MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following "Management's Discussion and Analysis of Financial Condition and Results of Operations" is provided to assist readers in understanding the Company's financial performance during the periods presented and significant trends which may impact the future performance of the Company. It should be read in conjunction with the Consolidated Financial Statements of the Company and the related notes thereto included elsewhere in this Annual Report.

The Company's primary business is the manufacture and sale of premium products and services to the oil and gas industry's exploration and production sectors. The Company's worldwide operations are largely driven by the level of exploration and production activity in major energy producing areas and the depth and drilling conditions of these projects. The level of worldwide drilling activity is influenced by the prices of oil and natural gas but may also be affected by political actions and uncertainties, environmental concerns, capital expenditure plans of exploration and production companies and the overall level of global economic growth and activity.

Management anticipates that total worldwide drilling activity will continue to increase from historical activity levels; however, the rate of growth may be lower than the 1996 growth rate. The average worldwide rig count increased approximately 7 percent over 1995 levels due to strong North American growth which was driven by higher U.S. land rig activity and record Canadian activity levels. The 1997 worldwide rig count is expected to increase from 1996 levels due to higher non-North American rig count activity, primarily in Latin America and the Middle and Far East geographic regions. Management believes that the Company's operations are well positioned to benefit from the expected increase in non-North American oil and gas drilling activity.

Management also believes, with the increase in offshore rig dayrates and other fixed costs, operators are shifting exploration and production spending toward value-added, technology-based products which reduce the cost of their overall drilling programs. Additionally, the significant level of extended-reach drilling programs, which often involve more difficult drilling conditions, increases the need for efficient products and services which reduce both drilling time and formation damage. The Company continues to focus on investing in the development of technology-based products which considerably improve the drilling process through increased efficiency and rates of penetration. Management believes the overall savings realized by the use of the Company's premium products, such as polycrystalline diamond drill bits, diamond enhanced three-cone drill bits and synthetic drilling fluids, compensate for the higher costs of these products over their non-premium counterparts.

The Company operates through four business units which market the products manufactured and services provided throughout the world. The following table presents revenue and average rig count information for the periods shown (in thousands, except rig count information):

Total

Total

Total

Smith Tool manufactures and sells three-cone bits for use in the oil and gas industry and in mining applications. Smith Tool's 1996 revenues increased $29.6 million, or 18 percent, from 1995 and 1995 revenues increased $12.2 million, or 8 percent, from 1994. The increase over 1995 relates to improved pricing, increased unit sales and a favorable shift in the sales mix toward premium bits. The majority of the increase from 1995 was generated in the United States; however, the introduction of the Magnum line of premium bits in the North Sea contributed to a significant increase in Europe/Africa revenues. Again, higher unit sales, improved pricing in the U.S. and higher non-North American drilling activity levels account for the majority of the revenue increase over 1994.

Smith Drilling & Completions manufactures and markets products and services used in the oil and gas industry for drilling, workover, well completion and well re-entry. Smith Drilling & Completions' 1996 revenues increased $33.5 million over 1995 and 1995 revenues increased $23.2 million over 1994. The increase in revenues over 1995 relates primarily to the increased level of re-entry activity in the U.S. Gulf Coast area and the addition of The Red Baron (Oil Tools Rental) Ltd.'s ("Red Baron") operations, which were acquired in October 1996. The variance over 1994 primarily relates to the increased sales volumes associated with higher non-North American drilling activity.

Smith Diamond Technology manufactures and markets shear bits featuring cutters made of polycrystalline diamond ("PDC") or natural diamond at its GeoDiamond division. Smith Diamond Technology also manufactures PDC and cubic boron nitride at its MegaDiamond and SupraDiamant subsidiaries. These ultrahard materials are used in the Company's three-cone and diamond drill bits and in other specialized cutting tools. Smith Diamond's revenues increased $23.1 million, or 65 percent, over 1995 and 1995 revenues increased $11.5 million, or 47 percent, over 1994. Higher unit sales, primarily in the United States and Latin America, driven by increased market growth, new product introductions and continued expansion into markets outside the U.S. account for the increase over 1995. The 47 percent increase over 1994 relates to higher sales volumes in Latin America, Europe/Africa and the Middle East and the inclusion of a full year's revenues for operations acquired during 1994.

Gross profit increased $99.5 million, or 34 percent, from the prior year. The higher gross profit resulted in an increase in the Company's gross profit margin from 33 percent in 1995 to 34 percent in 1996. The improvement in margins primarily resulted from the revenue growth and related cost efficiencies generated by the Smith Diamond operations, which were formed in 1995.

Operating expenses, consisting of selling expenses and general and administrative expenses, increased $53.3 million or 26 percent from the prior year; however, as a percentage of revenues, operating expenses decreased from 23 percent in 1995 to 22 percent in 1996. The increase in absolute dollars is due to increased variable costs associated with the higher level of revenues and incremental costs associated with the acquired business operations for which no amounts were included in the prior year.

