Summary of SMITH INTERNATIONAL INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
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, the Company's 2008 Annual Report on Form 10-K and other current filings with the Commission.
Company Products and Operations
The Company is a leading global provider of premium products and services used during the drilling, completion and production phases of oil and natural gas development activities. In August 2008, we broadened our capabilities in key drilling and completion-related product technologies with the acquisition of W-H Energy Services, Inc. ("W-H"). We provide a comprehensive line of technologically-advanced products and engineering services, including drilling and completion fluid systems, solids-control and separation equipment, waste-management services, three-cone and diamond drill bits, borehole enlargement services, tubulars, directional systems, measurement-while-drilling and logging-while-drilling services, coiled tubing, cased-hole wireline and other complementary downhole tools and services. 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 driven principally 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 five 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 nearly 80 percent of the current rig count focused on natural gas finding and development activities. Conversely, drilling in areas outside of North America is more dependent on crude oil fundamentals, which influence 80 percent of current 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 53 percent of the Company's consolidated revenues were generated in North America during the first quarter of 2009, Smith's profitability was influenced by business levels in markets outside of North America. The Distribution segment, which accounts for approximately one-fourth of consolidated revenues and primarily supports a North American customer base, serves to distort the geographic revenue mix of the Company's oilfield operations. Excluding the impact of the Distribution segment, approximately 60 percent of the Company's revenues were generated in markets outside of North America in the first quarter of 2009. Business Outlook
The Company's current year results will be influenced by a material reduction in average worldwide drilling activity attributable to the significant economic slowdown and the ongoing weakness in global credit markets. We believe the impact of lower activity levels will be partially offset by the addition of the acquired W-H business lines and the concentration of our oilfield business base in markets outside North America, areas which tend to be more stable from an oil and gas investment standpoint. Near-term activity levels will likely be impacted by the annual spring break-up in Canada, which limits land-based drilling activity in that market during a portion of the second quarter. Seasonal drilling restrictions have resulted in a significant decline in the Canadian rig count from the average level reported for the first quarter of 2009, which will contribute to the reduction in average worldwide drilling activity for the second quarter.
The majority of the rig count decline from the prior year is expected to occur in the United States where drilling activity is currently 50 percent below the average level reported in 2008 and will likely decline further in the coming months. The decrease in U.S. drilling activity is attributable to the lower number of land-based programs, which are generally more sensitive to commodity prices. Customer spending in most international markets, which is primarily driven by oil-directed activities, has not been significantly impacted to date. Although the long-term outlook for the energy sector is favorable due to supply and demand fundamentals, the current state of the world economies could lead to further weakness in exploration and production spending levels - further reducing demand for the Company's products and services and adversely impacting future results.

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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," "should" 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, overall demand for and pricing of the Company's products and services, 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, and changes in laws or regulations and other risk factors that are discussed beginning on page 25 of this Form 10-Q, in the Company's Form 10-K for the fiscal year ended December 31, 2008, and other documents filed with the Securities and Exchange Commission, 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. 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.

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Results of Operations
Segment Discussion
Our business is segregated into three operating divisions, M-I SWACO, Smith Oilfield and Distribution, which is the basis upon which we report our results. The M-I SWACO segment consists of a majority-owned drilling fluid and environmental services joint venture operation. The Smith Oilfield segment is comprised of our wholly-owned drilling and completion services operations, which includes drill bits, directional drilling services and downhole tools. The Distribution segment consists of the Wilson distribution operations and a majority-owned interest in CE Franklin, Ltd., a publicly-traded Canadian distribution company. Finally, general corporate primarily reflects expenses related to corporate personnel, administrative support functions and long-term incentive compensation programs.

