock. The convertible preferred stock carried a cumulative annual dividend of 8.75% ($2.1875 per share based on a $25 value) was payable quarterly and was convertible into common stock at $8 per share, subject to certain antidilution adjustments. The Preferred Stock had a liquidation preference of $25 per share plus cash equal to any accumulated and unpaid dividends, and was redeemable at the Company's option at any time at a redemption price of $25 per share plus cash equal to any accumulated and unpaid dividends, provided that the average closing price of the common stock for the 20 trading days ending on the fifth day before mailing the notice of redemption was at least 125% of the conversion price if mailed before February 10, 1994. The Company issued 800,000 shares of the preferred stock for $20.0 million in cash in a private placement of securities in 1988. These shares were issued to the public in a secondary offering of the preferred stock in 1990. At December 31, 1992, 798,800 shares of preferred stock were outstanding.
In June 1993, the Company called the remaining shares of preferred stock for redemption in accordance with the terms of the Certificate of Designation with regard to the preferred stock. All holders of the preferred stock surrendered their shares for conversion into 2,496,250 shares of common stock of the Company. For purposes of the Consolidated Statements of Cash Flows, this conversion of preferred stock to common stock is a non-cash transaction, and, therefore, is not reflected in the Consolidated Statements of Cash Flows for the year ended December 31, 1993. As of December 31, 1994, there were no shares of the preferred stock outstanding.
Class C Warrants and Treasury Securities
During 1990, the Company issued 300,000 shares of common stock and 451,357 Class C warrants to an international subsidiary of the Company. These Class C Warrants were exercisable until February 28, 1995 at a price of $1.00 per share. The Company recorded these warrants at their estimated value at the date of issue of $16.125 per warrant. This transaction is reflected as treasury securities in the consolidated balance sheets and consolidated statements of shareholders' equity at December 31, 1993. In 1994, the international
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
subsidiary exchanged the 451,357 Class C Warrants with the parent to acquire the parent's 64% interest in the Canadian drilling fluids subsidiary.
In June 1993, the Board of Directors approved a stock repurchase program whereby the Company was authorized to buy up to 3 million shares of its outstanding common stock. The program contemplates that the Company may, from time to time, purchase shares in the open market. This program is funded by the Company's cash balances. As of December 31, 1994, the Company had purchased 158,400 shares of common stock under the stock repurchase program at a cost of $1.3 million. These shares are reflected as treasury securities in the Consolidated Balance Sheets and Consolidated Statements of Shareholders' Equity.
Unaudited Subsequent Event-Class A and Class B Warrants
On February 28, 1995, the Company's Class A Warrants and the Company's Class B Warrants expired in accordance with the terms of the warrant agreements. During 1995, prior to expiration, 142,880 Class A Warrants and 123 Class B Warrants were exercised and converted into 143,003 shares of the Company's common stock. The Company received $1.2 million in connection with this exercise and conversion of these warrants.
8. EMPLOYEE STOCK OPTIONS, RESTRICTED STOCK AWARDS AND STOCK APPRECIATION RIGHTS
As of December 31, 1994, the Company has outstanding stock options granted under two plans: the 1989 Long-Term Incentive Compensation Plan ("1989 Plan") and the 1982 Stock Option Plan ("1982 Plan"). No further options may be granted under the 1982 Plan. Options issued in 1982, 1983, 1984 and 1985 under the 1982 Plan were cancelled and reissued effective June of 1986 at an option price which represented the fair market value on the date of reissuance.
The options, exercisable at various dates through December 2003, are conditioned upon continued employment. A summary of stock option transactions for 1994, 1993 and 1992 are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The 1994 grants include stock options of 513,300 shares at a $13.13 exercise price. The 1993 grants included stock options of 199,500 shares and 240,000 shares at exercise prices of $8.38 and $10.31, respectively. Included in the 1992 grants were stock options of 257,487 shares and 20,000 shares at exercise prices of $8.38 and $9.25, respectively. Of the total $8.38 stock options, the Company granted 167,497 shares in exchange for certain Stock Appreciation Rights valued at an exercise price of $10.53 - $16.09. All stock options discussed above, with the exception of the stock options granted at $9.25, vest over a four year period from the date of grant. The stock options granted at $9.25 were fully vested at the date of grant.
