UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
COMMISSION FILE NUMBER 1-8514
SMITH INTERNATIONAL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-3822631
(STATE OR OTHER JURISDICTION 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)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (281) 443-3370
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, $1.00 PAR VALUE NEW YORK STOCK EXCHANGE, INC.
PACIFIC EXCHANGE, INC.
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes [X] No [ ].
The aggregate market value of the voting stock held by non-affiliates
on June 30, 2003 was $3,669,886,810 (99,888,046 shares at the closing price on
the New York Stock Exchange of $36.74). On June 30, 2003, 102,460,806 shares of
common stock were outstanding. For this purpose all shares held by officers and
directors and their respective affiliates are considered to be held by
affiliates, but neither the Registrant nor such persons concede that they are
affiliates of the Registrant.
There were 103,969,738 shares of common stock outstanding on March 8, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement related to the Registrant's 2004 Annual
Meeting of Stockholders are incorporated by reference into Part III of this Form
10-K.
TABLE OF CONTENTS
PART I
Item 1. Business.......................................................................................... 1
Item 2. Properties........................................................................................ 8
Item 3. Legal Proceedings................................................................................. 9
Item 4. Submission of Matters to a Vote of Security Holders............................................... 9
Item 4A. Officers of the Registrant........................................................................ 9
PART II
Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters...................... 10
Item 6. Selected Financial Data........................................................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations............. 12
Item 7A. Qualitative and Quantitative Market Risk Disclosures.............................................. 22
Item 8. Financial Statements and Supplementary Data....................................................... 23
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.............. 52
Item 9A. Controls and Procedures........................................................................... 52
PART III
Item 10. Directors and Executive Officers of the Registrant................................................ 52
Item 11. Executive Compensation............................................................................ 52
Item 12. Security Ownership of Certain Beneficial Owners and Management.................................... 52
Item 13. Certain Relationships and Related Transactions.................................................... 52
Item 14. Principal Accountant Fees and Services............................................................ 52
PART IV
Item 15. Exhibits, Financial Statement Schedule and Report on Form 8-K..................................... 53
PART I
ITEM 1. BUSINESS
GENERAL
Smith International, Inc. ("Smith" or the "Company") is a leading
worldwide supplier of 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 equipment, waste-management
services, production chemicals, three-cone and diamond drill bits, turbines,
fishing services, drilling tools, underreamers, casing exit and multilateral
systems, packers and liner hangers. The Company also offers supply-chain
management solutions through an extensive North American branch network
providing pipe, valves, fittings, mill, safety and other maintenance products.
The Company was incorporated in the state of California in January 1937
and reincorporated under Delaware law in May 1983. The Company's executive
offices are headquartered at 411 North Sam Houston Parkway, Suite 600, Houston,
Texas 77060 and its telephone number is (281) 443-3370. The Company's annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K and amendments to those reports filed or furnished pursuant to Section 13(a)
or 15(d) of the Exchange Act of 1934 are made available free of charge on the
Company's Internet website at www.smith.com as soon as reasonably practicable
after the Company has electronically filed such material with, or furnished it
to, the Securities and Exchange Commission.
The Company's operations are aggregated into two reportable segments:
Oilfield Products and Services and Distribution. The Oilfield Products and
Services segment consists of: M-I SWACO, which provides drilling and completion
fluid systems and services, solids-control and separation equipment,
waste-management services and oilfield production chemicals; Smith Technologies,
which manufactures and sells three-cone drill bits, diamond drill bits and
turbine products; and Smith Services, which manufactures and markets products
and services used for drilling, workover, well completion and well re-entry
operations. The Distribution segment consists of one business unit, Wilson,
which markets pipe, valves and fittings as well as mill, safety and other
maintenance products to energy and industrial markets.
Financial information regarding reportable segments and international
operations appears in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and in Note 15 of the Notes to Consolidated
Financial Statements included elsewhere in this Form 10-K. Information related
to business combinations appears in Note 3 of the Notes to Consolidated
Financial Statements included elsewhere in this Form 10-K.
BUSINESS OPERATIONS
OILFIELD PRODUCTS AND SERVICES SEGMENT
M-I SWACO
Fluid Products and Services. The Company is a leading worldwide
provider of drilling, reservoir drill-in and completion fluid systems, products
and engineering services to end users engaged in drilling oil and natural gas
wells. Drilling fluids are used to cool and lubricate the bit during drilling
operations, contain formation pressures, suspend and remove rock cuttings from
the hole and maintain the stability of the wellbore. Engineering services are
provided to ensure that the fluid products are applied effectively to optimize
drilling operations. These services include recommending products and services
during the well planning phase; monitoring drilling fluid properties;
recommending adjustments during the drilling phase; and analyzing/benchmarking
well results after completion of the project to improve the efficiencies of
future wells.
M-I SWACO offers water-base, oil-base and synthetic-base drilling fluid
systems. Water-base drilling fluids are the world's most widely utilized
systems, having application in both land and offshore environments. Typically,
these systems comprise an engineered blend of weighting materials used to
contain formation pressures, and a broad range of chemical additives, designed
to yield the specific drilling performance characteristics required for a given
drilling project. Oil-base drilling fluids, which primarily are used to drill
water-sensitive shales, reduce torque and drag and are widely used in areas
where stuck pipe is likely to occur. In certain drilling areas of the world,
oil-base systems exhibit comparably higher penetration rates when compared to
water-base systems, significantly reducing time on location and overall drilling
costs. Synthetic-base drilling fluids are used in drilling environments where
oil-base fluids are environmentally prohibited and provide the performance
benefits of oil-base systems. Synthetic-base systems are particularly
advantageous in the deepwater environment. M-I SWACO also provides a
comprehensive line of reservoir drill-in fluids which combine the high
performance properties of a premium drilling fluid with minimal damaging
characteristics of a brine completion fluid.
1
Completion fluids (clear brines) are solids-free, clear-salt solutions
with high specific gravities and are non-damaging to the producing formation.
Operators use these specially designed fluid systems in combination with a
comprehensive range of specialty chemicals to control bottom-hole pressures,
while meeting the specific corrosion inhibition, viscosity and fluid loss
requirements necessary during the completion and workover phase of a well. These
systems are specially engineered to maximize well production by minimizing
formation damage that can be caused by solids-laden systems. M-I SWACO provides
a complete line of completion fluids products and services, including low- and
high-density brines, specialty chemicals, filtration and chemical treatment
services, wellsite engineering and technical and laboratory support services.
Fluid Competition. The major competitors in the worldwide drilling
fluids market, which approximated $3.5 billion in 2003, are Baroid Drilling
Fluids (a division of Halliburton Company ("Halliburton")) and INTEQ (a division
of Baker Hughes, Inc. ("Baker Hughes")). While M-I SWACO and these companies
supply a majority of the market, the drilling fluids industry is highly
competitive, with a significant number of smaller, locally based competitors.
The major competitors in the worldwide completion fluids market, which
approximated $0.5 billion in 2003, are Baroid Completion Fluids (a division of
Halliburton), Tetra Technologies, Inc., BJ Services Company and Ambar, Inc.
Generally competition for sales of drilling and completions fluids is
based on a number of factors, including wellsite engineering services, product
quality and availability, technical support, service response and price.
SWACO Products and Services. M-I SWACO provides services, equipment and
engineering for solids control, pressure control and waste management to the
worldwide drilling market.
Solids-control equipment is used to remove drill cuttings from the
fluid system, allowing the drilling fluid to be cleaned and recirculated. Solids
are normally separated from the drilling fluid using one or a combination of the
following: balanced elliptical and linear-motion shale shakers, desanders,
disilters, hydroclones, mud cleaners and centrifuges. M-I SWACO designs,
manufactures, sells and rents a comprehensive, proprietary line of this
equipment for oil and gas drilling processes throughout the world. The Company
is also a leading manufacturer and supplier of screens used in solids-control
equipment for both oilfield and certain industrial markets. M-I SWACO
complements its product offering by providing engineering and technical support
to operators and drilling contractors from the planning stages of their projects
through waste removal and site remediation.
Operators employ M-I SWACO-manufactured pressure-control equipment to
drill safely and economically in sour-gas and high-pressure zones. Well killing
and high-pressure control drilling chokes, together with related operating
consoles, are used in the drilling process during well kicks and well clean-up
and testing operations. Degassers and mud gas separators are designed to remove
and safely vent entrained gases, including toxic gases such as hydrogen sulfide
and corrosive oxygen, from the drilling mud. This equipment reduces the risk of
dangerous and costly blowouts caused by recirculating mud that contains natural
gas. Key products in M-I SWACO's pressure control product line include the MUD
D-GASSER(R) and SUPER CHOKE(TM), both of which hold strong market positions as
do the SUPER MUD GAS SEPARATOR(TM) and the SUPER AUTOCHOKE(TM). The latter
products represent key advancements in hands-free well pressure control and
underbalanced drilling operations.
With drilling operations expanding into more environmentally sensitive
areas, there has been increased focus on the effective collection, treatment and
disposal of waste produced during the drilling of a well. M-I SWACO provides
operators with value-added solutions designed to minimize and treat drilling
waste. The Company provides a full suite of waste handling, minimization and
management products and services, including the CLEANCUT(R) pneumatic conveyance
system for collection and transportation of drill cuttings related to offshore
drilling programs. M-I SWACO also provides rig vacuum systems for cuttings
recovery, high-gravity force drying equipment for liquid/solid separation and
cuttings slurification and re-injection processes for reducing haul-off waste.
In addition, through the THERMAL PHASE SEPARATION(TM) process, M-I SWACO
provides operators a proven technology for maximizing the recovery of drilling
fluids, while minimizing wastes. M-I SWACO's waste treatment services encompass
a wide range of activities, including site assessment, drill cuttings injection,
water treatment, pit closure and remediation, bioremediation, dewatering and
thermal processing. The Company has established ENVIROCENTERS(R) in Norway,
Germany and the United States designed specifically for recovering, treating and
recycling solid and liquid drilling wastes.
SWACO Competition. M-I SWACO competes with Brandt/Rigtech (a subsidiary
of Varco International, Inc.) and Derrick/Oil Tools. Additionally, there are a
number of regional suppliers that provide a limited range of equipment and
services tailored for local markets. Competition is based on product
availability, equipment performance, technical support and price.
2
Oilfield Production Chemicals. M-I SWACO provides a complete line of
oilfield specialty chemicals and related technical services through its Oilfield
Production Chemical division, acquired in January 2003. Oilfield production
chemicals are used to enhance the flow of hydrocarbons from the wellbore by
eliminating paraffin, scale and other byproducts encountered during the
production process. Oilfield production chemicals are also used to protect
piping and other equipment associated with the production, transportation and
processing of oil and gas.
Production Chemical Competition. The major competitors in the
worldwide oilfield production chemical market include Baker Petrolite (a
division of Baker Hughes), Ondeo-Nalco Energy Services (a division of Nalco
Company) and Champion Technologies, Inc. Generally, competition is based on
product quality, product performance, technical support and price.
Smith Technologies
Products and Services. Smith Technologies is a worldwide leader in the
design, manufacture and marketing of drill bits primarily used in drilling oil
and natural gas wells. In addition, Smith Technologies is the leading provider
of downhole turbine drilling products (referred to as "turbodrills") and
services that enhance the operating performance of petroleum drill bits in
certain applications. Smith Technologies' product offerings are designed
principally for the premium market segments where faster drilling rates and
greater footage drilled provide significant economic benefits in reducing the
total cost of a well.
Smith Technologies designs, manufactures and markets three-cone drill
bits for the petroleum industry, ranging in size from 3 1/2 to 28 inches in
diameter. These three-cone bits comprise two major components - the body and the
cones, which contain different types of pointed structures referred to as
"cutting structures" or "teeth." The cutting structures are either an integral
part of the steel cone with a hardmetal-applied surface (referred to as "milled
tooth") or made of an inserted material (referred to as "insert"), which is
usually tungsten carbide. The Company also produces three-cone drill bits in
which the tungsten carbide insert is coated with polycrystalline diamond. In
certain formations, bits produced with diamond-enhanced inserts last longer and
increase penetration rates, which substantially decreases overall drilling
costs. Smith Technologies is the leading provider of drill bits utilizing
diamond-enhanced insert technology.
In addition, Smith Technologies designs, manufactures and markets
diamond drill bits. Diamond bits consist of a single body made of either a
matrix powder alloy or steel. The cutting structures of diamond bits consist of
either polycrystalline diamond cutters, which are brazed on the bit, or natural
or synthetic diamonds, which are impregnated in the bit. These bits range in
size from 2 3/4 to 26 inches in diameter.
Smith Technologies also designs, assembles and markets a comprehensive
line of turbodrills and provides related technical support. Turbodrills, which
operate directly above the drill bit, use the hydraulic energy provided by
drilling fluid pumps on the rig floor to deliver torque to and rotate the drill
bit. These proprietary tools are designed to provide faster rates of
penetration, operate in much higher temperature formations, deliver longer
downhole life and produce better wellbore quality than conventional positive
displacement drilling motors. The turbine drilling motor provides operators with
cost effective solutions in demanding environments such as horizontal
applications, hard formations and high-temperature zones.
The Company manufactures polycrystalline diamond and cubic boron
nitride materials that are used in the Company's three-cone and diamond drill
bits and other specialized cutting tools. The Company believes that it is one of
the world's largest manufacturers of polycrystalline diamond and the only drill
bit manufacturer with substantial capabilities in this area. Smith Technologies
also develops and uses patented processes for applying diamonds to a curved
surface which optimize the performance of inserts used in drill bits. As a
result, Smith Technologies enjoys a competitive advantage in both material cost
and technical ability over other drill bit companies. In addition, the Company's
in-house diamond research, engineering and manufacturing capabilities enhance
the Company's ability to develop the application of diamond technology across
other Smith product lines and into non-energy markets.
Competition. Besides the Company, Hughes Christensen (a division of
Baker Hughes), Security DBS (a division of Halliburton) and ReedHycalog (a
division of Grant Prideco, Inc.) are the three major competitors in the drill
bit business. While Smith Technologies and these companies supply the majority
of the worldwide drill bit market, which approximated $1.3 billion in 2003, they
compete with more than 20 companies. Generally, competition for sales of drill
bits is based on a number of factors, including performance, quality,
reliability, service, price, technological advances and breadth of products. The
Company believes its quality, reliability and technological advances, such as
diamond-enhanced inserts, provide its products with a competitive advantage.
3
Smith Services
Products and Services. Smith Services is a leading global provider of
technologically advanced drilling, fishing, remedial, multilateral and
completion products, services and solutions to the oil and gas drilling
industry.
Smith Services' Drilling Systems business provides a broad range of
downhole impact tools for drilling applications as well as numerous other
specialized downhole drilling products and services. Smith Services sells and
rents impact drilling tools such as the HYDRA-JAR(R) tool and the ACCELERATOR(R)
tool, which are used to free stuck drill strings during the drilling process.
Additionally, drilling performance tools such as the HYDRA-THRUST(R) tool, used
in the drilling process to maintain constant weight on the drill bit, and
Drilling on Gauge subs used for maintaining hole gauge and quality of the
wellbore, are examples of Smith Services continuous commitment to developing new
technology. Smith Services also offers tubular drill string components, such as
drill collars, subs, stabilizers, kellys and HEVI-WATE(TM) drill pipe, and
provides related inspection services, including drill string repair and rebuild
services. These components and their placement in the drill string are supported
by engineering and field technical services in order to optimize bottom hole
management techniques. Through state-of-the-art software, Smith Services aids
the customer in maximizing the life of drill string components. Rotating
drilling heads for flow control in underbalanced drilling applications and
automatic connection torque monitoring and control systems are also designed and
manufactured by Smith Services. Smith Services also manufactures and markets
hole openers and underreamers which are designed to create larger hole diameters
in certain sections of the wellbore. The Company's patented RHINO(R) Reamer,
REAMASTER(R) and simultaneous drilling and hole enlargement system are three
examples of products that aid the customer in realizing lower drilling costs
through technology. Through the use of the simultaneous drilling and hole
enlargement system above the drill bit, the operator may drill the main bore
with the bit and enlarge the diameter of the hole above the drill bit in the
same run.
Smith Services' Fishing and Remedial Systems business provides a
comprehensive package of fishing, remedial and thru-tubing services. Fishing
operations clear and remove obstructions from a wellbore that may arise during
drilling, completion or workover activities or during a well's production phase.
This operation requires a wide variety of specialty tools, including fishing
jars, milling tools and casing cutters, all of which are manufactured by Smith
Services. These tools are operated by Company service personnel or sold or
rented to third-party fishing companies.
Smith Services provides Wellbore Departure Systems and Multilateral
Junctions through the manufacture of proprietary casing exit tools which are
installed by highly trained technicians. These systems, which include the
patented TRACKMASTER(R)WHIPSTOCK SYSTEM, PACK-STOCK(R), ANCHOR-STOCK(R) and the
MX(R) Multilateral Junction, allow the operator to divert around obstructions in
the main wellbore or reach multiple production zones from the main wellbore
(known as multilateral completions). In addition, Smith Services' DRILLAHEAD
SYSTEM combined with the XITOR(R), GEOTRACK(TM) and One-trip mills, which mill
the casing exit and continue to drill several hundred feet of formation, provide
for a "no trip" system which saves the customer time and reduces their overall
drilling costs. The Company also provides mechanical, hydraulic and explosive
pipe-cutting services to remove casing during well or platform abandonment.
Smith Services' Completion Systems business specializes in providing
fit-for-purpose liner hanger, liner cementing equipment, isolation packers,
retrievable and permanent packers, packer products and multilateral completion
equipment. Liner hangers allow strings of casing to be suspended within the
wellbore without having to extend the string all the way to the surface and are
also used to isolate production zones and formations. Most directional and
multilateral wells include one or more hangers due to the difficult casing
programs and need for zonal isolation. Using Smith Services' POCKET SLIP(TM)
liner hanger system, long heavy liners can be suspended with minimal casing
distortion and maximum flow-by area. Packers are mechanically or hydraulically
actuated devices which lock into place at specified depths in the well and
provide a seal between zones through expanding-element systems. The devices
therefore create isolated zones within the wellbore to permit either specific
formation production or allow for certain operations, such as cementing or
acidizing, to take place without damaging the reservoir.
