UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

SCHEDULE 14A

Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934

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Smith International, Inc.

(Name of Registrant as Specified In Its Charter)

 

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NOTICE OF ANNUAL MEETING OF STOCKHOLDERS

 

May 12, 2009

 

 

To Our Stockholders:

 

The Annual Meeting of Stockholders (the “Annual Meeting”) of Smith International, Inc. (the “Company”) will be held on Tuesday, May 12, 2009, at 9:00 a.m. local time, at the Hotel du Pont, 11th & Market Streets, Wilmington, Delaware, to consider and take action on the following:

 

1. Election of three Class II directors: Robert Kelley, Luiz Rodolfo Landim Machado and Doug Rock, each for a term of three years ending at the 2012 Annual Meeting of Stockholders or until their successors are duly elected and qualified; and

 

2. Ratification of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2009.

 

Your Board of Directors recommends a vote “FOR” Proposals 1 and 2.

 

Important Notice Regarding the Availability of Proxy Materials for the Stockholder Meeting to Be Held on May 12, 2009: This proxy statement and the 2008 Annual Report to Stockholders are available on the following website: www.proxydocs.com/sii.

 

The Board of Directors has fixed the close of business on March 13, 2009 as the record date for determining stockholders who are entitled to notice of and to vote at the Annual Meeting.

 

By Order of the Board of Directors

 

 

Richard E. Chandler, Jr.

Secretary

 

Houston, Texas

April 13, 2009

 

YOUR VOTE IS IMPORTANT.

 

Please vote your proxy promptly so that your shares will be represented, even if you plan to attend the Annual Meeting. You can vote by Internet, by telephone, or by using the proxy card that is enclosed. Please see your proxy card for specific instructions on how to vote.

 

 

PROXY STATEMENT

 

TABLE OF CONTENTS

 

 

P. O. Box 60068
Houston, TX 77205-0068

 

PROXY STATEMENT

 

The Board of Directors of Smith International, Inc. is soliciting your proxy to vote your shares of the Company’s common stock (“Common Stock”) at the 2009 Annual Meeting. We are distributing this Proxy Statement and the accompanying proxy card beginning on or about April 13, 2009. We solicit proxies to give all stockholders of record an opportunity to vote on matters that will be presented at the Annual Meeting. In this Proxy Statement, you will find information to assist you in voting your shares. Your vote is very important.

 

Except as otherwise specifically noted in this Proxy Statement, “we,” “our,” “us,” and similar words as well as “Smith” and the “Company” refer to Smith International, Inc.

 

Who may vote?

 

You are entitled to vote your shares of our Common Stock if you are a stockholder of record on March 13, 2009. At the close of business on March 13, 2009, a total of 219,252,060 shares of Common Stock were outstanding and entitled to vote. Each share of Common Stock has one vote. The enclosed proxy card shows the number of shares that you are entitled to vote. For a period of at least ten days prior to the Annual Meeting, a complete list of stockholders entitled to vote at the Annual Meeting will be open to examination by any stockholder during ordinary business hours at the office of the Corporate Secretary at 1310 Rankin Road, Houston, Texas 77073.

 

How do I vote?

 

Stockholders of record may vote in person or by telephone, internet or mail. If you are voting by mail, please sign, date and mail the enclosed proxy card. If you are voting by telephone or internet, please follow the instructions on the enclosed proxy card.

 

Whether or not you plan to attend the meeting, we encourage you to vote by proxy as soon as possible.

 

If you hold your shares in more than one type of account or your shares are registered differently, you may receive more than one proxy card. We encourage you to vote each proxy card that you receive.

 

If you choose to attend the meeting in person, you will be asked to present valid picture identification and, if you hold your shares through a broker, you will be asked to present a copy of your brokerage statement showing your stock ownership as of March 13, 2009. For directions to the meeting, contact the Hotel du Pont, Wilmington, Delaware at 302-594-3100.

 

How will my shares be voted?

 

If you vote by proxy, the individuals named on the proxy card (your proxies) will vote your shares in the manner you indicate. You may specify on your proxy card whether your shares should be voted for all of the nominees for director or your vote may be withheld with respect to one or more of the nominees. You may also specify whether you approve, disapprove or abstain from the other proposals.

 

If you sign and return your proxy card without indicating your voting instructions, your shares will be voted FOR the election of all nominees for director and FOR Proposal 2.

What if my shares are held by a broker?

 

If your Common Stock is held by a broker, bank or other nominee (in “street name”), your broker must vote those shares in accordance with your instructions. However, if you do not give voting instructions to your broker within ten days of the meeting, your broker may vote your shares for you on any matter that the New York Stock Exchange (“NYSE”) determines to be routine. If the broker cannot vote on a particular matter because it is not routine, there is a “broker non-vote” on that matter. An abstention counts as a vote against a proposal.

 

If you hold your shares in street name and you wish to vote in person at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares. If the meeting is adjourned, your Common Stock will be voted as specified on your proxy card on the new meeting date, unless you have revoked your proxy instructions.

 

May I revoke or change my vote?

 

You may revoke or change your proxy at any time before it is exercised by submitting written notice of revocation to Smith’s Corporate Secretary so that he receives it before the Annual Meeting; voting again by telephone, internet or mail; or voting in person at the Annual Meeting.

 

Attendance at the Annual Meeting will not by itself revoke a previously granted proxy. If you hold your shares in street name and you wish to change your vote at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares.

 

What constitutes a quorum?

 

The holders of a majority of the outstanding shares of Common Stock entitled to vote constitutes a quorum for the transaction of business at the Annual Meeting. If you have returned valid proxy instructions or attend the meeting in person, your Common Stock will be counted for the purpose of determining whether there is a quorum, even if you wish to abstain from voting on some or all matters introduced at the meeting. “Broker non-votes” also count for quorum purposes.

 

How many votes are required to approve each proposal?

