UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2006

OR

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

For the transition period from                      to                     

Smith International, Inc.

(Exact name of Registrant as specified in its charter)

Delaware		95-3822631
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

411 North Sam Houston Parkway, Suite 600
Houston, Texas		77060
(Address of principal executive offices)		(Zip Code)

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

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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 R No £

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer R       Accelerated Filer £       Non-Accelerated Filer £.

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No R

The number of shares outstanding of the Registrant’s common stock as of August 2, 2006 was 213,994,607.

 

 

INDEX

		Page
		No.
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS For the Three Months and Six Months ended June 30, 2006 and 2005			1
CONSOLIDATED CONDENSED BALANCE SHEETS As of June 30, 2006 and December 31, 2005			2
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS For the Six Months ended June 30, 2006 and 2005			3
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
Item 3. Quantitative and Qualitative Disclosures about Market Risk			21
Item 4. Controls and Procedures			21
PART II — OTHER INFORMATION
Items 1—4			22
Items 5—6			23
SIGNATURES			24
EXHIBIT INDEX			25
Certification of CEO Pursuant to Rule 13a-14
Certification of CFO Pursuant to Rule 13a-14
Certification Pursuant to Section 1350

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

SMITH INTERNATIONAL, INC.

(In thousands, except per share data)

(Unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Revenues		$	1,738,263			$	1,350,203			$	3,420,384			$	2,638,401
Costs and expenses:
Costs of revenues			1,193,250				951,065				2,348,768				1,853,851
Selling expenses			228,255				191,320				449,449				375,194
General and administrative expenses			71,298				52,436				139,589				105,802
Total costs and expenses			1,492,803				1,194,821				2,937,806				2,334,847
Operating income			245,460				155,382				482,578				303,554
Interest expense			14,685				10,992				27,521				21,332
Interest income			(696	)			(436	)			(1,293	)			(804	)
Income before income taxes and minority interests			231,471				144,826				456,350				283,026
Income tax provision			70,910				46,828				143,572				91,974
Minority interests			41,728				29,938				86,729				56,840
Net income		$	118,833			$	68,060			$	226,049			$	134,212
Earnings per share:
Basic		$	0.59			$	0.34			$	1.13			$	0.66
Diluted		$	0.59			$	0.33			$	1.12			$	0.66
Weighted average shares outstanding:
Basic			200,457				202,215				200,725				202,597
Diluted			202,162				204,027				202,371				204,636

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

SMITH INTERNATIONAL, INC.

(In thousands, except par value data)

(Unaudited)

		June 30,				December 31,
		2006				2005
Assets
Current Assets:
Cash and cash equivalents		$	88,502			$	62,543
Receivables, net			1,366,755				1,200,289
Inventories, net			1,295,954				1,059,992
Deferred tax assets, net			38,697				48,467
Prepaid expenses and other			81,116				65,940
Total current assets			2,871,024				2,437,231
Property, Plant and Equipment, net			734,006				665,389
Goodwill, net			765,792				737,048
Other Intangible Assets, net			103,131				78,779
Other Assets			165,385				141,467
Total Assets		$	4,639,338			$	4,059,914
Liabilities and Stockholders’ Equity
Current Liabilities:
Short-term borrowings and current portion of long-term debt		$	164,371			$	133,650
Accounts payable			560,836				479,206
Accrued payroll costs			102,077				108,419
Income taxes payable			95,921				91,303
Other			129,385				120,575
Total current liabilities			1,052,590				933,153
Long-Term Debt			792,005				610,857
Deferred Tax Liabilities			120,681				107,838
Other Long-Term Liabilities			94,480				86,853
Minority Interests			825,511				742,708
Commitments and Contingencies (Note 13)
Stockholders’ Equity:
Preferred stock, $1 par value; 5,000 shares authorized; no shares issued or outstanding in 2006 or 2005			—				—
Common stock, $1 par value; 250,000 shares authorized; 213,971 shares issued in 2006 (213,270 shares issued in 2005)			213,971				213,270
Additional paid-in capital			409,332				383,695
Retained earnings			1,409,461				1,215,483
Accumulated other comprehensive income			20,152				6,901
Less — Treasury securities, at cost; 13,831 common shares in 2006 (12,301 common shares in 2005)			(298,845	)			(240,844	)
Total stockholders’ equity			1,754,071				1,578,505
Total Liabilities and Stockholders’ Equity		$	4,639,338			$	4,059,914

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

SMITH INTERNATIONAL, INC.

