UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____ to ____
Commission file number
1-8514
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 77060
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)
(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 [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
The number of shares outstanding of the Registrant's common stock as of August
11, 2003 was 100,084,966.
INDEX
PAGE NO.
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the Three Months and Six Months ended June 30, 2003 and 2002................................... 1
CONSOLIDATED CONDENSED BALANCE SHEETS
As of June 30, 2003 and December 31, 2002.......................................................... 2
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the Six Months ended June 30, 2003 and 2002.................................................... 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. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES............................................... 21
ITEM 4. CONTROLS AND PROCEDURES............................................................................ 21
PART II - OTHER INFORMATION
ITEMS 1-4................................................................................................... 22
ITEMS 5-6................................................................................................... 23
SIGNATURES........................................................................................................... 24
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Revenues ........................................................ $ 877,657 $ 801,038 $ 1,686,494 $ 1,628,415
Costs and expenses:
Costs of revenues ........................................... 615,747 564,783 1,186,241 1,150,658
Selling expenses ............................................ 142,839 127,753 279,967 258,812
General and administrative expenses ......................... 39,654 34,622 77,715 70,617
------------ ------------ ------------ ------------
Total costs and expenses ................................ 798,240 727,158 1,543,923 1,480,087
------------ ------------ ------------ ------------
Operating income ................................................ 79,417 73,880 142,571 148,328
Interest expense ................................................ 10,902 10,566 21,174 20,988
Interest income ................................................. (522) (674) (1,102) (1,080)
------------ ------------ ------------ ------------
Income before income taxes, minority interests and
cumulative effect of change in accounting principle ......... 69,037 63,988 122,499 128,420
Income tax provision ............................................ 22,314 19,306 39,154 38,951
Minority interests .............................................. 16,823 17,760 31,730 33,817
------------ ------------ ------------ ------------
Income before cumulative effect of change in accounting
principle ................................................... 29,900 26,922 51,615 55,652
Cumulative effect of change in accounting principle ............. -- -- (1,154) --
------------ ------------ ------------ ------------
Net income ...................................................... $ 29,900 $ 26,922 $ 50,461 $ 55,652
============ ============ ============ ============
Basic:
Earnings per share before cumulative effect of change in
accounting principle .................................... $ 0.30 $ 0.27 $ 0.52 $ 0.56
Cumulative effect of change in accounting principle ......... -- -- (0.01) --
------------ ------------ ------------ ------------
Earnings per share .......................................... $ 0.30 $ 0.27 $ 0.51 $ 0.56
============ ============ ============ ============
Diluted:
Earnings per share before cumulative effect of change in
accounting principle .................................... $ 0.30 $ 0.27 $ 0.51 $ 0.56
Cumulative effect of change in accounting principle ......... -- -- (0.01) --
------------ ------------ ------------ ------------
Earnings per share .......................................... $ 0.30 $ 0.27 $ 0.50 $ 0.56
============ ============ ============ ============
Weighted average shares outstanding:
Basic ....................................................... 99,736 98,944 99,501 98,892
Diluted ..................................................... 100,892 100,272 100,579 100,071
The accompanying notes are an integral part of these
consolidated condensed financial statements.
1
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
(In thousands, except par value data)
June 30, December 31,
2003 2002
------------ ------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ................................................ $ 43,841 $ 86,750
Receivables, net ......................................................... 755,009 633,918
Inventories, net ......................................................... 700,804 634,488
Deferred tax assets, net ................................................. 24,347 25,403
Prepaid expenses and other ............................................... 54,834 46,355
------------ ------------
Total current assets ................................................. 1,578,835 1,426,914
------------ ------------
Property, Plant and Equipment, net ........................................... 528,442 519,220
Goodwill, net ................................................................ 679,372 620,075
Other Assets ................................................................. 195,690 183,336
------------ ------------
Total Assets ................................................................. $ 2,982,339 $ 2,749,545
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current portion of long-term debt .............. $ 166,923 $ 159,692
Accounts payable ......................................................... 309,640 256,069
Accrued payroll costs .................................................... 52,709 49,946
Income taxes payable ..................................................... 51,439 43,936
Other .................................................................... 86,438 85,453
------------ ------------
Total current liabilities ............................................ 667,149 595,096
------------ ------------
Long-Term Debt ............................................................... 472,149 441,967
Deferred Tax Liabilities ..................................................... 68,829 64,679
Other Long-Term Liabilities .................................................. 75,563 67,011
Minority Interests ........................................................... 551,443 517,257
Commitments and Contingencies (See Note 11)
STOCKHOLDERS' EQUITY:
Preferred stock, $1 par value; 5,000 shares authorized; no shares
issued or outstanding in 2003 or 2002 ................................ -- --
Common stock, $1 par value; 150,000 shares authorized; 102,461 shares
issued in 2003 (101,546 shares issued in 2002) ....................... 102,461 101,546
Additional paid-in capital ............................................... 366,062 345,911
Retained earnings ........................................................ 706,104 655,643
Accumulated other comprehensive income ................................... 1,709 (10,435)
Less - Treasury securities, at cost; 2,384 common shares ................. (29,130) (29,130)
------------ ------------
Total stockholders' equity ........................................ 1,147,206 1,063,535
------------ ------------
Total Liabilities and Stockholders' Equity ................................... $ 2,982,339 $ 2,749,545
============ ============
The accompanying notes are an integral part of these
consolidated condensed financial statements.