 

Proposal 1: Directors must be elected by a majority of the votes cast at the meeting. If a nominee is not elected, he must promptly tender his resignation to the Board, which will determine, based on a recommendation from the Nominating and Corporate Governance Committee, whether to accept or reject the resignation. In the event of a vacancy on the Board, a majority of the remaining directors will appoint a successor or decrease the size of the Board.

 

Proposal 2: The affirmative vote of a majority of the shares represented at the meeting and entitled to vote on a particular matter is required to approve the ratification of Deloitte & Touche as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2009.

 

An abstention counts as a vote against a proposal.

 

What other matters will be acted upon at the meeting?

 

We do not know of any other matters that will be presented at the Annual Meeting, other than those mentioned in this Proxy Statement.

 

Who pays the cost of this proxy solicitation?

 

We will pay the cost of solicitation of proxies including preparing, printing and mailing this Proxy Statement. We have retained Laurel Hill Advisory Group, LLC to help us in soliciting proxies for a fee of $7,000, plus reasonable out-of-pocket costs and expenses. We will also reimburse brokers, banks and other nominees for their costs in sending proxy materials to beneficial owners of our Common Stock. Other proxy solicitation expenses that we will pay include those for preparation, mailing, returning and tabulating the proxies.

 

At the Annual Meeting, stockholders will elect three persons as Class II directors to hold office until the 2012 Annual Meeting, or until they are succeeded by other qualified directors who have been appointed or elected. The nominees are Robert Kelley, Luiz Rodolfo Landim Machado and Doug Rock.

 

Directors must be elected by a majority of the votes cast at the meeting. We will vote your shares as you specify on your proxy card. If you properly execute and return your proxy card (in paper form, electronically via the internet or by telephone), but do not specify how you want your shares voted, we will vote them for the election of all of the nominees listed below.

 

Each of the nominees is a current member of the Board of Directors and has consented to serve if elected. Although management does not contemplate the possibility, in the event any nominee is not a candidate or is unable to serve as a director at the time of the election, the proxies will vote for any nominee who is designated by the present Board of Directors to fill the vacancy.

 

A brief biography of all directors is presented below:

 

 

Directors to be elected to Class II for a term expiring in 2012:

 

 

WE RECOMMEND A VOTE “FOR” THE ELECTION OF THE DIRECTOR NOMINEES.

 

 

Class I directors to continue in office until 2011:

 

 

Class III directors to continue in office until 2010:

 

 

The following table shows certain information about stock ownership of all persons known to the Company to own of record or beneficially more than 5% of the outstanding Common Stock of the Company. This information is based upon information furnished to the Company by these persons and statements filed with the Securities and Exchange Commission (“SEC”):

 

 

 

 

The following table shows the number of shares of Common Stock beneficially owned as of March 23, 2009 by each director or nominee for director, the executive officers named in the Summary Compensation Table included later in this Proxy Statement and all directors and executive officers as a group. Except as otherwise indicated, the persons listed below have sole voting power and investment power relating to the shares shown.

 

 

 

 

Corporate Governance Guidelines

 

Our Corporate Governance Guidelines outline the functions of the Board, director qualifications and responsibilities, and various processes and procedures designed to ensure effective and responsive governance. The full text of the guidelines is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 1310 Rankin Road, Houston, Texas 77073.

 

Board Structure

 

Our Board of Directors currently consists of seven directors. Board agendas include regularly scheduled sessions for the independent directors to meet without management present. The Board has designated Mr. Gibbs as Lead Director to chair executive sessions of the non-management directors. As Lead Director, Mr. Gibbs’ responsibilities are to:

 

 

Board Meetings

 

The Board and its committees meet throughout the year on a set schedule, and also hold special meetings and act by written consent from time to time as appropriate. The Board of Directors held eleven meetings during 2008. All directors attended at least 75% of the meetings of the Board of Directors and of all committees on which they served. The Company does not have a policy regarding directors’ attendance at the Annual Meeting of Stockholders. Although no directors attended the 2008 Annual Meeting in person, all were available telephonically.

 

Director Independence

 

The Board annually evaluates the independence of the directors of the Company and has affirmatively determined that all directors (including Clyde Buck who served as a director until May 13, 2008) are independent except Doug Rock and John Yearwood, who are employees of the Company, and Loren Carroll, who was an employee of the company within the past three years. The Board’s determination regarding independence and financial expertise of its members is based on applicable laws and regulations, Smith’s Corporate Governance Guidelines, the rules of the SEC and NYSE and a review of any direct or indirect relationship between each director or his immediate family and Smith. To be considered independent, the Board of Directors must affirmatively determine that a director has no material relationship with Smith. In each case, the Board of Directors broadly considers all relevant facts and circumstances, including the director’s commercial, industrial, consulting, legal, accounting, charitable and familial relationships and such other criteria as the Board of Directors may determine from time to time. In evaluating the independence of each non-employee director, the Board considered that in the ordinary course of business our subsidiaries buy from or sell to companies with which our directors have relationships as follows:

 

 

(5) Mr. Carroll is a director of Forest Oil Corporation.

With respect to each of the three most recent completed fiscal years, none of the payments to or payments received from any of the companies for which our directors are employees exceeded the greater of $1.0 million or 2% of such company’s consolidated gross revenues. All of these companies expect to continue their business relationship in 2009.

 

Communication with the Board

 

Stockholders and interested parties who wish to communicate with the non-management directors as a group, the Lead Director, or with any individual director, may do so by contacting Smith’s Corporate Secretary at 1310 Rankin Road, Houston, Texas 77073. Smith’s Corporate Secretary will then relay all communications to the appropriate director or group of directors.

 

Committees of the Board

 

The Board has delegated various responsibilities and authority to different Board Committees as described in this section of this Proxy Statement. The Board has determined that all committee members are independent and satisfy the relevant additional independence requirements for the members of such committees imposed by the SEC, the NYSE or the Company. Each committee operates under a formal charter adopted by the Board, the full text of which may be found on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 1310 Rankin Road, Houston, Texas 77073.

