SMITH INTERNATIONAL INC, 10-K405, 1997-03-21

SMITH INTERNATIONAL INC
10-K405, 1997-03-21
MISCELLANEOUS CHEMICAL PRODUCTS

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

(MARK ONE)

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

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

COMMISSION FILE NUMBER 1-8514

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

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

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

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

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

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

The aggregate market value of the voting stock held by non-affiliates on
March 13, 1997 was $1,774,052,865 (39,423,397 shares at the closing price on
the New York Stock Exchange of $45.00). For this purpose all shares held by
officers and directors and their respective affiliates are considered to be
held by affiliates, but neither the registrant nor such persons concede that
they are affiliates of the Registrant.

There were 40,199,788 shares of common stock outstanding at March 13,
1997.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement related to the Registrant's 1997 Annual
Meeting of Shareholders are incorporated by reference into Part III of this
Form 10-K.

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PART I

ITEM 1. BUSINESS

GENERAL

Smith International, Inc. ("Smith" or the "Company") was incorporated in
the State of California in January 1937 and reincorporated under Delaware law
in May 1983. The Company is a leading worldwide supplier of products and
services to the oil and gas drilling and production industry. Smith produces
and markets drilling fluids and systems through its majority-owned subsidiary,
M-I Drilling Fluids L.L.C. ("M-I"). Smith also manufactures and markets
technologically-advanced drill bits through its Smith Tool and Smith Diamond
Technology units and manufactures and markets drilling and completion products
and services through its Smith Drilling & Completions unit. Approximately 98
percent of the Company's revenues are derived from the oil and gas drilling and
production industry with the remainder related to the mining and industrial
markets.

The Company's business units supply products and provide services to the
petroleum services segment. The information regarding business segments and
U.S. and non-U.S. operations appears in Note 11 of the Notes to Consolidated
Financial Statements included elsewhere in this Form 10-K.

ACQUISITIONS AND DISPOSITIONS

The Company has acquired and disposed of certain assets during the past
five years. A description of the material transactions follows.

Acquisitions of A-Z/Grant and Lindsey Completion Systems

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

Acquisition of M-I Drilling Fluids 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.

Acquisition of The Red Baron 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.

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Sale of Directional Drilling Business

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

INDUSTRY OVERVIEW

Substantially all of the Company's products and services are used in the
process of drilling oil and natural gas wells. Therefore, the level of drilling
activity is a useful general indicator of the demand for the products and
services of the Company at any given time. The level of drilling activity is
determined by a variety of factors over which the Company has no control,
including the current and anticipated market price of crude oil and natural
gas, the production levels of the Organization of Petroleum Exporting Countries
("OPEC") and other oil and gas producers, the regional supply and demand for
oil and natural gas, the level of worldwide economic activity and the long-term
effect of worldwide energy conservation measures. The worldwide average rig
count increased approximately 7 percent from 1,713 in 1995 to 1,842 in 1996.

Management anticipates that total worldwide drilling activity will
continue to increase from historical activity levels; however, the rate of
growth may be lower than the 1996 growth rate. The average worldwide rig count
increased approximately 7 percent over 1995 levels due to strong North American
growth which was driven by higher U.S. land rig activity and record Canadian
activity levels. The 1997 worldwide rig count is expected to increase from 1996
levels due to higher non-U.S. rig count activity, primarily in Latin America
and the Middle and Far East geographic regions.

BUSINESS OPERATIONS

M-I Drilling Fluids L.L.C.

Products and Services. Through its majority-owned subsidiary M-I, the
Company provides drilling fluids systems, products and technical services to
end users engaged in drilling oil, natural gas and geothermal wells worldwide.
Drilling fluid products and systems are used to cool and lubricate the bit
during drilling operations, contain formation pressures, keep rock cuttings in
suspension to remove them from the hole and maintain the stability of the
wellbore. Technical services are provided to ensure that the products and
systems are applied effectively to optimize drilling operations. These services
include recommending products and systems during the well planning phase,
testing drilling fluid properties and recommending adjustments during the
drilling phase and analyzing well results after the well is completed to
improve the performance of wells to be drilled in the future.

M-I offers water-base, oil-base and synthetic-base drilling fluid systems.
These are chemically complex systems comprised of a number of products designed
to ensure that the diverse functions of the fluid are met. Weighting agents,
composed of high specific gravity materials such as barite and hematite are
added to drilling fluid systems to increase their density. When drilling
through pressurized zones, the added weight creates hydrostatic pressures that
hold back formation pressures and prevent an influx of fluids from the
formation into the hole. Thickening agents, or viscosifiers, produce the
viscosity needed to remove the cuttings from the bit and provide adequate gel
strength to suspend the cuttings when circulation is interrupted. Bentonite, a
naturally occurring clay, is the most widely used viscosifier. Polymers are
used to control viscosity and gel strengths and for thinning a fluid that has
become too thick from formation cuttings. Loss circulation materials, such as
fibers, flakes and shells, plug pores in the formation to prevent the loss of
the drilling fluid system into the formation. Finally, specialty products are
used in certain circumstances to complement the base products, acting to reduce
torque and drag, free stuck pipe and add or enhance temperature stability.

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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.

In June 1996, M-I completed the acquisition of Anchor, one of the largest
suppliers of products and services in the global drilling fluids industry. The
acquisition strengthened M-I's market position in the Eastern Hemisphere
drilling fluids market, most notably, in the North Sea and West African
markets; expanded M-I's offering in synthetic and advanced water-base fluid
designs; and provided an additional laboratory and technical support facility
to complement its primary facility in Houston, Texas.

During 1996, M-I also completed the construction of completion fluid
mixing and storage facilities at several of its major U.S. supply bases to
serve the Gulf Coast completion fluid market. 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 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.

In September 1996, M-I finalized a joint venture agreement with Sonatrach,
the state oil company of Algeria. This joint venture, M-I Algeria S.P.A., will
supply an extensive line of drilling, completion and workover fluids as well as
advanced production chemicals. It will also provide products and technical
service support in fluids engineering, solids control and waste minimization
technologies, including the environmentally-responsible disposal of fluid
wastes. As the major shareholder in the joint venture, M-I hopes to achieve a
stronger, long-term presence in Algeria, one of the world's fastest growing
regions in the foreseeable future for exploration and production.

M-I's geothermal/air drilling operations provide air drilling services to
the geothermal, oil and natural gas drilling markets. These services include
the rental of high-volume, high-pressure compressors and related equipment,
along with expert technical support and fluid products associated with air
drilling.

M-I's Federal Wholesale and Industrial Products group specializes in
marketing drilling fluids products and chemicals to the waterwell, mining,
trenchless technology, general industrial, construction and foundry industries.
Federal also provides wholesale drilling fluid products to other drilling fluid
suppliers and large-quantity long-term product tenders to operators who require
products without engineering services.

Through its Swaco operations, a complete line of solids control, pressure
control, rig instrumentation and waste remediation 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 dominant
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.

With the acquisition of Baker Hughes Treatment Services in January 1995,
Swaco expanded its role as a leading supplier of waste minimization and product
recovery services to the oilfield industry. These services include location
management services, including the monitoring of waste fluids and solids and
the design and maintenance of reserve pits and ditches at the drilling
location. Swaco also provides waste treatment services, such as water
treatment, dewatering and the slurrification/solidification of contaminated
wastes; and waste disposal services, including land farming or bioremediation
of drilling waste, thermal desorption, annular injection and trenching/burial
services.

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

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

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

Smith Tool

Products. The Company offers drill bits under the Smith Tool(TM) and Smith
Mining(TM) product lines. The Smith Tool unit designs, manufactures and markets
drill bits used in drilling oil and gas wells and mining applications. Drill
bit sizes range from 3 1/2 to 28 inches in diameter for the petroleum industry
and from 2 15/16 to 16 inches in diameter for the mining industry. Most bits
manufactured by the Company are three-cone drill bits. The surfaces of the
cones are comprised of different types of pointed structures that are referred
to as "cutting structures" or "teeth." The cutting structures are either an
integral part of the steel cone with a hardmetal applied surface (referred to
as "milled tooth") or made of an inserted material (referred to as "insert")
which is usually tungsten carbide. 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. The Company is the only
manufacturer offering this product on a commercial basis.

The cutting structures in mining bits are principally tungsten carbide
inserts. Mining bits are typically utilized for shallow drilling to place
explosives for blasting in open pit mining operations. Other mining bits using
both tungsten carbide and diamond enhanced inserts have been designed for use
with air driven percussion tools and are known as hammer bits.

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

Smith Drilling & Completions

Products and Services. The Smith Drilling & Completions business unit
manufactures and markets product lines under the following names: Drilco/Grant,
A-Z/Servco, Smith Red Baron and Lindsey Completion Systems. In general, all
product lines are manufactured, marketed, sold and maintained by the same
management, operations and sales personnel operating out of 29 locations
outside the U.S. and 19 U.S. locations. Houston, Texas is the sales,
management, engineering and manufacturing headquarters for this business unit.

The Drilco/Grant product group includes rotating drilling heads, automatic
connection torque monitoring and control systems, downhole drilling tools,
tubular drill string components, drilling tool inspection products and services
and machine shop services. The rotating drilling heads are rented and sold to
the end users primarily in air drilling areas

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and in underbalanced drilling areas. The downhole tools are sold or rented to
the end users and include stabilizers to centralize the drill string and
reamers to maintain a uniform hole diameter.

The tubular products, manufactured under the Drilco/Grant product group,
include: drill collars, to provide drilling weight to the bit; Hevi-Wate(TM)
drill pipe, to provide stress transition between drill collars and conventional
drill pipe or to provide drilling weight to the bit in horizontal drilling;
connecting subs, to attach drill string members of differing diameters and
connections; and kellys, to rotate the drill string on conventional drilling
rigs.

The A-Z/Servco and Smith Red Baron product groups provide downhole
remedial, re-entry and fishing tools for use in connection with the drill
string for specialized drilling and workover operations. 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). These products provide a sidetrack or section milling
operation to remove a section of casing permitting the well to be re-drilled
using the existing casing slot. In addition the product groups provide hole
opening and underreaming services to enlarge the wellbore to allow for annular
area for proper cementing of the casing or for gravel pack displacement; packer
milling to remove production packers; conventional milling to remove wellbore
obstructions; mechanical, hydraulic and explosive pipe cutting to remove casing
during a well abandonment; and fishing services to remove wellbore obstructions
during workover operations, including coil tubing operations.

The Lindsey Completion Systems product line includes liner hangers,
cementing products and tools, liner top packers and tie-back equipment, setting
tools, plus the service personnel to supervise the running and setting of the
necessary liner and completion products. These products are used primarily in
deep wells and in critical well completions because of the technological
advantage.

The Company maintains field service centers which provide inspection and
repair services of the Company's drill string components, customer-owned
tubular goods and for the Company's rental tools and services. These field
service centers also serve as the distribution points for all the Smith
Drilling & Completions' products and are an important part of the Company's
marketing efforts.

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

Smith Diamond Technology

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

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

INTERNATIONAL OPERATIONS

Sales to the oil drilling markets outside the U.S. are a key strategic
focus of Smith management. The Company markets its products and services
through its subsidiaries, joint ventures and sales agents in virtually all
petroleum producing areas of the world, including Canada, the North Sea/Europe,
the Middle East, Latin America, Asia/Pacific and Africa. As a result, 61
percent of the Company's total revenues in 1996 were generated from sales in
non-U.S. markets, compared to 59 percent in 1995.

Historically, drilling activity outside the U.S. has been less volatile
than in the U.S. due to the relatively high costs of exploration and
development programs which can only be undertaken by major oil companies,
consortiums and national oil companies. These entities operate under longer
term strategic priorities than do the independent drilling operators that are
more common in the U.S. market.

SALES AND DISTRIBUTION

The Company markets its products on a worldwide basis, employing Company
personnel and independent sales agents. In addition, independent distributors
and unconsolidated joint ventures market the Company's products in many
locations. Sales efforts are also directed to end users in the drilling and
completion industry including independent drilling contractors, major and
independent oil companies and national oil companies.

The Company's sales force is supported by field service centers worldwide.
The Company considers that its worldwide sales position has been significantly
enhanced by its field service centers presently maintained in every major oil
and gas producing area. These field service centers serve as bases for the
sales force and rental tool operations and also provide an opportunity to
market a wider range of the Company's products than could be marketed by a
sales office. The Company's field service centers are also important factors in
maintaining good customer relations since they are designed primarily for
repair and maintenance of drill string components and rental tools.

MANUFACTURING

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

Management believes that it has sufficient existing manufacturing capacity
to meet anticipated demand for its products and services.

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.

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The Company purchases a variety of raw materials for its Smith Tool, Smith
Diamond Technology and Smith Drilling & Completions units, including alloy and
stainless steel bars, tungsten carbide inserts and forgings. Generally, the
Company is not dependent on any single source of supply for any of its raw
materials or purchased components. The Company purchases a significant amount
of tungsten carbide inserts and U.S. forging requirements from two suppliers
under separate supply agreements. The Company believes that numerous
alternative supply sources are available for all such materials. The Company
produces PDC in Provo, Utah; Grenoble, France; and Scurelle, Italy for
utilization in various Company products as well as direct customer sales. The
Company believes that it enjoys a competitive advantage in the manufacture of
diamond drill bits because it is the only diamond drill bit manufacturer
producing its own PDC.

PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS

The M-I business unit maintains an aggressive research and development
effort, reflecting the market's demands for better performance in the more
hostile drilling environments and the heightened concern over protecting the
environment where drilling and completion operations are conducted. Through its
research facilities in Houston, Texas; Stavanger, Norway; and Bogota, Colombia,
it provides basic research, testing and technical support for its field
engineers. Its environmental services group evaluates and monitors toxicity
data and safe material handling procedures on all of its products, enabling the
customer to design a drilling program that is environmentally responsible and
safe.

M-I's focus on research and development has led to the development and
introduction of several new drilling fluids products, systems and services,
most notably, FLO-PRO(TM), the family of NOVA(TM) systems, VIRTUAL
HYDRAULICS(TM), KLA-GARD(TM) and DRIL-KLEEN(TM). The FLO-PRO system is a
rheologically-engineered water-base system designed to drill the productive
interval of horizontal and highly-deviated wells. The non-damaging character of
a FLO-PRO system, coupled with its cuttings suspension and transport
performance, results in reduced drilling and completion costs as well as
maximum reservoir productivity. In the summer of 1995, FLO-PRO's contribution
was formally recognized by the drilling industry when it was awarded Petroleum
Engineer International's Special Meritorious Award for Engineering Innovation.