In addition, as part of the 1989 Plan, the Company granted 82,540 Stock Appreciation Rights in 1991 at an exercise price range of $10.52 - $14.73 and 80,775 Stock Appreciation Rights in 1990 at an exercise price range of $12.56 - $16.09. At December 31, 1994, there were 9,164 of these rights outstanding. These rights vest over a four year period from date of grant, and are exercisable until February 2001. Upon exercise of the rights, appreciation is paid by distributing cash or shares at the option of the Company.
At December 31, 1994, there were 911,933 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.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. EMPLOYEE BENEFITS
The Company has non-contributory pension plans in the U.S and the United Kingdom. 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 domestic pension benefits and fully funding those benefits in 1987, a contribution was not necessary for 1994 and 1993. Most of the employees of M-I are not covered by any pension plans.
The following tables detail the components of pension expense for the three years ended December 31, 1994, the funded status of the plans and major assumptions used to determine these amounts:
Reconciliation of Funded Status of the Plan
In 1993 and 1994, the Company adjusted its discount rate related to the domestic pension plan for current and former employees of the Smith Drill Bits and the Smith Drilling and Completion Services Units to more accurately reflect current market trends. For 1993, the Company reduced its discount rate from 8.5% to 7.0%. As a result, the projected benefit obligation exceeded the fair value of the plan's assets by $2.5 million. This amount was recorded as an additional minimum liability in the Consolidated Balance Sheets at December 31, 1993. For 1994, the Company increased its discount rate from 7.0% to 8.875%. This resulted in a reduction in the amount by which the projected benefit obligation exceeded the fair value of the plan's assets from $2.5 million in 1993 to $1.0 million. This amount was recorded as reduction to the additional minimum liability in the Consolidated Balance Sheets at December 31, 1994.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company has several other pension plans covering certain international employees. Pension expense for these plans totaled $0.4 million in 1994, $0.2 million in 1993 and $0.4 million in 1992. Based on the latest available actuarial valuations, total accumulated plan benefits are $2.6 million and net assets available for benefits are $3.4 million.
The Company has an Employee 401(k) Plan which allows eligible participating employees to make contributions in either a Company stock fund or any one of seven mutual funds managed by Vanguard Group of Investment Companies (Vanguard) or a combination thereof. The Company contributes for all eligible employees a percentage of their qualified compensation into the Plan. Contribution percentages range from 2% for employees under the age of 40 to 6% for employees who are 60 years of age or older. Contributions to this plan by the Company totaled approximately $1.5 million in 1994, $1.7 million in 1993 and $2.0 million in 1992. Effective January 1, 1990, the Company also initiated an additional plan to fund a matching contribution ranging from 0% to 100% of an individual employee's 401(k) contributions based on the Company achieving a certain level of operating income as a percentage of total revenue for the year. The Company recorded an expense of $2.9 million in 1994 and $1.2 million in 1993 for this provision of the plan. No expense was required or recorded for matching contributions for 1992.
The M-I Drilling Fluids Unit has an Employee 401(k) Plan which allows eligible participating employees to make contributions in either a Company stock fund or any one of seven mutual funds managed by Vanguard or a combination thereof. M-I contributes for all eligible employees 3% of their qualified compensation into the Plan. In addition, a 1 1/2% matching contribution of an individual employee's 401(k) contributions can be made based upon the attainment of a certain level of operating income as a percentage of total revenue for the year. M-I recorded contributions to this plan of approximately $1.7 million in 1994.
The Company and its subsidiaries provide certain health care benefits for retired employees. Most of the employees who retire from the Company are eligible for these benefits. The cost of postretirement health care benefits were recognized as an expense as claims were paid in 1992. These costs totaled approximately $0.2 million in 1992.