2
SMITH INTERNATIONAL, INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Six Months Ended
June 30,
----------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ................................................................ $ 50,461 $ 55,652
Adjustments to reconcile net income to net cash provided by operating
activities, excluding the net effects of acquisitions:
Cumulative effect of change in accounting principle ................... 1,154 --
Depreciation and amortization ......................................... 49,941 43,200
Minority interests .................................................... 31,730 33,817
Provision for losses on receivables ................................... 898 6,110
Gain on disposal of property, plant and equipment ..................... (5,046) (3,730)
Foreign currency translation losses (gains) ........................... 667 (1,021)
Changes in operating assets and liabilities:
Receivables ........................................................... (109,643) 40,560
Inventories ........................................................... (55,773) 24,599
Accounts payable ...................................................... 47,522 (47,678)
Other current assets and liabilities .................................. 13,288 (35,828)
Other non-current assets and liabilities .............................. (7,474) (2,680)
------------ ------------
Net cash provided by operating activities ................................. 17,725 113,001
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired ........................... (78,007) (5,049)
Purchases of property, plant and equipment ................................ (45,871) (50,630)
Proceeds from disposal of property, plant and equipment ................... 12,072 10,644
------------ ------------
Net cash used in investing activities ..................................... (111,806) (45,035)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt .................................. 58,855 706
Principal payments of long-term debt ...................................... (30,722) (53,365)
Net change in short-term borrowings ....................................... 8,182 (1,053)
Proceeds from exercise of stock options ................................... 14,616 2,293
Distribution to minority interest partner ................................. -- (15,600)
------------ ------------
Net cash provided by (used in) financing activities ....................... 50,931 (67,019)
------------ ------------
Effect of exchange rate changes on cash ................................... 241 350
------------ ------------
Increase (decrease) in cash and cash equivalents .......................... (42,909) 1,297
Cash and cash equivalents at beginning of period .......................... 86,750 44,683
------------ ------------
Cash and cash equivalents at end of period ................................ $ 43,841 $ 45,980
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest .................................................... $ 21,046 $ 21,339
Cash paid for income taxes ................................................ $ 23,812 $ 23,736
The accompanying notes are an integral part of these
consolidated condensed financial statements.
3
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(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 2002 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.
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
On January 1, 2003, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations," which
addresses the financial accounting and reporting for retirement obligations and
costs associated with tangible long-lived assets. SFAS No. 143 requires that
liabilities for asset retirement obligations be recognized during the periods
incurred rather than when expended. The Company's asset retirement obligations
principally relate to the removal of leasehold improvements upon exiting certain
leased properties, primarily associated with the M-I operations. Upon adoption,
the Company recognized a charge of $2.5 million, or $1.2 million after tax and
minority interests, to reflect the cumulative amount of expense which was
required to be recognized as of January 1, 2003. This amount has been recorded
as a cumulative effect of change in accounting principle in the accompanying
consolidated condensed statement of operations. Additionally, the Company
recorded a $3.7 million long-term liability at the adoption date reflecting the
present value of projected future asset retirement obligations. The differential
of $1.2 million, which primarily represents the associated capitalized
retirement costs, will be charged to earnings over the remaining leasehold
period. Neither the amount charged to earnings in 2003 nor the pro forma effect
for the three-month and six-month periods ended June 30, 2002 (assuming adoption
of SFAS No. 143 as of January 1, 2002) were significant to net income or
earnings per share amounts.
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. Unless otherwise discussed, management believes the
impact of recently issued standards, which are not yet effective, will not have
a material impact on the Company's consolidated financial statements upon
adoption.
4
3. BUSINESS COMBINATIONS
During the six months ended June 30, 2003, the Company completed two
acquisitions for aggregate cash consideration of $78.0 million. The
consideration primarily relates to M-I's purchase of certain oilfield chemical
assets of Dynea International ("Dynea"), which was acquired for $77.8 million.
The Dynea operations, based in Norway, provide a complete line of oilfield
specialty chemicals used to eliminate hydrocarbon flow problems encountered
during production and transportation.
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 has been recorded as
goodwill in the amount of $57.2 million. The purchase price allocations related
to these acquisitions are based upon 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. Pro forma results of operations have not been
presented because the effect of these acquisitions was not material to the
Company's consolidated condensed financial statements.
