UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

SCHEDULE 14A

Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934

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Smith International, Inc.

(Name of Registrant as Specified In Its Charter)

 

(Name of Person(s) Filing Proxy Statement, if other than the Registrant)

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NOTICE OF ANNUAL MEETING OF STOCKHOLDERS

 

May 13, 2008

 

 

To Our Stockholders:

 

The Annual Meeting of Stockholders (the “Annual Meeting”) of Smith International, Inc. (the “Company”) will be held on Tuesday, May 13, 2008, at 9:00 a.m. local time, at 700 King Street, Wilmington, Delaware, to consider and take action on the following:

 

 

Your Board of Directors recommends a vote “FOR” Proposals 1, 2, 3, and 4.

 

Important Notice Regarding the Availability of Proxy Materials for the Stockholder Meeting to Be Held on May 13, 2008: This proxy statement, along with the 2007 Annual Report to Stockholders, are available on the following website: www.edocumentview.com/sii.

 

The Board of Directors has fixed the close of business on March 14, 2008 as the record date for determining stockholders who are entitled to notice of and to vote at the meeting.

 

By Order of the Board of Directors

 

Richard E. Chandler, Jr.

Secretary

 

Houston, Texas

April [  ], 2008

 

YOUR VOTE IS IMPORTANT.

 

Please vote your proxy promptly so that your shares will be represented, even if you plan to attend the Annual Meeting. You can vote by Internet, by telephone, or by using the proxy card that is enclosed. Please see your proxy card for specific instructions on how to vote. Brokers cannot vote for Proposal 2 without your instructions.

 

 

PROXY STATEMENT

 

TABLE OF CONTENTS

 

P. O. Box 60068

Houston, TX 77205-0068

 

PROXY STATEMENT

 

The Board of Directors of Smith International, Inc. is soliciting your proxy to vote your shares of the Company’s common stock (“Common Stock”) at the 2008 Annual Meeting. We are distributing this Proxy Statement and the accompanying proxy card beginning on or about April   , 2008. We solicit proxies to give all stockholders of record an opportunity to vote on matters that will be presented at the Annual Meeting. In this Proxy Statement, you will find information to assist you in voting your shares. Your vote is very important.

 

Except as otherwise specifically noted in this Proxy Statement, “we,” “our,” “us,” and similar words as well as “Smith” and the “Company” refer to Smith International, Inc.

 

Who may vote?

 

You are entitled to vote your shares of our Common Stock if you are a stockholder of record on March 14, 2008. At the close of business on March 14, 2008, a total of 200,816,561 shares of Common Stock were outstanding and entitled to vote. Each share of Common Stock has one vote. The enclosed proxy card shows the number of shares that you are entitled to vote.

 

How do I vote?

 

Stockholders of record may vote in person or by telephone, internet or mail. If you are voting by mail, please sign, date and mail the enclosed proxy card. If you are voting by telephone or internet, please follow the instructions on the enclosed proxy card.

 

Whether or not you plan to attend the meeting, we encourage you to vote by proxy as soon as possible.

 

If you hold your shares in more than one type of account or your shares are registered differently, you may receive more than one proxy card. We encourage you to vote each proxy card that you receive.

 

If you choose to attend the meeting in person, you will be asked to present valid picture identification and, if you hold your shares through a broker, you will be asked to present a copy of your brokerage statement showing your stock ownership as of March 14, 2008. For directions to the meeting, contact the Doubletree Hotel Downtown Wilmington, Delaware at 302-655-0400.

 

How will my shares be voted?

 

If you vote by proxy, the individuals named on the proxy card (your proxies) will vote your shares in the manner you indicate. You may specify on your proxy card whether your shares should be voted for all of the nominees for director or your vote may be withheld with respect to one or more of the nominees. You may also specify whether you approve, disapprove or abstain from the other proposals.

 

If you sign and return your proxy card without indicating your voting instructions, your shares will be voted FOR the election of all nominees for director and FOR Proposals 2, 3, and 4.

 

What if my shares are held by a broker?

 

If your Common Stock is held by a broker, bank or other nominee (in “street name”), your broker must vote those shares in accordance with your instructions. However, if you do not give voting instructions to your broker

within ten days of the meeting, your broker may vote your shares for you on any matter that the New York Stock Exchange determines to be routine. If the broker cannot vote on a particular matter because it is not routine, there is a “broker non-vote” on that matter. Broker non-votes do not count as votes for or against Proposals 2 and 4, but will count as votes against Proposal 3. An abstention counts as a vote against a proposal. Abstentions and broker non-votes have no effect on the outcome of the election of directors.

 

If you hold your shares in street name and you wish to vote in person at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares. If the meeting is adjourned, your Common Stock will be voted as specified on your proxy card on the new meeting date, unless you have revoked your proxy instructions.

 

May I revoke or change my vote?

 

You may revoke or change your proxy at any time before it is exercised by submitting written notice of revocation to Smith’s Corporate Secretary so that he receives it before the Annual Meeting; voting again by telephone, internet or mail; or voting in person at the Annual Meeting.

 

Attendance at the Annual Meeting will not by itself revoke a previously granted proxy. If you hold your shares in street name and you wish to change your vote at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares.

 

What constitutes a quorum?

 

The holders of a majority of the outstanding shares of Common Stock entitled to vote constitutes a quorum for the transaction of business at the Annual Meeting. If you have returned valid proxy instructions or attend the meeting in person, your Common Stock will be counted for the purpose of determining whether there is a quorum, even if you wish to abstain from voting on some or all matters introduced at the meeting. “Broker non-votes” also count for quorum purposes.

