8-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 8-K

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

Date of Report (Date of earliest event reported): August 15, 2008

SMITH INTERNATIONAL, INC.

Delaware
(State or other jurisdiction of
incorporation) 1-8514
(Commission File Number) 95-3822631
(IRS Employer Identification
No.)

16740 Hardy Street, Houston, Texas 77032
(Address of principal executive offices) (Zip Code)

(281) 443-3370
(Registrant’s telephone number, including area code)

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions:

o Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

o Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

o Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

o Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

TABLE OF CONTENTS

Consent of Deloitte & Touche LLP

Management's Discussion and Analysis

Consolidated Financial Statements and Supplementary Data

Item 8.01 Other Events

     Subsequent to June 30, 2008, Smith International, Inc. (the “Company”) modified its segment reporting disclosure to provide investors with increased visibility into its oilfield business operations. The M-I SWACO unit has been separated from the Company’s other oilfield business operations and is being reported as a separate segment. Additionally, the Company no longer allocates corporate expenses to the various reporting segments.

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

     The segment information and related discussion included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data” included in the Company’s Form 10-K for the fiscal year ended December 31, 2007 has been recast to conform to the current segment reporting structure.

     The information is attached to this Current Report on Form 8-K as Exhibit 99.01 and 99.02. The information contained in this filing has been updated only to reflect the changes summarized above. It has not been otherwise updated for events occurring after the date of the Company’s consolidated financial statements, which were originally presented in the Company’s Report on Form 10-K for the fiscal year ended December 31, 2007, filed on February 29, 2008. This Current Report on Form 8-K should be read in conjunction with our Reports on Form 10-Q for the quarters ended March 31, 2008 and June 30, 2008, and our Current Reports on Form 8-K for updates of other events.

Item 9.01 Financial Statements and Exhibits

(d) Exhibits

Exhibit Number	Description
23.01	Consent of Deloitte & Touche LLP.
99.01	Management’s Discussion and Analysis of Financial Condition and Results of Operations which has been recast to reflect changes to the Company’s segment reporting disclosure for the fiscal year ended December 31, 2007 (Part II — Item 7 of the Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the SEC on February 29, 2008).
99.02	Consolidated Financial Statements and Supplementary Data which has been recast to reflect changes to the Company’s segment reporting disclosure for the fiscal year ended December 31, 2007 (Part II — Item 8 of the Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the SEC on February 29, 2008).

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

	SMITH INTERNATIONAL (Registrant)
Date: August 15, 2008	By:	/s/ Richard E. Chandler, Jr.
		Name:	Richard E. Chandler, Jr.
		Title:	Senior Vice President, General Counsel and Secretary

Exhibit Number	Description
23.01	Consent of Deloitte & Touche LLP.
99.01	Management’s Discussion and Analysis of Financial Condition and Results of Operations which has been recast to reflect changes to the Company’s segment reporting disclosure for the fiscal year ended December 31, 2007 (Part II — Item 7 of the Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the SEC on February 29, 2008).
99.02	Consolidated Financial Statements and Supplementary Data which has been recast to reflect changes to the Company’s segment reporting disclosure for the fiscal year ended December 31, 2007 (Part II — Item 8 of the Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the SEC on February 29, 2008).

EX-23.01

EXHIBIT 23.01

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement Nos. 333-141049, 333-88918, 333-65912, 333-76633, 333-76635, 333-75763, 33-56693, 33-69840, 33-31556, and 2-76939 on Form S-8 and in No. 333-127677 on Form S-3, and in No. 333-151897 on Form S-4 of our reports dated February 29, 2008 (August 15, 2008 as to segment changes described in notes 7 and 15) , relating to the financial statements and financial statement schedule of Smith International, Inc. (which report expresses an unqualified opinion and includes an explanatory paragraph relating to the Company’s adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123r, “Share-Based Payment” as of January 1, 2006; SFAS No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans” as of December 31, 2006; and Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” on January 1, 2007) and of our report dated February 29, 2008 relating to the effectiveness of internal control over financial reporting appearing in this current Report on Form 8-K of Smith International, Inc. dated August 15, 2008.

DELOITTE & TOUCHE LLP
Houston, Texas
August 15, 2008

EX-99.01

EXHIBIT 99.01

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

     The following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is provided to assist readers in understanding the Company’s financial performance during the periods presented and significant trends which may impact the future performance of the Company. This discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the related notes thereto included elsewhere in this Form 10-K. This discussion includes forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from the statements we make in this section due to a number of factors that are discussed beginning on page 10.

Company Products and Operations

     The Company is a leading global provider of premium products and services to the oil and gas exploration and production industry. The Company provides a comprehensive line of technologically-advanced products and engineering services, including drilling and completion fluid systems, solids-control and separation equipment, waste-management services, oilfield production chemicals, three-cone and diamond drill bits, turbines, borehole enlargement tools, tubulars, fishing services, drilling tools, underreamers, casing exit and multilateral systems, packers and liner hangers. The Company also offers supply chain management solutions through an extensive North American branch network providing pipe, valves and fittings as well as mill, safety and other maintenance products.

     The Company’s operations are largely driven by the level of exploration and production (“E&P”) spending in major energy-producing regions around the world and the depth and complexity of these projects. Although E&P spending is significantly influenced by the market price of oil and natural gas, it may also be affected by supply and demand fundamentals, finding and development costs, decline and depletion rates, political actions and uncertainties, environmental concerns, the financial condition of independent E&P companies and the overall level of global economic growth and activity. In addition, approximately six percent of the Company’s consolidated revenues relate to the downstream energy sector, including petrochemical plants and refineries, whose spending is largely impacted by the general condition of the U.S. economy.

     Capital investment by energy companies is largely divided into two markets, which vary greatly in terms of primary business drivers and associated volatility levels. North American drilling activity is primarily influenced by natural gas fundamentals, with approximately 80 percent of the current rig count focused on natural gas finding and development activities. Conversely, drilling in areas outside of North America is more dependent on crude oil fundamentals, which influence over three-quarters of international drilling activity. Historically, business in markets outside of North America has proved to be less volatile as the high cost E&P programs in these regions are generally undertaken by major oil companies, consortiums and national oil companies as part of a longer-term strategic development plan. Although 54 percent of the Company’s consolidated revenues were generated in North America during 2007, Smith’s profitability was largely dependent upon business levels in markets outside of North America. The Distribution segment, which accounts for 24 percent of consolidated revenues and primarily supports a North American customer base, serves to distort the geographic revenue mix of the Company’s oilfield business operations. Excluding the impact of the Distribution segment, approximately 60 percent of the Company’s 2007 revenues were generated in markets outside of North America.

     Finally, over the past few years, a number of factors have driven an increase in the importance of national oil companies (NOCs) in the global energy industry. NOCs currently control approximately 80 percent of world oil reserves and account for nearly three-quarters of production. As we look forward, NOCs and their governments will likely have more control over the pace and the manner in which oil and gas resources are developed – which could have implications for Smith and other oilfield service industry participants. We believe we have been successful developing strong business relationships with NOCs, which contribute a sizable portion of our revenues.

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Business Outlook

     After experiencing 14 percent compound annual rig count growth in North America over the past five-year period, North American activity levels are forecasted to remain relatively flat during the near-term. Markets outside North America should continue to expand as the increased number of drilling programs in the Eastern Hemisphere, combined with the addition of a number of newbuild offshore rigs scheduled for delivery in 2008 and beyond, contribute to increased customer spending levels.

     Although a number of factors influence forecasted exploration and production spending, the Company’s business is highly dependent on the general economic environment in the United States and other major world economies – which ultimately impacts energy consumption and the resulting demand for our products and services. A global economic slowdown could pare energy demand and adversely impact business volumes across our operations and the future financial results of the Company.

2

Results of Operations

Segment Discussion

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

     The segment reporting structure has been modified from our historical presentation in order to provide investors with increased visibility into the oilfield business operations. More specifically, the M-I SWACO unit has been separated from our other oilfield business operations and is being reported as a separate segment. Additionally, the Company no longer allocates corporate expenses to the various reporting segments.

     The accompanying revenue information and discussion has been presented by business unit in order to provide additional information in analyzing the Company’s operations. Additionally, the reported operating income for each segment has been determined using an internal management reporting structure and does not include all costs and expenses required to present results on a standalone basis.

	For the Years Ended December 31,
	2007					2006					2005
	Amount			%		Amount			%		Amount			%
Financial Data: (dollars in thousands)
Revenues:
M-I SWACO	$	4,422,408			50	$	3,573,395			49	$	2,682,511			48
Smith Technologies(1)		1,018,578			12		884,616			12		654,611			12
Smith Services(1)		1,191,583			14		929,727			12		641,877			12
Oilfield operations		6,632,569			76		5,387,738			73		3,978,999			72
Distribution operations		2,131,761			24		1,945,821			27		1,600,004			28
Total	$	8,764,330			100	$	7,333,559			100	$	5,579,003			100
Geographic Revenues:
United States:
M-I SWACO	$	1,172,448			13	$	1,079,441			15	$	793,123			14
Smith Drilling and Evaluation		1,223,833			14		930,556			12		600,441			11
Distribution		1,571,525			18		1,374,732			19		1,127,142			20
Total United States		3,967,806			45		3,384,729			46		2,520,706			45
Canada:
M-I SWACO		181,249			2		225,084			3		171,130			3
Smith Drilling and Evaluation		157,443			2		179,037			2		142,782			3
Distribution		432,738			5		487,167			7		399,653			7
Total Canada		771,430			9		891,288			12		713,565			13
Non-North America:
M-I SWACO		3,068,711			35		2,268,870			31		1,718,258			31
Smith Drilling and Evaluation		828,885			10		704,750			10		553,265			10
Distribution		127,498			1		83,922			1		73,209			1
Total Non-North America		4,025,094			46		3,057,542			42		2,344,732			42
Total Revenue	$	8,764,330			100	$	7,333,559			100	$	5,579,003			100
Operating Income:
M-I SWACO	$	729,412			16.5	$	553,304			15.5	$	347,008			12.9
Smith Drilling and Evaluation		619,038			28.0		495,301			27.3		309,303			23.9
Distribution		97,154			4.6		104,730			5.4		66,634			4.2
Corporate and other		(75,807	)		*		(73,254	)		*		(52,384	)		*
Total	$	1,369,797			15.6	$	1,080,081			14.7	$	670,561			12.0

(1)	In 2007, the Company formed the Smith Borehole Enlargement (“SBE”) group, combining various product and service offerings from Smith Technologies and Smith Services. Due to the formation of SBE, prior period revenues were reclassified to conform to the current presentation.
*	Not meaningful

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	For the Years Ended December 31,
	2007				2006				2005
	Amount		%		Amount		%		Amount		%
Market Data:
Average Worldwide Rig Count:(1)
United States		1,961		46		1,901		47		1,666		47
Canada		311		7		413		10		408		11
Non-North America		2,009		47		1,747		43		1,517		42
Total		4,281		100		4,061		100		3,591		100
Onshore		3,719		87		3,523		87		3,069		85
Offshore		562		13		538		13		522		15
Total		4,281		100		4,061		100		3,591		100
Average Commodity Prices:
Crude Oil ($/Bbl)(2)	$	72.36			$	66.25			$	56.71
Natural Gas ($/mcf)(3)		7.12				6.98				9.01

(1)	Source: M-I SWACO.
(2)	Average daily West Texas Intermediate (“WTI”) spot closing prices, as quoted by NYMEX.
(3)	Average daily Henry Hub, Louisiana spot closing prices, as quoted by NYMEX.

M-I SWACO Segment

Revenues

     M-I SWACO primarily provides drilling and completion fluid systems, engineering and technical services to the oil and gas industry. Additionally, these operations provide oilfield production chemicals and manufacture and market equipment and services used for solids-control, particle separation, pressure control, rig instrumentation and waste-management. M-I SWACO is significantly influenced by its exposure to the global offshore market, which constitutes 50 percent of the revenue base, and to exploration and production spending for land-based projects outside of North America, which contributes approximately 30 percent of the unit’s revenues. Offshore drilling programs, which accounted for approximately 13 percent of the worldwide rig count in 2007, are generally more revenue-intensive than land-based projects due to the complex nature of the related drilling environment. For the year ended December 31, 2007, M-I SWACO reported revenues of $4.4 billion, an increase of 24 percent over the amounts reported in the 2006 fiscal year. Three-quarters of the revenue improvement was attributable to growth in Eastern Hemisphere markets, largely reflecting a 40 percent increase in offshore business volumes related to new contract awards and increased customer activity in the North Sea, Middle East/Asia and West Africa regions. Western Hemisphere revenues grew 13 percent above the prior year level due to the impact of new land-based contract awards in Mexico and higher customer spending in the deepwater markets of the United States and Brazil. M-I SWACO’s revenues totaled $3.6 billion for the year ended December 31, 2006, an increase of 33 percent over the prior year. Excluding the impact of acquired operations, revenues grew 31 percent over the prior year. Approximately two-thirds of the base revenue increase was generated in markets outside of North America, primarily reflecting new contract awards and increased customer activity in the Europe/Africa and Middle East offshore markets. North American base revenues grew 33 percent above the prior year level, largely attributable to increased investment by exploration and production companies in land-based drilling projects and the impact of price increases implemented in late 2005.