 

Members of the Committees of the Board.

 

 

 

 

Audit Committee.  During 2008, the Audit Committee met twelve times, including telephone meetings, to discuss relevant accounting, auditing, internal control and disclosure matters. The Audit Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

The Board of Directors has determined that all members are financially literate and that all members qualify as audit committee financial experts.

 

Compensation and Benefits Committee.  During 2008, the Compensation and Benefits Committee met ten times. The Compensation and Benefits Committee charter permits the Compensation and Benefits Committee to

delegate its authority to sub-committees. The Compensation and Benefits Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Nominating and Corporate Governance Committee.  During 2008, the Nominating and Corporate Governance Committee met six times. The Nominating and Corporate Governance Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Director Qualifications and Nominations

 

The Nominating and Corporate Governance Committee will consider nominees proposed by stockholders. To recommend a prospective nominee for the Nominating and Corporate Governance Committee’s consideration, you may submit the candidate’s name and qualifications to Smith’s Corporate Secretary at 1310 Rankin Road, Houston, Texas 77073. Recommendations from stockholders for nominees must be received by Smith’s Corporate Secretary within the parameters set forth under the section “Stockholders’ Proposals.”

 

The process for identifying and evaluating director nominees includes the following steps:

 

(1) the Nominating and Corporate Governance Committee, Chairman of the Board or other Board members identify a need to fill vacancies or add newly created directorships;

 

(2) the Chairman of the Nominating and Corporate Governance Committee initiates a search and seeks input from Board members and senior management and, if necessary, hires a search firm or obtains advice from legal or other advisors;

 

(3) director candidates, including any candidates properly proposed by stockholders in accordance with the Company’s Bylaws, are identified and presented to the Nominating and Corporate Governance Committee;

 

(4) initial interviews of candidates are conducted by the Chairman of the Nominating and Corporate Governance Committee;

 

(5) the Nominating and Corporate Governance Committee meets to consider and approve final candidate(s) and conduct further interviews as necessary; and

 

(6) the Nominating and Corporate Governance Committee makes recommendations to the full Board for inclusion in the slate of directors at the Annual Meeting.

 

The evaluation process will be the same whether the nominee is recommended by a stockholder or by a member of the Board of Directors. The Nominating and Corporate Governance Committee is responsible for establishing the selection criteria for candidates from time to time and reviewing with the Board such criteria and the appropriate skills and characteristics required of Board members in the context of the then current make-up of the Board. At a minimum, the Nominating and Corporate Governance Committee must be satisfied that each

nominee for director has the necessary business and/or professional knowledge and experience relevant to the Company, its business and the goals and perspectives of its stockholders; is well regarded in the community, with a long term, good reputation for high ethical standards; has good common sense and judgment; has a positive record of accomplishment in present and prior positions; has an excellent reputation for preparation, attendance, participation, interest and initiative on other boards on which he or she may serve; and has the time, energy, interest and willingness to become involved in the Company and its future.

 

Compensation Committee Interlocks and Insider Participation

 

During 2008, Messrs. Buck (until May 13, 2008), Gibbs (after May 13, 2008), Fraser and Kelley served as members of the Company’s Compensation and Benefits Committee. None of the Compensation and Benefits Committee members has served as an employee or officer of the Company, and none of the Company’s executive officers has served as a director or member of the compensation committee of another entity, which has an executive officer serving as a member of the Company’s Board.

 

Code of Business Conduct and Ethics

 

All of our officers, employees and directors are required to comply with our Code of Business Conduct and Ethics to help ensure that our business is conducted in accordance with the highest standards of ethical behavior. Our Code of Business Conduct and Ethics covers all areas of professional conduct, including customer relationships, conflicts of interest, insider trading, financial disclosure, intellectual property and confidential information, as well as requiring strict adherence to all laws and regulations applicable to our business. Employees may report any violations or suspected violations of the Code by using Smith’s ethics hotline. The Code includes an anti-retaliation statement. The full text of the Code of Business Conduct and Ethics, as well as any waiver of a provision of the Code granted to any senior officer or director or material amendment to the Code, if any, is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 1310 Rankin Road, Houston, Texas 77073.

 

Overview

 

Compensation Objectives.  We have designed our executive compensation program to reward our executives based on Company, business unit and individual performance. The general objectives of our executive compensation program are to:

 

 

Compensation Philosophy.  The Compensation and Benefits Committee (referred to as the “Compensation Committee”) bases its executive compensation philosophy on the following principles:

 

 

Decision Process.  The Compensation Committee makes all executive compensation decisions. The Compensation Committee retained Frederic W. Cook & Co., Inc. (referred to in this section as “Cook”), an independent compensation consultant, to assist it in the decision making process. Cook works exclusively for the Compensation Committee and does not undertake assignments for management.

 

In October of each year, the Compensation Committee reviews preliminary recommendations from Cook based on current and comparative compensation data, including benchmarking results as discussed below. For all executive officers other than the CEO, the Compensation Committee reviews recommendations and comparative data provided by Cook and, in conjunction with additional input from the CEO and Senior Vice President of Human Resources, especially as to individual executive performance, makes its decision. For the CEO, the Compensation Committee uses recommendations and comparative data provided by Cook in making its decision.

 

Generally, the Compensation Committee makes final compensation decisions and sets performance targets in December of each year to correspond with the business plan for the Company’s upcoming fiscal year and with their evaluation of executive performance for the current year. Executive compensation decisions become effective January 1 of the upcoming fiscal year. With the exception of equity incentive awards for new hires or promotions, which are typically granted at the next Compensation Committee meeting after the hire or promotion date, the Company grants equity incentive awards only in December.

