Notes to Consolidated Financial Statements

Basis of Presentation

Smith International, Inc. (the "Company") is engaged in the manufacture and sale of premium products and services to customers in the oil and gas industry. The consolidated financial statements include the accounts of the Company and all wholly and majority owned subsidiaries. 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. All significant intercompany accounts and transactions have been eliminated.

Significant Risks and Uncertainties

Preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosed amounts of contingent assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates.

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.

Fixed Assets

Fixed assets, consisting of rental equipment and property, plant and equipment, are stated at cost. The Company computes depreciation on fixed assets using principally the straight-line method. The estimated useful lives used in computing depreciation range from 30 to 40 years for buildings, 3 to 20 years for machinery and equipment, and 3 to 7 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.

Cost 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 reserves are removed from the accounts and the resulting gain or loss is included in the results of operations.

Valuation of Inventories

Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out ("LIFO") method for substantially all U.S. inventories and by the first-in, first-out ("FIFO") method for all other inventories. Inventory costs consist of materials, labor and factory overhead.

Goodwill

Goodwill, which represents the excess of costs over the fair value of net assets acquired, is amortized on a straight-line basis over 40 years. The Company continually evaluates whether subsequent events or circumstances have occurred that indicate the remaining useful life of goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. Management believes that there have been no events or circumstances which warrant revision to the remaining useful life or which affect the recoverability of goodwill.

Foreign Currency Translation and Transactions

Gains and losses resulting from balance sheet translation of operations outside the U.S. where the applicable foreign currency is the functional currency are included as a separate component of shareholders' equity. Gains and losses resulting from balance sheet translation of operations outside the U.S. where the U.S. dollar is the functional currency are included in the Consolidated Statements of Operations.

All foreign currency transaction gains and losses are recognized currently in the Consolidated Statements of Operations.

Environmental Obligations

Expenditures for environmental obligations that relate to current operations are expensed or capitalized, as appropriate. Expenditures that relate to an existing condition caused by past operations and which do not contribute to current or future revenue generation are expensed. Liabilities are recorded when remedial efforts are probable and the costs can be reasonably estimated.

Income Taxes

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes". This standard requires an asset and liability approach for financial accounting and income tax reporting based on enacted tax rates.

Revenue Recognition

The Company's revenues are composed of product sales and rental, service and other revenues. The Company recognizes product sales revenues upon delivery to the customer. Rental, service and other revenues are recorded when such services are performed.

Minority Interests

The Company records minority interests expense which primarily represents the portion of the earnings of M-I Drilling Fluids L.L.C. ("M-I") applicable to the 36 percent minority interest partner. In addition, minority interests includes income and expense associated with M-I's minority interest ownership position in other joint ventures.

Earnings Per Common Share

Earnings per share is computed using the weighted average number of shares of common stock and common stock equivalents outstanding during the year. Common stock equivalents include the number of shares issuable upon exercise of stock options, less the number of shares that could have been repurchased with the exercise proceeds using the treasury stock method.

Employee Benefits

The Company accounts for postretirement benefits in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This standard requires the cost of postretirement benefits to be recognized over the employee service periods.

The provisions of SFAS No. 87, "Employers' Accounting for Pensions", require an additional minimum liability to be recognized for a defined benefit plan to the extent that the accumulated pension benefit obligation exceeds the fair value of pension plan assets and any accrued pension liabilities. An offsetting intangible asset is recorded in the amount of the additional minimum liability, not to exceed the amount of any unrecognized prior service costs and any unrecognized transition obligation. Amounts exceeding the unrecognized prior service costs and unrecognized transition obligation are reflected in other current liabilities in the Consolidated Balance Sheets.

Reclassifications

Certain prior year amounts have been reclassified to conform to current year presentation.

Acquisition of M-I Drilling Fluids L.L.C.