Operating Income

     Operating income for the M-I SWACO segment was $729.4 million, or 16.5 percent of revenues for the year ended December 31, 2007. Operating margins were 1.0 percentage point above the prior year level, reflecting incremental operating margins of 21 percent. The period-to-period improvement was primarily influenced by expansion in the segment’s gross profit margins, attributable to increased business volumes and a favorable product shift associated with higher relative growth experienced in the offshore market. On an absolute dollar basis, fiscal 2007 operating income increased $176.1 million over the prior year, largely attributable to the impact of higher revenue volumes on reported gross profit, partially offset by growth in variable-based operating

4

expenses associated with the expanding business base. For the 2006 fiscal year, operating income for the M-I SWACO segment was $553.3 million, or 15.5 percent of revenues. Segment operating margins were 2.6 percentage points above the prior year level, with incremental operating income approximating 23 percent of revenues. The operating margin improvement was predominantly driven by increased business volumes, but was also influenced by the higher mix of premium fluid revenues and pricing initiatives. To a lesser extent, the margin improvement was attributable to improved fixed cost coverage in sales and administrative functions. On an absolute dollar basis, fiscal 2006 operating income increased $206.3 million over the prior year, largely attributable to the impact of a 33 percent increase in business volumes on gross profit, mitigated by higher variable-based operating expenses.

Smith Drilling and Evaluation Segment

Revenues

     Smith Technologies designs and manufactures three-cone and diamond drill bits, turbines and borehole enlargement tools for use in the oil and gas industry. Due to the nature of its product offerings, revenues for these operations typically correlate more closely to the rig count than any of the Company’s other businesses. For the year ended December 31, 2007, Smith Technologies reported revenues of $1.0 billion, an increase of 15 percent over the prior year — significantly above the comparable five percent growth in worldwide activity levels. Approximately 60 percent of the year-over-year revenue growth was reported outside North America, driven by significant growth in demand for borehole enlargement products, strong three-cone drill bit sales volumes in Europe/Africa and, to a lesser extent, increased activity levels. Revenue growth in North America compared favorably to the prior year and the corresponding change in activity levels, largely reflecting the influence of improved diamond bit rental volumes and improved market penetration for three-cone products in the United States. For the year ended December 31, 2006, Smith Technologies reported revenues of $884.6 million, an increase of 35 percent over the prior year level. The majority of the revenue increase was reported by the Western Hemisphere operations, influenced by higher U.S. land-based drilling activity, improved pricing and, to a lesser extent, strong demand for turbine products in the Latin America market. Revenues generated in the Eastern Hemisphere region increased 35 percent, contributing one-third of the revenue improvement over the prior year. The year-over-year increase reflects growth in the Middle East, Former Soviet Union and the North Sea area, attributable to new contract awards and improved market penetration.

     Smith Services manufactures and markets products and services used in the oil and gas industry for drilling, work-over, well completion and well re-entry. Smith Services’ revenues are heavily influenced by the complexity of drilling projects, which drive demand for a wider range of its product offerings. In recent years, growth in the number of U.S. land-based drilling programs has resulted in strong demand for additional rigs and related drilling equipment, including the Company’s premium tubular products and drill pipe. Excluding the impact of tubular sales volumes, revenues for Smith Services are relatively balanced between North America and the international markets. Smith Services revenues totaled $1.2 billion for the year ended December 31, 2007, up 28 percent from the 2006 level. Approximately two-thirds of the year-over-year revenue growth was attributable to increased demand for tubular products, predominantly in the United States. Excluding the impact of tubular product sales and rentals, business volumes rose 15 percent from the prior year — favorably impacted by increased demand for high-performance drilling, fishing and remedial products and services, including the hydra-jar^® tool, in the U.S. and North Sea markets. For the year ended December 31, 2006, Smith Services reported revenues of $929.7 million, 45 percent above the 2005 fiscal year. The year-over-year revenue growth was significantly influenced by increased demand for tubular products in the U.S. market. Excluding the impact of tubular product sales, business volumes increased 24 percent above the prior year. The majority of the non-tubular business growth was reported in North America, reflecting increased customer demand for premium remedial product and service lines. The revenue growth in markets outside of North America was driven by increased demand for remedial product offerings, primarily in the Middle East, North Sea and Former Soviet Union regions.

5

Operating Income

     Operating income for the Smith Drilling and Evaluation segment was $619.0 million, or 28.0 percent of revenues for the year ended December 31, 2007. The segment operating margins were 70 basis points above the prior year level, reflecting incremental operating margins of approximately 31 percent. The period-to-period operating margin increase was experienced in the Smith Services operations, influenced by improved business volumes, pricing initiatives and intrasegment borehole enlargement royalties, which contributed to growth in the underlying gross profit margins. The 2.5 percentage point improvement in Smith Services’ year-over-year profitability levels was partially offset by the financial performance of the Smith Technologies operations. The recognition of incremental costs associated with a technology licensing agreement entered into in September 2006 and, to a lesser extent, increased demand for borehole enlargement tools, which generate intrasegment royalty charges and, therefore, carry lower comparable margins, contributed to Smith Technologies’ margin performance. For the 2006 fiscal year, operating income for the Smith Drilling and Evaluation segment was $495.3 million, or 27.3 percent of revenues. The reported operating income for the segment includes $220.8 million of earnings attributable to the Smith Services unit. Segment operating margins were 3.4 percentage points above the prior year level, with incremental operating income approximating 36 percent of revenues. The majority of the period-to-period operating margin improvement was experienced in the Smith Services unit which, due to its significant tubular business content, has generated higher comparable revenue growth rates than the Smith Technologies operations. The 4.6 percentage point increase in Smith Services’ year-over-year profitability levels was primarily influenced by gross margin expansion, reflecting higher revenue volumes and improved rental tool fleet utilization. The Smith Technologies’ unit also reported increased year-over-year profitability levels associated with higher demand for drill bit product offerings and improved product pricing.

Distribution Segment

Revenues

     Wilson markets pipe, valves and fittings, as well as mill, safety and other maintenance products to energy and industrial markets, primarily through an extensive network of supply branches in the United States and Canada.  The segment has the most significant North American revenue exposure of any of the Company’s operations with 94 percent of Wilson’s 2007 revenues generated in those markets.  Moreover, approximately 25 percent of Wilson’s revenues relate to sales to the downstream energy sector, including petrochemical plants and refineries, whose spending is largely influenced by the general state of the U.S. economic environment.  Additionally, certain customers in this sector utilize petroleum products as a base material and, accordingly, are adversely impacted by increases in crude oil and natural gas prices. For the year ended December 31, 2007, Wilson reported revenues of $2.1 billion, 10 percent above the 2006 fiscal year.  The revenue growth was reported by the energy operations, influenced by higher U.S. drilling activity levels and increased line pipe project spending. The impact of lower Canadian business volumes during 2007, related to the corresponding decline in drilling activity levels, was substantially offset by project-related spending in Europe/Africa. For the year ended December 31, 2006, Wilson reported revenues of $1.9 billion, 22 percent above the prior year.  Two-thirds of the revenue growth was generated by the upstream energy operations, reflecting higher spending by exploration and production companies associated with increased North American drilling and completion activity and the impact of new contract awards.  Industrial and downstream sales volumes grew 13 percent, influenced by increased customer spending related to line pipe projects.

6

Operating Income

     Operating income for the Distribution segment in fiscal 2007 was $97.2 million, or 4.6 percent of revenues.  Segment operating margins deteriorated 80 basis points, reflecting the impact on gross profit of an increased proportion of line pipe and international project business volumes, which carry relatively lower margins, and the influence of the year-over-year decline in Canadian drilling activity levels. On an absolute dollar basis, operating income was $7.6 million below the amount reported in 2006, largely due to the impact of the unfavorable business mix on gross profit and higher variable-based operating expenses. For the year ended December 31, 2006, operating income for the Distribution segment in fiscal 2006 was $104.7 million, or 5.4 percent of revenues.  The operating margin improvement of 1.2 percentage points reflects lower operating expenses as a percentage of revenues and, to a lesser extent, gross margin expansion.  Incremental operating income was 11 percent of revenues, with the majority of the growth attributable to the energy sector operations, influenced by increased coverage of fixed sales and administrative costs.  On an absolute dollar basis, segment operating income was $38.1 million above the amount reported in 2005, impacted by a 22 percent increase in revenue volumes on the segment’s reported gross profit, partially offset by higher variable-based operating expenses.

Consolidated Discussion

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

	For the Years Ended December 31,
	2007					2006					2005
	Amount			%		Amount			%		Amount			%
Revenues	$	8,764,330			100	$	7,333,559			100	$	5,579,003			100
Gross profit		2,855,657			33		2,344,271			32		1,685,138			30
Operating expenses		1,485,860			17		1,264,190			17		1,014,577			18
Operating income		1,369,797			16		1,080,081			15		670,561			12
Interest expense		69,990			1		62,967			1		44,446			1
Interest income		(4,068	)		—		(2,982	)		—		(1,692	)		—
Income before income taxes and minority interests		1,303,875			15		1,020,096			14		627,807			11
Income tax provision		408,471			5		326,674			4		202,743			4
Minority interests		248,353			3		191,416			3		122,759			2
Net income	$	647,051			7	$	502,006			7	$	302,305			5

2007 versus 2006

     Consolidated revenues increased to $8.8 billion for the year ended December 31, 2007, 20 percent above the prior year. Oilfield business volumes contributed more than 85 percent of the revenue increase – influenced by significant growth in offshore business volumes outside North America and the impact of new land-based contracts in Latin America and the Former Soviet Union. To a lesser extent, the year-over-year revenue expansion reflects higher demand for tubular and drill bit products in the United States.

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     Gross profit totaled $2.9 billion, or 33 percent of revenues, 60 basis points above the gross profit margins generated in the 2006 fiscal year. The results reflect improved oilfield business margins and, to a lesser extent, an increased proportion of oilfield revenues, which generate higher comparable margins. On an absolute dollar basis, gross profit was $511.4 million, or 22 percent, above the prior year primarily reflecting the increased sales volumes in the oilfield operations.

     Operating expenses, consisting of selling, general and administrative expenses increased $221.7 million from the amount reported in 2006; however, as a percentage of revenues decreased 30 basis points. Improved fixed cost coverage in the general and administrative functions accounted for the operating expense percentage decline. The majority of the absolute dollar increase was attributable to variable-related costs associated with the improved business volumes, including increased investment in personnel and infrastructure.

     Net interest expense, which represents interest expense less interest income, totaled $65.9 million in 2007. Net interest expense increased $5.9 million from the prior year, influenced by the inclusion of certain acquisition-related borrowings in the later half of 2006.

     The effective tax rate approximated 31 percent, approximately 70 basis points below the prior year level. The favorable comparison to the 2006 effective rate, as well as the U.S. statutory rate, was influenced by the higher proportion of M-I SWACO’s U.S. partnership earnings and lower state income tax accrual rates. Based on the structure of M-I SWACO’s U.S. operations, the minority partner is directly responsible for taxes on its share of U.S. partnership earnings. Accordingly, the Company properly consolidates the pretax income related to the minority partner’s share of U.S. partnership earnings but excludes the related tax provision.

     Minority interest expense reflects the portion of the results of majority-owned operations which are applicable to the minority interest partners. Minority interest expense totaled $248.4 million in 2007, a $56.9 million increase from the prior year. The year-over-year increase primarily reflects the improved profitability levels in the M-I SWACO joint venture.

2006 versus 2005

     Consolidated revenues increased to $7.3 billion for the year ended December 31, 2006, 31 percent above the prior year. The majority of the year-over-year revenue growth was reported in the oilfield businesses attributable to a combination of higher worldwide drilling activity, a favorable product and business mix and, to a lesser extent, improved pricing. On a geographic basis, two-thirds of the revenue improvement was generated in the Western Hemisphere market, which accounted for the majority of the year-over-year increase in drilling activity levels. The year-over-year revenue variance was also driven by the strength in the Company’s international operations which reported a 33 percent increase in revenues.

     Gross profit totaled $2.3 billion, or 32 percent of revenues, two percentage points above the gross profit margins generated in 2005. Although the margin expansion was largely driven by the impact of increased sales volumes on fixed manufacturing and service infrastructure costs, an improved business mix and product pricing also had a favorable effect. On an absolute dollar basis, gross profit was $659.1 million above the prior year period primarily reflecting the increased sales volumes in the oilfield business operations.

     Operating expenses, consisting of selling, general and administrative expenses increased $249.6 million from the amount reported in the 2005 fiscal year; however, as a percentage of revenues decreased 95 basis points. Improved fixed cost coverage in the sales and administrative functions accounted for the operating expense percentage decline. The majority of the absolute dollar increase was attributable to variable costs directly associated with the improved business volumes, including increased investment in personnel and infrastructure. To a lesser extent, increased employee profit-sharing amounts directly attributable to the reported profitability levels, incremental operating expenses of acquired operations and stock-based compensation expense also contributed to the year-over-year operating expense growth.

8

     Net interest expense, which represents interest expense less interest income, totaled $60.0 million in 2006. Net interest expense increased $17.2 million from the 2005 level reflecting higher average debt levels in 2006 due to borrowings related to the financing of several acquisitions and, to a lesser extent, an increase in variable interest rates.

     The effective tax rate approximated 32 percent, partially impacted by the settlement of a U.S. tax audit that resulted in the release of certain deferred tax reserves during the second quarter of 2006. Excluding the tax settlement, the effective rate was comparable to the level reported in the prior year, but below the U.S. statutory rate due to the impact of M-I SWACO’s U.S. partnership earnings for which the minority partner is directly responsible for its related income taxes. The Company properly consolidates the pretax income related to the minority partner’s share of U.S. partnership earnings but excludes the related tax provision.