5
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 which could have occurred if additional shares
were issued for stock option exercises under the treasury stock method. Certain
outstanding employee stock options were not included in the computation of
diluted earnings per common share for the three-month and six-month periods
ended June 30, 2002, as the exercise price was greater than the average market
price for the Company's stock during the corresponding periods. 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 Six Months Ended
June 30, June 30,
----------------------------------- -----------------------------------
2003 2002 2003 2002
---------------- ---------------- ---------------- ----------------
BASIC EPS BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE:
Income before cumulative effect of change
in accounting principle .................... $ 29,900 $ 26,922 $ 51,615 $ 55,652
================ ================ ================ ================
Weighted average number of common
shares outstanding ......................... 99,736 98,944 99,501 98,892
================ ================ ================ ================
Basic EPS before cumulative effect of
change in accounting principle ............. $ 0.30 $ 0.27 $ 0.52 $ 0.56
================ ================ ================ ================
DILUTED EPS BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE:
Income before cumulative effect of change
in accounting principle .................... $ 29,900 $ 26,922 $ 51,615 $ 55,652
================ ================ ================ ================
Weighted average number of common
shares outstanding ......................... 99,736 98,944 99,501 98,892
Dilutive effect of stock options ............. 1,156 1,328 1,078 1,179
================ ================ ================ ================
100,892 100,272 100,579 100,071
================ ================ ================ ================
Diluted EPS before cumulative effect of
change in accounting principle ............. $ 0.30 $ 0.27 $ 0.51 $ 0.56
================ ================ ================ ================
6
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,
certain 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,
2003 2002
------------ ------------
Raw materials ............................................................. $ 62,036 $ 49,880
Work-in-process ........................................................... 61,679 54,201
Products purchased for resale ............................................. 170,280 155,202
Finished goods ............................................................ 431,392 399,252
------------ ------------
725,387 658,535
Reserves to state certain domestic inventories (cost of $275,952
and $265,304 in 2003 and 2002, respectively) on a LIFO basis ............ (24,583) (24,047)
------------ ------------
$ 700,804 $ 634,488
============ ============
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following (in thousands):
June 30, December 31,
2003 2002
------------ ------------
Land ............................................................ $ 33,995 $ 33,412
Buildings ....................................................... 131,621 125,589
Machinery and equipment ......................................... 503,642 506,245
Rental tools .................................................... 307,952 268,134
------------ ------------
977,210 933,380
Less-accumulated depreciation ................................... 448,768 414,160
------------ ------------
$ 528,442 $ 519,220
============ ============
7
7. GOODWILL AND OTHER INTANGIBLE ASSETS
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, 2002 ............. $ 582,786 $ 37,289 $ 620,075
Goodwill acquired ........................... 57,116 95 57,211
Purchase price and other adjustments ........ 1,699 387 2,086
------------ ------------ ------------
Balance as of June 30, 2003 ................. $ 641,601 $ 37,771 $ 679,372
============ ============ ============
Additionally, the Other Assets balance reflected in the accompanying
consolidated condensed balance sheets includes $64.9 million and $60.1 million
of intangible assets (net of accumulated amortization of $16.7 million and $13.2
million) as of June 30, 2003 and December 31, 2002, respectively. The Company
amortizes identifiable intangible assets, generally consisting of patents,
trademarks and non-compete agreements, on a straight-line basis over their
expected useful lives, which range from three to 27 years.
8. 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,
--------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income ............................................ $ 29,900 $ 26,922 $ 50,461 $ 55,652
Changes in unrealized fair value of
derivatives, net .................................... 667 1,750 1,073 1,785
Currency translation adjustments ...................... 7,108 10,649 11,071 10,182
------------ ------------ ------------ ------------
Comprehensive income .................................. $ 37,675 $ 39,321 $ 62,605 $ 67,619
============ ============ ============ ============
As of June 30, 2003, accumulated other comprehensive income in the accompanying
consolidated condensed balance sheet includes $1.8 million of cumulative
currency translation gains and $3.4 million of cumulative changes in the
unrealized fair value of derivatives, partially offset by $3.5 million of
cumulative pension liability adjustments.
8
9. STOCK-BASED COMPENSATION
The Company's Board of Directors and its stockholders have authorized an
employee stock option plan. As of June 30, 2003, 5.3 million shares were issued
and outstanding under the program and an additional 3.3 million shares were
authorized for future issuance. 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.
Certain option awards granted on December 4, 2001 were subject to stockholder
approval which was not obtained until April 24, 2002. Accordingly, these options
were granted with a strike price more than five percent below the market value
on the date of issuance and do not meet the conditions necessary to qualify as a
non-compensatory option grant. Compensation expense related to these grants is
being recognized over the four-year vesting period and resulted in the inclusion
in the accompanying consolidated condensed statement of operations of $0.1
million of related expense for each of the three month periods ended June 30,
2003 and 2002 and $0.2 million and $0.1 million of related expense for the six
month periods ended June 30, 2003 and 2002, respectively.
The Company continues to apply Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations in
accounting for its stock option program, as allowed under SFAS No. 123,
"Accounting for Stock-Based Compensation." Therefore, for all options other than
those mentioned above, the Company elects to make pro forma disclosures versus
recognizing the related compensation expense in the accompanying consolidated
condensed financial statements.
Had the Company elected to apply the accounting standards of SFAS No. 123, the
Company's net income and earnings per share on a diluted basis would have
approximated the pro forma amounts indicated below (in thousands, except per
share data):
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income, as reported ............................... $ 29,900 $ 26,922 $ 50,461 $ 55,652
Add: Stock-based compensation expense
included in reported income, net of related
tax effect ........................................ 68 46 137 46
Less: Total stock-based compensation
expense determined under the Black-
Scholes option-pricing model, net of
related tax effect ................................ (2,347) (1,942) (4,694) (3,837)
------------ ------------ ------------ ------------
Net income, pro forma ................................. $ 27,621 $ 25,026 $ 45,904 $ 51,861
============ ============ ============ ============
Earnings per share:
As reported:
Basic ............................................. $ 0.30 $ 0.27 $ 0.51 $ 0.56
Diluted ........................................... 0.30 0.27 0.50 0.56
Pro forma:
Basic ............................................. $ 0.28 $ 0.25 $ 0.46 $ 0.52
Diluted ........................................... 0.27 0.25 0.46 0.52
In addition to the stock option program described above, the Company maintains a
stock grant program. The stock grants are issued at par value and are subject to
a four-year cliff-vesting schedule. Compensation expense, calculated as the
difference between the market value on the date of grant and the exercise price,
is being recognized ratably over the vesting period and resulted in the
inclusion in the accompanying consolidated condensed statements of operations of
$0.2 million and $0.1 million of related expense for the three month periods
ended June 30, 2003 and 2002, respectively, and $0.3 million of related expense
for each of the six month periods ended June 30, 2003 and 2002.