                                                     Three Months Ended March 31,
                                                    2009                      2008
                                              Amount          %         Amount          %
   Financial Data: (Dollars in thousands)
   Revenues:
   M-I SWACO                                $ 1,159,337        48     $ 1,228,429        51
   Smith Oilfield                               682,400        28         574,498        25
   Distribution                                 569,742        24         568,071        24

   Total                                    $ 2,411,479       100     $ 2,370,998       100


   Geographic Revenues:
   United States:
   M-I SWACO                                $   259,889        11     $   306,265        13
   Smith Oilfield                               397,481        16         309,062        13
   Distribution                                 432,170        18         397,352        17

   Total United States                        1,089,540        45       1,012,679        43


   Canada:
   M-I SWACO                                     40,926         2          46,362         2
   Smith Oilfield                                37,938         1          47,594         2
   Distribution                                 113,420         5         140,469         6

   Total Canada                                 192,284         8         234,425        10


   Non-North America:
   M-I SWACO                                    858,522        36         875,802        37
   Smith Oilfield                               246,981        10         217,842         9
   Distribution                                  24,152         1          30,250         1

   Total Non-North America                    1,129,655        47       1,123,894        47

   Total Revenues                           $ 2,411,479       100     $ 2,370,998       100


   Operating Income:
   M-I SWACO                                $   147,508        13     $   207,798        17
   Smith Oilfield                               105,765        16         163,006        28
   Distribution                                  15,521         3          29,884         5
   General corporate                            (27,116 )       *         (21,881 )       *

   Total                                    $   241,678        10     $   378,807        16

* not meaningful

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                                                  Three Months Ended March 31,
                                                   2009                   2008
                                             Amount         %       Amount        %
         Market Data:
         Average Worldwide Rig Count: (1)
         United States                          1,347        35       2,009        44
         Canada                                   293         7         446        10
         Non-North America                      2,228        58       2,142        46

         Total                                  3,868       100       4,597       100


         Onshore                                3,274        85       4,024        88
         Offshore                                 594        15         573        12

         Total                                  3,868       100       4,597       100


         Average Commodity Prices:
         Crude Oil ($/Bbl) (2)              $   43.31               $ 97.82
         Natural Gas ($/mcf) (3)                 4.47                  8.74

(1) Source: M-I
SWACO.

(2) Average daily West Texas Intermediate ("WTI") spot closing prices, as quoted by NYMEX.

(3) Average daily Henry Hub, Louisiana spot closing prices, as quoted by NYMEX.

M-I SWACO
Revenues
M-I SWACO primarily provides drilling and completion fluid systems, engineering and technical services to the oil and gas industry. Additionally, these operations provide oilfield production chemicals and manufacture and market equipment and services used for solids control, particle separation, pressure control, rig instrumentation and waste management. M-I SWACO is significantly influenced by its exposure to the global offshore market, which constitutes 50 percent of the revenue base, and to exploration and production spending for land-based projects outside of North America, which contributes approximately 33 percent of the division's revenues. Offshore drilling programs, which accounted for 15 percent of the worldwide rig count in the first quarter of 2009, are generally more revenue intensive than land-based projects due to the complex nature of the related drilling environment. M-I SWACO reported revenues of $1.16 billion for the first quarter of 2009, six percent below the March 2008 period. Approximately 80 percent of the year-on-year revenue decrease related to the Eastern Hemisphere markets - impacted by lower land-based drilling activity in Russia, reduced customer spending in the Caspian and North Sea markets and the strengthening of the U.S. dollar relative to several key European currencies in which a material proportion of the business is transacted. Western Hemisphere revenues declined modestly from the prior year period as lower U.S. onshore business volumes were largely offset by deepwater activity expansion in Latin America.
Operating Income
Operating income for the M-I SWACO segment totaled $147.5 million for the three months ended March 31, 2009 - translating into operating margins of 12.7 percent. Excluding the impact of $19.3 million of severance and facility closure costs included in the March 2009 period, operating income approximated $166.8 million, or 14.4 percent of revenues. Excluding costs incurred in connection with downsizing initiatives, operating margins declined 2.5 percentage points from the prior year period reflecting the impact of reduced business volumes and, to a lesser extent, lower U.S. onshore-related product pricing. On an absolute dollar basis, adjusted operating income was $41.0 million below the prior year's level - as the impact of lower revenue volumes and product pricing was partially offset by reduced variable-based operating expenses.