During the first quarter of 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and recorded the total outstanding liability related to such retiree benefits of $1.3 million as the cumulative effect of a change in accounting principle in the consolidated statements of operations.
Prior to May 1, 1993, the Company had two retiree medical coverage plans. Effective May 1, 1993 the two plans were combined into one plan, the Smith International, Inc. Retiree Medical Plan. The 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. For 1993, the cap was $25,000 per retiree per year. The cap will be adjusted annually for inflation, which is currently assumed to be 4 percent.
Prior to March 1, 1994, M-I had provided retiree medical coverage to its employees under the M-I Drilling Fluids Retiree Medical Plan. As part of the Company's acquisition of M-I, eligibility for inclusion in the plan was closed as of March 1, 1994. Active M-I employees are not eligible for benefits under the closed M-I plan; however, they will be eligible for postretirement medical benefits under the Smith International, Inc. Retiree Medical Plan. The closed M-I plan continues to provide postretirement medical benefits to the eligible M-I retirees and their dependents. The dollar amount of M-I's portion of the cost of benefits under this closed plan is capped at a lifetime maximum benefit of $500,000 per retiree. Any costs in excess of the capped amount is the responsibility of the retiree or their dependents.
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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:
Postretirement benefit expense recognized in income from continuing operations for the years ended December 31, 1994 and 1993 is summarized as follows:
The health care cost trend rate assumption can have a significant effect on the amounts reported. For measurement purposes, an 11% and 12% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1994 and 1993, 1993 respectively. The rate was assumed to gradually decrease to 7% for 1998 and to remain at that level thereafter. An increase of one percentage point in the health care cost trend rate would not have a material effect on either the accumulated postretirement benefit obligation or the aggregate of the service and interest cost components of the postretirement benefits expense.
The weighted-average discount rates used in determining the accumulated postretirement benefit obligation for 1994 and 1993 were 8.5%-8.875% and 7.0%, respectively.
10. STOCKHOLDERS' RIGHTS PLAN
On June 19, 1990, the Company adopted a Stockholder Rights Plan ("the Rights Plan"). The Rights Plan provides for a dividend distribution of one preferred stock purchase right ("Right") for each outstanding share of the Company's Common Stock, to shareholders of record at the close of business on June 29, 1990. The Rights Plan is designed to deter coercive takeover tactics and to prevent an acquiror from gaining control of the Company without offering a fair price to all of the Company's shareholders. The Rights will expire on June 19, 2000.
Each Right entitles shareholders to buy one-hundredth of a newly issued share of Series A Junior Participating Preferred Stock of the Company at an exercise price of $50. The Rights are exercisable only if a person or group (a) acquires beneficial ownership of 20% or more of the Common Stock or (b) acquires beneficial ownership of 1% or more of the Company's Common Stock if such person or group is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared or (c) commences a tender or exchange offer which upon consummation such person or group would beneficially own 20% or more of the Common Stock of the Company. However, the Rights will not become exercisable if Common Stock is acquired pursuant to an offer for all shares which a majority of the independent directors, excluding all officers
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of the Company, determine to be fair to and otherwise in the best interests of the Company and its shareholders.
If any person or group becomes the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if such person or group is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared, other than (in either case) pursuant to an offer for all shares as described above, then each Right not owned by such person or group or certain related parties will entitle its holder to purchase, at the Right's then current exercise price, shares of the Company's Common Stock (or, in certain circumstances as determined by the Board, cash, other property, or other securities) having a value of twice the Right's exercise price. In addition, if, after any person becomes the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if such person is a 20%-or-more shareholder on the date when the Rights dividend distribution is declared, the Company is involved in the merger or other business combination transaction with another person in which its Common Stock is changed or converted, or sells 50% or more of its assets or earning power to another person, each Right will entitle its holder to purchase, at the Right's then current exercise price, shares of common stock of such other person having a value of twice the Right's exercise price.