On February 28, 1994, the Company acquired a 64 percent interest in M-I in exchange for cash and a note payable totaling $160.0 million. M-I is a Houston, Texas based provider of drilling and completion fluids and systems, solids-control equipment and waste management services to the oil and gas drilling industry.

Acquisition of Anchor Drilling Fluids, A.S.

On June 11, 1996, M-I acquired the assets of Anchor Drilling Fluids, A.S. ("Anchor") in exchange for cash of approximately $105.3 million. Anchor is a Stavanger, Norway based operation which is principally engaged in providing drilling fluid products and services to the offshore oil and gas industry. The Company utilized $73.4 million of borrowings under new loan agreements to finance their portion of the purchase price and retire certain debt assumed in the acquisition. The minority partner contributed $41.3 million to fund their portion of the purchase price and retire certain debt, which is included in Minority Interests in the accompanying Consolidated Balance Sheets.

Acquisition of the Red Baron Ltd.

On October 9, 1996, the Company acquired all of the outstanding shares of The Red Baron (Oil Tools Rental) Ltd. ("Red Baron") in exchange for cash and notes payable of approximately $40.3 million. Red Baron is an Aberdeen, Scotland based supplier of fishing and other downhole remedial products and services to the oil and gas industry.

Other Acquisitions

The Company acquired certain other operations during 1996, 1995 and 1994 with an aggregate purchase price of $6.2 million, $7.8 million and $6.3 million, respectively. These acquisitions have generally been financed with cash.

The above acquisitions have been recorded using the purchase method of accounting and, accordingly, the acquired operations have been included in the results of operations since their respective acquisition dates. The purchase price was allocated to the net assets acquired based upon their estimated fair market values at the dates of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired amounted to approximately $119.6 million in 1996 and $6.0 million in 1995, which has been recorded as goodwill.

The balances included in the Consolidated Balance Sheets related to the current year acquisitions are based upon preliminary information and are subject to change when additional information concerning final asset and liability valuations is obtained. Material changes in the preliminary allocations are not anticipated by management.

The following unaudited pro forma supplemental information presents 1995 and 1996 consolidated results of operations as if the Anchor and Red Baron acquisitions had occurred on January 1, 1995 and 1996, respectively (in thousands, except per share amounts):


(unaudited)	1996	1995
Revenues	$1,230,828	$1,018,845
Net Income	$ 63,725	$ 45,573
Earnings Per Share	$ 1.60	$ 1.16

The unaudited pro forma supplemental information is based on historical information and does not include estimated cost savings; therefore, it does not purport to be indicative of the results of operations had the combinations been in effect at the dates indicated or of future results for the combined entities.

The following schedule summarizes investing activities related to current year acquisitions:


Fair value of assets, net of cash acquired of $7,766	$104,898
Goodwill recorded	119,640
Less: Total Liabilities assumed	(81,941)
Less: Minority interest partner's contribution	(37,914)
Cash paid for acquisition of businesses, net of cash acquired	$104,683

The following summarizes the Company's outstanding long-term debt at December 31:


	1996	1995
Notes payable: Notes payable to insurance companies maturing between 1998 and 2006. Interest payable quarterly or semi-annually at rates ranging from 6.02% to 9.83%	$116,000	$ 76,000

Bank revolvers payable: $80.0 million revolving note expiring March 31, 2001. Interest payable quarterly at base rate (8.25% at December 31, 1996) or adjusted Eurodollar interbank rate, as defined (6.16% at December 31, 1996) and described below	55,000	40,400

M-I Drilling Fluids $40.0 million revolving note expiring March 31, 2001. Interest payable quarterly at base rate (8.25% at December 31, 1996) or adjusted Eurodollar interbank rate, as defined (6.11% at December 31, 1996) and described below	37,200	10,000

Term Loans: 320.0 million Norwegian Krone facility with a bank group expiring March 31, 2001. Interest payable semi-annually at a Eurokrone rate, as defined (4.985% at December 31, 1996) and described below	44,626	-----

Other	1,422	1,547
	254,248	127,947

Less current portion of long-term debt	(25,805)	(10,709)

Long Term Debt	$228,443	$117,238

Principal payments of long-term debt for years subsequent to 1997 are as follows:


1998	$30,784
1999	20,139
2000	20,139
2001	140,681
Thereafter	16,700
	$228,443	_______

In connection with the Anchor acquisition, the Company entered into a 320.0 million Norwegian Krone term loan with a bank group. The unsecured credit agreement provides for interest at a Eurokrone rate ranging from NIBOR + 1/2 to NIBOR + 3/4, based on the debt to capital ratio of the Company.