The NOVA family includes NOVADRIL(TM), NOVAPLUS(TM) and NOVATEC(TM), which
together comprise M-I's olefin-base non-toxic invert emulsion drilling fluids
systems. These systems offer many of the performance advantages of conventional
fluid systems but, because they are man-made olefins and contain no aromatics
or other Clean Water Act priority pollutants, they avoid the environmental
problems associated with using diesel oil. NOVA systems have been successfully
used in all sectors of the North Sea, Australia and the U.S. Gulf of Mexico,
particularly in the Gulf's emerging deepwater frontiers where drilling
performance and environmental quality are paramount.

VIRTUAL HYDRAULICS is an advanced engineering software tool designed to
simulate the effects of temperature and pressure on the viscosity and
circulating densities for oil- and synthetic-base drilling fluid systems. An
understanding of synthetic fluid rheology is a critical element in the
operator's plan to prevent the loss of fluid to the formation, thereby reducing
overall drilling costs.

With the acquisition of Anchor, M-I expanded its synthetic technology to
include AQUAMUL II(TM), an acetal base fluid that offers hydraulics and hole
cleaning capabilities, high temperature stability and lubricity and
contamination tolerance. This technology provides M-I with one of the most
complete lines of synthetic systems in the drilling fluids industry. Anchor
also contributed GLYDRIL 2000(TM), a glycol-base polymer fluid system designed
for highly water-sensitive shales. Like AQUAMUL II, this system strengthens
M-I's line of premium drilling fluid systems.

KLA-GARD is a shale stabilizer that reduces the swelling of
water-sensitive or thick "gumbo" shales that inhibit drilling performance. The
DRILL-KLEEN detergent is a concentrated, low-toxicity additive designed to
prevent bit- and bottom-hole assembly balling in all water-base drilling
fluids, promoting higher rates of penetration in drilling operations.

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The Smith Tool, Smith Drilling & Completions and Smith Diamond Technology
units maintain product development and engineering departments
whose activities are directed to developing new products and processes,
improving existing product lines and designing specialized products to meet
customer requirements. Experimental work in metallurgy also comprises a
significant portion of the work of these departments. For example, recent new
product developments include: the Magnum(TM) line of rock bits, tungsten carbide
insert and milled tooth Spinodal(TM) bearing roller cone bits, Diamond Enhanced
Insert roller cone bits, steerable motor PDC and roller cone bits; Diamond
Enhanced Stabilizers; Twin Edge(TM), Geo-Grid(TM), GeoCoat(TM) and Sonic(TM)
cutters for PDC drill bits and Diamond Enhanced Impax(TM) hammer bits; the
Servco Millmaster(TM) carbide cutting structure; the Trackmaster(TM) one trip
side tracking system; and the Servco Superdome(TM) PDC underreamers and hole
openers. In recent years, the Company has received special meritorious awards
for engineering innovations from Petroleum Engineer International magazine. One
such award was for the placement of PDC on curved surfaces for rock bit cutting
structures, underreamers and hole openers while another was for the development
of a new hardfacing material for use on milled tooth drill bits.

The Company also maintains a drill bit data base which records the
performance of substantially all drill bits used in the U.S. over the last 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 with product development. Management believes this
proprietary data base gives the Company a competitive advantage in the drill
bit business.

The Company has historically maintained its research and engineering
expenditures at a high level to enable it to maintain its technological and
performance leadership and to broaden its product lines. The Company's
expenditures for research and engineering activities amounted to $27.8 million
in 1996, $21.4 million in 1995 and $14.6 million in 1994. In 1996, research and
engineering expenditures approximated 2.4 percent of revenues.

Although the Company has over 650 patents and regards its patents and
patent applications as important in the operation of its business, it does not
believe that any significant portion of its business is materially dependent
upon any single patent or group of patents or generally upon patent protection.

EMPLOYEES

At December 31, 1996, the Company had 5,975 full time employees throughout
the world. Most of the Company's employees in the United States 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.

8
<PAGE> 10

ITEM 2. PROPERTIES

The principal facilities and properties utilized by the Company at
December 31, 1996 are shown in the table below. Generally the facilities and
properties are owned by the Company with the exception of the Grenoble, France
location.

<TABLE>
<CAPTION>
Approx.
Principal Products Processed Land Bldg. Space
Location or Manufactured (Acres) (sq. ft.)
- -------- --------------- ------- ---------
<S> <C> <C> <C>
M-I Drilling Fluids Unit:
Greybull, Wyoming .......... Bentonite mine and processing 8,394 110,000
Appleton, Wisconsin ........ Drilling fluid chemical products 10 93,000
Wharton County, Texas ...... Drilling fluid chemical products 100 61,000
Milos, Greece .............. Bentonite mine and processing 124 55,000
Karmoy, Norway ............. Barite and bentonite processing 5 51,000
Greystone, Nevada .......... Barite mine and processing 268 50,000
Battle Mountain, Nevada .... Barite processing 23 43,000
Zelmou, Morocco ............ Barite mine 3,954 41,000
Zavalla, Texas ............. Drilling fluid chemical products 33 36,000
Amelia, Louisiana .......... Barite processing 26 25,000
Galveston, Texas ........... Barite processing 6 21,000
Aberdeen, Scotland ......... Barite and bentonite processing 2 12,000
Foss/Aberfeldy, Scotland ... Barite mine and processing 102 10,000
Westlake, Louisiana ........ Barite processing 3 --

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

The Company considers its mines and manufacturing and processing
facilities to be in good condition and adequately maintained. Due to a
historical downturn that occurred in the business, the Company's manufacturing
facilities operated below capacity. A portion of the U.S. facilities are
currently being held for sale by the Company.

9
<PAGE> 11

ITEM 3. LEGAL PROCEEDINGS

Executive Life

On March 4, 1992, the Company was served with a complaint in the U.S.
District Court in the Central District of California, entitled Lynn Martin,
Secretary of the U.S. Dept. of Labor v. Smith International, Inc., et al.,
which alleged violations of the Employee Retirement Income Security Act of 1974
("ERISA") arising out of the Company's purchase of Executive Life Insurance
Company ("Executive Life") annuities. Executive Life was placed in
conservatorship in 1991 by the California Insurance Commissioner and has since
emerged from conservatorship as Aurora National Life Assurance Company, Inc.
("Aurora"). Aurora will honor in part Executive Life's past and continuing
commitments under the annuities outstanding; however, a portion of these
obligations will not be paid. In December 1994, the parties agreed in principle
to a settlement. Pursuant to a consent order, the Company paid $4.07 million
into an escrow account, the majority of which was paid by the Company's
insurance carrier. The Company recognized its portion of the settlement of
approximately $1.0 million in 1994. The settlement is on deposit in the escrow
account and the parties have agreed on the amount and manner of the
distributions to the Plan participants, however, the timing is subject to a
court hearing. In the opinion of management, this matter will not have a
material adverse effect on the Company's consolidated financial condition or
results of operations.

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

Sheridan. On March 31, 1987, the Sheridan Site Committee (the "Committee")
filed a claim on behalf of itself and 59 potentially responsible parties
("PRPs") at the Sheridan Disposal Services site in Hempstead, Texas, a NPL
site. The claim was based on the Company's alleged liability to the claimants
for "contribution and potential cost recovery for administrative and remedial
work" expenses incurred and to be incurred by them in connection with the
Sheridan Disposal site. On August 28, 1987, the Company reached a settlement
and agreed to pay its allocable share of response costs incurred by the
Committee, such share to be limited to the lesser of $3.0 million or 2.93
percent of actual response costs. Based upon an EPA Record of Decision ("ROD"),
total remediation costs are estimated, on a preliminary basis, to be
approximately $28 million. On this basis, the Company's share would be $0.8
million.

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

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

Chemform. The Company operated a business and held a leasehold interest in
property located in Pompano Beach, Florida (the "Chemform Site") between May
14, 1976 and March 16, 1979, at which time the Company sold the business and
assigned the lease. The EPA placed the Chemform Site on the NPL on October 4,
1989. On September 22, 1992, the EPA issued the ROD for a portion of the
Chemform Site. The ROD selected a "No Action with Monitoring" alternative,
under which groundwater would be monitored quarterly for at least one year.
Although the Company and two other PRPs have completed four quarters of
groundwater monitoring, the Florida Department of Environmental Protection
("Florida DEP") has requested that additional monitoring be performed. The
Company and two other PRPs are presently conducting discussions with the EPA
and the Florida DEP regarding whether additional

10
<PAGE> 12

monitoring work will be required and, if so, what the scope of such work will
be. The final scale of the monitoring work is not yet known. It is also not yet
known whether any groundwater remediation work will thereafter be required.

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

General Environmental. At December 31, 1996, the remaining recorded
liability for estimated future clean-up costs for the sites discussed above as
well as properties currently or previously owned or leased by the Company was
$3.6 million. As additional information becomes available, the Company may be
required to provide for additional environmental clean-up costs for Superfund
sites and for properties currently or previously owned or leased by the
Company. However, the Company believes that none of its clean-up obligations
will result in liabilities having a material adverse effect on the Company's
consolidated financial position or results of operations.

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

Not applicable.

11
<PAGE> 13

ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT

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

<TABLE>
<CAPTION>
NAME, AGE AND POSITIONS PRINCIPAL OCCUPATION DURING PAST FIVE YEARS
----------------------- -------------------------------------------
<S> <C>
Douglas L. Rock(50)................. Chairman of the Board since February
Chairman of the Board, 1991; Chief Executive Officer,
Chief Executive Officer, President and Chief Operating Officer
Operating Officer since March 1989.

Loren K. Carroll(53)................ President and Chief Executive Officer of
Executive Vice President and M-I Drilling Fluids, L.L.C. since March
Chief Financial Officer of the 1994; Executive Vice President and
Company; President and Chief Chief Financial Officer since October
Executive Officer of M-I 1992; member of the Board of Directors
Drilling Fluids L.L.C. since November 1987; President of the
Geneva Business Services and a Director
of Geneva Companies from March 1989 to
October 1992.

Neal S. Sutton(51).................. Senior Vice President--Administration
Senior Vice President-- since December 1994; Vice
Administration, General President--Administration from March
Counsel and Secretary 1992 to December 1994; Vice President,
Secretary and General Counsel of the
Company since January 1991.

John J. Kennedy(44)................. Vice President, Chief Accounting Officer
Vice President, Chief and Treasurer since March 1994;
Accounting Officer and Treasurer from May 1991 to March 1994.
Treasurer

D. Barry Heppenstall(50)........... President, Smith Tool since May 1994;
President, Smith Tool Vice President and General
Manager--Drill Bits from March 1992 to
May 1994; Vice President--Smith Tool
Manufacturing from September 1990 to
March 1992.

Richard A. Werner(55)............... President, Smith Drilling & Completions
President, Smith Drilling & since May 1994; Vice President and
Completions General Manager--Smith Drilling and
Completion Services from December 1993
to May 1994; Vice President and General
Manager--Drilco/Servco from March 1993
to December 1993; Vice President and
General Manager--Downhole Tools and
Services from May 1991 to March 1993.

Roger A. Brown(51).................. President, Smith Diamond Technology since
President, Smith Diamond April 1995; Vice President and General
Technology Manager, Eastern Hemisphere Operations,
Reda Pump Company, Division of Camco
International, Inc. from November 1993
to March 1995; President, Hycalog,
Division of Camco International, Inc.
from November 1990 to October 1993.
</TABLE>

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

12
<PAGE> 14

PART II

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

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

<TABLE>
<CAPTION>
COMMON STOCK
------------
HIGH LOW
---- ---
<S> <C> <C>
1995
First Quarter ...................................... 14 1/2 11
Second Quarter ..................................... 19 3/8 14
Third Quarter ...................................... 19 15 1/8
Fourth Quarter ..................................... 23 7/8 15
1996
First Quarter ...................................... 25 1/2 19 7/8
Second Quarter ..................................... 33 3/8 24 3/8
Third Quarter ...................................... 36 5/8 29 3/8
Fourth Quarter ..................................... 48 35 1/4
</TABLE>

On March 13, 1997, the Company had 3,146 Common Stock holders of record
and the last reported closing price on the New York Stock Exchange Composite
Tape was $45.00.

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.

13
<PAGE> 15

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues ............................ $1,156,658 $ 874,544 $ 653,901 $ 220,712 $ 210,669
Gross profit ........................ 392,062 292,540 221,274 79,963 71,535
Income from continuing
operations before litigation
settlement, interest and taxes .... 132,520 86,248 60,104 18,575 10,260

Income (loss) from continuing
operations before discontinued
operations and change
in accounting principle ........... 64,444 45,592 35,879 (3,995) 1,164
Income (loss) from discontinued
operations ........................ -- -- -- 73,623 (2,975)
Loss from change in accounting
principle ......................... -- -- -- (1,300) --
Net income (loss) ................... $ 64,444 $ 45,592 $ 35,879 $ 68,328 $ (1,811)

PER SHARE DATA:
Net income (loss) applicable to
common stock -
From continuing operations
before discontinued operations
and change in accounting
principle ....................... $ 1.62 $ 1.16 $ 0.92 $ (0.13) $ (0.02)
From discontinued operations ..... -- -- -- 1.95 (0.08)
From change in accounting
principle ....................... -- -- -- (0.03) --
---------- ---------- ---------- ---------- ----------
Net income (loss) ................ $ 1.62 $ 1.16 $ 0.92 $ 1.79 $ (0.10)
========== ========== ========== ========== ==========

BALANCE SHEET DATA:
Total assets ........................ $1,074,582 $ 702,844 $ 619,780 $ 348,386 $ 370,482

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

Total shareholders' equity .......... $ 368,536 $ 300,886 $ 253,121 $ 214,466 $ 149,785
</TABLE>

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

14
<PAGE> 16

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

GENERAL

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

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

Management anticipates that total worldwide drilling activity will
continue to increase from historical activity levels; however, the rate of
growth may be lower than the 1996 growth rate. The average worldwide rig count
increased approximately 7 percent over 1995 levels due to strong North American
growth which was driven by higher U.S. land rig activity and record Canadian
activity levels. The 1997 worldwide rig count is expected to increase from 1996
levels due to higher non-North American rig count activity, primarily in Latin
America and the Middle and Far East geographic regions. Management believes that
the Company's operations are well positioned to benefit from the expected
increase in non-North American oil and gas drilling activity.

Management also believes, with the increase in offshore rig dayrates and
other fixed costs, operators are shifting exploration and production spending
toward value-added, technology-based products which reduce the cost of their
overall drilling programs. Additionally, the significant level of
extended-reach drilling programs, which often involve more difficult drilling
conditions, increases the need for efficient products and services which reduce
both drilling time and formation damage. The Company continues to focus on
investing in the development of technology-based products which 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.

