ITEM 1. BUSINESS
GENERAL
Smith International, Inc. ("Smith" or the "Company") is a leading worldwide supplier of premium products and services to the oil and gas exploration and production industry, the petrochemical industry and other industrial markets. The Company provides a comprehensive line of technologically-advanced products and engineering services, including drilling and completion fluid systems, solids control equipment, waste management services, three-cone drill bits, diamond drill bits, fishing services, drilling tools, underreamers, sidetracking systems, packers and liner hangers. The Company also operates an extensive network of supply branches through which it markets pipe, valves, fittings and other capital and expendable maintenance products. The Company was incorporated in the State of California in January 1937 and reincorporated under Delaware law in May 1983. The Company's executive offices are headquartered at 16740 Hardy Street, Houston, Texas 77032 (telephone number 281/443-3370).
The Company operates through five business units which provide products and services throughout the world. The Company's business units are (i) M-I Fluids, a division of M-I L.L.C. ("M-I"), which provides drilling and completion fluid systems and services; (ii) M-I SWACO, a division of M-I, which provides solids control, pressure control and rig instrumentation equipment and waste management services; (iii) Smith Bits which manufactures and sells three-cone and diamond drill bits for use in the oil and gas industry and in mining operations; (iv) Smith Drilling & Completions which manufactures and markets products and services used for drilling, workover, well completion, fishing and well re-entry operations and (v) Wilson Supply ("Supply") which markets pipe, valves, fittings and other capital and expendable maintenance products to the petroleum and petrochemical industries.
For information regarding revenues of the Company's five business units see Management's Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.
The Company's business units supply products and provide services primarily to the oil and gas exploration and production industry. The information regarding industry segments and international operations appears in Note 14 of the Notes to Consolidated Financial Statements included elsewhere in this Form 10-K.
ACQUISITIONS AND DISPOSITIONS
Subsequent to December 31, 1998, the Company announced the signing of a definitive agreement with Schlumberger Limited related to the combination of the M-I and Schlumberger Dowell Drilling Fluid operations under a joint venture arrangement in which the Company would own 60 percent. The Company is also negotiating a definitive agreement with Conemsco, Inc. related to the combination of certain operations to form an oilfield distribution and supply joint venture in which the Company would own 80 percent. A discussion of these transactions appears in Note 16 of the Notes to the Consolidated Financial Statements included elsewhere in this Form 10-K. In addition to these planned acquisitions, the Company has acquired certain other operations during the prior five year period. A description of the material transactions follows.
Acquisition of M-I L.L.C.
On February 28, 1994, the Company acquired a 64 percent interest in M-I in exchange for cash and a note payable totaling $160.0 million. M-I is a Houston, Texas based provider of drilling and completion fluids and systems, solids-control equipment and waste management services to the oil and gas drilling industry.
Acquisition of Anchor Drilling Fluids, A.S.
On June 11, 1996, M-I acquired the assets of Anchor Drilling Fluids, A.S. ("Anchor") in exchange for cash of approximately $105.3 million. Anchor is a Stavanger, Norway based operation which is principally engaged in providing drilling fluid products and services to the offshore oil and gas industry.
Acquisition of The Red Baron (Oil Tools Rental) Ltd.
On October 9, 1996, the Company acquired all of the outstanding shares of The Red Baron (Oil Tools Rental) Ltd. ("Red Baron") in exchange for cash and notes payable of approximately $40.3 million. Red Baron is an Aberdeen, Scotland based supplier of fishing and other downhole remedial products and services to the oil and gas industry.
Acquisition of Wilson Industries, Inc.
On April 30, 1998, the Company merged with Wilson Industries, Inc. ("Wilson"), a Houston, Texas based provider of products and services to the worldwide petroleum and petrochemical industries. In connection with the merger, the Company issued a total of 7.9 million of its shares in exchange for all of the outstanding shares of common stock of Wilson.
Acquisition of Safeguard Disposal Systems, Inc.
On May 27, 1998, the Company acquired all of the outstanding shares of Safeguard Disposal Systems, Inc. ("Safeguard"), a company engaged in the rental of vacuum and collection systems used in the oil and gas industry. The Company issued stock and cash consideration totaling $42.7 million in exchange for the equity interests of Safeguard and M-I acquired other Safeguard-related assets for $4.8 million. Subsequent to the acquisition date, the Company contributed the Safeguard assets to M-I partly in exchange for a $16.6 million contribution from the former minority interest partner.
Acquisition of Minority Interest in M-I
On August 31, 1998, the Company acquired the remaining 36 percent interest in M-I previously held by Halliburton Company ("Halliburton"). The Company issued a $265.0 million non-interest bearing promissory note to Halliburton in exchange for their minority ownership interest.
INDUSTRY OVERVIEW
The Company's worldwide operations are largely driven by the level of exploration and production activity in major energy producing areas and the depth and drilling conditions of these projects. The level of worldwide drilling activity is influenced by energy prices but may also be affected by expectations related to the worldwide supply for crude oil and natural gas, finding and development costs, decline and depletion rates, political actions and uncertainties, environmental concerns, capital expenditure plans of exploration and production companies and the overall level of global economic growth and activity.
Management anticipates that the 1999 average worldwide rig count will decline from historical activity levels due to the continuing weakness in crude oil prices. The average worldwide rig count decreased over 13 percent from 1997 levels due in part to the decline in U.S. land-based drilling programs, which are generally more sensitive to energy prices. Although the long-term outlook for exploration and production activity is favorable based upon expected growth in worldwide energy consumption, several factors have, and may continue to, impact activity levels on a short-term basis. Continuing weakness in oil prices combined with the impact of a worldwide supply imbalance contributed to the U.S. rig count reaching an all-time record low in the first quarter of 1999. In response to the commodity price weakness major and independent oil companies, on which the Company relies for a large portion of its revenues, have announced 1999 capital expenditure plans which are significantly below 1998 spending levels. If crude oil prices remain at or below current levels for a prolonged period of time, management believes demand for the Company's products and services could continue to be adversely impacted in the U.S. and certain other markets.
BUSINESS OPERATIONS
M-I Fluids
Products and Services. The Company is the leading worldwide provider of drilling fluids systems, products and technical services to end users engaged in drilling oil, natural gas and geothermal wells. Drilling fluid products and systems are used to cool and lubricate the bit during drilling operations, contain formation pressures, suspend and remove rock cuttings from the hole and maintain the stability of the wellbore. Technical services are provided to ensure that the products and systems are applied effectively to optimize drilling operations. These services include recommending products and services during the well planning phase; testing drilling fluid properties and recommending adjustments during the drilling phase and analyzing well results after the project is complete to improve the performance of wells to be drilled in the future.
M-I Fluids offers water-base, oil-base and synthetic-base drilling fluid systems. Water-base drilling fluids are the most widely utilized system around the world, having application in both land and offshore environments. They are typically comprised of an engineered blend of weighting materials, which are used to contain formation pressures, as well as a broad range of chemical additives, which yield specific drilling performance features required for a given drilling environment. Oil-base drilling fluids are used to drill water-sensitive shales, to reduce torque and drag and to drill in areas where stuck pipe is likely to occur. These systems are low viscosity systems that sharply increase rates of penetration in certain drilling areas of the world. Synthetic-base drilling fluids are used in similar drilling environments and often exceed the superior performance characteristics of oil-base drilling fluids.
Completion fluids, also known as clear brine fluids, are solids-free, clear salt solutions that have high specific gravities. Combined with a range of specialty chemicals, these fluids are used by operators in the oil and gas industry to control bottom-hole pressures and to meet a well's specific corrosion, inhibition, viscosity and fluid loss requirements during the completion and workover phases. These systems are specially designed to maximize well production by minimizing formation damage that can be caused by solids-laden systems. M-I Fluids provides a complete line of completion fluids products and services, including a full range of low- and high-density brines, specialty chemicals, filtration and chemical treatment services used in the reclamation of these specialized fluids and technical engineering and laboratory support services.
Competition. M-I Fluids competes in a number of distinct segments and faces a number of different competitors within the oil service industry. The major competitors in the worldwide drilling fluids industry are Baroid Drilling Fluids (a division of Halliburton), INTEQ (a division of Baker Hughes, Inc. ("Baker Hughes")) and Dowell Drilling Fluids (a division of Schlumberger, Inc. ("Schlumberger")). While these companies supply a majority of the market, the drilling fluids industry is highly competitive, with a significant number of smaller, locally-based competitors as well as limited product producers that market their products without technical services. Competition is based upon technical services provided at the wellsite, product quality and availability, service response and price.
M-I Completion Fluids has four main competitors in the sale of clear brine fluids to end-use markets: Baroid Completion Fluids (a division of Halliburton), Tetra Technologies, Inc., OSCA, Inc. (a subsidiary of Great Lakes Chemical Corporation) and Ambar, Inc. This market is highly competitive, and competition is based primarily on product availability, technical service and price.
M-I SWACO
Products and Services. Through M-I's SWACO division, a complete line of solids control, pressure control, rig instrumentation and waste management services are offered to the worldwide drilling market on both a sale and rental basis. Key products in the pressure control line include the D-Gasser and Super Choke, which hold strong market positions, as well as the Super Mud Gas Separator, which protects against the large pressure surges encountered in underbalanced drilling operations used in horizontal wells. The solids control product line of shakers, hydroclones and centrifuges has been designed to offer operators the option to drill "dry locations", where drilling fluid waste is minimized and handled in an environmentally safe manner. SWACO's rig instrumentation line features the SMART(TM) and GEO-SMART Data Acquisition Systems, advanced monitoring systems that measure, monitor and display the drilling status of a well with high speed accuracy.
Competition. SWACO competes with Brandt/EPI (a subsidiary of Tuboscope Inc.), Derrick Oil Services and Martin Decker Totco (a subsidiary of Varco Industries). Additionally, there are a number of regional suppliers that provide a limited breadth of equipment and services tailored for their local markets. Competition is based on product availability, equipment performance, technical support and price.
Smith Bits
In July 1998, the Company consolidated the previously separate Smith Tool and Smith Diamond Technology business units and formed Smith Bits.
Products. The Smith Bits business unit is a worldwide leader in the design, manufacture and marketing of drill bits used in drilling oil and gas wells and in mining applications under the Smith Tool(TM), GeoDiamond(TM) and Smith Mining(TM) product lines. Most bits manufactured by Smith Bits are three-cone drill bits for the petroleum industry, which range in size from 3 1/2 to 28 inches in diameter. These three-cone bits are comprised of two major components - the body and the cones, which contain different types of pointed structures referred to as "cutting structures" or "teeth." The cutting structures are either an integral part of the steel cone with a hardmetal applied surface (referred to as "milled tooth") or made of an inserted material (referred to as "insert") which is usually tungsten carbide. In the last few years, there has been a significant increase in demand for drill bits in which the tungsten carbide insert is coated with polycrystalline diamond ("PDC"). Products with diamond enhanced inserts last longer and increase penetration rates, which decreases overall drilling costs in certain formations. Smith Bits is the leading provider of drill bits utilizing diamond enhanced insert technology.