 

How many votes are required to approve a proposal?

 

Directors (Proposal 1) must be elected by a plurality of the votes cast at the meeting. This means that the two nominees receiving the greatest number of votes will be elected. The affirmative vote of a majority of the shares represented at the meeting and entitled to vote on a particular matter is required to approve Proposals 2 and 4. The affirmative vote of a majority of the outstanding shares is required to approve Proposal 3. Broker non-votes do not count as votes for or against Proposals 2 and 4, but will count as votes against Proposal 3. An abstention counts as a vote against a proposal. Abstentions and broker non-votes have no effect on the outcome of the election of directors.

 

What other matters will be acted upon at the meeting?

 

We do not know of any other matters that will be presented at the Annual Meeting, other than those mentioned in this Proxy Statement.

 

Who pays the cost of this proxy solicitation?

 

We will pay the cost of solicitation of proxies including preparing, printing and mailing this Proxy Statement. We have retained Morrow & Co. to help us in soliciting proxies for a fee of $7,500, plus reasonable out-of-pocket costs and expenses. We will also reimburse brokers, banks and other nominees for their costs in sending proxy materials to beneficial owners of our Common Stock. Other proxy solicitation expenses that we will pay include those for preparation, mailing, returning and tabulating the proxies.

 

At the Annual Meeting, stockholders will elect two persons as Class I directors to hold office until the 2011 Annual Meeting, or until they are succeeded by other qualified directors who have been appointed or elected. The nominees are Loren K. Carroll and Dod A. Fraser.

Directors must be elected by a plurality of the votes cast at the meeting. This means that the two nominees receiving the greatest number of votes will be elected. Votes withheld for any director will not be counted. We will vote your shares as you specify on your proxy card. If you properly execute and return your proxy card (in paper form, electronically via the internet or by telephone), but do not specify how you want your shares voted, we will vote them for the election of all of the nominees listed below.

 

Each of the nominees is a current member of the Board of Directors and has consented to serve if elected. Although management does not contemplate the possibility, in the event any nominee is not a candidate or is unable to serve as a director at the time of the election, the proxies will vote for any nominee who is designated by the present Board of Directors to fill the vacancy.

 

A brief biography of all directors is presented below:

 

Directors to be elected to Class I for a term expiring in 2011:

 

 

WE RECOMMEND A VOTE “FOR” THE ELECTION OF THE DIRECTOR NOMINEES.

 

Class II directors to continue in office until 2009:

 

Class III directors to continue in office until 2010:

 

 

 

The following table shows certain information about stock ownership of all persons known to the Company to own of record or beneficially more than 5% of the outstanding Common Stock of the Company. This information is based upon information furnished to the Company by these persons and statements filed with the SEC:

 

 

 

 

The following table shows the number of shares of Common Stock beneficially owned as of March 15, 2008 by each director or nominee for director, the executive officers named in the Summary Compensation Table included later in this Proxy Statement and all directors and executive officers as a group. Except as otherwise indicated, the persons listed below have sole voting power and investment power relating to the shares shown.

 

 

 

 

Corporate Governance Guidelines

 

Our Corporate Governance Guidelines outline the functions of the Board, director qualifications and responsibilities, and various processes and procedures designed to ensure effective and responsive governance. The full text of the guidelines is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 16740 East Hardy Road, Houston, Texas 77032.

 

Board Structure

 

Our Board of Directors currently consists of seven directors. Board agendas include regularly scheduled sessions for the independent directors to meet without management present. The Board has designated Mr. Gibbs as Lead Director to chair executive sessions of the non-management directors.

 

G. Clyde Buck has reached retirement age pursuant to our Corporate Governance Guidelines and is, therefore, not standing for re-election as a director. Upon completion of Mr. Buck’s service as a director on May 13, 2008, the Board will reduce its size to six members. At that time, it is anticipated that Mr. Buck will become an advisory director to the Board. In this capacity, Mr. Buck will be invited to attend meetings of the Board and its committees and will have access to materials distributed to the Board, but will not be entitled to vote at such meetings.

 

Board Meetings

 

The Board and its committees meet throughout the year on a set schedule, and also hold special meetings and act by written consent from time to time as appropriate. The Board of Directors held five meetings during 2007. All directors attended at least 75% of the meetings of the Board of Directors and of all committees on which they served. The Company does not have a policy regarding directors’ attendance at the Annual Meeting of Stockholders. No directors attended the 2007 Annual Meeting.

 

Director Independence

 

The Board annually evaluates the independence of the directors and has affirmatively determined that all directors (including Jerry W. Neely who served as a director during the 2007 year until April 25, 2007) are independent except Doug Rock and Loren Carroll, who are employees of the Company. The Board’s determination regarding independence and financial expertise of its members is based on applicable laws and regulations, Smith’s Corporate Governance Guidelines, the rules of the New York Stock Exchange and a review of any direct or indirect relationship between each director or his immediate family and Smith. To be considered independent, the Board of Directors must affirmatively determine that a director has no material relationship with Smith. In each case, the Board of Directors broadly considers all relevant facts and circumstances, including the director’s commercial, industrial, consulting, legal, accounting, charitable and familial relationships and such other criteria as the Board of Directors may determine from time to time. In evaluating the independence of each non-employee director, the Board considered that in the ordinary course of business our subsidiaries buy from or sell to companies with which our directors have relationships as follows:

 

(1) Mr. Gibbs is Chairman of the Board, President & Chief Executive Officer of, and Mr. Buck is a director of, Frontier Oil Corporation.