15
<PAGE> 17
RESULTS OF OPERATIONS

Revenues

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

Revenues by Area:

U.S .............................. $ 451,147 39 $ 358,392 41 $ 280,435 43
Export ........................... 71,470 6 50,454 6 56,421 9
Non-U.S .......................... 634,041 55 465,698 53 317,045 48
---------- ---- ---------- ---- ---------- ----
Total .......................... $1,156,658 100 $ 874,544 100 $ 653,901 100
========== ==== ========== ==== ========== ====

Average Annual Active Rig Count:

U.S .............................. 779 724 775
Canada ........................... 270 231 260
Non-North America ................ 793 758 734
---------- ---------- ----------
Total .......................... 1,842 1,713 1,769
========== ========== ==========
</TABLE>

16
<PAGE> 18

M-I Drilling Fluids L.L.C.

M-I Drilling Fluids, L.L.C. ("M-I"), which was acquired in February 1994,
contributed 65 percent of the Company's revenues in 1996. The business unit
provides drilling fluid and completion fluid systems, engineering and
environmental services, solids control, pressure control, rig instrumentation
and waste management services. M-I's 1996 revenues increased $195.9 million, or
35 percent, from 1995 and 1995 revenues increased $173.8 million, or 45
percent, from 1994. The increase over 1995 relates primarily to the incremental
revenues associated with the Anchor Drilling Fluids A.S. ("Anchor") operations,
which were acquired in June 1996, and an increased level of deep-water drilling
activity in the U.S. Gulf Coast area. The revenue increase over 1994 was
primarily attributable to the inclusion in 1995 of a full year's revenues for
acquired operations and higher sales volumes.

Smith Tool

Smith Tool manufactures and sells three-cone bits for use in the oil and
gas industry and in mining applications. Smith Tool's 1996 revenues increased
$29.6 million, or 18 percent, from 1995 and 1995 revenues increased $12.2
million, or 8 percent, from 1994. The increase over 1995 relates to improved
pricing, increased unit sales and a favorable shift in the sales mix toward
premium bits. The majority of the increase from 1995 was generated in the
United States; however, the introduction of the Magnum line of premium bits in
the North Sea contributed to a significant increase in Europe/Africa revenues.
Again, higher unit sales, improved pricing in the U.S. and higher non-North
American drilling activity levels account for the majority of the revenue
increase over 1994.

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' 1996 revenues
increased $33.5 million over 1995 and 1995 revenues increased $23.2 million
over 1994. The increase in revenues over 1995 relates primarily to the
increased level of re-entry activity in the U.S. Gulf Coast area and the
addition of The Red Baron (Oil Tools Rental) Ltd.'s ("Red Baron") operations,
which were acquired in October 1996. The variance over 1994 primarily relates
to the increased sales volumes associated with higher non-North American
drilling activity.

Smith Diamond Technology

Smith Diamond Technology manufactures and markets shear bits featuring
cutters made of polycrystalline diamond ("PDC") or natural diamond at its
Geodiamond division. Smith Diamond Technology also 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. Smith Diamond's revenues increased $23.1
million, or 65 percent, over 1995 and 1995 revenues increased $11.5 million, or
47 percent, over 1994. Higher unit sales, primarily in the United States and
Latin America, driven by increased market growth, new product introductions and
continued expansion into markets outside the U.S. account for the increase over
1995. The 47 percent increase over 1994 relates to higher sales volumes in
Latin America, Europe/Africa and the Middle East and the inclusion of a full
year's revenues for operations acquired during 1994.

17
<PAGE> 19

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

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------------------------------
1996 1995 1994
----------------------- ----------------------- -----------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Revenues .................................. $1,156,658 100 $ 874,544 100 $ 653,901 100
---------- ---- ---------- ---- ---------- ----
Gross Profit .............................. 392,062 34 292,540 33 221,274 34
Operating expenses ........................ 259,542 22 206,292 23 161,170 25
---------- ---- ---------- ---- ---------- ----
Income before interest and taxes .......... 132,520 12 86,248 10 60,104 9
Interest expense, net ..................... 16,445 2 12,238 1 8,572 1
---------- ---- ---------- ---- ---------- ----
Income before income taxes and minority
interests ................................. 116,075 10 74,010 9 51,532 8
Income tax provision ...................... 26,798 2 12,609 2 6,815 1
---------- ---- ---------- ---- ---------- ----
Income before minority interests .......... 89,277 8 61,401 7 44,717 7
Minority interests ........................ 24,833 2 15,809 2 8,838 1
---------- ---- ---------- ---- ---------- ----
Net Income ................................ $ 64,444 6 $ 45,592 5 $ 35,879 6
========== ==== ========== ==== ========== ====
</TABLE>

1996 Versus 1995

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

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

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

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

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

18
<PAGE> 20

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

1995 Versus 1994

Total revenues for 1995 increased $220.6 million, or 34 percent, from
1994. The increase primarily related to the inclusion of a full year's revenues
for operations acquired in 1994. Higher non-U.S. drilling activity, primarily
in Latin America which experienced double digit growth, increased unit sales
and improved pricing also contributed to the increase over 1994.

Gross profit increased $71.2 million, or 32 percent, from 1994. The
increase was due primarily to the impact of acquired operations. In addition,
the increase in gross profit reflected higher non-U.S. volumes, due to the
higher level of drilling activity, and higher sales in the U.S.

Operating expenses, consisting of selling expenses and general and
administrative expenses, increased $45.1 million or 28 percent from the prior
year; however, as a percentage of revenues, operating expenses decreased from
1994. The increase in absolute expenses is due primarily to increased variable
costs related to the higher level of revenues and incremental expenses
associated with the operations acquired. In addition, the increase in operating
expenses reflects the establishment of the Smith Diamond Technology business
unit, which was formed in 1995, and the expansion of M-I operations in Latin
America.

Net interest expense, which represents interest expense less interest
income, increased $3.6 million from $8.6 million in 1994 to $12.2 million in
1995. The increase in net interest expense was due to higher debt levels
necessary to fund working capital requirements and business acquisitions.

The effective tax rate for the year approximated 17 percent which is lower
than the statutory rate and higher than the prior year's effective rate of 13
percent. The effective tax rate for the year was lower than the statutory rate
and higher than the prior year's rate due primarily to the impact of U.S. net
operating loss carryforwards utilized.

Minority interests represent the share of M-I's profits associated with
the 36 percent minority partner's interest in those operations and, to a lesser
extent, minority interests in investments in other joint ventures held by M-I.
Minority interests increased $7.0 million from $8.8 million in 1994 to $15.8
million in 1995. The increase in minority interests was due to the higher level
of M-I's earnings.

19
<PAGE> 21

LIQUIDITY AND CAPITAL RESOURCES

General

The Company's financial condition remained strong at December 31, 1996.
Working capital at December 31, 1996 increased approximately $64.8 million, or
22 percent, from the prior year-end. In 1996, cash generated internally
exceeded cash required to support the Company's operations resulting in a $10.7
million increase in cash from the prior year-end.

During the year, the Company invested approximately $61.2 million in
property, plant and equipment which is net of cash proceeds arising from
certain asset disposals. Capital expenditures for 1997 are expected to continue
at this level, which includes routine additions of equipment used to support
the Company's operations as well as expenditures to increase productivity and
efficiency. Although 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 for
the foreseeable future, continued growth at current levels may require
increases to the Company's existing borrowing facilities.

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. At December 31, 1996, the Company had approximately $26.6
million of funds available for borrowing under its $120.0 million and other
long-term revolving line of credit facilities. Additionally, the Company has
approximately $40.0 million of non-U.S. borrowing facilities with various banks
which had available borrowing capacity of $24.9 million at December 31, 1996.

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

The Company has been named as a potentially responsible party in
connection with three sites on the U.S. Environmental Protection Agency's
National Priorities List. At December 31, 1996, the recorded liability for
estimated future clean-up costs for Superfund sites as well as properties
currently or previously owned or leased by the Company was $3.6 million. As
additional information becomes available, the Company may be required to
provide for additional environmental clean-up costs. However, the Company
believes that none of these obligations will result in liabilities having a
material adverse effect on the Company's consolidated financial position or
results of operations. See Footnote 12, "Commitments and Contingencies" for
further discussion of environmental liabilities.

Because of its substantial operations outside the U.S., the Company is
exposed to currency fluctuations and exchange risks. To mitigate the effect of
fluctuations in exchange rates on foreign currency denominated balances, the
Company utilizes a protective hedge program. The program is designed to hedge
net balance sheet positions which expose the Company to exchange rate risk. To
the extent possible, the Company matches assets and liabilities denominated in
foreign currencies and uses hedging instruments to cover certain unmatched
positions. See Footnote 5, "Financial Instruments" for further discussion of
hedging instruments.

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

The Company has completed several acquisitions during the periods
presented and intends to continue evaluating 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.

20
<PAGE> 22

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, 1996 and 1995, and the related consolidated statements of operations,
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 1996. 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, 1996 and 1995, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1996, in conformity with generally accepted
accounting principles.

ARTHUR ANDERSEN LLP

Houston, Texas
February 3, 1997

21
<PAGE> 23

SMITH INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
-------------------------------------
1996 1995 1994
---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Revenues ............................................ $1,156,658 $ 874,544 $ 653,901
---------- ---------- ----------

Costs and expenses:
Costs of revenues ................................. 764,596 582,004 432,627
Selling expenses .................................. 194,875 158,300 116,151
General and administrative expenses ............... 64,667 47,992 45,019
---------- ---------- ----------
Total costs and expenses ....................... 1,024,138 788,296 593,797
---------- ---------- ----------

Income before interest and taxes .................... 132,520 86,248 60,104

Interest expense .................................... 18,654 14,101 10,014
Interest income ..................................... (2,209) (1,863) (1,442)
---------- ---------- ----------

Income before income taxes and minority interests ... 116,075 74,010 51,532
Income tax provision ................................ 26,798 12,609 6,815
---------- ---------- ----------

Income before minority interests .................... 89,277 61,401 44,717

Minority interests .................................. 24,833 15,809 8,838
---------- ---------- ----------

Net income .......................................... $ 64,444 $ 45,592 $ 35,879
========== ========== ==========

Earnings per share .................................. $ 1.62 $ 1.16 $ 0.92
========== ========== ==========

Average common and common equivalent
shares outstanding ................................ 39,880 39,383 39,065
========== ========== ==========
</TABLE>

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

22
<PAGE> 24
SMITH INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

ASSETS

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1996 1995
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
CURRENT ASSETS:

Cash and cash equivalents ................................. $ 25,540 $ 14,845
Receivables, less allowance for doubtful accounts of $6,424
and $6,838 in 1996 and 1995, respectively ............... 309,062 230,590
Inventories ............................................... 295,041 221,952
Deferred tax assets, net .................................. 8,979 3,925
Prepaid expenses and other ................................ 26,655 13,979
---------- ----------

Total current assets ...................................... 665,277 485,291
---------- ----------

PROPERTY, PLANT AND EQUIPMENT:

Land ...................................................... 17,880 16,997
Buildings ................................................. 40,170 31,199
Machinery and equipment ................................... 305,491 250,221
---------- ----------

363,541 298,417

Less -- accumulated depreciation .......................... 158,290 165,918
---------- ----------

Net property, plant and equipment ......................... 205,251 132,499
---------- ----------

OTHER ASSETS, including assets held for sale of
$3,173 and $6,175 in 1996 and 1995, respectively .......... 43,257 41,129

GOODWILL, net of accumulated amortization of $6,043
and $3,275 in 1996 and 1995, respectively .................. 160,797 43,925
---------- ----------

TOTAL ASSETS ................................................. $1,074,582 $ 702,844
========== ==========
</TABLE>

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

23
<PAGE> 25
SMITH INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1996 1995
---------- ----------
(IN THOUSANDS, EXCEPT PAR VALUE DATA)
<S> <C> <C>
CURRENT LIABILITIES:

Short-term borrowings .......................................... $ 49,178 $ 14,438
Current portion of long-term debt .............................. 25,805 10,709
Accounts payable ............................................... 106,962 71,439
Accrued payroll costs .......................................... 42,836 30,922
Income taxes payable ........................................... 19,706 11,977
Other .......................................................... 56,014 45,804
---------- ----------
Total current liabilities .................................... 300,501 185,289
---------- ----------
LONG-TERM DEBT ................................................... 228,443 117,238
OTHER LONG-TERM LIABILITIES ...................................... 22,361 15,754
MINORITY INTERESTS ............................................... 154,741 83,677
COMMITMENTS AND CONTINGENCIES (Note 12) .......................... -- --

SHAREHOLDERS' EQUITY:
Preferred Stock, $1 par value; 5,000 shares authorized;
no shares issued or outstanding in 1996 or 1995 .............. -- --
Common stock, $1 par value; 60,000 shares authorized; 40,157
shares issued and outstanding in 1996 (39,807 in 1995) ....... 40,157 39,807
Common stock warrants - Class C; no warrants outstanding
in 1996 (451 in 1995) ....................................... -- 7,278
Additional paid-in capital ..................................... 278,955 275,432
Retained earnings (accumulated deficit) ........................ 62,482 (1,962)
Cumulative translation adjustments ............................. (5,356) (5,755)
Less - treasury securities, at cost; 656 common shares in
1996 (629 common shares and 451 Class C warrants in 1995) .... (7,702) (13,914)
---------- ----------
Total shareholders' equity ................................. 368,536 300,886
---------- ----------

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY ....................... $1,074,582 $ 702,844
========== ==========
</TABLE>

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

24
<PAGE> 26
SMITH INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(IN THOUSANDS, EXCEPT SHARE AND WARRANT DATA)