Competition. Smith Services' major competitors in the drilling,
remedial, re-entry and fishing services markets are Weatherford International,
Inc. ("Weatherford"), Baker Oil Tools (a division of Baker Hughes) and numerous
small local companies. The main competitors in the liner hanger and packer
markets are Baker Oil Tools, Weatherford and TIW Corporation. The main
competitors in the drilling and fishing jar market and the fishing product and
service market are Weatherford and National-Oilwell Inc. ("National-Oilwell").
Competition in the drilling and completions sales, rental and services market is
primarily based on performance, quality, reliability, service, price and
response time and, in some cases, breadth of products.
4
DISTRIBUTION SEGMENT
Wilson
Products and Services. Wilson is a supply-chain management company
which provides products and services to the energy, refining, petrochemical,
power generation and mining industries. Wilson operates an extensive network of
supply branches, service centers and sales offices through which it markets
pipe, valves and fittings as well as mill, safety and other maintenance
products, predominately in the United States and Canada. In addition, Wilson
provides warehouse management, vendor integration and various surplus and
inventory management services. The majority of Wilson's operations are focused
on North American distribution of maintenance, repair and operating supplies and
equipment with the remainder associated with line pipe and automated valve
products (including valve, actuator and control packages).
Approximately two-thirds of Wilson's 2003 revenues were generated in
the energy sector, which includes exploration and production companies and
companies with operations in the petroleum industry's pipeline sector. The
remainder related to sales in the downstream and industrial market, including
refineries, petrochemical and power generation plants and other energy-focused
operations.
Competition. Wilson's competitors in its energy segment operations
include National-Oilwell, Redman Pipe and Supply Company and a significant
number of smaller, locally based operations. Wilson's competitors in the
downstream and industrial market include McJunkin Corporation, WW Grainger and
Hagemeyer NV. The distribution market that Wilson participates in is highly
competitive. Generally, competition involves numerous factors, including price,
experience, customer service and equipment availability.
NON-U.S. OPERATIONS
Sales to oil and gas exploration and production markets outside the
United States are a key strategic focus of Smith's management. The Company
markets its products and services through subsidiaries, joint ventures and sales
agents located in virtually all petroleum-producing areas of the world,
including Canada, Europe/Africa, the Middle East, Latin America and the Far
East. Approximately 56 percent, 53 percent and 48 percent of the Company's
revenues in 2003, 2002 and 2001, respectively, were derived from equipment or
services sold or provided outside the United States. The Company's Distribution
operations constitute a significant portion of the consolidated revenue base and
are concentrated in North America which serves to distort the geographic revenue
mix of the Company's Oilfield segment operations. Excluding the impact of the
Distribution operations, 65 percent, 64 percent and 59 percent of the Company's
revenues were generated in non-U.S. markets in 2003, 2002 and 2001,
respectively.
Historically, drilling activity outside the United States has been less
volatile than U.S. based activity as the high cost exploration and production
programs outside the United States are generally undertaken by major oil
companies, consortiums and national oil companies. These entities operate under
longer-term strategic priorities than do the independent drilling operators that
are more common in the U.S. market.
SALES AND DISTRIBUTION
Sales and service efforts are directed to end users in the exploration
and production industry, including major and independent oil companies, national
oil companies and independent drilling contractors. The Company's products and
services are primarily marketed through the direct sales force of each business
unit. In certain non-U.S. markets where direct sales efforts are not
practicable, the Company utilizes independent sales agents, distributors or
joint ventures.
Smith maintains field service centers, which function as repair and
maintenance facilities for rental tools, operations for remedial and completion
service and a base for the Company's global sales force, in all major oil and
gas producing regions of the world. The location of these service centers near
the Company's customers is an important factor in maintaining favorable customer
relations.
5
MANUFACTURING
The Company's manufacturing operations, along with quality control
support, are designed to ensure that all products and services marketed by the
Company will meet standards of performance and reliability consistent with the
Company's reputation in the industry.
Management believes that it generally has sufficient internal
manufacturing capacity to meet anticipated demand for its products and services.
During periods of peak demand, certain business units utilize outside resources
to provide additional manufacturing capacity.
RAW MATERIALS
Through its company-owned mines in and outside the United States, M-I
SWACO has the capability to produce a large portion of its requirements for
barite and bentonite. Barite reserves are mined in the United States, the United
Kingdom and Morocco. Bentonite is produced from ore deposits in the United
States. Mining exploration activities continue worldwide to locate and evaluate
ore bodies to ensure deposits are readily available for production when market
conditions dictate. In addition to its own production, M-I SWACO purchases the
majority of its worldwide barite requirement from suppliers outside the United
States, mainly the People's Republic of China, India and Morocco.
The Company purchases a variety of raw materials for its Smith
Technologies and Smith Services units, including alloy and stainless steel bars,
tungsten carbide inserts and forgings. Generally, the Company is not dependent
on any single source of supply for any of its raw materials or purchased
components, and believes that numerous alternative supply sources are available
for all such materials. The Company produces polycrystalline diamond materials
in Provo, Utah and Scurelle, Italy for utilization in various Company products
as well as direct customer sales. The Company believes that it enjoys a
competitive advantage in the manufacture of diamond drill bits because it is the
only diamond drill bit producer with substantial polycrystalline diamond
manufacturing capabilities.
PRODUCT DEVELOPMENT, ENGINEERING AND PATENTS
The Company's business units maintain product development and
engineering departments whose activities are focused on improving existing
products and services and developing new technologies to meet customer demands
for improved drilling performance and environmental-based solutions for drilling
and completion operations. The Company's primary research facilities are located
in Houston, Texas; Stavanger, Norway; Aberdeen, Scotland; and Florence,
Kentucky.
The Company also maintains a drill bit database which records the
performance of drill bits over the last 18 years, including those manufactured
by competitors. This database gives the Company the ability to monitor, among
other things, drill bit failures and performance improvements related to product
development. Management believes this proprietary database gives the Company a
competitive advantage in the drill bit business.
The Company has historically invested significant resources in research
and engineering in order to provide customers with broader product lines and
technologically-advanced products and services. The Company's expenditures for
research and engineering activities are attributable to the Company's Oilfield
Products and Services segment and totaled $55.6 million in 2003, $50.6 million
in 2002 and $50.8 million in 2001. In 2003, research and engineering
expenditures approximated 2.1 percent of the Company's Oilfield Products and
Services segment revenues.
Although the Company has over 1,600 issued and pending patents and
regards its patents and patent applications as important in the operation of its
business, it does not believe that any significant portion of its business is
materially dependent upon any single patent.
EMPLOYEES
At December 31, 2003, the Company had 11,971 full time employees
throughout the world. Most of the Company's employees in the United States are
not covered by collective bargaining agreements except in certain U.S. mining
operations of M-I SWACO and several distribution locations of Wilson. The
Company considers its labor relations to be satisfactory.
6
RISK FACTORS
This document and other filings with the Securities and Exchange
Commission contain "forward-looking statements", as defined in the Private
Securities Litigation Reform Act of 1995. These forward-looking statements
discuss the Company's outlook, financial projections, business strategies as
well as various other matters.
Our forward-looking statements are based on assumptions that we believe
to be reasonable but that may not prove to be accurate. All of the Company's
forward-looking information is, therefore, subject to risks and uncertainties
that could cause actual results to differ materially from the results expected.
Although it is not possible to identify all factors, these risks and
uncertainties include the risk factors discussed below.
Demand for our products and services is dependent upon the level of oil
and natural gas exploration and development activities. The level of worldwide
oil and natural gas development activities is primarily influenced by the price
of oil and natural gas and price expectations. In addition to oil and natural
gas prices, the following factors impact exploration and development activity
and may lead to significant changes in worldwide activity levels:
Overall level of global economic growth and activity;
Actual and perceived changes in the supply and demand for oil
and natural gas;
Political stability of oil-producing countries;
Finding and development costs of operations; and
Decline and depletion rates for oil and natural gas wells.
Changes in any of these factors could adversely impact our financial
condition or results of operations.
We are a multinational oilfield service company and have operations in
certain countries that are inherently subject to risks of war, local economic
conditions, political disruption, civil disturbance and policies that may:
Disrupt oil and gas exploration and production activities and
our operations;
Restrict the movement of funds and other assets;
Lead to U.S. government or international sanctions; and
Limit access to markets.
The occurrence of any of these events could adversely impact our
financial condition or results of operations.
7
ITEM 2. PROPERTIES
The principal facilities and properties utilized by the Company at
December 31, 2003 are shown in the table below. Generally, the facilities and
properties are owned by the Company.
Approx.
Principal Products Processed Land Bldg. Space
Location or Manufactured (Acres) (sq. ft.)
---------------------------------------- ----------------------------------------------------- ---------- ---------------
Oilfield Products and Services Segment:
Houston, Texas..................... Tubulars, surface and downhole tools, remedial
products, liner hangers, diamond drill bits,
drilling and fishing jars and fishing tool equipment 73 708,000
Ponca City, Oklahoma............... Three-cone drill bits 15 207,000
Florence, Kentucky................. Separator units, mill units, parts, screens and motors 15 145,000
Aberdeen, Scotland................. Downhole tools and remedial products 10 132,000
Greybull, Wyoming.................. Bentonite mine and processing 8,394 110,000
Tulsa, Oklahoma.................... Oilfield and industrial screening products 7 95,000
Saline di Volterra, Italy.......... Three-cone drill bits 11 92,000
Edinburgh, Scotland................ Wire cloth and oilfield screening products 3 91,400
Aberdeen, Scotland................. Downhole tools 10 91,000
Karmoy, Norway..................... Barite and bentonite processing 5 51,000
Greystone, Nevada.................. Barite mine and processing 268 50,000
Battle Mountain, Nevada............ Barite processing 23 43,000
Provo, Utah........................ Synthetic diamond materials 4 43,000
Nisku, Canada...................... Tubulars and drill collars 10 42,000
Zelmou, Morocco.................... Barite mine 3,954 41,000
Zavalla, Texas..................... Drilling fluid chemical products 33 36,000
Nivellas, Belgium.................. Separator units, mill units, parts, screens and motors 5 32,000
Scurelle, Italy.................... Diamond drill bits and synthetic diamond materials 4 31,000
Amelia, Louisiana.................. Barite processing 26 25,000
Spruce Grove, Canada............... Drilling fluid processing 3 24,000
Berra, Italy....................... Solids control equipment 2 24,000
Salzweld, Germany.................. Drilling fluid processing 2 23,000
Galveston, Texas................... Barite processing 6 21,000
Macon, Georgia..................... Separator units and screens 1 18,000
Aberdeen, Scotland................. Barite and bentonite processing 2 12,000
Foss/Aberfeldy, Scotland........... Barite mine and processing 102 10,000
Mountain Springs, Nevada........... Barite mine 900 -
Distribution Segment:
Houston, Texas..................... Pipe, valves and fittings 11 198,000
The Company considers its mines and manufacturing and processing
facilities to be in good condition and adequately maintained.
The Company's headquarters is located in a leased office building in
Houston, Texas. The Company leases various other administrative and sales
offices, as well as warehouses and service centers in the United States and
other countries in which it conducts business. Management believes that it will
be able to renew and extend its property leases on terms satisfactory to the
Company or, if necessary, locate substitute facilities on acceptable terms.
8
ITEM 3. LEGAL PROCEEDINGS
Information relating to various commitments and contingencies,
including legal proceedings, is described in Note 16 of the Notes to
Consolidated Financial Statements included elsewhere in this Form 10-K.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4A. OFFICERS OF THE REGISTRANT
(a) The names and ages of all officers of the Company, all positions
and offices with the Company presently held by each person named and their
business experience are stated below. Positions, unless otherwise specified, are
with the Company.
NAME, AGE AND POSITIONS PRINCIPAL CURRENT OCCUPATION AND OTHER SIGNIFICANT POSITIONS HELD
----------------------- -----------------------------------------------------------------
Doug Rock (57)...................... Chairman of the Board since February 1991, elected Chief Executive Officer in March 1989 and
Chairman of the Board, Chief served as President and Chief Operating Officer since December 1987. Held various
Executive Officer, President positions since joining the Company in June 1974, served as President of the Company's
and Chief Operating Officer Drilco Division beginning April 1982 and was named President of the Company's Smith
Tool Division in July 1985.
Loren K. Carroll (60)............... President and Chief Executive Officer of M-I SWACO since March 1994, Executive Vice
Executive Vice President of President since October 1992 and member of the Board of Directors since November 1987.
the Company; President and Joined Company in December 1984 as Vice President and Chief Financial Officer and served
and Chief Executive Officer of in that capacity until March 1989. Rejoined the Company in October 1992 as Executive Vice
M-I SWACO President and Chief Financial Officer.
Neal S. Sutton (58)................. Senior Vice President--Administration, General Counsel and Secretary since December 1994.
Senior Vice President-- Joined Company as Vice President, Secretary and General Counsel in January 1991 and
Administration, General named Vice President-Administration in March 1992.
Counsel and Secretary
Margaret K. Dorman (40)............. Senior Vice President, Chief Financial Officer and Treasurer since June 1999. Joined
Senior Vice President, Chief Company as Director of Financial Reporting in December 1995 and named Vice President,
Financial Officer and Treasurer Controller and Assistant Treasurer in February 1998.
Roger A. Brown (58)................. President, Smith Technologies since July 1998. Joined Company as President, Smith Diamond
President, Smith Technologies Technology in April 1995.
John J. Kennedy (51)................ President and Chief Executive Officer, Wilson since June 1999. Joined Company as Treasury
President and Manager in November 1986, named Treasury Director responsible for International
Chief Executive Officer, Wilson Operations in November 1987 and served as Treasurer beginning May 1991. Elected Vice
President, Chief Accounting Officer and Treasurer in March 1994 and named Senior Vice
President, Chief Financial Officer and Treasurer in April 1997.
Richard A. Werner (62).............. President, Smith Services since May 1994. Joined Company as Vice President and General
President, Smith Services Manager-Downhole Tools and Services in May 1991 and named Vice President and General
Manager-Drilco/Servco in March 1993. Served as Vice President and General Manager-Smith
Services beginning December 1993.
David R. Cobb (38).................. Vice President and Controller since July 2002. Joined Company as Assistant Controller in
Vice President and Controller October 2001. Assistant Treasurer, Kent Electronics Corporation from April 1997 to
September 2001.
Earl M. Springer (53)............... Vice President, Business Development since February 1998. Joined Company as District
Vice President, Business Manager of M-I SWACO in November 1990 and named Senior Account Representative of M-I
Development SWACO in September 1993. Served as Manager of Technology Development beginning August
1994 and named Manager of Business Development in July 1997.
9
Geri D. Wilde (53).................. Vice President, Taxes since February 1998. Joined Company as Manager of Taxes and Payroll
Vice President, Taxes and of M-I SWACO in December 1986 and named Director of Taxes and Assistant Treasurer in
Assistant Treasurer April 1997.
(b) All officers of the Company are elected annually by the Board of
Directors at the meeting held immediately following the annual meeting of
stockholders. They hold office until their successors are elected and qualified.
There are no family relationships between the officers of the Company.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY
HOLDER MATTERS
The common stock of the Company is traded on the New York Stock
Exchange and the Pacific Stock Exchange. The following are the high and low sale
prices for the Company's common stock as reported on the New York Stock Exchange
Composite Tape for the periods indicated, and adjusted for the two-for-one stock
split effective July 8, 2002.
COMMON STOCK
-------------------------
HIGH LOW
----------- -----------
2002
First Quarter $ 34.94 $ 23.19
Second Quarter 38.72 30.23
Third Quarter 36.24 25.79
Fourth Quarter 35.95 26.55
2003
First Quarter 36.48 29.85
Second Quarter 41.55 34.47
Third Quarter 39.30 33.96
Fourth Quarter 42.52 35.86
On March 8, 2004, the Company had 2,139 common stock holders of record
and the last reported closing price on the New York Stock Exchange Composite
Tape was $51.50.
The Company has not paid dividends on its common stock since the first
quarter of 1986. The determination of the amount of future cash dividends to be
declared and paid on the common stock, if any, will depend upon the Company's
financial condition, earnings and cash flow from operations, the level of its
capital expenditures, its future business prospects and other factors that the
Board of Directors deems relevant.
10
ITEM 6. SELECTED FINANCIAL DATA
FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999(b)
--------------- --------------- --------------- --------------- --------------
(In thousands, except per share data)
STATEMENT OF OPERATIONS DATA:
Revenues................................ $ 3,594,828 $ 3,170,080 $ 3,551,209 $ 2,761,014 $ 1,806,153
Gross profit............................ 1,075,931 918,302 1,045,804 745,169 467,940
Operating income........................ 328,747 256,148 371,510 199,026 149,532
Income before cumulative effect of
change in accounting principle....... 124,634 93,189 152,145 72,800 56,724
Earnings per share before cumulative
effect of change in accounting
principle - diluted basis(a)......... 1.24 0.93 1.51 0.72 0.58
BALANCE SHEET DATA:
Total assets............................ $ 3,097,047 $ 2,749,545 $ 2,735,828 $ 2,295,287 $ 1,894,575
Long-term debt.......................... 488,548 441,967 538,842 374,716 346,647
Total stockholders' equity.............. 1,235,776 1,063,535 949,159 817,481 720,220
The Notes to Consolidated Financial Statements and Management's
Discussion and Analysis of Financial Condition and Results of Operations
included elsewhere in this Form 10-K should be read in order to understand
factors such as changes in the method of accounting for goodwill, business
combinations completed during 2003, 2002 and 2001, and unusual items which may
affect the comparability of the information shown above.
(a) All fiscal years prior to 2002 have been restated for the impact of a
two-for-one stock split, which was effective July 8, 2002.
(b) In July 1999, the Company completed a transaction with Schlumberger
Limited related to the combination of certain M-I SWACO and Dowell
drilling fluid operations under a joint venture arrangement.
Schlumberger contributed its non-U.S. drilling fluid operations and
paid cash consideration of $280.0 million to the Company in exchange
for a 40 percent minority ownership interest in the combined
operations. The Company recognized a non-recurring gain of $81.4
million in connection with this transaction.
11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following "Management's Discussion and Analysis of Financial
Condition and Results of Operations" is provided to assist readers in
understanding the Company's financial performance during the periods presented
and significant trends which may impact the future performance of the Company.
This discussion should be read in conjunction with the Consolidated Financial
Statements of the Company and the related notes thereto included elsewhere in
this Form 10-K.