 

(2) Mr. Fraser is a director of Forest Oil Corporation.

 

(3) Mr. Kelley is a director of Cabot Oil and Gas Corporation and OGE Energy Corp.

 

(4) Mr. Yearwood is a director of Logan Oil Tools and Sheridan Production Partners and is a senior advisor to Schlumberger. Schlumberger is also the minority partner in our M-I SWACO business unit, a 60 percent-owned joint venture.

 

With respect to each of the most recent three completed fiscal years, none of the payments to or payments received from any of the companies for which our directors are employees exceeded the greater of $1.0 million or

2% of such company’s consolidated gross revenues. All of these companies expect to continue their business relationship in 2008.

 

Communication with the Board

 

Stockholders and interested parties who wish to communicate with the non-management directors as a group, the Lead Director, or with any individual director, may do so by contacting Smith’s Corporate Secretary at 16740 East Hardy Road, Houston, Texas 77032. Smith’s Corporate Secretary will then relay all communications to the appropriate director or group of directors.

 

Committees of the Board

 

The Board has delegated various responsibilities and authority to different Board Committees as described in this section of this Proxy Statement. The Board has determined that all committee members are independent and satisfy the relevant additional independence requirements for the members of such committees imposed by the SEC or the Company. Each committee operates under a formal charter adopted by the Board, the full text of which may be found on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 16740 East Hardy Road, Houston, Texas 77032.

 

Members of the Committees of the Board.

 

 

 

 

Audit Committee.  During 2007, the Audit Committee met ten times, including telephone meetings, to discuss relevant accounting, auditing, internal control and disclosure matters. The Audit Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

The Board of Directors has determined that all members are financially literate and that all members qualify as audit committee financial experts.

 

Compensation and Benefits Committee.  During 2007, the Compensation and Benefits Committee met seven times. The Compensation and Benefits Committee charter permits the Compensation and Benefits

Committee to delegate its authority to sub-committees. The Compensation and Benefits Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Nominating and Corporate Governance Committee.  During 2007, the Nominating and Corporate Governance Committee met five times. The Nominating and Corporate Governance Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Director Qualifications and Nominations

 

The Nominating and Corporate Governance Committee will consider nominees proposed by stockholders. To recommend a prospective nominee for the Nominating and Corporate Governance Committee’s consideration, you may submit the candidate’s name and qualifications to Smith’s Corporate Secretary at 16740 East Hardy Road, Houston, Texas 77032. Recommendations from stockholders for nominees must be received by Smith’s Corporate Secretary not later than the date set forth under the section “Stockholders’ Proposals.”

 

The process for identifying and evaluating director nominees includes the following steps:

 

(1) the Nominating and Corporate Governance Committee, Chairman of the Board or other Board members identify a need to fill vacancies or add newly created directorships;

 

(2) the Chairman of the Nominating and Corporate Governance Committee initiates a search and seeks input from Board members and senior management and, if necessary, hires a search firm or obtains advice from legal or other advisors;

 

(3) director candidates, including any candidates properly proposed by stockholders in accordance with the Company’s Bylaws, are identified and presented to the Nominating and Corporate Governance Committee;

 

(4) initial interviews of candidates are conducted by the Chairman of the Nominating and Corporate Governance Committee;

 

(5) the Nominating and Corporate Governance Committee meets to consider and approve final candidate(s) and conduct further interviews as necessary; and

 

(6) the Nominating and Corporate Governance Committee makes recommendations to the full Board for inclusion in the slate of directors at the Annual Meeting.

 

The evaluation process will be the same whether the nominee is recommended by a stockholder or by a member of the Board of Directors. The Nominating and Corporate Governance Committee is responsible for establishing the selection criteria for candidates from time to time and reviewing with the Board such criteria and the appropriate skills and characteristics required of Board members in the context of the then current make-up of the Board. At a minimum, the Nominating and Corporate Governance Committee must be satisfied that each

nominee for director has the necessary business and/or professional knowledge and experience relevant to the Company, its business and the goals and perspectives of its stockholders; is well regarded in the community, with a long term, good reputation for high ethical standards; has good common sense and judgment; has a positive record of accomplishment in present and prior positions; has an excellent reputation for preparation, attendance, participation, interest and initiative on other boards on which he or she may serve; and has the time, energy, interest and willingness to become involved in the Company and its future.

 

Compensation Committee Interlocks and Insider Participation

 

During 2007, Messrs. Gibbs (until April 25, 2007), Buck, Fraser and Kelley served as members of the Company’s Compensation and Benefits Committee. None of the Compensation and Benefits Committee members has served as an employee or officer of the Company, and none of the Company’s executive officers has served as a director or member of the compensation committee of another entity, which has an executive officer serving as a member of the Company’s Board.

 

Code of Business Conduct and Ethics

 

All of our officers, employees and directors are required to comply with our Code of Business Conduct and Ethics to help ensure that our business is conducted in accordance with the highest standards of ethical behavior. Our Code of Business Conduct and Ethics covers all areas of professional conduct, including customer relationships, conflicts of interest, insider trading, financial disclosure, intellectual property and confidential information, as well as requiring strict adherence to all laws and regulations applicable to our business. Employees may report any violations or suspected violations of the Code by using Smith’s ethics hotline. The Code includes an anti-retaliation statement. The full text of the Code of Business Conduct and Ethics, as well as any waiver of a provision of the Code granted to any senior officer or director or material amendment to the Code, if any, is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 16740 East Hardy Road, Houston, Texas 77032.