<TABLE>
<CAPTION>
COMMON STOCK COMMON STOCK WARRANTS
--------------------- ---------------------- ADDITIONAL
NUMBER NUMBER PAID-IN
OF SHARES AMOUNT OF WARRANTS AMOUNT CAPITAL
---------- -------- ----------- -------- ----------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1993 ................... 39,311,447 $ 39,311 2,549,082 $ 7,278 $ 271,582
Exercise of stock options and stock grants ... 97,495 98 -- -- 722
Exercise of common stock warrants ............ 23,891 24 (23,891) -- 179
Net income ................................... -- -- -- -- --
Translation adjustment for the period ........ -- -- -- -- --
---------- -------- ---------- -------- ----------
Balance, December 31, 1994 ................... 39,432,833 $ 39,433 2,525,191 $ 7,278 $ 272,483
Exercise of stock options and stock grants ... 230,940 230 -- -- 1,908
Exercise of common stock warrants ............ 143,572 144 (143,572) -- 1,041
Expiration of common stock warrants .......... -- -- (1,930,262) -- --
Net income ................................... -- -- -- -- --
Translation adjustment for the period ........ -- -- -- -- --
---------- -------- ---------- -------- ----------
Balance, December 31, 1995 ................... 39,807,345 $ 39,807 451,357 $ 7,278 $ 275,432
Exercise of stock options and stock grants ... 349,233 350 -- -- 3,523
Expiration of common stock warrants .......... -- -- (451,357) (7,278) --
Purchases of treasury stock .................. -- -- -- -- --
Net income ................................... -- -- -- -- --
Translation adjustment for the period ........ -- -- -- -- --
---------- -------- ---------- -------- ----------
Balance, December 31, 1996 ................... 40,156,578 $ 40,157 0 $ 0 $ 278,955
========== ======== ========== ======== ==========
<CAPTION>
TREASURY SECURITIES
----------------------------------------------
RETAINED COMMON STOCK WARRANTS
EARNINGS CUMULATIVE --------------------- ---------------------
(ACCUMULATED TRANSLATION NUMBER OF NUMBER OF
DEFICIT) ADJUSTMENTS SHARES AMOUNT WARRANTS AMOUNT
------------ ----------- --------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1993 ................... $ (83,433) $ (6,358) (628,583) $ (6,636) (451,357) $ (7,278)
Exercise of stock options and stock grants ... -- -- -- -- -- --
Exercise of common stock warrants ............ -- -- -- -- -- --
Net income ................................... 35,879 -- -- -- -- --
Translation adjustment for the period ........ -- 1,753 -- -- -- --
------------ ----------- --------- -------- --------- --------
Balance, December 31, 1994 ................... $ (47,554) $ (4,605) (628,583) $ (6,636) (451,357) $ (7,278)
Exercise of stock options and stock grants ... -- -- -- -- -- --
Exercise of common stock warrants ............ -- -- -- -- -- --
Expiration of common stock warrants .......... -- -- -- -- -- --
Net income ................................... 45,592 -- -- -- -- --
Translation adjustment for the period ........ -- (1,150) -- -- -- --
------------ ----------- --------- -------- --------- --------
Balance, December 31, 1995 ................... $ (1,962) $ (5,755) (628,583) $ (6,636) (451,357) $ (7,278)
Exercise of stock options and stock grants ... -- -- -- -- -- --
Expiration of common stock warrants .......... -- -- -- -- 451,357 7,278
Purchases of treasury stock .................. -- -- (27,271) (1,066) -- --
Net income ................................... 64,444 -- -- -- -- --
Translation adjustment for the period ........ -- 399 -- -- -- --
------------ ----------- --------- -------- --------- --------
Balance, December 31, 1996 ................... $ 62,482 $ (5,356) (655,854) $ (7,702) 0 $ 0
============ =========== ========= ======== ========= ========
</TABLE>

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

25
<PAGE> 27
SMITH INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------
1996 1995 1994
---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash flows from operating activities:
Net income ................................................ $ 64,444 $ 45,592 $ 35,879
Adjustments to reconcile net income to net cash
provided by operating activities, excluding the
net effects of acquisitions:
Depreciation and amortization ......................... 31,601 25,540 21,802
Minority interests .................................... 24,833 15,809 8,838
Provision for losses on receivables ................... 1,490 1,024 1,642
Gain on disposal of property, plant and equipment ..... (4,100) (4,198) (5,675)
Foreign currency translation losses ................... 62 1,112 1,986
Changes in operating assets and liabilities:
Receivables ............................................. (37,756) (29,847) (18,457)
Inventories, net ........................................ (52,991) (19,961) (20,180)
Accounts payable ........................................ 18,712 3,448 6,396
Other current assets and liabilities .................... (945) (72) (21,074)
Other non-current assets and liabilities ................ (15,254) (11,259) 5,444
---------- ---------- ----------
Net cash provided by operating activities ........... 30,096 27,188 16,601
---------- ---------- ----------

Cash flows from investing activities:
Acquisition of businesses, net of cash acquired ........... (104,683) (6,131) (168,363)
Purchases of property, plant and equipment ................ (72,958) (35,126) (24,140)
Proceeds from disposal of property, plant and equipment ... 11,711 10,042 10,435
---------- ---------- ----------
Net cash used in investing activities .................. (165,930) (31,215) (182,068)
---------- ---------- ----------

Cash flows from financing activities:
Proceeds from issuance of long-term debt .................. 124,641 12,238 92,000
Principal payments of long-term debt ...................... (14,910) (10,401) (12,788)
Net increase in short-term borrowings ..................... 34,121 8,038 3,295
Proceeds from exercise of stock options and
warrants ................................................ 3,873 3,323 1,023
Purchases of treasury stock ............................... (1,066) -- --
Distributions to minority interests, net .................. -- (2,520) (11,394)
---------- ---------- ----------
Net cash provided by financing activities ............... 146,659 10,678 72,136
---------- ---------- ----------
Effect of exchange rate changes on cash ..................... (130) 49 (85)
---------- ---------- ----------
Increase (decrease) in cash and cash equivalents ............ 10,695 6,700 (93,416)
Cash and cash equivalents at beginning of year .............. 14,845 8,145 101,561
---------- ---------- ----------
Cash and cash equivalents at end of year .................... $ 25,540 $ 14,845 $ 8,145
========== ========== ==========
</TABLE>

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

26
<PAGE> 28
SMITH INTERNATIONAL, INC.

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

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

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

Significant Risks and Uncertainties

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

Cash and Cash Equivalents

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

Fixed Assets

Fixed assets, consisting of rental equipment and property, plant and
equipment, are stated at cost. The Company computes depreciation on fixed
assets using principally the straight-line method. The estimated useful lives
used in computing depreciation range from 30 to 40 years for buildings, 3 to 20
years for machinery and equipment, and 3 to 7 years for rental equipment.
Leasehold improvements are amortized over the lives of the leases or the
estimated useful lives of the improvements, whichever is shorter. For income
tax purposes, accelerated methods of depreciation are used.

Cost of major renewals and betterments are capitalized 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 results of operations.

Valuation of Inventories

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

27
<PAGE> 29
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Goodwill

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

Foreign Currency Translation and Transactions

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

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

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.

Minority Interests

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

Earnings Per Common Share

Earnings per share is computed using the weighted average number of
shares of common stock and common stock equivalents outstanding during the
year. Common stock equivalents include the number of shares issuable upon
exercise of stock options, less the number of shares that could have been
repurchased with the exercise proceeds using the treasury stock method.

28
<PAGE> 30
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Employee Benefits

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

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

Reclassifications

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

2. ACQUISITIONS

Acquisition of M-I Drilling Fluids 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. The
Company utilized $73.4 million of borrowings under new loan agreements to
finance their portion of the purchase price and retire certain debt assumed in
the acquisition. The minority partner contributed $41.3 million to fund their
portion of the purchase price and retire certain debt, which is included in
Minority Interests in the accompanying Consolidated Balance Sheets.

Acquisition of The Red Baron 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.

Other Acquisitions

The Company acquired certain other operations during 1996, 1995 and 1994
with an aggregate purchase price of $6.2 million, $7.8 million and $6.3
million, respectively. These acquisitions have generally been financed with
cash.

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 $119.6 million in 1996 and $6.0 million in 1995, which has been
recorded as goodwill.

29
<PAGE> 31
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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 1995
and 1996 consolidated results of operations as if the Anchor and Red Baron
acquisitions had occurred on January 1, 1995 and 1996, respectively (in
thousands, except per share amounts):

<TABLE>
<CAPTION>
1996 1995
----------- ----------
(UNAUDITED)
<S> <C> <C>
Revenues ........................ $ 1,230,828 $1,018,845
Net income....................... $ 63,725 $ 45,573
Earnings per share............... $ 1.60 $ 1.16
</TABLE>

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

The following schedule summarizes investing activities related to
current year acquisitions:

<TABLE>
<S> <C>
Fair value of assets, net of cash acquired of $7,766... $104,898
Goodwill recorded...................................... 119,640
Less: Total liabilities assumed....................... (81,941)
Less: Minority interest partner's contribution........ (37,914)
--------
Cash paid for acquisition of businesses, net of
cash acquired........................................ $104,683
========
</TABLE>

3. INVENTORIES

Inventories consist of the following at December 31:
<TABLE>
<CAPTION>
1996 1995
-------- --------
<S> <C> <C>
Raw materials................................ $ 30,614 $ 31,052
Work-in-process.............................. 45,985 40,718
Finished goods............................... 233,139 163,597
-------- --------
309,738 235,367
Reserves to state certain U.S. inventories
($117,360 in 1996 and $99,113 in 1995)
on a LIFO basis............................ (14,697) (13,415)
-------- --------
$295,041 $221,952
======== ========
</TABLE>

<PAGE> 32
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

4. DEBT

The following summarizes the Company's outstanding long-term debt at
December 31:

<TABLE>
<CAPTION>
1996 1995
-------- --------
<S> <C> <C>
Notes payable:
Notes payable to insurance companies maturing between 1998 and
2006. Interest payable quarterly or semi-annually at rates
ranging from 6.02% to 9.83%............................................ $116,000 $ 76,000

Bank revolvers payable:
$80.0 million revolving note expiring March 31, 2001. Interest
payable quarterly at base rate (8.25% at December 31, 1996) or
adjusted Eurodollar interbank rate, as defined (6.16% at
December 31, 1996) and described below................................. 55,000 40,400

M-I Drilling Fluids $40.0 million revolving note expiring March 31,
2001. Interest payable quarterly at base rate (8.25% at December
31, 1996) or adjusted Eurodollar interbank rate, as defined (6.11%
at December 31, 1996) and described below.............................. 37,200 10,000

Term Loans:
320.0 million Norwegian Krone facility with a bank group expiring
March 31, 2001. Interest payable semi-annually at a Eurokrone rate,
as defined (4.985% at December 31, 1996) and described below........... 44,626 -

Other 1,422 1,547
-------- --------
254,248 127,947
Less current portion of long-term debt .................................. (25,805) (10,709)
-------- --------
Long-Term Debt......................................................... $228,443 $117,238
======== ========
</TABLE>

Principal payments of long-term debt for years subsequent to 1997 are as
follows:

<TABLE>
<S> <C>
1998......................................... $ 30,784
1999......................................... 20,139
2000......................................... 20,139
2001......................................... 140,681
Thereafter................................... 16,700
--------
$228,443
========
</TABLE>

In connection with the Anchor acquisition, the Company entered into a
320.0 million Norwegian Krone term loan with a bank group. The unsecured
credit agreement provides for interest at a Eurokrone rate ranging from NIBOR
+1/2 to NIBOR +3/4, based on the debt to capital ratio of the Company.

In 1996, the Company also re-negotiated its existing revolving line of
credit agreements increasing the amounts available under the Company's and
M-I's U.S. lines from $85.0 million to $120.0 million. The unsecured revolving
credit agreements provide for the election of interest at a base rate or a
Eurodollar rate ranging from LIBOR + 3/8 to LIBOR + 5/8, based upon the debt to
capital ratio of the Company. The agreements require the quarterly payment of a
commitment fee ranging from 1/8 percent to 1/4 percent of the unutilized credit
facility, based on the debt to capital ratio. As of December 31, 1996 the
borrowing capacity under these and other long-term lines of credit approximated
$26.6 million.

31
<PAGE> 33
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Certain of the Company's subsidiaries outside the U.S. have short-term
lines of credit with various banks totaling approximately $40.0 million. At
December 31, 1996, the borrowing capacity under these lines of credit
approximated $24.9 million. At December 31, 1996 and 1995, the short-term lines
of credit carried interest at a weighted average rate of 12 and 18 percent,
respectively. The majority of these lines are under unsecured credit
agreements.

Included in Short-term borrowings in the accompanying Consolidated
Balance Sheet is $34.1 million of notes payable related to the acquisition of
the Red Baron. The notes, which are secured by a letter of credit, are payable
on demand on any semi-annual interest payment date after July 1, 1997.

The Company was in compliance with all of its loan covenants under the
various loan indentures at December 31, 1996 and 1995. 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, 1996, 1995 and 1994
amounted to $17.5 million, $14.3 million and $7.0 million, respectively.

5. FINANCIAL INSTRUMENTS

Interest Rate Contracts

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

At December 31, 1996 and 1995, the Company had notional principal
amounts of interest rate swaps on outstanding debt of $90.6 million and $46.0
million, respectively. Gains and losses from interest rate swaps are
recognized currently in the Consolidated Statements of Operations. All swap
agreements, which are hedges against certain debt obligations, are classified
as for "purposes other than trading" under the provisions of SFAS No. 119.

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

Foreign Currency Forward Contracts and Options

From time to time, the Company enters into spot and forward contracts
under foreign exchange lines as a hedge against accounts payable in foreign
currencies. Market value gains and losses on such forward contracts are
recognized currently, and the resulting amounts offset foreign exchange gains
or losses on the related accounts payable as payments are made. At December
31, 1996 and 1995, foreign exchange contracts outstanding totaled $17.3 million
and $22.8 million, respectively.

The Company also purchases foreign exchange option contracts to hedge
certain operating exposures. Premiums paid under these contracts are expensed
over the life of the option contract. Gains arising on these options are
recognized at the time the options are exercised. The Company had $12.3
million and $7.9 million of foreign exchange option contracts outstanding at
December 31, 1996 and 1995, respectively.

Fair Value

Management believes the carrying value of long-term debt does not
materially differ from the fair value, using rates currently available for debt
of similar terms and maturity. The fair

32
<PAGE> 34
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

value of interest rate swaps, for which no amounts were recorded, was $(0.5)
million and $(1.0) million at December 31, 1996 and 1995, respectively. 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.

6. INCOME TAXES

The geographical sources of income before income taxes and minority
interests for the three years ended December 31, 1996, were as follows:

<TABLE>
<CAPTION>
1996 1995 1994
-------- ------- -------
<S> <C> <C> <C>
Income before income taxes
and minority interests:
U.S........................... $ 68,564 $54,896 $49,583
Non-U.S....................... 47,511 19,114 1,949
-------- ------- -------
Total......................... $116,075 $74,010 $51,532
======== ======= =======
</TABLE>

The income tax provision is summarized as follows:

<TABLE>
<CAPTION>
1996 1995 1994
------- ------- ------
<S> <C> <C> <C>
Current -
U.S......................... $ 9,159 $ 1,605 $ 413
Non-U.S.....................
17,808 10,700 5,532
State....................... 1,319 1,245 793
------- ------- ------
28,286 13,550 6,738
------- ------- ------
Deferred -
U.S......................... (1,940) 7 64
Non-U.S..................... 452 (948) 13
------- ------- ------
(1,488) (941) 77
------- ------- ------
Income tax provision.......... $26,798 $12,609 $6,815
======= ======= ======
</TABLE>

Deferred taxes are principally attributable to timing differences
related to depreciation expense and net operating loss ("NOL") and tax credit
carryforwards. In 1996, 1995 and 1994, the Company reported the tax benefit of
operating loss carryforwards as a reduction in the provision for income taxes
in accordance with SFAS No. 109.

