The following is management's discussion and analysis of certain significant factors that have affected aspects of the Company's financial position, results of operations, comprehensive income and cash flows during the periods included in the accompanying consolidated financial statements. This discussion should be read in conjunction with the Company's consolidated financial statements and notes thereto presented elsewhere in this report. For a discussion of our results of operations for the year endedDecember 31, 2019 compared to the year endedDecember 31, 2018 , see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" in our Annual Report on Form 10-K for the year endedDecember 31, 2019 .
Overview
Dril-Quip designs, manufactures, sells and services highly engineered drilling and production equipment that is well suited primarily for use in deepwater, harsh environment and severe service applications. The Company's principal products consist of subsea and surface wellheads, subsea and surface production trees, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, liner hangers, wellhead connectors, diverters and safety valves.Dril-Quip's products are used by major integrated, large independent and foreign national oil and gas companies and drilling contractors throughout the world.Dril-Quip also provides technical advisory assistance on an as-requested basis during installation of its products, as well as rework and reconditioning services for customer-ownedDril-Quip products. In addition,Dril-Quip's customers may rent or purchase running tools from the Company for use in the installation and retrieval of the Company's products.
Oil and Gas Prices
Both the market for drilling and production equipment and services and the Company's business are substantially dependent on the condition of the oil and gas industry and, in particular, the willingness of oil and gas companies to make capital expenditures on exploration, drilling and production operations. The outbreak of COVID-19 in 2020 and the disputes over oil production early in the year by theOPEC and non-OPEC nations resulted in oil prices reaching historic lows in the earlier part of 2020. Subsequent to this, theOPEC and non-OPEC nations have since implemented substantial production cuts to stabilize oil prices. However, the initial dispute coupled with the effects of the pandemic led to a significant decline in crude oil prices, resulting in a challenging industry environment. Lower crude oil and natural gas prices have resulted in a trend of customers seeking to renegotiate contract terms with the Company, including extensions of delivery terms and, in some instances, contract revisions. In some cases, a customer may already hold inventory of the Company's equipment, which delays the placement of new orders. In addition, some of the Company's customers could experience liquidity or solvency issues or could otherwise be unable or unwilling to perform under a contract, which could ultimately lead a customer to declare bankruptcy or otherwise encourage a customer to seek to repudiate, cancel or renegotiate a contract. An extended period of reduced crude oil and natural gas prices may accelerate these trends. If the Company experiences significant contract terminations, suspensions or scope adjustments to its contracts, then its financial condition, results of operations and cash flows may be adversely impacted. Oil and gas prices and the level of drilling and production activity have historically been characterized by significant volatility. See "Item 1A. Risk Factors-A material or extended decline in expenditures by the oil and gas industry could significantly reduce our revenue and income." During 2020, Brent crude oil prices fluctuated significantly, with a high of$70.25 per barrel, a low of$9.12 per barrel, and an average of$41.96 per barrel compared to an average of$64.28 per barrel in 2019 and$71.34 per barrel in 2018. According to theJanuary 2021 release of the Short-Term Energy Outlook published by the EIA, Brent crude oil prices are projected to average$52.70 per barrel in 2021 and$53.44 per barrel in 2022.The International Energy Agency projected the global oil demand to grow by approximately 5.5 million barrels per day to a total of 96.6 million barrels per day in 2021 based on itsJanuary 2021 Oil Market Report. Rig Count Detailed below is the average contracted offshore rig count (rigs currently drilling as well as rigs committed, but not yet drilling) for the Company's geographic regions for the years endedDecember 31, 2020 , 2019 and 2018. The rig count data includes floating rigs (semi-submersibles and drillships) and jack-up rigs. The Company has included only these types of rigs as they are the primary assets used to deploy the Company's products. 2020 2019 2018 Floating Rigs Jack-up Rigs Floating Rigs Jack-up Rigs Floating Rigs Jack-up Rigs Western Hemisphere 55 47 52 43 56 37 Eastern Hemisphere 47 60 63 74 57 63 Asia-Pacific 34 259 39 252 34 231 Total 136 366 154 369 147 331
Source: IHS-Petrodata RigBase-
According to IHS-Petrodata RigBase, as ofDecember 31, 2020 , there were 461 rigs contracted for the Company's geographic regions (126 floating rigs and 335 jack-up rigs), which represents a 14.6% decrease from the rig count of 540 rigs (156 floating rigs and 384 jack-up rigs) as ofDecember 31, 2019 . TheDecember 31, 2019 rig count represented a 10.9% increase from the rig count onDecember 31, 2018 of 487 rigs (146 floating rigs and 341 jack-up rigs). 32
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Table of Contents Regulation The demand for the Company's products and services is also affected by laws and regulations relating to the oil and gas industry in general, including those specifically directed to offshore operations. The adoption of new laws and regulations, or changes to existing laws or regulations that curtail exploration and development drilling for oil and gas for economic or other policy reasons, could adversely affect the Company's operations by limiting demand for its products. InMarch 2018 , the President ofthe United States issued a proclamation imposing a 25 percent global tariff on imports of certain steel products, effectiveMarch 23, 2018 . The President subsequently proposed an additional 25 percent tariff on approximately$50 billion worth of imports fromChina , and the government ofChina responded with a proposal of an additional 25 percent tariff onU.S. goods with a value of$50 billion . The initialU.S. tariffs