In 1996, the Company also re-negotiated its existing revolving line of credit agreements increasing the amounts available under the Company's and M-I's U.S. lines from $85.0 million to $120.0 million. The unsecured revolving credit agreements provide for the election of interest at a base rate or a Eurodollar rate ranging from LIBOR + 3/8 to LIBOR + 5/8, based upon the debt to capital ratio of the Company. The agreements require the quarterly payment of a commitment fee ranging from 1/8 percent to 1/4 percent of the unutilized credit facility, based on the debt to capital ratio. As of December 31, 1996 the borrowing capacity under these and other long-term lines of credit approximated $26.6 million.

Certain of the Company's subsidiaries outside the U.S. have short-term lines of credit with various banks totaling approximately $40.0 million. At December 31, 1996, the borrowing capacity under these lines of credit approximated $24.9 million. At December 31, 1996 and 1995, the short-term lines of credit carried interest at a weighted average rate of 12 and 18 percent, respectively. The majority of these lines are under unsecured credit agreements.

Included in Short-term borrowings in the accompanying Consolidated Balance Sheet is $34.1 million of notes payable related to the acquisition of the Red Baron. The notes, which are secured by a letter of credit, are payable on demand on any semi-annual interest payment date after July 1, 1997.

The Company was in compliance with all of its loan covenants under the various loan indentures at December 31, 1996 and 1995. The indentures relating to its long-term debt contain certain covenants restricting the payment of cash dividends to the Company's common shareholders based on net income and operating cash flow formulas, as defined. The Company has not paid dividends on its Common Stock since the first quarter of 1986.

Interest paid during the years ended December 31, 1996, 1995 and 1994 amounted to $17.5 million, $14.3 million and $7.0 million, respectively.

Interest Rate Contracts

From time to time the Company enters into interest rate swaps with the intent of managing the exposure to interest rate risk. Interest rate swaps are contractual agreements between two parties for the exchange of interest payments on a notional principal amount and agreed upon fixed or floating rates, for defined time periods.

At December 31, 1996 and 1995, the Company had notional principal amounts of interest rate swaps on outstanding debt of $90.6 million and $46.0 million, respectively. Gains and losses from interest rate swaps are recognized currently in the Consolidated Statements of Operations. All swap agreements, which are hedges against certain debt obligations, are classified as for "purposes other than trading" under the provisions of SFAS No. 119.

In the unlikely event that the counterparty fails to perform under the contract, the Company bears the credit risk that payments due to Smith may not be made.

Foreign Currency Forward Contracts and Options

From time to time, the Company enters into spot and forward contracts under foreign exchange lines as a hedge against accounts payable in foreign currencies. Market value gains and losses on such forward contracts are recognized currently, and the resulting amounts offset foreign exchange gains or losses on the related accounts payable as payments are made. At December 31, 1996 and 1995, foreign exchange contracts outstanding totaled $17.3 million and $22.8 million, respectively.

The Company also purchases foreign exchange option contracts to hedge certain operating exposures. Premiums paid under these contracts are expensed over the life of the option contract. Gains arising on these options are recognized at the time the options are exercised. The Company had $12.3 million and $7.9 million of foreign exchange option contracts outstanding at December 31, 1996 and 1995, respectively.