9
10. 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,
Smith Bits 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,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Revenues:
Oilfield Products and Services ..................... $ 659,121 $ 583,658 $ 1,262,681 $ 1,176,528
Distribution ....................................... 218,536 217,380 423,813 451,887
------------ ------------ ------------ ------------
$ 877,657 $ 801,038 $ 1,686,494 $ 1,628,415
============ ============ ============ ============
Revenues by Area:
United States ...................................... $ 392,146 $ 384,933 $ 759,461 $ 776,881
Canada ............................................. 71,353 62,130 157,634 150,349
Non-North America .................................. 414,158 353,975 769,399 701,185
------------ ------------ ------------ ------------
$ 877,657 $ 801,038 $ 1,686,494 $ 1,628,415
============ ============ ============ ============
Operating Income:
Oilfield Products and Services ..................... $ 81,590 $ 76,376 $ 150,523 $ 152,315
Distribution ....................................... (478) (881) (4,577) (813)
General corporate .................................. (1,695) (1,615) (3,375) (3,174)
------------ ------------ ------------ ------------
$ 79,417 $ 73,880 $ 142,571 $ 148,328
============ ============ ============ ============
11. COMMITMENTS AND CONTINGENCIES
Standby Letters of Credit and Guarantees
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. The majority of these outstanding instruments
guarantee payment of notes issued to former shareholders of an acquired entity
as well as to insurance companies which re-insure certain liability coverages of
the Company's insurance captive. Excluding the impact of these instruments, for
which the related liabilities are reflected in the accompanying consolidated
condensed balance sheets, the Company is contingently liable for approximately
$35.4 million of standby letters of credit and bid, performance and surety bonds
at June 30, 2003. Management does not expect any material amounts to be drawn on
these instruments.
The Company has also provided guarantees for loans related to certain joint
ventures accounted for by the equity method of accounting. As the net assets of
the joint ventures are available to satisfy obligations as they become due,
management believes the likelihood is remote that the Company will be required
to make payments related to these agreements. The Company's estimated maximum
exposure under these loan guarantees approximated $12.4 million as of June 30,
2003.
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.
In connection with most business acquisitions, the Company obtains contractual
indemnifications from the seller related to environmental matters. These
indemnifications generally provide for the reimbursement of environmental
clean-up costs incurred by the Company for events occurring or circumstances
existing prior to the purchase date, whether the event or circumstance was known
or unknown at that time. A substantial portion of the Company's total
environmental exposure is associated with its M-I operations, which are subject
to various indemnifications from former owners.
10
As of June 30, 2003, the Company has established an environmental reserve of
approximately $12.5 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, 2003, the Company does
not believe that these differences will have a material impact on the Company's
financial position or results of operations, subject to the indemnifications in
place. During the first quarter of 2003, the Company initiated legal action
against M-I's former owners to address issues associated with certain provisions
of the environmental indemnification provided. In the event that i) M-I's former
owners and other parties to indemnification agreements with the Company do not
fulfill their obligations, and ii) costs incurred to remediate the identified
properties reach estimated maximum exposure limits, the Company would be
required to establish additional environmental reserves of up to $25.0 million,
impacting earnings and cash flows in future periods.
11
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 2002 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 branch
network providing pipe, valves, fittings and mill, safety and other maintenance
products.
Management believes the increasing complexity of drilling programs has resulted
in a shift in exploration and production spending toward value-added,
technology-based products, which reduce operators' overall drilling costs. The
Company continues to focus on investing in the development of technology-based
products that considerably improve the drilling process through increased
efficiency and rates of penetration and reduced formation damage. Management
believes the overall savings realized by the use of the Company's premium
products, such as polycrystalline diamond drill bits, diamond-enhanced
three-cone drill bits and synthetic drilling fluids, compensate for the higher
costs of these products over their non-premium counterparts.
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 spending is largely
influenced by commodity prices, 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 general
financial condition of independent E&P companies and the overall level of global
economic growth and activity. Capital investment by energy companies is largely
divided between two markets which vary in terms of business drivers and
volatility levels. North American drilling activity is primarily influenced by
natural gas fundamentals, with over 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 over 70 percent 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 2003, Smith's profitability is
largely dependent upon business levels in markets outside of North America,
including Europe/Africa and Latin America. The Distribution segment, which
accounts for approximately one-quarter 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, 61 percent of the Company's second quarter 2003
revenues were generated outside of North America.
12
MARKET AND INDUSTRY ACTIVITY
The worldwide rig count is currently 15 percent above year-end 2002 levels,
driven by a strong rebound in U.S. land-based drilling. The significant increase
in U.S. drilling activity has resulted in record natural gas injections during
the second quarter of 2003, favorably impacting storage levels which have
recovered to within ten percent of their five-year historical average. Higher
levels of gas storage have placed downward pressure on prices, which are
currently 15 percent below the average level experienced in the first half of
2003. In addition to the potential impact from declining commodity prices,
continued asset rationalization by major multinational oil companies and
operational curtailments in the Gulf of Mexico due to tropical weather
disturbances could effect near-term exploration and production spending.
Overall, the Company's business outlook 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. Changes in the global economic environment could impact worldwide
drilling activity and future financial results of the Company.
13
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, Smith Bits
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 (dollars in
thousands).