(In thousands)

(Unaudited)

		Six Months Ended
		June 30,
		2006				2005
Cash flows from operating activities:
Net income		$	226,049			$	134,212
Adjustments to reconcile net income to net cash provided by operating activities, excluding the net effects of acquisitions:
Depreciation and amortization			68,625				56,953
Minority interests			86,729				56,840
Deferred income tax provision			12,055				7,908
Provision for losses on receivables			4,215				2,059
Increase in LIFO inventory reserves			14,948				22,211
Gain on disposal of property, plant and equipment			(9,717	)			(6,919	)
Foreign currency translation losses (gains)			1,075				(331	)
Share-based compensation expense			13,385				1,313
Equity earnings, net of dividends received			(6,399	)			(1,557	)
Gain on sale of operations			(5,930	)			—
Changes in operating assets and liabilities:
Receivables			(161,082	)			(110,156	)
Inventories			(247,057	)			(124,363	)
Accounts payable			71,390				35,019
Other current assets and liabilities			(12,089	)			(13,207	)
Other non-current assets and liabilities			(16,262	)			(14,480	)
Net cash provided by operating activities			39,935				45,502
Cash flows from investing activities:
Acquisitions, net of cash acquired			(58,019	)			(4,667	)
Purchases of property, plant and equipment			(113,965	)			(71,323	)
Proceeds from disposal of property, plant and equipment			15,807				12,982
Proceeds from sale of operations			9,296				—
Net cash used in investing activities			(146,881	)			(63,008	)
Cash flows from financing activities:
Proceeds from issuance of long-term debt			393,031				122,960
Principal payments of long-term debt			(215,290	)			(46,400	)
Net change in short-term borrowings			36,782				(5,054	)
Purchases of treasury stock			(58,001	)			(68,766	)
Proceeds from share-based compensation plans			8,598				25,754
Payment of common stock dividends			(28,105	)			(12,227	)
Debt issuance costs			(4,744	)			—
Net cash provided by financing activities			132,271				16,267
Effect of exchange rate changes on cash			634				(748	)
Increase (decrease) in cash and cash equivalents			25,959				(1,987	)
Cash and cash equivalents at beginning of period			62,543				53,596
Cash and cash equivalents at end of period		$	88,502			$	51,609
Supplemental disclosures of cash flow information:
Cash paid for interest		$	27,448			$	21,242
Cash paid for income taxes			123,830				82,754

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

SMITH INTERNATIONAL, INC.

(Unaudited)

1. Basis of Presentation of Interim Financial Statements

The accompanying unaudited consolidated condensed financial statements of Smith International, Inc. and subsidiaries (the “Company”) were prepared in accordance with U.S. generally accepted accounting principles and applicable rules and regulations of the Securities and Exchange Commission (the “Commission”) pertaining to interim financial information. These interim financial statements do not include all information or footnote disclosures required by generally accepted accounting principles for complete financial statements and, therefore, should be read in conjunction with the audited financial statements and accompanying notes included in the Company’s 2005 Annual Report on Form 10-K and other current filings with the Commission. All adjustments which are, in the opinion of management, of a normal and recurring nature and are necessary for a fair presentation of the interim financial statements have been included.

Preparation of financial statements in conformity with U.S. 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. If the underlying estimates and assumptions, upon which the financial statements are based, change in future periods, actual amounts may differ from those included in the accompanying consolidated condensed financial statements.

In July 2005, the Company’s Board of Directors approved a two-for-one stock split, which was effected in the form of a stock dividend. Stockholders of record as of August 5, 2005 were entitled to the dividend, which was distributed on August 24, 2005. Unless otherwise noted, all share and earnings per share amounts included in the accompanying consolidated condensed statements of operations for the three and six-month periods ended June 30, 2005, and accompanying notes have been restated for the effect of the stock split.

Management believes the consolidated condensed financial statements present fairly the financial position, results of operations and cash flows of the Company as of the dates indicated. The results of operations for the interim periods presented may not be indicative of results for the fiscal year.

2. Recent Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) which are adopted by the Company as of the specified effective date. Effective January 1, 2006, the Company has adopted Statement of Financial Accounting Standards (“SFAS”) No. 123r, “Share-Based Payment,” (“SFAS No. 123r”) using the modified prospective method. Based on stock options outstanding as of December 31, 2005, the adoption of SFAS No. 123r is expected to result in the recognition of $14.4 million of future compensation expense, of which $8.9 million is expected to be recorded during the 2006 fiscal year. See Note 11 for further disclosure regarding SFAS No. 123r.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”, and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken, or expected to be taken, on a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the provisions of FIN 48 and have not yet determined the impact, if any, on our consolidated condensed financial statements.

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

3. Acquisitions and Dispositions

During the six months ended June 30, 2006, the Company completed four acquisitions in exchange for aggregate cash consideration of $58.0 million. The consideration primarily relates to the purchase of Norwegian-based Epcon Offshore AS, completed in February 2006, which provides proprietary technology designed to optimize the removal of hydrocarbons from produced water.

These acquisitions have been recorded using the purchase method of accounting and, accordingly, the acquired operations have been included in the results of operations since the date of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired approximated $28.7 million and has been recorded as goodwill in the June 30, 2006 consolidated condensed balance sheet. The purchase price allocations related to these acquisitions are based on preliminary information and are subject to change when additional data concerning final asset and liability valuations is obtained; however, material changes in the preliminary allocations are not anticipated by management.

Subsequent to June 30, 2006, the Company completed the acquisition of Specialised Petroleum Services Group Limited (“SPS”) of Aberdeen, Scotland in exchange for cash consideration of approximately $165 million. See Note 14 to the consolidated condensed financial statements for additional discussion regarding SPS.

Additionally, during the three months ended June 30, 2006, the Company completed the disposition of its ownership interest in two oilfield business operations for aggregate cash proceeds of $9.3 million. These transactions resulted in an aggregate pre-tax gain of approximately $5.9 million and, $2.9 million net of taxes and minority interest, which has been reflected as a reduction to general and administrative expenses in the accompanying consolidated condensed statements of operations.