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Smith Oilfield
Revenues
The Smith Oilfield segment provides three-cone and diamond drill bits, tubulars, borehole enlargement tools, drill motors, directional drilling, measurement-while-drilling, and logging-while-drilling services, as well as completions, coiled tubing, cased-hole wireline and drilling related services. Approximately two-thirds of the segment's business base is concentrated in North America driven, in part, by the significance of increased unconventional drilling projects in the U.S. land-based market and the complexity of drilling programs - which drive demand for a wider range of product offerings. For the three months ended March 31, 2009, Smith Oilfield's revenues totaled $682.4 million, a 19 percent improvement over the comparable prior year period. The reported revenue growth reflects the inclusion of the W-H operations which more than offset the impact of the significant decline in North American drilling activity. Excluding the impact of acquired operations, segment revenues declined 16 percent from the prior year level driven by reduced demand for drill pipe and premium tubular products. Additionally, the revenue performance was influenced by lower drill bit volumes associated with the reduction in North American onshore projects and increased pricing pressure experienced in the U.S. market.
Operating Income
Operating income for the Smith Oilfield segment was $105.8 million for the three months ended March 31, 2009. After excluding severance-related charges incurred in the current year quarter, operating income totaled $118.1 million, or 17.3 percent of revenues. Excluding costs incurred in connection with downsizing initiatives, operating margins declined 11.1 percentage points from the prior year period reflecting the loss of a significant proportion of fixed-cost rental and service offering revenue, a decrease in higher-relative margin drill bit sales and modest pricing erosion. On an absolute dollar basis, adjusted operating income was $44.9 million below the prior year's level - influenced by reduced business volumes, lower product pricing and the inclusion of incremental operating expenses associated with the W-H business infrastructure. Distribution
Revenues
The Distribution segment 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 96 percent of first quarter 2009 revenues generated in those markets. Moreover, just under one-quarter of the segment's revenues relate to sales to the downstream energy sector, including petrochemical plants and refineries, whose spending is largely influenced by the general state of the U.S. economic environment. Additionally, certain customers in this sector utilize petroleum products as a base material and, accordingly, are impacted by crude oil and natural gas prices. Distribution revenues totaled $569.7 million for the first quarter of 2009, slightly above the prior year period. Increased capital project spending associated with unconventional drilling programs and pipeline expansion projects in the United States offset the impact of lower Canadian drilling and completion activity and reduced U.S. downstream business volumes.
Operating Income
Operating income for the Distribution segment was $15.5 million for the three months ended March 31, 2009 - translating into operating margins of 2.7 percent. After excluding the impact of $0.7 million of severance costs included in the March 2009 period, operating income approximated $16.2 million, or 2.8 percent of revenues. Excluding costs incurred in connection with downsizing initiatives, operating margins declined 2.5 percentage points from the prior year period influenced by growth in line pipe sales, which carry lower comparable margins, and decreased product pricing. On an absolute dollar basis, adjusted operating income was $13.7 million below the prior year's level as the impact of the unfavorable business mix and lower pricing was partially offset by reduced variable-based operating expenses.

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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 March 31,
                                                          2009                                2008
                                                  Amount              %               Amount              %
Revenues                                       $  2,411,479            100         $  2,370,998            100

Gross profit                                        692,302             29              781,484             33
Selling, general and administrative
expenses                                            450,624             19              402,677             17

Operating income                                    241,678             10              378,807             16
Interest expense                                     27,524              1               16,301              1
Interest income                                        (358 )            -                 (896 )            -

Income before income taxes and
noncontrolling interests                            214,512              9              363,402             15
Income tax provision                                 70,318              3              117,291              5
Noncontrolling interests in net income of
subsidiaries                                         47,259              2               71,120              3

Net income attributable to Smith               $     96,935              4         $    174,991              7