Fair Value

Management believes the carrying value of long-term debt does not materially differ from the fair value, using rates currently available for debt of similar terms and maturity. The fair value of interest rate swaps, for which no amounts were recorded, was $(0.5) million and $(1.0) million at December 31, 1996 and 1995, respectively. The fair value of the remaining financial instruments, including cash and cash equivalents, receivables, payables, short-term debt and foreign currency contracts, approximates the carrying value due to the short-term nature of these instruments.

The geographical sources of income before income taxes and minority interests for the three years ended December 31, 1996 were as follows:


	1996	1995	1994
Income before income taxes and minority interests: U.S. Non - U.S.	$68,564 47,511	$54,896 19,114	$49,583 1,949
Total	$116,075	$ 74,010	$ 51,532

The income tax provision is summarized as follows:


	1996	1995	1994
Current: ___U.S. ___Non - U.S. ___State	$ 9,159 17,808 1,319	$ 1,605 10,700 1,245	$ 413 5,532 793
	28,286	13,550	6,738
Deferred: ___U.S. ___Non - U.S.	(1,940) 452	7 (948)	64 13
	(1,488)	(941)	77
Income Tax Provision	$26,798	$12,609	$6,815

Deferred taxes are principally attributable to timing differences related to depreciation expense and net operating loss ("NOL") and tax credit carryforwards. In 1996, 1995 and 1994, the Company reported the tax benefit of operating loss carryforwards as a reduction in the provision for income taxes in accordance with SFAS No. 109.

The consolidated effective tax rate (as a percentage of income before income taxes and minority interests) is reconciled to the U.S. Federal Statutory rate as follows:


	1996	1995	1994
U.S. Federal statutory tax rate	35.0%	35.0%	35.0%
Utilization of U.S. net operating loss carryforwards	(9.2)	(18.4)	(22.3)
Minority interests' share of U.S. partnership earnings	(5.6)	(7.2)	(6.7)
Permanent differences	1.8	2.3	(3.3)
States taxes, net	1.2	1.7	1.6
Non - U.S. tax provisions which vary from the U.S. rate/Non-U.S. losses with no tax benefit realized	0.9	4.2	8.6
Other items, net	(1.0)	(0.6)	0.3
Effective tax rate	23.1%	17.0%	13.2%

The components of deferred taxes are as follows:


	December 31, 1996	December 31, 1995	Net Change
Deferred tax liabilities attributed to the excess of net book basis over remaining tax basis (principally depreciation): U.S. Non - U.S.	$ (11,037) (9,789)	$ (10,278) (4,461)	$ (759) (5,328)
Total deferred tax liabilities	(20,826)	(14,739)	(6,087)

Deferred tax assets attributed to net operating loss and tax credit carryforwards: ___U.S. ___Non - U.S.	23,986 27,860	29,903 19,808	(5,917) 8,052

Other deferred tax assets (principally accrued liabilities not deductible until paid): ___U.S. ___Non - U.S.	16,125 7,910	14,355 4,722	1,770 3,188
Subtotal	75,881	68,788	7,093
Valuation allowance	(46,725)	(48,381)	1,656

Subtotal deferred tax assets	29,156	20,407	8,749

Net deferred tax assets	$ 8,330	$ 5,668	$ 2,662

Balance sheet presentation:


	December 31, 1996	December 31, 1995	Net Change
Deferred tax assets, net	$ 8,979	$ 3,925	$ 5,054
Other assets	1,410	1,743	(333)
Other long-term liabilities	(2,059)	-----	(2,059)

Net deferred tax assets	$ 8,330	$ 5,668	$ 2,662

The net increase in deferred tax assets of $2.7 million is primarily attributed to the acquisition of Anchor and the Red Baron as discussed in Note 2.