were implemented onJuly 6, 2018 , covering$34 billion worth of Chinese goods, with another$16 billion of goods facing tariffs beginning onAugust 23, 2018 . InSeptember 2018 , the President directed theU.S. Trade Representative (USTR) to place additional tariffs on approximately$200 billion worth of additional imports fromChina . These tariffs, which took effect onSeptember 24, 2018 , were initially set at a level of 10 percent until the end of the year, at which point the tariffs were to rise to 25 percent. However, onDecember 19, 2018 , USTR postponed the date on which the rate of the additional duties would increase to 25 percent untilMarch 2, 2019 . OnMay 9, 2019 , USTR announced thatthe United States increased the level of tariffs from 10 percent to 25 percent on approximately$200 billion worth of Chinese imports. The President also ordered USTR to begin the process of raising tariffs on essentially all remaining imports fromChina , which are valued at approximately$300 billion . OnAugust 13, 2019 andAugust 23, 2019 , USTR announced the imposition of an additional tariff of 15 percent on approximately$300 billion worth of Chinese imports, effectiveSeptember 1, 2019 (orDecember 15, 2019 for certain articles). Following the conclusion of a phase one trade deal withChina , USTR suspended the implementation of the 15 percent additional duty on approximately$160 billion worth of Chinese imports and reduced the applicable duty from 15 percent to 7.5 percent for$120 billion worth of Chinese imports. Negotiations for a phase two trade deal withChina had begun prior to the outbreak of the global COVID-19 pandemic and if continued could lead to additional changes to the tariff rates described above.President Biden has indicated that these tariffs will likely remain in place while the new administration assessesthe United States' current posture, including a review of the phase one trade deal withChina . The imposition of any additional tariffs or initiation of trade restrictions by or againstthe United States could cause our cost of raw materials to increase or affect the markets for our products. However, given the uncertainty regarding the scope and duration of these trade actions bythe United States and other countries, their ultimate impact on our business and operations remains uncertain. InNovember 2018 ,the United States ,Mexico andCanada signedthe United States -Mexico-Canada Agreement (USMCA), the successor agreement to the North American Free Trade Agreement (NAFTA). The three countries have all ratified the new agreement, and onJuly 1, 2020 , the USMCA became effective.
Business Environment
Oil and gas prices and the level of drilling and production activity have been characterized by significant volatility in recent years. Worldwide military, political, economic and other events have contributed to oil and natural gas price volatility and are likely to continue to do so in the future. Lower crude oil and natural gas prices have resulted in a trend of customers seeking to renegotiate contract terms with the Company, including reductions in the prices of its products and services, extensions of delivery terms and, in some instances, contract cancellations or revisions. In some cases, a customer may already hold an inventory of the Company's equipment, which may delay the placement of new orders. In addition, some of the Company's customers could experience liquidity or solvency issues or could otherwise be unable or unwilling to perform under a contract, which could ultimately lead a customer to enter bankruptcy or otherwise encourage a customer to seek to repudiate, cancel or renegotiate a contract. An extended period of reduced crude oil and natural gas prices may accelerate these trends. If the Company experiences significant contract terminations, suspensions or scope adjustments to its contracts, then its financial condition, results of operations and cash flows may be adversely impacted. The Company expects continued pressure in both crude oil and natural gas prices, as well as in the level of drilling and production related activities. Even during periods of high prices for oil and natural gas, companies exploring for oil and gas may cancel or curtail programs, seek to renegotiate contract terms, including the price of products and services, or reduce their levels of capital expenditures for exploration and production for a variety of reasons. A prolonged delay in the recovery of commodity prices could also lead to further material impairment charges to tangible or intangible assets or otherwise result in a material adverse effect on the Company's results of operations. OnJune 24, 2020 , the Company andProserv Group, Inc. ("Proserv") announced an agreement pursuant to which the Company would rely uponProserv for the manufacture and supply of subsea control systems but on a non-exclusive basis. The agreement allows the Company to continue to serve its existing subsea controls customers with the support and collaboration ofProserv and follows the Company's strategic decision to consolidate the supply and development of control systems with a dedicated subsea controls provider. This arrangement will allow the Company to avoid operating and research and development costs related to subsea controls, which were expected to be between$8 million and$10 million per year. The COVID-19 pandemic continues to have an impact globally. While we have been actively monitoring the worldwide spread of COVID-19, the extent to which the pandemic will ultimately impact our business remains difficult to predict. Our priority remains the safety of our employees, clients and the communities in which we live and operate. We are taking a measured approach in bringing our 33