 

Overview

 

Compensation Objectives.  We have designed our executive compensation program to reward our executives based on Company, business unit and individual performance. The general objectives of our executive compensation program are to:

 

 

Pay for Performance.  We believe that executives should be rewarded for outstanding performance. Our compensation philosophy ties direct financial incentives in the form of cash awards and long-term equity awards to our annual performance goals. We base these performance goals on consolidated or business unit financial results, depending upon the executive officer’s position with the Company. We reward individual performance through adjustments in annual base salary.

 

Decision Process.  Our Compensation and Benefits Committee (referred to in this section as the “Compensation Committee”) makes all executive compensation decisions. The Compensation Committee has retained Frederic W. Cook & Co., Inc. (referred to in this section as “Cook”), an independent compensation consultant reporting solely to the Compensation Committee, to assist it in making executive compensation decisions.

 

In October of each year, Cook provides current and comparative compensation data, including benchmarking results as discussed below, to the Compensation Committee and makes preliminary compensation recommendations. For all executive officers other than the CEO, the Compensation Committee discusses Cook’s

recommendations with our CEO and Senior Vice President of Human Resources and receives additional recommendations related to items such as individual and business unit performance and the Company’s overall compensation objectives. With respect to CEO compensation, Cook recommends a level of equity compensation consistent with benchmarking results, but does not provide recommendations for base salary or annual cash bonus awards. Company management has no input into CEO compensation.

 

The Compensation Committee makes final compensation decisions in December each year to correspond with the Board of Directors’ approval of the Company’s upcoming fiscal year’s business plan and with the Compensation Committee’s evaluation of executive performance for the current year. The Compensation Committee meets separately in executive session to review the CEO’s performance, set his performance objectives for the next fiscal year and set his compensation. Executive compensation decisions become effective January 1 of the upcoming fiscal year. With the exception of equity incentive awards for new hires or promotions, which are granted at the next regularly scheduled Compensation Committee meeting after the hire or promotion date, equity incentive awards are granted only in December.

 

Benchmarking Group.  The worldwide energy industry is a competitive environment for executive talent. To attract and retain a high level of executive expertise, we must remain competitive with the pay of companies with whom we compete for executive talent. Cook provides us with general compensation information related to our industry and specific compensation information related to a group of companies in our industry whose executives have similar duties and responsibilities. The Compensation Committee generally attempts to provide total target compensation between the median and 75th percentile of the range of executive compensation paid by the benchmarking group, with variation based on levels of responsibility and contributions to the Company. The following companies compose our benchmarking group:

 

 

Fixed v. Variable Pay.  Our compensation program is divided into two general categories, fixed and variable pay. Fixed pay consists of base salary and provides the named executive officers with a level of assured cash compensation appropriate for their positions within the Company. Variable pay includes annual cash bonus awards and annual performance-based equity awards, each as explained in more detail below. The Compensation Committee believes that a substantial portion of total compensation should be at- risk to the named executive officers and tied to the Company’s financial performance goals. Therefore, variable pay represents about 80% of a named executive officer’s total target compensation and is not earned unless financial performance goals are met.

 

At the beginning of each year, the Compensation Committee approves consolidated and business unit performance matrices which set forth targets for the variable pay component of executive compensation. These matrices are based on the financial performance goals established in the Company’s annual business plan. Because the goals are established in December of each year and market conditions fluctuate throughout the year, the performance goals may not correspond to subsequent annual earnings estimates released by the Company. We expect that each member of our senior management team will produce outstanding results and have established performance targets that are generally achievable under the annual business plan.

 

Executive Position Grade Levels.  The Compensation Committee sets grade levels for each executive management position based on levels of responsibility and authority within the Company. The grade level for each

individual executive officer typically corresponds to his or her management position. To recognize the exceptional contributions of an individual executive officer, he or she may be placed in a grade level higher than the corresponding grade level for his or her management position. Variable pay awards and equity grants, as well as perquisite benefits, are consistent within each grade level.

 

Alignment of Interests with Stockholders.  Equity-based compensation constitutes approximately 65% of our total target executive officer compensation. Performance measures are tied in large part to overall stockholder wealth. Our emphasis on equity- and performance-based compensation provides our executives with incentive to create long-term stockholder value while keeping fixed base salary costs as one of the smallest components of total target compensation. Further, it is consistent with our compensation philosophy that our executive management should be rewarded when financial performance goals are met or exceeded, thereby creating value for our stockholders.

 

Executive Compensation Components

 

Below is a summary of the various components of executive compensation.