Pro forma results of operations have not been presented because the effect of these transactions was not material to the Company’s consolidated condensed financial statements.

4. Earnings Per Share

Basic earnings per share (“EPS”) is computed using the weighted average number of common shares outstanding during the period. Diluted EPS gives effect to the potential dilution of earnings that could have occurred if additional shares were issued for stock option exercises and restricted stock awards under the treasury stock method. As of June 30, 2006, 12,378 outstanding employee stock options were excluded from the computation of diluted earnings per common share because they were anti-dilutive during the corresponding period. All employee stock options were included in the computation in the second quarter of 2005. The following schedule reconciles the income and shares used in the basic and diluted EPS computations (in thousands, except per share data):

		Three Months Ended June 30,								Six Months Ended June 30,
		2006				2005				2006				2005
Basic EPS:
Net income		$	118,833			$	68,060			$	226,049			$	134,212
Weighted average number of common shares outstanding			200,457				202,215				200,725				202,597
Basic EPS		$	0.59			$	0.34			$	1.13			$	0.66
Diluted EPS:
Net income		$	118,833			$	68,060			$	226,049			$	134,212
Weighted average number of common shares outstanding			200,457				202,215				200,725				202,597
Dilutive effect of stock options and restricted stock units			1,705				1,812				1,646				2,039
			202,162				204,027				202,371				204,636
Diluted EPS		$	0.59			$	0.33			$	1.12			$	0.66

5. Inventories

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

		June 30,				December 31,
		2006				2005
Raw materials		$	112,029			$	86,961
Work-in-process			135,493				111,399
Products purchased for resale			355,556				303,307
Finished goods			782,424				632,925
			1,385,502				1,134,592
Reserves to state certain U.S. inventories (FIFO cost of $472,379 and $386,643 in 2006 and 2005, respectively) on a LIFO basis			(89,548	)			(74,600	)
		$	1,295,954			$	1,059,992

During the first half of 2006, the Company recorded additional LIFO reserves of $14.9 million, primarily related to the revaluation of on-hand inventories to current standards, largely reflecting higher manufacturing costs in the Oilfield segment.

6. Property, Plant and Equipment

Property, plant and equipment consist of the following (in thousands):

		June 30,				December 31,
		2006				2005
Land		$	39,647			$	37,753
Buildings			167,477				153,467
Machinery and equipment			622,560				587,808
Rental tools			529,197				472,913
			1,358,881				1,251,941
Less-Accumulated depreciation			(624,875	)			(586,552	)
		$	734,006			$	665,389

7. Goodwill and Other Intangible Assets

Goodwill

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

		Oilfield				Distribution
		Segment				Segment				Consolidated
		(in thousands)
Balance as of December 31, 2005		$	699,142			$	37,906			$	737,048
Goodwill acquired			26,430				2,314				28,744
Balance as of June 30, 2006		$	725,572			$	40,220			$	765,792

Other Intangible Assets

The Company amortizes other identifiable intangible assets on a straight-line basis over the periods expected to be benefited, ranging from three to 27 years. The components of these other intangible assets included in the accompanying consolidated condensed balance sheets, are as follows (in thousands):

		June 30, 2006												December 31, 2005
																										Weighted
		Gross												Gross												Average
		Carrying				Accumulated								Carrying				Accumulated								Amortization
		Amount				Amortization				Net				Amount				Amortization				Net				Period (years)
Patents		$	69,928			$	18,994			$	50,934			$	43,191			$	16,938			$	26,253				12.9
License agreements			31,231				8,819				22,412				29,308				7,181				22,127				10.3
Non-compete agreements and trademarks			32,097				14,592				17,505				29,150				12,414				16,736				9.4
Customer lists and contracts			17,282				5,002				12,280				17,282				3,619				13,663				11.5
		$	150,538			$	47,407			$	103,131			$	118,931			$	40,152			$	78,779				11.6

Amortization expense of other intangible assets was $3.9 million and $2.3 million for the three-month periods ended June 30, 2006 and 2005, respectively, and $7.3 million and $4.6 million for the six-month periods ended June 30, 2006 and 2005, respectively. Additionally, estimated future amortization expense is expected to range between $9.1 million and $15.6 million per year for the next five fiscal years.

8. Debt

The following summarizes the Company’s outstanding debt (in thousands):

		June 30,				December 31,
		2006				2005
Current:
Short-term borrowings		$	156,388			$	122,174
Current portion of long-term debt			7,983				11,476
		$	164,371			$	133,650
Long-Term:
Notes, net of unamortized discounts		$	658,429			$	386,959
Revolving credit facilities			138,500				232,700
Term loans and other			3,059				2,674
			799,988				622,333
Less current portion of long-term debt			(7,983	)			(11,476	)
		$	792,005			$	610,857

During the second quarter of 2006, the Company completed a public offering of $275.0 million of 6.00 percent Senior Notes (the “Notes”) which mature in June 2016. The Notes have an effective interest rate of 6.11 percent and interest is payable semi-annually. The Company received net proceeds of $272.8 million from the offering, which was primarily used to repay indebtedness under the Smith U.S. revolving credit facility.