 

Benchmarking Group.  The worldwide energy industry is a competitive environment for executive talent. To attract and retain a high level of executive expertise, we must remain competitive with the pay of companies with whom we compete for executive talent. Cook provides us with general compensation information related to our industry and specific compensation information related to a group of companies in our industry whose executives have similar duties and responsibilities. The following companies compose our benchmarking group:

 

 

Executive Position Grade Levels.  The Company has established nine executive management grade levels. We assign all executive officers in the Company to a grade level consistent with the responsibility and authority of the position. The Compensation Committee, with the assistance of Cook, uses the grade levels to establish guidelines for salary, target annual incentive awards, target long-term incentive awards, and perquisite benefits. The grade level for each individual executive officer typically corresponds to his or her management position; however, occasionally we may advance an individual to a higher level to recognize exceptional contributions. Variable pay awards and equity grants, as well as perquisite benefits, are consistent within each grade level.

 

Fixed versus Variable Pay.  We divide our compensation program into two general categories, fixed and variable pay. Fixed pay consists of base salary and provides our executive officers with a level of assured cash compensation appropriate for their positions within the Company. Variable pay includes annual cash bonus awards and annual equity awards (each as explained in more detail below) and is the largest component of executive management’s total target compensation. Typically, the equity awards to executive officers are solely performance-based awards that are not earned unless financial performance goals are met.

 

Performance Matrix.  At the beginning of each year, the Compensation Committee approves consolidated and business unit performance matrices that establish targets for the variable pay component of executive compensation. Generally, these matrices are based on the financial performance goals established in the Company’s annual business plan. Because the goals are pre-determined and market conditions fluctuate throughout the year, the performance goals may not correspond to annual earnings guidance released by the Company.

 

This process has resulted in the establishment of performance goals that are not easily met and require excellent performance and effort by management regardless of general market conditions. For instance, in performance year 2008, when the Company reported record earnings and returns during a period of robust market activity in the oil field service industry, the annual cash bonus awards for our named executive officers ranged from

44% to 200% of target and the performance-based equity awards were 92.6% of target. For the last three years, the awards to the named executive officers as a percent of target are set forth in the table below.

 

 

Alignment of Interests with Stockholders.  Long-term equity incentives comprise a significant portion of total compensation for our executives. We award all long-term equity incentives as restricted stock units which vest ratably over either three or four years, depending on the type of award (three years for performance-based awards and four years for time-based awards). As a result, executives receive and hold a significant amount of equity in the Company, thereby aligning their interests with those of the stockholders and providing incentive to avoid excessive risks. For instance, for the 2008 performance year, equity-based compensation constituted approximately 65% of our total target executive officer compensation. Our Compensation Committee encourages stock ownership by executive management and periodically reviews the ownership levels and considers the appropriateness of implementing stock ownership guidelines. Our Compensation Committee has chosen not to require stock ownership guidelines for the executive management at this time. Our Insider Trading Policy prohibits our executive officers from engaging in any hedging or monetization transactions involving Company securities.

 

Executive Compensation Components

 

Annual Base Salary.  The Compensation Committee sets salaries for each executive by reference to the executive grade level of the position and individual performance. The criteria used in evaluating individual performance, including that of the CEO, vary depending on the executive’s function, but generally include:

 

 

Base salary generally represents about 20% of total target compensation for the named executive officers and remains at the median level of the salary range, but may exceed the median if deemed appropriate by the Compensation Committee.

 

Annual Cash Bonus.  Our executive officers participate in the Executive Officer Annual Incentive Plan (“AIP”) which provides for annual cash bonuses. The Compensation Committee ties approximately 18% of each named executive officer’s total target compensation to the achievement of financial performance goals under the AIP.

 

Participants in the AIP can earn an annual cash bonus based upon the achievement of established financial performance goals of the Company for each fiscal year, as described above in “Fixed versus Variable Pay”. The target annual bonus percentages for the executive officers are determined based upon the grade level of the executive officer and are generally close to the median of the benchmarking group. The payout award, if any, is determined by multiplying the actual annual cash bonus percentage earned by the product of the target annual cash bonus percentage times the executive’s base salary.

 

Depending upon the Company’s financial performance, the AIP payout can range from zero to 200% of the target annual cash bonus percentage. Upon the achievement of the target financial performance goals, participants earn 100% of their target annual cash bonus.

 

The Compensation Committee has no discretion to increase any award after establishing the performance targets, but may decrease or eliminate any annual bonus award, even if the Company meets its financial performance targets. The Company intends that the AIP comply with Section 162(m) of the Internal Revenue

Code of 1986, as amended (the “Code”) so that amounts paid under the AIP will be fully deductible by the Company for federal income tax purposes.

 

Annual Restricted Stock Unit Award.  The annual restricted stock unit (“Unit”) award, issued pursuant to the Third Amended and Restated Long-Term Incentive Compensation Plan (“LTIP”), is the largest single component of total target annual compensation. Units represent the right to receive shares of common stock in the future, depending upon the achievement of the target equity goal for the coming year (for performance-based Unit awards) or continued employment with the Company (for time-based Unit awards). As discussed above, in typical years, executive officers receive only performance-based Unit awards.

 

The Compensation Committee sets the monetary value of the awards by grade level, generally at the 60th to 65th percentile level for equity awards granted by the benchmarking group. All executive officers in the same grade level receive Unit awards of the same monetary value. Award recipients do not own the underlying shares until the awards have been earned and vested; accordingly, participants have no voting rights on the shares and do not receive dividends until the shares are earned and vested. The number of target Units granted is determined based on the closing price of the common stock on the date of grant, discounted for the present value of the dividends that are not paid on the unvested shares based on the dividend rate at the time of the award. The time-based Units vest in equal installments over a four-year period based on continued employment requirements. If the performance-based Units are earned at year-end by meeting the predetermined financial performance goals, they vest in equal installments over a three-year period based on continued employment requirements.

 

Depending upon performance, the payout for the performance-based Unit awards could range from zero to 130% of the target. Upon the achievement of the target equity goal, participants earn 100% of the Units awarded. Once the financial performance goals have been set, the Compensation Committee does not exercise any discretion in the number of Units awarded.