     Minority interest expense reflects the portion of the results of majority-owned operations which are applicable to the minority interest partners. Minority interest expense totaled $191.4 million in 2006, a $68.7 million increase from 2005. The year-over-year increase primarily reflects the higher profitability of the M-I SWACO joint venture and, to a lesser extent, improved earnings reported by CE Franklin Ltd.

Liquidity and Capital Resources

General

     At December 31, 2007, cash and cash equivalents equaled $158.3 million. During 2007, the Company generated $688.5 million of cash flows from operations, which is $410.0 million above the amount reported in 2006. The year-over-year improvement is attributable to lower comparable working capital investment, associated with slower growth in global drilling activity, combined with higher profitability levels experienced in the Company’s oilfield business operations.

     In 2007, cash flows used in investing activities totaled $347.6 million, primarily consisting of amounts required to fund capital expenditures and, to a lesser extent, acquisitions. The Company invested $310.8 million in property, plant and equipment, net of cash proceeds associated with certain asset disposals. Acquisition funding, which largely related to the purchase of D.S.I. Inspection Services, Inc. and CE Franklin’s acquisition of Jen Supply Ltd., resulted in cash outflows of $53.5 million.

     Projected net capital expenditures for 2008 are forecasted to total $325 million, relatively consistent with spending levels reported for 2007. The majority of the forecasted expenditures relate to routine additions of rental tool and manufacturing equipment to support the Company’s business operations and maintain the existing capital equipment base.

     Cash flows used in financing activities totaled $265.8 million in 2007. The Company’s strong operating cash flow performance enabled the funding of investing activities and $159.6 million of combined share repurchases and dividend payments, while still having sufficient availability to repay $103.5 million of outstanding borrowings under various loan agreements.

     The Company’s primary internal source of liquidity is cash flow generated from operations. Cash flow generated from operations is primarily influenced by the level of worldwide drilling activity, which affects profitability levels and working capital requirements. Capacity under revolving credit agreements is also available, if necessary, to fund operating or investing activities. As of December 31, 2007, the Company had $245.0 million drawn and $4.5 million of letters of credit issued under various U.S. revolving credit facilities, resulting in $170.5 million of capacity available for future operating or investing needs. The Company also has revolving credit facilities in place outside of the United States, which are generally used to finance local operating needs. At the end of fiscal 2007, the Company had available borrowing capacity of $164.1 million under the non-U.S. borrowing facilities.

9

     The Company’s external sources of liquidity include debt and equity financing in the public capital markets, if needed. The Company carries an investment-grade credit rating with recognized rating agencies, generally providing the Company with access to debt markets. The Company’s overall borrowing capacity is, in part, dependent on maintaining compliance with financial covenants under the various credit agreements. As of December 31, 2007, the Company was well within the covenant compliance thresholds under its various loan indentures, as amended, providing the ability to access available borrowing capacity. Management believes funds generated by operations, amounts available under existing credit facilities and external sources of liquidity will be sufficient to finance capital expenditures and working capital needs of the existing operations for the foreseeable future.

     Management continues to evaluate opportunities to acquire products or businesses complementary to the Company’s operations. Additional acquisitions, if they arise, may involve the use of cash or, depending upon the size and terms of the acquisition, may require debt or equity financing.

     The Company makes regular quarterly distributions under a dividend program. On February 6, 2008, the Company’s Board of Directors increased the quarterly cash dividend to $0.12 per share. The current annualized payout of approximately $96 million is expected to be funded with cash flows from operations and, if necessary, amounts available under existing credit facilities. The level of future dividend payments will be at the discretion of the Company’s Board of Directors and will depend upon the Company’s financial condition, earnings, cash flows, compliance with certain debt covenants and other relevant factors.

     The Company’s Board of Directors has authorized a share buyback program that allows for the repurchase of up to 20 million shares of the Company’s common stock, subject to regulatory issues, market considerations and other relevant factors. As of December 31, 2007, the Company had 15.7 million shares remaining under the current authorization. Future repurchases under the program may be executed from time to time in the open market or in privately negotiated transactions and will be funded with cash flows from operations or amounts available under existing credit facilities.

     The Company believes it has sufficient existing manufacturing capacity to meet current demand for its products and services. Additionally, inflation has had a modest impact on the Company’s financial results in the three most recent fiscal years, with the Company experiencing escalation in wages, transportation costs and, to some extent, petrochemical and other commodity prices during 2007. The Company expects to be able to continue to offset the impact of future cost inflation through productivity gains and pricing initiatives.

     The Company has not engaged in off-balance sheet financing arrangements through special purpose entities, and the consolidation of the Company’s minority ownership positions would not result in an increase in reported leverage ratios. The Company has no contractual arrangements in place that could result in the issuance of additional shares of the Company’s common stock at a future date other than the Company’s stock-based compensation program, which is discussed in Note 1, “Summary of Significant Accounting Policies,” and Note 14, “Long-Term Incentive Compensation.”

10

Contractual Obligations, Commitments and Contingencies

Contractual Obligations

     The following table summarizes the Company’s debt maturities, estimated interest on fixed rate long-term debt and future minimum payments under non-cancelable operating leases having initial terms in excess of one year as of December 31, 2007 (in thousands):

			Amount of Commitment Expiration per Period
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Debt maturities	$	985,105	$	139,481	$	298,060	$	272,797	$	274,767
Interest on fixed rate long-term debt		186,657		31,350		62,700		34,857		57,750
Operating lease commitments		317,053		72,775		91,449		45,523		107,306
Total	$	1,488,815	$	243,606	$	452,209	$	353,177	$	439,823

     Amounts related to commitments under capital lease agreements, purchase obligations and other long-term liabilities reflected in the accompanying consolidated balance sheet, including pension and other postretirement obligations, have been excluded from the above table due to immateriality.

     Moreover, the required disclosure related to the Company’s $45.9 million of liabilities associated with uncertain tax positions has been omitted from the above table. Due to the complex application of tax regulations, combined with our inability to predict when tax audits in various jurisdictions may be concluded, the Company is unable to reasonably estimate the timing of cash settlements, if any, related to its uncertain tax positions.

Standby Letters of Credit

     In the normal course of business with customers, vendors and others, the Company is contingently liable for performance under standby letters of credit and bid, performance and surety bonds. Certain of these outstanding instruments guarantee payment to insurance companies which reinsure certain liability coverages of the Company’s insurance captive. Excluding the impact of these instruments, for which $17.8 million of related liabilities are reflected in the accompanying consolidated balance sheet, the Company was contingently liable for approximately $136.2 million of standby letters of credit and bid, performance and surety bonds at December 31, 2007. Management does not expect any material amounts to be drawn on these instruments.

Insurance

     The Company maintains insurance coverage for various aspects of its business and operations. The Company has elected to retain a portion of losses that occur through the use of deductibles and retentions under its insurance programs. Amounts in excess of the self-insured retention levels are fully insured to limits believed appropriate for the Company’s operations. Self-insurance accruals are based on claims filed and an estimate for claims incurred but not reported. While management believes that amounts accrued in the accompanying consolidated financial statements are adequate for expected liabilities arising from the Company’s portion of losses, estimates of these liabilities may change as circumstances develop.

Litigation

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

11

Environmental

     The Company routinely establishes and reviews the adequacy of reserves for estimated future environmental clean-up costs for properties currently or previously operated by the Company.

     As of December 31, 2007, the Company’s environmental reserve totaled $7.6 million. This amount reflects the future undiscounted estimated exposure related to identified properties, without regard to indemnifications from former owners. While actual future environmental costs may differ from estimated liabilities recorded at December 31, 2007, the Company does not believe that these differences will have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

Critical Accounting Policies and Estimates

     The discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company evaluates its estimates on an on-going basis, based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

     The Company believes the following describes significant judgments and estimates used in the preparation of its consolidated financial statements:

Allowance for doubtful accounts. The Company extends credit to customers and other parties in the normal course of business. Management regularly reviews outstanding receivables and provides for estimated losses through an allowance for doubtful accounts. In evaluating the level of established reserves, management makes judgments regarding the parties’ ability to make required payments, economic events and other factors. As the financial condition of these parties change, circumstances develop or additional information becomes available, adjustments to the allowance for doubtful accounts may be required.

Inventory reserves. The Company has made significant investments in inventory to service its customers around the world. On a routine basis, the Company uses judgments in determining the level of reserves required to state inventory at the lower of cost or market. Management’s estimates are primarily influenced by technological innovations, market fundamentals and the physical condition of products. Changes in these or other factors may result in adjustments to the carrying value of inventory.

Goodwill. The Company has acquired a number of operations during the past decade, which has resulted in the recording of a material amount of goodwill. Under SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company is required to perform an annual goodwill impairment evaluation, which is largely influenced by future cash flow projections. Estimating future cash flows of the Company’s operations requires management to make judgments about future operating results and working capital requirements. Although the majority of the goodwill relates to the Company’s oilfield business operations, $51.5 million of goodwill relates to Distribution transactions. Changes in cash flow assumptions or other factors that negatively impact the fair value of the operations would influence the evaluation and may result in the determination that a portion of the goodwill is impaired when the annual analysis is performed.

12

Self-Insurance. The Company maintains insurance coverage for various aspects of its business and operations. The Company retains a portion of losses that occur through the use of deductibles and retentions under self-insurance programs. Management regularly reviews estimates of reported and unreported claims and provides for losses through insurance reserves. As claims develop and additional information becomes available, adjustments to loss reserves may be required.

Income taxes. Deferred tax assets and liabilities are recognized for differences between the book basis and tax basis of the net assets of the Company. In providing for deferred taxes, management considers current tax regulations, estimates of future taxable income and available tax planning strategies. In certain cases, management has established reserves to reduce deferred tax assets to estimated realizable value. If tax regulations, operating results or the ability to implement tax planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. The Company recognizes tax benefits related to uncertain tax positions when, based on technical merits, it is more likely than not the respective positions will be sustained on examination by the taxing authorities. Adjustments to the recorded liabilities for uncertain tax positions may be required pursuant to the ultimate settlement of an income tax audit, the refinement of an estimate in light of changes to any facts or circumstances, or the expiration of a statute of limitations.

Environmental Obligations. The Company records liabilities for environmental obligations when remedial efforts are probable and the costs can be reasonably estimated. Management’s estimates are based on currently enacted laws and regulations. As more information becomes available or environmental laws and regulations change, such liabilities may be required to be adjusted. Additionally, in connection with acquisitions, the Company generally obtains indemnifications from the seller related to environmental matters. If the indemnifying parties do not fulfill their obligations, adjustments of recorded amounts may be required.

Recent Accounting Pronouncements

     From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date.

     In December 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) establishes accounting and disclosure requirements for business combinations including the recognition and measurement of assets acquired, liabilities assumed, and any noncontrolling ownership interest purchased in a transaction. SFAS 141(R) also sets forth new guidance regarding the treatment of transaction-related costs and establishes additional disclosure requirements that will enable users to evaluate the nature and financial effects of business combinations. We are currently evaluating the provisions of SFAS 141(R) which are effective, and will be adopted by the Company, on January 1, 2009.

     In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“SFAS 160”) which addresses the accounting and disclosure requirements for subsidiaries which are not wholly-owned. Under SFAS 160, the Company will be required to classify the minority interest liability reflected in the accompanying consolidated balance sheet as a component of stockholders’ equity. Moreover, the Company will be required to present net income attributable to the Company and the minority partners’ ownership interest separately on the consolidated statement of operations. We are currently evaluating the provisions of SFAS 160 which are effective, and will be adopted by the Company, on January 1, 2009 to determine any additional impact on the Company’s consolidated financial statements.

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

13

EX-99.02

EXHIBIT 99.02

Item 8. Financial Statements and Supplementary Data

Management’s Report on Internal Control Over Financial Reporting

Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rule 13a — 15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is designed to provide reasonable, not absolute, assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable, not absolute, assurance with respect to financial statement preparation and presentation.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that the Company’s internal control over financial reporting was effective as of December 31, 2007.

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2007 has been audited by Deloitte & Touche LLP, the independent registered public accounting firm who also audited the Company’s consolidated financial statements. The Deloitte & Touche LLP audit report on the effectiveness of the Company’s internal control over financial reporting appears on page 15 of this Form 8-K.

/s/ Doug Rock Doug Rock	/s/ Margaret K. Dorman Margaret K. Dorman
Chairman of the Board and	Senior Vice President,
Chief Executive Officer	Chief Financial Officer and Treasurer

1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
Smith International, Inc.
Houston, Texas

We have audited the internal control over financial reporting of Smith International, Inc. and subsidiaries (the “Company”) as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2007 of the Company and our report dated February 29, 2008 (August 15, 2008 as it relates to the segment change described in Notes 7 and 15) expressed an unqualified opinion on those financial statements and financial statement schedule and included an explanatory paragraph regarding the Company’s adoption of new accounting standards.

DELOITTE & TOUCHE LLP

Houston, Texas
February 29, 2008

2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
Smith International, Inc.
Houston, Texas

We have audited the accompanying consolidated balance sheets of Smith International, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in Part IV, Item 15 (a) (2). These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board
(United States). 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, such consolidated financial statements present fairly, in all material respects, the financial position of Smith International, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123r, “Share-Based Payment” as of January 1, 2006 and Financial Accounting Standards Board Interpretation (“FASB”) No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” on January 1, 2007. Additionally, as discussed in Note 13 to the consolidated financial statements, the Company adopted SFAS No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans” as of December 31, 2006.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 29, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.