Principal payments of long-term debt for the twelve-month periods ending subsequent to June 30, 2007 are as follows (in thousands):

2008		$	158,531
2009			649
2010			29
2011			358,073
Thereafter			274,723
		$	792,005

9. Comprehensive Income

Comprehensive income includes net income and changes in the components of accumulated other comprehensive income during the periods presented. The Company’s comprehensive income is as follows (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Net income		$	118,833			$	68,060			$	226,049			$	134,212
Changes in unrealized fair value of derivatives, net			1,052				(2,013	)			1,641				(2,199	)
Pension liability adjustments			—				—				—				(476	)
Currency translation adjustments			11,067				(7,149	)			11,610				(13,266	)
Comprehensive income		$	130,952			$	58,898			$	239,300			$	118,271

Accumulated other comprehensive income in the accompanying consolidated condensed balance sheet consists of the following (in thousands):

		June 30,				December 31,
		2006				2005
Currency translation adjustments		$	24,758			$	13,148
Unrealized fair value of derivatives			(535	)			(2,176	)
Pension liability adjustments			(4,071	)			(4,071	)
Accumulated other comprehensive income		$	20,152			$	6,901

10. Employee Benefit Plans

The Company maintains various noncontributory defined benefit pension plans covering certain U.S. and non-U.S. employees. In addition, the Company and certain subsidiaries have postretirement benefit plans which provide health care benefits to a limited number of current, and in some cases, future retirees. Net periodic benefit expense related to the pension and postretirement benefit plans, on a combined basis, approximated $1.0 million for each of the three-month periods ended June 30, 2006 and 2005, respectively, and $2.0 million for each of the six-month periods ended June 30, 2006 and 2005, respectively. Company contributions to the pension and postretirement benefit plans during 2006 are expected to total approximately $3.2 million.

11. Long-Term Incentive Compensation

The Company’s Board of Directors and its stockholders have authorized a long-term incentive plan for the benefit of key employees.

Restricted stock units are considered compensatory awards and compensation expense related to these units is being recognized over the established vesting period in the accompanying consolidated condensed financial statements. However, prior to the mandatory adoption of SFAS No. 123r on January 1, 2006, companies could continue to apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and related interpretations in accounting for its stock option program. Accordingly, for periods ended prior to January 1, 2006, the Company elected to make pro forma footnote disclosures rather than recognizing the related compensation expense in the consolidated financial statements.

Had the Company elected to apply the accounting standards of SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and earnings per share for the three and six-month periods ended June 30, 2005 would have approximated the pro forma amounts indicated below (in thousands, except per share data):

		For the periods ended
		June 30, 2005
		Three				Six
		Months				Months
Net income as reported		$	68,060			$	134,212
Add: Stock-based compensation expense included in reported income, net of related tax effect			744				903
Less: Total stock-based compensation expense determined under fair value methods, net of related tax effect			(3,062	)			(5,483	)
Net income, pro forma		$	65,742			$	129,632
Earnings per share:
As reported:
Basic		$	0.34			$	0.66
Diluted			0.33				0.66
Pro forma:
Basic		$	0.33			$	0.64
Diluted			0.32				0.63

Restricted Stock

The restricted stock program consists of a combination of performance-based restricted stock units (“performance-based units”) and time-based restricted stock units (“time-based units”). The number of performance-based units issued under the program, which can range from zero to 115 percent of the target units granted, is solely dependent upon the return on equity achieved by the Company in the fiscal year subsequent to the award. Estimated compensation expense for the performance-based units, calculated as the difference between the market value and the exercise price, is recognized over the three-year vesting period. Compensation expense related to time-based units is recognized over a four-year vesting period.

Compensation expense related to restricted stock awards totaled $4.4 million and $1.1 million for the three-month periods ended June 30, 2006 and 2005, respectively, and $8.8 million and $1.4 million for the six-month periods ended June 30, 2006 and 2005, respectively. A summary of the Company’s restricted stock program is presented below:

						Weighted								Weighted
						Average								Average								Aggregate
		Time-				Grant-				Performance-				Grant-				Total				Intrinsic
		Based				Date Fair				Based				Date Fair				Restricted				Value(b)
		Units				Value				Units				Value				Stock Units				(in thousands)
Outstanding at December 31, 2005			239,340			$	34.00				1,264,251	(a)		$	36.28				1,503,591			$	55,371
Granted			1,167				41.83				5,980				41.66				7,147				298
Forfeited			(7,132	)			32.67				(30,477	)			37.52				(37,609	)
Vested			(14,500	)			15.53				(113,827	)			29.68				(128,327	)			5,311
Outstanding at June 30, 2006			218,875			$	35.31				1,125,927			$	36.95				1,344,802			$	59,512

Stock Options

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

														Aggregate
						Weighted				Weighted Average				Intrinsic
		Shares				Average				Remaining				Value
		Under Option				Exercise Price				Contractual Life				(in thousands)
Outstanding at December 31, 2005			4,751,824			$	18.37				7.0			$	89,067
Granted			12,378				38.79								—
Forfeited			(64,054	)			20.44								—
Exercised			(539,426	)			15.88								13,925
Outstanding at June 30, 2006			4,160,722			$	18.72				6.8			$	107,149
Exercisable at June 30, 2006			2,167,008			$	16.85				6.3			$	59,846