 

In 2005, the Company made the decision to award Units rather than Non-Qualified Stock Options, which we had issued since 1989. In reaching the decision to award Units, the Compensation Committee evaluated, among other considerations, changes to the required accounting treatment of stock option awards and other tax and accounting implications of various types of equity awards. Awarding Units instead of Non-Qualified Stock Options reduces stockholder dilution because the Company can offer equal long-term value while issuing fewer shares. Performance-based Unit awards are earned only when the financial performance goals are met. All Unit awards contain a retention element and align executive management with stockholder interests. For these reasons, the Compensation Committee has determined that Units are the most appropriate long-term equity based incentive for our Company and are the only type of equity incentive that the Company currently awards to its executive officers.

 

2008 Compensation and Performance Year Awards.  The Company’s acquisition of W-H Energy Services, Inc. increased the responsibilities of Mr. Dudman and Ms. Dorman, leading the Compensation Committee to increase their base salaries by 10.5% for Mr. Dudman and 12.1% for Ms. Dorman effective August 25, 2008. To maintain parity between Mr. McKenzie and Mr. Dudman, the Compensation Committee also increased Mr. McKenzie’s salary by 10.5% effective August 25, 2008. In addition, the Compensation Committee increased the annual cash bonus target for each of these individuals to 85% as shown below.

 

The 2008 corporate performance metrics, set in December 2007 and used in the AIP and the LTIP, are: (i) earnings per share and (ii) return on stockholder equity, as shown in the tables below. The business unit metrics for the AIP are earnings and return on operating assets or return on equity goals for each specific business unit. When consolidated, the business unit goals align with the consolidated corporate earnings per share and return on equity goals. The Compensation Committee selected these financial measurements because these metrics are readily understood by the executives, provide a balanced incentive to increase income while managing the Company’s investment in its net assets, and relate directly to the creation of economic value that is ultimately reflected in share value.

Annual Cash Bonus.  For the 2008 performance year, the grade level and target AIP percentages for the named executive officers were as follows:

 

 

 

 

The AIP performance matrix for the 2008 performance year set a corporate earnings per share target of $3.80 and a return on stockholder equity target of 26.7%. The matrix is set forth below. Because the matrix did not contemplate the acquisition of W-H Energy Services, the performance results were calculated on an adjusted basis excluding W-H Energy Services. For the 2008 performance year, the Company’s adjusted earnings per share was $3.68 and adjusted return on stockholder equity was 25.7%; resulting in a payout of 86.0% to Mr. Rock and Ms. Dorman.

 

ANNUAL PERFORMANCE PLAN 2008 CORPORATE PERFORMANCE MATRIX

 

 

The business unit matrices and payout calculations follow a similar model, with the same payout range, but with financial targets that are specific to each business unit. Because management restructured the business after the acquisition of W-H Energy Services and the targets were set based on the previous structure, the AIP calculations for the business unit management reflected the previous company structure. In addition, they were calculated on an adjusted basis excluding W-H Energy Services. The actual performance levels achieved by the business units ranged from above to below the target goals, resulting in Messrs. McKenzie, Dudman and Kennedy earning 79.8%, 44.3% and 200.0%, respectively, of their target annual cash bonus percentage.

 

Annual Equity Award.  All Units granted to the executive officers in 2007 for the 2008 performance year were performance-based Units. The target was return on stockholder equity at the same level of 26.7% as for the AIP. The matrix is set forth below. As with the AIP, because the matrix did not contemplate the acquisition of W-H Energy Services, the performance results were calculated on a pro-forma basis excluding W-H Energy Services. For the 2008 performance year, the Company’s pro-forma return on stockholder equity was 25.7%, resulting in each individual earning 92.6% of their target Unit award.

ANNUAL PERFORMANCE-BASED RESTRICTED SHARES
2008 FISCAL YEAR AWARD MATRIX

 

 

2009 Compensation and Performance Year Awards.  As discussed above, generally the Compensation Committee makes compensation decisions for the upcoming fiscal year in December of each year. In December 2008, the global business environment was significantly deteriorating and the economic outlook was extremely volatile, particularly as related to projections for oil price and rig count, two key matrices for our business. In addition, the market value of our common stock had declined significantly from the beginning of 2008, as had that of the S&P 500 Index, the Philadelphia Oil Service Index (OSX), and our peer companies, including those of our benchmarking group. It was against this backdrop that our Compensation Committee made their compensation decisions for 2009.

 

When approving the December 2008 equity awards, the Compensation Committee considered the possibility that global industry conditions, along with general economic market conditions, could worsen beyond any then-current projections. In that case, 2009 performance targets may not be reasonably achievable for non-business related reasons outside the control or influence of management, resulting in a zero payout for all performance-based compensation. Historically, we had granted equity awards to our executive officers that were 100% performance-based. To ensure the retention value of the 2009 equity pay component, particularly during these uncertain market conditions, the Compensation Committee granted 20% of the total equity awards as time-based Units for all executive officers, except our Chief Executive Officer, Mr. Yearwood. The remaining 80% of the equity awards continued to consist of performance-based Units. Mr. Yearwood received only performance-based Units. In addition, because of the drop in the market value of our common stock as compared to historic levels, our Compensation Committee lowered the total equity grant amounts to the executive officers by 8.66%.

 

In December 2008, Messrs. Rock and McKenzie stepped down from their positions and received employment agreements discussed below in “Change of Control and Employment Agreements”. Neither received equity awards in December 2008. Ms. Dorman received an annual base salary increase of $39,000 and Mr. Dudman received an annual base salary increase of $26,000, each effective on January 1, 2009. Mr. Kennedy declined his 2009 annual base salary increase.

 

In December 2008, the Compensation Committee also set a 2009 annual base salary for Mr. Yearwood of $1,000,000 and an annual target cash bonus percentage of 100% of his base salary.