DELOITTE & TOUCHE LLP

Houston, Texas
February 29, 2008
(August 15, 2008 as it relates to the segment change described in Notes 7 and 15)

3

SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value data)

	December 31,
	2007			2006
Assets
Current Assets:
Cash and cash equivalents	$	158,267		$	80,379
Receivables, net (Note 1)		1,750,561			1,592,230
Inventories, net		1,658,172			1,457,371
Deferred tax assets, net		46,220			51,070
Prepaid expenses and other		114,515			89,977
Total current assets		3,727,735			3,271,027
Property, Plant and Equipment, net		1,105,880			887,044
Goodwill, net		896,442			867,647
Other Intangible Assets, net		128,359			141,140
Other Assets		203,464			168,617
Total Assets	$	6,061,880		$	5,335,475
Liabilities and Stockholders’ Equity
Current Liabilities:
Short-term borrowings and current portion of long-term debt	$	139,481		$	287,704
Accounts payable		655,413			654,215
Accrued payroll costs		153,453			154,756
Income taxes payable		80,181			130,339
Other		144,772			152,454
Total current liabilities		1,173,300			1,379,468
Long-Term Debt		845,624			800,928
Deferred Tax Liabilities		160,244			143,124
Other Long-Term Liabilities		157,042			102,904
Minority Interests		1,130,773			922,114
Commitments and Contingencies (Note 16)
Stockholders’ Equity:
Preferred stock, $1 par value; 5,000 shares authorized; no shares issued or outstanding in 2007 or 2006		—			—
Common stock, $1 par value; 250,000 shares authorized; 217,586 shares issued in 2007 (214,947 shares issued in 2006)		217,586			214,947
Additional paid-in capital		533,429			442,155
Retained earnings		2,219,224			1,653,480
Accumulated other comprehensive income		67,840			23,227
Less — Treasury securities, at cost; 16,825 common shares in 2007 (15,031 common shares in 2006)		(443,182	)		(346,872	)
Total stockholders’ equity		2,594,897			1,986,937
Total Liabilities and Stockholders’ Equity	$	6,061,880		$	5,335,475

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

4

SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)

	For the Years Ended December 31,
	2007			2006			2005
Revenues	$	8,764,330		$	7,333,559		$	5,579,003
Costs and expenses:
Costs of revenues		5,908,673			4,989,288			3,893,865
Selling expenses		1,177,359			969,825			786,668
General and administrative expenses		308,501			294,365			227,909
Total costs and expenses		7,394,533			6,253,478			4,908,442
Operating income		1,369,797			1,080,081			670,561
Interest expense		69,990			62,967			44,446
Interest income		(4,068	)		(2,982	)		(1,692	)
Income before income taxes and minority interests		1,303,875			1,020,096			627,807
Income tax provision		408,471			326,674			202,743
Minority interests		248,353			191,416			122,759
Net income	$	647,051		$	502,006		$	302,305
Earnings per share:
Basic	$	3.23		$	2.51		$	1.50
Diluted		3.20			2.49			1.48
Weighted average shares outstanding:
Basic		200,244			200,252			201,651
Diluted		201,947			202,008			204,522

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

5

SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

	For the Years Ended December 31,
	2007			2006			2005
Cash flows from operating activities:
Net income	$	647,051		$	502,006		$	302,305
Adjustments to reconcile net income to net cash provided by operating activities, excluding the net effects of acquisitions:
Minority interests		248,353			191,416			122,759
Depreciation and amortization		193,296			150,384			117,722
Share-based compensation expense		34,239			27,280			5,947
Increase in LIFO inventory reserves		22,712			18,942			22,144
Deferred income tax provision		22,265			3,737			10,636
Provision for losses on receivables		5,082			7,578			4,216
Foreign currency translation losses		4,059			3,376			1,213
Gain on disposal of property, plant and equipment		(21,133	)		(18,893	)		(14,812	)
Equity earnings, net of dividends received		(17,170	)		(9,247	)		(10,420	)
Gain on sale of operations		(1,534	)		(6,473	)		(5,898	)
Changes in operating assets and liabilities:
Receivables		(154,355	)		(364,834	)		(243,882	)
Inventories		(202,436	)		(412,748	)		(197,204	)
Accounts payable		(9,760	)		161,111			105,832
Other current assets and liabilities		(58,262	)		48,975			3,487
Other non-current assets and liabilities		(23,920	)		(24,126	)		(15,996	)
Net cash provided by operating activities		688,487			278,484			208,049
Cash flows from investing activities:
Acquisition-related payments, net of cash acquired		(53,452	)		(226,727	)		(81,328	)
Purchases of property, plant and equipment		(355,821	)		(308,470	)		(177,845	)
Proceeds from disposal of property, plant and equipment		45,045			35,743			26,426
Proceeds from settlement of property insurance claims		—			15,026			—
Proceeds from sale of operations		16,655			13,504			20,496
Net cash used in investing activities		(347,573	)		(470,924	)		(212,251	)
Cash flows from financing activities:
Proceeds from issuance of long-term debt		146,847			803,635			187,804
Principal payments of long-term debt		(272,676	)		(426,557	)		(57,592	)
Net change in short-term borrowings		22,302			(30,299	)		14,478
Debt issuance costs		—			(4,744	)		—
Purchases of common stock under Repurchase Program		(83,529	)		(102,894	)		(117,820	)
Payment of common stock dividends		(76,026	)		(60,074	)		(36,353	)
Excess tax benefit from share-based compensation		27,271			8,724			11,405
Net proceeds related to long-term incentive awards		18,101			20,393			39,847
Distributions to minority interest partner		(48,097	)		—			(28,000	)
Net cash provided by (used in) financing activities		(265,807	)		208,184			13,769
Effect of exchange rate changes on cash		2,781			2,092			(620	)
Increase in cash and cash equivalents		77,888			17,836			8,947
Cash and cash equivalents at beginning of year		80,379			62,543			53,596
Cash and cash equivalents at end of year	$	158,267		$	80,379		$	62,543
Supplemental disclosures of cash flow information:
Cash paid for interest	$	74,536		$	62,161		$	44,217
Cash paid for income taxes		384,145			291,981			177,697

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

6

SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
For the Years Ended December 31, 2007, 2006 and 2005
(In thousands, except share data)

											Accumulated			Treasury Securities
	Common Stock				Additional						Other			Common Stock						Total
	Number of				Paid-in			Retained			Comprehensive			Number of						Stockholders’
	Shares		Amount		Capital			Earnings			Income			Shares			Amount			Equity
Balance, January 1, 2005		105,296,653	$	105,297	$	432,395		$	961,574		$	24,404			(4,222,466	)	$	(122,859	)	$	1,400,811
Net income		—		—		—			302,305			—			—			—			302,305
Currency translation adjustments		—		—		—			—			(14,635	)		—			—			(14,635	)
Changes in unrealized fair value of derivatives		—		—		—			—			(2,044	)		—			—			(2,044	)
Minimum pension liability adjustments		—		—		—			—			(824	)		—			—			(824	)
Comprehensive income		—		—		—			302,305			(17,503	)		—			—			284,802
Purchases of common stock under Repurchase Program		—		—		—			—			—			(2,198,800	)		(117,820	)		(117,820	)
Dividends declared		—		—		—			(48,396	)		—			—			—			(48,396	)
Exercise of stock options and non-employee equity awards		1,749,605		1,749		51,542			—			—			—			—			53,291
Vesting of restricted stock		34,632		35		—			—			—			(4,276	)		(165	)		(130	)
Share-based compensation		—		—		5,947			—			—			—			—			5,947
Two-for-one common stock split (Note 1 and 11)		106,188,814		106,189		(106,189	)		—			—			(5,875,386	)		—			—
Balance, December 31, 2005		213,269,704		213,270		383,695			1,215,483			6,901			(12,300,928	)		(240,844	)		1,578,505
Net income		—		—		—			502,006			—			—			—			502,006
Currency translation adjustments		—		—		—			—			12,407			—			—			12,407
Changes in unrealized fair value of derivatives		—		—		—			—			2,425			—			—			2,425
Minimum pension liability adjustments		—		—		—			—			857			—			—			857
Comprehensive income		—		—		—			502,006			15,689			—			—			517,695
Impact of SFAS 158 adoption (Note 13)		—		—		—			—			637			—			—			637
Purchases of common stock under Repurchase Program		—		—		—			—			—			(2,656,987	)		(102,894	)		(102,894	)
Dividends declared		—		—		—			(64,009	)		—			—			—			(64,009	)
Exercise of stock options and non-employee equity awards		1,376,213		1,376		31,180			—			—			—			—			32,556
Vesting of restricted stock		300,834		301		—			—			—			(73,163	)		(3,134	)		(2,833	)
Share-based compensation		—		—		27,280			—			—			—			—			27,280
Balance, December 31, 2006		214,946,751		214,947		442,155			1,653,480			23,227			(15,031,078	)		(346,872	)		1,986,937
Net income		—		—		—			647,051			—			—			—			647,051
Currency translation adjustments		—		—		—			—			46,743			—			—			46,743
Changes in unrealized fair value of derivatives		—		—		—			—			506			—			—			506
Changes in pension and other postretirement benefits		—		—		—			—			(2,636	)		—			—			(2,636	)
Comprehensive income		—		—		—			647,051			44,613			—			—			691,664
Impact of FIN 48 adoption (Note 1)		—		—		—			(1,191	)		—			—			—			(1,191	)
Purchases of common stock under Repurchase Program		—		—		—			—			—			(1,570,300	)		(83,529	)		(83,529	)
Dividends declared		—		—		—			(80,116	)		—			—			—			(80,116	)
Exercise of stock options and non-employee equity awards		1,790,706		1,790		57,035			—			—			—			—			58,825
Vesting of restricted stock		848,760		849		—			—			—			(223,892	)		(12,781	)		(11,932	)
Share-based compensation		—		—		34,239			—			—			—			—			34,239
Balance, December 31, 2007		217,586,217	$	217,586	$	533,429		$	2,219,224		$	67,840			(16,825,270	)	$	(443,182	)	$	2,594,897

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

7

SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All dollar amounts are expressed in thousands, unless otherwise noted)

1. Summary of Significant Accounting Policies

Basis of Presentation

     Smith International, Inc. (“Smith” or the “Company”) provides premium products and services to the oil and gas exploration and production industry. The accompanying consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States and all applicable financial statement rules and regulations of the Securities and Exchange Commission (the “Commission”). Management believes the consolidated financial statements present fairly the financial position, results of operations and cash flows of the Company as of the dates indicated.

     The consolidated financial statements include the accounts of the Company and all wholly and majority-owned subsidiaries, after the elimination of all significant intercompany accounts and transactions. Investments in affiliates in which ownership interest ranges from 20 to 50 percent, and the Company exercises significant influence over operating and financial policies, are accounted for on the equity method. All other investments are carried at cost, which does not exceed the estimated net realizable value of such investments.

Stock Split

     In July 2005, the Company’s Board of Directors approved a two-for-one stock split, which was effected in the form of a stock dividend. Stockholders of record as of August 5, 2005 were entitled to the dividend, which was distributed on August 24, 2005.

Use of Estimates

     Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosed amounts of contingent assets and liabilities and the reported amounts of revenues and expenses. Management believes the most significant estimates and assumptions are associated with the valuation of accounts receivable, inventories, goodwill and deferred taxes as well as the determination of liabilities related to environmental obligations and self-insurance programs. If the underlying estimates and assumptions, upon which the financial statements are based, change in future periods, actual amounts may differ from those included in the accompanying consolidated financial statements.

Cash and Cash Equivalents

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

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts to provide for receivables which may ultimately be uncollectible. Reserves are determined in light of a number of factors including customer specific conditions, economic events and the Company’s historical loss experience. At December 31, 2007 and 2006, the allowance for doubtful accounts was $17.3 million and $16.7 million, respectively.

8

Inventories

     Inventories are stated at the lower of cost or market. Cost is determined using the average cost method for the majority of the Company’s inventories; however, certain of the Company’s U.S.-based inventories are valued utilizing the last-in, first-out (“LIFO”) method. Inventory costs consist of materials, labor and factory overhead.

Fixed Assets

     Fixed assets, consisting of rental equipment and property, plant and equipment, are stated at cost, net of accumulated depreciation. The Company computes depreciation on fixed assets using principally the straight-line method; however, for income tax purposes, accelerated methods of depreciation are used. The estimated useful lives used in computing depreciation generally range from 20 to 40 years for buildings, three to 25 years for machinery and equipment, and five to ten years for rental equipment. Leasehold improvements are amortized over the initial lease term or the estimated useful lives of the improvements, whichever is shorter. Depreciation expense for the years ended December 31, 2007, 2006 and 2005 was $161.6 million, $129.6 million and $106.8 million, respectively.

     Costs of major renewals and betterments are capitalized as fixed assets; however, expenditures for maintenance, repairs and minor improvements are charged to expense when incurred. When fixed assets are sold or retired, the remaining cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is included in the consolidated statement of operations.