Three Months Ended June 30, Six Months Ended June 30,
----------------------------------------- ---------------------------------------------
2003 2002 2003 2002
------------------- ------------------- -------------------- ----------------------
Amount % Amount % Amount % Amount %
--------- ------ --------- ------ ----------- ----- ----------- -------
FINANCIAL DATA:
Revenues:
M-I ............................... $ 460,386 52 $ 401,642 50 $ 876,675 52 $ 798,298 49
Smith Bits ........................ 96,506 11 77,146 10 188,745 11 166,624 10
Smith Services .................... 102,229 12 104,870 13 197,261 12 211,606 13
--------- ------ --------- ------ ----------- ----- ----------- -------
Oilfield Products and Services .. 659,121 75 583,658 73 1,262,681 75 1,176,528 72
Distribution ...................... 218,536 25 217,380 27 423,813 25 451,887 28
--------- ------ --------- ------ ----------- ----- ----------- -------
Total ..................... $ 877,657 100 $ 801,038 100 $ 1,686,494 100 $ 1,628,415 100
========= ====== ========= ====== =========== ===== =========== =======
Revenues by Area:
United States ..................... $ 392,146 45 $ 384,933 48 $ 759,461 45 $ 776,881 48
Canada ............................ 71,353 8 62,130 8 157,634 9 150,349 9
Non-North America ................. 414,158 47 353,975 44 769,399 46 701,185 43
--------- ------ --------- ------ ----------- ----- ----------- -------
Total ..................... $ 877,657 100 $ 801,038 100 $ 1,686,494 100 $ 1,628,415 100
========= ====== ========= ====== =========== ===== =========== =======
Operating Income:
Oilfield Products and Services .... $ 81,590 12 $ 76,376 13 $ 150,523 12 $ 152,315 13
Distribution ...................... (478) * (881) * (4,577) * (813) *
General Corporate ................. (1,695) * (1,615) * (3,375) * (3,174) *
--------- ------ --------- ------ ----------- ----- ----------- -------
Total ..................... $ 79,417 9 $ 73,880 9 $ 142,571 8 $ 148,328 9
========= ====== ========= ====== =========== ===== =========== =======
MARKET DATA:
M-I Average Worldwide Rig Count:
United States ..................... 1,223 50 940 46 1,138 46 909 42
Canada ............................ 189 8 144 7 322 13 265 12
Non-North America ................. 1,047 42 981 47 1,027 41 991 46
--------- ------ --------- ------ ----------- ----- ----------- -------
Total ..................... 2,459 100 2,065 100 2,487 100 2,165 100
========= ====== ========= ====== =========== ===== =========== =======
Average Commodity Prices:
Crude Oil ($/Bbl) (1) ............. $ 28.95 $ 26.24 $ 31.48 $ 23.94
Natural Gas ($/mcf) (2) ........... $ 5.37 $ 3.13 $ 5.75 $ 2.73
(1) Average West Texas Intermediate ("WTI") spot closing prices.
(2) Average weekly composite spot U.S. wellhead prices.
*not meaningful
14
Oilfield Products and Services Segment
Revenues
M-I provides drilling and completion fluid systems, engineering and technical
services to the oil and gas industry through its M-I Fluids division. M.I's
SWACO division manufactures and markets equipment and services for
solids-control, separation, pressure control, rig instrumentation and
waste-management. M-I also provides a complete line of oilfield specialty
chemicals and related technical services through its Oilfield Production
Chemical division, acquired in January 2003. The M-I operations account for the
largest proportion of the Company's Oilfield segment revenues and 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 15 percent of the
revenue base. U.S. offshore drilling programs, which account for five 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's
revenues totaled $460.4 million for the second quarter of 2003, 15 percent above
the prior year period. Excluding the impact of acquisitions completed over the
past year, revenues increased nine percent. The base revenue growth was
primarily generated in markets outside of North America reflecting increased
customer activity in Europe/Africa, which contributed to higher sales of
synthetic fluids, and new contract awards in the Middle East region. For the
six-month period, M-I reported revenues of $876.7 million, a ten percent
increase over the amounts reported in the first half of 2002. The revenue growth
was split relatively equally between acquisitions and internal growth. The
majority of the base revenue increase was reported in the international markets,
specifically Latin America, the Former Soviet Union and the Middle East region,
reflecting increased demand for synthetic drilling and completion fluid
products.
Smith Bits 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 Smith Bits correlate more closely to the rig
count than any of the Company's other operations. Smith Bits reported revenues
of $96.5 million for the second quarter of 2003, an increase of 25 percent over
the comparable prior-year period. The year-over-year comparison was influenced
by incremental revenues from acquisitions completed in the latter half of 2002
and several large international export orders. Excluding the effect of these
items, petroleum drill bit base revenues were approximately 17 percent above the
level reported in the second quarter of 2002, reflecting the year-over-year
change in worldwide rig activity. The majority of the base revenue growth was
reported in North America where a 30 percent increase in drilling activity
impacted sales of petroleum three-cone bits. For the six-month period, Smith
Bits reported revenues of $188.7 million, a 13 percent increase over the
comparable period of 2002. Excluding the effect of acquisitions, base revenues
were approximately six percent above the first half of 2002 due to higher North
American drilling activity. Lower sales in markets outside North America
attributable, in part, to reduced international export orders served to offset
the revenue improvement reported in the United States and Canada.
Smith Services manufactures and markets products and services used in the oil
and gas industry for drilling, workover, 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, 2003, Smith Services' revenues totaled $102.2 million,
three percent below the prior year quarter. The revenue decline from the prior
year was reported in Europe/Africa and Latin America reflecting reduced customer
spending for remedial products and services associated with lower activity
levels in the related markets. North American revenues were relatively
consistent with amounts reported in the second quarter of 2002 as higher sales
volumes associated with the increase in land-based drilling programs were offset
by a more than 40 percent reduction in drill pipe product sales, which are not
highly correlated to drilling activity. For the first half of 2003, Smith
Services reported revenues of $197.3 million, a seven percent decrease from the
comparable prior year period. The revenue decline related to the reduction in
U.S. drill pipe product sales, which were less than one-half of the amount
reported in the prior year period. Excluding the impact of drill pipe sales,
revenues were comparable to the first half of 2002, as the effect of increased
sales volumes attributable to the higher North American activity levels were
offset by the impact of reduced customer activity in the North Sea and certain
Latin American markets, which influenced sales of remedial and completion
products and services.