MANAGEMENT OVERVIEW
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 and fittings as well as 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 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 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 10
percent of the Company's consolidated revenues relate to the downstream energy
sector, including petrochemical plants and refineries, whose spending is largely
impacted by the general condition of the U.S. economy.
Capital investment by energy companies is largely divided into two
markets which vary greatly in terms of primary business drivers and associated
volatility levels. North American drilling activity is primarily influenced by
natural gas fundamentals, with approximately 85 percent of the current rig count
focused on natural gas finding and development activities. Conversely, drilling
in areas outside of North America is more dependent on crude oil fundamentals,
which influence over three-quarters of international drilling activity.
Historically, business in markets outside of North America has proved to be less
volatile as the high cost E&P programs in these regions are generally undertaken
by major oil companies, consortiums and national oil companies as part of a
longer-term strategic development plan. Although over half of the Company's
consolidated revenues were generated in North America during 2003, Smith's
profitability was largely dependent upon business levels in markets outside of
North 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, 59 percent of the Company's 2003 revenues were generated in markets
outside of North America.
12
MARKET AND INDUSTRY ACTIVITY AND OUTLOOK
The 2003 average worldwide rig count grew 19 percent above the prior
year level, primarily associated with a strong land-based North American
drilling recovery. The Company anticipates a modest increase in E&P spending in
2004, which is somewhat dependent upon commodity prices remaining at or near the
average level reported in 2003. The incremental spending is expected to be
largely concentrated in markets outside North America, as E&P companies develop
higher-reserve projects to address production declines associated with
historical underinvestment in their upstream operations. Although there are
several factors which could influence forecasted spending, the Company's
business is highly dependent on the general economic environment in the United
States and other major world economies, which ultimately impact energy
consumption and the resulting demand for our products and services. Any
deterioration in the global economic environment could adversely impact
worldwide drilling activity and the future financial results of the Company.
FORWARD-LOOKING STATEMENTS
This discussion contains forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995 concerning, among other
things, the Company's 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
"believe," "anticipate," "forecast," "expect," "estimate," "project" and similar
terms. The statements are based on certain assumptions and analyses made by the
Company that it believes are appropriate under the circumstances. Such
statements are subject to general economic and business conditions, industry
conditions, changes in laws or regulations and other risk factors outlined
elsewhere in this Form 10-K, 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 vary.
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
SWACO, Smith Technologies and Smith Services. The Distribution segment includes
the Wilson business unit. The revenue discussion below has been summarized by
business unit in order to provide additional information in analyzing the
Company's operations.
FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------------------------------------------
2003 2002 2001
------------------------- ------------------------ -------------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
------------- ---------- -------------- --------- --------------- ---------
FINANCIAL DATA: (dollars in thousands)
Revenues:
M-I SWACO............................. $ 1,865,851 52 $ 1,558,672 49 $ 1,627,600 46
Smith Technologies.................... 403,261 11 324,735 10 398,204 11
Smith Services........................ 409,162 11 399,502 13 398,327 11
------------- ---------- ------------- --------- --------------- ---------
Oilfield Products and Services...... 2,678,274 74 2,282,909 72 2,424,131 68
Wilson................................ 916,554 26 887,171 28 1,127,078 32
------------- ---------- ------------- --------- --------------- ---------
Total............................. $ 3,594,828 100 $ 3,170,080 100 $ 3,551,209 100
============= ========== ============= ========= =============== =========
Geographic Revenues:
United States:
Oilfield Products and Services...... $ 925,148 26 $ 813,946 26 $ 1,000,201 28
Distribution........................ 667,095 18 678,764 21 829,177 24
------------- ---------- ------------- --------- ------------- ---------
Total United States............... 1,592,243 44 1,492,710 47 1,829,378 52
------------- ---------- ------------- --------- ------------- ---------
Canada:
Oilfield Products and Services...... 171,653 5 117,014 4 145,882 4
Distribution........................ 191,221 5 169,626 5 254,242 7
------------- ---------- ------------- --------- ------------- ---------
Total Canada...................... 362,874 10 286,640 9 400,124 11
------------- ---------- ------------- --------- ------------- ---------
Non-North America:
Oilfield Products and Services...... 1,581,483 44 1,351,949 43 1,278,048 36
Distribution........................ 58,228 2 38,781 1 43,659 1
------------- ---------- ------------- --------- ------------- ---------
Total Non-North America........... 1,639,711 46 1,390,730 44 1,321,707 37
------------- ---------- ------------- --------- ------------- ---------
Total Revenue................. $ 3,594,828 100 $ 3,170,080 100 $ 3,551,209 100
============= ========== ============= ========= ============= =========
Operating Income:
Oilfield Products and Services........ $ 343,486 13 $ 266,692 12 $ 354,614 15
Distribution.......................... (7,897) - (4,026) - 22,893 2
General Corporate..................... (6,842) * (6,518) * (5,997) *
------------- ---------- ------------- --------- ------------- ---------
Total............................. $ 328,747 9 $ 256,148 8 $ 371,510 10
============= ========== ============= ========= ============= =========
MARKET DATA:
Average Worldwide Rig Count: (1)
United States......................... 1,216 47 946 43 1,307 49
Canada................................ 339 13 255 12 330 12
Non-North America..................... 1,050 40 990 45 1,037 39
------------- ---------- ------------- --------- ------------- ---------
Total............................. 2,605 100 2,191 100 2,674 100
============= ========== ============= ========= ============= =========
Average Commodity Prices:
Crude Oil ($/Bbl)(2).................. $ 31.06 $ 26.08 $ 25.89
Natural Gas ($/mcf)(3)................ 5.29 3.10 3.84
(1) Source: M-I SWACO.
(2) Average West Texas Intermediate ("WTI") spot closing prices.
(3) Average weekly composite spot U.S. wellhead prices.
*not meaningful
14
Oilfield Products and Services Segment
Revenues
M-I SWACO primarily provides drilling and completion fluid systems,
engineering and technical services to the oil and gas industry. Additionally,
these operations provide oilfield production chemicals and manufacture and
market equipment and services used for solids-control, particle separation,
pressure control, rig instrumentation and waste-management. M-I SWACO is
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 13 percent of the
revenue base. U.S. offshore drilling programs, which account for approximately
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 SWACO's revenues totaled $1.9 billion for the year ended
December 31, 2003, an increase of 20 percent above the prior year period.
Excluding the effect of acquired operations, revenues rose 14 percent above 2002
levels impacted by increased sales volumes in markets outside of North America.
On a geographic basis, increased E&P spending and new contract awards in Latin
America, the Former Soviet Union ("FSU") and West Africa influenced the higher
reported revenues. The year-over-year base revenue growth was also impacted by
the significant increase in the number of North American land-based drilling
programs and, to a lesser extent, a favorable customer mix in the U.S. offshore
market. For the year ended December 31, 2002, M-I SWACO reported revenues of
$1.6 billion, a decline of four percent from 2001 revenue levels. Excluding the
impact of acquired operations, revenues were ten percent below the prior period
and compared to an 18 percent decline in the average worldwide rig count. The
majority of the base revenue decline was attributable to the lower number of
land-based drilling programs in the Western Hemisphere markets, primarily the
United States, Argentina and Venezuela. Lower sales of synthetic drilling
fluids, related to a 22 percent reduction in the average number of U.S. offshore
drilling projects, accounted for the remainder of the year-to-year variance.
Smith Technologies designs, manufactures and sells three-cone drill
bits, diamond drill bits and turbines for use in the oil and gas industry. Due
to the nature of its product offerings, revenues for these operations correlate
more closely to the rig count than any of the Company's other businesses. Smith
Technologies reported revenues of $403.3 million for the year ended December 31,
2003, an increase of 24 percent over the prior year. Excluding incremental
revenues from businesses acquired in the latter half of 2002, base revenues were
approximately 19 percent above the prior year and approximated the increase in
the worldwide rig count. The year-to-year base revenue growth was generated in
North America, reflecting the higher level of land-based drilling activity and,
to a lesser extent, the impact of new product introductions. For the year ended
December 31, 2002, Smith Technologies' revenues totaled $324.7 million. Revenues
for the Smith Technologies unit were 18 percent below the prior year and
mirrored the decline in worldwide activity levels. The majority of the revenue
variance resulted from lower unit sales of three-cone bits, reflecting the 28
percent reduction in U.S. drilling activity. Reduced activity levels in certain
Latin American markets, specifically Colombia, Argentina and Venezuela,
accounted for the remainder of the year-to-year variance.
Smith Services manufactures and markets products and services used in
the oil and gas industry for drilling, work-over, well completion and well
re-entry. Revenues for Smith Services are evenly distributed between North
America and the international markets and are heavily influenced by the
complexity of drilling projects, which drive demand for a wider range of its
product offerings. For the year ended December 31, 2003, Smith Services reported
revenues of $409.2 million, a two percent increase from the prior year. The
year-to-year revenue comparison was impacted by a 50 percent reduction in U.S.
drill pipe product sales, which are not highly correlated to drilling activity.
Excluding the impact of drill pipe sales, revenues increased seven percent above
the prior year, primarily attributable to higher E&P spending in North America
and certain Middle East markets. On a product basis, the majority of the core
revenue growth was driven by higher demand for remedial product and service
lines, including new product introductions. For the year ended December 31,
2002, Smith Services reported revenues of $399.5 million. Revenues were
comparable with amounts reported in 2001, as incremental revenues from acquired
operations offset a 13 percent decline in base business volumes. The base
revenue reduction primarily reflects the effect of a 27 percent decline in North
American activity levels, which impacted demand for drilling-related products
and services, including tubulars and inspection services.
15
Operating Income
Operating income for the Oilfield Products and Services segment was
$343.5 million, or 12.8 percent of revenues, for the year ended December 31,
2003. Segment operating margins increased one percentage point above the prior
year level reflecting a combination of gross margin expansion and, to a lesser
extent, reduced operating expenses as a percentage of revenues. The gross
margins were influenced by a favorable shift in the revenue mix towards
higher-margin products and, to a lesser extent, improved expense coverage
resulting from the impact of increased sales volumes on the segment's
manufacturing and service infrastructure. For the year ended December 31, 2002,
Oilfield operating income was $266.7 million, a 25 percent decline from the
prior year period. Operating margins for the segment were 11.7 percent,
approximately three percentage points below the prior year's level. The
year-to-year decrease in segment operating income relates to decreased gross
profit, primarily associated with lower sales volumes. To a lesser extent,
decreased demand for higher-margin products, specifically drill bits and premium
drilling fluids which accounted for over three quarters of the revenue decline,
contributed to the gross profit reduction. Segment operating expenses were
comparable with the prior year, as the effect of lower employee profit-sharing
requirements and the elimination of goodwill amortization was offset by
incremental expenses associated with acquired operations and higher costs
incurred under medical and casualty insurance programs.
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 over 90 percent of Wilson's 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 largely influenced by the general state of the
U.S. economic environment. Additionally, certain customers in this sector
utilize petroleum products as a base material and, accordingly, are adversely
impacted by increases in crude oil and natural gas prices. Wilson reported
revenues of $916.6 million for the year ended December 31, 2003, three percent
above the prior year. The year-over-year revenue increase was reported in the
energy sector operations driven by the higher level of North American drilling
and completion activity. Lower industrial sales volumes, primarily related to
reduced maintenance and repair spending in the refining, petrochemical and power
generation customer base impacted the reported revenue variance. For the year
ended December 31, 2002, Wilson's revenues totaled $887.2 million, a 21 percent
decline from the prior year period. Over 70 percent of the revenue variance was
reported in the energy sector operations related to a combination of lower North
American drilling and completion activity and reduced Canadian tubular product
sales due to increased competition from steel mills. Lower spending for major
maintenance programs and projects by customers in the U.S. industrial and
petrochemical markets contributed to the remainder of the segment's revenue
variance.
Operating Income
Operating income for the Distribution segment declined $3.9 million
from the 2002 level, impacted by a $4.6 million charge recorded in the fourth
quarter of 2003. Approximately $3.8 million of this amount was an
inventory-related charge, while the remainder provided for estimated losses
associated with the bankruptcy of a large industrial customer. Excluding this
charge, Distribution operating results increased $0.7 million over the amount
reported in 2002, equating to incremental operating income of approximately two
percent of revenues. The incrementals were below those historically reported in
the segment, impacted by the higher mix of project and export orders, which
typically generate lower comparable margins. For the year ended December 31,
2002, Distribution segment operating income declined $26.9 million from the
amounts reported in 2001, equating to decremental operating margins of 11
percent. The decrementals reflect the significant reduction in gross profit
associated with the reported revenue decline, partially offset by lower
variable-based operating expenses.
Other
The Distribution segment goodwill balance, which approximated $37.8
million as of December 31, 2003, is subject to an annual impairment test. This
evaluation is largely influenced by future cash flow projections, and,
therefore, requires management to make judgments about future operating results
and working capital requirements. As noted above, Wilson's financial performance
has been impacted by the lower level of business volumes experienced in its
downstream and industrial sector. Changes in cash flow assumptions or other
factors which negatively impact the estimated fair value of the Distribution
business would influence the evaluation and might result in the determination
that a portion of the goodwill is impaired when the analysis is performed during
the first quarter of 2004.
16
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):
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------------------------------------------------------
2003 2002 2001
-------------------------- -------------------------- ----------------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
------------- ---------- ------------- ---------- -------------- ----------
Revenues............................ $ 3,594,828 100 $ 3,170,080 100 $ 3,551,209 100
------------- ---------- ------------- ---------- ------------- ----------
Gross profit........................ 1,075,931 30 918,302 29 1,045,804 29
Operating expenses.................. 747,184 21 662,154 21 674,294 19
------------- ---------- ------------- ---------- -------------- ----------
Operating income.................... 328,747 9 256,148 8 371,510 10
Interest expense.................... 40,964 1 40,928 1 45,359 1
Interest income..................... (1,973) - (2,579) - (2,895) -
------------- ---------- ------------- ---------- -------------- ----------
Income before income taxes,
minority interests and cumulative
effect of change in accounting
principle......................... 289,756 8 217,799 7 329,046 9
Income tax provision................ 93,334 3 66,632 2 106,397 3
Minority interests.................. 71,788 2 57,978 2 70,504 2
------------- ---------- ------------- ---------- -------------- ----------
Income before cumulative effect
of change in accounting principle.. 124,634 3 93,189 3 152,145 4
------------- ---------- ------------- ---------- -------------- ----------
Cumulative effect of change in
accounting principle, net of tax
and minority interests............ (1,154) - - - - -
------------- ---------- ------------- ---------- ------------- ----------
Net income.......................... $ 123,480 3 $ 93,189 3 $ 152,145 4
============= ========== ============= ========== ============= ==========
2003 versus 2002
Consolidated revenues were $3.6 billion for the year ended December 31,
2003, 13 percent above the prior year's level. The majority of the revenue
growth was reported in the Company's Oilfield operations, impacted by increased
worldwide drilling activity and, to a lesser extent, revenues from acquired
operations. Excluding incremental revenues from acquired operations, base
business revenues grew 10 percent over the prior year as demand for the
Company's products and services was impacted by increased North American
drilling activity as well as customer spending and new contract awards in
markets outside the United States and Canada.
Gross profit was $1.1 billion, 17 percent above the prior year period.
The increase in gross profit reflects higher sales volumes associated with the
increased worldwide activity levels. Gross profit margins for the year were 30
percent of revenues, one percentage point above the gross profit margins
reported in the prior year. The gross margin improvement was primarily impacted
by an increased proportion of Oilfield segment sales, which traditionally
generate higher gross profit margins than the Distribution segment. To a lesser
extent, a favorable shift in the product mix towards higher-margin products,
including drill bits and premium drilling fluids, contributed to the margin
expansion.
Operating expenses, consisting of selling, general and administrative
expenses, increased $85.0 million from the amount reported in 2002. The majority
of the year-to-year increase was attributable to higher variable costs directly
associated with the improved business volumes, as well as increased investment
in people and infrastructure to support the expanding base business. To a lesser
extent, the operating expense variance was impacted by incremental expenses
associated with acquired operations. As a percentage of revenues, operating
expenses were comparable with the prior year.
17
Net interest expense, which represents interest expense less interest
income, equaled $39.0 million in 2003. Net interest expense was relatively
consistent with the prior year amount as average debt levels were comparable
between the periods.
The effective tax rate approximated 32 percent, which was above the 31
percent effective rate reported in the prior year, but below the U.S. statutory
rate. 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 minority partner
is directly responsible for its 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 one percentage point from the prior year due to a shift in the
geographic mix of pre-tax income toward higher rate jurisdictions and, to a
lesser extent, a lower proportion of M-I SWACO'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 totaled $71.8 million in 2003, a $13.8 million increase from the prior
year. The increase predominantly reflects the higher profitability of the M-I
SWACO joint venture during 2003.
The cumulative effect of change in accounting principle included for
2003 represents the impact of the adoption of Statement of Financial Accounting
Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations."
2002 versus 2001
Consolidated revenues were $3.2 billion for the year ended December 31,
2002, 11 percent below the prior year's level. The majority of the revenue
reduction was reported in the Company's Distribution operations, which are
concentrated in North America and were impacted by the significant decline in
corresponding activity levels. The revenue variance was also influenced by the
impact of revenues from acquired operations and, to a lesser extent, the
contribution of certain Oilfield segment operations to an unconsolidated joint
venture in the fourth quarter of 2001. Excluding the net impact of acquired and
divested operations, base revenues declined 15 percent from the prior year, as
demand for the Company's products and services was impacted by a 26 percent
reduction in Western Hemisphere drilling activity. Base revenue growth in the
Eastern Hemisphere markets, attributable to increased activity levels and new
contract awards, served to partially offset the overall revenue decline.
Gross profit was $918.3 million, 12 percent below the prior year
period. The decrease in gross profit reflects lower sales volumes associated
with the reduction in worldwide activity levels and, to a lesser extent,
decreased demand for higher-margin Oilfield segment products. Gross profit
margins for the year were 29 percent of revenues, comparable with the prior year
period. An increased proportion of Oilfield segment revenues in 2002, which
generate higher gross profit margins than the Distribution operations, served to
mask the margin deterioration reported in the Oilfield segment.
Operating expenses, consisting of selling, general and administrative
expenses decreased $12.1 million from the amount reported in 2001. The operating
expense decline was attributable to cost reduction efforts initiated in response
to the decrease in Western Hemisphere activity levels, lower employee
profit-sharing requirements and the elimination of goodwill amortization in
accordance with SFAS No. 142. Incremental expenses from acquired operations and
the increased cost of medical and casualty insurance programs served to
partially offset the overall expense decline. As a percentage of revenues,
operating expenses increased two percentage points, reflecting lower fixed cost
coverage related to the overall sales and administrative functions in both of
the Company's operating segments.