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

<TABLE>
<CAPTION>
1996 1995 1994
---- ---- -----
<S> <C> <C> <C>
U.S. Federal statutory tax rate.............. 35.0% 35.0% 35.0%
Utilization of U.S. net operating
loss carryforwards......................... (9.2) (18.4) (22.3)
Minority interests' share of U.S.
partnership earnings....................... (5.6) (7.2) (6.7)
Permanent differences........................ 1.8 2.3 (3.3)
State taxes, net............................. 1.2 1.7 1.6
Non-U.S. tax provisions which vary from the
U.S. rate/non-U.S. losses with no
tax benefit realized....................... 0.9 4.2 8.6
Other items, net............................. (1.0) (0.6) 0.3
---- ---- -----
Effective tax rate......................... 23.1% 17.0% 13.2%
==== ==== =====
</TABLE>

33
<PAGE> 35
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The components of deferred taxes are as follows:

<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31, NET
1996 1995 CHANGE
----------- ------------ -------
<S> <C> <C> <C>
Deferred tax liabilities attributed
to the excess of net book basis
over remaining tax basis
(principally depreciation):
U.S.......................................... $(11,037) $(10,278) $ (759)
Non-U.S...................................... (9,789) (4,461) (5,328)
-------- -------- -------
Total deferred tax liabilities................. (20,826) (14,739) (6,087)
-------- -------- -------
Deferred tax assets attributed to
net operating loss and tax credit
carryforwards:
U.S.......................................... 23,986 29,903 (5,917)
Non-U.S...................................... 27,860 19,808 8,052

Other deferred tax assets (principally accrued
liabilities not deductible until paid):
U.S.......................................... 16,125 14,355 1,770
Non-U.S...................................... 7,910 4,722 3,188
-------- -------- -------
Subtotal................................... 75,881 68,788 7,093

Valuation allowance.............................. (46,725) (48,381) 1,656
-------- -------- -------

Subtotal deferred tax assets................... 29,156 20,407 8,749
-------- -------- -------

Net deferred tax assets........................ $ 8,330 $ 5,668 $ 2,662
======== ======== =======

</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31, NET
1996 1995 CHANGE
----------- ------------ -------
<S> <C> <C> <C>
Balance sheet presentation:

Deferred tax assets, net....................... $ 8,979 $ 3,925 $ 5,054
Other assets................................... 1,410 1,743 (333)
Other long-term liabilities.................... (2,059) - (2,059)
------- ------- -------
Net deferred tax assets..................... $ 8,330 $ 5,668 $ 2,662
======= ======= =======
</TABLE>

The net increase in deferred tax assets of $2.7 million is primarily
attributed to the acquisition of Anchor and the Red Baron as discussed in
Note 2.

For U.S. tax reporting purposes, the Company has cumulative NOL
carryforwards in the amount of approximately $13.5 million at December 31,
1996. These losses were generated in 1988 and 1992 in the amounts of $11.4
million, and $2.1 million, respectively. Losses in 1988 and 1992 are available
to reduce future U.S. taxable income that may be generated through the years
2003 and 2007, respectively. On certain changes in equity ownership of the
Company, the ability to utilize NOL carryforwards becomes subject to limitation
under Section 382 of the Internal

34
<PAGE> 36
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Revenue Code of 1986, as amended. In the opinion of management, the
application of Section 382 will not materially limit the availability of net
tax loss carryforwards.

Also available to reduce future U.S. income taxes are unused alternative
minimum tax credits of $13.7 million and investment and other business tax
credits of $5.5 million at December 31, 1996. These tax credits expire as
follows: $2.6 million in 1998, $1.6 million in 1999, $1.1 million in 2000 and
$0.2 million in 2001 through 2004. Income taxes paid during the years ended
December 31, 1996, 1995 and 1994 amounted to $17.4 million, $3.8 million and
$7.0 million, respectively.

The Company does not provide deferred taxes on the undistributed
earnings of its non-U.S. subsidiaries because it considers these earnings
permanently invested. The Company's non-U.S. subsidiaries currently have
undistributed earnings of $17.9 million at December 31, 1996, which if
repatriated would be generally sheltered from U.S. tax by foreign tax credits.

7. CAPITAL STOCK

Common stock warrants

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

8. EMPLOYEE STOCK OPTIONS

As of December 31, 1996, the Company has outstanding stock options
granted under two plans: the 1989 Long-Term Incentive Compensation Plan ("1989
Plan") and the 1982 Stock Option Plan ("1982 Plan"). Matters such as vesting
periods and expiration of options are determined on a plan by plan or grant by
grant, basis. The options, exercisable at various dates through December 2006,
are conditioned upon continued employment.

During the current year the Company adopted SFAS No. 123 ("SFAS 123")
"Accounting for Stock-Based Compensation". SFAS 123, which is effective for
fiscal years beginning after December 15, 1995, establishes financial
accounting and reporting standards for stock-based employee compensation plans
and for transactions in which an entity issues its equity instruments to
acquire goods and services from non-employees. SFAS 123 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 income statement or making pro forma disclosures in
the notes to the financial statements.

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

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

Earnings per share As reported $ 1.62 $ 1.16
Pro forma $ 1.60 $ 1.16
</TABLE>

35
<PAGE> 37
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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

A summary of the Company's stock option plans as of December 31, 1996,
1995 and 1994, and changes during those years is presented below:

<TABLE>
<CAPTION>
Weighted-Average
Shares Exercise
Under Option Price
------------ ----------------
<S> <C> <C>
Outstanding at December 31, 1993...... 1,002,832 $ 10.12

Options granted....................... 513,300 13.13
Options forfeited..................... (41,562) 13.87
Options exercised..................... (97,495) 8.69
---------

Outstanding at December 31, 1994...... 1,377,075 11.22

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

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

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

Outstanding at December 31, 1996...... 1,263,018 $ 18.46
</TABLE>

The following summarizes information about fixed stock options
outstanding at December 31, 1996:

<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
--------------------------------------------- -------------------------
Weighted Weighted Weighted
Average Average Average
Range of Number Remaining Exercise Number Exercise
Exercise Prices Outstanding Contractual Life Price Exercisable Price
- --------------- ----------- ---------------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$ 5.50 - $10.31 278,766 6.1 $ 9.10 170,016 $ 8.89
$12.56 - $17.88 731,582 7.3 14.31 311,590 13.90
$22.50 - $41.13 252,670 9.5 40.79 -- --
--------- --- ------ ------- ------
1,263,018 7.5 $18.46 481,606 $12.13
========= === ====== ======= ======
</TABLE>

At December 31, 1996, there were 443,329 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. No further options may be granted under the 1982 Plan.

36
<PAGE> 38
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

9. EMPLOYEE BENEFITS

Pension Plans

The Company has pension plans in the U.S. and the United Kingdom.
Benefit accruals under the Company's U.S. pension plan, which have been frozen
since 1987, covered substantially all the U.S. employees of the Company at that
date. Due to the freezing of U.S. pension benefits and fully funding those
benefits in 1987, no material contributions were made to the Plan in 1996, 1995
or 1994. Most of the employees of M-I are not covered by a pension plan.

The following tables detail the components of pension expense for the
three years ended December 31, 1996, the funded status of the plans and major
assumptions used to determine these amounts:

<TABLE>
<CAPTION>
1996 1995 1994
------- ------- -------
<S> <C> <C> <C>
Service cost ........................... $ 311 $ 286 $ 266
Interest cost .......................... 1,020 942 862
Actual return on plan assets ........... (1,771) (796) (299)
Prior service cost ..................... 6 8 --
Net amortization and deferral
and other ............................ 685 (199) (645)
------- ------- -------
Net periodic pension cost .............. $ 251 $ 241 $ 184
======= ======= =======
</TABLE>

Reconciliation of Funded Status of the Plan:

<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Actuarial present value of benefit obligations:

Vested benefit obligation ................................ $ 13,252 $ 11,672 $ 9,863
======== ======== ========
Accumulated benefit obligation ........................... $ 13,375 $ 11,834 $ 9,993
======== ======== ========
Projected benefit obligation ............................. $ 14,481 $ 12,700 $ 10,681
Plan assets at fair value ................................ 15,804 12,926 11,166
-------- -------- --------
Projected benefit obligation less than Plan assets ....... $ 1,323 $ 226 $ 485
Unrecognized prior service cost .......................... 28 34 11
Unrecognized net (gain) loss ............................. (759) 211 (133)
Additional minimum liability ............................. (480) (880) (978)
-------- -------- --------
Pension (liability) asset recognized in the Balance
Sheet .................................................. $ 112 $ (409) $ (615)
======== ======== ========

Weighted-average assumed discount rate ..................... 7.8% - 9.0% 7.0% - 9.0% 8.5% - 8.9%

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

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

The Company has several other pension plans covering certain non-U.S.
employees as well as a pension plan covering directors. Pension expense, total
accumulated plan benefits and net assets available for benefits for these plans
were not material at December 31, 1996, 1995 or 1994.

37
<PAGE> 39
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Retirement Plans

The Company established the Smith International, Inc. 401(k) Retirement
Plan (the "Plan") for the benefit of all eligible employees. Employees may
voluntarily contribute up to 12 percent of compensation, as defined, to the
Plan. The Company makes retirement and, in certain cases, matching
contributions to each participant's account under the Plan. The Company's
retirement contributions range from 2 percent to 6 percent of each
participant's qualified compensation. In addition, the Company may provide
discretionary matching contributions to participants who are employed by the
Company on December 31. The Company's contributions to the Plan totaled
approximately $4.9 million, $3.9 million and $4.4 million in 1996, 1995 and
1994, 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, along with a 100 percent matching
contribution of the first 1/2 percent of their voluntary contributions.
Further, effective January 1, 1996, the Company's Board of Directors approved
an additional profit-sharing match of up to 2 1/2 percent of participant's
voluntary contributions. Total contributions under the M-I Plan approximated
$4.2 million in 1996, $2.2 million in 1995 and $1.7 million in 1994.

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

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

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

<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Accumulated postretirement
benefit obligation:
- Retirees ........................... $ (5,538) $ (5,105) $ (4,829)
- Actives ............................ (3,773) (3,543) (3,248)
Plan assets at fair value .............. -- -- --
-------- -------- --------
Accumulated postretirement
benefit obligation in excess of
plan assets .......................... (9,311) (8,648) (8,077)
Unrecognized net gain and
prior service cost ................... (1,487) (1,832) (2,510)
-------- -------- --------
Accrued postretirement
benefit cost ......................... $(10,798) $(10,480) $(10,587)
======== ======== ========
</TABLE>

38
<PAGE> 40
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Postretirement benefit expense recognized in the Consolidated Statements of
Operations for the three years ended December 31, 1996, is summarized as
follows:

<TABLE>
<CAPTION>
1996 1995 1994
----- ----- -----
<S> <C> <C> <C>
Service cost ................................ $ 103 $ 83 $ 87
Interest cost on accumulated
postretirement benefit obligation
and other ................................. 704 686 701

Net amortization ............................ (116) (170) (159)
----- ----- -----
Postretirement benefit expense .............. $ 691 $ 599 $ 629
===== ===== =====
</TABLE>

The health care cost trend rate assumption can have a significant effect
on the amounts reported. For measurement purposes, the Smith International
Inc. Retiree Medical Plan ("Smith Medical Plan") assumes a 9 percent, 10
percent and 11 percent annual rate of increase in the per capita cost of
covered health care benefits for 1996, 1995 and 1994, respectively; and the M-I
Drilling Fluids Retiree Medical Plan assumes a 5 percent increase for the
periods presented. The Smith Medical Plan rate was assumed to gradually
decrease to 7 percent for 1998 and to remain at that level thereafter. An
increase of one percentage point in the health care cost trend rate would
increase the accumulated postretirement benefit obligation and the aggregate of
the service and interest cost components of the postretirement benefits expense
by $1.2 million and $0.1 million, respectively.

The weighted-average discount rates used in determining the accumulated
postretirement benefit obligation for 1996, 1995 and 1994 were 8.0 percent, 8.4
percent and 8.5-8.9 percent, respectively.

10. STOCKHOLDERS' RIGHTS PLAN

During 1990, the Company adopted a Stockholder 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.

39
<PAGE> 41
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

11. INDUSTRY SEGMENTS AND INTERNATIONAL OPERATIONS

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

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

<TABLE>
<CAPTION>
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
Revenues:
United States:
Domestic .......................... $ 451,147 $ 358,392 $ 280,435
Export ............................ 71,470 50,454 56,421
North Sea/Europe .................... 242,828 168,135 122,971
Latin America ....................... 153,540 112,587 44,065
Other ............................... 237,673 184,976 150,009
---------- ---------- ----------
$1,156,658 $ 874,544 $ 653,901
========== ========== ==========

Income before interest and taxes:
United States ..................... $ 56,387 $ 37,115 $ 33,520
North Sea/Europe .................. 29,289 15,129 10,993
Latin America ..................... 22,296 21,307 2,279
Other ............................. 36,337 23,083 23,497
---------- ---------- ----------
$ 144,309 $ 96,634 $ 70,289
========== ========== ==========

Identifiable assets:
United States ..................... $ 466,711 $ 418,588 $ 372,410
North Sea/Europe .................. 309,791 94,648 109,283
Latin America ..................... 138,988 87,322 52,202
Other ............................. 159,092 102,286 85,885
---------- ---------- ----------
$1,074,582 $ 702,844 $ 619,780
========== ========== ==========
</TABLE>

General corporate expenses and interest income and expense have been
excluded from income before interest and taxes in the table above. Results of
operations as reported in the accompanying consolidated financial statements
include general corporate expenses of $11.8 million in 1996, $10.4 million in
1995 and $10.2 million in 1994.

Transfers between geographic areas, which are eliminated upon
consolidation, are excluded from the above presentation. These transfers are
recorded by the Company and its subsidiaries based on their various
intercompany pricing agreements. U.S. sales to affiliates amounted to $169.5
million, $126.1 million and $85.2 million in 1996, 1995 and 1994, respectively.
Non-U.S. sales to affiliates approximated $93.0 million, $58.2 million and
$47.0 million in 1996, 1995 and 1994, respectively.

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

40
<PAGE> 42
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

12. 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
$13.8 million, $12.9 million and $11.7 million in 1996, 1995 and 1994,
respectively.

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

<TABLE>
<CAPTION>
YEARS ENDING
DECEMBER 31, AMOUNT
------------ -------
<S> <C>
1997 $12,247
1998 9,729
1999 6,876
2000 4,844
2001 3,739
Thereafter 20,481
-------
$57,916
=======
</TABLE>

Litigation

The Company is a defendant in various legal proceedings arising in the
ordinary course of business. A description of certain of these proceedings
follows.