Smith Bits also designs, manufactures and markets shear drill bits featuring cutters made of PDC or natural diamond. The Company manufactures PDC and cubic boron nitride at its MegaDiamond and Supradiamant subsidiaries. These ultrahard materials are used in the Company's three-cone and diamond drill bits and in other specialized cutting tools. MegaDiamond developed and uses patented processes for applying diamonds to a curved surface with multiple transition layers. Smith is the only oilfield equipment manufacturer that develops, manufactures and markets its own synthetic diamond materials, which provide the Company a cost and technological advantage. In addition, the Company's in-house diamond research, engineering and manufacturing capabilities enhance the Company's ability to develop the application of diamond technology across other Smith product lines and into several non-energy cutting tool markets. The Company believes that its ability to develop specialized diamond inserts for specific applications has and continues to provide new business opportunities.
Mining bits are typically used for shallow drilling to place explosives for blasting in open pit mining operations. The cutting structures in mining bits are principally tungsten carbide insert ("TCI"). Other mining bits using both tungsten carbide and diamond enhanced inserts have been designed for use with air percussions tools and are known as hammer bits.
Competition. Besides the Company, Hughes Christensen (a division of Baker Hughes), Security DBS (a division of Halliburton) and Reed/Hycalog (a division of Schlumberger) are the three major competitors in the drill bit business. While the Company and Hughes Christensen maintain the leading shares of worldwide revenues of drill bits, they compete with over 20 other competitors. Competition for sales of drill bits is generally based on a number of factors, including performance, quality, reliability, service, price, technological advances and breadth of products. The Company believes its quality and reliability as well as technological advances, such as diamond enhanced inserts, provide its products with a competitive advantage.
Smith Drilling & Completions
Products and Services. The Smith Drilling & Completions business unit provides drilling, remedial and completion products and services to end users engaged in drilling oil, natural gas and geothermal wells. Approximately 80 percent of Smith Drilling & Completions' revenues are related to product rentals and associated technical services with the remaining revenue generated from product sales. Smith Drilling & Completions' operational groups include Drilling Technology, Downhole Solutions, Completion Technology, Houston Engineers and Wilson Downhole.
Drilling Technology products and services include the Drilco/Grant product lines, the TIPSA, S.A. and Faster Oilfield Services operations. The product and service offerings include: rotating drilling heads for underbalanced drilling; automatic connection torque monitoring and control systems; downhole drilling tools; tubular drill string components (drill collars, subs, kellys, Hevi-WateTM drill pipe); drilling tool and drill string inspection products and services; drill string repair and rebuild services and production tubulars and sucker rod inspection and repair.
Downhole Solutions products and services include the A-Z/Servco product lines, Red Baron and Tri-Tech Fishing Services. The product and service offerings include: remedial, re-entry and fishing services used in specialized drilling and workover operations; underreaming and hole opening services to provide additional annular space in the well bore for cementing and/or gravel packing; coiled and thru-tubing products and services; mechanical, hydraulic, and explosive pipe cutting to remove casing during a well or platform abandonment and multi-lateral installations. Downhole Solutions' products include the patented Reamaster(TM) and Underream-While-Drilling System(TM) which allow two operations to be performed simultaneously. The product group also includes the patented Millmaster(TM) Performance Milling System, the patented Packstock(TM) and Anchorstock(TM) Performance Window Cutting System and the newly developed Trackmaster(TM).
Completion Technology products and services include the Lindsey Completion Systems and Milcor packers operations which offer products and services including liner hangers, cementing products and tools, liner top packers and tie-back equipment, setting tools, permanent and temporary packers plus the service personnel to install these products in the well bore.
The Houston Engineers operations were acquired in connection with the Wilson acquisition. Houston Engineers specializes in the design and distribution of drilling and fishing jars with associated accelerators, as well as, general fishing tools. Houston Engineers is a worldwide leader in drilling jars with its Hydra-JarR. Other innovations include the Hydra-ThrustTM and Hydra-ThoraxTM tools which are designed to maintain constant weight on the drill bit and to absorb drill string torsional and axial vibrations, respectively. In addition, Houston Engineers provides technically innovative impact tools for fishing and coil tubing applications, which aid in well remedial operations.
Wilson Downhole was added to the Smith Drilling & Completions group as a result of the Wilson acquisition. The group provides directional drilling, motor and Measurement While Drilling products and services to U.S. operators.
In general, all products are manufactured by the same management with each specific product group marketed, maintained and operated by group specific management with overall operations in 90 locations in 24 countries. Houston, Texas is the sales, management, engineering and manufacturing headquarters for this business unit.
Competition. The Company's major competitors in the drilling, remedial, re-entry and fishing services markets are Weatherford Inc., Baker Oil Tools (a division of Baker Hughes) and numerous small local companies. The main competitors in the completion market are Baker Oil Tools and TIW Corporation. Competition in the drilling and completions sales, rentals and services market is primarily based on performance, quality, reliability, service, price, response time and, in some cases, breadth of products. The main competitor in the drilling jar market is Dailey International ("Dailey") and, in the Fishing Jar and Tool market, the competitors include Dailey and Bowen Oil Tools (a division of IRI International). Smith Drilling & Completions attributes its competitive position to its commitment to technological advancements that add value to the customer's programs plus the quality, performance and service of its products and employees.
Wilson Supply
Products and Services. Wilson Supply is a diversified supplier and servicer serving the international petroleum and petrochemical industries. Supply operates an extensive network of supply branches, service centers and sales offices through which it markets pipe, valves, fittings and other capital and expendable maintenance products throughout the world, predominately in the U.S. The majority of Supply's operations are focused on the domestic distribution of general oil and gas supplies and equipment with the remainder primarily associated with tubular products (including casing, tubing and drill pipe and line pipe) and automated valve products (including valve, actuator and control packages). Supply's diverse customer base includes refining and chemical companies, pipeline companies, engineering and construction companies, mining companies, utilities and pulp and paper mills in the downstream sector, in addition to major integrated oil companies, independent exploration and production companies, drilling contractors and other oilfield service companies in the upstream sector.
Competition. Supply's major competitors in the distribution business are National Oilwell Inc. and McJunkin Corporation. The oilfield equipment supply industry is highly competitive. Generally, competition involves numerous factors including price, experience, customer service and equipment availability. Supply markets its products and services to exploration and production companies as well as to companies with operations in the refining, chemical and pipeline segments of the petroleum industry and as a result is considered to be both an "upstream" and "downstream" competitor. Fluctuations in the demand for products and services from customers with operations in these segments tend to provide a diversified revenue base.
NON-U.S. OPERATIONS
Sales to oil and gas exploration and production markets outside the U.S. are a key strategic focus of Smith's management. The Company markets its products and services through subsidiaries, joint ventures and sales agents located in virtually all petroleum producing areas of the world; including Canada, the North Sea/Europe, the Middle East, Latin America, Asia/Pacific and Africa. As a result, 52 percent of the Company's total revenues in 1998 were generated from sales in non-U.S. markets.
Historically, drilling activity outside the U.S. has been less volatile than U.S. based activity as the high cost of exploration and production programs outside the U.S. are generally undertaken by major oil companies, consortiums and national oil companies. These entities operate under longer term strategic priorities than do the independent drilling operators that are more common in the U.S. market.
SALES AND DISTRIBUTION
Sales and service efforts are directed to end users in the drilling and completion industry including major and independent oil companies, national oil companies and independent drilling contractors. The Company's products and services are primarily marketed through the direct sales force of each business unit. In certain non-U.S. markets where direct sales efforts are not practicable, the Company utilizes independent sales agents, distributors or joint ventures.
Smith maintains field service centers, which function as repair and maintenance facilities for rental tools, operations for remedial and completion service and a base for the Company's global sales force, in every major oil and gas producing area of the world. The location of these service centers near the Company's customers is an important factor in maintaining favorable customer relations.
MANUFACTURING
The Company's manufacturing operations, along with quality control support, are designed to ensure that all products and services marketed by the Company will meet standards of performance and reliability consistent with the Company's reputation in the industry.
Management believes that it generally has sufficient internal manufacturing capacity to meet anticipated demand for its products and services. During periods of peak demand certain business units utilize outside resources to provide additional manufacturing capacity.
RAW MATERIALS
Through its company-owned mines located in the U.S. and abroad, M-I has the capability to produce a large portion of its requirements for barite and bentonite. Barite reserves are located in the U.S., the United Kingdom and Morocco. Bentonite is produced from ore deposits in the U.S. and Greece. Mining exploration activities continue worldwide to locate and evaluate ore bodies to ensure deposits are ready for production when market conditions dictate. In addition to its own production, M-I purchases a majority of its worldwide barite requirements from suppliers outside the U.S., located mainly in the People's Republic of China, India and Morocco.
The Company purchases a variety of raw materials for its Smith Bits and Smith Drilling & Completions units, including alloy and stainless steel bars, tungsten carbide inserts and forgings. Generally, the Company is not dependent on any single source of supply for any of its raw materials or purchased components. The Company purchases a significant amount of tungsten carbide inserts and U.S. forging requirements from two suppliers under separate supply agreements. The Company believes that numerous alternative supply sources are available for all such materials. The Company produces PDC in Provo, Utah and Scurelle, Italy for utilization in various Company products as well as direct customer sales. The Company believes that it enjoys a competitive advantage in the manufacture of diamond drill bits because it is the only diamond drill bit manufacturer producing its own PDC.
PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS
The Company's business units maintain product development and engineering departments whose activities are focused on improving existing products and services and developing new ones to meet customers demands for improved drilling performance and environmental-based solutions for drilling and completion operations. The Company's primary research facilities are located in Houston, Texas; Stavanger, Norway and Bogota, Colombia.
The Company also maintains a drill bit database which records the performance of substantially all drill bits used in the U.S. over the last 15 years, including those manufactured by competitors. This database gives the Company the ability to monitor, among other things, drill bit failures and performance improvements related to product development. Management believes this proprietary data base gives the Company a competitive advantage in the drill bit business.
The Company has historically invested significant resources in research and engineering in order to provide customers with broader product lines and technologically-advanced products and services. The Company's expenditures for research and engineering activities amounted to $41.0 million in 1998, $34.9 million in 1997 and $27.8 million in 1996. In 1998, research and engineering expenditures approximated 1.9 percent of revenues.