Net interest expense, which represents interest expense less interest
income, decreased $4.1 million from 2001. The minimal increase in average debt
levels, primarily related to financing acquisitions in the fourth quarter of the
prior year, was more than offset by the impact of reduced short-term interest
rates on the Company's variable rate debt.
The effective tax rate approximated 31 percent, which was below both
the 32 percent effective rate reported in the prior year and the U.S. statutory
rate. 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 minority partner
is directly responsible for its 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 declined one percentage point from the prior year due to the elimination of
goodwill amortization, a portion of which was not tax deductible, and a
favorable shift in the geographic mix of pre-tax income toward lower rate
jurisdictions.
Minority interests reflect the portion of the results of majority-owned
operations which are applicable to the minority interest partners. Minority
interests totaled $58.0 million in 2002, a $12.5 million reduction from 2001.
The decrease reflects the lower profitability of the M-I SWACO joint venture,
partially offset by the impact of acquiring a majority interest in United
Engineering Services LLC in the fourth quarter of 2001.
18
LIQUIDITY AND CAPITAL RESOURCES
General
At December 31, 2003, cash and cash equivalents equaled $51.3 million.
During 2003, the Company's operations generated $142.6 million of cash flows as
compared to the $323.5 million generated by the Company's operations in the
prior year. The significant recovery of worldwide drilling activity has driven
higher working capital investment, particularly accounts receivable and
inventories, in contrast to the prior year when declining business levels
contributed to positive cash flow from working capital accounts.
In 2003, cash flows used in investing activities totaled $177.8
million, consisting of amounts required to fund acquisitions and, to a lesser
extent, capital expenditures. Acquisition funding, which primarily related to
the purchase of the oilfield production chemical operations of Dynea
International, resulted in cash outflows of $101.8 million in 2003. The Company
also invested $76.0 million in property, plant and equipment, net of cash
proceeds arising from certain asset disposals. Projected net capital
expenditures for 2004 are expected to approximate $95.0 million, as higher
drilling activity and an expanding business base impact the level of investment
in manufacturing and rental tool equipment. Capital spending in 2004 is expected
to primarily consist of spending for routine additions of property and equipment
to support the Company's operations and maintenance of the Company's capital
equipment base.
The combination of excess cash balances held at the beginning of the
year and cash flows from operations exceeded cash required to fund investing
activities resulting in repayments of $16.9 million in outstanding indebtedness.
Cash flows used in financing activities totaled $1.9 million for 2003 as debt
repayments were largely offset by cash proceeds associated with the exercise of
employee stock options.
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. The Company has various revolving credit facilities in the
United States. As of December 31, 2003, the Company had $315.8 million of
capacity available under these facilities for future operating or investing
needs. The Company also has revolving credit facilities in place outside of the
United States, which are generally used to finance local operating needs. At
year-end, the Company had available borrowing capacity of $82.7 million under
the non-U.S. borrowing facilities.
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. The Company's overall
borrowing capacity is, in part, dependent on maintaining compliance with
financial covenants under the various credit agreements. As of year-end, the
Company was well within the covenant compliance thresholds under its various
loan indentures, as amended, providing the ability to access available borrowing
capacity. Management believes funds generated by 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. Additional 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.
The Company has not engaged in off-balance sheet financing arrangements
through special purpose entities, and the consolidation of the Company's
minority ownership positions would not result in an increase in reported
leverage ratios. The Company has no contractual arrangements in place that could
result in the issuance of additional shares of the Company's common stock at a
future date other than the Company's stock option program, which is discussed in
Note 1, "Summary of Significant Accounting Policies," and Note 14, "Employee
Stock Options."
The Company believes that it has sufficient existing manufacturing
capacity to meet current demand for its products and services. Additionally,
inflation has not had a material effect on the Company in recent years and is
expected to have a modest impact on the operations in the foreseeable future.
The Company has generally been able to offset most of the effects of inflation
through productivity gains, cost reductions and price increases.
19
Contractual Obligations, Commitments and Contingencies
Contractual Obligations
The following table summarizes the Company's debt maturities and future
minimum payments under non-cancelable operating leases having initial terms in
excess of one year as of December 31, 2003 (in thousands):
Amount of Commitment Expiration per Period
--------------------------------------------------------------
Total Less than 1 1-3 3-5 More than
year years years 5 years
------------ ------------- ------------ ------------- ------------
Debt maturities.................. $ 578,295 $ 89,747 $ 112,292 $ 156,868 $ 219,388
Operating lease commitments...... 148,924 35,231 47,682 24,849 41,162
------------ ------------- ------------ ------------- ------------
Total............................ $ 727,219 $ 124,978 $ 159,974 $ 181,717 $ 260,550
============ ============= ============ ============= ============
Amounts related to commitments under capital lease agreements, as well
as pension and other postretirement obligations, were immaterial for the periods
presented.
Standby Letters of Credit and Guarantees
In the normal course of business with customers, vendors and others,
the Company is contingently liable for its performance under standby letters of
credit and bid, performance and surety bonds. Certain of these outstanding
instruments guarantee payment of notes issued to former shareholders of an
acquired entity as well as to insurance companies which reinsure certain
liability coverages of the Company's insurance captive. Excluding the impact of
these instruments, for which the $31.6 million of related liabilities are
reflected in the accompanying consolidated balance sheets, the Company is
contingently liable for approximately $41.6 million of standby letters of credit
and bid, performance and surety bonds at December 31, 2003. Management does not
expect any material amounts to be drawn on these instruments.
The Company has also provided loan guarantees related to certain joint
ventures accounted for under the equity method of accounting. As the net assets
and cash flows of these entities are available to satisfy obligations as they
become due, management believes the likelihood is remote that the Company will
be required to perform under these guarantees. The Company's estimated maximum
exposure under these loan guarantees approximated $17.2 million as of December
31, 2003.
Insurance
The Company maintains insurance coverage for various aspects of its
business and operations. The Company has elected to retain a portion of losses
that occur through the use of deductibles and retentions under its insurance
programs. Amounts in excess of the self-insured retention levels are fully
insured to limits believed appropriate for the Company's operations.
Self-insurance accruals are based on claims filed and an estimate for claims
incurred but not reported. While management believes that amounts accrued in the
accompanying consolidated financial statements are adequate for expected
liabilities arising from the Company's portion of losses, estimates of these
liabilities may change as circumstances develop.
Litigation
The Company is a defendant in various legal proceedings arising in the
ordinary course of business. In the opinion of management, these matters will
not have a material adverse effect on the Company's consolidated financial
position or results of operations.
Environmental
The Company routinely establishes and reviews the adequacy of reserves
for estimated future environmental clean-up costs for properties currently or
previously operated by the Company.
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 SWACO operations, which are
subject to various indemnifications from former owners.
20
As of December 31, 2003, the Company's environmental reserve
approximated $10.0 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 December 31, 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 SWACO's former owners to address issues
associated with certain provisions of the environmental indemnification
provided. This matter is expected to go to trial during the fourth quarter of
2004. In the event that i) M-I SWACO'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 financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires
management 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.
The Company believes the following describes significant judgments and
estimates used in the preparation of its consolidated financial statements:
Allowance for doubtful accounts. The Company extends credit to customers and
other parties in the normal course of business. Management regularly reviews
outstanding receivables and provides for estimated losses through an
allowance for doubtful accounts. In evaluating the level of established
reserves, management makes judgments regarding the parties' ability to make
required payments, economic events and other factors. As the financial
condition of these parties change, circumstances develop or additional
information becomes available, adjustments to the allowance for doubtful
accounts may be required.
Inventory reserves. The Company has made significant investments in
inventory to service its customers around the world. On a routine basis, the
Company uses judgments in determining the level of reserves required to
state inventory at the lower of cost or market. Management's estimates are
primarily influenced by technological innovations, market activity levels
and the physical condition of products. Changes in these or other factors
may result in adjustments to the carrying value of inventory.
Goodwill. The Company has acquired a number of operations during the past
decade, which has resulted in the recording of a material amount of
goodwill. Under SFAS No. 142, "Goodwill and Other Intangible Assets," the
Company is required to perform an annual goodwill impairment evaluation,
which is largely influenced by future cash flow projections. Estimating
future cash flows of the Company's operations requires management to make
judgments about future operating results and working capital requirements.
Although the majority of the goodwill relates to the Company's Oilfield
operations, $37.8 million of goodwill has been recorded which relates to
Distribution transactions. Wilson's financial performance has been impacted
by the lower level of business volumes experienced in its downstream and
industrial sector. Changes in cash flow assumptions or other factors which
negatively impact the fair value of the Distribution business would
influence the evaluation and might result in the determination that a
portion of the goodwill is impaired when the analysis is performed during
the first quarter of 2004.
Self-Insurance. The Company maintains insurance coverage for various aspects
of its business and operations. The Company retains a portion of losses that
occur through the use of deductibles and retentions under self-insurance
programs. Management regularly reviews estimates of reported and unreported
claims and provides for losses through insurance reserves. As claims develop
and additional information becomes available, adjustments to loss reserves
may be required.
Income taxes. Deferred tax assets and liabilities are recognized for
differences between the book basis and tax basis of the net assets of the
Company. In providing for deferred taxes, management considers current tax
regulations, estimates of future taxable income and available tax planning
strategies. In certain cases, management has established reserves to reduce
deferred tax assets to estimated realizable value. If tax regulations,
operating results or the ability to implement tax planning strategies vary,
adjustments to the carrying value of deferred tax assets and liabilities may
be required.
21
Environmental Obligations. The Company records liabilities for environmental
obligations when remedial efforts are probable and the costs can be
reasonably estimated. Management's estimates are based on currently enacted
laws and regulations. As more information becomes available or environmental
laws and regulations change, such liabilities may be required to be
adjusted. Additionally, in connection with acquisitions, the Company
generally obtains indemnifications from the seller related to environmental
matters. If the indemnifying parties do not fulfill their obligations,
adjustments of recorded amounts may be required.
RECENT ACCOUNTING PRONOUNCEMENTS
From time to time, new accounting pronouncements are issued by the
Financial Accounting Standards Board ("FASB") which are adopted by the Company
as of the specified effective date. 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 7A. QUALITATIVE AND QUANTITATIVE MARKET RISK DISCLOSURES
The Company is exposed to market risks from changes in interest rates
and foreign exchange rates and enters into various hedging transactions to
mitigate these risks. The Company does not use financial instruments for trading
or speculative purposes. See Note 9, "Financial Instruments," for additional
discussion of hedging instruments.
The Company's exposure to interest rate changes is managed through the
use of a combination of fixed and floating rate debt and by entering into
interest rate contracts, from time to time, on a portion of its long-term
borrowings. The Company had no interest rate contracts outstanding as of
December 31, 2003 and 2002. At December 31, 2003, 22 percent of the Company's
long-term debt carried a variable interest rate. Management believes that
significant interest rate changes will not have a material near-term impact on
the Company's future earnings or cash flows.
The Company's exposure to changes in foreign exchange rates is managed
primarily through the use of forward exchange contracts. These contracts
increase or decrease in value as foreign exchange rates change, to protect the
value of the underlying transactions denominated in foreign currencies. All
currency contracts are components of the Company's hedging program and are
entered into for the sole purpose of hedging an existing or anticipated currency
exposure. The gains and losses on these contracts offset changes in the value of
the related exposures. The terms of these contracts generally do not exceed two
years. As of December 31, 2003, the notional amounts of fair value hedge
contracts and cash flow hedge contracts outstanding were $45.5 million and $9.2
million, respectively, and the fair value exceeded the notional amount of these
contracts by $1.9 million. As of December 31, 2002, the notional amounts of fair
value hedge contracts and cash flow hedge contracts outstanding were $43.4
million and $31.4 million, respectively, and the fair value exceeded the
notional amount of these contracts by $3.6 million. In some areas, where hedging
is not cost effective, the Company addresses foreign currency exposure utilizing
working capital management.
The Company utilizes a "Value-at-Risk" ("VAR") model to determine the
maximum potential one-day loss in the fair value of its foreign exchange
sensitive financial instruments. The VAR model estimates were made assuming
normal market conditions and a 95 percent confidence level. The Company's VAR
computations are based on the historical price movements in various currencies
(a "historical" simulation) during the year. The model includes all of the
Company's foreign exchange derivative contracts. Anticipated transactions, firm
commitments and assets and liabilities denominated in foreign currencies, which
certain of these instruments are intended to hedge, were excluded from the
model. The VAR model is a risk analysis tool and does not purport to represent
actual losses in fair value that will be incurred by the Company, nor does it
consider the potential effect of favorable changes in market factors. The
estimated maximum potential one-day loss in fair value of currency sensitive
instruments, calculated using the VAR model, was not material to the Company's
financial position or results of operations.
22
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Below is a copy of the report previously issued by Arthur Andersen LLP, the
Company's former independent public accountants, related to the Company's
consolidated financial statements for the years ended December 31, 2001 and
2000. Arthur Andersen ceased operations in 2002 and is unable to issue an
updated report. Certain financial statements covered by this report have not
been included in the accompanying financial statements.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Smith International, Inc.:
We have audited the accompanying consolidated balance sheets of Smith
International, Inc. (a Delaware corporation) and subsidiaries as of December 31,
2001 and 2000, and the related consolidated statements of operations,
stockholders' equity and comprehensive income and cash flows for each of the
three years in the period ended December 31, 2001. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Smith
International, Inc. and subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001, in conformity with accounting principles
generally accepted in the United States.
ARTHUR ANDERSEN LLP
Houston, Texas
January 29, 2002
23
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Smith International, Inc.:
We have audited the accompanying consolidated balance sheets of Smith
International, Inc. and subsidiaries (the "Company") as of December 31, 2003 and
2002, and the related consolidated statements of operations, stockholders'
equity and comprehensive income, and cash flows for the years then ended. Our
audits also included the 2003 and 2002 financial statement schedules listed in
Part IV, Item 15(a)(2). These financial statements and financial statement
schedules are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and financial statement
schedules based on our audits. The consolidated financial statements and
financial statement schedule of the Company as of December 31, 2001 and for the
year then ended, prior to the revisions discussed below, were audited by other
auditors who have ceased operations. Those auditors expressed an unqualified
opinion on those financial statements in their report dated January 29, 2002.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the 2003 and 2002 consolidated financial statements present
fairly, in all material respects, the financial position of Smith International,
Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of its
operations and its cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of America. Also,
in our opinion, such 2003 and 2002 financial statement schedules, when
considered in relation to the basic consolidated financial statements taken as a
whole, present fairly in all material respects the information set forth
therein.
As discussed in Notes 1 and 2 to the financial statements, the Company adopted
the provisions of Statement of Financial Accounting Standards ("SFAS") No. 143,
"Accounting for Asset Retirement Obligations" in 2003 and SFAS No. 142,
"Goodwill and Other Intangible Assets" in 2002.
As discussed above, the consolidated financial statements and financial
statement schedule of the Company as of December 31, 2001 and for the year then
ended were audited by other auditors who have ceased operations. Those financial
statements have been revised to i) give effect to a two-for-one stock split
during 2002 (Notes 1, 4, 11 and 14), ii) include the transitional disclosures
required by SFAS No. 142 (Notes 1 and 7), and iii) include expanded disclosures
relating to the Company's supplemental executive retirement plan (Note 12). We
audited the adjustments, transitional disclosures and expanded disclosures
described above. Our procedures included a) agreeing previously reported
weighted average shares outstanding, stock option, net income and goodwill
amounts to the previously issued financial statements, b) agreeing the
transitional adjustments and expanded disclosure amounts to the Company's
underlying records obtained from management, and c) testing the mathematical
accuracy of the applicable 2001 amounts. In our opinion, such adjustments and
disclosures for 2001 are appropriate and have been properly applied. However, we
were not engaged to audit, review or apply any procedures to the 2001
consolidated financial statements and financial statement schedule of the
Company other than with respect to such adjustments and disclosures, and
accordingly, we do not express an opinion or any other form of assurance on the
2001 consolidated financial statements and financial statement schedule taken as
a whole.
DELOITTE & TOUCHE LLP
Houston, Texas
March 11, 2004
24
SMITH INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value data)
DECEMBER 31,
---------------------------------
2003 2002
-------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents.................................................. $ 51,286 $ 86,750
Receivables, net (Note 1).................................................. 801,819 633,918
Inventories, net........................................................... 739,627 634,488
Deferred tax assets, net................................................... 31,238 25,403
Prepaid expenses and other................................................. 55,826 46,355
-------------- -------------
Total current assets................................................... 1,679,796 1,426,914
-------------- -------------
PROPERTY, PLANT AND EQUIPMENT, NET............................................. 534,871 519,220
GOODWILL, NET.................................................................. 690,593 620,075
OTHER ASSETS................................................................... 191,787 183,336
-------------- -------------
TOTAL ASSETS................................................................... $ 3,097,047 $ 2,749,545
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current portion of long-term debt................ $ 89,747 $ 159,692
Accounts payable........................................................... 310,754 256,069
Accrued payroll costs...................................................... 73,723 49,946
Income taxes payable....................................................... 69,301 43,936
Other...................................................................... 87,399 85,453
-------------- -------------
Total current liabilities.............................................. 630,924 595,096
-------------- -------------
LONG-TERM DEBT................................................................. 488,548 441,967
DEFERRED TAX LIABILITIES....................................................... 80,065 64,679
OTHER LONG-TERM LIABILITIES.................................................... 74,066 67,011
MINORITY INTERESTS............................................................. 587,668 517,257
COMMITMENTS AND CONTINGENCIES (Note 16)
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; 102,720 shares
issued in 2003 (101,546 shares issued in 2002)......................... 102,720 101,546
Additional paid-in capital................................................. 371,438 345,911
Retained earnings.......................................................... 779,123 655,643
Accumulated other comprehensive income..................................... 11,625 (10,435)
Less - Treasury securities, at cost; 2,384 common shares in 2003 and 2002.. (29,130) (29,130)
-------------- -------------
Total stockholders' equity.............................................. 1,235,776 1,063,535
-------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..................................... $ 3,097,047 $ 2,749,545
============== =============
The accompanying notes are an integral part of these financial statements.