 

Annual Base Salary.  The Compensation Committee does not use a specific formula for evaluating individual performance. Instead, executives are assessed primarily by the CEO based upon their contributions to the Company’s business success. The CEO is assessed solely by the Compensation Committee in executive session. The criteria used in evaluating individual performance, including that of the CEO, vary depending on the executive’s function, but generally include:

 

 

The Compensation Committee sets each executive’s base salary in light of individual performance and the salary range paid by the benchmarking group. Representing about 20% of total target compensation, base salaries generally remain at the median level of the salary range but may increase to or exceed the 75^th percentile for outstanding performance. Based on his leadership, business results, Company growth and future strategy development, Mr. Rock received a merit increase to base salary of 11%, effective January 1, 2008. In addition, the Compensation Committee increased the grade level of the management position held by Ms. Dorman, increasing her salary range and making her eligible for a higher percentage annual cash bonus target and a higher level of equity awards. As a result of these changes and in recognition of her individual performance, Ms. Dorman received a 15% salary increase, which places her at the median level. The Compensation Committee also increased Mr. Dudman’s grade level, increasing his salary within the benchmarking group and making him eligible for a higher percentage annual cash bonus target and a higher level of equity awards. Mr. Dudman received a 21% salary increase which places him above the 75^th percentile for the grade level of his management position, but provides target compensation equal to that of the President of M-I SWACO. In providing this change in grade level, the Compensation Committee recognized Mr. Dudman’s excellent management skills, accomplishments in growing Smith Services to record performance levels and his leadership role within and future value to the Smith organization. All other named executive officers received merit increases in a range of 5% to 6%.

 

Annual Cash Bonus.  Our executive officers participate in the Executive Officer Annual Incentive Plan (“AIP”) which provides for annual cash bonuses. The Compensation Committee ties approximately 18% of each named executive officer’s total target compensation to the achievement of financial performance goals under the AIP.

Participants in the AIP can earn an annual cash bonus based upon the achievement of established financial performance goals for each fiscal year. The target annual bonus percentages for the executive officers are determined based upon the grade level of the executive officer and are generally close to the median of the benchmarking group. The payout award, if any, is determined by multiplying the actual annual bonus percentage earned by the executive’s base salary in effect as of the beginning of the AIP’s fiscal year. For the 2007 and 2008 performance years, the target annual bonus percentages and grade levels for the named executive officers are as follows:

 

 

The actual payout under the AIP for any fiscal year is variable and tied to consolidated performance for corporate officers or business unit performance for business unit officers. The financial performance goals are measured using two metrics, generally (i) earnings per share and (ii) return on equity; however, for business unit management, the metrics are defined as operating earnings and return on operating assets for that business unit. When consolidated, the business unit operating income goals and return on operating assets goals are aligned with the consolidated corporate earnings per share and return on equity goals. The Compensation Committee has chosen return on stockholder equity and earnings per share (and the related operating income and return on operating assets for the business units) as the performance measures for the AIP because these metrics are tied to overall stockholder wealth, are readily understood by the executives and provide a balanced incentive to increase income while managing the Company’s investment in its net assets.

 

Depending upon performance, the payout can range from zero to 200% of the target annual cash bonus percentage. Upon the achievement of the target financial performance goals, participants earn 100% of their target annual cash bonus. Generally, the actual financial performance achieved must be 80% or more of both target metric goals in order to earn any payout under the AIP and must be 120% or more of both target metric goals in order to earn a payout under the AIP of 200% of the target amount. For the 2007 fiscal year, the corporate earnings per share goal was $2.97 and the return on stockholder equity target was 27.2%. For the fiscal year ended December 31, 2007, the actual performance levels achieved by the Company and business units ranged from above to below the target goals, resulting in each named executive officer earning between 35% and 162% of their target annual cash bonus percentage.

 

The Compensation Committee has no discretion to increase any award once the performance targets have been established, but may decrease or eliminate any annual bonus award due to unacceptable individual performance, even if the financial performance targets are met. The AIP is intended to comply with Section 162(m) of the Internal Revenue Code of 1986 and, as such, amounts paid under the AIP are fully deductible by the Company for federal income tax purposes.

 

Annual Performance-Based Restricted Stock Unit Award.  The annual performance-based restricted stock unit (“Unit”) award is the largest potential component of total target annual compensation. The Compensation Committee awards Units to the executive officers in December of each year under the Smith International, Inc. Second Amended and Restated 1989 Long-Term Incentive Compensation Plan (“LTICP”). Units represent the right to receive shares of common stock in the future, depending upon the achievement of the consolidated return on equity goal for the coming year.

 

The Compensation Committee sets the monetary value of the awards by grade level, generally at the 60th to 65th percentile level for equity awards granted by the benchmarking group. Shares subject to Unit awards are not owned until the financial performance goal is obtained and the awards have vested, accordingly participants have no voting rights on the shares and do not receive dividends until the shares are earned and vested. The number of target

Units granted is determined based on the closing price of the common stock on the date of grant, discounted for the present value of the dividends that are not paid on the unvested shares. If the Units are earned at year end, they vest in equal installments over a three-year period, based on continued employment requirements.

 

Depending upon performance, the payout for the 2007 performance period could range from zero to 115% of the target number of Units awarded to the executive officers. Upon the achievement of the return on equity goal, participants earn 100% of the Units awarded. Generally, the actual financial performance achieved must be 80% or more of the return on equity goal in order to earn any Units and must be 110% or more of the return on equity goal in order to earn 115% of the target Unit award. After financial performance goals have been set, the Compensation Committee does not exercise any discretion in the amount of Units awarded. For the 2008 performance period, the payout range was changed to zero to 130%, with more aggressive financial performance required to achieve the maximum payout. For the 2007 fiscal year, the return on equity goal was 27.2%. For fiscal year ended December 31, 2007, the actual performance level achieved by the Company was above the maximum target goal, resulting in each individual earning 106.5% of their target Unit award.