Goodwill and Other Intangible Assets

     Goodwill represents the excess of cost over the fair value of net assets acquired. Recorded goodwill balances are not amortized but, instead, are evaluated for impairment annually or more frequently if circumstances indicate that an impairment may exist. The goodwill valuation, which is prepared during the first quarter of each calendar year, is largely influenced by projected future cash flows and, therefore, is significantly impacted by estimates and judgments.

     The Company amortizes other identifiable intangible assets on a straight-line basis over the periods expected to be benefited, ranging from two to 27 years. The components of these other intangible assets generally consist of patents, license agreements, non-compete agreements, trademarks and customer lists and contracts.

Impairment of Long-Lived Assets

     Management reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If an evaluation is required, the estimated undiscounted future cash flows associated with the asset will be compared to the asset’s carrying amount to determine if an impairment exists.

Environmental Obligations

     Expenditures for environmental obligations that relate to current operations are expensed or capitalized, as appropriate. Liabilities are recorded when environmental clean-up efforts are probable and their cost is reasonably estimated, and are adjusted as further information is obtained. Such estimates are based on currently enacted laws and regulations and are not discounted to present value.

Liabilities Related to Self-Insurance Programs

     The Company is self-insured for certain casualty and employee medical insurance liabilities of its U.S. operations. Expenditures for casualty and medical claims are recorded when incurred after taking into consideration recoveries available under stop-loss insurance policies. Additionally, reserves are established to provide for the estimated cost of settling known claims as well as medical and casualty exposures projected to have been incurred but not yet reported.

9

Foreign Currency Translation and Transactions

     Gains and losses resulting from balance sheet translation of operations outside the United States where the applicable foreign currency is the functional currency are included as a component of accumulated other comprehensive income within stockholders’ equity. Gains and losses resulting from balance sheet translation of operations outside the United States where the U.S. dollar is the functional currency are included in the consolidated statements of operations.

     Gains and losses resulting from foreign currency transactions, excluding cash flow hedges discussed below, are recognized currently in the consolidated statements of operations.

Financial Instruments

     The nature of the Company’s business activities involves the management of various financial and market risks, including those related to changes in currency exchange rates and interest rates. The Company utilizes derivative financial instruments such as foreign exchange contracts, foreign exchange options and interest rate contracts to mitigate or eliminate certain of those risks. The Company does not enter into derivative instruments for speculative purposes.

     The Company records changes in fair market value related to fair value hedges, which includes foreign exchange contracts, to selling expenses in the consolidated statements of operations. Changes in value related to cash flow hedges, which includes foreign exchange contracts, foreign exchange options and interest rate swaps, are recorded in accumulated other comprehensive income and are recognized in the consolidated statement of operations when the hedged item affects earnings.

Income Taxes

     The Company accounts for income taxes using an asset and liability approach for financial accounting and income tax reporting based on enacted tax rates. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some portion, or all, of the deferred tax assets will not be realized.

     The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. This interpretation addresses the determination of whether tax benefits claimed, or expected to be claimed, on a tax return should be recorded in the financial statements. The Company recognizes the tax benefit from an uncertain tax position when, based on technical merits, it is more likely than not the position will be sustained on examination by the taxing authorities. In connection with the adoption of FIN 48, the Company was required to record an additional $1.2 million of tax liabilities, including related interest and penalties, with a corresponding reduction in stockholders’ equity during the first quarter of 2007.

     The Company records penalty and interest amounts related to income tax matters as income tax expense in the accompanying financial statements. For the year ended December 31, 2007, the Company included $1.4 million and $0.9 million of interest and penalties, respectively, in income tax expense.

Revenue Recognition

     The Company’s revenues, which are composed of product, rental, service and other revenues, are generally subject to contractual arrangements which specify price and general terms and conditions. The Company recognizes product revenues, net of applicable provisions for returns, when title and the related risk of loss transfers to the customer. Rental, service and other revenues are recorded when such services are performed and collectibility is reasonably assured.

10

Minority Interests

     The Company records minority interest expense which reflects the portion of the earnings of majority-owned operations which are applicable to the minority interest partners. The minority interest amount primarily represents the share of the M-I SWACO profits associated with the minority partner’s 40 percent interest in those operations. To a lesser extent, minority interests include the portion of CE Franklin Ltd. and other joint venture earnings applicable to the respective minority shareholders.

Long-term Incentive Compensation

     The Company’s Board of Directors and its stockholders have authorized a long-term incentive plan for the benefit of key employees. Although the Plan provides for the issuance of various stock-based awards, the Compensation Committee has elected to issue restricted stock units and, prior to December, 2005, stock option awards.

     Restricted stock units are considered compensatory awards and compensation expense related to these units is recognized over the established vesting period in the accompanying consolidated financial statements.

     Accounting for the stock option program was impacted by the mandatory adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123r, “Share-Based Payment,” (“SFAS No. 123r”) on January 1, 2006. In connection with the implementation, the Company utilized the modified prospective method; and, accordingly, results for prior periods have not been restated. Prior to January 1, 2006, companies could apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations in accounting for its stock option program. Accordingly, for the 2005 fiscal year, the Company has elected to make pro forma footnote disclosures rather than recognizing the related compensation expense for stock option awards in the consolidated financial statements.

     Had the Company elected to apply the accounting standards of SFAS No. 123, “Accounting for Stock-Based Compensation”, the 2005 fiscal year’s net income and earnings per share would have approximated the pro forma amounts indicated below (in thousands, except per share data):

	2005
Net income, as reported	$	302,305
Add: Stock-based compensation expense included in reported income, net of related tax effect		3,952
Less: Total stock-based compensation expense determined under fair value methods, net of related tax effect		(13,056	)
Net income, pro forma	$	293,201
Earnings per share:
As reported:
Basic	$	1.50
Diluted		1.48
Pro forma:
Basic	$	1.45
Diluted		1.43

Recent Accounting Pronouncements

     From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date.

11

     In December 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) establishes accounting and disclosure requirements for business combinations including the recognition and measurement of assets acquired, liabilities assumed, and any noncontrolling ownership interest purchased in a transaction. SFAS 141(R) also sets forth new guidance regarding the treatment of transaction-related costs and establishes additional disclosure requirements that will enable users to evaluate the nature and financial effects of business combinations. We are currently evaluating the provisions of SFAS 141(R) which are effective, and will be adopted by the Company, on January 1, 2009.

     In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“SFAS 160”) which addresses the accounting and disclosure requirements for subsidiaries which are not wholly-owned. Under SFAS 160, the Company will be required to classify the minority interest liability reflected in the accompanying consolidated balance sheet as a component of stockholders’ equity. Moreover, the Company will be required to present net income attributable to the Company and the minority partners’ ownership interest separately on the consolidated statement of operations. We are currently evaluating the provisions of SFAS 160 which are effective, and will be adopted by the Company, on January 1, 2009 to determine any additional impact on the Company’s consolidated financial statements.

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

2. Acquisitions

     During 2007, the Company completed five acquisitions in exchange for aggregate cash consideration of $39.9 million and the assumption of certain liabilities. The 2007 transactions primarily consist of the following:

On May 16, 2007, Smith Services acquired D.S.I. Inspection Services, Inc. (“DSI”) in exchange for cash consideration of approximately $16.7 million. DSI, based in the United States, is a provider of inspection, machine shop and other related services. The Company may be required to fund additional cash consideration of up to $2.0 million related to the DSI transaction upon the lapse of certain contingencies.

On December 3, 2007, CE Franklin acquired the outstanding stock of Jen Supply Ltd. (“Jen Supply”) in exchange for $12.4 million of cash and a $0.5 million note. Jen Supply, based in Alberta, Canada is an oilfield equipment distributor. CE Franklin may be required to fund additional cash consideration of $2.5 million under the terms of an earn-out arrangement.

     The excess of the purchase price over the estimated fair value of net assets acquired approximated $19.4 million, primarily pertaining to the DSI and Jen Supply transactions, and has been recorded as goodwill in the consolidated balance sheet. Based on the structure of the transactions, the majority of the goodwill related to the 2007 acquisitions is not expected to be deductible for tax purposes. The purchase price allocations related to these acquisitions are based on preliminary information and are subject to change when additional data concerning final asset and liability valuations is obtained; however, material changes in the preliminary allocations are not anticipated by management.

     In certain situations, the Company negotiates transaction terms which provide for the payment of additional consideration if various financial and/or business objectives are met. In addition to the acquisition consideration discussed above, the Company paid $13.5 million of purchase consideration to settle obligations related to earn-out arrangements during 2007. The acquisition-related payments are reflected in the consolidated balance sheet as goodwill.

12

     During 2006, the Company completed seven acquisitions in exchange for aggregate cash consideration of $226.7 million and the assumption of certain liabilities. The 2006 transactions primarily consist of the following:

On February 23, 2006, M-I SWACO acquired Epcon Offshore AS (“Epcon”) in exchange for cash consideration of approximately $44.9 million. Epcon, based in Porsgrunn, Norway, is a global provider of proprietary water treatment technology designed to optimize the removal of hydrocarbons from water generated during the oil and gas production process.

On August 3, 2006, M-I SWACO acquired Specialised Petroleum Services Group Limited (“SPS”) in exchange for cash consideration of approximately $165.4 million. SPS, based in Aberdeen, Scotland, is a global provider of patented well-bore clean-up products and engineering services used to remove debris from the wellbore to facilitate improved well production.

     The excess of the purchase price over the estimated fair value of the net assets acquired amounted to $129.3 million, primarily pertaining to SPS and Epcon, and has been recorded as goodwill in the accompanying consolidated balance sheet.

     During 2005, the Company completed six acquisitions in exchange for aggregate cash consideration of $81.3 million and the assumption of certain liabilities. The 2005 transactions primarily consist of the following:

On August 17, 2005, Smith Services acquired certain operating assets of Tubular Technology, Inc. (“TTI”) and associated companies for cash consideration of $23.2 million. The acquired operations provide a full range of products and services used during the installation of corrosion-resistant alloy tubulars and also offer proprietary products and technical services used during the completion-phase of oil and gas wells, primarily to customers in the U.S. Gulf Coast region.

On November 1, 2005, Smith Services acquired certain operating assets of Nunez Oil Field Pipe, Ltd. (“Nunez”) and associated companies for cash consideration of $41.4 million. The acquired companies rent and repair premium drill pipe, drill collars, and blow-out preventers and perform machine shop and related inspection services in the United States.

     The excess of the purchase price over the estimated fair value of the net assets acquired amounted to $23.4 million, primarily pertaining to Nunez and TTI, and has been recorded as goodwill in the accompanying consolidated balance sheet.

     These acquisitions have been recorded using the purchase method of accounting and, accordingly, the acquired operations have been included in the results of operations since the date of acquisition. Pro forma results of operations have not been presented because the effect of these acquisitions was not material to the Company’s consolidated financial statements.

     The following schedule summarizes investing activities related to 2007, 2006 and 2005 acquisitions included in the consolidated statements of cash flows:

	2007			2006			2005
Fair value of tangible and identifiable intangible assets, net of cash acquired	$	26,185		$	171,125		$	68,597
Goodwill acquired		19,422			129,278			23,444
Payments to former shareholders of businesses acquired		13,522			—			—
Total liabilities assumed		(5,677	)		(73,676	)		(10,713	)
Cash paid for acquisitions, net of cash acquired	$	53,452		$	226,727		$	81,328

13

3. Dispositions

     From time to time, the Company divests of select business operations. During 2007, the Company completed the disposition of certain majority-owned venture operations in exchange for aggregate cash consideration of $16.7 million and eliminated related net assets, including $10.2 million of goodwill. During the years ended December 31, 2006 and 2005, the Company completed the disposition of its ownership interest in certain Oilfield operations in exchange for aggregate cash consideration of $13.5 million and $20.5 million, respectively.

     These transactions resulted in an aggregate pre-tax gain of approximately $1.5 million, $6.5 million and $5.9 million for the year’s ended December 31, 2007, 2006 and 2005, respectively. The impact of these dispositions has been reflected as a reduction in general and administrative expenses in the accompanying consolidated statements of operations for the respective periods. Pro forma results of operations have not been presented because the effect of these dispositions was not material to the Company’s consolidated financial statements.

4. Earnings Per Share

     Basic earnings per share (“EPS”) is computed using the weighted average number of common shares outstanding during the period. Diluted EPS gives effect to the potential dilution of earnings that could have occurred if additional shares were issued for stock option and restricted stock awards under the treasury stock method. For the years ended December 31, 2007 and 2006, an immaterial number of outstanding stock-based awards, were excluded from the computation of diluted EPS because they were anti-dilutive. The following schedule reconciles the income and shares used in the basic and diluted EPS computations (in thousands, except per share data):

	2007		2006		2005
Net Income	$	647,051	$	502,006	$	302,305
Weighted average number of common shares outstanding		200,244		200,252		201,651
Basic EPS	$	3.23	$	2.51	$	1.50
Net Income	$	647,051	$	502,006	$	302,305
Weighted average number of common shares outstanding		200,244		200,252		201,651
Dilutive effect of stock options and restricted stock units		1,703		1,756		2,871
		201,947		202,008		204,522
Diluted EPS	$	3.20	$	2.49	$	1.48

5. Inventories

     Inventories consist of the following at December 31:

	2007			2006
Raw materials	$	139,218		$	117,812
Work-in-process		173,836			147,543
Finished goods		1,461,373			1,285,558
		1,774,427			1,550,913
Reserves to state certain U.S. inventories (FIFO cost of $611,062 and $559,943 in 2007 and 2006, respectively) on a LIFO basis		(116,255	)		(93,542	)
	$	1,658,172		$	1,457,371

     During 2007, the Company recorded additional LIFO reserves of $22.7 million. The increase primarily relates to the revaluation of on-hand inventories to current unit cost standards, reflecting modest cost inflation experienced in the Oilfield manufacturing operations.