25
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------
2003 2002 2001
------------ ------------ ------------
Revenues.............................................. $ 3,594,828 $ 3,170,080 $ 3,551,209
Costs and expenses:
Costs of revenues................................... 2,518,897 2,251,778 2,505,405
Selling expenses.................................... 586,163 520,509 520,004
General and administrative expenses................. 161,021 141,645 138,561
Goodwill amortization............................... - - 15,729
------------ ------------ ------------
Total costs and expenses.......................... 3,266,081 2,913,932 3,179,699
------------ ------------ ------------
Operating income...................................... 328,747 256,148 371,510
Interest expense...................................... 40,964 40,928 45,359
Interest income....................................... (1,973) (2,579) (2,895)
------------ ------------ ------------
Income before income taxes, minority interests
and cumulative effect of change in accounting
principle........................................... 289,756 217,799 329,046
Income tax provision.................................. 93,334 66,632 106,397
Minority interests.................................... 71,788 57,978 70,504
------------ ------------ ------------
Income before cumulative effect of change in
accounting principle................................ 124,634 93,189 152,145
Cumulative effect of change in accounting principle,
net of tax and minority interests................... (1,154) - -
------------ ------------ ------------
Net income............................................ $ 123,480 $ 93,189 $ 152,145
============ ============ ============
Basic:
Earnings per share before cumulative effect of
change in accounting principle.................... $ 1.25 $ 0.94 $ 1.53
Cumulative effect of change in accounting principle,
net of tax and minority interests................. (0.01) - -
------------ ------------ ------------
Earnings per share.................................. $ 1.24 $ 0.94 $ 1.53
============ ============ ============
Diluted:
Earnings per share before cumulative effect of
change in accounting principle.................... $ 1.24 $ 0.93 $ 1.51
Cumulative effect of change in accounting principle,
net of tax and minority interests................. (0.01) - -
------------ ------------ ------------
Earnings per share.................................. $ 1.23 $ 0.93 $ 1.51
============ ============ ============
Weighted average shares outstanding:
Basic............................................... 99,815 98,984 99,504
Diluted............................................. 100,903 100,091 100,448
The accompanying notes are an integral part of these financial statements.
26
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------
2003 2002 2001
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income........................................................... $ 123,480 $ 93,189 $ 152,145
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...................................... 101,709 89,327 92,895
Minority interests................................................. 71,788 57,978 70,504
Deferred income tax provision (benefit)............................ 8,154 23,560 (1,156)
Provision for losses on receivables................................ 3,835 9,593 2,986
Increase (decrease) in LIFO inventory reserves..................... 231 439 (1,163)
Gain on disposal of property, plant and equipment.................. (8,463) (4,645) (6,385)
Foreign currency translation losses (gains)........................ 1,516 (864) 889
Changes in operating assets and liabilities:
Receivables........................................................ (161,205) 119,600 (31,748)
Inventories........................................................ (90,167) 33,675 (33,819)
Accounts payable................................................... 49,452 (32,817) (35,738)
Other current assets and liabilities............................... 46,001 (48,339) 5,415
Other non-current assets and liabilities........................... (4,903) (17,170) (9,060)
------------ ------------ ------------
Net cash provided by operating activities........................ 142,582 323,526 205,765
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired...................... (101,789) (60,152) (248,127)
Purchases of property, plant and equipment........................... (98,923) (97,051) (127,642)
Proceeds from disposal of property, plant and equipment.............. 22,902 18,247 18,228
Purchases of stock in majority-owned subsidiary...................... - (231) (2,084)
------------ ------------ ------------
Net cash used in investing activities............................ (177,810) (139,187) (359,625)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt............................. 116,615 15,902 371,250
Principal payments of long-term debt................................. (135,499) (130,775) (222,584)
Net change in short-term borrowings.................................. 2,014 (1,170) (26,052)
Purchases of treasury stock.......................................... - - (21,428)
Proceeds from exercise of stock options.............................. 18,958 5,047 5,519
Contributions from (distributions to) minority interest partner...... (4,000) (31,600) 55,400
------------ ------------ ------------
Net cash provided by (used in) financing activities.............. (1,912) (142,596) 162,105
------------ ------------ ------------
Effect of exchange rate changes on cash................................ 1,676 324 (106)
------------ ------------ ------------
Increase (decrease) in cash and cash equivalents....................... (35,464) 42,067 8,139
Cash and cash equivalents at beginning of year......................... 86,750 44,683 36,544
------------ ------------ ------------
Cash and cash equivalents at end of year............................... $ 51,286 $ 86,750 $ 44,683
============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest................................................. $ 41,306 $ 41,150 $ 39,422
Cash paid for income taxes............................................. 50,980 39,743 87,860
The accompanying notes are an integral part of these financial statements.
27
SMITH INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(In thousands, except share data)
COMMON STOCK ACCUMULATED
----------------------------- ADDITIONAL OTHER
NUMBER OF PAID-IN RETAINED COMPREHENSIVE
SHARES AMOUNT CAPITAL EARNINGS INCOME
----------- ----------- ---------- ----------- ------------
Balance, December 31, 2000........... 50,418,930 $ 50,419 $ 382,248 $ 410,309 $ (17,793)
Comprehensive income:
Net income....................... - - - 152,145 -
Currency translation adjustments. - - - - (5,057)
Changes in unrealized fair value
of derivatives................. - - - - (963)
Minimum pension liability
adjustments.................... - - - - (935)
----------- ----------- ---------- ----------- ------------
Comprehensive income................. - - - 152,145 (6,955)
Purchases of treasury stock.......... - - - - -
Exercise of stock options and stock
grants............................. 175,000 175 7,741 - -
----------- ----------- ---------- ----------- ------------
Balance, December 31, 2001........... 50,593,930 50,594 389,989 562,454 (24,748)
Comprehensive income:
Net income....................... - - - 93,189 -
Currency translation adjustments. - - - - 13,597
Changes in unrealized fair value
of derivatives................. - - - - 3,266
Minimum pension liability
adjustments.................... - - - - (2,550)
----------- ----------- ---------- ----------- ------------
Comprehensive income................. - - - 93,189 14,313
Exercise of stock options and stock
grants............................. 276,993 277 6,597 - -
Two-for-one common stock split
(Note 11).......................... 50,675,019 50,675 (50,675) - -
----------- ----------- ---------- ----------- ------------
Balance, December 31, 2002........... 101,545,942 101,546 345,911 655,643 (10,435)
Comprehensive income:
Net income....................... - - - 123,480 -
Currency translation adjustments. - - - - 22,073
Changes in unrealized fair value
of derivatives................. - - - - 36
Minimum pension liability
adjustments.................... - - - - (49)
----------- ----------- ---------- ----------- ------------
Comprehensive income................. - - - 123,480 22,060
Exercise of stock options and stock
grants............................. 1,174,364 1,174 25,527 - -
----------- ----------- ---------- ----------- ------------
Balance, December 31, 2003........... 102,720,306 $ 102,720 $ 371,438 $ 779,123 $ 11,625
=========== =========== ========== =========== ============
TREASURY SECURITIES
--------------------------------
COMMON STOCK
-------------------------------- TOTAL
NUMBER OF STOCKHOLDERS'
SHARES AMOUNT EQUITY
------------ ----------- -----------
Balance, December 31, 2000........... (655,854) $ (7,702) $ 817,481
Comprehensive income:
Net income....................... - - 152,145
Currency translation adjustments. - - (5,057)
Changes in unrealized fair value
of derivatives................ - - (963)
Minimum pension liability
adjustments.................... - - (935)
------------ ------------ -----------
Comprehensive income................. - - 145,190
Purchases of treasury stock.......... (536,200) (21,428) (21,428)
Exercise of stock options and stock
grants............................. - - 7,916
------------ ------------ -----------
Balance, December 31, 2001........... (1,192,054) (29,130) 949,159
Comprehensive income:
Net income....................... - - 93,189
Currency translation adjustments. - - 13,597
Changes in unrealized fair value
of derivatives................. - - 3,266
Minimum pension liability
adjustments.................... - - (2,550)
------------ ------------ -----------
Comprehensive income................. - - 107,502
Exercise of stock options and stock
grants............................. - - 6,874
Two-for-one common stock split
(Note 11).......................... (1,192,054) - -
------------ ------------ -----------
Balance, December 31, 2002........... (2,384,108) (29,130) 1,063,535
Comprehensive income:
Net income....................... - - 123,480
Currency translation adjustments. - - 22,073
Changes in unrealized fair value
of derivatives................. - - 36
Minimum pension liability
adjustments.................... - - (49)
------------ ------------ -----------
Comprehensive income................. - - 145,540
Exercise of stock options and stock
grants............................. - - 26,701
------------ ------------ -----------
Balance, December 31, 2003........... (2,384,108) $ (29,130) $ 1,235,776
============ ============ ===========
The accompanying notes are an integral part of these financial statements.
28
SMITH INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All dollar amounts are expressed in thousands, unless otherwise noted)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Smith International, Inc. ("Smith" or the "Company") provides premium
products and services to the oil and gas exploration and production industry,
the petrochemical industry and other industrial markets. The accompanying
consolidated financial statements were prepared in accordance with accounting
principles generally accepted in the United States and all applicable financial
statement rules and regulations of the Securities and Exchange Commission (the
"Commission"). Management believes the consolidated financial statements present
fairly the financial position, results of operations and cash flows of the
Company as of the dates indicated.
The consolidated financial statements include the accounts of the
Company and all wholly and majority-owned subsidiaries, after the elimination of
all significant intercompany accounts and transactions. Investments in
affiliates in which ownership interest ranges from 20 to 50 percent, and the
Company exercises significant influence over operating and financial policies,
are accounted for on the equity method. All other investments are carried at
cost, which does not exceed the estimated net realizable value of such
investments.
Certain reclassifications have been made to the prior years' financial
information to conform to the 2003 presentation.
Use of Estimates
Preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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. Management believes the most
significant estimates and assumptions are associated with the valuation of
accounts receivable, inventories, goodwill and deferred taxes as well as the
determination of liabilities related to environmental obligations and
self-insurance programs. 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 financial
statements.
Cash and Cash Equivalents
The Company considers all highly liquid financial instruments purchased
with an original maturity of three months or less to be cash equivalents.
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts to provide for
receivables which may ultimately be uncollectible. Reserves are determined in
light of a number of factors including customer specific conditions, economic
events and the Company's historical loss experience. At December 31, 2003 and
2002, the allowance for doubtful accounts was $12.1 million and $12.3 million,
respectively.
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 consist of
materials, labor and factory overhead.
29
Fixed Assets
Fixed assets, consisting of rental equipment and property, plant and
equipment, are stated at cost, net of accumulated depreciation. The Company
computes depreciation on fixed assets using principally the straight-line
method. The estimated useful lives used in computing depreciation generally
range from 20 to 40 years for buildings, three to 25 years for machinery and
equipment, and five to ten years for rental equipment. Leasehold improvements
are amortized over the lives of the leases or the estimated useful lives of the
improvements, whichever is shorter. For income tax purposes, accelerated methods
of depreciation are used.
Costs of major renewals and betterments are capitalized as fixed
assets. Expenditures for maintenance, repairs and minor improvements are charged
to expense when incurred. When fixed assets are sold or retired, the remaining
cost and related accumulated depreciation are removed from the accounts and the
resulting gain or loss is included in the consolidated statement of operations.
Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over the fair value of net
assets acquired. On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets,"
which addresses financial accounting and reporting matters. Under the provisions
of SFAS No. 142, goodwill is not amortized, but is evaluated annually for
impairment or more frequently if circumstances indicate that an impairment may
exist. The goodwill valuation, which is prepared during the first quarter of
each calendar year, is largely influenced by projected future cash flows and,
therefore, is significantly impacted by estimates and judgments.
Prior to 2002, goodwill was amortized over periods ranging from 20 to
40 years and resulted in the inclusion of $15.7 million of goodwill amortization
in the accompanying 2001 financial statements.
The Company amortizes other identifiable intangible assets on a
straight-line basis over the periods expected to be benefited, ranging from
three to 27 years. The components of these other intangible assets, recorded in
Other Assets in the accompanying consolidated balance sheets generally consist
of patents, license agreements, non-compete agreements, trademarks and customer
lists and contracts.
Impairment of Long-Lived Assets
Management reviews long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount may not be
recoverable. If an evaluation is required, the estimated undiscounted future
cash flows associated with the asset will be compared to the asset's carrying
amount to determine if an impairment exists.
Environmental Obligations
Expenditures for environmental obligations that relate to current
operations are expensed or capitalized, as appropriate. Liabilities are recorded
when environmental clean-up efforts are probable and their cost is reasonably
estimated, and are adjusted as further information is obtained. Such estimates
are based on currently enacted laws and regulations and are not discounted to
present value.
30
Liabilities Related to Self-Insurance Programs
The Company is self-insured for certain casualty and employee medical
insurance liabilities of its U.S. operations. Expenditures for casualty and
medical claims are recorded when incurred after taking into consideration
recoveries available under stop-loss insurance policies. Additionally, reserves
are established to provide for the estimated cost of settling known claims as
well as medical and casualty exposures projected to have been incurred but not
yet reported.
Foreign Currency Translation and Transactions
Gains and losses resulting from balance sheet translation of operations
outside the United States where the applicable foreign currency is the
functional currency are included as a component of Accumulated other
comprehensive income within stockholders' equity. Gains and losses resulting
from balance sheet translation of operations outside the United States where the
U.S. dollar is the functional currency are included in the consolidated
statements of operations.
Gains and losses resulting from foreign currency transactions,
excluding cash flow hedges discussed below, are recognized currently in the
consolidated statements of operations.
Financial Instruments
The nature of the Company's business activities involves the management
of various financial and market risks, including those related to changes in
currency exchange rates and interest rates. The Company utilizes derivative
financial instruments such as foreign exchange contracts, foreign exchange
options and interest rate contracts to mitigate or eliminate certain of those
risks. The Company does not enter into derivative instruments for speculative
purposes.
The Company records changes in fair market value related to fair value
hedges, which includes foreign exchange contracts, to General and administrative
expenses in the consolidated statements of operations. Changes in value related
to cash flow hedges, which includes foreign exchange contracts, foreign exchange
options and interest rate swaps, are recorded in Accumulated other comprehensive
income and are recognized in the consolidated statement of operations when the
hedged item affects earnings.
Income Taxes
The Company accounts for income taxes using an asset and liability
approach for financial accounting and income tax reporting based on enacted tax
rates. Deferred tax assets are reduced by a valuation allowance when it is more
likely than not that some portion, or all, of the deferred tax assets will not
be realized.
Revenue Recognition
The Company's revenues, which are composed of product, rental, service
and other revenues, are generally subject to contractual arrangements which
specify price and general terms and conditions. The Company recognizes product
revenues, net of applicable provisions for returns, when title and the related
risk of loss transfers to the customer. Rental, service and other revenues are
recorded when such services are performed and collectibility is reasonably
assured.
Minority Interests
The Company records minority interest expense which reflects the
portion of the earnings of majority-owned operations which are applicable to the
minority interest partners. The minority interest amount primarily represents
the share of the M-I SWACO profits associated with the minority partner's 40
percent interest in those operations. To a lesser extent, minority interests
include the portion of CE Franklin Ltd. and United Engineering Services LLC
earnings applicable to the respective minority shareholders.
31
Stock-Based Compensation
The Company's Board of Directors and its stockholders have authorized
an employee stock option plan. As of December 31, 2003, 6.1 million shares were
issued and outstanding under the program and an additional 2.3 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 of $0.4 million and $0.3 million of related expense in the
accompanying consolidated statements of operations for the years ended December
31, 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
financial statements.
Had the Company elected to apply the accounting standards of SFAS No.
123, the Company's net income and earnings per share would have approximated the
pro forma amounts indicated below (in thousands, except per share data):
2003 2002 2001
--------------- --------------- ---------------
Net income, as reported.................................... $ 123,480 $ 93,189 $ 152,145
Add: Stock-based compensation expense included in
reported income, net of related tax effect............. 273 182 -
Less: Total stock-based compensation expense
determined under the Black-Scholes option-pricing
model, net of related tax effect....................... (9,457) (7,894) (6,432)
--------------- --------------- ---------------
Net income, pro forma...................................... $ 114,296 $ 85,477 $ 145,713
=============== =============== ===============
Earnings per share:
As reported:
Basic.................................................... $ 1.24 $ 0.94 $ 1.53
Diluted.................................................. 1.23 0.93 1.51
Pro forma:
Basic.................................................... $ 1.15 $ 0.86 $ 1.46
Diluted.................................................. 1.13 0.85 1.45
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 of $0.5 million, $0.6 million and $0.6 million of
related expense in the accompanying consolidated statements of operations for
the years ended December 31, 2003, 2002 and 2001, respectively.
32
Audited Financial Information for 2001
Arthur Andersen LLP ("Arthur Andersen") served as the Company's
independent auditors until their dismissal on April 15, 2002, at which time
Smith's Board of Directors appointed Deloitte & Touche LLP. Prior to their
dismissal, Arthur Andersen performed an audit of the Company's consolidated
financial statements as of December 31, 2001 and for the fiscal year then ended
and issued an unqualified opinion dated January 29, 2002.
Arthur Andersen ceased operations during 2002 and is unable to consent
to the inclusion of their previously issued opinion on the Company's financial
statements in filings with the Commission. Although the accompanying
consolidated statements of operations, stockholders' equity and comprehensive
income and cash flows for the year ended December 31, 2001, are not covered by a
current consent from the Company's former independent auditors, management has
included these financial statements in order to provide historical information
as required by the Commission. Management is not aware of any event or
circumstance which would have precluded Arthur Andersen from reissuing their
opinion on the 2001 financial statements.
Recent Accounting Pronouncements
From time to time, new accounting pronouncements are issued by the
Financial Accounting Standards Board ("FASB") which are adopted by the Company
as of the specified effective date. 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.
2. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
On January 1, 2003, the Company adopted 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 SWACO 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 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 years ended December 31, 2002 and 2001 (assuming
adoption of SFAS No. 143 as of January 1, 2001) were significant to net income
or earnings per share amounts.