Although the Company has over 700 patents and regards its patents and patent applications as important in the operation of its business, it does not believe that any significant portion of its business is materially dependent upon any single patent or group of patents or upon patent protection in general.
EMPLOYEES
At December 31, 1998, the Company had 7,641 full time employees throughout the world. Most of the Company's employees in the U.S. are not covered by collective bargaining agreements except in certain U.S. mining operations of M-I. The Company considers its labor relations to be satisfactory.
ITEM 2.
ITEM 2. PROPERTIES
The principal facilities and properties utilized by the Company at December 31, 1998 are shown in the table below. Generally the facilities and properties are owned by the Company.
Smith Bits and Smith Drilling & Completions:
The Company considers its mines and manufacturing and processing facilities to be in good condition and adequately maintained.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Information relating to various commitments and contingencies, including legal proceedings, is described in Note 15 of the Notes to Consolidated Financial Statements included elsewhere in this Form 10-K.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 4A. OFFICERS OF THE REGISTRANT
(a) The names and ages of all officers of the Company, all positions and offices with the Company presently held by each person named and their business experience during the last five years are stated below. Positions, unless otherwise specified, are with the Company.
(b) All officers of the Company are elected annually by the Board of Directors at the meeting of the Board of Directors held immediately following the annual meeting of shareholders. They hold office until their successors are elected and qualified.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS.
The common stock of the Company is traded on the New York Stock Exchange and the Pacific Stock Exchange. The following are the high and low sale prices for the Company's common stock as reported on the New York Stock Exchange Composite Tape for the periods indicated.
On March 24, 1999, the Company had 2,977 common stock holders of record and the last reported closing price on the New York Stock Exchange Composite Tape was $41.75.
The Company has not paid dividends on its common stock since the first quarter of 1986. The determination of the amount of future cash dividends to be declared and paid on the common stock, if any, will depend upon the Company's financial condition, earnings and cash flow from operations, the level of its capital expenditures, its future business prospects and other factors that the Board of Directors deem relevant. In addition, the Company's debt agreements contain covenants restricting the payment of cash dividends to the Company's common stockholders based on net earnings and operating cash flow formulas as defined.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The Notes to Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K should be read in order to understand factors such as accounting changes, business combinations, or other unusual items which may affect the comparability of the information shown above.
(a) On February 28, 1994, the Company acquired a 64 percent interest in M-I from Dresser Industries, Inc. in exchange for consideration of $160.0 million.
ITEM 7.
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. On April 30, 1998, the Company acquired all of the outstanding stock of Wilson Industries, Inc. ("Wilson") in a transaction accounted for as a pooling of interests. Accordingly, the accompanying financial information gives effect to the acquisition for all periods presented. The following 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.
The Company's primary business is the manufacture and sale of premium products and services to the oil and gas industry's exploration and production sectors. The Company's worldwide operations are largely driven by the level of exploration and production activity in major energy producing areas and the depth and drilling conditions of these projects. The level of worldwide drilling activity is influenced by energy prices but may also be affected by expectations related to the worldwide supply for crude oil and natural gas, finding and development costs, decline and depletion rates, political actions and uncertainties, environmental concerns, capital expenditure plans of exploration and production companies and the over-all level of global economic growth and activity.
Management anticipates that the 1999 average worldwide rig count will decline from historical activity levels due to the continuing weakness in crude oil prices. The average worldwide rig count decreased over 13 percent from 1997 levels due in part to the decline in U.S. land-based drilling programs, which are generally more sensitive to energy prices. Although the long-term outlook for exploration and production activity is favorable based upon expected growth in worldwide energy consumption, several factors have, and may continue to, impact activity levels on a short-term basis. Continuing weakness in oil prices combined with the impact of a worldwide supply imbalance contributed to the U.S. rig count reaching an all-time record low in the first quarter of 1999. In response to the commodity price weakness major and independent oil companies, on which the Company relies for a large portion of its revenues, have announced 1999 capital expenditure plans which are significantly below 1998 spending levels. If crude oil prices remain at or below current levels for a prolonged period of time, management believes demand for the Company's products and services could continue to be adversely impacted in the U.S. and certain other markets.
Management also believes that operators are shifting exploration and production spending toward value-added, technology-based products which reduce the cost of their overall drilling programs. Additionally, the significant level of extended-reach drilling programs, which often involve more difficult drilling conditions, increases the need for efficient products and services which reduce both drilling time and formation damage. The Company continues to focus on investing in the development of technology-based products that considerably improve the drilling process through increased efficiency and rates of penetration. Management believes the overall savings realized by the use of the Company's premium products, such as polycrystalline diamond drill bits, diamond enhanced three-cone drill bits and synthetic drilling fluids, compensate for the higher costs of these products over their non-premium counterparts.
RESULTS OF OPERATIONS
Revenues
Although the Company provides products to the petrochemical industry and certain industrial markets, the majority of the Company's revenues are derived from sales to the oil and gas exploration and production industry. The Company operates through five business units which market the Company's products and services throughout the world. The following table presents revenue and average rig count information for the periods shown (in thousands, except rig count information):
M-I Fluids
M-I Fluids, a division of M-I L.L.C. ("M-I"), provides drilling fluid and completion fluid systems, engineering and technical services to the oil and gas industry. M-I Fluids' 1998 revenues decreased $4.1 million from 1997, and 1997 revenues increased $202.7 million, or 30 percent, from 1996. Revenues were relatively comparable with 1997 as lower U.S. volumes associated with weak oil prices were offset by higher demand in Europe/Africa and Latin America. The growth over 1996 relates to increased U.S. activity levels, particularly in the U.S. Gulf Coast area, and the inclusion of revenues from acquired operations.
M-I SWACO
M-I SWACO, a division of M-I, manufactures and markets equipment and services for solids control, pressure control, rig instrumentation and waste management. M-I SWACO's 1998 revenues increased $17.6 million, or 14 percent, from 1997, and 1997 revenues increased $46.0 million, or 56 percent, from 1996. The majority of the revenue growth over 1997 was reported in the U.S. and Europe/Africa which benefited from incremental revenues from acquired operations and increased demand for fluid processing equipment and services. The revenue growth over 1996 related to increased demand for SWACO's solids control equipment, particularly in Latin America and the U.S., and the impact of acquisitions.
Smith Bits
Smith Bits manufactures and sells three-cone and diamond bits primarily for use in the oil and gas industry. The unit's MegaDiamond and Supradiamant subsidiaries manufacture polycrystalline diamond and cubic boron nitride materials which are used in drill bits and in other specialized cutting tools. In July 1998, the Company consolidated the previously separate Smith Tool and Smith Diamond Technology business units and formed Smith Bits. Smith Bits 1998 revenues decreased $19.8 million, or 6 percent, from 1997 and 1997 revenues increased $72.5 million, or 28 percent, from 1996. The revenue decline from 1997 related to lower North American activity levels which resulted in decreased unit sales of petroleum three-cone bits. The impact of the decline in unit sales was partially offset by improved pricing combined with increased volumes in the Eastern Hemisphere. The increase in revenues over 1996 represents higher drilling activity in North America, increased market penetration in the Eastern Hemisphere and continued expansion into new markets.
Smith Drilling & Completions
Smith Drilling & Completions manufactures and markets products and services used in the oil and gas industry for drilling, workover, well completion and well re-entry. Smith Drilling & Completions' 1998 revenues increased $28.0 million, or 9 percent, over 1997, and 1997 revenues increased $101.6 million, or 52 percent, from 1996. The majority of the revenue growth was reported outside North America and related to increased demand across all product lines. Over half of the increase from 1996 relates to the impact of acquisitions, with higher levels of re-entry drilling activity in the U.S. Gulf Coast area also contributing to the growth.
Wilson Supply
Wilson Supply markets pipe, valves, fittings and other capital and expendable maintenance products to the petroleum and petrochemical industries primarily through an extensive network of U.S. supply branches. 1998 revenues decreased $70.7 million, or 13 percent, from 1997, and 1997 increased $93.3 million, or 21 percent, from 1996. On a geographic basis, the revenue decrease from 1997 was reported in the U.S., which was adversely impacted by a decline in drilling activity levels. On a product basis, lower tubular revenues associated with a decline in unit sales and increased competitive pricing pressures contributed the majority of the revenue decrease. The revenue increase over 1996 resulted primarily from increased activity levels in the U.S. and increased demand from major alliance customers.
For the periods indicated, the following table summarizes the results of the Company and presents these results as a percentage of total revenues (dollars in thousands):
1998 Versus 1997
Total revenues for 1998 decreased $49.2 million, or 2 percent, from the prior year as weak oil prices effected drilling activity levels across all geographic regions. The revenue decline was reported in the U.S. and related to the effects of lower land-based drilling activity, which is generally more sensitive to energy price levels. Increased demand in geographic regions outside the U.S. served to partially offset the reported revenue decline. On a product basis, the overall decrease related to lower tubular sales in the Wilson Supply operations which was associated with the activity level decline. If drilling activity remains at or below current levels, management believes reduced customer spending may continue to impact reported revenues in future periods.
Gross profit declined $23.5 million, or 4 percent, from the 1997 fiscal year. Gross profit margins were comparable year-to-year approximating 30 percent in both periods. On an absolute dollar basis, the majority of the gross profit decline related to recording inventory write-downs in the fourth quarter of 1998 due to the effects of the downturn in the oil and gas industry. Decreased manufacturing volumes associated with the revenue decline has had a minimal impact on the reported margins to date; however, if revenues and the related volumes continue to decline, gross margins in future periods could be adversely impacted. Additionally, industry conditions could create increased price competition in the markets in which the Company participates, the effect of which could negatively impact the gross profit line.
Operating expenses, consisting of selling expenses, general and administrative expenses and merger and restructuring costs, increased $100.1 million, or 25 percent, from the prior fiscal year. The majority of the dollar variance relates to the merger and restructuring charges recorded during the year related to restructuring efforts and costs associated with the acquisition and integration of the Wilson operations.
During 1998, management evaluated the current economic conditions in the oil and gas industry and committed to several restructuring initiatives to lower costs and remain competitive in the present environment. The merger and restructuring costs included efforts to reduce the number of employees to appropriate levels to correspond with activity declines, close and consolidate manufacturing facilities, exit product offerings, combine business units and eliminate duplicate cost structures and write-off assets which, due to current industry and economic conditions, were determined to have no future value. In addition to the restructuring costs, certain amounts were recognized to consolidate and integrate the Wilson operations. The restructuring efforts, which will be substantially completed by the first quarter of 1999, have resulted in reduced employee-related costs. Additionally, although headcount reductions associated with the relocation of the manufacturing facilities resulted in lower employee-related costs, increased efficiencies have also resulted from the combination of the previously separate manufacturing operations. As of December 31, 1998, the remaining reserve for restructuring expenditures approximated $36.3 million. See Footnote 3, "Special Charges," for further discussion of the merger and restructuring costs.