The Company will generally be entitled to redeem the Rights at $.01 cents per Right at any time until the tenth business day (subject to extension) following public announcement that a person has become the beneficial owner of 20% or more of the Company's Common Stock, or acquires 1% or more of the Common Stock if a 20%-or-more shareholder on the date when the Rights dividend distribution is declared.
11. SUPPLEMENTARY INCOME STATEMENT INFORMATION
Amounts charged to expense for continuing operations is as follows:
12. QUARTERLY INFORMATION (UNAUDITED)
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Included in the results for 1994 are a full year of the operations of A-Z/Grant and Lindsey, ten months of operations for M-I and six months of operations of Supradiamant. For a further discussion of these acquisitions, see Note 2.
Included in third quarter of 1993 results is a special charge of $19.9 million ($0.51 per common share in the third quarter and $0.53 per common share for the full year) relating to the settlement of drill bit litigation (See Note 14). Due to the conversion of the preferred stock into common stock (See Note 7) in the second quarter of 1993, the total year income (loss) per common share amounts do not equal the sum of the quarterly income (loss) per common share amounts.
13. INDUSTRY SEGMENTS AND INTERNATIONAL OPERATIONS
The Company operates primarily in one industry segment: petroleum services. The products and services of the petroleum services segment are primarily used in the drilling of oil and gas wells. The following chart sets forth information concerning the Company's continuing domestic and international operations:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
General corporate expenses and interest income and expense have been excluded from income from continuing operations before interest and taxes in the table above. Results of operations as reported in the accompanying consolidated financial statements include general corporate expenses of $10.2 million in 1994, $5.9 million in 1993 and $5.7 million in 1992.
Transfers between geographic areas are recorded by the Company and its subsidiaries based on their various intercompany pricing agreements.
United States revenues include $56.4 million in 1994, $29.9 million in 1993 and $27.9 million in 1992 exported to various international markets. These markets include North Sea/Europe, Africa, Middle East, Latin America, Far East/Asia, and Canada. With the exception of North Sea/Europe, neither export nor international sales to any one of these individual markets exceeded 10% of consolidated revenues.
No single customer accounts for 10% or more of consolidated revenues for the periods presented.
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.
14. COMMITMENTS AND CONTINGENT LIABILITIES
Leases
The Company leases certain facilities and machinery and equipment under operating leases. The Company also leases certain machinery and equipment under capital leases. At December 31, 1994 and 1993, machinery and equipment included $3.2 million and $3.0 million, respectively (before accumulated amortization of $1.1 million and $0.7 million, respectively) related to capital leases. These capital leases are recorded in other current and other long-term liabilities in the accompanying consolidated balance sheets.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Future minimum payments under all non-cancellable leases having initial terms of one year or more are as follows:
Litigation
In January 1991, the Company and several of the Company's competitors were served with a federal grand jury subpoena for documents, principally concerning the Company's sales, marketing and pricing activities for tri-cone rock bits produced and sold by the Company. In June 1992, Baker Hughes entered a plea of guilty to an Information charging it with a single count of violating Section 1 of the Sherman Act for the period March through May 11, 1989 and agreed to pay a $1.0 million fine to the U.S. government. On November 23, 1993, the Company entered a plea of guilty to a violation of Section 1 of the Sherman Act for the same period and paid a fine to the U.S. government of $0.7 million.
After it was served the subpoena by the grand jury, the Company was served with complaints in three civil proceedings. Each action alleged violations of Section 1 of the Sherman Act. The cases were consolidated for discovery purposes with four other cases filed against other tri-cone rock bit manufacturers, but not the Company, in the Southern District of Texas, which made allegations similar to those made against the Company. The consolidated case was captioned Red Eagle Resources Corporation, Inc., et al. v. Baker Hughes, Inc., Baker Hughes Production, Inc., Hughes Tool Company, Reed Tool Company, a/k/a/ Baker RTC, Inc., Camco International, Inc., Smith International, Inc., and Dresser Industries, Inc., Civil Action No. 91-H-627. In September 1992, the district court certified the case as a class action. The class consisted of direct purchasers of rock bits from defendants in the period September 1, 1986, through January 15, 1992.