For U.S. tax reporting purposes, the Company has cumulative NOL carryforwards in the amount of approximately $13.5 million at December 31, 1996. These losses were generated in 1988 and 1992 in the amounts of $11.4 million, and $2.1 million, respectively. Losses in 1988 and 1992 are available to reduce future U.S. taxable income that may be generated through the years 2003 and 2007, respectively. On certain changes in equity ownership of the Company, the ability to utilize NOL carryforwards becomes subject to limitation under Section 382 of the Internal Revenue Code of 1986, as amended. In the opinion of management, the application of Section 382 will not materially limit the availability of net tax loss carryforwards.

Also available to reduce future U.S. income taxes are unused alternative minimum tax credits of $13.7 million and investment and other business tax credits of $5.5 million at December 31, 1996. These tax credits expire as follows: $2.6 million in 1998, $1.6 million in 1999, $1.1 million in 2000 and $0.2 million in 2001 through 2004. Income taxes paid during the years ended December 31, 1996, 1995 and 1994 amounted to $17.4 million, $3.8 million and $7.0 million, respectively.

The Company does not provide deferred taxes on the undistributed earnings of its non-U.S. subsidiaries because it considers these earnings permanently invested. The Company's non-U.S. subsidiaries currently have undistributed earnings of $17.9 million at December 31, 1996, which if repatriated would be generally sheltered from U.S. tax by foreign tax credits.

As of December 31, 1996, the Company has outstanding stock options granted under two plans: the 1989 Long-Term Incentive Compensation Plan ("1989 Plan") and the 1982 Stock Option Plan ("1982 Plan"). Matters such as vesting periods and expiration of options are determined on a plan by plan or grant by grant, basis. The options, exercisable at various dates through December 2006, are conditioned upon continued employment.

During the current year the Company adopted SFAS No. 123 ("SFAS 123") "Accounting for Stock-Based Compensation". SFAS 123, which is effective for fiscal years beginning after December 15, 1995, establishes financial accounting and reporting standards for stock-based employee compensation plans and for transactions in which an entity issues its equity instruments to acquire goods and services from non-employees. SFAS 123 requires, among other things, that compensation cost be calculated for fixed stock options at the grant date by determining fair value using an option-pricing model. The Company has the option of recognizing the compensation cost over the vesting period as an expense in the income statement or making pro forma disclosures in the notes to the financial statements.

The Company continues to apply APB Opinion 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized in the accompanying consolidated financial statements for its stock option plans. Had the Company elected to apply SFAS 123, the Company's net income and earnings per share would have approximated the pro forma amounts indicated below:

	1996	1995
Net Income
___As reported	$ 64,444	$ 45,592
___Pro forma	$ 63,958	$ 45,495

Earnings per share
___As reported	$ 1.62	$ 1.16
___Pro forma	$ 1.60	$ 1.16

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model resulting in a weighted-average fair value of $12.37 and $7.50 for grants made during the years ended December 31, 1996 and 1995, respectively. The following assumptions were used for option grants in 1996 and 1995, respectively; dividend yield of 1.6 percent and 1.0 percent; expected volatility of 23 percent and 38 percent, risk-free interest rates of 6.2 percent and 6.9 percent and an expected life of six years. The compensation expense included in the above pro forma net income may not be indicative of amounts to be included in future periods as the fair value of options granted prior to 1995 was not determined.

A summary of the Company's stock option plans as of December 31, 1996, 1995 and 1994, and changes during those years is presented below:


	Share Under Option	Weighted Average Exercise Price
Outstanding at December 31, 1993	1,002,832	$ 10.12

Options granted	513,300	13.13
Options forfeited	(41,562)	13.87
Options exercised	(97,495)	8.69

Outstanding at December 31, 1994	1,377,075	11.22

Options granted	225,485	16.82
Options forfeited	(13,574)	11.62
Options exercised	(228,940)	9.35

Outstanding at December 31, 1995	1,360,046	12.43

Options granted	252,670	40.79
Options forfeited	(1,290)	17.88
Options exercised	(348,408)	11.13

Outstanding at December 31, 1996	1,263,018	$ 18.46

The following summarizes information about fixed stock options outstanding at December 31, 1996:

	Options Outstanding			Options Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price	Number Exercisable	Weighted Average Exercise Price
$ 5.50 - $ 10.31	278,766	6.1	$ 9.10	170,016	$ 8.89

$ 12.56 - $ 17.88	731,582	7.3	14.31	311,590	13.90

$ 22.50 - $ 41.13	252,670	9.5	40.79	-----	-----

	1,263,018	7.5	$ 18.46	481,606	$ 12.13

At December 31, 1996, there were 443,329 shares of common stock reserved under the 1989 Plan for the future granting of stock options, awarding of additional restricted stock options and/or awarding of additional Stock Appreciation Rights. No further options may be granted under the 1982 Plan.

Pension Plans

The Company has pension plans in the U.S. and the United Kingdom. Benefit accruals under the Company's U.S. pension plan, which have been frozen since 1987, covered substantially all the U.S. employees of the Company at that date. Due to the freezing of U.S. pension benefits and fully funding those benefits in 1987, no material contributions were made to the Plan in 1996, 1995 or 1994. Most of the employees of M-I are not covered by a pension plan.

The following tables detail the components of pension expense for the three years ended December 31, 1996, the funded status of the plans and major assumptions used to determine these amounts:


	1996	1995	1994
Service cost	$ 311	$ 286	$ 266
Interest cost	1,020	942	862
Actual return on plan assets	(1,771)	(796)	(299)
Prior service cost	6	8	---
Net amortization and deferral and other	685	(199)	(645)
Net periodic pension cost	$ 251	$ 241	$ 184

Reconciliation of Funded Status of the Plan:


	1996	1995	1994
Actuarial present value of benefit obligations: Vested benefit obligation	$ 13,252	$ 11,672	$ 9,863

Accumulated benefit obligation	$ 13,375	$ 11,834	$ 9,993

Projected benefit obligation	$ 14, 481	$ 12,700	$ 10,681
Plan assets at fair value	15,804	12,926	11,166

Projected benefit obligation less than Plan assets	$ 1,323	$ 226	$ 485
Unrecognized prior service cost	28	34	11
Unrecognized net (gain) loss	(759)	211	(133)
Additional minimum liability	(480)	(880)	(978)

Pension (liability) asset recognized in the Balance Sheet	$ 112	$ (409)	$ (615)

Weighted-average assumed discount rate	7.8-9.0%	7.0-9.0%	8.5-8.9%

Rate of compensation increases in the U.K (none in the U.S. due to freezing of benefits)	7.0%	7.5%	7.5%

Weighted-average expected long-term rate of return on Plan assets	8.5-9.0%	8.5-9.0%	8.5-9.0%

The Company has several other pension plans covering certain non-U.S. employees as well as a pension plan covering directors. Pension expense, total accumulated plan benefits and net assets available for benefits for these plans were not material at December 31, 1996, 1995 or 1994.

Retirement Plans

The Company established the Smith International, Inc. 401(k) Retirement Plan (the "Plan") for the benefit of all eligible employees. Employees may voluntarily contribute up to 12 percent of compensation, as defined, to the Plan. The Company makes retirement and, in certain cases, matching contributions to each participant's account under the Plan. The Company's retirement contributions range from 2 percent to 6 percent of each participant's qualified compensation. In addition, the Company may provide discretionary matching contributions to participants who are employed by the Company on December 31. The Company's contributions to the Plan totaled approximately $4.9 million, $3.9 million and $4.4 million in 1996, 1995 and 1994, respectively.

M-I has a Company Profit-Sharing and Savings Plan (the "M-I Plan") under which participating employees may defer up to 12 percent of their compensation, as defined. Under the terms of the M-I 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 3 percent of qualified compensation, along with a 100 percent matching contribution of the first 1 1/2 percent of their voluntary contributions. Further, effective January 1, 1996, the Company's Board of Directors approved an additional profit-sharing match of up to 2 1/2 percent of participant's voluntary contributions. Total contributions under the M-I Plan approximated $4.2 million in 1996, $2.2 million in 1995 and $1.7 million in 1994.