Compensation expense recorded for stock options in the three and six-month periods ended June 30, 2006 was $2.3 million, and $4.6 million, respectively. The pro forma net income and earnings per share data disclosed for the comparable 2005 period has been determined as if the Company had accounted for its employee stock-based compensation program under the fair value method of SFAS No. 123. The Company used an open form (lattice) model to determine the fair value of options granted during 2006 and 2005, and accordingly, calculate the stock-based compensation expense. The fair value and assumptions used for the periods ended June 30, are as follows:

		2006				2005
Fair value of stock options granted		$	11.92			$	8.53
Expected life of option (years)			5.0				5.0
Expected stock volatility			31.0	%			31.0	%
Expected dividend yield			0.8	%			0.2	%
Risk-free interest rate			4.3	%			4.0	%

Share-based Compensation Expense

The total unrecognized share-based compensation expense, consisting of restricted stock and stock options, for awards outstanding as of June 30, 2006 was $48.8 million and, net of taxes and minority interests, approximately $30.2 million, which will be recognized over a weighted-average period of 1.3 years.

12. Industry Segments

The Company manufactures and markets premium products and services to the oil and gas exploration and production industry, the petrochemical industry and other industrial markets. The Company aggregates its operations into two reportable segments: Oilfield Products and Services and Distribution. The Oilfield Products and Services segment consists of three business units: M-I SWACO, Smith Technologies and Smith Services. The Distribution segment includes the Wilson business unit. The following table presents financial information for each reportable segment and geographical revenues on a consolidated basis (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Revenues:
Oilfield Products and Services		$	1,277,104			$	969,003			$	2,488,712			$	1,879,164
Distribution			461,159				381,200				931,672				759,237
		$	1,738,263			$	1,350,203			$	3,420,384			$	2,638,401
Revenues by Area:
United States		$	815,090			$	631,174			$	1,558,401			$	1,202,136
Canada			178,164				123,298				447,051				314,956
North America			993,254				754,472				2,005,452				1,517,092
Latin America			134,671				115,039				259,168				229,273
Europe/Africa			384,467				296,682				728,838				555,347
Middle East			155,014				124,266				290,634				227,706
Far East			70,857				59,744				136,292				108,983
Non-North America			745,009				595,731				1,414,932				1,121,309
		$	1,738,263			$	1,350,203			$	3,420,384			$	2,638,401
Operating Income:
Oilfield Products and Services		$	231,948			$	145,876			$	451,743			$	283,732
Distribution			22,206				14,044				48,232				27,561
General corporate			(8,694	)			(4,538	)			(17,397	)			(7,739	)
		$	245,460			$	155,382			$	482,578			$	303,554

13. Commitments and Contingencies

Standby Letters of Credit

In the normal course of business with customers, vendors and others, the Company is contingently liable for performance under standby letters of credit and bid, performance and surety bonds. Certain of these outstanding instruments guarantee payment to insurance companies with respect to certain liability coverages of the Company’s insurance captive. Excluding the impact of these instruments, for which $23.2 million of related liabilities are reflected in the accompanying consolidated condensed balance sheet, the Company was contingently liable for approximately $49.9 million of standby letters of credit and bid, performance and surety bonds at June 30, 2006. Management does not expect any material amounts to be drawn on these instruments.

Litigation

Rose Dove Egle v. John M. Egle, et al.

In April 1997, the Company acquired all of the equity interests in Tri-Tech Fishing Services, L.L.C. (“Tri-Tech”) in exchange for cash consideration of approximately $20.4 million (the “Transaction”).

In August 1998, the Company was added as a defendant in a First Amended Petition filed in the 15th Judicial District Court, Parish of Lafayette, Louisiana entitled Rose Dove Egle v. John M. Egle, et al. In the amended petition, the plaintiffs alleged that, due to an improper conveyance of ownership interest by the Tri-Tech majority partner prior to the Transaction, Smith purchased a portion of its equity interest from individuals who were not legally entitled to their Tri-Tech shares. The suit was tried in the first quarter of 2004, and a jury verdict of approximately $4.8 million was rendered in favor of the plaintiffs. The Company has appealed the verdict and does not anticipate a ruling until the first quarter of 2007. Based upon the facts and circumstances and the opinion of outside legal counsel, management believes that an unfavorable outcome on this matter is not probable at this time. Accordingly, the Company has not recognized a loss provision in the accompanying consolidated condensed financial statements.

Other

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

Environmental

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

As of June 30, 2006, the Company’s environmental reserve totaled $9.4 million. This amount reflects the future undiscounted estimated exposure related to identified properties, without regard to indemnifications from former owners. While actual future environmental costs may differ from estimated liabilities recorded at June 30, 2006, the Company does not believe that these differences will have a material impact on the Company’s financial position or results of operations.

During the first quarter of 2006, the Company settled a pending legal action which sought to clarify certain contractual provisions of an environmental indemnification provided by M-I SWACO’s former owners. The two parties executed a settlement agreement whereby the former owners agreed to pay an outstanding receivable owed to the Company, assume all environmental liabilities associated with two identified sites and reimburse the Company for certain future environmental remediation costs. The impact of the settlement, which was recorded in the first quarter of 2006, was not material to the Company’s financial condition or results of operations as of or for the six months ended June 30, 2006.