The Company was named a defendant in an action entitled Lynn Martin,
Secretary of the U.S. Dept. of Labor v. Smith International, Inc., et al.,
which alleged violations of the Employee Retirement Income Security Act of 1974
("ERISA") arising out of the Company's purchase of Executive Life Insurance
Company ("Executive Life") annuities. Executive Life was placed in
conservatorship in 1991 by the California Insurance Commissioner and has since
emerged from conservatorship as Aurora National Life Assurance Company, Inc.
("Aurora"). Aurora will honor in part Executive Life's past and continuing
commitments under the annuities outstanding; however, a portion of these
obligations will not be paid. In December 1994, the parties agreed in
principle to a settlement. Pursuant to a consent order, the Company paid $4.07
million into an escrow account, the majority of which was paid by the Company's
insurance carrier. The Company recognized its portion of the settlement of
approximately $1.0 million in 1994. The settlement is on deposit in the escrow
account and the parties have agreed on the amount and manner of the
distributions to the Plan participants, however, the timing is subject to a
court hearing. In the opinion of management, this matter will not have a
material adverse effect on the Company's consolidated financial condition or
results of operations.

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

Sheridan. On March 31, 1987, the Sheridan Site Committee (the
"Committee") filed a claim on behalf of itself and 59 potentially responsible
parties ("PRPs") at the Sheridan Disposal Services site in Hempstead, Texas, a
NPL site. The claim was based on the Company's alleged liability to the
claimants for "contribution and potential cost recovery for administrative and
remedial work" expenses incurred and to be incurred by them in connection with
the Sheridan Disposal site. On August 28, 1987, the Company reached a
settlement and agreed to pay its allocable share of response costs incurred by
the Committee, such share to be limited to the lesser of $3.0 million or 2.93
percent of actual response costs. Based upon an EPA Record of Decision
("ROD"), total remediation costs are estimated, on a preliminary basis, to be
approximately $28 million. On this basis, the Company's share would be $0.8
million.

41
<PAGE> 43
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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

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

On September 16, 1993, the EPA issued the ROD for the remainder of the
Chemform Site, which addressed site-related soil contamination. The ROD
determined that no further Superfund action was necessary to address Operable
Unit Two at the site; however, the Florida DEP requested that additional soil
be removed at the Chemform Site. The Company and the two other PRPs performed
the soil removal requested under the oversight of the Florida DEP and has
provided a Technical Memorandum summarizing this action to the EPA and the
Florida DEP. The Company has not received any written response from either the
EPA or the Florida DEP. In April 1996, the Company and the other PRPs received
a letter from the EPA demanding approximately $.8 million in response and
oversight costs. The Company and the other PRP's are contesting this claim and
are requesting additional information. As the EPA still retains jurisdiction
over the Chemform Site, it is possible that additional issues may arise which
would require further resolution, including the claim by the EPA for payment of
past oversight or response costs incurred. The Company intends to scrutinize
and, if necessary, vigorously contest any such claims made by the EPA.

At December 31, 1996, the remaining recorded liability for estimated
future clean-up costs for the sites discussed above as well as properties
currently or previously owned or leased by the Company was $3.6 million. As
additional information becomes available, the Company may be required to
provide for additional environmental clean-up costs for Superfund sites and for
properties currently or previously owned or leased by the Company. However,
the Company believes that none of its clean-up obligations will result in
liabilities having a material adverse effect on the Company's consolidated
financial position or results of operations.

42
<PAGE> 44
SMITH INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

13. QUARTERLY INFORMATION (UNAUDITED)

<TABLE>
<CAPTION>
1996 FIRST SECOND THIRD FOURTH YEAR
--------- --------- --------- --------- ----------
<S> <C> <C> <C> <C> <C>
Revenues ................ $ 238,820 $ 270,272 $ 310,657 $ 336,909 $1,156,658
========= ========= ========= ========= ==========
Gross profit ............ $ 80,909 $ 90,323 $ 103,398 $ 117,432 $ 392,062
========= ========= ========= ========= ==========
Net income .............. $ 12,948 $ 14,981 $ 16,604 $ 19,911 $ 64,444
========= ========= ========= ========= ==========
Earnings per share ...... $ 0.33 $ 0.38 $ 0.42 $ 0.50 $ 1.62
========= ========= ========= ========= ==========
</TABLE>

<TABLE>
<CAPTION>
1995 FIRST SECOND THIRD FOURTH YEAR
--------- --------- --------- --------- ----------
<S> <C> <C> <C> <C> <C>
Revenues ................ $ 199,603 $ 205,976 $ 229,437 $ 239,528 $ 874,544
========= ========= ========= ========= ==========
Gross profit ............ $ 65,536 $ 68,797 $ 76,643 $ 81,564 $ 292,540
========= ========= ========= ========= ==========
Net income .............. $ 10,805 $ 10,124 $ 11,743 $ 12,920 $ 45,592
========= ========= ========= ========= ==========
Earnings per share ...... $ 0.28 $ 0.26 $ 0.30 $ 0.33 $ 1.16
========= ========= ========= ========= ==========
</TABLE>

43
<PAGE> 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

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

ITEM 11. EXECUTIVE COMPENSATION

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

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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

PART IV

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

(A) FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
REFERENCE
---------
<S> <C>
(1) Financial statements included in this report:
Report of Independent Public Accountants ........................ 21
Consolidated Statements of Operations for the years ended
December 31, 1996, 1995 and 1994 ............................... 22
Consolidated Balance Sheets at December 31, 1996 and 1995 ....... 23-24
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 1996, 1995 and 1994 ................... 25
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1995 and 1994 ............................... 26
Notes to Consolidated Financial Statements ...................... 27-43
</TABLE>

44
<PAGE> 46
<TABLE>
<S> <C>
(2) Financial statement schedule for the years ended December 31,
1996, 1995 and 1994:
Report of Independent Public Accountants on Financial Statement
Schedule ...................................................... 48
II Valuation and qualifying accounts and reserves ............... 49
</TABLE>

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

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

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

4.1 -- Rights Agreement, dated as of June 19, 1990, between
the Company and First Chicago Trust Company of New
York. Filed as Exhibit 4.13 to the Company's report on
Form 10-K for the year ended December 31, 1991 and
incorporated herein by reference.

4.2 -- 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.

4.3 -- 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.

4.4 -- 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.

9. -- Not applicable.

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

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

45
<PAGE> 47
10.3 -- Smith International, Inc. 1989 Long Term Incentive
Compensation Plan, as amended to date. Filed as
Exhibit 10.3 to the Company's report on Form 10-K for
the year ended December 31, 1994 and incorporated
herein by reference.

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

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

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

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

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

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

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

10.11 -- Employment Agreement dated January 2, 1991 between the
Company and Neal S. Sutton.

10.12 -- Employment Agreement dated May 1, 1991 between the
Company and Richard A. Werner.

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

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

46
<PAGE> 48
10.16 -- Amendment to Employment Agreement dated January 2,
1991 between the Company and Neal S. Sutton.

10.17 -- Amendment to Employment Agreement dated May 1, 1991
between the Company and Richard A. Werner.

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

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

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

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

11. -- Not applicable.

12. -- Not applicable.

13. -- Not applicable.

18. -- Not applicable.

19. -- Not applicable.

21. -- Subsidiaries of the Company

23. -- Not applicable.

24.1 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registration Statement No. 33-31556.

24.2 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registration Statement No. 33-69840.

24.3 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registration Statement No. 33-56693.

27 -- Financial Data Schedule

(B) REPORTS ON FORM 8-K.

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

47
<PAGE> 49
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 Financial Statements of Smith International, Inc.
and subsidiaries included in this Form 10-K, and have issued our report thereon
dated February 3, 1997. Our audits were made for the purpose of forming an
opinion on the basic financial statements taken as a whole. The 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 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
February 3, 1997

48
<PAGE> 50
SCHEDULE II

SMITH INTERNATIONAL, INC.

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
ADDITIONS
BALANCE AT CHARGED BALANCE
BEGINNING TO AT END
OF YEAR EXPENSE WRITE-OFFS OTHER OF YEAR
---------- --------- ---------- ------- -------
<S> <C> <C> <C> <C> <C>
Allowance for Doubtful Accounts:
Year Ended--December 31, 1996 ........ $ 6,838 $ 1,490 $(2,338) $ 434(a) $ 6,424
Year Ended--December 31, 1995 ........ $ 8,679 $ 1,024 $(2,865) -- $ 6,838
Year Ended--December 31, 1994 ........ $ 4,995 $ 1,642 $(2,705) $ 4,747(a) $ 8,679
</TABLE>

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

49
<PAGE> 51
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 21, 1997

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

<TABLE>
<S> <C> <C>
/s/ DOUGLAS L. ROCK Chairman of the Board, Chief
- --------------------------------------- Executive Officer, President and
(Douglas L. Rock) Chief Operating Officer March 21, 1997

/s/ LOREN K. CARROLL Executive Vice President and Chief
- -------------------------------------- Financial Officer March 21, 1997
(Loren K. Carroll)

/s/ JOHN J. KENNEDY Vice President, Chief Accounting
- -------------------------------------- Officer and Treasurer March 21, 1997
(John J. Kennedy)

/s/ BENJAMIN F. BAILAR Director March 21, 1997
- --------------------------------------
(Benjamin F. Bailar)

/s/ G. CLYDE BUCK Director March 21, 1997
- ---------------------------------------
(G. Clyde Buck)

/s/ JAMES R. GIBBS Director March 21, 1997
- ---------------------------------------
(James R. Gibbs)

/s/ JERRY W. NEELY Director March 21, 1997
- ---------------------------------------
(Jerry W. Neely)

/s/ H. MOAK ROLLINS Director March 21, 1997
- ----------------------------------------
(H. Moak Rollins)
</TABLE>

<PAGE> 52
EXHIBIT INDEX

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

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

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

9. -- Not applicable.

10.2 -- Smith International, Inc. 1982 Stock Option Plan.
Filed as Exhibit 10.2 to the Company's report on Form
10-K for the year ended December 31, 1995 and
incorporated herein by reference.
</TABLE>
<PAGE> 53
<TABLE>
<S> <C>
10.3 -- Smith International, Inc. 1989 Long Term Incentive
Compensation Plan, as amended to date. Filed as
Exhibit 10.3 to the Company's report on Form 10-K for
the year ended December 31, 1994 and incorporated
herein by reference. 10.4 -- Smith International, Inc.
Directors' Retirement Plan as amended to date. Filed
as Exhibit 10.4 to the Company's report on Form 10-K
for the year ended December 31, 1995 and incorporated
herein by reference.

10.11 -- Employment Agreement dated January 2, 1991 between the
Company and Neal S. Sutton.

10.12 -- Employment Agreement dated May 1, 1991 between the
Company and Richard A. Werner.

10.15 -- Amendment to Employment Agreement dated October 16,
1989 between the Company and D. Barry Heppenstall.
Filed as Exhibit 10.15 to the Company's report on Form
10-K for the year ended December 31, 1995 and
incorporated herein by reference.
</TABLE>
<PAGE> 54
<TABLE>
<S> <C>
10.16 -- Amendment to Employment Agreement dated January 2,
1991 between the Company and Neal S. Sutton.

10.17 -- Amendment to Employment Agreement dated May 1, 1991
between the Company and Richard A. Werner.

11. -- Not applicable.

12. -- Not applicable.

13. -- Not applicable.

18. -- Not applicable.

19. -- Not applicable.

21. -- Subsidiaries of the Company

23. -- Not applicable.

24.1 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registraiton Statement No. 33-31556.

24.2 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registration Statement No. 33-69840.

24.3 -- Consent of Arthur Andersen L.L.P. regarding Form S-8
Registration Statement No. 33-56693. 27

27. -- Financial Data Schedule
</TABLE>

<PAGE> 1
EXHIBIT 10.11

EMPLOYMENT AGREEMENT

THIS EMPLOYMENT AGREEMENT (the "Agreement"), made this 2nd day of January,
1991, is entered into by SMITH INTERNATIONAL, INC., a Delaware corporation with
its principal place of business at Houston, Texas (the "Company"), and NEAL S.
SUTTON residing at Shiro, Texas (the "Executive").

The Company desires to employ the Executive, and the Executive desires to
be employed by the Company. In consideration of the mutual covenants and
promises contained herein, and the good and valuable consideration, the receipt
and sufficiency of which are hereby acknowledged by the parties hereto, the
parties hereto agree as follows:

1. Term of Employment.

1.1. The Company hereby agrees to employ the Executive because of the
extraordinary and unique services the Executive can render to the company, and
the Executive accepts employment with the Company, upon the terms set forth in
this Agreement, for the period commencing on the date hereof (the "Commencement
Date") and ending on December 31, 1993, unless sooner terminated in accordance
with the provisions of Section 4.

1.2. On January 2, 1991 and on each anniversary ("Anniversary Date")
of the period of employment hereunder (the "Employment Period") shall
be extended for one additional year, but, provided the Executive is still
employed hereunder, the Employment Period shall end forthwith at the earlier of
the Executive attaining the age of 65 years or if the Executive begins to
receive benefits under any pension or retirement income plan provided by the
Company or any of its subsidiaries.

2. Title; Capacity; Duties. The Executive shall serve as Vice President,
General Counsel and Secretary or in such other position as the Company's Board
of Directors (the "Board") may determine from time to time. The foregoing
description of Executive position shall not limit the Company from assigning to
Executive other duties and functions in addition to or in substitution for
those described above. The Executive shall be subject to the supervision of,
and shall have such authority as is delegated to him by the Board, the
Company's Chief Executive Officer or such other senior executive(s) as the
Board or the Chief Executive Officer shall determine.

3. Compensation and Benefits.

3.1. Salary. The Company shall pay the Executive, in regular periodic
installments, consistent with the Company's general pay practices, an annual
base salary of $135,000.00 for each one year period, commencing on the
Commencement Date, during the Employment Period. Such salary shall be subject
to adjustment as determined by the Board in its annual review of Executive's
performance hereunder. Executive specifically acknowledges that Company has no
obligation to increase said salary as a result of such review.

<PAGE> 2

3.2. Fringe Benefits and Bonus. The Executive shall be entitled to
participate in all bonus, stock purchase, warrant, stock option and any other
form of benefit programs that the Company establishes and makes available to
its executive employees, if any, to the extent that Executive's position,
tenure, salary, age, health and other qualifications make him eligible
to participate.

3.3. Reimbursement of Expenses. The Company shall reimburse the
Executive for all reasonable travel, entertainment and other expenses incurred
or paid by the Executive in connection with, or related to, the
performance of his duties, responsibilities or services under this
Agreement, upon presentation by the Executive of documentation, expense
statements, vouchers and/or such other supporting information as the Board of
Directors may request.