14

6. Property, Plant and Equipment

     Property, plant and equipment consist of the following at December 31:

	2007			2006
Land and improvements	$	62,546		$	55,138
Buildings		235,545			181,419
Machinery and equipment		880,562			717,761
Rental tools		726,333			597,468
		1,904,986			1,551,786
Less — Accumulated depreciation		(799,106	)		(664,742	)
	$	1,105,880		$	887,044

7. Goodwill and Other Intangible Assets

Goodwill

     The following table presents goodwill on a segment basis as of the dates indicated, as well as changes in the account during the period shown. Beginning and ending goodwill balances are presented net of accumulated amortization of $53.6 million:

			Smith
			Drilling and
	M-I SWACO		Evaluation			Distribution		Total
Balance as of December 31, 2005	$	557,021	$	142,121		$	37,906	$	737,048
Goodwill acquired		126,879		85			2,314		129,278
Purchase price and other adjustments		—		890			431		1,321
Balance as of December 31, 2006		683,900		143,096			40,651		867,647
Goodwill acquired		4,422		4,833			10,167		19,422
Goodwill related to disposed operations		—		(10,197	)		—		(10,197	)
Purchase price and other adjustments		18,843		—			727		19,570
Balance as of December 31, 2007	$	707,165	$	137,732		$	51,545	$	896,442

Other Intangible Assets

     The components of other intangible assets at December 31 are as follows:

	2007						2006
													Weighted
													Average
	Gross						Gross						Amortization
	Carrying		Accumulated				Carrying		Accumulated				Period
	Amount		Amortization		Net		Amount		Amortization		Net		(years)
Patents	$	112,485	$	35,190	$	77,295	$	101,269	$	19,547	$	81,722		13.5
License agreements		31,688		14,204		17,484		31,231		10,661		20,570		10.6
Non-compete agreements and trademarks		36,704		21,032		15,672		33,421		15,662		17,759		9.7
Customer lists and contracts		34,603		16,695		17,908		29,403		8,314		21,089		8.9
	$	215,480	$	87,121	$	128,359	$	195,324	$	54,184	$	141,140		12.0

15

     Amortization expense of other intangible assets was $31.3 million, $20.3 million and $10.4 million for the years ended December 31, 2007, 2006 and 2005, respectively. Amortization expense is expected to approximate $23.4 million for fiscal year 2008 and is anticipated to range between $10.4 million and $18.2 million per year for the 2009 – 2012 fiscal years.

8. Debt

     The following summarizes the Company’s outstanding debt at December 31:

	2007			2006
Current:
Short-term borrowings	$	111,609		$	89,307
Current portion of long-term debt		27,872			198,397
Short-term borrowings and current portion of long-term debt	$	139,481		$	287,704
Long-Term:
Notes:
6.0% Senior Notes maturing June 2016 with an effective interest rate of 6.11%. Interest payable semi-annually (presented net of unamortized discount of $262 and $293 in 2007 and 2006, respectively)	$	274,738		$	274,707
6.75% Senior Notes maturing February 2011 with an effective interest rate of 6.83%. Interest payable semi-annually (presented net of unamortized discount of $249 and $368 in 2007 and 2006, respectively)		219,751			219,632
7.0% Senior Notes repaid in September 2007		—			149,931
7.7% Senior Notes repaid in July 2007		—			7,143
Bank revolvers payable:
$275 million revolving note expiring May 2010. Interest payable quarterly at base rate (7.25% at December 31, 2007) or Eurodollar rate, as defined (5.57% at December 31, 2007) and described below		245,000			119,000
M-I SWACO $125 million revolving note expiring May 2010. Interest payable quarterly at base rate or Eurodollar rate, as defined and described below		—			41,500
Term Loans:
M-I SWACO £80 million term loan payable to a financial institution. Principal due in semi-annual installments of £6.7 million through December 2012. Interest payable at Eurocurrency rate of LIBOR plus 35 basis points (6.32% at December 31, 2007)		133,235			157,686
M-I SWACO €27.5 million term loan repaid in June 2007		—			28,868
Other		772			858
		873,496			999,325
Less-Current portion of long-term debt		(27,872	)		(198,397	)
Long-term debt	$	845,624		$	800,928
Principal payments of long-term debt for years subsequent to 2008 are as follows:
2009	$	26,523
2010		271,536
2011		246,274
2012		26,524
Thereafter		274,767
	$	845,624

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     Short-term borrowings consist of amounts outstanding under lines of credit and short-term notes. Certain subsidiaries of the Company have unsecured credit facilities with non-U.S. banks aggregating $275.7 million with $164.1 million of additional borrowing capacity available under these facilities at December 31, 2007. These borrowings had a weighted average interest rate of 6.6 percent and 7.6 percent at December 31, 2007 and 2006, respectively.

     In addition to the credit facilities discussed above, the Company has a $400 million unsecured revolving credit facility provided by a syndicate of nine financial institutions. The revolving credit agreement (the “Agreement”) allows for the election of interest at a base rate, or a Eurodollar rate ranging from LIBOR plus 40 to 50 basis points depending on the borrowing levels drawn under the facility. The Agreement also requires the payment of a quarterly commitment fee of 10 basis points on the unutilized portion of the facility and compliance with certain customary covenants, including a 40 percent debt-to-total capitalization limitation.

     The 6.0 percent and 6.75 percent Senior Notes (the “Public Notes”) are unsecured obligations of the Company issued under an Indenture dated September 8, 1997. The Indenture contains no financial covenants, nor any restrictions related to the payment of cash dividends to common stockholders. The Company’s Public Notes are redeemable by the Company, in whole or in part, at any time prior to maturity at a redemption price equal to accrued interest plus the greater of the principal amount or the present value of the remaining principal and interest payments.

     Borrowings under the M-I SWACO £80 million term loan are unsecured and require compliance with certain customary covenants, including debt-to-total capitalization and debt-to-EBITDA limitations. The term loan can be prepaid, in whole or in part, without penalty subject to required notice periods and compliance with minimum prepayment amounts.

     The Company was in compliance with its loan covenants under the various loan indentures, as amended, at December 31, 2007.

9. Financial Instruments

Foreign Currency Contracts

     The Company enters into spot and forward contracts as a hedge against foreign currency denominated assets and liabilities and foreign currency commitments. The term of these contracts generally do not exceed two years. For fair value hedges, realized and unrealized gains and losses are recognized currently through earnings, and the resulting amounts generally offset foreign exchange gains or losses on the related accounts. The Company recognized expense of approximately $5.8 million, $5.9 million and $4.4 million in 2007, 2006 and 2005, respectively, related to net realized and unrealized losses on fair value hedge contracts. Gains or losses on designated cash flow hedge contracts are deferred to accumulated other comprehensive income and recognized in the consolidated statement of operations when the hedged item affects earnings. The Company recognized income of $1.7 million in 2007, and expense of $1.6 million and $0.9 million in 2006 and 2005, respectively, related to cash flow hedge contracts. As of December 31, 2007, the notional amounts of fair value hedge contracts and cash flow hedge contracts outstanding were $110.3 million and $12.7 million, respectively, and the fair value was greater than the notional amount of these contracts by $0.8 million. As of December 31, 2006, the notional amount of fair value hedge contracts and cash flow hedge contracts outstanding were $126.9 million and $20.8 million, respectively, and the fair value was less than the notional amount of these contracts by $0.2 million.

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Fair Value of Other Financial Instruments

     The recorded and fair values of long-term debt at December 31 are as follows:

	2007				2006
	Recorded		Fair		Recorded		Fair
	Value		Value		Value		Value
Long-term Debt	$	873,496	$	889,104	$	999,325	$	1,015,062

     The fair value of publicly-traded long-term debt was primarily determined using quoted market prices. The fair value of the remaining financial instruments, including cash and cash equivalents, receivables, payables and short-term and bank borrowings, approximates the carrying value due to the nature of these instruments.

Concentration of Credit Risk

     We sell our products and services to numerous companies in the oil and natural gas industry. The significant energy 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. Although this concentration could affect our overall exposure to credit risk, we believe that we are exposed to minimal risk since the majority of our business is conducted with major companies within the industry. We perform periodic credit evaluations of our customers’ financial condition and generally do not require collateral for our accounts receivable. In some cases, we will require payment in advance or security in the form of a letter of credit or bank guarantee.

10. Income Taxes

     The geographical sources of income before income taxes and minority interests for the three years ended December 31, 2007 were as follows:

	2007		2006		2005
Income before income taxes and minority interests:
United States	$	644,283	$	443,453	$	225,207
Non-United States		659,592		576,643		402,600
Total	$	1,303,875	$	1,020,096	$	627,807

     The income tax provision is summarized as follows:

	2007		2006		2005
Current:
United States	$	172,948	$	127,964	$	62,243
Non-United States		208,352		183,695		124,881
State		4,906		11,278		4,983
		386,206		322,937		192,107
Deferred:
United States		21,849		2,308		8,073
Non-United States		381		1,289		2,349
State		35		140		214
		22,265		3,737		10,636
Income tax provision	$	408,471	$	326,674	$	202,743

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     The Company’s income tax provision includes amounts related to the anticipated repatriation of certain earnings of its non-U.S. subsidiaries. Undistributed earnings above the amounts upon which taxes have been provided, which approximated $329.2 million at December 31, 2007, are intended to be permanently invested by the Company. It is not practicable to determine the amount of applicable taxes that would be incurred if any of such earnings were repatriated.

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

	2007			2006			2005
U.S. federal statutory tax rate		35.0	%		35.0	%		35.0	%
Minority partners’ share of U.S. partnership earnings		(3.0	)		(2.6	)		(2.5	)
Non-deductible expenses		1.1			0.9			1.1
Benefit of extraterritorial income exclusion, manufacturer’s production exclusion and research credits		(0.9	)		(0.5	)		(0.8	)
State taxes, net		0.3			1.1			0.8
Non-U.S. tax provisions which vary from the U.S. rate/non-U.S. losses with no tax benefit realized		(1.2	)		(1.3	)		(0.9	)
Change in valuation allowance		(0.1	)		—			(0.1	)
Other items, net		0.1			(0.6	)		(0.3	)
Effective tax rate		31.3	%		32.0	%		32.3	%

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

	2007			2006
Deferred tax liabilities attributed to the excess of net book basis over remaining tax basis (principally depreciation and amortization):
United States	$	(116,886	)	$	(99,443	)
Non-United States		(87,766	)		(84,244	)
Total deferred tax liabilities		(204,652	)		(183,687	)
Deferred tax assets attributed to net operating loss and tax credit carryforwards:
United States		—			—
Non-United States		14,672			18,395
Other deferred tax assets (principally accrued liabilities not deductible until paid and inventory reserves):
United States		71,453			76,298
Non-United States		17,981			15,160
Subtotal		104,106			109,853
Valuation allowance		(14,662	)		(16,232	)
Total deferred tax assets		89,444			93,621
Net deferred tax liabilities	$	(115,208	)	$	(90,066	)
Balance sheet presentation:
Deferred tax assets, net	$	46,220		$	51,070
Other assets		8,206			8,822
Income taxes payable		(9,390	)		(6,834	)
Deferred tax liabilities		(160,244	)		(143,124	)
Net deferred tax liabilities	$	(115,208	)	$	(90,066	)

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     At December 31, 2007, the accompanying consolidated financial statements include $14.7 million of deferred tax assets associated with operating loss carryforwards in tax jurisdictions outside the United States. Although a significant portion of these losses will carryforward indefinitely and are available to reduce future tax liabilities of the respective foreign entity, management currently believes that the majority of these assets will not be realized and has, accordingly, established a $14.7 million valuation reserve. The $1.6 million decrease from the prior year-end valuation reserve reflects the impact of changes in currency exchange rates, the expiration of operating loss carryforwards and changes in the anticipated realizability of certain foreign deferred tax assets.

Liability for Uncertain Tax Positions

     In addition to the tax liabilities discussed above, the Company establishes reserves for positions taken on tax matters which, although considered appropriate under the regulations, could potentially be successfully challenged by authorities during a tax audit or review. The accompanying consolidated balance sheet includes liabilities of $45.9 million and $29.6 million to provide for uncertain tax positions taken as of December 31, 2007 and 2006, respectively.

     The uncertain tax liability as of December 31, 2007, which is primarily reflected in Other long-term liabilities, consists of $34.5 million of unrecognized tax benefits, $7.6 million of interest and $3.8 million of penalties. Although the Company does not expect to report a significant change in the amount of liabilities recorded for uncertain tax positions during the next twelve-month period, changes in the recorded reserves could impact future reported results. Accordingly, if the Company’s uncertain tax positions were allowed by the relevant taxing authorities during a review or expired unchallenged, approximately $27.1 million of the uncertain tax liability would be recorded as a reduction in tax expense with the remaining $18.8 million recorded as a decrease to goodwill or other balance sheet accounts.