Postretirement Benefit Plans

The Company and its subsidiaries provide certain health care benefits for retired employees. Many of the employees who retire from the Company are eligible for these benefits.

The Smith International, Inc. Retiree Medical Plan provides postretirement medical benefits to retirees and their spouses. The retiree medical plan has an annual limitation (a "cap") on the dollar amount of the Company's portion of the cost of benefits incurred by retirees under the plan. The remaining cost of benefits in excess of the cap is the responsibility of the participants. The cap will be adjusted annually for inflation, which is currently assumed to be 4 percent.

M-I provides retiree medical coverage to eligible retirees and their dependents under the M-I Drilling Fluids Retiree Medical Plan. Eligibility for inclusion in that plan; however, was closed as of January 1, 1994, to the majority of M-I's employees. M-I contributes to the cost of the benefits under this plan; however, these costs are reviewed annually for inflation, and limited to a maximum 5 percent increase in M-I's contribution per year. Any costs in excess of M-I's maximum contribution are the responsibility of the retiree or their dependents.

The following table sets forth the plans' unfunded status reconciled with the amount shown in the Company's Consolidated Balance Sheets at December 31:


	1996	1995	1994
Accumulated postretirement benefit obligation: -Retirees -Actives -Plan assets at fair value	$ (5,538) (3,773) -----	$ (5,105) (3,543) -----	$ (4,829) (3,248) -----

Accumulated postretirement benefit obligation in excess of plan assets	(9,311)	(8,648)	(8,077)
Unrecognized net gain and prior service cost	(1,487)	(1,832)	(2,510)

Accrued postretirement benefit cost	$ (10,798)	$ (10,480)	$ (10,587)

Postretirement benefit expense recognized in the Consolidated Statements of Operations for the three years ended December 31, 1996 is summarized as follows:


	1996	1995	1994
Service cost	$ 103	$ 83	$ 87
Interest cost on accumulated postretirement benefit obligation and other	704	686	701
Net amortization	(116)	(170)	(159)

Postretirement benefit expense	$ 691	$ 599	$ 629

The health care cost trend rate assumption can have a significant effect on the amounts reported. For measurement purposes, the Smith International Inc. Retiree Medical Plan ("Smith Medical Plan") assumes a 9 percent, 10 percent and 11 percent annual rate of increase in the per capita cost of covered health care benefits for 1996, 1995 and 1994, respectively; and the M-I Drilling Fluids Retiree Medical Plan assumes a 5 percent increase for the periods presented. The Smith Medical Plan rate was assumed to gradually decrease to 7 percent for 1998 and to remain at that level thereafter. An increase of one percentage point in the health care cost trend rate would increase the accumulated postretirement benefit obligation and the aggregate of the service and interest cost components of the postretirement benefits expense by $1.2 million and $0.1 million, respectively.

The weighted-average discount rates used in determining the accumulated postretirement benefit obligation for 1996, 1995 and 1994 were 8.0 percent, 8.4 percent and 8.5-8.9 percent, respectively.

During 1990, the Company adopted a Stockholder Rights Plan ("Rights Plan"). 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 29, 1990. The Board also authorized the issuance of one such Right for each share of the Company's common stock issued after June 29, 1990 until the occurrence of certain events.

Each Right entitles the holder thereof (except an Acquiring Person) to purchase, at an exercise price of $50, shares of the Company's common stock having a market value of twice the Right's exercise price. The Rights are exercisable upon the occurrence of certain events related to a person acquiring or announcing the intention to acquire beneficial ownership of 20 percent or more of the Company's common stock. The Rights are not exercisable in the event the Company's common stock is acquired pursuant to a Qualifying Offer, as defined in the Rights Plan. 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 $0.01 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 19, 2000.

	SMITH INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1996 ANNUAL REPORT	( All dollar amounts are expressed in thousands, unless otherwise noted )