15
Operating Income
Operating income for the Oilfield Products and Services segment was $81.6
million or 12.4 percent of revenues in the second quarter of 2003. Segment
operating margins declined approximately one percentage point from both the
prior year quarter and first six months of 2002. The operating margins were
influenced by increased investment in people and infrastructure to support
business expansion. To a lesser extent, an unfavorable shift in business mix
from higher-margin product lines and geographic areas to products and regions
with lower comparable margins impacted Oilfield segment margins, as pricing has
remained relatively consistent. On an absolute dollar basis, operating income
was $5.2 million above the prior year quarter as higher revenue volumes
favorably impacted the segment's reported gross profit. For the six-month
period, the shift in product and geographic revenue mix discussed above combined
with the reported operating expense growth contributed to the reduction in
segment operating income.
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 approximately 95 percent of Wilson's second quarter 2003
revenues generated in those markets. Moreover, approximately one-third of
Wilson's revenues relate to sales to the downstream energy sector, including
petrochemical plants and refineries, whose spending is effected by changes in
crude oil and natural gas prices as well as the general U.S. economic
environment. Wilson reported revenues of $218.5 million for the second quarter
of 2003, relatively consistent with the prior year quarter. Increased energy
branch sales associated with improved North American activity levels were
largely offset by reduced spending in the industrial sector, primarily by
engineering and construction and petrochemical customers. In the first six
months of 2003, Wilson reported revenues totaling $423.8 million, a decline of
six percent from the first half of 2002. The revenue variance from the prior
year period reflects lower spending in the industrial customer base, including
engineering and construction, refining and petrochemical operations. To a lesser
extent, the six-month revenue comparison was impacted by reduced tubular product
sales in Canada as certain customers began purchasing tubular goods directly
from the manufacturer.
Operating Income
Operating income for the Distribution segment increased $0.4 million from the
amount reported in the prior year quarter, reducing the segment operating loss
to $0.5 million in the second quarter of 2003. The operating income variance
reflects increased gross profit primarily associated with a favorable shift in
product mix in the energy branch operations, partially offset by higher
variable-based operating expenses. On a year-to-date basis, segment operating
income declined $3.8 million from the amount reported in the first six months of
2002. The decrease reflects lower gross profit related to the reduction in
industrial distribution revenues.
16
Consolidated Results
For the periods indicated, the following table summarizes the results of the
Company and presents these results as a percentage of total revenues (dollars in
thousands):
Three Months Ended June 30, Six Months Ended June 30,
-------------------------------------------- ---------------------------------------------
2003 2002 2003 2002
-------------------- --------------------- --------------------- ---------------------
Amount % Amount % Amount % Amount %
--------- ------- ----------- ------ ----------- ------ ----------- ------
Revenues ........................... $ 877,657 100 $ 801,038 100 $ 1,686,494 100 $ 1,628,415 100
--------- ------- ----------- ------ ----------- ------ ----------- ------
Gross profit ....................... 261,910 30 236,255 29 500,253 30 477,757 29
Operating expenses ................. 182,493 21 162,375 20 357,682 21 329,429 20
--------- ------- ----------- ------ ----------- ------ ----------- ------
Operating income ................... 79,417 9 73,880 9 142,571 9 148,328 9
Interest expense ................... 10,902 1 10,566 1 21,174 1 20,988 1
Interest income .................... (522) -- (674) -- (1,102) -- (1,080) --
--------- ------- ----------- ------ ----------- ------ ----------- ------
Income before income taxes,
minority interests and
cumulative effect of change in
accounting principle ............. 69,037 8 63,988 8 122,499 8 128,420 8
Income tax provision ............... 22,314 3 19,306 3 39,154 3 38,951 3
Minority interests ................. 16,823 2 17,760 2 31,730 2 33,817 2
--------- ------- ----------- ------ ----------- ------ ----------- ------
Income before cumulative effect
of change in accounting
principle ........................ 29,900 3 26,922 3 51,615 3 55,652 3
Cumulative effect of change in
accounting principle ............. -- -- -- -- (1,154) -- -- --
--------- ------- ----------- ------ ----------- ------ ----------- ------
Net income ......................... $ 29,900 3 $ 26,922 3 $ 50,461 3 $ 55,652 3
========= ======= =========== ====== =========== ====== =========== ======
Consolidated revenues were $877.7 million for the second quarter of 2003, ten
percent above the prior year period. Excluding the impact of four acquisitions
completed during the past year, revenues increased six percent as higher
activity levels influenced demand across Oilfield segment product lines. Over
two-thirds of the base revenue growth was reported in markets outside of North
America, reflecting higher drilling activity and the impact of new contract
awards. For the first half of 2003, consolidated revenues were $1.7 billion,
four percent above the comparable 2002 period. The year-over-year revenue
improvement was largely attributable to the impact of acquisitions. Base
revenues were relatively consistent with the comparable period of the prior
year, as lower demand associated with the U.S. industrial distribution customer
base offset the revenue growth experienced in the Oilfield segment operations.
17
Gross profit totaled $261.9 million for the second quarter of 2003,
approximately 11 percent above the prior year period. The increase in gross
profit reflects the higher sales volumes reported in the Company's Oilfield
operations associated with improved worldwide activity levels. Gross profit
margins for the second quarter of 2003 were 30 percent of revenues and compared
to margins of 29 percent reported in the prior year quarter. The margin
improvement reflects an increased proportion of revenues reported in the
Oilfield segment, which traditionally generate higher gross profit margins than
the Distribution operations, more than offsetting the minimal Oilfield segment
margin deterioration related to an unfavorable shift in the business mix. For
the six-month period, gross profit totaled $500.3 million, or 30 percent of
revenues, one percentage point above the comparable period of the prior year.