Consolidated revenues totaled $2.41 billion for the three months ended March 31, 2009, representing a two percent increase over amounts reported in the prior year quarter. Excluding the impact of incremental revenues associated with the W-H transaction, base-business levels declined seven percent from the year-ago quarter. The base-business performance reflects the sharp reduction in North American activity that resulted in decreased demand for drill pipe and premium tubular products, reduced drill bit sales volumes and, to a lesser extent, lower pricing across various product and service offerings.
Gross profit was $692.3 million for the first quarter of 2009, reflecting an 11 percent reduction from the prior year's results. Gross margins decreased 4.3 percentage points from the year-ago period influenced by reduced revenue volumes and, to a lesser extent, lower product and service pricing. On an absolute dollar basis, gross profit was $89.2 million below the prior year's level evidencing a significant decline in revenue volumes without a comparable reduction in associated costs, an unfavorable shift in the sales mix towards lower relative-margin offerings and reduced product pricing. Selling, general and administrative expenses totaled $450.6 million, a 12 percent increase over the amounts reported in the prior year quarter. Excluding the impact of $32.3 million of severance and facility closure costs included in the March 2009 period, operating expenses increased $15.6 million over the prior year quarter. Incremental costs associated with the W-H sales and administrative functions were partially offset by lower variable-based expenses associated with the reduced business volumes.
Net interest expense, which represents interest expense less interest income, equaled $27.2 million in the first quarter of 2009. The $11.8 million year-over-year reported increase in net interest reflects borrowings required to fund the W-H acquisition. The substantial decline in short-term Eurodollar interest rates experienced during the March 2009 quarter partially offset the impact of the incremental borrowings on interest expense.
The effective tax rate for the March 2009 quarter approximated 32.8 percent, approximately 50 basis points above the prior year level. The unfavorable comparison to the prior year quarter is primarily attributable to the W-H acquisition which resulted in a shift in the geographic mix of earnings towards a higher relative-rate tax jurisdiction. The effective tax rate was lower than the U.S. statutory rate due to the impact of M-I SWACO's U.S. partnership earnings for which the noncontrolling interest partner is directly responsible for its related income taxes. The Company properly consolidates the pretax income related to the minority partner's share of U.S. partnership earnings but excludes the related tax provision.

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Noncontrolling interests reflect the portion of the results of majority-owned operations that are applicable to noncontrolling ownership interests. Noncontrolling interests totaled $47.3 million for the March 2009 quarter, $23.9 million below the amount reported in the prior year period - primarily associated with a decline in profitability levels in the M-I SWACO joint venture.
Liquidity and Capital Resources
General
At March 31, 2009, cash and cash equivalents equaled $201.5 million. During the first three months of 2009, the Company generated $197.8 million of cash flows from operations. The amount was above the prior-year period as reduced year-on-year profitability levels related to the sharp downturn in drilling activity were offset by lower required working capital investment. Cash flows used in investing activities for the March 2009 period totaled $16.9 million - $46.1 million below the prior year quarter. The decrease from the prior year period reflects the sale of certain non-core businesses acquired in connection with the W-H transaction. Excluding the impact of these divestitures, cash flows used in investing activities rose $18.9 million from the prior year, reflecting routine additions of equipment and rental tools to support market expansion and maintain the existing capital equipment base. The Company invested $74.7 million in property, plant and equipment during the first three months of 2009, after taking into consideration cash proceeds arising from certain asset disposals.
Projected net capital expenditures for 2009 are expected to total $300 million, approximately $70 million below the spending levels reported in the prior fiscal year. A significant portion of the planned capital investment relates to rental tool additions for our recently acquired directional drilling operations to support geographic expansion efforts outside the United States.
Cash flows used in financing activities totaled $139.5 million for the three months ended March 31, 2009, $33.2 million above the prior year quarter. The Company's operating cash flow performance enabled the funding of investing activities, $30.3 million of combined common stock dividend and noncontrolling joint venture partner distributions and other financing-related outflows, while still having sufficient capacity to repay $64.4 million of outstanding borrowings under various loan agreements.
The Company's primary internal source of liquidity is cash flow generated from operations. Cash flows generated from operations is primarily influenced by the level of worldwide drilling activity, which affects profitability levels and working capital requirements. Capacity under revolving credit agreements is also available, if necessary, to fund operating or investing activities. As of March 31, 2009, the Company had $197.0 million drawn and $4.5 million of letters of credit issued under various U.S. revolving credit facilities, resulting in $233.5 million of capacity available for future operating or investing needs. Revolving credit facilities in place outside of the United States, which are generally used to finance local operating needs, had available borrowing capacity of $118.9 million as of March 31, 2009. Additionally, the Company negotiated a $525.0 million term loan facility with a syndicate of financial institutions during the first quarter of 2009. The facility, which expires on June 5, 2009, was undrawn at the end of the quarter.
The Company's external sources of liquidity include debt and equity financing in the public capital markets, if needed. The Company carries an investment-grade credit rating with recognized rating agencies, generally providing the Company with access to debt markets as evidenced by the recent $1.0 billion public debt issuance. The Company's overall borrowing capacity is, in part, dependent on . . .