3. BUSINESS COMBINATIONS
During 2003, the Company completed three acquisitions in exchange for
aggregate cash consideration of $92.1 million and the assumption of certain
liabilities. In addition, cash payments of $9.7 million were made during the
year to former shareholders of businesses acquired in 2002 to fund amounts due
under earn-out arrangements and repay seller-financed notes. The 2003
transactions primarily consist of the following:
On January 29, 2003, M-I SWACO acquired certain oilfield chemical assets of
Dynea International ("Dynea") in exchange for cash consideration of $77.8
million. The acquired operations, formerly based in Norway, provide a
complete line of oilfield specialty chemicals used to eliminate hydrocarbon
flow problems encountered during production and transportation.
On October 1, 2003, M-I SWACO acquired certain operating assets of Alpine
Mud Products for cash consideration of $14.1 million. The acquired
operations market a line of specialty fluid additives used to enhance rates
of penetration in critical drilling applications, primarily to customers in
the U.S. Gulf Coast region.
The excess of the purchase price over the estimated fair value of the
net assets acquired amounted to $66.1 million, which has been recorded as
goodwill predominantly in the Oilfield Products and Services segment.
33
Substantially all of the goodwill related to the 2003 acquisitions is expected
to be deductible for tax purposes. The purchase price allocation related to
certain of the 2003 acquisitions is based upon preliminary information and is
subject to change when additional data concerning the contingent consideration
and final asset and liability valuations is obtained. Material changes in the
preliminary allocations are not anticipated by management.
During 2002, the Company completed four acquisitions in exchange for
aggregate cash consideration of $60.2 million, the issuance of $24.8 million of
notes payable and the assumption of certain liabilities. The 2002 transactions
primarily consist of the following:
On July 31, 2002, the Company acquired certain turbodrilling assets of
Neyrfor-Weir Ltd. in exchange for cash consideration of $25.3 million. The
acquired operations, which design proprietary turbodrilling equipment and
provide related services for horizontal and directional drilling
applications, have been integrated into the Company's Oilfield Products and
Services segment.
On October 11, 2002, M-I SWACO acquired CleanCut Technologies ("CleanCut")
for cash consideration of $16.1 million and the issuance of notes to
sellers totaling $23.9 million. CleanCut, formerly based in Scotland,
designs, manufactures and installs waste collection and transportation
systems for offshore drilling operations.
On November 28, 2002, M-I SWACO acquired IKF Services, a drilling fluids
and solids-control company located in Russia, for cash consideration of
$13.4 million. In addition, M-I SWACO may be obligated to provide
additional consideration of up to $6.9 million in 2004, dependent upon
whether certain financial and business objectives provided under the
earn-out arrangement are met.
The excess of the purchase price over the estimated fair value of the
net assets acquired amounted to $35.6 million, which has been recorded as
goodwill in the Oilfield Products and Services segment.
During 2001, the Company completed 15 acquisitions in exchange for
aggregate cash consideration of $248.1 million and the assumption of certain
liabilities. On a combined basis, the minority partner in M-I SWACO contributed
$43.4 million of cash to the joint venture in connection with transactions
completed during the year. The 2001 transactions primarily consist of the
following:
On January 31, 2001, the Company acquired substantially all of the U.S. net
assets of Van Leeuwen Pipe and Tube Corporation ("Van Leeuwen") for cash
consideration of $41.1 million. Van Leeuwen, a leading provider of pipe,
valves and fittings to the refining, petrochemical and power generation
industries, has been integrated into the Company's Distribution segment
operations.
On August 22, 2001, M-I SWACO acquired BW Group plc ("BW Group"), based in
Scotland, for cash consideration of $20.5 million and the assumption of
certain indebtedness. BW Group provides drilling and completion fluids and
related engineering services to the North Sea market.
On October 2, 2001, M-I SWACO acquired The SulfaTreat Company, a natural
gas production services company headquartered in the United States, for
cash consideration of $35.0 million.
On October 23, 2001, M-I SWACO acquired the oilfield and industrial screen
operations of Madison Filter Belgium S.A. ("Madison") for cash
consideration of $93.5 million. Madison, which includes United Wire Ltd.
based in Scotland and Southwestern Wire Cloth, Inc. based in the United
States, manufactures and markets screens for oilfield shakers and provides
screening products for use in a broad range of industrial markets.
The excess of the purchase price over the estimated fair value of the
net assets acquired amounted to $137.1 million, which has been recorded as
goodwill. Of this amount, $135.8 million relates to the Oilfield Products and
Services segment and $1.3 million is associated with the Distribution segment.
Goodwill associated with 2001 acquisitions completed prior to July 1 was
amortized on a straight-line basis over a 20-year period; however, goodwill
related to transactions completed subsequent to that date was not amortized in
accordance with the provisions of SFAS No. 142.
34
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. Pro forma results of
operations have not been presented because the effect of these acquisitions was
not material to the Company's consolidated financial statements.
The following schedule summarizes investing activities related to 2003,
2002 and 2001 acquisitions included in the consolidated statements of cash
flows:
2003 2002 2001
-------------- ------------- --------------
Fair value of tangible and identifiable intangible assets, net of
cash acquired........................................................... $ 34,922 $ 57,480 $ 195,500
Goodwill acquired.......................................................... 66,147 35,616 137,100
Payments to former shareholders of businesses acquired in 2002............. 9,692 - -
Total liabilities assumed.................................................. (8,972) (32,944) (84,473)
-------------- ------------- --------------
Cash paid for acquisition of businesses, net of cash acquired ............. $ 101,789 $ 60,152 $ 248,127
============== ============= ==============
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.
During 2002, the Company's Board of Directors approved a two-for-one stock split
effected in the form of a stock dividend. All weighted average share and option
amounts prior to that date have been restated for the effect of the stock split.
Outstanding employee stock options of 1.1 million, 1.7 million and 0.4 million
as of December 31, 2003, 2002 and 2001, respectively, were not included in the
computation of diluted earnings per common share as the exercise price was in
excess of the average market price for the Company's stock during the
corresponding period. The following schedule reconciles the income and shares
used in the basic and diluted EPS computations (in thousands, except per share
data):
2003 2002 2001
--------------- -------------- ---------------
BASIC EPS:
Income before cumulative effect of change in
accounting principle.............................. $ 124,634 $ 93,189 $ 152,145
============= ============= ==============
Weighted average number of common
shares outstanding................................ 99,815 98,984 99,504
============= ============= ==============
Basic EPS before cumulative effect of change in
accounting principle.............................. $ 1.25 $ 0.94 $ 1.53
============= ============= ==============
Basic EPS before cumulative effect of change in
accounting principle, excluding impact of
goodwill amortization............................. $ 1.25 $ 0.94 $ 1.62
============= ============= ==============
DILUTED EPS:
Income before cumulative effect of change in
accounting principle.............................. $ 124,634 $ 93,189 $ 152,145
============= ============= ==============
Weighted average number of common
shares outstanding................................ 99,815 98,984 99,504
Dilutive effect of stock options.................... 1,088 1,107 944
------------- ------------- --------------
100,903 100,091 100,448
============= ============= ==============
Diluted EPS before cumulative effect of change in
accounting principle.............................. $ 1.24 $ 0.93 $ 1.51
============= ============= ==============
Diluted EPS before cumulative effect of change in
accounting principle, excluding impact of
goodwill amortization............................. $ 1.24 $ 0.93 $ 1.61
============= ============= ==============
35
5. INVENTORIES
Inventories consist of the following at December 31:
2003 2002
--------------- --------------
Raw materials............................................................... $ 62,631 $ 49,880
Work-in-process............................................................. 66,151 54,201
Products purchased for resale............................................... 170,973 155,202
Finished goods.............................................................. 464,151 399,252
--------------- --------------
763,906 658,535
Reserves to state certain U.S. inventories (FIFO cost of $266,328 and
$265,304 in 2003 and 2002, respectively) on a LIFO basis.................. (24,279) (24,047)
--------------- --------------
$ 739,627 $ 634,488
=============== ==============
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following at December 31:
2003 2002
--------------- --------------
Land........................................................................ $ 38,394 $ 33,412
Buildings................................................................... 134,568 125,589
Machinery and equipment..................................................... 511,615 506,245
Rental tools................................................................ 323,977 268,134
--------------- --------------
1,008,554 933,380
Less-accumulated depreciation............................................... 473,683 414,160
--------------- --------------
$ 534,871 $ 519,220
=============== ==============
36
7. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The following table presents goodwill on a segment basis as of the
dates indicated, as well as changes in the account during the period shown.
Beginning and ending goodwill balances are presented net of accumulated
amortization of $53.6 million:
Oilfield Distribution
Segment Segment Consolidated
-------------- ------------- ------------
Balance as of December 31, 2001......................... $ 537,509 $ 37,041 $ 574,550
Goodwill acquired....................................... 35,616 - 35,616
Purchase price and other adjustments.................... 9,661 248 9,909
-------------- ------------- ------------
Balance as of December 31, 2002......................... 582,786 37,289 620,075
Goodwill acquired....................................... 66,052 95 66,147
Purchase price and other adjustments.................... 3,984 387 4,371
-------------- ------------- ------------
Balance as of December 31, 2003......................... $ 652,822 $ 37,771 $ 690,593
============== ============= =============
Other Intangible Assets
The components of other intangible assets, recorded in Other Assets in
the accompanying consolidated balance sheets at December 31, are as follows:
2003 2002
-------------------------------------------- ------------------------------------------
Weighted
Gross Gross Average
Carrying Accumulated Carrying Accumulated Amortization
Amount Amortization Net Amount Amortization Net Period
----------- ------------- --------- --------- ------------- -------- ------------
(years)
Patents........... $ 38,520 $ 12,015 $ 26,505 $ 36,359 $ 9,478 $ 26,881 16.4
License
agreements...... 19,086 2,193 16,893 16,376 319 16,057 11.6
Non-compete
agreements and
trademarks...... 19,583 5,649 13,934 15,099 3,241 11,858 11.6
Customer lists
and contracts.. 8,724 877 7,847 5,488 200 5,288 16.6
-------- ---------- --------- -------- ---------- --------- --------
$ 85,913 $ 20,734 $ 65,179 $ 73,322 $ 13,238 $ 60,084 14.2
======== ========== ========= ======== ========== ========= ========
Amortization expense of other intangible assets was $7.5 million, $3.4
million and $2.1 million for the years ended December 31, 2003, 2002 and 2001,
respectively. Additionally, estimated future amortization expense is expected to
range between $4.2 million and $8.0 million a year for the next five fiscal
years.
37
8. DEBT
The following summarizes the Company's outstanding debt at December 31:
2003 2002
------------- -------------
CURRENT:
Short-term borrowings......................................................... $ 53,090 $ 49,978
Current portion of long-term debt............................................. 36,657 109,714
------------- -------------
Short-term borrowings and current portion of long-term debt................. $ 89,747 $ 159,692
============= =============
LONG-TERM:
Notes:
6.75% Senior Notes maturing February 2011 with an effective interest rate
of 6.83%. Interest payable semi-annually (presented net of unamortized
discount of $723 and $840 in 2003 and 2002, respectively)................... $ 219,277 $ 219,160
7.0% Senior Notes maturing September 2007 with an effective interest rate
of 7.07%. Interest payable semi-annually (presented net of unamortized
discount of $381 and $485 in 2003 and 2002, respectively)................... 149,619 149,515
Floating Rate Senior Notes repaid October 2003 (presented net of unamortized
discount of $127 in 2002)................................................... - 74,873
7.7% Senior Secured Notes maturing July 2007. Principal due in equal annual
installments of $7.1 million. Interest payable semi-annually............... 28,571 35,714
7.63% Notes payable to insurance companies maturing April 2006. Principal
due in equal annual installments of $3.3 million. Interest payable
semi-annually............................................................... 10,000 13,333
Notes payable to various individuals maturing September 2004. Interest
payable quarterly at adjusted LIBOR as defined (1.27% at December 31, 2003). 16,262 23,854
Bank revolvers payable:
$250.0 million revolving note expiring July 2005. Interest payable
quarterly at base rate (4.00% at December 31, 2003) or Eurodollar rate,
as defined (1.81% at December 31, 2003) and described below................. 66,000 15,000
M-I SWACO $150.0 million revolving note expiring July 2005.
Interest payable quarterly at base rate (4.00% at December 31,
2003) or Eurodollar rate, as defined
(1.81% at December 31, 2003) and described below............................ - -
Term Loans:
M-I SWACO 315.0 million Norwegian Krone term loan payable to a
financial institution. Principal due in semi-annual installments of
45.0 million Krone through June 2006. Interest payable semi-annually
at adjusted Norwegian Interbank Offered Rate (3.33% at December 31, 2003)... 31,118 -
Other......................................................................... 4,358 20,232
------------- -------------
525,205 551,681
Less-current portion of long-term debt........................................ (36,657) (109,714)
------------- --------------
Long-term Debt.............................................................. $ 488,548 $ 441,967
============= ==============
Principal payments of long-term debt for years subsequent to 2004 are
as follows:
2005............................................................ $ 96,566
2006............................................................ 15,726
2007............................................................ 156,868
2008............................................................ -
Thereafter...................................................... 219,388
-------------
$ 488,548
=============
38
The Company's short-term borrowings consist of amounts outstanding
under lines of credit and short-term loans. Certain subsidiaries of the Company
have unsecured credit facilities with non-U.S. banks aggregating $135.8 million.
At December 31, 2003, $82.7 million of additional borrowing capacity was
available under these facilities. These borrowings had a weighted average
interest rate of 8.3 percent and 8.0 percent at December 31, 2003 and 2002,
respectively.
In addition to the credit facilities discussed above, the Company has
an unsecured revolving credit facility provided by a syndicate of nine financial
institutions. The revolving credit agreement (the "Agreement"), which expires
July 2005, includes a $400.0 million committed line of credit with a $25.0
million letter of credit sub-facility. The Agreement allows for the election of
interest at a base rate, or a Eurodollar rate ranging from LIBOR plus 62.5 to
75.0 basis points depending on amounts drawn under the facility. The Agreement
also requires the payment of a quarterly commitment fee of 15 basis points on
the unutilized portion of the facility and compliance with certain customary
covenants, including maintenance of specified debt-to-total capitalization and
interest coverage ratios, as defined. The LIBOR interest margins and the
commitment fee are subject to adjustment depending on the senior debt rating of
the Company. As of December 31, 2003, the Company had $66.0 million drawn and
$18.2 million of letters of credit issued under the facility, resulting in
additional borrowing capacity of $315.8 million.
The 6.75 percent and 7.0 percent Senior Notes are unsecured obligations
of the Company issued under an Indenture dated September 8, 1997. The Indenture
contains no financial covenants, nor any restrictions related to the payment of
cash dividends to common stockholders. The Company's 6.75 percent and 7.0
percent Senior Notes are redeemable by the Company, in whole or in part, at any
time prior to maturity at a redemption price equal to accrued interest plus the
greater of the principal amount or the present value of the remaining principal
and interest payments.
The Company was in compliance with its loan covenants under the various
loan indentures, as amended, at December 31, 2003.
9. FINANCIAL INSTRUMENTS
Foreign Currency Contracts
The Company enters into spot and forward contracts as a hedge against
foreign currency denominated assets and liabilities and foreign currency
commitments. The terms of these contracts generally do not exceed two years. For
fair value hedges, settlement and market value gains and losses are recognized
currently through earnings, and the resulting amounts generally offset foreign
exchange gains or losses on the related accounts. Gains or losses on designated
cash flow hedge contracts are deferred to Accumulated other comprehensive income
and recognized in the consolidated statement of operations when the hedged item
affects earnings. As of December 31, 2003, the notional amounts of fair value
hedge contracts and cash flow hedge contracts outstanding were $45.5 million and
$9.2 million, respectively, and the fair value exceeded the notional amount of
these contracts by $1.9 million. As of December 31, 2002, the notional amounts
of fair value hedge contracts and cash flow hedge contracts outstanding were
$43.4 million and $31.4 million, respectively, and the fair value exceeded the
notional amount of these contracts by $3.6 million.
Fair Value of Other Financial Instruments
The recorded and fair values of long-term debt at December 31 are as
follows:
2003 2002
------------------------------------ -------------------------------
Recorded Fair Recorded Fair
Value Value Value Value
----------- ------------ ----------- -----------
Long-term Debt...................... $ 525,205 $ 576,917 $ 551,681 $ 597,143
The fair value of long-term debt was primarily determined using quoted
market prices. The fair value of the remaining financial instruments, including
cash and cash equivalents, receivables, payables and short-term borrowings,
approximates the carrying value due to the short-term nature of these
instruments.
39
10. INCOME TAXES
The geographical sources of income before income taxes and minority
interests for the three years ended December 31, 2003 were as follows:
2003 2002 2001
------------ ------------ ------------
Income before income taxes, minority interests and cumulative
effect of change in accounting principle:
United States........................................... $ 62,984 $ 40,198 $ 174,223
Non-United States....................................... 226,772 177,601 154,823
------------ ------------ ------------
Total................................................... $ 289,756 $ 217,799 $ 329,046
============ ============ ============
The income tax provision is summarized as follows:
2003 2002 2001
------------ ------------ ------------
Current:
United States........................................... $ 22,604 $ (3,027) $ 57,553
Non-United States....................................... 61,440 44,260 46,226
State................................................... 1,136 1,839 3,774
------------ ------------ ------------
85,180 43,072 107,553
------------ ------------ ------------
Deferred:
United States........................................... 756 18,738 (5,341)
Non-United States....................................... 7,398 4,822 4,185
------------ ------------ ------------
8,154 23,560 (1,156)
------------ ------------ ------------
Income tax provision...................................... $ 93,334 $ 66,632 $ 106,397
============ ============ ============
The consolidated effective tax rate (as a percentage of income before
income taxes, minority interests and cumulative effect of change in accounting
principle) is reconciled to the U.S. federal statutory tax rate as follows:
2003 2002 2001
------------ ------------ ------------
U.S. federal statutory tax rate............................ 35.0% 35.0% 35.0%
Minority partners' share of U.S. partnership earnings...... (3.1) (3.6) (4.3)
Non-deductible expenses.................................... 1.1 0.7 1.7
Benefit of foreign sales corporation and
extraterritorial income exclusion........................ (0.7) (0.7) (1.1)
State taxes, net........................................... 0.6 0.8 1.1
Non-U.S. tax provisions which vary from the
U.S. rate/non-U.S. losses with no tax benefit realized... 0.8 (1.2) -
Change in valuation allowance.............................. (1.3) - -
Other items, net........................................... (0.2) (0.5) (0.1)
------------- ----------- ------------
Effective tax rate......................................... 32.2% 30.5% 32.3%
============= =========== ============
40
The components of deferred taxes at December 31 are as follows:
2003 2002
------------ ------------
Deferred tax liabilities attributed to the excess of
net book basis over remaining tax basis (principally
depreciation):
United States.......................................... $ (60,795) $ (50,727)
Non-United States...................................... (46,517) (38,225)
------------ ------------
Total deferred tax liabilities........................... (107,312) (88,952)
------------ ------------
Deferred tax assets attributed to net operating loss
and tax credit carryforwards:
United States.......................................... - 2,088
Non-United States...................................... 16,039 21,817
Other deferred tax assets (principally accrued
liabilities not deductible until paid and inventories):
United States.......................................... 49,400 41,868
Non-United States...................................... 6,243 2,249
------------ ------------
Subtotal............................................. 71,682 68,022
Valuation allowance........................................ (15,283) (18,916)
------------ ------------
Total deferred tax assets................................ 56,399 49,106
------------ ------------
Net deferred tax liabilities......................... $ (50,913) $ (39,846)
============ ============
Balance sheet presentation:
Deferred tax assets, net................................. $ 31,238 $ 25,403
Other assets............................................. 4,140 6,263
Income taxes payable..................................... (6,226) (6,833)
Deferred tax liabilities................................. (80,065) (64,679)
------------ ------------
Net deferred tax liabilities......................... $ (50,913) $ (39,846)
============ ============
At December 31, 2003, the accompanying consolidated financial
statements include $16.0 million of deferred tax assets associated with
operating loss carryforwards in tax jurisdictions outside the United States.