14. Subsequent Event

In August 2006, M-I SWACO acquired SPS of Aberdeen, Scotland in exchange for cash consideration of approximately $165 million. The acquired operations, which provide well-bore cleaning technology for critical well applications, reported revenues of approximately $38 million for the six months ended June 30, 2006. The transaction was funded with borrowings under the Company’s existing revolving credit facilities.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

The following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is provided to assist readers in understanding the Company’s financial performance during the periods presented and significant trends which may impact the future performance of the Company. This discussion should be read in conjunction with the consolidated condensed financial statements of the Company and the related notes thereto included elsewhere in this Form 10-Q and the Company’s 2005 Annual Report on Form 10-K.

Company Products and Operations

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

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

Capital investment by energy companies is largely divided into two markets, which vary greatly in terms of primary business drivers and associated volatility levels. North American drilling activity is primarily influenced by natural gas fundamentals, with approximately 85 percent of the current rig count focused on natural gas finding and development activities. Conversely, drilling in areas outside of North America is more dependent on crude oil fundamentals, which influence over three-quarters of international drilling activity. Historically, business in markets outside of North America has proved to be less volatile as the high cost E&P programs in these regions are generally undertaken by major oil companies, consortiums and national oil companies as part of a longer-term strategic development plan. Although over half of the Company’s consolidated revenues were generated in North America during the second quarter of 2006, Smith’s profitability was largely dependent upon business levels in markets outside of North America. The Distribution segment, which accounts for approximately 27 percent of consolidated revenues and primarily supports a North American customer base, serves to distort the geographic revenue mix of the Company’s Oilfield segment operations. Excluding the impact of the Distribution operations, 56 percent of the Company’s second quarter 2006 revenues were generated in markets outside of North America.

Business Outlook

Near-term drilling activity will largely be influenced by the seasonal recovery in Canada, supported by a significant increase in the number of Canadian land-based drilling projects from the levels experienced in the second quarter of 2006. And, drilling activity in markets outside of Canada is expected to increase modestly throughout the remainder of the year as exploration and production companies continue to invest in large projects in the Eastern Hemisphere market. Tropical weather disturbances are, however, typically experienced in the Gulf of Mexico during the third calendar quarter which influences the level of planned drilling programs and, in certain circumstances, may result in the curtailment of some drilling operations in the revenue-intensive U.S. offshore market. Although a number of factors impact drilling activity levels, our business is highly dependent on the general economic environment in the United States and other major world economies – which ultimately impact energy consumption and the resulting demand for our products and services. A significant deterioration in the global economic environment could adversely impact worldwide drilling activity and the future financial results of the Company.

Forward-Looking Statements

This document contains forward-looking statements within the meaning of the Section 21E of the Securities Exchange Act of 1934, as amended, concerning, among other things, our outlook, financial projections and business strategies, all of which are subject to risks, uncertainties and assumptions. These forward-looking statements are identified by their use of terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “project” and similar terms. These statements are based on certain assumptions and analyses that we believe are appropriate under the circumstances. Such statements are subject to, among other things, general economic and business conditions, the level of oil and natural gas exploration and development activities, global economic growth and activity, political stability of oil-producing countries, finding and development costs of operations, decline and depletion rates for oil and natural gas wells, seasonal weather conditions, industry conditions, changes in laws or regulations and other risk factors outlined in the Company’s Form 10-K for the fiscal year ended December 31, 2005, and Item 1A. of this Form 10-Q, many of which are beyond the control of the Company. Should one or more of these risks or uncertainties materialize, or should the assumptions prove incorrect, actual results may differ materially from those expected, estimated or projected. Our management believes these forward-looking statements are reasonable. However, you should not place undue reliance on these forward-looking statements, which are based only on our current expectations. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to publicly update or revise any of them in light of new information, future events or otherwise.

Results of Operations

Segment Discussion

The Company markets its products and services throughout the world through four business units which are aggregated into two reportable segments. The Oilfield Products and Services segment consists of three business units: M-I SWACO, Smith Technologies and Smith Services. The Distribution segment includes the Wilson business unit. The revenue discussion below has been summarized by business unit in order to provide additional information in analyzing the Company’s operations.