 

In 2005, the Company made the decision to award Units rather than Non-Qualified Stock Options, which had been issued under the LTICP since 1989. In reaching the decision to award Units, the Compensation Committee evaluated, among other considerations, changes to the required accounting treatment of stock option awards and other tax and accounting implications of various types of equity awards. Awarding Units instead of Non-Qualified Stock Options reduces stockholder dilution because the Company can offer equal long term value while issuing fewer shares. Unit awards are earned only when the performance goal is met, contain a retention element and align executive management with stockholder interests. For these reasons, the Compensation Committee has determined that Units are the most appropriate long-term equity based incentive for our Company and are the only type of equity incentive that the Company currently awards to its executive officers.

 

Perquisites.  The Company has an interest in ensuring the physical and mental wellness of its employees and, therefore, provides for a reimbursement of up to $3,000 for an annual physical for each executive officer. In addition, in lieu of providing specific perquisites, the Company provides a set cash dollar amount of specifically identified perquisites. This dollar amount is consistent within each grade level and is paid in 26 equal bi-weekly payments annually, as identified in the footnotes to the Summary Compensation Table. The executive officers do not need to spend their allowance on the specified items, but are free to use the allowance at their discretion. We believe that providing a set dollar amount allows our executive officers more flexibility and is more efficient to administer than reimbursing for each individual expense. The amount provided is reviewed periodically and is consistent with perquisites provided by the benchmarking group. In addition, our executive officers may receive personal administrative assistant services at no incremental cost to the Company. Perquisite amounts are not considered annual salary for bonus purposes or 401(k) contributions.

 

401(k) Plan.  The Company believes that financial security during retirement is an important benefit to provide to our executive management. For this reason, the Company and various subsidiaries offer 401(k) plans to their employees, including their executive officers. Because the Company and subsidiary plans operate and are administered in a similar fashion, for purposes of this discussion, the 401(k) plans will be referred to in the singular. Participants may contribute up to the federal limit in the 401(k) plan. The Company makes various levels of contributions to the 401(k) plan, including age-weighted contributions and performance-based matching contributions as defined in the 401(k) plan. Although the majority of the Company’s peers have both defined benefit and defined contribution plans, the Compensation Committee elected to implement a defined contribution plan (the 401(k) plan) to control Company costs. The Company’s 401(k) plan is consistent with similar plans available generally in the energy industry. Executive officers participate in the 401(k) plan on the same basis as other employees.

 

Supplemental Executive Retirement Plan.  In addition to the 401(k) plan described above, Company officers, including all of the executive officers, and other key employees are eligible to participate in the Company’s Post-2004 Supplemental Executive Retirement Plan (Post-2004 SERP). In connection with the adoption of the Post-2004 SERP, the Company suspended contributions to its previous SERP (SERP), except for guaranteed interest contributions discussed in the narrative disclosure following the Nonqualified Deferred Compensation Table. The SERP and Post-2004 SERP were implemented to allow Company officers to defer

additional pre-tax compensation for retirement without regard to the limits placed on 401(k) plans under the Internal Revenue Code. We believe that the Post-2004 SERP is an important tool for the retirement planning efforts of our officers. Moreover, after reviewing data from the benchmarking group, our Compensation Committee determined that the Post-2004 SERP is important to remain competitive in the compensation arena. Additional information regarding the operation of the SERP and Post-2004 SERP may be found in the footnotes and narrative disclosure following the Nonqualified Deferred Compensation Table.

 

Change of Control and Employment Agreements

 

Change of Control Employment Agreements.  The Company has entered into Change of Control Employment Agreements with nine executive officers, including all of the named executive officers. After benchmarking studies performed by outside legal counsel at the request of the Compensation Committee in 1999, the Compensation Committee adopted a form of Change of Control Agreement. In 2005, the Compensation Committee again retained outside legal counsel to perform an update of the benchmarking study to determine whether the Change of Control Agreements remained competitive in the Company’s industry. As a result of this analysis, the Compensation Committee revised the form of Change of Control Agreement to reduce the termination multiple for future agreements, as discussed in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

The Compensation Committee has determined that the Change of Control Agreements are a necessary component of our compensation package in order for us to provide competitive compensation arrangements, particularly because such agreements are standard in our industry. Moreover, we believe that the Change of Control Agreements help us to attract and retain our named executive officers by reducing the personal uncertainty and anxiety that arises from the possibility of a future business combination. We selected objective criteria to determine whether a change of control has occurred for purposes of the Change of Control Agreements in order to reduce the likelihood of a dispute in the event of a change of control and to help ensure that the agreements are triggered only under circumstances when a true transfer of control or ownership has occurred. While the Change of Control Agreements do not influence decisions regarding compensation elements, the Compensation Committee periodically reviews the terms of the Change of Control Agreements so that they remain generally consistent with those of the benchmarking group. Additional information regarding the Change of Control Agreements may be found in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

Employment Agreements.  When the Company emerged from bankruptcy in 1987, it offered employment agreements to certain key officers. The only executive officers with the 1987 employment agreements are Messrs. Rock and Dudman. These agreements were entered into primarily as a retention tool but also because the Board of Directors felt that Messrs. Rock and Dudman could provide extraordinary and unique management and strategy skills to maintain and grow the Company. The Compensation Committee has reviewed these contracts and has concluded that they should remain in place but no longer offers new employment agreements to executive officers. Both agreements contain severance provisions that would entitle each individual to receive a lump sum payment in cash equal to his current annual base salary and bonus through the end of the employment period in the event that such individual were to be terminated by the Company (other than for cause, death or disability) or if for any reason his position is eliminated or otherwise becomes redundant, except in the event of a change of control as explained in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

Pension Plan.  The Company has a defined benefit pension plan, which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Any benefits under the pension plan are offset by benefits paid under a previous pension plan of the Company. Mr. Rock is the only named executive officer with any benefit accruals under the plan. Additional information regarding the plan may be found in the narrative discussion following the Pension Benefits Table.