Although the majority of these losses will carryforward indefinitely and are
available to reduce future tax liabilities of the respective foreign entity, we
do not currently believe the majority of these assets will be realized and have,
accordingly, established a $15.3 million valuation reserve.
The valuation allowance as of December 31, 2002 totaled $18.9 million
which consisted of established reserves for foreign operating loss carryforwards
as well as amounts associated with certain recorded U.S. deferred tax assets.
During 2003, the valuation allowance was reduced by $3.6 million as a result of
changes in the anticipated realizability of U.S. deferred tax assets.
The Company has provided additional taxes for the anticipated
repatriation of certain earnings of its non-U.S. subsidiaries. Undistributed
earnings above the amounts upon which additional taxes have been provided, which
approximated $108.6 million at December 31, 2003, are intended to be permanently
invested by the Company. It is not practicable to determine the amount of
applicable taxes that would be incurred if any of such earnings were
repatriated.
41
11. STOCKHOLDERS' EQUITY
Stock Split
On June 6, 2002, the Company's Board of Directors approved a
two-for-one stock split, effected in the form of a stock dividend. Stockholders
of record as of June 20, 2002 were entitled to the dividend, which was
distributed on July 8, 2002. Unless otherwise noted, all share and option
amounts included in the accompanying consolidated financial statements and
related notes reflect the effect of the stock split.
Treasury Share Repurchases
During 2001, the Company's Board of Directors authorized a share
buyback program which allows for the repurchase of up to five million shares of
common stock, subject to regulatory issues, market considerations and other
factors. During 2001, the Company repurchased 536,200 shares, on a pre-split
basis, of common stock at an aggregate cost of $21.4 million. The acquired
shares, as adjusted for the two-for-one stock split, have been added to the
Company's treasury stock holdings and may be used in the future for acquisitions
or other corporate purposes. Future repurchases under the program may be
executed from time to time in the open market or in privately negotiated
transactions.
Stockholder Rights Plan
On June 8, 2000, the Company adopted a Stockholder Rights Plan (the
"Rights Plan") to replace a similar plan which expired on June 19, 2000. As part
of the Rights Plan, the Company's Board of Directors declared a dividend of one
preferred stock purchase right ("Right") for each share of the Company's common
stock outstanding on June 20, 2000. The Board also authorized the issuance of
one such Right for each share of the Company's common stock issued after June
20, 2000 until the occurrence of certain events.
The Rights are exercisable upon the occurrence of certain events
related to a person (an "Acquiring Person") acquiring or announcing the
intention to acquire beneficial ownership of 20 percent or more of the Company's
common stock. When the rights become exercisable, each holder (except an
Acquiring Person) will be entitled to purchase, at an effective exercise price
of $175, shares of the Company's common stock having a market value of twice the
Right's exercise price, subject to adjustment. The Acquiring Person will not be
entitled to exercise these Rights. In addition, if the Company is involved in a
merger or other business combination transaction, or sells 50 percent or more of
its assets or earning power to another entity, each Right will entitle its
holder to purchase, at the Right's then current exercise price, shares of common
stock of such other entity having a value of twice the Right's exercise price.
The Rights are subject to redemption at the option of the Board of
Directors at a price of one-half of a cent per Right until the occurrence of
certain events. The Rights currently trade with the Company's common stock, have
no voting or dividend rights and expire on June 8, 2010.
Accumulated Other Comprehensive Income
Accumulated other comprehensive income in the accompanying consolidated
balance sheets consists of the following:
2003 2002
----------- -----------
Currency translation adjustments..................................................... $ 12,820 $ (9,253)
Unrealized fair value of derivatives................................................. 2,339 2,303
Pension liability adjustments........................................................ (3,534) (3,485)
----------- -----------
Accumulated other comprehensive income (loss)........................................ $ 11,625 $ (10,435)
=========== ===========
Approximately $1.7 million of the cumulative changes in unrealized fair
value of derivatives is expected to be recognized as after-tax earnings during
the fiscal year ending December 31, 2004.
42
12. RETIREMENT PLANS
Defined Contribution Plans
The Company established the Smith International, Inc. 401(k) Retirement
Plan (the "Smith Plan") for the benefit of all eligible employees. Employees may
voluntarily contribute up to 12 percent of compensation, as defined, to the
Smith Plan. The Company makes retirement, matching and, in certain cases,
discretionary matching contributions to each participant's account under the
Smith Plan. Participants receive a full match of the first 1 1/2 percent of
their contributions along with a retirement contribution ranging from two
percent to six percent of their qualified compensation. In addition, the Board
of Directors may provide discretionary matching contributions based upon
financial performance to participants who are employed by the Company on
December 31.
M-I SWACO has a Company Profit-Sharing and Savings Plan (the "M-I SWACO
401(k) Plan") under which participating employees may contribute up to 15
percent of their compensation, as defined. Under the terms of this plan,
qualified employees are eligible to receive basic, matching and profit-sharing
contributions with the approval of the Employee Benefits Committee and, in
certain instances, the Board of Directors. Participants are eligible to receive
a basic contribution equal to three percent of qualified compensation, and a
full match of the first 1 1/2 percent of their contributions. In addition, the
Board of Directors may provide discretionary profit-sharing contributions based
upon financial performance to participants who are employed by M-I SWACO on
December 31.
The Company recognized expense totaling $25.0 million, $17.6 million
and $25.5 million in 2003, 2002 and 2001, respectively, related to Company
contributions to the plans.
Certain of the Company's subsidiaries sponsor various defined
contribution plans. The Company's contributions under these plans for each of
the three years in the period ended December 31, 2003, were immaterial.
Deferred Compensation Plan
The Company maintains a Supplemental Executive Retirement Plan
("SERP"), a non-qualified, deferred compensation program, for the benefit of
officers and certain other eligible employees of the Company. Participants may
contribute, on a pre-tax basis, amounts ranging from 50 to 100 percent of cash
compensation, as defined. Plan provisions allow for retirement and matching
contributions, similar to those provided under the Company's defined
contribution programs, and, in certain cases, an interest contribution in order
to provide a yield on short-term investments equal to 120 percent of the
long-term applicable federal rate, as defined.
In the event of insolvency or bankruptcy, plan assets are available to
satisfy the claims of all general creditors of the Company. Accordingly, the
accompanying consolidated balance sheets reflect the aggregate participant
balances as both an asset and a liability of the Company. As of December 31,
2003 and 2002, $35.8 million and $30.6 million, respectively, are included in
Other Assets with a corresponding amount recorded in Other Long-Term
Liabilities.
During the years ended December 31, 2003, 2002 and 2001, Company
contributions to the plan totaled $2.4 million, $1.9 million and $1.1 million,
respectively.
43
13. EMPLOYEE BENEFIT PLANS
The Company currently maintains various noncontributory defined benefit
pension plans covering certain U.S. and non-U.S. employees. Future benefit
accruals and the addition of new participants under the U.S. plans were frozen
prior to 1998.
The Company and certain subsidiaries have postretirement benefit plans
which provide health care benefits to a limited number of current, and in
certain cases, future retirees. Individuals who elect to contribute premiums are
eligible to participate in the Company's medical and prescription drug programs,
with certain limitations. In addition to premiums, the retiree is responsible
for deductibles and any required co-payments and is subject to annual and
lifetime dollar spending caps.
The following tables disclose the changes in benefit obligations and
plan assets during the periods presented and reconcile the funded status of the
plans to the amounts included in the accompanying consolidated balance sheets:
PENSION PLANS POSTRETIREMENT BENEFIT PLANS
------------------------------- --------------------------------
2003 2002 2003 2002
--------------- -------------- -------------- ---------------
Changes in benefit obligations:
Benefit obligations at beginning of year......... $ 17,307 $ 16,251 $ 10,581 $ 15,709
Service cost..................................... - 11 219 220
Interest cost.................................... 1,120 1,145 685 981
Plan participants' contributions................. - - 735 624
Actuarial loss (gain)............................ 1,503 789 783 (4,084)
Plan amendments.................................. - - - (1,435)
Benefits paid.................................... (987) (889) (1,843) (1,434)
----------- ----------- ----------- -----------
Benefit obligations at end of year............... $ 18,943 $ 17,307 $ 11,160 $ 10,581
=========== =========== =========== ===========
Changes in plan assets:
Fair value of plan assets at beginning of year... $ 13,740 $ 13,288 $ - $ -
Actual return on plan assets..................... 2,293 (1,164) - -
Employer contributions........................... 570 2,505 1,108 810
Plan participants' contributions................. - - 735 624
Benefits paid.................................... (987) (889) (1,843) (1,434)
----------- ----------- ----------- ------------
Fair value of plan assets at end of year......... $ 15,616 $ 13,740 $ - $ -
=========== =========== =========== ============
Funded status.................................... $ (3,327) $ (3,567) $ (11,160) $ (10,581)
Unrecognized net actuarial loss (gain)........... 4,864 5,073 (3,391) (4,425)
Unrecognized prior service cost.................. - - (1,916) (2,281)
----------- ----------- ----------- -----------
Net prepaid benefit (accrued liability).......... $ 1,537 $ 1,506 $ (16,467) $ (17,287)
=========== =========== =========== ===========
The net prepaid benefit associated with the Pension Plans is reflected
in the accompanying consolidated balance sheets in the following captions:
Prepaid expenses and other....................... $ 1,453 $ 1,422
Other long-term liabilities...................... (5,087) (5,012)
Accumulated other comprehensive income........... 5,171 5,096
----------- -----------
Net amount recognized............................ $ 1,537 $ 1,506
=========== ===========
Accrued liabilities associated with the Postretirement Benefit Plans,
which totaled $16.5 million and $17.3 million as of December 31, 2003 and 2002,
respectively, are reflected in the accompanying consolidated balance sheets as
Other Long-Term Liabilities.
Company contributions to the pension and postretirement benefit plans
during 2004 are expected to be comparable to the aggregate of $1.7 million
contributed in 2003.
44
Net periodic benefit expense and the weighted average assumptions used
to determine the net benefit expense for the fiscal years ended December 31 and
the projected benefit obligation at December 31 are as follows:
PENSION PLANS POSTRETIREMENT BENEFIT PLANS
---------------------------------------- -------------------------------------
2003 2002 2001 2003 2002 2001
----------- ----------- ----------- ---------- ---------- ---------
Components of net periodic benefit expense:
Service cost............................. $ - $ 11 $ 50 $ 219 $ 220 $ 221
Interest cost............................ 1,120 1,145 1,061 685 981 993
Return on plan assets.................... (960) (988) (887) - - -
Amortization of prior service cost....... - - - (365) (243) (234)
Amortization of loss (gain).............. 295 73 260 (251) (243) (350)
----------- ----------- ----------- ---------- ---------- --------
Net periodic benefit expense............. $ 455 $ 241 $ 484 $ 288 $ 715 $ 630
=========== =========== =========== ========== ========== ========
Net periodic benefit expense:
Discount rate............................ 6.75% 7.25% 7.40% 6.75% 7.25% 7.40%
Expected return on plan assets........... 8.50% 8.50% 8.50% N/A N/A N/A
Projected benefit obligation:
Discount rate............................ 6.00% 6.75% 7.25% 6.00% 6.75% 7.25%
Expected return on plan assets........... 8.50% 8.50% 8.50% N/A N/A N/A
Additional Pension Plan Information
In determining the expected return on plan assets, the Company
considers the investment mix, the historical market performance and economic and
other indicators of future performance. The Company primarily utilizes a mix of
common stock and fixed income index funds to generate asset returns comparable
with the general market. The investment mix of pension assets at December 31 is
summarized in the following table:
2003 2002
---------- ---------
Common stock and related index funds............................................... 70% 35%
Fixed income securities and related index funds.................................... 25 20
Insurance annuities................................................................ - 25
Money market funds................................................................. 5 20
---------- ---------
Total......................................................................... 100% 100%
========== =========
For pension plans with accumulated benefit obligations in excess of
plan assets, the following table sets forth the projected and accumulated
benefit obligations and the fair value of plan assets at December 31:
2003 2002
---------- ----------
Projected benefit obligation............................................................. $ 18,943 $ 17,307
Accumulated benefit obligation........................................................... 18,943 17,247
Plan assets at fair value................................................................ 15,616 13,740
45
Additional Postretirement Benefit Plan Information
The assumed health care cost trend rates used to determine the
projected postretirement benefit obligation at December 31 are as follows:
2003 2002
------------ -----------
Health care cost trend rate for current year......... 10% 11%
Rate that the cost trend rate gradually declines
(ultimate trend rate)............................... 5% 5%
Year that the rate reaches the ultimate trend rate... 2008 2008
A one-percentage point change in assumed health care cost trend rates
would have the following effects on the benefit obligations and the aggregate of
the service and interest cost components of the postretirement benefits expense:
ONE-PERCENTAGE- ONE-PERCENTAGE-
POINT INCREASE POINT DECREASE
-------------- --------------
Effect on total service and interest cost.................... $ 81 $ (86)
Effect on accumulated postretirement benefit obligation...... 483 (711)
46
14. EMPLOYEE STOCK OPTIONS
A summary of the Company's stock option program is presented below.
SHARES WEIGHTED AVERAGE
UNDER OPTION EXERCISE PRICE
--------------- ----------------
Outstanding at December 31, 2000........................... 4,303,382 $ 21.31
Options granted............................................ 1,266,600 23.50
Options forfeited.......................................... (59,184) 19.54
Options exercised.......................................... (342,000) 16.13
--------------- ----------------
Outstanding at December 31, 2001........................... 5,168,798 22.21
Options granted............................................ 1,399,180 33.66
Options forfeited.......................................... (116,722) 24.43
Options exercised.......................................... (223,492) 13.93
--------------- ----------------
Outstanding at December 31, 2002........................... 6,227,764 25.04
Options granted............................................ 1,047,000 38.82
Options forfeited.......................................... (38,196) 29.77
Options exercised.......................................... (1,161,564) 19.02
--------------- ----------------
Outstanding at December 31, 2003........................... 6,075,004 $ 28.53
=============== ================
The number of outstanding fixed stock options exercisable at December
31, 2002 and 2001 was 3,205,106 and 2,344,510, respectively. These options had a
weighted average exercise price of $21.21 and $20.46 at December 31, 2002 and
2001, respectively. The following summarizes information about fixed stock
options outstanding at December 31, 2003:
Options Outstanding Options Exercisable
--------------------------------------------------- -----------------------------
Weighted Weighted Weighted
Average Average Average
Range of Number Remaining Exercise Number Exercise
Exercise Prices Outstanding Contractual Life Price Exercisable Price
------------------------ --------------- ------------------ ----------- ------------ -------------
$ 6.56 - $ 8.94 15,268 1.3 $ 7.36 15,268 $ 7.36
$11.78 - $19.60 1,147,022 5.5 16.40 1,147,022 16.40
$20.56 - $27.82 1,480,569 7.2 23.14 847,497 22.85
$30.75 - $38.82 3,432,145 8.3 35.01 1,252,029 32.73
--------------- ------------------ ----------- ------------ -------------
6,075,004 7.5 $ 28.53 3,261,816 $ 24.30
=============== ================== =========== ============ =============
The pro forma net income and earnings per share data disclosed in Note
1 has been determined as if the Company had accounted for its employee
stock-based compensation program under the fair value method of SFAS No. 123.
The Company used the Black-Scholes option-pricing model to determine the fair
value of each option grant and, accordingly, calculate the stock-based
compensation expense. The fair value and assumptions used are as follows:
2003 2002 2001
------------------ ------------------ ------------------
Fair value of stock options granted................. $13.02 $15.36 $11.89
Expected life of option (years)..................... 5.0 5.0 6.0
Expected stock volatility........................... 31.0% 46.3% 47.0%
Expected dividend yield............................. N/A N/A N/A
Risk-free interest rate............................. 3.5% 3.2% 4.2%
47
15. INDUSTRY SEGMENTS AND INTERNATIONAL 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 aggregates its operations into two
reportable segments: Oilfield Products and Services and Distribution. The
Oilfield Products and Services segment consists of three business units: M-I
SWACO, which provides drilling and completion fluid systems and services,
solids-control and separation equipment, waste-management services and oilfield
production chemicals; Smith Technologies, which designs, manufactures and sells
three-cone drill bits, diamond drill bits and turbine products; and Smith
Services, which manufactures and markets products and services used for
drilling, workover, well completion and well re-entry operations. The principal
markets for the Oilfield segment include all major oil and gas-producing regions
of the world, with approximately 60 percent of revenues generated in markets
outside of North America. Oilfield segment customers primarily include major
multi-national, independent and national, or state-owned, oil companies.
The Distribution segment consists of one business unit, Wilson, which
markets pipe, valves, fittings and mill, safety and other maintenance products
to energy and industrial markets. The Distribution segment has the most
significant North American exposure of any of the Company's operations with
approximately 90 percent of revenues derived in the United States and Canada.