The increase was attributable to the Oilfield operations associated with the
higher overall sales volumes, partially offset by the impact of the revenue
reduction reported in the Distribution segment. The gross profit margin
improvement for the six-month period comparison was, again, influenced by the
higher proportion of Oilfield segment sales.
Operating expenses, consisting of selling, general and administrative expenses,
increased $20.1 million and $28.3 million from the prior year quarter and the
first six months of 2002, respectively. The majority of the increase for both
periods relates to a combination of incremental expenses associated with
acquired operations and additional sales engineering and support costs,
including investment in people and infrastructure, related to new contract
awards. To a lesser extent, higher costs associated with U.S. medical and
casualty insurance programs, increased employee profit-sharing amounts and other
variable-related costs contributed to the period-to-period variance.
Net interest expense, which represents interest expense less interest income,
equaled $10.4 million in the second quarter of 2003. Net interest expense
increased $0.5 million from the prior year period primarily reflecting higher
average debt levels associated with the funding of acquisitions and working
capital investment. Net interest expense for the six-month period was relatively
comparable with the prior year period.
The effective tax rate for the second quarter approximated 32 percent, which is
lower than the U.S. statutory rate due to the impact of M-I's U.S. partnership
earnings for which the minority partner is directly responsible for their
related income taxes. The Company properly consolidates the pre-tax income
related to the minority partner's share of U.S. partnership earnings but
excludes the related tax provision. The effective tax rate increased two
percentage points above the second quarter of 2002, reflecting the lower
proportion of M-I's U.S. partnership earnings and, to a lesser extent, an
unfavorable shift in the geographic mix of pre-tax income toward higher rate
jurisdictions. The effective tax rate for the six-month period was 32 percent,
two percentage points above the level reported in the comparable prior year
period. The higher rate in the first half of 2003 primarily reflects the lower
proportion of M-I's U.S. partnership earnings.
Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests was $0.9 million and $2.1 million below amounts reported in the prior
year quarter and the first half of 2002, respectively. The variance in both
periods relates to the lower profitability reported in the M-I operations,
partially offset by the impact of improved earnings associated with the C.E.
Franklin Ltd. operations.
The cumulative effect of change in accounting principle represents the impact of
the first quarter adoption of Statement of Financial Accounting Standards
("SFAS") No. 143, "Accounting for Asset Retirement Obligations."
18
LIQUIDITY AND CAPITAL RESOURCES
General
At June 30, 2003, cash and cash equivalents equaled $43.8 million.
Cash flow provided by operating activities was $17.7 million for the first half
of 2003 as compared to the $113.0 million generated by the Company's operations
in the prior year period. The increased level of exploration and production
spending in 2003 has driven higher working capital investment, particularly
accounts receivable and inventories, in contrast to the prior year period when
declining business levels contributed to positive cash flow from working capital
accounts.
During the first six months of 2003, cash flows used in investing activities
totaled $111.8 million, consisting of amounts required to fund acquisitions and,
to a lesser extent, capital expenditures. In the first half of 2003, the Company
finalized two acquisitions, including the purchase of the oilfield production
chemical operations of Dynea International, in exchange for cash consideration
of $78.0 million. The Company also invested $33.8 million in property, plant and
equipment, net of cash proceeds arising from certain asset disposals. The level
of cash used for investing activities was in excess of the $45.0 million
utilized in the prior year period, with the variance primarily related to
current year acquisition funding.
Cash flow provided by financing activities totaled $50.9 million for the first
half of 2003. Operating cash flow was not sufficient to fully fund current year
acquisitions, resulting in a $36.3 million increase in outstanding debt levels.
To a lesser extent, stock option exercises, which resulted in cash proceeds of
$14.6 million during the first half of 2003, had a positive effect on reported
cash flow.
The Company's primary internal source of liquidity is cash flow generated from
operations. Cash flow generated by 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 June
30, 2003, the Company had $361.8 million of funds available under U.S. revolving
credit facilities to fund future operating or investing needs of its worldwide
operations. The Company also has revolving credit facilities in place outside
the United States, which are generally used to finance local operating needs. At
June 30, 2003, borrowing capacity of $63.9 million was available under the
non-U.S. borrowing facilities.
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. The Company's overall borrowing capacity is, in part,
dependent on maintaining compliance with financial covenants under the various
credit agreements. As of June 30, 2003, the Company was within the covenant
compliance thresholds under its various loan indentures, as amended, providing
the ability to access available borrowing capacity. Management believes funds
generated from operations, amounts available under existing credit facilities
and external sources of liquidity will be sufficient to finance capital
expenditures and working capital needs of the existing operations for the
foreseeable future. Management continues to evaluate opportunities to acquire
products or businesses complementary to the Company's operations. These
acquisitions, if they arise, may involve the use of cash or, depending upon the
size and terms of the acquisition, may require debt or equity financing.
19
Commitments and Contingencies
Standby Letters of Credit and Guarantees
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. The majority of these outstanding instruments
guarantee payment of notes issued to former shareholders of an acquired entity
as well as to insurance companies which re-insure certain liability coverages of
the Company's insurance captive. Excluding the impact of these instruments, for
which the related liabilities are reflected in the accompanying consolidated
condensed balance sheets, the Company is contingently liable for approximately
$35.4 million of standby letters of credit and bid, performance and surety bonds
at June 30, 2003. Management does not expect any material amounts to be drawn on
these instruments.
The Company has also provided guarantees for loans related to certain joint
ventures accounted for by the equity method of accounting. As the net assets of
the joint ventures are available to satisfy obligations as they become due,
management believes the likelihood is remote that the Company will be required
to make payments related to these agreements. The Company's estimated maximum
exposure under these loan guarantees approximated $12.4 million as of June 30,
2003.