Net interest expense, which represents interest expense less interest income, increased $14.4 million over the prior year. A significant portion of the increase relates to the notional interest recorded on the note issued to Halliburton Company ("Halliburton") in connection with the purchase of their partnership interest in M-I. The remainder of the increase relates to the higher level of borrowings required to fund other business acquisitions and finance general working capital needs.
The effective tax rate for the year approximated 32 percent, which is higher than the prior year's effective rate and lower than the U.S. statutory rate. The rate was higher than the prior year's effective rate due to the inclusion of non-deductible costs in the merger and restructuring charges. The effective tax rate was lower than the statutory rate which primarily related to the utilization of foreign tax losses and U.S. minimum tax credits.
Minority interests represent the share of M-I's profits associated with the former minority partner's interest in those operations and, to a lesser extent, minority interests in investments in other joint ventures held by M-I. Minority interests decreased $17.9 million, or 45 percent, from the prior year due to the impact of acquiring Halliburton's ownership interest in M-I.
1997 Versus 1996
Total revenues for 1997 increased $516.0 million, or 31 percent, from the prior year as the Company experienced strong growth across all business units and geographic areas. Half of the revenue increase was reported in North America which benefited from higher drilling activity levels and, to a lesser extent, the impact of acquired operations. The addition of the Anchor and Red Baron operations, which had significant operations in the Eastern Hemisphere, and increased market penetration in Latin America also contributed to the revenue growth. Non-U.S. revenues continue to account for a significant portion of the Company's operations approximating 47 percent of total revenues in both fiscal years.
Gross profit increased $179.9 million, or 38 percent, from the 1996 fiscal year. Gross profit margins continued to improve with the Company reporting a one percent increase in margins over the prior year. Increased manufacturing efficiencies associated with the higher volumes, the effect of price increases enacted during the year and the favorable impact of acquired operations all contributed to the margin improvement.
Operating expenses, consisting of selling expenses and general and administrative expenses, increased $79.7 million from the prior fiscal year; however, as a percentage of revenues, operating expenses were reduced in excess of one percentage point. The dollar variance over the prior year relates to increased variable costs associated with the higher level of revenues and, to a lesser extent, costs associated with acquired operations.
Net interest expense, which represents interest expense less interest income, increased $10.0 million over the prior year. The increase in net interest expense relates to the higher level of borrowings used to fund acquisitions. Borrowings required to finance general working capital needs, which increased as a result of the revenue growth experienced by the Company, have also contributed to the higher net interest expense amounts.
The effective tax rate for the year approximated 27 percent, which is higher than the prior years' effective rate and lower than the U.S. statutory rate. The rate exceeded the effective rate for 1996 as the prior year benefited from U.S. net operating loss carryforwards ("NOL carryforwards"), which were fully utilized during 1997. The effective tax rate was lower than the statutory rate due to the impact of NOL carryforwards and the method of recording the former minority interest partner's U.S. earnings.
Prior to acquiring the minority interest ownership in M-I, the Company properly consolidated the pretax income related to the partner's share of U.S. partnership earnings but excluded the related taxes.
Minority interests represent the share of M-I's profits associated with the former minority partner's interest in those operations and, to a lesser extent, minority interests in investments in other joint ventures held by M-I. Minority interests increased $14.7 million from the prior year due to the increased profitability of the M-I operations.
LIQUIDITY AND CAPITAL RESOURCES
General
Cash and cash equivalents decreased $14.4 million during the year and equaled $22.7 million at December 31, 1998. The Company's operations generated $124.1 million of cash flows in 1998 which is a $85.2 million increase over the amounts reported in the prior year. The effect of the decline in drilling activity on operations favorably impacted working capital levels, with decreased receivables accounting for the majority of the change from the prior year. Cash flows from operations for the year were sufficient to fund capital expenditures and acquisition requirements resulting in repayments of borrowings under available facilities.
In 1998, the Company invested $102.8 million in property, plant and equipment net of cash proceeds arising from certain asset disposals. Capital expenditures for 1999 are expected to decline significantly due to the industry downturn and will consist of spending for maintenance of the Company's capital equipment base and, to a lesser extent, will include routine additions of equipment used to support the Company's operations. The Company believes funds generated from operations, cash on hand and amounts available under existing credit facilities will be sufficient to finance capital expenditures and other working capital needs of the existing operations for the foreseeable future.
The Company funded $34.7 million of business acquisitions during 1998. Subsequent to year-end, the Company announced the signing of a definitive agreement with Schlumberger Limited ("Schlumberger") related to the combination of both company's drilling fluid operations. The Company is also negotiating a definitive agreement with Conemsco, Inc. ("Conemsco") related to the formation of an oilfield distribution and supply joint venture. In connection with the transactions each of the respective parties are required to contribute certain assets and, under the drilling fluids joint venture arrangement, Schlumberger will pay the Company cash consideration of $280.0 million. In connection with the distribution joint venture, the Company is required to purchase additional ownership interest from Conemsco which will result in a cash payment as determined under the terms of the agreement. See Footnote 16, "Subsequent Events", for further discussion of potential acquisitions. Although there are no assurances as to whether either of these transactions will be agreed to by the parties or ultimately consummated, in the event these are completed, future cash outlays may be required to combine and consolidate the previously separate operations. Aside from the potential transactions discussed above, management continues to evaluate opportunities to acquire products or businesses complimentary to the Company's operations. These acquisitions, if they arise, may involve the use of cash or, depending upon the size and terms of the acquisition, may require debt or equity financing.
The Company's primary internal source of liquidity is cash flow generated from operations. External sources of liquidity include debt and, if needed, equity financing. The Company has various revolving line of credit facilities in and outside the U.S. for operating and financing needs. The Company had approximately $124 million of funds available under its long-term revolving line of credit facilities at December 31, 1998. Additionally, the Company had approximately $66 million of non-U.S. short-term borrowing facilities with various banks which had available borrowing capacity of $38 million at year-end.
On October 29, 1996, the Company was served with a complaint in the U.S. District Court entitled Rock Bit International, Inc. v. Smith International, Inc. This lawsuit is a patent infringement dispute alleging that drill bits made by the Company infringe a U.S. patent owned by Rock Bit International ("RBI") which was issued on September 8, 1992. RBI alleges that the Company infringes its patent by making and selling certain three-cone rock bits having cutting structures covered by the claims of RBI's patent. The Company commenced discovery in late 1997 and has continued through late 1998. The Company is vigorously contesting this lawsuit and believes that it does not infringe the RBI patent and that the patent is invalid. See Footnote 15, "Commitments and Contingencies", for further discussion of litigation.
The Company has been named as a potentially responsible party in connection with four sites on the U.S. Environmental Protection Agency's National Priorities List. At December 31, 1998, the recorded liability for estimated future clean-up costs for the Superfund as well as other environmental sites was $2.9 million. As more information becomes available, the Company may be required to provide for additional environmental clean-up costs. Management, however, believes that none of these obligations will result in liabilities having a material adverse effect on the Company's consolidated financial position or results of operations. See Footnote 15, "Commitments and Contingencies" for further discussion of environmental liabilities.
The Company believes that it has sufficient existing manufacturing capacity to meet current demand for its products and services. Additionally, inflation has not had a material effect on the Company in recent years, and is expected to have a modest impact on the operations in the foreseeable future. The Company has generally been able to offset most of the effects of inflation through productivity gains, cost reductions and price increases.
Because of the substantial level of operations outside the U.S., the Company is exposed to currency fluctuations and exchange risks. To mitigate the effect of fluctuations in exchange rates on foreign currency denominated balances, the Company utilizes a protective hedge program. The program is designed to hedge certain net balance sheet positions which expose the Company to exchange rate risk. To the extent possible, the Company matches assets and liabilities denominated in foreign currencies and uses hedging instruments to cover certain unmatched positions. See Footnote 7, "Financial Instruments," for further discussion of hedging instruments.
NEW ACCOUNTING AND REGULATORY PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities", effective for fiscal periods beginning after June 15, 1999. This standard establishes accounting and reporting standards requiring that every derivative instrument be recorded and measured at its fair value. The Statement requires that changes in fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The impact of adopting SFAS 133 has not yet been quantified but is not expected to have a material impact upon the Company's financial position or results of operations.
In April 1998, the Accounting Standards Executive Committee issued Statement of Position 98-5 ("SOP 98-5"), "Reporting on the Costs of Start-Up Activities", effective for fiscal periods beginning after December 15, 1998. The statement requires costs of start-up activities and organization costs to be expensed as incurred. The Company is required to adopt SOP 98-5 in the first quarter of 1999 and does not expect adoption to have a material adverse impact on the Company's financial position or results of operations.
YEAR 2000
The Company continues to implement modifications to its business systems in order to achieve Year 2000 date conversion compliance without an effect on customers or business operations.
The Company's business systems are comprised of a mix of off-the-shelf and internally-developed systems that vary greatly in size, complexity and technical architecture. The Company's Year 2000 task force has performed a complete review of all systems and has finalized the identification of the critical and non-critical components within five defined groups. The necessary changes in computer instructional code continue to be made by upgrading the off-the-shelf software in which the application was created. Year 2000 compliance for the majority of the Company's enterprise applications was achieved with the Oracle 10.7 implementation in the first quarter of 1998. The Company continues to install new applications and upgrade existing ones in order to bring applications for international locations into compliance and migration or replacement plans are in place for systems that are not currently Year 2000 compliant. As of December 31, 1998 all of the Company's critical systems were Year 2000 compliant and the Company expects all non-critical systems will be compliant by the third quarter of 1999. At December 31, 1998, the Company estimates that the implementation and testing process for both Information Technology ("IT") and non-IT systems was over 70 percent complete.
During 1998, the Company communicated with major suppliers, financial institutions and others with whom it does business to address their compliance efforts and the Company's exposure in the event of the failure of these efforts. The Company is currently validating the responses received and is seeking additional information where necessary. Although the Company has not yet determined the complete status of Year 2000 compliance of its suppliers and financial institutions, a written contingency program has been developed. Management continues to believe that non-compliance by the Company's suppliers is insignificant but failure of its financial institutions could have a material effect on the Company's financial position or results of operations.
The estimated costs related to achieving Year 2000 compliance are not expected to have a material impact on the Company's financial condition or results of operations. All expenditures related to the Year 2000 initiative will be funded with cash flows from operations.
QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES
The Company is currently exposed to certain market risks arising from transactions that are entered into in the normal course of business. These risks relate to interest rate changes and fluctuations in foreign exchange rates. The Company does not believe these risks are material.
The Company's exposure to interest rate changes is managed through the use of a combination of fixed and floating rate debt and by entering into interest rate swaps on a portion of its long-term borrowings. The fair value of interest rate swaps as of December 31, 1998 and 1997 was not material. At December 31, 1998, after considering the effect of interest rate swaps, ten percent of the Company's long-term debt carried a variable interest rate. Management believes that significant interest rate changes will not have a material near-term impact on the Company's future earnings or cash flows.
The Company's exposure to changes in foreign exchange rates is managed primarily through the use of forward exchange contracts. These contracts increase or decrease in value as foreign exchange rates change, to protect the value of the underlying transactions denominated in foreign currencies. All currency contracts are components of the Company's hedging program and are entered into for the sole purpose of hedging an existing or anticipated currency exposure. In some areas, where hedging is not cost effective, the Company addresses foreign currency exposure utilizing working capital management. Management believes that a significant fluctuation in the foreign exchange rates would not have a material near-term effect on the Company's future earnings or cash flows.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Smith International, Inc.:
We have audited the accompanying consolidated balance sheets of Smith International, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity and comprehensive income and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Smith International, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Houston, Texas January 29, 1999
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (IN THOUSANDS, EXCEPT SHARE AND WARRANT DATA)
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(ALL DOLLAR AMOUNTS ARE EXPRESSED IN THOUSANDS, UNLESS OTHERWISE NOTED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Smith International, Inc. (the "Company") is engaged in the manufacture and sale of premium products and services to customers in the oil and gas industry. The consolidated financial statements include the accounts of the Company and all wholly and majority-owned subsidiaries. Investments in affiliates in which ownership interest ranges from 20 to 50 percent, and the Company exercises significant influence over operating and financial policies, are accounted for on the equity method. All other investments are carried at cost, which does not exceed the estimated net realizable value of such investments. All significant intercompany accounts and transactions have been eliminated.
The consolidated financial statements for the periods ended December 31, 1997 and 1996 have been restated to include the accounts of Wilson Industries, Inc. ("Wilson"). On April 30, 1998, the Company acquired all of the equity interests in Wilson in a transaction accounted for as a pooling of interests.
Significant Risks and Uncertainties
Preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosed amounts of contingent assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers all highly liquid financial instruments purchased with an original maturity of three months or less to be cash equivalents.
Fixed Assets
Fixed assets, consisting of rental equipment and property, plant and equipment, are stated at cost. The Company computes depreciation on fixed assets using principally the straight-line method. The estimated useful lives used in computing depreciation generally range from 20 to 40 years for buildings, 3 to 25 years for machinery and equipment, and 5 to 7 years for rental equipment. Leasehold improvements are amortized over the lives of the leases or the estimated useful lives of the improvements, whichever is shorter. For income tax purposes, accelerated methods of depreciation are used.
Cost of major renewals and betterments are capitalized as fixed assets. Expenditures for maintenance, repairs and minor improvements are charged to expense when incurred. When fixed assets are sold or retired, the remaining cost and related reserves are removed from the accounts and the resulting gain or loss is included in the Consolidated Statements of Operations.
Valuation of Inventories
Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out ("FIFO") method for the majority of the Company's inventories. The remaining inventories are costed under the last-in, first out ("LIFO") or average cost methods. Inventory costs consist of materials, labor and factory overhead.
Goodwill
Goodwill, which represents the excess of costs over the fair value of net assets acquired, is amortized on a straight-line basis over 40 years. The Company continually evaluates whether subsequent events or circumstances have occurred that indicate the remaining useful life of goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Management believes that there have been no events or circumstances which warrant revision to the remaining useful life or which affect the recoverability of goodwill.
Foreign Currency Translation and Transactions
Gains and losses resulting from balance sheet translation of operations outside the U.S. where the applicable foreign currency is the functional currency are included as a separate component of shareholders' equity. Gains and losses resulting from balance sheet translation of operations outside the U.S. where the U.S. dollar is the functional currency are included in the Consolidated Statements of Operations.
All foreign currency transaction gains and losses are recognized currently in the Consolidated Statements of Operations.
Financial Instruments
The Company enters into various instruments, including derivatives, to manage interest rate and foreign exchange risks. Derivatives are limited in use and are not entered into for speculative purposes. The instruments are classified as for "purposes other than trading" under the provisions of SFAS No. 119.
The Company enters into interest rate swaps to manage interest rate risk on a portion of its long-term borrowings. The differential to be received or paid is accrued, as interest rates change, and recognized currently in the Consolidated Statements of Operations.
The Company enters into foreign exchange contracts to hedge certain foreign currency denominated assets or liabilities and currency commitments. Gains and losses on foreign exchange contracts are recognized currently and are generally offset by gains or losses on the related assets or liabilities. If the transaction qualifies as a hedge, the resulting gains and losses are deferred.
Environmental Obligations
Expenditures for environmental obligations that relate to current operations are expensed or capitalized, as appropriate. Expenditures that relate to an existing condition caused by past operations and which do not contribute to current or future revenue generation are expensed. Liabilities are recorded when remedial efforts are probable and the costs can be reasonably estimated.
Income Taxes
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". This standard requires an asset and liability approach for financial accounting and income tax reporting based on enacted tax rates.
Revenue Recognition
The Company's revenues are composed of product sales and rental, service and other revenues. The Company recognizes product sales revenues upon delivery to the customer. Rental, service and other revenues are recorded when such services are performed.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
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 amounts primarily represent the share of the M-I L.L.C. ("M-I") profits associated with the former minority partner's interest in those operations. In August 1998, the Company acquired the remaining 36 percent interest in the M-I operations from Halliburton Company ("Halliburton").
Employee Benefits
The Company accounts for postretirement benefits in accordance with SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions".
In 1998, the Company adopted SFAS No. 132, "Employers' Disclosures about Pension and Other Postretirement Benefits" which standardizes the disclosures for pensions and other postretirement benefit plans and requires additional information related to changes in benefit obligations and the fair value of plan assets.
Comprehensive Income
In 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income", which requires companies to display comprehensive income and its components as part of the basic financial statements. The required disclosures are presented in the accompanying Consolidated Statements of Shareholders' Equity and Comprehensive Income.
Reclassifications
Certain prior year amounts have been reclassified to conform to current year presentation.
2. ACQUISITIONS
Acquisition of Anchor Drilling Fluids, A.S.
On June 11, 1996, M-I acquired the assets of Anchor Drilling Fluids, A.S. ("Anchor") in exchange for cash of approximately $105.3 million. Anchor is a Stavanger, Norway based operation which is principally engaged in providing drilling fluid products and services to the offshore oil and gas industry. The Company utilized $73.4 million of borrowings under new loan agreements to finance their portion of the purchase price and retire certain debt assumed in the acquisition. The former minority interest partner in M-I contributed $41.3 million to fund their portion of the purchase price and retire certain debt.
Acquisition of The Red Baron (Oil Tools Rental) Ltd.
On October 9, 1996, the Company acquired all of the outstanding shares of The Red Baron (Oil Tools Rental) Ltd. ("Red Baron") in exchange for cash and notes payable of approximately $40.3 million. Red Baron is an Aberdeen, Scotland based supplier of fishing and other downhole remedial products and services to the oil and gas industry.
Acquisition of Tri-Tech Fishing Services, L.L.C.
On April 16, 1997, the Company acquired all of the equity interests in Tri-Tech Fishing Services, L.L.C. ("Tri-Tech") in exchange for consideration totaling approximately $20.4 million. Tri-Tech is a supplier of fishing and other downhole remedial products and services to the U.S. Gulf Coast area.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Acquisition of Fleming Oilfield Services, Ltd.
On October 16, 1997, the Company acquired all of the outstanding shares of Fleming Oilfield Services, Ltd. ("Fleming") in exchange for cash of approximately $17.3 million. Fleming is a Calgary, Alberta based supplier of drilling fluids products and services to the Canadian oil and gas industry.
Acquisition of Safeguard Disposal Systems, Inc.
On May 27, 1998, the Company acquired all of the outstanding shares of Safeguard Disposal Systems, Inc. ("Safeguard"), a company engaged in the rental of vacuum and collection systems used in the oil and gas industry. The Company issued stock and cash consideration totaling $42.7 million in exchange for the equity interests of Safeguard and M-I acquired other Safeguard-related assets for $4.8 million. Subsequent to the acquisition date, the Company contributed the Safeguard assets to M-I partly in exchange for a $16.6 million contribution from the former minority interest partner.
Acquisition of Minority Interest in M-I
On August 31, 1998, the Company acquired the remaining 36 percent interest in M-I previously held by Halliburton. The Company issued a $265.0 million non-interest bearing promissory note to Halliburton in exchange for their minority ownership interest. The discounted value of the note, which matures on April 28, 1999, is classified as short-term borrowings in the accompanying balance sheet.
Other Acquisitions
In 1998, the Company completed the purchase of various other operations. These operations were acquired in exchange for cash of $20.5 million, consisting of purchase consideration and amounts due under earn-out arrangements, which was financed with borrowings against available lines of credit. Additionally, several other acquisitions were completed in 1997 and 1996 in exchange for consideration of $43.0 million and $6.2 million, respectively. These acquisitions have generally been financed with cash, new term loans or borrowings against available lines of credit.
The above acquisitions have been recorded using the purchase method of accounting and, accordingly, the acquired operations have been included in the results of operations since their respective acquisition dates. The purchase price was allocated to the net assets acquired based upon their estimated fair market values at the dates of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired amounted to approximately $86.4 million in 1998 and $54.2 million in 1997, which has been recorded as goodwill.
The balances included in the Consolidated Balance Sheets related to the current year acquisitions are based upon preliminary information and are subject to change when additional information concerning final asset and liability valuations is obtained. Material changes in the preliminary allocations are not anticipated by management.
The following unaudited pro forma supplemental information presents consolidated results of operations as if the Company's current and prior year acquisitions had occurred on January 1, 1997 (in thousands, except per share amounts):
The unaudited pro forma supplemental information is based on historical information and does not include estimated cost savings; therefore, it does not purport to be indicative of the results of operations had the combinations been in effect at the dates indicated or of future results for the combined entities.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The following schedule summarizes investing activities related to current year acquisitions included in the Consolidated Statements of Cash Flows:
Acquisition of Wilson Industries, Inc.