 

Other Executive Compensation Components

 

Perquisites.  The Company has an interest in ensuring the physical and mental wellness of its employees and, therefore, provides for a reimbursement of up to $3,000 for an annual physical for each executive officer. In addition, in lieu of providing specific perquisites, the Company provides a set dollar amount of specifically identified perquisites. This dollar amount is consistent within each grade level and is paid annually in 26 equal bi-weekly payments, as identified in the footnotes to the Summary Compensation Table. The executive officers do not need to spend their allowance on the specified items, but are free to use the allowance at their discretion. We believe that providing a set dollar amount allows our executive officers more flexibility and is more efficient to administer

than reimbursing for each individual expense. The amount provided is reviewed periodically and is consistent with perquisites provided by the benchmarking group. In addition, our executive officers may receive personal administrative assistant services at no incremental cost to the Company. Perquisite amounts are not considered annual salary for bonus purposes or 401(k) contributions.

 

401(k) Plan.  The Company believes that financial security during retirement is an important benefit to provide to our executive management. For this reason, the Company and various subsidiaries offer 401(k) plans to their employees, including their executive officers. Because the Company and subsidiary plans operate and are administered in a similar fashion, for purposes of this discussion, the 401(k) plans will be referred to in the singular. Participants may contribute up to the federal limit in the 401(k) plan. The Company makes various levels of contributions to the 401(k) plan, including age-weighted contributions and performance-based matching contributions as defined in the 401(k) plan. Although the majority of the Company’s peers have both defined benefit and defined contribution plans, the Compensation Committee elected to implement a defined contribution plan (the “401(k) plan”) to control Company costs. The Company’s 401(k) plan is consistent with similar plans available generally in the energy industry. Executive officers participate in the 401(k) plan on the same basis as other employees.

 

Supplemental Executive Retirement Plan.  In addition to the 401(k) plan described above, Company officers, including all of the executive officers, and other key employees are eligible to participate in the Company’s Post-2004 Supplemental Executive Retirement Plan (“Post-2004 SERP”). In connection with the adoption of the Post-2004 SERP, the Company suspended contributions to its previous SERP (“SERP”), except for guaranteed interest contributions discussed in the narrative disclosure following the Nonqualified Deferred Compensation Table. The SERP and Post-2004 SERP were implemented to allow Company officers to defer additional pre-tax compensation for retirement without regard to the limits placed on 401(k) plans under the Internal Revenue Code. We believe that the Post-2004 SERP is an important tool for the retirement planning efforts of our officers. Moreover, after reviewing data from the benchmarking group, our Compensation Committee determined that the Post-2004 SERP is important to remain competitive in the compensation arena. Additional information regarding the operation of the SERP and Post-2004 SERP may be found in the footnotes and narrative disclosure following the Nonqualified Deferred Compensation Table.

 

Change of Control and Employment Agreements

 

Change of Control Agreements.  The Company has entered into Change of Control Agreements with nine executive officers, including all of the named executive officers and any executive officers who also serve as directors. After reviewing benchmarking studies performed by outside legal counsel at the request of the Compensation Committee in 1999, the Compensation Committee adopted a form of Change of Control Agreement. In 2005 and again in 2008, the Compensation Committee retained outside legal counsel to perform an update of the benchmarking study to determine whether the Change of Control Agreements remained competitive in the Company’s industry. Because of this analysis, the Compensation Committee revised the form of Change of Control Agreement to reduce the termination multiple for future agreements, as discussed in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

The Compensation Committee has determined that the Change of Control Agreements are a necessary component of our compensation package in order for us to provide competitive compensation arrangements, particularly because such agreements are standard in our industry. In addition, they make executives neutral to change of control transactions that are in the best interests of the company and its stockholders, and thereby help create, rather than diminish, stockholder value. Moreover, we believe that the Change of Control Agreements help us to attract and retain our executive officers by reducing the personal uncertainty and anxiety that arises from the possibility of a future business combination. We selected objective criteria to determine whether a change of control has occurred for purposes of the Change of Control Agreements in order to reduce the likelihood of a dispute in the event of a change of control and to help ensure that the agreements are triggered only under circumstances when a true transfer of control or ownership has occurred. While the Change of Control Agreements do not influence decisions regarding compensation elements, the Compensation Committee periodically reviews the terms of the Change of Control Agreements so that they remain generally consistent with those of the benchmarking group. Additional information regarding the Change of Control Agreements may be found in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

Employment Agreements.  When the Company emerged from bankruptcy in 1987, it offered employment agreements to certain key officers. The only executive officers with the 1987 employment agreements are Messrs. Rock and Dudman. The Company entered into these agreements primarily as a retention tool, but also because the Board of Directors felt that Messrs. Rock and Dudman could provide extraordinary and unique management and strategy skills to maintain and grow the Company. The Compensation Committee has reviewed these contracts and has concluded that they should remain in place, but no longer offers these types of employment agreements to executive officers. As discussed below, effective January 1, 2009, Mr. Rock entered into a new employment agreement with the Company, which terminated and replaced his 1987 employment agreement and his Change of Control Agreement. Mr. Dudman’s 1987 agreement contains severance provisions that would entitle him to receive a lump sum payment in cash equal to his current annual base salary, bonus and benefits through the end of the employment period (three years) in the event that he were to be terminated by the Company (other than for cause, death or disability) or if for any reason his position is eliminated or otherwise becomes redundant, except in the event of a change of control, in which case severance would be paid pursuant to his Change of Control Agreement as explained in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

In December 2008, Mr. Rock executed an employment agreement with the Company wherein he will serve as a Special Executive Advisor to the Chief Executive Officer for a period of approximately one and a half years, commencing January 1, 2009, and ending on the first day following the conclusion of the Company’s annual meeting of stockholders for the calendar year 2010. The agreement provides for an annual base salary of $1.3 million, a target bonus of 120% of base salary with respect to the Company’s 2009 fiscal year and eligibility to participate in all Company benefit and perquisite plans during the employment period other than the Company’s Long-Term Incentive Compensation Plan.