On August 27, 1993, without admitting any form of liability, the Company entered into an agreement with the plaintiffs to settle all claims against the Company. The Company recorded a special charge of $19.9 million to cover the cost of the settlement of $16.8 million and related estimated legal fees and other costs and expenses. On October 28, 1993, an order was entered which gave final approval to this settlement.
Chevron USA Inc., which opted not to be part of the above mentioned class action, filed suit against the Company in the United States District Court for the Southern District of Texas, Houston Division, entitled Chevron USA Inc., acting by and through its division Chevron USA Production Company v. Baker Hughes, Inc., Reed Tool Company a/k/a Baker RTC, Inc., Camco International, Inc., Smith International, Inc. and Dresser Industries, Inc. Cause No. H-93-949, alleging violations of Section 1 of the Sherman Act. On July 12, 1994, without admitting any liability, the Company and Camco International, Inc. entered into an agreement with the plaintiffs to pay $0.5 million. The Company's portion of the agreed payment was $0.3 million. On July 25, 1994, the U.S. District Judge signed and entered an Agreed Order of Dismissal giving final approval to this settlement.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On March 4, 1992, the Company was served with a complaint in the U.S. District Court in the Central District of California, entitled Lynn Martin, Secretary of the U.S. Dept. of Labor v. Smith International, Inc., et al., Case No. CV-92-1196. In addition, seven of its employees or former employees (the "Individual Defendants") were also served. The complaint alleges violations of the Employee Retirement Income Security Act of 1974 ("ERISA") arising out of the Company's purchase of annuities from Executive Life Insurance Company ("Executive Life"), upon the termination of its Pension Plan in August 1985. On April 11, 1991, Executive Life was placed in conservatorship in California state court by the California Insurance Commissioner. As a result of the conservatorship and reorganization, Executive Life emerged in 1993 as Aurora National Life Assurance Company, Inc. ("Aurora") from the conservatorship proceeding. Under the rehabilitation plan as ordered by the Los Angeles Superior Court judge, Aurora will honor in part Executive Life's past and continuing commitments under the outstanding annuities; however, a portion of these obligations will not be paid by Aurora (the "Shortfall").
In November 1994, the Company was dismissed from the lawsuit after obtaining summary judgment in its favor on the ground that the Company's 1986 bankruptcy barred the Department of Labor's claim. The Individual Defendants remained in the lawsuit.
Trial of the Department of Labor's claims against the Individual Defendants and the Company's and the Individual Defendants' crossclaims was scheduled to begin on December 6, 1994. Prior to the trial, the parties agreed in principle to a settlement whereby: (i) the Department of Labor will be paid the sum of $4.07 million (which represents an actuarial estimate of the Shortfall); (ii) the Department of Labor will distribute the $4.07 million to the participants and beneficiaries of the Company's Pension Plan consistent with the goal of making the participants and beneficiaries whole to the extent possible from the $4.07 million payment only; (iii) the Company and the Department of Labor will sign a consent order which, among other things, provides that the Company neither admits nor denies the allegations of the Department of Labor's complaint; (iv) the Company will reasonably cooperate with the Department of Labor in their efforts to equitably distribute the $4.07 million; and (v) the Individual Defendants will not be required to sign the consent order and they will be dismissed with prejudice upon the payment of the $4.07 million to the Department of Labor. A substantial portion of the $4.07 million settlement will be paid by the Company's insurance carrier. The Company accrued its portion of the settlement of approximately $1.0 million in 1994.
The parties are in the process of preparing settlement documents. The Company anticipates that the settlement will be fully documented and all payments made to the Department of Labor by April 1995.
The Company also is named in a number of environmental legal actions related to the conduct of its business. The major actions relate to several Superfund sites including the Sheridan Disposal Services site in Hempstead, Texas, the Operating Industries, Inc. site in Monterey Park, California and the Chemform site in Pompano Beach, Florida. The Company has notified its insurance companies of potential claims for each of the above sites and coverage has been denied.