     A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

Balance as of January 1, 2007	$	22,629
Additions for tax positions of prior years		7,271
Reductions for tax positions of prior years		(2,758	)
Additions for tax positions in the current year		8,324
Settlements with tax authorities		(200	)
Reductions due to the lapse of applicable statute of limitations		(728	)
Balance as of December 31, 2007	$	34,538

     The Company operates in more than 70 countries and is subject to income taxes in most of those jurisdictions. The following table summarizes the earliest tax years that remain subject to examination by taxing authorities in the major jurisdictions in which the Company operates:

Jurisdiction	Earliest Open Tax Period
Canada		2000
Italy		2002
Norway		1997
Russia		2004
United Kingdom		2001
United States		2001

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11. Stockholders’ Equity

Dividend Program

     In February 2005, the Company’s Board of Directors approved a regular quarterly cash dividend program. The Board of Directors declared dividends of $80.1 million, or $0.40 per share; $64.0 million, or $0.32 per share; and $48.4 million, or $0.24 per share, for the years ended December 31, 2007, 2006 and 2005, respectively.

     The level of future dividend payments will be at the discretion of the Board of Directors and will depend upon the Company’s financial condition, earnings and cash flow from operations, the level of its capital expenditures, compliance with certain debt covenants, its future business prospects and other factors that the Board of Directors deem relevant.

Stock Split

     On July 21, 2005, the Company’s Board of Directors approved a two-for-one stock split, which was effected in the form of a stock dividend. Stockholders of record as of August 5, 2005 were entitled to the dividend, which was distributed on August 24, 2005.

Common Stock Repurchases

     In October 2005, the Company’s Board of Directors approved a share repurchase program that allows for the purchase of up to 20 million shares of the Company’s common stock, subject to regulatory issues, market considerations and other relevant factors. The Company has purchased $83.5 million, $102.9 million and $117.8 million of common stock during 2007, 2006, and 2005, respectively, under the existing and a previously authorized repurchase program (collectively the “Repurchase Programs”). As of December 31, 2007, approximately 15.7 million shares remained available for purchase under the current program which may be executed from time to time in the open market. Common stock obtained by the Company through the Repurchase Programs has been added to the Company’s treasury stock holdings.

     In addition, certain participants in the long-term incentive plans surrender shares of common stock in order to satisfy tax withholding obligations. The Company acquired an immaterial number of shares in the prior three year period which have been added to the Company’s treasury stock holdings and may be used in the future for acquisitions or other corporate purposes. These shares are not considered acquisitions under the Company’s Repurchase Programs.

Stockholder Rights Plan

     On June 8, 2000, the Company adopted a Stockholder Rights Plan (the “Rights Plan”). As part of the Rights Plan, the Company’s Board of Directors declared a dividend of one junior participating preferred stock purchase right (“Right”) for each share of the Company’s common stock outstanding on June 20, 2000. The Board also authorized the issuance of one such Right for each share of the Company’s common stock issued after June 20, 2000 until the occurrence of certain events.

     The Rights are exercisable upon the occurrence of certain events related to a person (an “Acquiring Person’) acquiring or announcing the intention to acquire beneficial ownership of 20 percent or more of the Company’s common stock. In the event any person becomes an Acquiring Person, each holder (except an Acquiring Person) will be entitled to purchase, at an effective exercise price of $87.50, subject to adjustment, shares of common stock having a market value of twice the Right’s exercise price. The Acquiring Person will not be entitled to exercise these Rights. In addition, if at any time after a person has become an Acquiring Person, the Company is involved in a merger or other business combination transaction, or sells 50 percent or more of its assets or earning power to another entity, each Right will entitle its holder to purchase, at an effective exercise

21

price of $87.50, subject to adjustment, shares of common stock of such other entity having a value of twice the Right’s exercise price. After a person or group becomes an Acquiring Person, but before an Acquiring Person owns 50% or more of the Company’s common stock, the Board may extinguish the Rights by exchanging one share of common stock, or an equivalent security, for each Right, other than Rights held by the Acquiring Person.

     In the event the Rights become exercisable and sufficient shares of the Company’s common stock are not authorized to permit the exercise of all outstanding Rights, the Company is required under the Rights Plan to take all necessary action including, if necessary, seeking stockholder approval to obtain additional authorized shares.

     The Rights are subject to redemption at the option of the Board of Directors at a price of one-quarter of a cent per Right until the occurrence of certain events. The Rights currently trade with Smith common stock, have no voting or dividend rights and expire on June 8, 2010.

Accumulated Other Comprehensive Income

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

	2007			2006
Currency translation adjustments	$	72,298		$	25,555
Unrealized fair value of derivatives		755			249
Pension and other postretirement benefits		(5,213	)		(2,577	)
Accumulated other comprehensive income	$	67,840		$	23,227

     Approximately $0.9 million of the unrealized fair value of derivatives is expected to be recognized as after-tax expense during the fiscal year ending December 31, 2008.

12. Retirement Plans

Defined Contribution Plans

     The Company established the Smith International, Inc. 401(k) Retirement Plan (the “Smith Plan”) for the benefit of all eligible employees. Employees may voluntarily contribute a percentage of their compensation, as defined, to the Smith Plan. The Company makes basic, retirement and, in certain cases, discretionary matching contributions to each participant’s account under the Smith Plan. Participants receive a basic match on contributions to the Smith Plan of up to 1¹/2 percent of qualified compensation and a retirement contribution ranging from two percent to six percent of qualified compensation. In addition, the Board of Directors may provide discretionary profit-sharing contributions based upon financial performance to participants who are employed by the Company on December 31.

     In 2004, the Company established the Wilson 401(k) Retirement Plan (the “Wilson Plan”) under which participating employees may voluntarily contribute a percentage of their compensation, as defined, to the Wilson Plan. Wilson makes matching contributions to each participant’s account ranging from ¹/4 percent to six percent of qualified compensation. In addition, the Board of Directors may provide discretionary profit-sharing contributions based upon financial performance to participants who are employed by Wilson on December 31.

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     M-I SWACO has a company Profit-Sharing and Savings Plan (the “M-I Retirement Plan”) under which participating employees may voluntarily contribute a percentage of their compensation, as defined. At its discretion, M-I SWACO may make basic, matching and in certain cases, discretionary matching contributions to each participant’s account under the M-I Retirement Plan. Participants are eligible to receive a basic contribution equal to three percent of qualified compensation, and a full match on employee contributions of up to 1¹/2 percent of qualified compensation. In addition, the Board of Directors may provide discretionary profit-sharing contributions based upon financial performance to participants who are employed by M-I SWACO on December 31.

     The Company recognized expense totaling $43.8 million, $50.5 million, and $37.8 million in 2007, 2006 and 2005, respectively, related to Company contributions to the plans.

     Certain of the Company’s subsidiaries sponsor various defined contribution plans. The Company’s contributions under these plans for each of the three years in the period ended December 31, 2007 were immaterial.

Deferred Compensation Plans

     The Company maintains Supplemental Executive Retirement Plans (“SERP”), non-qualified, deferred compensation programs, for the benefit of officers and certain other eligible employees of the Company. Participants may contribute up to 100 percent of cash compensation, on a pre-tax basis, as defined. Plan provisions allow for retirement and matching contributions, similar to those provided under the Company’s defined contribution programs, and, in certain cases, an interest contribution in order to provide a yield on short-term investments equal to 120 percent of the long-term applicable federal rate, as defined.

     In the event of insolvency or bankruptcy, plan assets are available to satisfy the claims of all general creditors of the Company. Accordingly, the accompanying consolidated balance sheets reflect the aggregate participant balances as both an asset and a liability of the Company. As of December 31, 2007 and 2006, $66.7 million and $59.3 million, respectively, are included in other assets with a corresponding amount recorded in other long-term liabilities.

     During the years ended December 31, 2007, 2006 and 2005, Company contributions to the plans totaled $1.3 million, $1.9 million and $2.5 million, respectively.

13. Employee Benefit Plans

     Effective December 31, 2006, the Company adopted the recognition provisions of SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires recognition of the funded status of an entity’s defined benefit pension and other postretirement benefit plans as an asset or liability in the Company’s consolidated balance sheet. Subsequent changes to the funded status are to be recognized through stockholders’ equity as a component of comprehensive income.

     The Company currently maintains various defined benefit pension plans covering certain U.S. and non-U.S. employees. Future benefit accruals and the addition of new participants under the U.S. plans were frozen prior to 1998.

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     The Company and certain subsidiaries have postretirement benefit plans which provide health care benefits to a limited number of current, and in certain cases, future retirees. Individuals who elect to contribute premiums are eligible to participate in the Company’s medical and prescription drug programs, with certain limitations. In addition to premiums, the retiree is responsible for deductibles and any required co-payments and is subject to annual and lifetime dollar spending caps.

     The following tables disclose the changes in benefit obligations and plan assets during the periods presented and reconcile the funded status of the plans to the amounts included in the accompanying consolidated balance sheets:

	Pension Plans						Postretirement Benefit Plans
	2007			2006			2007			2006
Changes in benefit obligations:
Benefit obligations at beginning of year	$	49,988		$	46,631		$	10,059		$	10,070
Service cost		4,461			3,111			381			267
Interest cost		3,104			2,456			563			538
Plan participants’ contributions		—			—			587			624
Actuarial loss (gain)		6,229			(1,349	)		(1,466	)		(565	)
Other		4,210			—			—			—
Benefits paid		(1,066	)		(861	)		(738	)		(875	)
Benefit obligations at end of year	$	66,926		$	49,988		$	9,386		$	10,059
Changes in plan assets:
Fair value of plan assets at beginning of year	$	44,616		$	38,993		$	—		$	—
Actual return on plan assets		2,182			3,797			—			—
Employer contributions		3,840			4,464			151			251
Plan participants’ contributions		—			—			587			624
Other		—			(1,777	)		—			—
Benefits paid		(1,066	)		(861	)		(738	)		(875	)
Fair value of plan assets at end of year	$	49,572		$	44,616		$	—		$	—
Funded status	$	(17,354	)	$	(5,372	)	$	(9,386	)	$	(10,059	)
Amounts recognized in the consolidated balance sheet:
Non-current assets	$	584		$	34		$	—		$	—
Other long-term liabilities		(17,938	)		(5,406	)		(9,386	)		(10,059	)
Net amount recognized	$	(17,354	)	$	(5,372	)	$	(9,386	)	$	(10,059	)
Amounts in accumulated other comprehensive income:
Net actuarial loss(gain)	$	7,907		$	4,396		$	(2,738	)	$	(1,906	)
Prior service costs		44			88			—			—
Net amount recognized	$	7,951		$	4,484		$	(2,738	)	$	(1,906	)

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Net Periodic Benefit Expense

     Net periodic benefit expense and the weighted average assumptions used to determine the net benefit expense for the fiscal years ended December 31, and the projected benefit obligation at December 31 are as follows:

	Pension Plans									Postretirement Benefit Plans
	2007			2006			2005			2007			2006			2005
Components of net periodic benefit expense:
Service cost	$	4,461		$	3,111		$	2,787		$	381		$	267		$	242
Interest cost		3,104			2,456			2,142			563			538			548
Return on plan assets		(3,478	)		(2,365	)		(2,292	)		—			—			—
Amortization of prior service cost		8			11			11			—			—			(91	)
Amortization of loss (gain)		286			818			706			(157	)		(87	)		(130	)
Plan termination		—			—			—			—			—			(4,467	)
Net periodic benefit expense (income)	$	4,381		$	4,031		$	3,354		$	787		$	718		$	(3,898	)
Other changes in plan assets and benefit obligations recognized in other comprehensive income (“OCI”):
Net (gain)/loss arising during the year	$	3,762			*			*		$	(989	)		*			*
Amortization of prior service (cost)/credit		(8	)		*			*			—			*			*
Amortization of net gain/(loss)		(286	)		*			*			157			*			*
Other comprehensive income	$	3,468			*			*		$	(832	)		*			*
Total net periodic benefit expense and OCI:	$	7,849			*			*		$	(45	)		*			*

*   Due to the adoption of SFAS 158, the pension and postretirement benefit plan disclosures are not comparable on a year-to-year basis.

Net periodic benefit expense:
Discount rate	5.75	%	5.50	%	5.75	%	5.75	%	5.50	%	5.75	%
Expected return on plan assets	8.50	%	8.50	%	8.50	%	N/A		N/A		N/A
Projected benefit obligation:
Discount rate	6.30	%	5.75	%	5.50	%	6.30	%	5.75	%	5.50	%
Expected return on plan assets	8.50	%	8.50	%	8.50	%	N/A		N/A		N/A

Additional Pension Plan Information

     In determining the expected return on plan assets, the Company considers the investment mix, the historical market performance and economic and other indicators of future performance. The Company primarily utilizes a mix of common stock and fixed income index funds to generate asset returns comparable with the general market. The investment mix of pension assets at December 31 is summarized in the following table:

	2007			2006
Common stock and related index funds		44	%		47	%
Fixed income securities and related index funds		44			40
Real estate		7			6
Money market funds		5			7
Total		100	%		100	%

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     For pension plans with accumulated benefit obligations in excess of plan assets, the following table sets forth the projected and accumulated benefit obligations and the fair value of plan assets at December 31:

	2007		2006
Projected benefit obligation	$	66,926	$	49,988
Accumulated benefit obligation		51,712		49,988
Plan assets at fair value		49,572		44,616

     Estimated future benefit payments based on projected future service are expected to range between $1.2 million and $1.9 million a year for the next five years and approximate $11.6 million for the five-year period ending December 31, 2017. Company contributions to the pension plans during 2008 are expected to be comparable with 2007 contribution levels.