Net interest expense, which represents interest expense less interest income, increased $4.2 million over the prior year. The increase in net interest expense relates to the higher level of borrowings to fund the business acquisitions. To a lesser extent, borrowings required to finance general working capital needs, which increased as a result of the revenue growth experienced by the Company, also contributed to the higher net interest expense amounts.

The effective tax rate for the year approximated 23 percent which is higher than the prior year's effective rate and lower than the U.S. statutory rate. The effective tax rate was higher than the prior year's rate and lower than the statutory rate due primarily to the impact of U.S. net operating loss carryforwards utilized.

Minority interests represent the share of M-I's profits associated with the 36 percent minority partner's interest in those operations and, to a lesser extent, minority interests in investments in other joint ventures held by M-I. Minority interests increased $9.0 million from the prior year due to the increased profitability of the M-I operations.

Gross profit increased $71.2 million, or 32 percent, from 1994. The increase was due primarily to the impact of acquired operations. In addition, the increase in gross profit reflected higher non-U.S. volumes, due to the higher level of drilling activity, and higher sales in the U.S.

Operating expenses, consisting of selling expenses and general and administrative expenses, increased $45.1 million or 28 percent from the prior year; however, as a percentage of revenues, operating expenses decreased from 1994. The increase in absolute expenses is due primarily to increased variable costs related to the higher level of revenues and incremental expenses associated with the operations acquired. In addition, the increase in operating expenses reflects the establishment of the Smith Diamond Technology business unit, which was formed in 1995, and the expansion of M-I operations in Latin America.

Net interest expense, which represents interest expense less interest income, increased $3.6 million from $8.6 million in 1994 to $12.2 million in 1995. The increase in net interest expense was due to higher debt levels necessary to fund working capital requirements and business acquisitions.

The effective tax rate for the year approximated 17 percent which is lower than the statutory rate and higher than the prior year's effective rate of 13 percent. The effective tax rate for the year was lower than the statutory rate and higher than the prior year's rate due primarily to the impact of U.S. net operating loss carryforwards utilized.

Minority interests represent the share of M-I's profits associated with the 36 percent minority partner's interest in those operations and, to a lesser extent, minority interests in investments in other joint ventures held by M-I. Minority interests increased $7.0 million from $8.8 million in 1994 to $15.8 million in 1995. The increase in minority interests was due to the higher level of M-I's earnings.

During the year, the Company invested approximately $61.2 million in property, plant and equipment which is net of cash proceeds arising from certain asset disposals. Capital expenditures for 1997 are expected to continue at this level, which includes routine additions of equipment used to support the Company's operations as well as expenditures to increase productivity and efficiency. Although the Company believes funds generated from operations, cash on hand and amounts available under existing credit facilities will be sufficient to finance capital expenditures and other working capital needs for the foreseeable future, continued growth at current levels may require increases to the Company's existing borrowing facilities.

The Company's primary internal source of liquidity is cash flow generated from operations. External sources of liquidity include debt and, if needed, equity financing. At December 31, 1996, the Company had approximately $26.6 million of funds available for borrowing under its $120.0 million and other long-term revolving line of credit facilities. Additionally, the Company has approximately $40.0 million of non-U.S. borrowing facilities with various banks which had available borrowing capacity of $24.9 million at December 31, 1996.

The Company believes that it has sufficient existing manufacturing capacity to meet current demand for its products and services.

The Company has been named as a potentially responsible party in connection with three sites on the U.S. Environmental Protection Agency's National Priorities List. At December 31, 1996, the recorded liability for estimated future clean-up costs for Superfund sites as well as properties currently or previously owned or leased by the Company was $3.6 million. As additional information becomes available, the Company may be required to provide for additional environmental clean-up costs. However, the Company believes that none of these obligations will result in liabilities having a material adverse effect on the Company's consolidated financial position or results of operations. See Footnote 12, "Commitments and Contingencies" for further discussion of environmental liabilities.

Because of its substantial operations outside the U.S., the Company is exposed to currency fluctuations and exchange risks. To mitigate the effect of fluctuations in exchange rates on foreign currency denominated balances, the Company utilizes a protective hedge program. The program is designed to hedge net balance sheet positions which expose the Company to exchange rate risk. To the extent possible, the Company matches assets and liabilities denominated in foreign currencies and uses hedging instruments to cover certain unmatched positions. See Footnote 5, "Financial Instruments" for further discussion of hedging instruments.

Inflation has not had a material effect on the Company in the last few years, and the effect is expected to be minor in the foreseeable future. In general, the Company has been able to offset most of the effects of inflation through productivity gains, cost reductions and price increases.

The Company has completed several acquisitions during the periods presented and intends to continue evaluating opportunities to acquire products or businesses complimentary to the Company's operations. These acquisitions, if they arise, may involve the use of cash or, depending upon the size and terms of the acquisition, may require debt or equity financing.