On April 30, 1998, the Company merged with Wilson, a Houston, Texas based provider of products and services to the worldwide petroleum and petrochemical industries. In connection with the merger, the Company issued a total of 7.9 million of its shares in exchange for all of the outstanding shares of common stock of Wilson. The transaction has been accounted for as a pooling of interests and, accordingly, the financial statements for the periods prior to the merger have been restated to include the accounts of Wilson.
Wilson adopted SFAS No.106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" on January 1, 1995 in compliance with the reporting rules for non-public companies. In connection with the restatement, the Company conformed reporting for SFAS No. 106 to the requirements for public companies which increased Wilson's historical net income for the year ended December 31, 1995 by $3.3 million. During the periods presented, certain reclassification entries were necessary in order to conform Wilson's method of reporting to the Company's method. Other adjustments to conform Wilson's accounting policies were immaterial and have been accounted for on a prospective basis.
The revenues and net income amounts included in the Consolidated Statements of Operations are disclosed in the following table with Wilson's amounts for the periods prior to the merger presented separately:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
3. SPECIAL CHARGES
During 1998, the Company recognized special charges totaling $97.4 million, or $69.3 million on an after-tax basis. Of that amount $82.5 million was recorded as merger and restructuring costs in the accompanying financial statements and relates to restructuring efforts undertaken in response to activity-level declines and costs required to consolidate and integrate the Wilson operations. The remaining $14.9 million of the charge consists of amounts required to reflect inventories at net realizable value and was recorded in costs of revenues.
In order to reduce costs and improve productivity, the Company has initiated various restructuring efforts to streamline the organizational structure, consolidate manufacturing operations and exit certain product line offerings. These actions have resulted in the recognition of $52.5 million of restructuring charges as reflected below. The restructuring efforts included the termination of approximately 2,100 individuals across all business operations and job functions, including manufacturing, sales and administrative positions. Although certain of the employee reductions related to the combination of two separate business units and the elimination of duplicate cost structures, the majority of the reductions were in response to the activity-level declines associated with the industry downturn. The restructuring charge also includes amounts to close manufacturing facilities and exit certain business operations. These amounts include costs related to the closure and relocation of one of the Company's European manufacturing operations along with the exit costs for a manufacturing operation and certain product line offerings which were discontinued due to economic considerations in Latin America. The remainder of the restructuring charge relates to asset write-offs necessitated by the prevailing economic environment, including non-recoverable assets recorded in Indonesia and certain assets located in the U.S. which has no future value. The restructuring efforts will be substantially completed by the first quarter of 1999.
In connection with the Wilson transaction, the Company recorded merger costs of approximately $30.0 million which consisted of transaction costs, including accounting, legal and investment banking costs and amounts to consolidate and integrate the existing Wilson operations. The remaining portion of the charge relates to severance costs, including payments required under "change of control" agreements, amounts incurred to relocate and consolidate two separate manufacturing operations located in the U.S. and write-off certain assets which were determined to have no future value.
The significant components of the special charges are included below (in thousands):
As of December 31, 1998, the remaining reserve for merger and restructuring costs approximated $36.3 million.
4. EARNINGS PER COMMON SHARE
In 1997, the Company adopted SFAS No. 128 "Earnings per Share". SFAS No. 128, which conforms the U.S. method of computing earnings per share ("EPS") with international accounting standards, requires dual presentation of basic and diluted EPS data. Basic EPS is computed using the weighted average number of common shares outstanding during the period. Diluted EPS gives effect to the potential dilution of earnings which could have occurred if additional shares were issued for stock option exercises under the treasury stock method. For purposes of the EPS computation, the 7.9 million
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
shares issued in connection with the Wilson transaction have been treated as if they had been issued and outstanding for all periods presented.
The following schedule reconciles the income and shares used in the basic and diluted EPS computations (in thousands, except per share data):
5. INVENTORIES
Inventories consist of the following at December 31:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
6. DEBT
The following summarizes the Company's outstanding debt at December 31:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Principal payments of long-term debt for years subsequent to 1999 are as follows:
The Company's short-term borrowings consist of amounts outstanding under short-term lines of credit and short-term loans. Certain subsidiaries of the Company have unsecured short-term line of credit facilities with banks aggregating approximately $66 million. At December 31, 1998, approximately $38 million of additional borrowing capacity was available under these facilities. These lines of credit had a weighted average interest rate of 13 percent and 11 percent at December 31, 1998 and 1997, respectively. The remainder of the balance primarily related to short-term loans with a bank which carry interest at rates ranging from 6.44 to 6.62 percent and are scheduled to mature by March 29, 1999.
In addition to the short-term borrowings, the Company also has a short-term note payable which was issued to Halliburton in connection with the acquisition of the remaining 36 percent interest in M-I. The $265 million non-interest bearing note matures on April 28, 1999 and is recorded in the accompanying financial statements at the discounted value.
At December 31, 1998, the Company had $200 million of unsecured revolving credit agreements in addition to the short-term facilities discussed above. These agreements provide for the election of interest at a base rate or a Eurodollar rate of LIBOR + 30 basis points and require the payment of a quarterly commitment fee of one-tenth of one percent of the unutilized credit facility. The interest and commitment fee percentages are determined based upon the senior debt rating of the Company, as defined. As of December 31, 1998 the borrowing capacity under these lines of credit approximated $124 million.
In connection with a public debt offering, the Company issued $150 million of unsecured 7 percent Senior Notes. The Notes are redeemable by the Company, in whole or in part, at any time prior to maturity at a redemption price equal to accrued interest plus the greater of the principal amount or the present value of the remaining principal and interest payments.
The Company was in compliance with its loan covenants under the various loan indentures at December 31, 1998 or had received satisfactory waivers from its lenders. The indentures relating to its long-term debt contain certain covenants restricting the payment of cash dividends to the Company's common shareholders based on net income and operating cash flow formulas, as defined. The Company has not paid dividends on its common stock since the first quarter of 1986.
Interest paid during the years ended December 31, 1998, 1997 and 1996 amounted to $40.8 million, $27.3 million and $20.3 million, respectively.
7. FINANCIAL INSTRUMENTS
Interest Rate Contracts
From time to time, the Company enters into interest rate swaps with the intent of managing its exposure to interest rate risk. Interest rate swaps are contractual agreements between two parties for the exchange of interest payments on a notional principal amount and agreed upon fixed or floating rates, for defined time periods.
At December 31, 1998 and 1997, the Company had notional principal amounts of interest rate swaps on outstanding debt of $71.1 million and $80.5 million, respectively. These agreements, which are hedges against certain obligations, terminate between April 1999 and March 2001. Gains and losses from interest rate swaps are recognized currently in the Consolidated Statements of Operations.
In the unlikely event that the counterparty fails to perform under the contract, the Company bears the credit risk that payments due to the Company may not be collected.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Foreign Currency Contracts and Options
From time to time, the Company enters into spot and forward contracts as a hedge against foreign currency denominated assets and liabilities and currency commitments. The terms of these contracts generally do not exceed one year. Market value gains and losses are recognized currently, and the resulting amounts generally offset foreign exchange gains or losses on the related accounts. Gains or losses on contracts are deferred if the transaction qualifies as a hedge. At December 31, 1998 and 1997, foreign exchange contracts outstanding totaled $40.0 million and $20.9 million, respectively.
The Company also purchases foreign exchange option contracts, with terms which generally do not exceed one year, to hedge certain operating exposures. Premiums paid under these contracts are expensed over the life of the option contract. Gains arising on these options are recognized at the time the options are exercised. The Company had $5.3 million and $12.0 million of foreign exchange option contracts outstanding at December 31, 1998 and 1997, respectively.
Fair Value
The fair value of the remaining financial instruments, including cash and cash equivalents, receivables, payables, short-term debt and foreign currency contracts, approximates the carrying value due to the short-term nature of these instruments.
8. INCOME TAXES
The geographical sources of income before income taxes and minority interests for the three years ended December 31, 1998 were as follows:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The income tax provision is summarized as follows:
Deferred taxes are principally attributable to timing differences related to depreciation expense, restructuring reserves and net operating loss ("NOL") and tax credit carryforwards. The Company reported the tax benefit of operating loss carryforwards utilized in 1997 and 1996 as a reduction in the provision for income taxes in accordance with SFAS No. 109.
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:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The components of deferred taxes at December 31 are as follows:
For U.S. tax reporting purposes, the Company utilized all cumulative NOL and investment and other business credits available during 1997. At December 31, 1998, alternative minimum tax credits of $11.1 million, with no expiration, are available to reduce future U.S. income taxes. Total foreign operating loss carryforwards at December 31, 1998 are approximately $31.8 million, of which $24.5 million have been offset by recording a valuation reserve. These losses are available to reduce the future tax liabilities of their respective foreign entities. Approximately $22.5 million of these losses will carryforward indefinitely, while the remaining losses expire at various dates.
Income taxes paid during the years ended December 31, 1998, 1997 and 1996 amounted to $40.7 million, $49.3 million and $20.9 million, respectively.
The Company has provided additional taxes for the anticipated repatriation of certain earnings of its non-U.S. subsidiaries. Undistributed earnings above the amounts upon which additional taxes have been provided, which approximated $31.7 million at December 31, 1998, 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.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
9. CAPITAL STOCK
Common stock warrants
All outstanding common stock warrants, which allowed for conversion into shares of the Company's common stock, expired during 1996. No common stock warrants were outstanding at December 31, 1998, 1997 or 1996.
10. STOCKHOLDERS' RIGHTS PLAN
During 1990, the Company adopted a Stockholders' Rights Plan ("Rights Plan"). As part of the Rights Plan, the Company's Board of Directors declared a dividend of one preferred stock purchase right ("Right") for each share of the Company's common stock outstanding on June 29, 1990. The Board also authorized the issuance of one such Right for each share of the Company's common stock issued after June 29, 1990 until the occurrence of certain events.
Each Right entitles the holder thereof (except an Acquiring Person) to purchase, at an exercise price of $50, shares of the Company's common stock having a market value of twice the Right's exercise price. The Rights are exercisable upon the occurrence of certain events related to a person acquiring or announcing the intention to acquire beneficial ownership of 20 percent or more of the Company's common stock. The Rights are not exercisable in the event the Company's common stock is acquired pursuant to a Qualifying Offer, as defined in the Rights Plan. In addition, if the Company is involved in a merger or other business combination transaction, or sells 50 percent or more of its assets or earning power to another entity, each Right will entitle its holder to purchase, at the Right's then current exercise price, shares of common stock of such other entity having a value of twice the Right's exercise price.
The Rights are subject to redemption at the option of the Board of Directors at a price of $0.01 per Right until the occurrence of certain events. The Rights currently trade with the Company's common stock, have no voting or dividend rights and expire on June 19, 2000.