Approximately two-thirds of Wilson's revenues are generated from customers in
the energy sector, which includes major multi-national and independent oil
companies, pipeline companies and contract drilling companies. The remainder
relates to sales in the downstream and industrial markets, which primarily
includes refineries, petrochemical and power generation plants.
The Company's revenues are derived principally from uncollateralized
customer sales. The significant energy industry concentration has the potential
to impact the Company's exposure to credit risk, either positively or
negatively, because customers may be similarly affected by changes in economic
or other conditions. The creditworthiness of the Company's customer base is
strong, with limited credit losses experienced on such receivables.
The following table presents financial information for each reportable
segment:
2003 2002 2001
------------ ------------ ------------
Revenues:
Oilfield Products and Services.................... $ 2,678,274 $ 2,282,909 $ 2,424,131
Distribution...................................... 916,554 887,171 1,127,078
------------ ------------ ------------
$ 3,594,828 $ 3,170,080 $ 3,551,209
============ ============ ============
Operating Income (Loss):
Oilfield Products and Services.................... $ 343,486 $ 266,692 $ 354,614
Distribution...................................... (7,897) (4,026) 22,893
General corporate................................. (6,842) (6,518) (5,997)
------------ ------------ ------------
$ 328,747 $ 256,148 $ 371,510
============ ============ ============
Capital Expenditures:
Oilfield Products and Services.................... $ 96,458 $ 91,056 $ 118,350
Distribution...................................... 2,009 3,401 7,173
General corporate................................. 456 2,594 2,119
------------ ------------ ------------
$ 98,923 $ 97,051 $ 127,642
============ ============ ============
Depreciation and Amortization:
Oilfield Products and Services.................... $ 93,541 $ 81,924 $ 84,311
Distribution...................................... 6,913 5,857 7,687
General corporate................................. 1,255 1,546 897
------------ ------------ ------------
$ 101,709 $ 89,327 $ 92,895
============ ============ ============
Total Assets:
Oilfield Products and Services.................... $ 2,584,044 $ 2,284,109 $ 2,250,332
Distribution...................................... 405,413 368,206 386,986
General corporate................................. 107,590 97,230 98,510
------------ ------------ ------------
$ 3,097,047 $ 2,749,545 $ 2,735,828
============ ============ ============
48
The following table presents consolidated revenues by region:
2003 2002 2001
------------ ------------ -------------
United States....................................... $ 1,592,243 $ 1,492,710 $ 1,829,378
Canada.............................................. 362,874 286,640 400,124
------------ ------------ -------------
North America..................................... 1,955,117 1,779,350 2,229,502
------------ ------------ -------------
Latin America....................................... 344,283 305,498 383,255
Europe/Africa....................................... 855,916 681,947 626,831
Middle East......................................... 302,872 276,365 195,922
Far East............................................ 136,640 126,920 115,699
------------ ------------ -------------
Non-North America................................. 1,639,711 1,390,730 1,321,707
------------ ------------ -------------
$ 3,594,828 $ 3,170,080 $ 3,551,209
============ ============ =============
The following table presents net property, plant and equipment by
region:
2003 2002 2001
------------ ------------ ------------
United States....................................... $ 295,243 $ 299,206 $ 287,630
Canada.............................................. 29,918 27,854 29,012
------------ ------------ ------------
North America..................................... 325,161 327,060 316,642
------------ ------------ ------------
Latin America....................................... 51,831 49,469 60,150
Europe/Africa....................................... 107,347 102,188 82,247
Middle East......................................... 32,364 24,988 18,208
Far East............................................ 18,168 15,515 11,250
------------ ------------ ------------
Non-North America................................. 209,710 192,160 171,855
------------ ------------ ------------
$ 534,871 $ 519,220 $ 488,497
============ ============ ============
The Company's expenditures for research and engineering activities are
attributable to the Company's Oilfield Products and Services segment and totaled
$55.6 million in 2003, $50.6 million in 2002 and $50.8 million in 2001.
16. COMMITMENTS AND CONTINGENCIES
Leases
The Company routinely enters into operating and capital leases for
certain of its facilities and equipment. Amounts related to assets under capital
lease were immaterial for the periods presented. Rent expense totaled $69.2
million, $61.3 million and $51.4 million in 2003, 2002 and 2001, respectively.
Future minimum payments under non-cancelable operating leases having
initial terms of one year or more are as follows:
AMOUNT
----------------
2004.................................................. $ 35,231
2005.................................................. 27,290
2006.................................................. 20,392
2007.................................................. 14,535
2008.................................................. 10,314
2009-2013............................................. 21,241
Thereafter............................................ 19,921
----------------
$ 148,924
================
In the normal course of business, the Company enters into lease
agreements with cancellation provisions as well as agreements with initial terms
of less than one year. The costs related to these leases have been reflected in
rent expense but have been appropriately excluded from the future minimum
payments presented above.
49
Standby Letters of Credit and Guarantees
In the normal course of business with customers, vendors and others,
the Company is contingently liable for its performance under standby letters of
credit and bid, performance and surety bonds. Certain of these outstanding
instruments guarantee payment of notes issued to former shareholders of an
acquired entity as well as to insurance companies which reinsure certain
liability coverages of the Company's insurance captive. Excluding the impact of
these instruments, for which $31.6 million of related liabilities are reflected
in the accompanying consolidated balance sheet, the Company is contingently
liable for approximately $41.6 million of standby letters of credit and bid,
performance and surety bonds at December 31, 2003. Management does not expect
any material amounts to be drawn on these instruments.
The Company has also provided loan guarantees related to certain joint
ventures accounted for under the equity method of accounting. As the net assets
and cash flows of these entities are available to satisfy obligations as they
become due, management believes the likelihood is remote that the Company will
be required to perform under these guarantees. The Company's estimated maximum
exposure under these loan guarantees approximated $17.2 million as of December
31, 2003.
Insurance
The Company maintains insurance coverage for various aspects of its
business and operations. The Company has elected to retain a portion of losses
that occur through the use of deductibles and retentions under its insurance
programs. Amounts in excess of the self-insured retention levels are fully
insured to limits believed appropriate for the Company's operations.
Self-insurance accruals are based on claims filed and an estimate for claims
incurred but not reported. While management believes that amounts accrued in the
accompanying consolidated financial statements are adequate for expected
liabilities arising from the Company's portion of losses, estimates of these
liabilities may change as circumstances develop.
Litigation
The Company is a defendant in various legal proceedings arising in the
ordinary course of business. In the opinion of management, these matters will
not have a material adverse effect on the Company's consolidated financial
position or results of operations.
Environmental
The Company routinely establishes and reviews the adequacy of reserves
for estimated future environmental clean-up costs for properties currently or
previously operated by the Company.
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 SWACO operations, which are
subject to various indemnifications from former owners.
As of December 31, 2003, the Company's environmental reserve
approximated $10.0 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 December 31, 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 SWACO's former owners to address issues
associated with certain provisions of the environmental indemnification
provided. This matter is expected to go to trial during the fourth quarter of
2004. In the event that i) M-I SWACO'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.
50
17. QUARTERLY INFORMATION (UNAUDITED)
FIRST SECOND THIRD FOURTH YEAR
------------- ------------- ------------- -------------- ----------------
(In thousands, except per share data)
2003
Revenues................................... $ 808,837 $ 877,657 $ 924,792 $ 983,542 $ 3,594,828
Gross profit............................... 238,343 261,910 278,402 297,276 1,075,931
Income before cumulative effect of
change in accounting principle........... 21,715 29,900 35,004 38,015 124,634
Net income................................. 20,561 29,900 35,004 38,015 123,480
EPS before cumulative effect of change
in accounting principle:
Basic.................................... 0.22 0.30 0.35 0.38 1.25
Diluted.................................. 0.22 0.30 0.35 0.38 1.24
2002
Revenues................................... $ 827,377 $ 801,038 $ 777,232 $ 764,433 $ 3,170,080
Gross profit............................... 241,502 236,255 217,725 222,820 918,302
Net income................................. 28,730 26,922 19,790 17,747 93,189
EPS:
Basic.................................... 0.29 0.27 0.20 0.18 0.94
Diluted.................................. 0.29 0.27 0.20 0.18 0.93
51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On April 18, 2002, the Company filed a Form 8-K reporting the dismissal
of the Company's independent public accountants, Arthur Andersen LLP, and the
engagement of Deloitte & Touche LLP as its new independent auditors.
ITEM 9A. 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 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.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information concerning directors of the Registrant, see the
information set forth following the caption "ELECTION OF DIRECTORS" in the
Company's definitive proxy statement to be filed no later than 120 days after
the end of the fiscal year covered by this Form 10-K (the "Proxy Statement"),
which information is incorporated herein by reference. For information
concerning executive officers of the Registrant, see Item 4A appearing in Part I
of this Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth following the caption "EXECUTIVE
COMPENSATION" in the Company's Proxy Statement is incorporated herein by
reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth following the captions "ELECTION OF
DIRECTORS", "STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "Equity
Compensation Plan Information" in the Company's Proxy Statement is incorporated
herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information set forth following the captions "ELECTION OF
DIRECTORS" and "EXECUTIVE COMPENSATION" in the Company's Proxy Statement is
incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information set forth following the captions "Fees Paid to Deloitte
& Touche LLP" in the Company's Proxy Statement is incorporated herein by
reference.
52
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORT ON FORM 8-K
(A) FINANCIAL STATEMENTS
PAGE
REFERENCE
(1) Financial statements included in this report:
Report of Independent Public Accountants........................................................... 23
Independent Auditors' Report....................................................................... 24
Consolidated Balance Sheets at December 31, 2003 and 2002.......................................... 25
Consolidated Statements of Operations for the years ended
December 31, 2003, 2002 and 2001................................................................. 26
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001................................................................. 27
Consolidated Statements of Stockholders' Equity and Comprehensive Income
for the years ended December 31, 2003, 2002 and 2001............................................. 28
Notes to Consolidated Financial Statements......................................................... 29
(2) Financial Statement Schedule II-Valuation and Qualifying Accounts and Reserves..................... 56
All other schedules have been omitted since the required information is
not present or not present in amounts sufficient to require submission of the
schedule or because the information required is included in the consolidated
financial statements or notes thereto.
(3) Exhibits and Index to Exhibits
3.1 - Restated Certificate of Incorporation of the Company as amended by Certificate of Amendment
of Articles of Incorporation of the Company, dated as of July 8, 1987, and Certificate of
Amendment to Restated Certificate of Incorporation of the Company, dated November 17, 1987.
Filed as Exhibit 3.1 to the Company's report on Form 10-K for the year ended December 31,
1993 and incorporated herein by reference.
3.2 - Certificate of Amendment to Restated Certificate of Incorporation of the Company, dated
May 23, 2001. Filed as Exhibit 3.2 to the Company's Registration Statement on Form S-8
dated July 26, 2001 and incorporated herein by reference.
3.3 - Bylaws of the Company as amended to date. Filed as Exhibit 3.1 to the Company's report on
Form 8-K dated August 13, 1998 (and filed on August 14, 1998) and incorporated herein by
reference.
4.1 - Rights Agreement, dated as of June 8, 2000, between the Company and First Chicago Trust
Company of New York, as Rights Agent. Filed as Exhibit 4.1 to the Company's report on Form
8-A, dated June 15, 2000, and incorporated herein by reference.
4.2 - Amendment to Rights Agreement dated June 8, 2000, by and among the Company and First Chicago
Trust Company of New York and effective as of October 1, 2001. Filed as Exhibit 4.1 to the
Company's report on Form 10-Q for the quarter ended September 30, 2001 and incorporated
herein by reference.
4.3 - Amendment No. 2 to Rights Agreement by and among the Company and EquiServe Trust Company,
N.A. and effective as of December 31, 2002. Filed as Exhibit 4.3 to the Company's report on
Form 10-K for the year ended December 31, 2002 and incorporated herein by reference.
53
4.4 - Form of Indenture between the Company and The Bank of New York, as Trustee. Filed as
Exhibit 4.1 to the Company's Registration Statement on Form S-3 dated August 22, 1997 and
incorporated herein by reference.
4.5 - Form of Note. Filed as Exhibit 4.2 to Amendment No. 1 to the Company's Registration
Statement on Form S-3 dated September 9, 1997 and incorporated herein by reference.
4.6 - Form of Note. Filed as Exhibit 4.1 to the Company's report on Form 8-K dated February 13,
2001 and incorporated herein by reference.
9. - Not applicable.
10.1 - Smith International, Inc. 1989 Long Term Incentive Compensation Plan, as amended to date.
Filed as Exhibit 10.1 to the Company's report on Form 10-K for the year ended December 31,
2002 and incorporated herein by reference.
10.2 - Smith International, Inc. Stock Plan for Outside Directors, as amended and restated
effective April 22, 2003.
10.3 - Smith International, Inc. Supplemental Executive Retirement Plan, as amended to date. Filed
as Exhibit 10.1 to the Company's report on Form 10-Q for the quarter ended September 30,
2001 and incorporated herein by reference.
10.6 - Employment Agreement dated December 10, 1987 between the Company and Douglas L. Rock. Filed
as Exhibit 10.11 to the Company's report on Form 10-K for the year ended December 31, 1993 and
incorporated herein by reference.
10.7 - Employment Agreement dated January 2, 1991 between the Company and Neal S. Sutton. Filed as
Exhibit 10.11 to the Company's report on Form 10-K for the year ended December 31, 1996 and
incorporated herein by reference.
10.8 - Employment Agreement dated May 1, 1991 between the Company and Richard A. Werner. Filed as
Exhibit 10.12 to the Company's report on Form 10-K for the year ended December 31, 1996 and
incorporated herein by reference.
10.9 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and Douglas
L. Rock. Filed as Exhibit 10.11 to the Company's report on Form 10-K for the year ended
December 31, 1999 and incorporated herein by reference.
10.10 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and Neal S.
Sutton. Filed as Exhibit 10.12 to the Company's report on Form 10-K for the year ended
December 31, 1999 and incorporated herein by reference.
10.12 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and Loren
K. Carroll. Filed as Exhibit 10.14 to the Company's report on Form 10-K for the year ended
December 31, 1999 and incorporated herein by reference.
10.13 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and
Margaret K. Dorman. Filed as Exhibit 10.15 to the Company's report on Form 10-K for the
year ended December 31, 1999 and incorporated herein by reference.
10.14 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and John J.
Kennedy. Filed as Exhibit 10.16 to the Company's report on Form 10-K for the year ended
December 31, 1999 and incorporated herein by reference.
54
10.15 - Change-of-Control Employment Agreement dated January 4, 2000 between the Company and Roger
A. Brown. Filed as Exhibit 10.17 to the Company's report on Form 10-K for the year ended
December 31, 1999 and incorporated herein by reference.
10.16 - Credit Agreement dated as of July 10, 2002 among the Company and M-I L.L.C., the Lenders
parties thereto and Comerica Bank, as Administrative Agent, ABN AMRO Bank N.V., as
Syndication Agent, Den Norske Bank ASA, as Documentation Agent, J.P. Morgan Securities Inc.,
and Credit Lyonnais New York Branch, as Co-Lead Arrangers and Joint Bookrunners. Filed as
Exhibit 10.1 to the Company's report on Form 10-Q for the quarter ended September 30, 2002
and incorporated herein by reference.
11. - Not applicable.
12. - Not applicable.
13. - Not applicable.
14. - Smith International, Inc. Code of Business Conduct and Ethics.
18. - Not applicable.
19. - Not applicable.
21.1 - Subsidiaries of the Company. Filed as Exhibit 21.1 to the Company's report on Form 10-K for
the year ended December 31, 2002 and incorporated herein by reference.
23.1 - Independent Auditors' Consent.
23.2 - Notice regarding Consent of Independent Public Accountants.
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,
filed herewith.
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,
filed herewith.
32.1 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, furnished herewith.
(B) REPORT ON FORM 8-K.
The Registrant filed a report on Form 8-K during the quarterly period
ended December 31, 2003. The filing was reported under "Item 7. Financial
Statements and Exhibits" and "Item 12. Disclosure of Results of Operations and
Financial Condition" and disclosed the following:
Form 8-K dated October 17, 2003 relating to a press release announcing
the Company's results for the quarter ended September 30, 2003.
55
SCHEDULE II
SMITH INTERNATIONAL, INC.
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(In thousands)
ADDITIONS DEDUCTIONS
------------------------------ -----------
BALANCE AT CHARGED BALANCE
BEGINNING TO AT END
OF YEAR EXPENSE OTHER(A) WRITE-OFFS OF YEAR
----------- ----------- ---------- ---------- ----------
Allowance for doubtful accounts:
Year ended December 31, 2003 $ 12,338 $ 3,835 $ - $ (4,038) $ 12,135
Year ended December 31, 2002 10,921 9,593 - (8,176) 12,338
Year ended December 31, 2001 10,211 2,986 1,029 (3,305) 10,921
(a) Amounts represent accounts receivable reserves related to acquisitions made
by the Company during the years presented.
56
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SMITH INTERNATIONAL, INC.
March 15, 2004 By: /s/ DOUG ROCK
-------------------------------------
Doug Rock
Chief Executive Officer,
President and Chief Operating Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities on the date indicated:
/s/ DOUG ROCK Chairman of the Board, March 15, 2004
------------------------ Chief Executive Officer,
(Doug Rock) President and
Chief Operating Officer
/s/ LOREN K. CARROLL Executive Vice President March 15, 2004
------------------------ and Director
(Loren K. Carroll)
/s/ MARGARET K. DORMAN Senior Vice President, March 15, 2004
------------------------ Chief Financial Officer
(Margaret K. Dorman) and Treasurer
/s/ BENJAMIN F. BAILAR Director March 15, 2004
------------------------
(Benjamin F. Bailar)
/s/ G. CLYDE BUCK Director March 15, 2004
------------------------
(G. Clyde Buck)
/s/ JAMES R. GIBBS Director March 15, 2004
------------------------
(James R. Gibbs)
/s/ JERRY W. NEELY Director March 15, 2004
------------------------
(Jerry W. Neely)
57
INDEX TO EXHIBITS
EXHIBIT NO. DESCRIPTION
----------- -----------
10.2 - Smith International, Inc. Stock Plan for Outside Directors,
as amended and restated effective April 22, 2003.
14. - Smith International, Inc. Code of Business Conduct and
Ethics.
23.1 - Independent Auditors' Consent.
23.2 - Notice regarding Consent of Independent Public Accountants.
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, filed herewith.
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, filed herewith.
32.1 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
furnished herewith.
58