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.
In connection with most business acquisitions, the Company obtains contractual
indemnifications from the seller related to environmental matters. These
indemnifications generally provide for the reimbursement of environmental
clean-up costs incurred by the Company for events occurring or circumstances
existing prior to the purchase date, whether the event or circumstance was known
or unknown at that time. A substantial portion of the Company's total
environmental exposure is associated with its M-I operations, which are subject
to various indemnifications from former owners.
As of June 30, 2003, the Company has established an environmental reserve of
approximately $12.5 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, 2003, the Company does
not believe that these differences will have a material impact on the Company's
financial position or results of operations, subject to the indemnifications in
place. During the first quarter of 2003, the Company initiated legal action
against M-I's former owners to address issues associated with certain provisions
of the environmental indemnification provided. In the event that i) M-I's former
owners and other parties to indemnification agreements with the Company do not
fulfill their obligations, and ii) costs incurred to remediate the identified
properties reach estimated maximum exposure limits, the Company would be
required to establish additional environmental reserves of up to $25.0 million,
impacting earnings and cash flows in future periods.
Critical Accounting Policies and Estimates
The discussion and analysis of financial condition and results of operations are
based upon the Company's consolidated condensed financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires the
Company to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. The Company evaluates its estimates on an on-going
basis, based on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances. Actual results may differ
from these estimates under different assumptions or conditions. In its 2002
Annual Report on Form 10-K, the Company has described the critical accounting
policies that require management's most significant judgments and estimates.
There have been no material changes in these critical accounting policies.
20
Recent Accounting Pronouncements
On January 1, 2003, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations," which
addresses the financial accounting and reporting for retirement obligations and
costs associated with tangible long-lived assets. SFAS No. 143 requires that
liabilities for asset retirement obligations be recognized during the periods
incurred rather than when expended. The Company's asset retirement obligations
principally relate to the removal of leasehold improvements upon exiting certain
leased properties, primarily associated with the M-I operations. Upon adoption,
the Company recognized a charge of $2.5 million, or $1.2 million after tax and
minority interests, to reflect the cumulative amount of expense which was
required to be recognized as of January 1, 2003. This amount has been recorded
as a cumulative effect of change in accounting principle in the accompanying
consolidated condensed statement of operations. Additionally, the Company
recorded a $3.7 million long-term liability at the adoption date reflecting the
present value of projected future asset retirement obligations. The differential
of $1.2 million, which primarily represents the associated capitalized
retirement costs, will be charged to earnings over the remaining leasehold
period. Neither the amount charged to earnings in 2003 nor the pro forma effect
for the three-month and six-month periods ended June 30, 2002 (assuming adoption
of SFAS No. 143 as of January 1, 2002) were significant to net income or
earnings per share amounts.
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. Unless otherwise discussed, management believes the
impact of recently issued standards, which are not yet effective, will not have
a material impact on the Company's consolidated financial statements upon
adoption.
ITEM 3. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES
The Company is exposed to certain market risks arising from transactions that
are entered into in the normal course of business which are primarily related to
interest rate changes and fluctuations in foreign exchange rates. During the
reporting period, no events or transactions have occurred which would materially
change the information disclosed in the Company's 2002 Annual Report on Form
10-K.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures and internal controls
designed to ensure that information required to be disclosed in our filings
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time frame specified in the Commission's rules and
regulations. Our principal executive and financial officers have evaluated our
disclosure controls and procedures within 90 days prior to the filing of the
Quarterly Report on Form 10-Q and have determined that such disclosure controls
and procedures are effective as of the end of the period covered by this report.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect those controls subsequent to the
evaluation date.
21
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Stockholders on April 22, 2003, stockholders of
the Company elected all nominated directors, approved an amendment to the
Smith International, Inc. 1989 Long-Term Incentive Compensation Plan, an
amendment to the Smith International, Inc. Stock Plan for Outside Directors, and
Deloitte & Touche LLP as auditors for 2003 by the votes shown below.
For Withheld
------------ ------------
Election of Directors:
Benjamin F. Bailar ................................ 91,435,505 3,954
Doug Rock ......................................... 90,958,943 480,516
For Against Abstain
------------ ------------ ------------
Approval of an amendment to the
Smith International, Inc. 1989 Long-Term
Incentive Compensation Plan ....................... 85,083,748 7,079,751 89,963
Approval of an amendment to the
Smith International, Inc. Stock Plan for
Outside Directors ................................. 90,630,781 1,568,141 54,540
Approval of Deloitte & Touche LLP as
auditors for the Company for 2003 ................. 90,808,824 1,406,699 37,939
22
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORT ON FORM 8-K
(a) Exhibits filed as part of this report:
31.1 Certification of Chief Executive Officer pursuant to
Rule 13a-14 or 15d-14 of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Rule 13a-14 or 15d-14 of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
(b) Exhibit furnished with this report:
32.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
(c) Report on Form 8-K
The Registrant furnished a report on Form 8-K during the
quarterly period ended June 30, 2003. The document was
reported under "Item 9. Regulation FD Disclosure" and
disclosed the following:
1. Form 8-K dated April 17, 2003 relating to a press
release announcing the Company's results for the
three months ended March 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SMITH INTERNATIONAL, INC.
Registrant
Date: August 14, 2003 By: /s/ DOUG ROCK
---------------------------------------
Doug Rock
Chairman of the Board, Chief Executive
Officer, President and Chief Operating
Officer
Date: August 14, 2003 By: /s/ MARGARET K. DORMAN
---------------------------------------
Margaret K. Dorman
Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Accounting Officer)
24