 

In addition, Mr. McKenzie entered into an Employment Agreement with the Company to serve as an advisor for a period of two years, commencing January 1, 2009. Mr. McKenzie’s Agreement provides for an annual base salary of $200,000, subject to adjustment, eligibility to participate in all Company benefit plans and a perquisite payment of $1,958 per month.

 

Pension Plan.  The Company has a defined benefit pension plan, which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Any benefits under the pension plan are offset by benefits paid under a previous pension plan of the Company. Mr. Rock is the only named executive officer with any benefit accruals under the plan. Additional information regarding the plan may be found in the narrative discussion following the Pension Benefits Table.

 

The Compensation and Benefits Committee has reviewed and discussed the Compensation Discussion and Analysis with management. Based on such review and discussion, the Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this proxy statement.

 

Robert Kelley, Chairman
Dod A. Fraser
James R. Gibbs

 

This report of the Compensation and Benefits Committee shall not be deemed “soliciting material,” or to be “filed” with the SEC or subject to Regulation 14A or 14C or to the liabilities of Section 18 of the Securities Exchange Act of 1934 (the “Exchange Act”), except to the extent that we specifically request that the information be treated as soliciting material or specifically incorporate it by reference into a document filed under the Securities Act of 1933 (the “Securities Act”) or the Exchange Act. Further, this report will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act except to the extent that we specifically incorporate this information by reference.

 

The following tables show compensation for services to the Company of the persons who during 2008 were the Principal Executive Officer, Principal Financial Officer, and the next three most highly compensated executive officers (the “Named Executive Officers”).

 

 

 

 

 

 

 

The following table provides information regarding incentive awards made to the Named Executive Officers during the 2008 fiscal year.

 

 

 

 

The following table shows the number of shares covered by exercisable and unexercisable options and unvested restricted stock units held by the Named Executive Officers on December 31, 2008. The market value of unvested awards is based on Smith’s closing market price of $22.89 per share on December 31, 2008.

 

 

 

 

The following table shows all stock options exercised and value received upon exercise, and all stock awards vested and value received upon vesting by the Named Executive Officers during the fiscal year ended December 31, 2008.

 

 

 

 

The following table shows the number of years of credited service of and present value of accumulated benefits payable to each of the Named Executive Officers under the Company’s Restated Pension Plan.

 

 

The Company has a defined benefit pension plan (the “Restated Pension Plan”), which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Since benefit accruals under the Restated Pension Plan have been frozen since March 1, 1987, the years of service for the Named Executive Officers include only the period from September 1, 1985 to March 1, 1987. The accumulated benefit presented above assumes a retirement age of 65, no pre-retirement decrements, a post-retirement mortality assumption based on the RP2000 Combined Healthy Mortality Table Projected by Scale AA to 2015, and payment in the form of a single life annuity.

 

The following table and narrative disclosure provides information regarding nonqualified deferred compensation with respect to each Named Executive Officer.

 

 

 

 

Smith International, Inc. Post-2004 Supplemental Executive Retirement Plan.  The Smith International, Inc. Post-2004 Supplemental Executive Retirement Plan (the “Post-2004 SERP”) is a non-qualified, deferred compensation plan, for the benefit of officers and certain other eligible employees of the Company as selected by the Compensation Committee. Participants may contribute, on a pre-tax basis, up to 100% of their cash compensation, as defined in the Post-2004 SERP. Distributions may generally be made either as a lump sum or installment payments following the participant’s termination of employment due to death, disability, retirement or other separation from service. Distributions may also be made on a limited basis and to the extent necessary as a lump sum upon the occurrence of the participant’s unforeseeable financial emergency as approved by the Compensation Committee. The Post-2004 SERP also provides for Company contributions, as follows:

 

Age-Weighted Contributions.  The Company provides an age-weighted contribution percentage (“AWCP”) ranging from 2% to 6% of qualified compensation, less any age-weighted contributions made to the participant’s 401(k) account. The Post-2004 SERP provides that the AWCP for executive officers is 6% of qualified compensation regardless of age. The difference between a participant’s (i) “Total 401(k) Compensation” and (ii) “Net 401(k) Compensation” is multiplied by the AWCP to compute the age-weighted contribution. “Total 401(k) Compensation” generally means the total of all cash amounts paid by the Company to a participant, including deferred amounts. “Net 401(k) Compensation” generally means Total 401(k) Compensation less participant contributions to the Post-2004 SERP, but not to exceed the limit set under the Internal Revenue Code.

 

Matching Contributions.  The Company provides a performance-based matching contribution ranging from zero to 100% of salary deferrals that mirrors the matching formulas in effect for the Company’s 401(k) Plan, but without regard to certain Code limits applicable to the 401(k) Plan. Matching contributions for all plan participants are limited to 6% of Total 401(k) Compensation, less the maximum dollar amount of matching contributions that could be made in their individual 401(k) accounts for that year. Executive officers receive 100% matching contributions subject to the same limitation.

 

Additional Company Contributions.  Deferred funds are placed with the fund trustee and invested at the discretion of the participant in a variety of funds, including a money market fund. The Company guarantees that the deferrals invested in the money market fund will yield interest at 120% of the long-term applicable federal rate (“AFR”). Therefore, in addition to the contributions described above, for the portion of each participant’s account invested in the money market fund that is earning less than 120% of AFR, the Company makes a contribution equal to the difference in interest between the money market fund rate actually earned by the money market fund and 120% of the AFR, which contribution is credited to the participant’s account.

Discretionary Profit Sharing Contributions.  The Compensation Committee may, in its discretion, determine the amount of any profit sharing contribution for a plan year and how that amount is to be allocated among the accounts of the Post-2004 SERP participants.