4. Employment Termination. The employment of the Executive by the Company
pursuant to the Agreement shall terminate upon the occurrence of any of the
following:

4.1. At the election of the Company for cause, immediately upon
written notice by the Company to the Executive. For the purposes of this
Section 4.1, cause for termination shall be deemed to exist upon (a) the
conviction of the Executive of, or the entry of a pleading of guilty or nolo
contendere by the Executive to, any crime involving moral turpitude or any
felony; or (b) any theft, embezzlement, fraud or other act of dishonesty
whether or not involving the Company, which, in the good faith finding of the
Board, will have a material adverse effect on the Company if Executive's
employment by the Company were to continue.

4.2. Upon the Executive's death or in accordance with the Company's
policies applicable to Executive in the event of the inability of the Executive
to provide services due to illness, disability, or physical or emotional
incapacity.

4.3. If for any reason the Executive's position is eliminated or
otherwise becomes redundant, or his responsibilities are substantially
decreased, whether because of merger, acquisition, sale of business or
assets, dissolution, tender offer, or any other reason.

4.4. The expiration of the Employment Period in accordance with
Section 1.2.

5. Effect of Termination.

5.1 Termination Pursuant to Section 4.1 or 4.4.
In the event the Executive's employment is terminated pursuant to Section 4.1
or 4.4, the company shall pay to the Executive the compensation and benefits
otherwise payable to him under Section 3 through the last day of his actual
employment by the Company. Any compensation previously earned by Executive
hereunder but not yet paid to him shall be accelerated and shall become payable
in a lump sun upon termination of employment.

5.2 Termination Pursuant to Section 4.2 or 4.3.
If the Executive's employment is terminated pursuant to Section 4.2 or 4.3, the
Company shall pay to the Executive or his personal representative, as the case
may be, the compensation which would otherwise be payable to the Executive
under section 3 in a lump sum, equal to the amounts in effect under section 3
through the end of the Employment Period. Any compensation previously earned
by Executive hereunder but not yet paid to him shall be accelerated and shall

<PAGE> 3

become payable in a lump sum upon termination of employment.

5.4 Survival. The provisions of sections 6, 7 and 8 shall survive the
termination of this Agreement.

6. Breach of Contract by Executive. Executive recognizes that the Company
is entering into this Agreement in order to obtain the exclusive use of his
personal services during the term hereof, that Executive's services are of a
special, unique, unusual, extraordinary, creative and intellectual character,
and that the commercial success of the enterprise for which Executive has been
hired depends primarily upon the unique character of his services. Executive
therefore agrees that the substantial portion of the Executive's services to
unrelated endeavors during the Employment Period, in violation of this
Agreement and without consent of the Company, shall be a material breach of
this Agreement. The Executive understands that such loss or diversion of his
services could neither be cured by the hiring of other executives nor could
damages be reasonably or adequately calculated and recovered in an action at
law, and therefore Executive further agrees that, to the extent permitted by
law, any material breach of this Agreement may, without limiting any other
remedies, be prevented or cured by an action for specific performance or
injunctive relief, without the need of the Company to post bond or other
security,

7. Non-Competition.

(a) During the Employment Period, the Executive will not directly or
indirectly:

(i) As an individual proprietor, partner, stockholder, officer,
executive, director, joint venturer, investor, lender, or in any other
capacity whatsoever (other than as a holder of not more than one percent (1%)
of the total outstanding stock of a publicly held company, engage in the
business of developing, producing, marketing or selling, whether at wholesale
or at retail, or of performing, providing, or offering, products and/or
services of the kind or type developed or being developed, produced, marketed,
sold, offered, provided or performed by the Company while the Executive was
employed by the Company; or

(ii) recruit, solicit or induce, or attempt to induce, any
executive or executives of the company or any other person or entity having any
continuing or periodic relationship with the Company to terminate their
employment with, to otherwise cease their relationship with, the Company, or

(iii) solicit, divert or take away, or attempt to divert or to
take away, the business or patronage of any of the customers or accounts, or
prospective customers or account, of the company which were contracted,
solicited or serviced by the Executive while employed by the Company

(b) If any restriction set forth in this section 7 is found by a
court of competent jurisdiction to be unenforceable because it extends for too
long period of time or over too great a range of activities or in too broad a
geographic area, it shall be interpreted to extend only over the maximum period
of time, range of activities or geographic areas as to which it may be
enforceable

(c) The restrictions contained in this Section 7 are necessary for the
protection of the business and goodwill of the Company and are considered by
the Executive to

<PAGE> 4

be reasonable for such purpose. The Executive agrees that any breach of this
Section 7 will cause the Company substantial and irrevocable damage and
therefore, the Company shall have the right, in addition to any other remedies
it may have, to seek specific performance and injunctive relief, without the
need to post a bond or other security.

8. Proprietary Information and Developments.

8.1. Proprietary Information.

(a) Executive agrees that all information and know-how, whether
or not in writing, of a private, secret or confidential nature concerning the
Company's business or financial affairs, business methods, suppliers or
customers (collectively, "Proprietary Information") is and shall be the
exclusive property at the Company. Executive will not disclose any
Proprietary Information to others outside the Company or use the same for any
unauthorized purposes without written approval by the Board, either during or
after his employment, unless and until such Proprietary Information has become
public knowledge without fault of the Executive.

(b) Executive agrees that all files, letters, memoranda,
reports, records, data, sketches, drawings, flow charts, business methods,
promotional materials, video or sound recordings, program listings, or other
written, photographic, or other tangible material containing Proprietary
Information, whether created by the Executive or others, which shall come
into his custody or possession, shall be and are the exclusive property of the
Company to be used by the Executive only in the performance of his duties for
the Company.

(c) Executive agrees that his obligation not to disclose or use
information, know-how and records of the types set forth in paragraphs (a)
and (b) above, also extends to such types of information, know-how, records
and intangible property of customers of the Company or suppliers to the Company
or other third parties who may have disclosed or entrusted the same to the
Company or to the Executive in the course of the Company's business.

8.2 Developments.

(a) Executive will make full and prompt disclosure to the
Company of all inventions, improvements, discoveries, methods, developments,
software and works of authorship, whether or not patentable or copyrightable,
which are created, made, conceived or reduced to practice by the Executive or
under his direction jointly with others during his employment by the Company,
whether or not during normal working hours or on the premises of the Company
(all of which are collectively referred to in this Agreement as "Developments").

(b) Executive agrees to assign and does hereby assign to the
Company (or any person or entity designated by the Company) all his right, title
and interest in and to all Developments and all related patents, patent
applications, copyrights and copyright applications. However, this Section
8.2(b) shall not apply to Developments which do not relate to the present or
planned business or research and development of the Company and which are made
and conceived by the Executive not during normal working hours, not on the
Company's premises and not using the Company's tools, devices, equipment or
Proprietary Information.

(c) Executive agrees to cooperate fully with the Company,
both during and after his employment with the Company, with respect to the
procurement, maintenance and

<PAGE> 5

enforcement of copyrights, patents and other intellectual and intangible
property rights (both in the United States and in foreign countries) relating
to Proprietary Information and Developments. Executive shall sign all papers,
including, without limitation, copyright applications and/or assignments.
patent applications and/or assignments, declarations, oaths, formal
assignments, assignments of proprietary rights, and powers of attorney, which
the Company may deem necessary or desirable in order to protect its rights and
interests in any Proprietary Information or Development.

8.3. Other Agreements. Executive further represents that his
performance of all the terms of this Agreement and as an Executive of the
Company does not and will not breach any agreement to keep in confidence
proprietary information, knowledge or data acquired by him in confidence or in
trust prior to his employment with the Company.

9. Notices. All notices required or permitted under this Agreement shall
be in writing and shall be deemed effective upon personal delivery or upon
deposit in the United States Post Office, by registered or certified mail,
postage prepaid, addressed to the other party at the address shown above, or at
such other address or addresses as either party shall designate to the other in
accordance with this Section 9. A copy of all notices given by Executive to
the Company shall be sent to each member of the Board.

10. Pronouns. Whenever the context may require, any pronouns used in
this Agreement shall include the corresponding masculine, feminine or neuter
forms, and the singular forms of nouns and pronouns shall include the plural,
and vice versa.

11. Entire Agreement. This Agreement constitutes the entire agreement
between the parties and supersedes all prior agreements and understandings,
whether written or oral, relating to the subject matter of this Agreement.

12. Amendment. This Agreement may be amended or modified only by a
written instrument executed by both the Company and Executive.

13. Governing Law. The Agreement shall be construed, interpreted and
enforced in accordance with the law of the state of Texas.

14. Successors and Assigns. This Agreement shall be binding upon and
inure to the benefit of both parties and their respective successors and
assigns, including any corporation with which or into which the Company may be
merged or which may succeed to its assets or business, provided, however, that
the obligations of Executive are personal and shall not be assigned by him.

15. Miscellaneous.

15.1. No delay or omission by the Company in exercising any
right under this Agreement shall operate as a waiver of that or any other right.
A waiver of consent given by the Company on any one occasion shall be effective
only in that instance and shall not be construed as a bar or waiver of any right
on any other occasion.

15.2. The captions of the sections of this Agreement are for
convenience of reference only and in no way define, limit or affect the scope or
substance of any section of this Agreement.

<PAGE> 6

15.3. In case any provision of this Agreement shall be invalid,
illegal or otherwise unenforceable, the validity, legality and enforceability of
the remaining provisions shall in no way be affected or impaired thereby.

IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of
the day and year set forth above.

SMITH INTERNATIONAL, INC. EXECUTIVE:

- ------------------------- --------------
Douglas L. Rock Neal S. Sutton
President

<PAGE> 1
EXHIBIT 10.12

EMPLOYMENT AGREEMENT

THIS EMPLOYMENT AGREEMENT (the "Agreement"), made this 1ST day of May,
1991, is entered into by SMITH INTERNATIONAL, INC., a Delaware corporation with
its principal place of business at Houston, Texas (the "Company"), and DICK
WERNER residing at Houston, Texas (the "Executive").

1. Term of Employment.

1.1. The Company hereby agrees to employ the Executive because of the
extraordinary and unique services the Executive can render to the company, and
the Executive accepts employment with the Company, upon the terms set forth in
this Agreement, for the period commencing on the date hereof (the "Commencement
Date") and ending on April 30, 1994, unless sooner terminated in accordance
with the provisions of Section 4.

1.2. On May 1, 1991 and on each anniversary ("Anniversary Date") of
that date, the period of employment hereunder (the "Employment Period") shall
be extended for one additional year, but, provided the Executive is still
employed hereunder, the Employment Period shall end forthwith at the earlier of
the Executive attaining the age of 65 years or if the Executive begins to
receive benefits under any pension or retirement income plan provided by the
Company or any of its subsidiaries.

2. Title; Capacity; Duties. The Executive shall serve as Vice
President/General Manager of Drilco/Servco or in such other position as the
Company's Board of Directors (the "Board") may determine from time to time.
The foregoing description of Executive position shall not limit the Company
from assigning to Executive other duties and functions in addition to or in
substitution for those described above. The Executive shall be subject to the
supervision of, and shall have such authority as is delegated to him by the
Board, the Company's Chief Executive Officer or such other senior executive(s)
as the Board or the Chief Executive Officer shall determine.

3. Compensation and Benefits.

3.1. Salary. The Company shall pay the Executive, in regular periodic
installments, consistent with the Company's general pay practices, an annual
base salary of $125,000.00 for each one year period, commencing on the
Commencement Date, during the Employment Period. Such salary shall be subject
to adjustment as determined by the Board in its annual review of Executive's
performance hereunder. Executive specifically acknowledges that Company has no
obligation to increase said salary as a result of such review.

<PAGE> 2

4. Employment Termination. The employment of the Executive by the Company
pursuant to the Agreement shall terminate upon the occurrence of any of the
following:

4.4. The expiration of the Employment Period in accordance with
Section 1.2.

5. Effect of Termination.

<PAGE> 3

become payable in a lump sum upon termination of employment.

5.4 Survival. The provisions of sections 6, 7 and 8 shall survive the
termination of this Agreement.

7. Non-Competition.

(a) During the Employment Period, the Executive will not directly or
indirectly:

(c) The restrictions contained in this Section 7 are necessary for the
protection of the business and goodwill of the Company and are considered by
the Executive to

<PAGE> 4

8. Proprietary Information and Developments.

8.1. Proprietary Information.

(a) Executive agrees that all information and know-how,
whether or not in writing, of a private, secret or confidential nature
concerning the Company's business or financial affairs, business methods,
suppliers or customers (collectively, "Proprietary Information") is and
shall be the exclusive property at the Company. Executive will not disclose
any Proprietary Information to others outside the Company or use the same for
any unauthorized purposes without written approval by the Board, either during
or after his employment, unless and until such Proprietary Information has
become public knowledge without fault of the Executive.

(c) Executive agrees that his obligation not to disclose or
use information, know-how and records of the types set forth in paragraphs (a)
and (b) above, also extends to such types of information, know-how, records
and intangible property of customers of the Company or suppliers to the Company
or other third parties who may have disclosed or entrusted the same to the
Company or to the Executive in the course of the Company's business.

8.2 Developments.

(b) Executive agrees to assign and does hereby assign to the
Company (or any person or entity designated by the Company) all his right,
title and interest in and to all Developments and all related patents, patent
applications, copyrights and copyright applications. However, this Section
8.2(b) shall not apply to Developments which do not relate to the present or
planned business or research and development of the Company and which are made
and conceived by the Executive not during normal working hours, not on the
Company's premises and not using the Company's tools, devices, equipment or
Proprietary Information.

(c) Executive agrees to cooperate fully with the
Company, both during and after his employment with the Company, with respect to
the procurement, maintenance and

<PAGE> 5

12. Amendment. This Agreement may be amended or modified only by a
written instrument executed by both the Company and Executive.

13. Governing Law. The Agreement shall be construed, interpreted and
enforced in accordance with the law of the state of Texas.

15. Miscellaneous.

15.1. No delay or omission by the Company in exercising any
right under this Agreement shall operate as a waiver of that or any other
right. A waiver of consent given by the Company on any one occasion shall be
effective only in that instance and shall not be construed as a bar or waiver
of any right on any other occasion.

15.2. The captions of the sections of this Agreement are for
convenience of reference only and in no way define, limit or affect the scope
or substance of any section of this Agreement.

<PAGE> 6

15.3. In case any provision of this Agreement shall be invalid,
illegal or otherwise unenforceable, the validity, legality and enforceability
of the remaining provisions shall in no way be affected or impaired thereby.

IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of
the day and year set forth above.

SMITH INTERNATIONAL, INC. EXECUTIVE:

- ------------------------- -----------------------------
Douglas L. Rock Dick Werner
President

<PAGE> 1
EXHIBIT 10.16

FIRST AMENDMENT

FIRST AMENDMENT dated as of November 12, 1992 to the Amendment to
Employment Agreement (the "Agreement") dated January 2, 1991 by and between
NEAL S. SUTTON (the "Employee") and Smith International, Inc., a Delaware
corporation (the "COMPANY").