Additional Postretirement Benefit Plan Information

     The assumed health care cost trend rates used to determine the projected postretirement benefit obligation at            December 31 are as follows:

	2007			2006
Health care cost trend rate for current year		10.9	%		12.0	%
Rate that the cost trend rate gradually declines (ultimate trend rate)		5.0	%		5.0	%
Year that the rate reaches the ultimate trend rate		2016			2016

     A one-percentage point change in assumed health care cost trend rates would have the following effects on the benefit obligations and the aggregate of the service and interest cost components of the postretirement benefits expense:

	One-		One-
	Percentage-		Percentage-
	Point Increase		Point Decrease
Effect on total service and interest cost	$	5	$	(80	)
Effect on accumulated postretirement benefit obligation		118		(867	)

     Estimated future benefit payments based on projected future service are expected to approximate $0.5 million a year for the next five years and $3.2 million for the five-year period ending December 31, 2017. Company contributions to the postretirement benefit plans during 2008 are expected to be comparable to the 2007 levels.

14. Long-Term Incentive Compensation

     As of December 31, 2007, the Company had outstanding restricted stock and stock option awards granted under the 1989 Long-Term Incentive Compensation Plan (the “Plan”). As of December 31, 2007, 1,074,185 shares were authorized for future issuance pursuant to the Plan.

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     Restricted Stock Units

     The restricted stock program consists of a combination of performance-based restricted stock units (“performance-based units”) and time-based restricted stock units (“time-based units”). The number of performance-based units issued under the program, which can range from zero to 130 percent of the target units granted, is solely dependent upon the return on equity achieved by the Company in the fiscal year subsequent to the award. A summary of the Company’s restricted stock program is presented below:

											Total
	Time-based Awards					Performance-based Awards					Restricted
	No. of Units			Fair Value(a)		No. of Units			Fair Value(a)		Stock Units
Outstanding at December 31, 2006		524,552		$	40.84		1,601,616	(b)	$	39.71		2,126,168
Granted		444,428			62.53		400,665			63.76		845,093
Forfeited		(19,913	)		40.51		(25,050	)		37.05		(44,963	)
Vested		(152,380	)		40.26		(696,380	)		37.39		(848,760	)
Outstanding at December 31, 2007		796,687		$	53.06		1,280,851		$	48.55		2,077,538

(a)	Reflects the weighted average grant-date fair value.
(b)	Reflects achievement of performance criteria for awards granted prior to December 2007.

     The total intrinsic value of restricted stock units vested during the years ended December 31, 2007, 2006, and 2005 was $48.7 million, $12.5 million, and $1.2 million, respectively. In addition, restrictions on approximately 684,000 performance-based units and 255,500 time-based units outstanding at December 31, 2007 are expected to lapse during the 2008 fiscal year.

     Stock Options

     Stock options are generally granted at the fair market value on the date of grant, vest over a four-year period and expire ten years after the date of grant. A summary of the Company’s stock option program is presented below:

				Weighted		Weighted
	Shares			Average		Average		Aggregate
	Under			Exercise		Remaining		Intrinsic Value
	Option			Price		Contractual Life		(in thousands)
Outstanding at December 31, 2006		3,351,381		$	18.78
Granted		—			—
Forfeited		(55,004	)		21.33
Exercised		(1,748,706	)		17.58
Outstanding at December 31, 2007		1,547,671		$	20.04		5.5	$	83,277
Exercisable at December 31, 2007		1,411,143		$	19.19		5.4	$	77,135

     The total intrinsic value of options exercised during the years ended December 31, 2007, 2006, and 2005 was $69.0 million, $34.3 million, and $48.7 million, respectively.

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     The Company used an open-form (lattice) model to determine the fair value of options granted, and accordingly, calculate the share-based compensation expense. The fair value and assumptions used are as follows:

	2006			2005
Fair value of stock options granted	$	11.92		$	8.53
Expected life of option (years)		5.0			5.0
Expected stock volatility		31.0	%		31.0	%
Expected dividend yield		0.8	%		0.8	%
Risk-free interest rate		4.3	%		3.9	%

     Expected volatilities are based on both historical volatility of the company’s stock price and implied volatility of exchange-traded options on the company’s stock. The expected life of options is based on historical data for options granted by the company after 1994. The risk-free rates are based on yields available at the time of grant on U.S. Treasury bonds for maturities consistent with the expected life assumption.

     Share-based Compensation Expense

     Compensation expense for stock options and time-based units is recognized over the four-year vesting period. For performance-based units, compensation expense is recognized over the three-year vesting period.

     Prior to the adoption of SFAS No. 123r, compensation expense for the performance-based units was calculated as the difference between the market value and the exercise price. After adoption of SFAS No. 123r, compensation expense for the performance-based units and time-based units is based on the grant-date fair value. Share-based compensation expense, consisting of restricted stock unit and stock option awards, for the year ended December 31, 2007 and 2006 was $34.2 million and $27.3 million, respectively, and net of taxes and minority interests, was $20.6 million and $17.5 million, respectively. For the year ended December 31, 2005, compensation expense related to restricted stock unit awards totaled $5.7 million.

     The total unrecognized share-based compensation expense, consisting of restricted stock and stock options, for awards outstanding as of December 31, 2007 was $92.7 million or approximately $55.5 million, net of taxes and minority interests, which will be recognized over a weighted-average period of 2.7 years.

15. Industry Segments and International Operations

     The Company provides premium products and services to the oil and gas exploration and production industry, aggregating its business operations into three reportable segments: M-I SWACO, Smith Drilling and Evaluation and Distribution. This segment reporting structure has been modified from our historical presentation in order to provide investors with increased visibility into the oilfield business operations. More specifically, the M-I SWACO unit has been separated from our other oilfield business operations and is being reported as a separate segment. Additionally, the Company no longer allocates corporate expenses to the various reporting segments.

     The M-I SWACO segment consists of a majority-owned joint venture operation which provides drilling and completion fluid systems, solids-control and separation equipment, waste-management services and oilfield production chemicals used in exploration and production activities. The Smith Drilling and Evaluation segment consists of Smith Technologies, a major drill bit industry participant,

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and Smith Services, a global provider of downhole tools, equipment and related services. Smith Technologies designs and manufactures three-cone and diamond drill bits, turbines and borehole enlargement tools for use in the oil and gas industry. Smith Services manufactures and markets products and services used in the oil and gas industry for drilling, workover, well completion and well re-entry operations. The Company’s oilfield operations provide products and services in all major oil and gas-producing regions of the world, with approximately 60 percent of these two segment’s revenues generated in markets outside of North America. Customers primarily include major multi-national, independent and national, or state-owned, oil companies.

     The Distribution segment consists of the Wilson distribution operations and a majority-owned interest in CE Franklin, Ltd., a publicly-traded Canadian distribution company. The Distribution segment has the most significant North American exposure of any of the Company’s operations with approximately 95 percent of revenues derived in the United States and Canada. Approximately three-fourths of Wilson’s revenues are generated from customers in the energy sector, which includes major multi-national and independent oil companies, pipeline companies and contract drilling companies. The remainder relates to sales in the downstream and industrial markets, which primarily includes refineries, petrochemical and power generation plants.

     The following table presents financial information for each reportable segment:

	2007			2006			2005
Revenues:
M-I SWACO	$	4,422,408		$	3,573,395		$	2,682,511
Smith Drilling and Evaluation		2,210,161			1,814,343			1,296,488
Distribution		2,131,761			1,945,821			1,600,004
	$	8,764,330		$	7,333,559		$	5,579,003
Operating Income (Loss):
M-I SWACO	$	729,412		$	553,304		$	347,008
Smith Drilling and Evaluation		619,038			495,301			309,303
Distribution		97,154			104,730			66,634
Corporate and other		(75,807	)		(73,254	)		(52,384	)
	$	1,369,797		$	1,080,081		$	670,561
Capital Expenditures:
M-I SWACO	$	184,027		$	203,454		$	117,383
Smith Drilling and Evaluation		149,829			88,619			56,127
Distribution		6,929			5,153			2,354
Corporate and other		15,036			11,244			1,981
	$	355,821		$	308,470		$	177,845
Depreciation and Amortization:
M-I SWACO	$	111,618		$	84,868		$	62,969
Smith Drilling and Evaluation		75,494			59,286			47,011
Distribution		4,763			4,840			6,435
Corporate and other		1,421			1,390			1,307
	$	193,296		$	150,384		$	117,722
Total Assets:
M-I SWACO	$	3,589,790		$	3,195,372		$	2,345,438
Smith Drilling and Evaluation		1,579,541			1,279,029			1,010,674
Distribution		752,221			737,445			596,867
Corporate and other		140,328			123,629			106,935
	$	6,061,880		$	5,335,475		$	4,059,914

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     The following table presents consolidated revenues by region, which is determined based on the location of the services provided and products sold:

	2007		2006		2005
United States	$	3,967,806	$	3,384,729	$	2,520,706
Canada		771,430		891,288		713,565
North America		4,739,236		4,276,017		3,234,271
Latin America		738,026		543,844		452,349
Europe/Africa		2,105,745		1,605,559		1,188,038
Middle East/Asia		1,181,323		908,139		704,345
Non-North America		4,025,094		3,057,542		2,344,732
	$	8,764,330	$	7,333,559	$	5,579,003

     The following table presents net property, plant and equipment by region:

	2007		2006		2005
United States	$	588,345	$	458,273	$	353,370
Canada		52,596		48,510		43,908
North America		640,941		506,783		397,278
Latin America		95,834		67,377		53,911
Europe/Africa		266,437		230,607		156,632
Middle East/Asia		102,668		82,277		57,568
Non-North America		464,939		380,261		268,111
	$	1,105,880	$	887,044	$	665,389

     The Company’s expenditures for research and engineering activities are attributable to the Company’s oilfield business operations and totaled $110.7 million in 2007, $88.3 million in 2006 and $73.6 million in 2005.

16. Commitments and Contingencies

Leases

     The Company routinely enters into operating and capital leases for certain of its facilities and equipment. Amounts related to assets under capital lease were immaterial for the periods presented. Rent expense totaled $166.5 million, $127.1 million, and $102.1 million in 2007, 2006, and 2005, respectively.

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

	Amount
2008	$	72,775
2009		54,589
2010		36,860
2011		25,832
2012		19,691
2013-2017		63,437
Thereafter		43,869
	$	317,053

     In the normal course of business, the Company enters into lease agreements with cancellation provisions as well as agreements with initial terms of less than one year. The costs related to these leases have been reflected in rent expense but have been appropriately excluded from the future minimum payments presented above.

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Standby Letters of Credit

     In the normal course of business with customers, vendors and others, the Company is contingently liable for performance under standby letters of credit and bid, performance and surety bonds. Certain of these outstanding instruments guarantee payment to insurance companies which reinsure certain liability coverages of the Company’s insurance captive. Excluding the impact of these instruments, for which $17.8 million of related liabilities are reflected in the accompanying consolidated balance sheet, the Company was contingently liable for approximately $136.2 million of standby letters of credit and bid, performance and surety bonds at December 31, 2007. Management does not expect any material amounts to be drawn on these instruments.

Insurance

     The Company maintains insurance coverage for various aspects of its business and operations. The Company has elected to retain a portion of losses that occur through the use of deductibles and retentions under its insurance programs. Amounts in excess of the self-insured retention levels are fully insured to limits believed appropriate for the Company’s operations. Self-insurance accruals are based on claims filed and an estimate for claims incurred but not reported. While management believes that amounts accrued in the accompanying consolidated financial statements are adequate for expected liabilities arising from the Company’s portion of losses, estimates of these liabilities may change as circumstances develop.

Litigation

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

Environmental

     The Company routinely establishes and reviews the adequacy of reserves for estimated future environmental clean-up costs for properties currently or previously operated by the Company.

     As of December 31, 2007, the Company’s environmental reserve totaled $7.6 million. This amount reflects the future undiscounted estimated exposure related to identified properties, without regard to indemnifications from former owners. While actual future environmental costs may differ from estimated liabilities recorded at December 31, 2007, the Company does not believe that these differences will have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

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17. Quarterly Information (Unaudited)

	First		Second		Third		Fourth		Year
	(In thousands, except per share data)
2007
Revenues	$	2,107,724	$	2,114,373	$	2,245,059	$	2,297,174	$	8,764,330
Gross profit		675,965		696,546		728,906		754,240		2,855,657
Net income		160,158		153,053		166,833		167,007		647,051
EPS:
Basic		0.80		0.76		0.83		0.83		3.23
Diluted		0.80		0.76		0.83		0.83		3.20
2006
Revenues	$	1,682,121	$	1,738,263	$	1,914,184	$	1,998,991	$	7,333,559
Gross profit		526,603		545,013		618,213		654,442		2,344,271
Net income		107,216		118,833		132,925		143,032		502,006
EPS:
Basic		0.53		0.59		0.66		0.72		2.51
Diluted		0.53		0.59		0.66		0.71		2.49

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SCHEDULE II

SMITH INTERNATIONAL, INC.

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(In thousands)

	Balance
	at		Charged					Balance
	Beginning		to					at End
	of Year		Expense		Write-offs			of Year
Allowance for doubtful accounts:
Year ended December 31, 2007	$	16,709	$	5,082	$	(4,513	)	$	17,278
Year ended December 31, 2006		13,884		7,578		(4,753	)		16,709
Year ended December 31, 2005		12,558		4,216		(2,890	)		13,884

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