 

Stock Ownership Guidelines.  Our Compensation Committee encourages stock ownership by executive management and periodically reviews the ownership levels and considers the appropriateness of implementing stock ownership guidelines. Our Compensation Committee has chosen not to require stock ownership guidelines for the executive management. However, as of March 15, 2008, the value of common stock owned by our CEO and

CFO are approximately 36 times and 19 times their current individual annual base salaries. This level of stock ownership evidences the alignment of the interests of our CEO and CFO with our investor’s interests. Our Insider Trading Policy prohibits our executive officers from engaging in any hedging or monetization transactions involving Company securities.

 

The Compensation and Benefits Committee has reviewed and discussed the Compensation Discussion and Analysis with management. Based on such review and discussion, the Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this proxy statement.

 

G. Clyde Buck, Chairman
Dod A. Fraser
Robert Kelley

 

The following tables show compensation for services to the Company of the persons who during 2007 were the Principal Executive Officer, Principal Financial Officer, and the next three most highly compensated executive officers (the “Named Executive Officers”).

 

 

 

 

 

 

 

 

 

The following table provides information regarding incentive awards made to the Named Executive Officers during the 2007 fiscal year.

 

 

 

 

The following table shows the number of shares covered by exercisable and unexercisable options and unvested restricted stock units held by the Company’s Named Executive Officers on December 31, 2007.

 

 

 

 

 

The following table shows all stock options exercised and value received upon exercise, and all stock awards vested and value received upon vesting by the Named Executive Officers during the fiscal year ended December 31, 2007.

 

 

 

 

The following table shows the number of years of credited service of and present value of accumulated benefits payable to each of the named Executive Officers under the Company’s Restated Pension Plan.

 

 

The Company has a defined benefit pension plan (the “Restated Pension Plan”), which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Since benefit accruals under the Restated Pension Plan have been frozen since March 1, 1987, the years of service for the Named Executive Officers include only the period from September 1, 1985 to March 1, 1987. The accumulated benefit presented above assumes a retirement age of 65, no pre-retirement decrements, a post-retirement mortality assumption based

on the RP2000 Combined Healthy Mortality Table Projected by Scale AA to 2015, and payment in the form of a single life annuity.

 

The following table and narrative disclosure provides information regarding nonqualified deferred compensation with respect to each Named Executive Officer.

 

 

 

 

Smith International, Inc. Post-2004 Supplemental Executive Retirement Plan.  The Smith International, Inc. Post-2004 Supplemental Executive Retirement Plan (the “Post-2004 SERP”) is a non-qualified, deferred compensation plan, for the benefit of officers and certain other eligible employees of the Company as selected by the Compensation Committee. Participants may contribute, on a pre-tax basis, up to 100% of their cash compensation, as defined in the Post-2004 SERP. Distributions may generally be made either as a lump sum or installment payments following the participant’s termination of employment due to death, disability, retirement or other separation from service. Distributions may also be made on a limited basis and to the extent necessary as a lump sum upon the occurrence of the participant’s unforeseeable financial emergency as approved by the Compensation Committee. The Post-2004 SERP also provides for Company contributions, as follows:

 

Age-Weighted Contributions.  The Company provides an age-weighted contribution percentage (“AWCP”) ranging from 2% to 6% of qualified compensation, less any age-weighted contributions made to the participant’s 401(k) account. The Post-2004 SERP provides that the AWCP for executive officers is 6% of qualified compensation regardless of age. The difference between a participant’s (i) “Total 401(k) Compensation” and (ii) “Net 401(k) Compensation” is multiplied by the AWCP to compute the age-weighted contribution. “Total 401(k) Compensation” generally means the total of all cash amounts paid by the Company to a participant, including deferred amounts. “Net 401(k) Compensation” generally means Total 401(k) Compensation less participant contributions to the Post-2004 SERP, but not to exceed the limit set under the Internal Revenue Code.

 

Matching Contributions.  The Company provides a performance-based matching contribution ranging from zero to 100% of salary deferrals that mirrors the matching formulas in effect for the Company’s 401(k) Plan, but without regard to certain Code limits applicable to the 401(k) Plan. Matching contributions for all plan participants are limited to 6% of Total 401(k) Compensation, less any performance-based matching contributions made in their individual 401(k) account. Executive officers receive 100% matching contributions subject to the same limitation.

 

Additional Company Contributions.  Deferred funds are placed with the fund trustee and invested at the discretion of the participant in a variety of funds, including a money market fund. The Company guarantees that the deferrals invested in the money market fund will yield interest at 120% of the long-term applicable federal rate (“AFR”). Therefore, in addition to the contributions described above, for the portion of each participant’s account invested in the money market fund that is earning less than 120% of AFR, the Company makes a contribution equal to the difference in interest between the money market fund rate actually earned by the money market fund and 120% of the AFR, which contribution is credited to the participant’s account.

Discretionary Profit Sharing Contributions.  The Compensation and Benefits Committee may, in its discretion, determine the amount of any profit sharing contribution for a plan year and how that amount is to be allocated among the accounts of the Post-2004 SERP participants.