 

In the event of insolvency or bankruptcy, all assets allocable to the Post-2004 SERP are available to satisfy the claims of all general unsecured creditors of the Company. The Company established a grantor trust to serve as a source of funds from which it can satisfy its obligations under the Post-2004 SERP. Participants in the Post-2004 SERP will have no rights to any assets held in the trust, except as general unsecured creditors of the Company. A participant’s rights to any amounts credited to an account under the Post-2004 SERP cannot be anticipated, alienated, sold, assigned, pledged, encumbered or charged by the participant and may only pass upon the participant’s death pursuant to a beneficiary designation made by the participant under the Post-2004 SERP. The Company may, by action of the Compensation Committee, terminate the Post-2004 SERP with respect to future contributions; provided, however, such termination shall not affect any participant’s right to receive any distribution due under the Post-2004 SERP.

 

The Post-2004 SERP will be interpreted by the Compensation Committee in such manner as necessary to comply with the requirements of Code Section 409A and the authority issued thereunder.

 

Smith International, Inc. Supplemental Executive Retirement Plan.  In connection with the adoption of the Post-2004 SERP and Code Section 409A, the Company suspended contributions to the SERP effective December 31, 2004, other than such contributions that were earned and vested as of December 31, 2004. However, the Company may be required to make contributions to participants’ accounts to guarantee an investment return equal to 120% of the AFR on deferrals invested in the money market fund, in the same manner as explained above.

 

With respect to Company insolvency or bankruptcy, participant’s rights, beneficiary designations and plan termination, the SERP is in all material respects the same as the Post-2004 SERP.

 

Employment Agreements.  As discussed in Compensation Discussion and Analysis above, during 2008 the Company had employment agreements from 1987 with Messrs. Rock and Dudman. Mr. Rock agreed to the termination of his agreement effective December 31, 2008. Mr. Dudman’s agreement remains in effect. Mr. Dudman’s agreement has an initial term of three years and is automatically extended for an additional year at each anniversary date. Automatic renewals may not be suspended by the Company without triggering severance. The agreement automatically terminates when Mr. Dudman reaches age 65. The employment agreement contains salary and other conditions of employment and entitles Mr. Dudman to participate in the Company’s bonus program and other benefit programs. If the employment of Mr. Dudman is terminated by the Company (other than for cause, death or disability) or if for any reason his position is eliminated or otherwise becomes redundant, Mr. Dudman would be entitled to receive a lump sum payment in cash equal to his current annual base salary, bonus and benefits through the end of the employment period; provided, however, that in the event of a change of control, the Change of Control Agreements discussed below would control, except with respect to any accrued obligations under the employment agreement that were not fully accrued under the applicable Change of Control Agreement.

 

Change of Control Agreements.  The Company has entered into Change of Control Agreements (“Change of Control Agreements”) with nine executive officers, including all of the Named Executive Officers. In the event of a “change of control” of the Company (as defined in the Change of Control Agreements), the Change of Control Agreements provide for the continued employment of the executive officers for a period of three years and provide for the continuation of salary and benefits.

 

“Change of Control” generally means (a) with certain exceptions, the acquisition of beneficial ownership of 30% or more of the outstanding shares of Common Stock or the combined voting power of the outstanding voting securities of the Company; (b) with certain exceptions, a change in the majority of the Board serving as directors as of the date of the Change of Control Agreement; (c) the consummation of a business combination transaction where (i) the beneficial owners of the Common Stock immediately prior to the business combination transaction own less than 60% of the outstanding shares of common stock (or equivalent securities) of the corporation resulting from such business combination transaction (the “Surviving Corporation”), (ii) with certain exceptions, a person is the

beneficial owner of 30% or more of the outstanding shares of common stock or the combined voting power of the outstanding voting securities of the Surviving Corporation, and (iii) less than a majority of the members of the board of directors (or equivalent governing body) of the Surviving Corporation were members of the Board at the time of the execution of the business combination agreement, or of the action of the Board, providing for the business combination transaction; or (d) approval by the Company’s shareholders of a complete liquidation or dissolution.

 

If, after a change of control event, the executive is terminated by the Company (other than for cause, death or disability), or if the executive elects to terminate his or her employment for “Good Reason” (as defined in the Change of Control Agreements), the executive is entitled to receive the following:

 

 

 

 

If the executive’s employment is terminated by reason of the executive’s death or disability, the executive or the estate of the executive shall be entitled to payment of Accrued Obligations and Other Benefits as explained above.

 

Termination Multiple.  Prior to December 19, 2008, the Change of Control Agreements for Messrs. Rock and Kennedy and Ms. Dorman included a termination multiple of three times for termination at any time within three years after the change of control event occurred. After December 19, 2008, the Change of Control Agreements for all executive officers include a termination multiple of three times for termination of employment in year one after the change of control event; two times in year two; and one time in year three.

 

Stock Incentive Plan.  The Company’s Third Amended and Restated 1989 Long-Term Incentive Compensation Plan provides for the vesting of all outstanding stock options and the satisfaction of all restrictions and conditions on restricted stock and other stock-based awards and the full vesting at 100% target levels of all performance-based awards, as of the day immediately preceding the change of control date.

 

Potential Payments upon a Change of Control.  The table below shows potential payments if an executive is terminated other than for cause or voluntary termination after a change of control event. The amounts assume that the change of control event and termination of employment were both effective on December 31, 2008, and are estimates that reflect the amounts that would be paid and the incremental value of benefits that would be enhanced through accelerated vesting of options and stock awards. The value of equity awards is based on Smith’s closing

market price of $22.89 per share on December 31, 2008. As discussed above, the accelerated vesting of outstanding equity awards occurs on the day immediately preceding the change of control date, regardless of whether the executive is terminated or terminates his or her employment following the change of control event. The table also assumes that the executive has been paid in full for salary due for the fiscal year and has no deferred compensation, pro-rated perquisites payments or accrued vacation due for the year. Because the termination is assumed to be on the same day as the change of control, amounts shown use a 3x termination multiple for all executives. If the termination of employment occurred in year two after the change of control event, the termination multiple would be 2x, and if the termination of employment occurred in year three after the change of control event, the termination multiple would be 1x.