11. EMPLOYEE STOCK OPTIONS
As of December 31, 1998, the Company had outstanding stock options granted under the 1989 Long-Term Incentive Compensation Plan ("1989 Plan"). Options are generally granted at the fair market value on the date of grant with matters such as vesting periods and expiration of options determined on a grant-by-grant basis. The options, exercisable at various dates through December 2008, are conditioned upon continued employment.
During 1997, all options remaining under the 1982 Stock Option Plan were exercised or forfeited. No further options may be granted under this Plan.
The Company has adopted the reporting standards of SFAS No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation". SFAS 123 established financial accounting and reporting standards for stock-based employee compensation and for transactions in which equity instruments are issued to non-employees for the acquisition of goods and services. This standard requires, among other things, that compensation cost be calculated for fixed stock options at the grant date by determining fair value using an option-pricing model. The Company has the option of recognizing the compensation cost over the vesting period as an expense in the Consolidated Statements of Operations or making pro forma disclosures in the notes to the consolidated financial statements.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The Company continues to apply APB Opinion 25 and related Interpretations in accounting for the Plan and, accordingly, no compensation cost has been recognized in the accompanying consolidated financial statements. Had the Company elected to apply the accounting standards of SFAS 123, the Company's net income and earnings per share would have approximated the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model which resulted in a weighted-average fair value of $10.87, $18.68 and $12.37 for grants made during the years ended December 31, 1998, 1997 and 1996, respectively. The following assumptions were used for option grants in 1998, 1997 and 1996, respectively; dividend yield of 1.7 percent, 1.5 percent and 1.6 percent; expected volatility of 39 percent, 19 percent and 23 percent; risk-free interest rates of 5.3 percent, 5.7 percent and 6.2 percent and an expected life of six years. The compensation expense included in the above pro forma net income may not be indicative of amounts to be included in future periods as the fair value of options granted prior to adopting SFAS 123 was not determined.
A summary of the Company's stock option plans as of December 31, 1998, 1997 and 1996, and changes during those years is presented below:
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The number of outstanding fixed stock options exercisable at December 31, 1997 and 1996 was 670,507 and 481,606, respectively. These options had a weighted-average exercise price of $15.22 and $12.13 at December 31, 1997 and 1996, respectively. The following summarizes information about fixed stock options outstanding at December 31, 1998:
At December 31, 1998, there were 1,737,329 shares of common stock reserved under the 1989 Plan for the future granting of stock options, awarding of additional restricted stock options and/or awarding of additional Stock Appreciation Rights.
12. EMPLOYEE BENEFITS
Pension Plans
The Company has pension plans in the U.S. and the United Kingdom ("U.K."). In 1987, Smith and Wilson amended their defined benefit plans to freeze all future benefit accruals and prohibit the addition of any new participants. At that time, the plans covered substantially all full-time U.S. employees of the respective companies. Due to the freezing of the plans, no material contributions were made to the plans for any period presented. Although M-I sponsors certain defined benefit plans, most of the M-I employees are not covered by a pension plan.
During 1997, a decision was made to terminate the U.K. pension plan and replace it with a defined contribution plan. All current and future obligations to plan participants are expected to be settled in 1999.
The Company has several other pension plans covering certain U.S. and non-U.S. employees as well as a pension plan covering directors. Pension expense, benefit obligations and the fair value of plan assets for these plans were not material at or for the periods ended December 31, 1998, 1997 or 1996.
Postretirement Benefit Plans
The Company and its subsidiaries provide certain health care benefits for retired employees. Many of the employees who retire from the Company are eligible for these benefits.
The Smith International, Inc. Retiree Medical Plan ("Smith Medical Plan") provides postretirement medical benefits to retirees and their spouses. The retiree medical plan has an annual limitation (a "cap") on the dollar amount of the Company's portion of the cost of benefits incurred by retirees under the Plan. The remaining cost of benefits in excess of the cap is the responsibility of the participants. The cap will be adjusted annually for inflation, which is currently assumed to be 4 percent.
M-I provides medical coverage to eligible retirees and their dependents under the M-I Drilling Fluids Retiree Medical Plan ("M-I Medical Plan"). Eligibility for inclusion in that plan; however, was closed as of January 1, 1994, to the majority of M-I's employees. M-I contributes to the cost of benefits under this plan; however, these costs are reviewed annually for inflation, and limited to a maximum 5 percent increase in M-I's contribution per year. Any costs in excess of M-I's maximum contribution are the responsibility of the retiree or their dependents.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Although Wilson provides postretirement medical coverage to eligible retirees and their spouses, new employees have not been eligible for inclusion under this program since February 1987. Eligible individuals are able to continue primary medical coverage under Wilson's group insurance programs until reaching the age of 65 at which time such coverage becomes secondary for participants electing to remain in the program. Participating retirees are required to contribute a portion of the insurance premiums under the program with Wilson responsible for any costs in excess of those contributions.
In 1998, the Company adopted the disclosure requirements of SFAS No. 132. 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.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Assumptions used for financial reporting purposes to compute net benefit expense and its components are as follows:
The health care cost trend rate assumption can have a significant effect on the amounts reported. An increase of one percentage point in the health care cost trend rate would increase the accumulated postretirement benefit obligation and the aggregate of the service and interest cost components of the postretirement benefits expense by $3.0 million and $0.1 million, respectively. A decrease of one percentage point in the health care cost trend rate would decrease the accumulated postretirement benefit obligation and the aggregate of the service and interest cost components of the postretirement benefits expense by $2.4 million and $0.1 million, respectively.
13. RETIREMENT PLANS
The Company established the Smith International, Inc. 401(k) Retirement Plan (the "Plan") for the benefit of all eligible employees. Employees may voluntarily contribute up to 12 percent of compensation, as defined, to the Plan. The Company makes retirement, matching and, in certain cases, discretionary matching contributions to each participant's account under the Plan. Participants receive a full match of the first 1 1/2 percent of their contributions along with a retirement contribution ranging from 2 percent to 6 percent of their qualified compensation. In addition, the Board of Directors may provide discretionary matching contributions based upon financial performance to participants who are employed by the Company on December 31. The Company's contributions to the Plan totaled approximately $5.1 million, $6.9 million and $4.9 million in 1998, 1997 and 1996, respectively.
M-I has a Company Profit-Sharing and Savings Plan (the "M-I Plan") under which participating employees may defer up to 12 percent of their compensation, as defined. Under the terms of the M-I Plan, qualified employees are eligible to receive basic, matching and profit-sharing contributions with the approval of the Employee Benefits Committee, and in certain instances, the Board of Directors. Participants are eligible to receive a basic contribution equal to 3 percent of qualified compensation, and a full match of the first 1 1/2 percent of their contributions. In addition, the Board of Directors may provide discretionary profit-sharing contributions based upon financial performance to participants who are employed by M-I on December 31. Total contributions under the M-I Plan approximated $4.0 million in 1998, $5.0 million in 1997 and $4.2 million in 1996.
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, 1998 were immaterial.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
14. INDUSTRY SEGMENTS AND INTERNATIONAL OPERATIONS
During 1998, the Company adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which modifies the required disclosures for operating segments of a business.
Although the Company provides products to the petrochemical industry and certain industrial markets, over 90 percent of the Company's revenues are derived from sales to the oil and gas exploration and production industry. Accordingly, the Company operates in one reportable segment which consists of five business units - M-I Fluids, M-I SWACO, Smith Bits, Smith Drilling & Completions and Wilson Supply. These operations primarily manufacture and sell products and provide services used in the drilling, completion, production and maintenance of oil and gas wells. The principal markets for this segment include all major oil and gas producing regions of the world including North America, Latin America, Europe/Africa, the Middle East and the Far East. The Company's customers include major multi-national, independent and national, or state-owned, oil companies.
The following table presents consolidated revenues by country:
The following table presents the net long-lived assets by country:
The Company's revenues are derived principally from uncollateralized sales to customers in the oil and gas industry. This industry concentration has the potential to impact the Company's exposure to credit risk, either positively or negatively, because customers may be similarly affected by changes in economic or other conditions. The creditworthiness of this customer base is strong, and the Company has not experienced significant credit losses on such receivables.
15. 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 $24.9 million, $20.2 million and $16.2 million in 1998, 1997 and 1996, respectively.
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Future minimum payments under all non-cancelable operating leases having initial terms of one year or more are as follows:
Litigation
On October 29, 1996, the Company was served with a complaint in the U.S. District Court entitled Rock Bit International, Inc. v. Smith International, Inc. This lawsuit is a patent infringement dispute alleging that drill bits made by the Company infringe a U.S. patent owned by Rock Bit International ("RBI") which was issued on September 8, 1992. RBI alleges that the Company infringes its patent by making and selling certain three-cone rock bits having cutting structures covered by the claims of RBI's patent. The Company commenced discovery in late 1997 and has continued through late 1998. The Company is vigorously contesting this lawsuit and believes that it does not infringe the RBI patent and that the patent is invalid.
The Company is a defendant in various other legal proceedings arising in the ordinary course of business. In the opinion of management, these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations.
Environmental
Although the Company believes it is in substantial compliance with environmental protection laws, estimating the costs of compliance with these regulations is difficult considering the continual changes in environmental legislation.
The Company is involved in several actions relating to alleged liability in connection with the U.S. Environmental Protection Agency's ("EPA") National Priorities List ("NPL") sites. The Company has been named as a potentially responsible party ("PRP") in the four NPL sites discussed below. Federal law generally imposes joint and several liability for site clean-up costs investigated under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (the "Superfund Act") without regard to fault or site ownership considerations.
Sheridan. The Company has been named a PRP in connection with the Sheridan Disposal Services Superfund site in Hempstead, Texas. On August 28, 1997, the Company reached a settlement and agreed to pay its allocable share of response costs incurred, with such share limited to the lesser of $3.0 million or 2.93 percent of actual response costs. Based upon an EPA Record of Decision, total remediation costs are estimated at approximately $28 million. On this basis, the Company's share would equal $0.8 million after taking into consideration amounts previously contributed.
Operating Industries. The Company is currently negotiating a settlement related to the Operating Industries, Inc. ("OII") Superfund site located in Monterey Park, California. During 1998, the Company received a de minimus settlement offer from the EPA to discharge existing and future obligations related to OII site response costs. The Company expects to make future contributions of approximately $0.2 million to cover its allocable share of site remediation costs.
Chemform. The Company has also been named a PRP in connection with the contamination of property located in Pompano Beach, Florida. In 1996, the EPA sought to collect approximately $0.8 million in response and oversite costs from the PRPs, of which the Company's share would have approximated $0.4 million. The Company and the other PRPs are contesting this claim and are requesting additional information.