The Agreement is hereby amended in the following respects:

1. Section 2(a) is amended to read in its entirety as follows:

(a) Base Salary. An amount in cash equal to three (3) times the
amount of EMPLOYEE'S Base Salary (as defined below). "Base Salary" is the
greater of the EMPLOYEE'S annual base salary (x) immediately prior to the
Change in Control or (y) on the effective date of his Covered Termination. Any
payments made hereunder are in lieu of any lump sum payment of base salary
required under the Employment Agreement as a result of the termination of
EMPLOYEE pursuant to Section 4.3 of the Employment Agreement.

2. Section 2(b) is amended to read in its entirety as follows:

(b) Bonus. An amount in cash equal to the amount of EMPLOYEE'S Target
Incentive Level for an Award under the COMPANY'S Annual Long Term Incentive
Plan as in effect on his date of Covered Termination, or, if greater, as in
effect immediately prior to the Change in Control.

3. At the end of Section 8, delete the period after the word "company" and
add the following:

; and provided, further, that for purposes of this subsection (b), any
good faith determination of an event described in clauses (i)-(vi) made by the
EMPLOYEE shall be conclusive; or (c) EMPLOYEE'S employment is terminated by the
COMPANY for a reason other than for cause in anticipation of a Change in
Control or at the request of a third party seeking to cause a Change in
Control.

4. Amend Section 11 so that it reads in its entirety as follows:

11. Definition of Change in Control. A "Change in Control" shall
mean any of the following events:

(a) The acquisition by any individual, entity or group (within the
meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934,
as amended (the "Exchange Act") (a "Person") of beneficial ownership (within
the meaning of Rule 13d-3 promulgated under the Exchange Act) of 50% or more
of the combined voting power of the then outstanding voting

<PAGE> 2

securities of the COMPANY entitled to vote generally in the election of
directors (the "Outstanding COMPANY Voting Securities"); provided, however,
that for purposes of this subsection (a), the following acquisitions shall not
constitute a Change of Control: (i) any acquisition directly from the COMPANY
(ii) any acquisition by the COMPANY, (iii) any acquisition by any employee
benefit plan (or related trust) sponsored or maintained by the COMPANY or any
corporation controlled by the COMPANY or (iv) any acquisition by an corporation
pursuant to a transaction which complies with clauses (i), (ii) and (iii) of
subsection (c) below; or

(b) individuals who, as of the date hereof, constitute the Board (the
"Incumbent Board") cease for any reason to constitute at least a majority of
the Board; provided, however, that any individual becoming a director
subsequent to the date hereof whose election, or nomination for election by the
COMPANY'S shareholders, was approved by a vote of at least a majority of the
directors then comprising the Incumbent Board shall be considered as though
such individual were a member of the Incumbent Board, but excluding, for this
purpose, any such individual whose initial assumption of office occurs as a
result of an actual or threatened election contest with respect to the election
or removal of directors or other actual or threatened solicitation of proxies
or consents by or on behalf of a Person other than the Board; or

(c) approval by the shareholders of the COMPANY of a reorganization,
merger or consolidation or sale or other disposition of all or substantially
all of the assets of the COMPANY (a "Business Combination"), in each case,
unless following such Business Combination, (i) all or substantially all of the
individuals and entities who were the beneficial owners of the Outstanding
COMPANY Voting Securities immediately prior to such Business Combination
beneficially own, directly or indirectly, more than 60% of, respectively, the
then outstanding shares of common stock and the combined voting power of the
then outstanding voting securities entitled to vote generally in the election
of directors, as the case may be, of the corporation resulting from such
Business Combination (including, without limitation, a corporation which as a
result of such transaction owns the COMPANY or all or substantially all of the
COMPANY'S assets either directly or through one or more subsidiaries) in
substantially the same proportions as their ownership, immediately prior to
such Business Combination of the Outstanding COMPANY Voting Securities, (ii) no
Person (excluding any employee benefit plan (or related trust) of the COMPANY
or such corporation resulting from such Business Combination) beneficially
owns, directly or indirectly, 50% or more of, respectively, the then
outstanding shares of common stock of the corporation resulting from such
Business Combination or the combined voting power of the then outstanding
voting securities of such corporation except to the extent that such ownership
existed prior to the Business Combination and (iii) at least a majority of the
members of the board of directors of the corporation resulting from such
Business Combination were members of the Incumbent Board at the time of the
execution of the initial agreement, or of the action of the Board, providing
for such Business Combination; or

(d) approval by the shareholders of the COMPANY of a complete
liquidation or dissolution of the COMPANY.

2
<PAGE> 3

5. Add a new Section 14 to read in its entirety as follows:

14. Reduction in Payments. (a) For purposes of this section, (i)
"Payment" shall mean any payment or distribution in the nature of compensation
to or for the benefit of EMPLOYEE, whether paid or payable pursuant to this
Agreement or otherwise; (ii) "Agreement Payment" shall mean a Payment paid or
payable pursuant to this Agreement (disregarding this Section); (iii) "Net
After Tax Receipt" shall mean the Present Value of a Payment net of all taxes
imposed on EMPLOYEE with respect thereto under Sections 1 and 4999 of the
Internal Revenue Code of 1986, as amended (the "Code"), determined by applying
the highest marginal rate under Section 1 of the Code which applied to the
EMPLOYEE'S taxable income for the immediately preceding taxable year; (iv)
"Present Value" shall mean such value determined in accordance with Section
2800 (d)(4) of the Code; and (v) "Safe Harbor" shall mean the sum of $1.00 less
than three times the EMPLOYEE'S "base amount" within the meaning of that term
in Section 280G of the Code.

(b) Anything in this Agreement to the contrary notwithstanding, in
the event Arthur Andersen & Co. (the "Accounting Firm") shall determine that
receipt of all Payments would subject EMPLOYEE to tax under Section 4999 of the
Code, it shall determine whether the receipt of the Safe Harbor would result in
greater Net After Tax Receipts to the EMPLOYEE than receipt of all the
Agreement Payments. If said firm determines that the receipt of the Safe
Harbor would so result, the aggregate Agreement Payments shall be reduced to
the Safe Harbor.

If the Accounting firm determines that aggregate Agreement Payments
should be reduced to the Safe Harbor, the COMPANY shall promptly give EMPLOYEE
notice to that effect and a copy of the detailed calculation thereof, and the
EMPLOYEE may then elect, in his sole discretion, which and how much of the
Agreement Payments shall be eliminated or reduced (as long as after such
election the present value of the aggregate Agreement Payments equals the Safe
Harbor), and shall advise the COMPANY in writing of his election within ten
days of his receipt of notice. If no such election is made by the EMPLOYEE
within such ten-day period, the COMPANY may elect which of such Agreement
Payments shall be eliminated or reduced (as long as after such election the
present value of the aggregate Agreement Payments equals the Safe Harbor) and
shall notify the EMPLOYEE promptly of such election. All determinations made by
the Accounting Firm under this Section shall be binding upon the COMPANY and
EMPLOYEE and shall be made within 60 days of a termination of employment of the
EMPLOYEE. As promptly as practicable following such determination, the COMPANY
shall pay to or distribute for the benefit of EMPLOYEE such Agreement Payments
as are then due to EMPLOYEE under this Agreement and shall promptly pay to or
distribute for the benefit of EMPLOYEE in the future such Agreement Payments as
become due to Employee under this Agreement.

(c) While it is the intention of the COMPANY and the EMPLOYEE to
reduce the amounts payable or distributable to EMPLOYEE hereunder only if the
aggregate Net After Tax Receipts to EMPLOYEE would thereby be increased, as a
result of the uncertainty in the application of Section 4999 of the Code at the
time of the initial determination by the Accounting Firm hereunder, it is
possible that amounts will not have been paid or distributed by

3
<PAGE> 4

the COMPANY to or for the benefit of EMPLOYEE pursuant to this Agreement which
should not have been so paid or distributed ("Overpayment") or that additional
amounts which will have not been paid or distributed by the COMPANY to or for
the benefit of EMPLOYEE pursuant to this Agreement could have been so paid or
distributed ("Underpayment"), in each case, consistent with the calculation of
the Reduced Amount hereunder. In the event that the Accounting Firm, based
either upon the assertion of a deficiency by the Internal Revenue Service
against the COMPANY or EMPLOYEE which the Accounting Firm believes has a high
probability of success determines that an Overpayment has been made, any such
Overpayment paid or distributed by the COMPANY to or for the benefit of
EMPLOYEE shall be treated for all purposes as a loan to EMPLOYEE which EMPLOYEE
shall repay to the COMPANY together with interest at the applicable federal
rate provided for in Section 7872 (f) (2) of the Code; provided, however, that
no such loan shall be deemed to have been made and no amount shall be payable
by EMPLOYEE to the COMPANY if and to the extent such deemed loan and payment
would not either reduce the amount on which the EMPLOYEE is subject to tax
under Section 1 and Section 4999 of the Code or generate a refund of such
taxes. In the event that the Accounting Firm, based upon controlling precedent
or substantial authority, determines that an Underpayment has occurred, any
such Underpayment shall be promptly paid by the COMPANY to or for the benefit
of the EMPLOYEE together with interest at the applicable federal rate provided
for in Section 7872 of the Code.

6. Add a new Section 15 to read in its entirety as follows:

15. Reimbursement. The COMPANY agrees to pay as incurred, to the
full extent permitted by law, all legal fees and expenses which the EMPLOYEE
may reasonably incur as a result of any contest (regardless of the outcome
thereof) by the COMPANY, the EMPLOYEE or others of the validity or
enforceability of, or liability under, any provision of this Agreement or any
guarantee of performance thereof (including as a result of any contest by the
EMPLOYEE about the amount of any payment pursuant to this Agreement), plus in
each case interest on any delayed payment at the applicable Federal rate
provided for in Section 7872 of the Code.

IN WITNESS WHEREOF, the parties have executed this First Amendment as of
the day and year first above written.

SMITH INTERNATIONAL, INC. NEAL S. SUTTON

By:
------------------------- ------------------------------

<PAGE> 1
EXHIBIT 10.17

FIRST AMENDMENT

FIRST AMENDMENT dated as of November 12, 1992 to the Amendment to
Employment Agreement (the "Agreement") dated May 1, 1991 by and between DICK
WERNER (the "Employee") and Smith International, Inc., a Delaware corporation
(the "COMPANY").

The Agreement is hereby amended in the following respects:

1. Section 2(a) is amended to read in its entirety as follows:

2. Section 2(b) is amended to read in its entirety as follows:

3. At the end of Section 8, delete the period after the word "company"
and add the following:

4. Amend Section 11 so that it reads in its entirety as follows:

11. Definition of Change in Control. A "Change in Control" shall
mean any of the following events:

<PAGE> 2

(d) approval by the shareholders of the COMPANY of a complete
liquidation or dissolution of the COMPANY.

<PAGE> 3

5. Add a new Section 14 to read in its entirety as follows:

(c) While it is the intention of the COMPANY and the EMPLOYEE to
reduce the amounts payable or distributable to EMPLOYEE hereunder only if the
aggregate Net After Tax Receipts to EMPLOYFE would thereby be increased, as a
result of the uncertainty in the application of Section 4999 of the Code at the
time of the initial determination by the Accounting Firm hereunder, it is
possible that amounts will not have been paid or distributed by

<PAGE> 4

6. Add a new Section 15 to read in its entirety as follows:

IN WITNESS WHEREOF, the parties have executed this First Amendment as of
the day and year first above written.

SMITH INTERNATIONAL, INC. DICK WERNER

By:
- ------------------------- -----------------------

<PAGE> 1
EXHIBIT 21

SUBSIDIARIES OF THE COMPANY

The following table sets forth all subsidiaries of Smith International,
Inc., other than inactive and insignificant subsidiaries that, considered in
the aggregate, would not constitute a significant subsidiary, indicating the
percentage of issued and outstanding voting securities beneficially owned by
it:

<TABLE>
<CAPTION>
% of Direct
Where and Indirect
Name of Subsidiary Incorporated Ownership
----------------------------------------------------------------------
<S> <C> <C>

Smith Internacional,
S.A. de C.V. Mexico l00%
Omega II Insurance Ltd. Bermuda l00%
S.I. Nederland B.V. Netherlands l00%
Smith International
Acquisition Corp. Delaware 100%
Smith International
Australia (Pty) Ltd. Australia l00%
Smith International
Canada Ltd. Canada l00%
Smith International
do Brasil Ltda. Brazil l00%
Smith International
Deutschland GmbH Germany l00%
Smith International
Gulf Services Ltd.* U.A.E. 49%
Smith International
France, S.A.R.L. France l00%
Smith International
Italia, S.p.A. Italy l00%
Smith International
(North Sea) Ltd. Scotland l00%
Smith Internacional
de Venezuela, C.A. Venezuela l00%
----------------------------------------------------------------------
</TABLE>

* Not consolidated; accounted for on the equity method of
accounting.

Except as indicated, all of the above subsidiaries are included in the
Company's consolidated financial statements.

EXHIBIT 21

<PAGE> 1
EXHIBIT 24.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the incorporation
by reference of our report dated February 3, 1997 included in this Form 10-K
into the Company's previously filed Registration Statement File No. 33-31556.

ARTHUR ANDERSEN LLP

Houston, Texas
March 19, 1997

<PAGE> 1
EXHIBIT 24.2

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

ARTHUR ANDERSEN LLP

Houston, Texas
March 19, 1997

<PAGE> 1
EXHIBIT 24.3

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

ARTHUR ANDERSEN LLP

Houston, Texas
March 19, 1997

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 25,540
<SECURITIES> 0
<RECEIVABLES> 315,486
<ALLOWANCES> 6,424
<INVENTORY> 295,041
<CURRENT-ASSETS> 665,277
<PP&E> 363,541
<DEPRECIATION> 158,290
<TOTAL-ASSETS> 1,074,582
<CURRENT-LIABILITIES> 300,501
<BONDS> 228,443
0
0
<COMMON> 40,157
<OTHER-SE> 328,379
<TOTAL-LIABILITY-AND-EQUITY> 1,074,582
<SALES> 1,156,658
<TOTAL-REVENUES> 1,156,658
<CGS> 764,596
<TOTAL-COSTS> 764,596
<OTHER-EXPENSES> 259,542
<LOSS-PROVISION> 1,490
<INTEREST-EXPENSE> 16,445
<INCOME-PRETAX> 116,075
<INCOME-TAX> 26,798
<INCOME-CONTINUING> 64,444
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 64,444
<EPS-PRIMARY> 1.62
<EPS-DILUTED> 1.62

</TABLE>