		Three Months Ended June 30,																Six Months Ended June 30,
		2006								2005								2006								2005
		Amount				%				Amount				%				Amount				%				Amount				%
Financial Data: (dollars in thousands)
Revenues:
M-I SWACO		$	849,134				49			$	659,971				49			$	1,651,684				48			$	1,278,517				48
Smith Technologies			186,985				10				137,681				10				366,413				11				279,905				11
Smith Services			240,985				14				171,351				13				470,615				14				320,742				12
Oilfield Products and Services			1,277,104				73				969,003				72				2,488,712				73				1,879,164				71
Wilson			461,159				27				381,200				28				931,672				27				759,237				29
Total		$	1,738,263				100			$	1,350,203				100			$	3,420,384				100			$	2,638,401				100
Geographic Revenues:
United States:
Oilfield Products and Services		$	481,287				28			$	344,965				26			$	925,509				27			$	662,020				25
Distribution			333,803				19				286,209				21				632,892				19				540,116				21
Total United States			815,090				47				631,174				47				1,558,401				46				1,202,136				46
Canada:
Oilfield Products and Services			75,336				4				49,444				4				191,669				6				136,575				5
Distribution			102,828				6				73,854				5				255,382				7				178,381				7
Total Canada			178,164				10				123,298				9				447,051				13				314,956				12
Non-North America:
Oilfield Products and Services			720,481				41				574,594				42				1,371,534				40				1,080,569				41
Distribution			24,528				2				21,137				2				43,398				1				40,740				1
Total Non-North America			745,009				43				595,731				44				1,414,932				41				1,121,309				42
Total Revenue		$	1,738,263				100			$	1,350,203				100			$	3,420,384				100			$	2,638,401				100
Operating Income:
Oilfield Products and Services		$	231,948				18			$	145,876				15			$	451,743				18			$	283,732				15
Distribution			22,206				5				14,044				4				48,232				5				27,561				4
General Corporate			(8,694	)			*				(4,538	)			*				(17,397	)			*				(7,739	)			*
Total		$	245,460				14			$	155,382				12			$	482,578				14			$	303,554				12
Market Data:
Average Worldwide Rig Count: (1)
United States			1,867				53				1,641				53				1,837				51				1,595				50
Canada			258				8				211				7				417				11				352				11
Non-North America			1,377				39				1,264				40				1,365				38				1,240				39
Total			3,502				100				3,116				100				3,619				100				3,187				100
Onshore			2,972				85				2,596				83				3,092				85				2,680				84
Offshore			530				15				520				17				527				15				507				16
Total			3,502				100				3,116				100				3,619				100				3,187				100
Average Commodity Prices:
Crude Oil ($/Bbl) (2)		$	70.72							$	53.16							$	67.13							$	51.66
Natural Gas ($/mcf) (3)		$	6.65							$	6.95							$	7.24							$	6.73

Oilfield Products and Services Segment

Revenues

M-I SWACO primarily provides drilling and completion fluid systems, engineering and technical services to the oil and gas industry. Additionally, these operations provide oilfield production chemicals and manufacture and market equipment and services used for solids-control, particle separation, pressure control, rig instrumentation and waste-management. M-I SWACO’s operations are significantly influenced by spending in markets outside of North America, which contributes approximately two-thirds of the unit’s revenues, and by its exposure to the U.S. offshore market, which constitutes approximately 10 percent of the revenue base. U.S. offshore drilling programs, which account for approximately three percent of the worldwide rig count, are generally more revenue-intensive than land-based projects due to the complex nature of the related drilling environment. M-I SWACO’s revenues totaled $849.1 million for the second quarter of 2006, an increase of 29 percent above the prior year period. The majority of the revenue increase was generated in markets outside of North America, where base revenues grew 25 percent, largely reflecting new contract awards, higher customer spending in the offshore markets of Europe/Africa and, to a lesser extent, an increase in underlying activity levels. North American revenues grew 34 percent above the prior year level, largely attributable to increased exploration and production spending related to land-based drilling programs and a favorable shift in the deepwater market customer mix. For the six-month period, M-I SWACO reported revenues of approximately $1.65 billion, a 29 percent increase over the amount reported in the first six months of 2005. Approximately 60 percent of the revenue increase was, again, generated in markets outside of North America, primarily the North Sea, Middle East and West Africa regions, reflecting new contract awards and increased customer activity in the revenue-intensive offshore market. North American revenues were 33 percent above the comparable prior year amount attributable to increased exploration and production spending on land-based drilling programs, price increases implemented in the last half of 2005 and a favorable customer mix in the U.S. offshore market.

Smith Technologies designs, manufactures and sells three-cone drill bits, diamond drill bits and turbines for use in the oil and gas industry. Due to the nature of its product offerings, revenues for these operations typically correlate more closely to the rig count than any of the Company’s other businesses. Moreover, Smith Technologies has the highest North American revenue exposure of the Oilfield segment units driven, in part, by the significance of its Canadian operations. Accordingly, the seasonal Canadian drilling decline, which occurs in the second quarter, adversely impacts the unit’s financial performance. Smith Technologies reported revenues of $187.0 million for the quarter ended June 30, 2006, an increase of 36 percent over the comparable prior year period. Approximately two-thirds of the year-over-year revenue growth was reported in North America, where sales volumes grew at more than twice the rate of the underlying change in rig count. The North American revenue increase was attributable to a combination of higher land-based drilling activity, increased market penetration, influenced in part by new product introductions, and the impact of price increases initiated over the past 12-month period. Revenues generated in markets outside North America grew 29 percent, comparing favorably to the corresponding change in activity levels, largely due to increased demand for diamond bits and continued market penetration of the turbodrill turbine product line. For the six-month period, Smith Technologies reported revenues of $366.4 million, a 31 percent improvement over the comparable period of 2005, influenced by the increase in worldwide activity levels. Approximately 75 percent of the revenue growth was generated in the Western Hemisphere, driven by increased demand for diamond drill bits and improved pricing in the premium North American market and, to a lesser extent, higher sales volumes of the turbodrill turbine product line.