Casmalia. During 1998, the Company was named a PRP in connection with a Superfund site located in Santa Barbara County, California. Although the Company has received a settlement offer from the EPA approximating $0.5 million,
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
it intends to scrutinize and, if necessary, contest the amounts sought due to the disproportionate allocation of costs under the settlement.
At December 31, 1998, the remaining recorded liability for estimated future clean-up costs for the sites discussed above as well as properties currently or previously owned or leased by the Company was $2.9 million. The Company believes that none of its clean-up obligations will result in liabilities having a material adverse effect on the Company's consolidated financial position or results of operations.
16. SUBSEQUENT EVENTS
Subsequent to December 31, 1998, the Company announced the signing of a definitive agreement with Schlumberger Limited ("Schlumberger") related to the combination of the M-I and Schlumberger Dowell Drilling Fluid operations under a joint venture arrangement in which the Company would own 60 percent. The agreement requires Schlumberger to contribute certain assets to the joint venture and pay cash consideration of $280.0 million to the Company in exchange for a 40 percent minority ownership interest in the combined operations. The transaction is expected to close early in the second quarter of 1999 and is subject to, among other conditions, approval by the governmental and regulatory entities in the U.S. There are no assurances as to whether this transaction will be ultimately consummated.
The Company is also negotiating a definitive agreement with Conemsco, Inc. ("Conemsco") related to the combination of certain operations to form an oilfield distribution and supply joint venture in which the Company would own 80 percent. The agreement requires Conemsco to contribute its distribution operations and its ownership interest in CE Franklin Ltd. in exchange for an interest in the combined operations. Additionally, the Company is required to pay cash consideration determined under the terms of the agreement in order to purchase a portion of Conemsco's ownership interest. The transaction is expected to close early in the second quarter of 1999 and is subject to approval by the Board of Directors of both companies. There are no assurances as to whether this transaction will be ultimately consummated.
17. QUARTERLY INFORMATION (UNAUDITED)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information concerning directors of the Registrant, see the information set forth following the caption "ELECTION OF DIRECTORS" in the Company's definitive proxy statement to be filed no later than 120 days after the end of the fiscal year covered by this Form 10-K (the "Proxy Statement"), which information is incorporated herein by reference. For information concerning executive officers of the Registrant, see Item 4A appearing in Part I of this Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth following the caption "EXECUTIVE COMPENSATION" in the Company's Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth following the captions "ELECTION OF DIRECTORS" and "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" in the Company's Proxy Statement is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth following the captions "ELECTION OF DIRECTORS" and "EXECUTIVE COMPENSATION" in the Company's Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) FINANCIAL STATEMENTS
All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements or notes thereto.
(3) EXHIBITS AND INDEX TO EXHIBITS
3.l - Restated Certificate of Incorporation of the Company as amended to date. Filed as Exhibit 3.1 to the Company's report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference.
3.2 - Bylaws of the Company as amended to date. Filed as Exhibit 3.1 to the Company's report on Form 8-K dated August 13, 1998 (and filed on August 14, 1998) and incorporated herein by reference.
4.1 - Rights Agreement, dated as of June 19, 1990, between the Company and First Chicago Trust Company of New York. Filed as Exhibit 4.1 to the Company's report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.
4.2 - Form of Indenture between the Company and The Bank of New York, as Trustee. Filed as Exhibit 4.1 to the Company's Registration Statement on Form S-3 dated August 22, 1997 and incorporated herein by reference.
4.3 - Form of Note. Filed as Exhibit 4.2 to Amendment No. 1 to the Company's Registration Statement on Form S-3 dated September 9, 1997 and incorporated herein by reference.
9. - Not applicable.
10.1 - Smith International, Inc. Supplemental Pension Plan as amended to date. Filed as Exhibit 10.1 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.2 - Smith International, Inc. 1989 Long Term Incentive Compensation Plan, as amended to date. Filed as Exhibit 10.3 to the Company's report on Form 10-K for the year ended December 31, 1994 and incorporated herein by reference.
10.3 - Smith International, Inc. Directors' Retirement Plan as amended to date. Filed as Exhibit 10.4 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.4 - Smith International, Inc. Supplemental Executive Retirement Plan, as amended. Filed as Exhibit 10.5 to the Company's report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference.
10.5 - Supply Agreement dated April 2, 1987 between the Company and TCM Holding Corporation and Rogers Tool Works, Inc. for the supply of tungsten carbide products. Filed as Exhibit 10.6 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.6 - Amendment to Supply Agreement dated January 22, 1993 between the Company and Rogers Tool Works, Inc. Filed as Exhibit 10.7 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.7 - Supply Agreement dated October 1, 1989 between the Company and Amforge-Smith Forge Company for the supply of forgings. Filed as Exhibit 10.8 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.8 - Employment Agreement dated December 10, 1987 between the Company and Douglas L. Rock. Filed as Exhibit 10.11 to the Company's report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference.
10.9 - Employment Agreement dated January 2, 1991 between the Company and Neal S. Sutton. Filed as Exhibit 10.11 to the Company's report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.
10.10 - Employment Agreement dated May 1, 1991 between the Company and Richard A. Werner. Filed as Exhibit 10.12 to the Company's report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference
10.11 - Amendment to Employment Agreement dated October 16, 1989 between the Company and Douglas L. Rock. Filed as Exhibit 10.14 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.12 - Amendment to Employment Agreement dated January 2, 1991 between the Company and Neal S. Sutton. Filed as Exhibit 10.16 to the Company's report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.
10.13 - Amendment to Employment Agreement dated May 1, 1991 between the Company and Richard A. Werner. Filed as Exhibit 10.17 to the Company's report on Form 10-K for the year ended December 31, 1996 and incorporated herein by reference.
10.14 - First Amendment to Amendment to Employment Agreement dated November 12, 1992 between the Company and Doug Rock. Filed as Exhibit 10.18 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.15 - First Amendment to Amendment to Employment Agreement dated November 12, 1992 between the Company and Neal S. Sutton. Filed as Exhibit 10.20 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.16 - First Amendment to Amendment to Employment Agreement dated November 12, 1992 between the Company and Dick Werner. Filed as Exhibit 10.21 to the Company's report on Form 10-K for the year ended December 31, 1995 and incorporated herein by reference.
10.17 - Long-Term Incentive Bonus Agreement dated November 11, 1997 between the Company (as successor in interest to Wilson Industries, Inc.) and Michael R. Chaddick.
10.18 - Note Agreement, dated as of May 21, 1996, between the Company and Principal Mutual Life Insurance Company, John Hancock Mutual Life Insurance Company, John Hancock Variable Life Insurance Company, IDS Certificate Company, Mellon Bank, N.A., as Trustee for AT&T Master Pension Trust and The Maritime Life Assurance Company. Filed as Exhibit 10.3 to the Company's report on Form 10-Q for the quarter ended June 30, 1996 and incorporated herein by reference.
10.19 - First Amendment and Waiver dated as of May 5, 1997, between the Company and Principal Mutual Life Insurance Company, John Hancock Mutual Life Insurance Company, John Hancock Variable Life Insurance Company, IDS Certificate Company, Mellon Bank, N.A., as Trustee for AT&T Master Pension Trust and The Maritime Life Assurance Company.
10.20 - Second Amendment dated as of July 31, 1998, between the Company and Principal Mutual Life Insurance Company, John Hancock Mutual Life Insurance Company, John Hancock Variable Life Insurance Company, IDS Certificate Company, Mellon Bank, N.A., as Trustee for AT&T Master Pension Trust and The Maritime Life Assurance Company.
10.21 - Loan Agreement dated as of April 4, 1996, by and among the Company and Texas Commerce Bank National Association, a national banking association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.1 to the Company's report on Form 10-Q for the quarter ended June 30, 1996 and incorporated herein by reference.
10.22 - Loan Agreement dated as of April 4, 1996, by and among M-I Drilling Fluids Company, L.L.C., Texas Commerce Bank National Association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.2 to the Company's report on Form 10-Q for the quarter ended June 30, 1996 and incorporated herein by reference.
10.23 - First Amendment to Loan Agreement dated April 8, 1997, by and among the Company and Texas Commerce Bank National Association, a national banking association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.1 to the Company's report on Form 10-Q for the quarter ended June 30, 1997 and incorporated herein by reference.
10.24 - First Amendment to Loan Agreement dated April 8, 1997, by and among M-I Drilling Fluids, L.L.C., Texas Commerce Bank National Association, a national banking association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.2 to the Company's report on Form 10-Q for the quarter ended June 30, 1997 and incorporated herein by reference.
10.25 - Second Amendment to Loan Agreement dated December 23, 1997, by and among the Company and Texas Commerce Bank National Association, a national banking association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.27 to the Company's report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.
10.28 - Second Amendment to Loan Agreement dated December 23, 1997, by and among M-I Drilling Fluids, L.L.C., Texas Commerce Bank National Association, a national banking association, individually and as Agent, and the other financial institutions parties thereto. Filed as Exhibit 10.28 to the Company's report on Form 10-K for the year ended December 31, 1997 and incorporated herein by reference.
11. - Not applicable.
12. - Not applicable.
13. - Not applicable.
18. - Not applicable.
19. - Not applicable.
21.1. - Subsidiaries of the Company
23.1 - Consent of Independent Public Accountants.
27.1 - Financial Data Schedule for the twelve months ended December 31, 1998.
27.2 - Restated Financial Data Schedule for the twelve months ended December 31, 1997.
(B) REPORTS ON FORM 8-K.
The registrant filed a Form 8-K dated November 16, 1998 reporting under "Item 2. Acquisition or Disposition of Assets" and "Item 7. Financial Statements and Exhibits" required disclosure related to the acquisition of the remaining 36 percent interest in M-I from Halliburton.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
To Smith International, Inc.:
We have audited, in accordance with generally accepted auditing standards, the consolidated balance sheets of Smith International, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 1998, included in this Form 10-K, and have issued our report thereon dated January 29, 1999. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The financial statement schedule listed in Part IV, Item 14(A)(2) for Smith International, Inc. and subsidiaries is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This financial statement schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Houston, Texas January 29, 1999
SCHEDULE II
SMITH INTERNATIONAL, INC.
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS)
(a) Amounts represent accounts receivable reserves related to acquisitions made by the Company during the years presented.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SMITH INTERNATIONAL, INC.
By: /s/ DOUGLAS L. ROCK ------------------------------------- Douglas L. Rock Chief Executive Officer, President and Chief Operating Officer
March 31, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities on the date indicated:
INDEX TO EXHIBITS