The Company reached a settlement with the Sheridan Site Committee (the Committee) with respect to the Sheridan Disposal Services site. The Company has 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% of actual response costs. The Company has also reached a settlement with the United States Environmental Protection Agency Region IX ("EPA") with respect to the Operating Industries, Inc. ("OII") site. The Company has agreed to pay its allocable share of total future site response costs incurred, such share to be limited to the lesser of $5.0 million or 0.65% of the future site response costs incurred. As of December 31, 1994, the Company anticipates that its ultimate liability for the Sheridan and OII sites will be substantially less than these maximum amounts.
Certain environmental problems may exist at the Chemform site in Pompano Beach, Florida, which is located in a highly industrialized area. The Company held a leasehold interest in this property between
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
May 14, 1976 and March 16, 1979. On October 4, 1989, the EPA listed the Chemform site on the National Priorities List. In October 1989, the Company and three other potential responsible parties (PRP's) entered into an administrative consent decree order with the EPA for the preparation of the Remedial Investigation and Feasibility Study ("RI/FS"). An amendment to the consent decree specified that the RI/FS would be addressed in two operable units: Operable Unit One addresses Site-related groundwater contamination, and Operable Unit Two addressed source and soil contamination. On September 22, 1992, EPA issued the Record of Decision ("ROD") for Operable Unit One, which selected a "No Action with Monitoring" alternative, under which groundwater will be monitored for at least one year. Four quarters of groundwater monitoring have now been completed. The State of Florida, as represented by the Florida Department of Environmental Protection ("Florida DEP"), has requested that additional monitoring work be performed. The final scale of the 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 Operable Unit Two at the Chemform Site, which addresses site-related soil contamination. The ROD determined that no further Superfund action is necessary to address Operable Unit Two at the Site; however, the Florida DEP requested that additional soil be removed. The Company and the two other PRPs have performed the soil removal requested, but it is unknown whether the Florida DEP will require any additional soil removal work. As the EPA still retains jurisdiction over the Chemform Site, it is possible that additional issues may arise which would require further resolution. The Company believes that the EPA will demand reimbursement of certain oversight expenses that the EPA allegedly has incurred in administering the Chemform site. The Company intends to scrutinize and, if necessary, vigorously contest any such claims made by the EPA.
In 1994, 1993 and 1992, the Company paid for various clean up activities and recorded additional provisions, charged to continuing operations, of $0.3 million, $0.5 million and $0.4 million, respectively, and also charged a provision of $1.5 million to the gain on sale of DDS operations in 1993 based on annually revised estimates of required future clean-up costs. In addition, estimated liabilities of approximately $2.5 million were recorded as part of the purchase price allocation for the Company's 1994 business acquisitions.
At December 31, 1994, the remaining recorded liability for estimated future clean-up costs for the sites discussed above as well as for properties currently or previously owned or leased by the Company totalled $6.1 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs for the Superfund sites and for properties currently or previously owned or leased by the Company. The Company believes that any additional unrecorded clean-up liabilities will not have a material adverse effect on the Company's consolidated financial position or the results of its operations.
PART III
ITEM 10.




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.

ITEM 11. EXECUTIVE COMPENSATION
The information set forth following the caption "EXECUTIVE COMPENSATION AND OTHER INFORMATION CONCERNING EXECUTIVE OFFICERS" in the Company's Proxy Statement is incorporated herein by reference.
ITEM 12.

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.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth following the captions "ELECTION OF DIRECTORS" and "EXECUTIVE COMPENSATION AND OTHER INFORMATION CONCERNING EXECUTIVE OFFICERS" in the Company's Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) FINANCIAL STATEMENTS
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
(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.
SMITH INTERNATIONAL, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS)
(a) Amount represents accounts receivable reserves related to M-I Drilling Fluids L.L.C. and Supradiamant upon purchase by the Company during the year ended December 31, 1994.
(b) Amount represents the reclassification of certain reserves relating to long-term receivables to trade accounts receivable.
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 10, 1995
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:
INDEX TO EXHIBITS