 

In the event of insolvency or bankruptcy, all assets allocable to the Post-2004 SERP are available to satisfy the claims of all general unsecured creditors of the Company. The Company established a grantor trust to serve as a source of funds from which it can satisfy its obligations under the Post-2004 SERP. Participants in the Post-2004 SERP will have no rights to any assets held in the trust, except as general creditors of the Company. A participant’s rights to any amounts credited to an account under the Post-2004 SERP cannot be anticipated, alienated, sold, assigned, pledged, encumbered or charged by the participant and may only pass upon the participant’s death pursuant to a beneficiary designation made by the participant under the Post-2004 SERP. The Company may, by action of the Compensation and Benefits Committee, terminate the Post-2004 SERP with respect to future contributions; provided, however, such termination shall not affect any participant’s right to receive any distribution due under the Post-2004 SERP.

 

The Post-2004 SERP will be interpreted by the Compensation and Benefits Committee in such manner as necessary to comply with the requirements of Code Section 409A and the authority issued thereunder.

 

Smith International, Inc. Supplemental Executive Retirement Plan.  In connection with the adoption of the Post-2004 SERP and Code Section 409A, the Company suspended contributions to the SERP effective December 31, 2004, other than such contributions that were earned and vested as of December 31, 2004. However, the Company may be required to make contributions to participants’ accounts to guarantee an investment return equal to 120% of the AFR on deferrals invested in the money market fund, in the same manner as explained above.

 

With respect to Company insolvency or bankruptcy, participant’s rights, beneficiary designations and plan termination, the SERP is in all material respects the same as the Post-2004 SERP.

 

Employment Agreements.  As discussed in Compensation Discussion and Analysis above, the Company has employment agreements from 1987 with Messrs. Rock and Dudman. These agreements have an initial term of three years and are automatically extended for an additional year at each anniversary date. Automatic renewals may not be suspended by the Company without triggering severance. The agreements automatically terminate when the respective executive reaches age 65. Each employment agreement contains salary and other conditions of employment and entitles the employee to participate in the Company’s bonus program and other benefit programs. If the employment of Mr. Rock or Mr. Dudman is terminated by the Company (other than for cause, death or disability) or if for any reason his position is eliminated or otherwise becomes redundant, Mr. Rock or Mr. Dudman, as applicable, would be entitled to receive a lump sum payment in cash equal to his current annual base salary and bonus through the end of the employment period; provided, however, that in the event of a change of control, the Change of Control Agreements discussed elsewhere in this proxy statement would control, except with respect to any accrued obligations under the employment agreements that were not fully accrued under the applicable Change of Control Agreement.

 

Change of Control Employment Agreements.  The Company has entered into Change of Control Employment Agreements (“Change of Control Agreements”) with nine executive officers, including all of the Named Executive Officers. In the event of a “change of control” of the Company (as defined in the Change of Control Agreements), the Change of Control Agreements provide for the continued employment of the executive officers for a period of three years and provide for the continuation of salary and benefits.

If, after a change of control event, the executive is terminated by the Company (other than for cause, death or disability), or if the executive elects to terminate his or her employment for “Good Reason” (as defined in the Change of Control Agreements), the executive is entitled to receive the following:

 

 

 

 

If the executive’s employment is terminated by reason of the executive’s death or disability, the executive or the estate of the executive shall be entitled to payment of Accrued Obligations and Other Benefits as explained above.

 

Termination Multiple.  The Change of Control Agreements for Messrs. Rock and Kennedy and Ms. Dorman include a termination multiple of three times for termination at any time within three years after the change of control event occurs. The Change of Control Agreements for Messrs. McKenzie and Dudman include a termination multiple of three times for termination of employment in year one after the change of control event; two times in year two; and one time in year three.

 

Stock Incentive Plan.  The Company’s Second Amended and Restated 1989 Long-Term Incentive Compensation Plan provides for the vesting of all outstanding stock options and the satisfaction of all restrictions and conditions on restricted stock and other stock-based awards and the full vesting at 100% target levels of all performance-based awards, as of the day immediately preceding the change of control date.

 

Potential Payments upon a Change of Control.  The table below shows potential payments if an executive is terminated other than for cause or voluntary termination after a change of control event. The amounts assume that the change of control event and termination of employment were both effective on December 31, 2007, and are estimates that reflect the amounts that would be paid and the incremental value of benefits that would be enhanced through accelerated vesting of options and stock awards. The value of equity awards is based on Smith’s closing market price of $73.85 on December 31, 2007, the last trading day before year end. As discussed above, the accelerated vesting of outstanding equity awards occurs on the day immediately preceding the change of control date, regardless of whether the executive is terminated or terminates his or her employment following the change of control event. The table also assumes that the executive has been paid in full for salary due for the fiscal year and has no deferred compensation, pro-rated perquisites payments or accrued vacation due for the year. Because the termination is assumed to be on the same day as the change of control, amounts shown in this column use a 3x

termination multiple for all executives. For Messrs. McKenzie and Dudman, if the termination of employment occurred in year two after the change of control event, the termination multiple would be 2x and if the termination of employment occurred in year three after the change of control event, the termination multiple would be 1x.

 

 

 

 

In the event of the executive’s termination of employment due to death or disability on December 31, 2007, payments would include the amounts indicated in column (b), (d) and (e) above.

 

Set forth below is a summary of the dollar values of the total annual compensation attributable to each non-employee director’s service to Smith during 2007.