Smith Services manufactures and markets products and services used in the oil and gas industry for drilling, work-over, well completion and well re-entry. Revenues for Smith Services are evenly distributed between North America and the international markets and are heavily influenced by the complexity of drilling projects, which drive demand for a wider range of its product offerings. For the quarter ended June 30, 2006, Smith Services’ revenues totaled $241.0 million, 41 percent above the prior year period. The year-over-year revenue growth was influenced, in part, by increased demand for tubular products, primarily in the U.S. market. Excluding the impact of tubular product sales, which are not highly correlated to drilling activity, business volumes increased 29 percent above the prior year period. The improvement was driven by higher worldwide exploration and production spending and strong demand for remedial product and service lines, impacted by the introduction of new sizes of the premium RHINO^® Reamer downhole tool and the introduction of this tool into new geographic markets. For the first half of 2006, Smith Services reported revenues of $470.6 million, a 47 percent increase from the comparable prior year period. Excluding the impact of increased tubular sales volumes, revenues were 30 percent above the level reported in the first six months of 2005. The revenue improvement largely reflects higher sales across all core product lines, driven by the general increase in global exploration and production spending levels.

Operating Income

Operating income for the Oilfield Products and Services segment was $231.9 million, or 18.2 percent of revenues, for the three months ended June 30, 2006. Segment operating margins were 310 basis points above the prior year period reflecting gross margin expansion, due to the impact of higher business volumes on fixed cost coverage and a favorable shift in business mix towards higher-margin product lines and geographic areas, and reduced operating expenses as a percentage of revenues. On an absolute dollar basis, second quarter 2006 operating income increased $86.1 million, reflecting the impact of a 32 percent increase in business volumes on gross profit, partially offset by growth in variable-based operating expenses, including additional investment in personnel and infrastructure to support the expanding business base. For the six-month period, Oilfield operating margins improved 3.1 percentage points, reflecting increased coverage of fixed sales and administrative costs and, to a lesser extent, gross margin expansion related to the impact of a favorable business mix period-to-period. On an absolute dollar basis, six-month operating income was $168.0 million above the comparable prior year period, attributable to the impact of higher revenue volumes on the segment’s reported gross profit, partially offset by growth in variable-based operating expenses associated with the expanding business base.

Distribution Segment

Revenues

Wilson markets pipe, valves, fittings and mill, safety and other maintenance products to energy and industrial markets, primarily through an extensive network of supply branches in the United States and Canada. The segment has the most significant North American revenue exposure of any of the Company’s operations with 95 percent of Wilson’s second quarter 2006 revenues generated in those markets. Moreover, approximately 30 percent of Wilson’s revenues relate to sales to the industrial and downstream energy sector, including petrochemical plants and refineries, whose spending is largely influenced by the general state of the U.S. economic environment. Additionally, certain customers in this sector utilize petroleum products as a base material and, accordingly, are adversely impacted by increases in crude oil and natural gas prices. Distribution revenues were $461.2 million for the second quarter of 2006, 21 percent above the comparable prior year period. Three-fourths of the year-over-year revenue growth was reported by the energy sector operations, largely influenced by increased North American drilling and completion activity levels. Industrial and downstream revenues grew 14 percent above the prior year level, reflecting the impact of increased project spending in the refining and petrochemical markets. In the first six months of 2006, Wilson reported revenues totaling $931.7 million, an increase of 23 percent from the first six months of 2005. The majority of the revenue variance from the prior year period was generated by the upstream energy operations, reflecting higher North American activity levels and the impact of new contract awards.

Operating Income

Operating income for the Distribution segment was $22.2 million, or 4.8 percent of revenues, for the quarter ended June 30, 2006. Segment operating income increased $8.2 million, or 58 percent, above the amount reported in the prior year period, equating to incremental operating margins of 10.2 percent. Incremental operating income was driven by year-over-year improvement reported in the energy sector operations attributable to increased coverage of fixed sales and administrative costs. The gross profit margin expansion reflects a reduced proportion of tubular business volumes and a lower expense ratio. On a year-to-date basis, Distribution operating margins improved 1.6 percentage points, again, reflecting the impact of gross margin expansion and lower operating expenses as a percentage of revenues. On an absolute dollar basis, segment operating income was $20.7 million above the amount reported in the first half of 2005. The operating income variance reflects the impact of higher revenue volumes on the segment’s reported gross profit, partially offset by growth in variable-based operating expenses.

Consolidated Results

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

		Three Months Ended June 30,																Six Months Ended June 30,
		2006								2005								2006								2005
		Amount				%				Amount				%				Amount				%				Amount				%
Revenues		$	1,738,263				100			$	1,350,203				100			$	3,420,384				100			$	2,638,401				100
Gross profit			545,013				31				399,138				30				1,071,616				31				784,550				30
Operating expenses			299,553				17				243,756				18				589,038				17				480,996				18
Operating income			245,460				14				155,382				12				482,578				14				303,554				12
Interest expense			14,685				1				10,992				1				27,521				1				21,332				1
Interest income			(696	)			—				(436	)			—				(1,293	)			—				(804	)			—
Income before income taxes and minority interests			231,471				13				144,826				11				456,350				13				283,026				11
Income tax provision			70,910				4				46,828				4				143,572				4				91,974				4
Minority interests			41,728				2				29,938				2				86,729				2				56,840				2
Net income		$	118,833				7			$	68,060				5			$	226,049				7			$	134,212				5