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employees back in the office. We continue to remain in close and regular contact with our employees, clients, suppliers, partners and governments globally to help them navigate these challenging times. The outbreak of COVID-19 and its development into a pandemic in the first quarter of 2020 resulted in significant economic disruption globally. Actions taken by various governmental authorities, individuals and companies around the world to prevent the spread of COVID-19 through social distancing have restricted travel, curtailed business operations, prohibited public gatherings and restricted the overall level of individual movement and in-person interaction across the globe. While the severity of the government-imposed restrictions in different regions and changes to consumer behavior have continued to evolve during the course of the pandemic, significant global economic disruptions have continued throughout 2020. With the recent increase in the number of COVID-19 cases during the fourth quarter, governments in certain jurisdictions have reimposed enhanced restrictions on business activity and travel. These actions and changes in consumer behavior resulting from the pandemic continue to impact our business and have significantly reduced global economic activity and caused global demand for oil and gas to decrease at an unprecedented rate. This demand reduction was further exacerbated by disputes over oil production by theOPEC and non-OPEC nations, especially during the first half of the year. Although theOPEC and non-OPEC nations have since agreed upon substantial production cuts to stabilize oil prices, the dispute has led to significant declines and volatility in crude oil prices, resulting in a challenging industry environment. The extent of the impact of the pandemic, including economic impacts that may persist following the widespread deployment of vaccines, and the decline in oil prices on our operational and financial performance will depend on future developments, which are uncertain and cannot be predicted. An extended period of economic disruption could have a material adverse impact on our business, results of operations, access to sources of liquidity and overall financial condition. In addition, the pandemic has continued to cause disruption to our suppliers and their sub-contractors. Our suppliers and their sub-contractors' operations experienced disruptions related to worker absenteeism, quarantine, travel and health-related restrictions. This in turn exerts downward pressure on our global manufacturing scheduling and capacity as our supply chain is disrupted causing delays in product shipments and leading to an increase of our inventory balance. As a result of these disruptions and the related downturn in customer activity, overall production output decreased by 6.5% as compared to the prior year. We actively review our global production plans with our supply chain and manufacturing groups and adopt contingency plans where possible to minimize the impact of these COVID-19 related disruptions. The proactive safety measures we had previously implemented in response to the COVID-19 pandemic to protect the health and safety of our employees, customers and suppliers globally will continue to remain in place until we have determined that the COVID-19 pandemic has been adequately contained. We enacted rigorous safety measures in all of our sites, including implementing social distancing protocols, requiring remote work arrangements where possible, staggering shifts, suspending travel, extensively and frequently disinfecting our workspaces and providing masks to those employees who must be physically present at work. Furthermore, we have also utilized government employee support packages where available, in an effort to retain employees during this uncertain period. We expect to continue to implement these measures until we determine that the COVID-19 pandemic is adequately contained. In compliance with the orders issued by certain local jurisdictions in which the Company operates, the Company has continued the practice of requiring all employees to wear a face mask or covering while working at all sites. We may take further safety precautions as government authorities require or recommend or as we determine to be in the best interests of our employees, customers and suppliers. All our facilities currently remain operational with staggered shifts which has impacted production output including quarantine requirements for our service technicians both before and after being deployed on an offshore engagement. We expect the constraints and limits imposed on our operations to slow or diminish our research and development activities and qualification activities with our customers. We do not believe that remote work arrangements have adversely affected our ability to maintain financial reporting systems, internal control over financial reporting and disclosure controls and procedures. The Company has taken steps and adjusted its workforce to be in line with the current situation as we continue to monitor ongoing market conditions. The extent to which our future results are affected by these externalities will depend on various factors and circumstances beyond our control, such as the duration and scope of the pandemic, additional actions by businesses and governments in response to the pandemic, the speed and effectiveness of containing the virus and developments in the global oil markets. We believe the COVID-19 pandemic will continue to negatively impact oilfield activity in 2021. Similarly, we expect that the oil price decline, and continued uncertainty regarding its duration, will continue to have a negative impact on oil and gas activities. In addition to this, COVID-19 and the associated depressed global economic conditions could also aggravate the risk factors identified in "Item 1A. Risk Factors", including leading to further material impairment charges. During 2020, the Company took advantage of the Payroll Tax Deferral provided by the Coronavirus, Aid, Relief and Economic Security Act ("CARES Act"). The Payroll Tax Deferral allows the Company to defer the payment of the Company's share of FICA taxes of 6.2%. As such, the Company was able to defer its share of FICA taxes for the period beginningMarch 27, 2020 and endingDecember 31, 2020 to 2021. This resulted in approximately$2.9 million in FICA cash tax payments being deferred to next year. The Company must still deposit its share of the Medicare hospital insurance tax of 1.45% as well as all of the employee's share of the payroll taxes withheld. The CARES Act also provides for the five-year carryback of Net Operating Losses ("NOLs") generated in the 2018, 2019 and 2020 taxable years. In addition, the taxable income limitation is temporarily removed, allowing NOLs to fully offset net taxable income. The Company filed returns to carryback its NOLs back to previous tax years to generate a refund of$31.0 million and expects to file a NOL carryback claim for the 2020 tax year in the second quarter of 2021. 34
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During 2020, the Company also took advantage of job support schemes in
The Company operates its business and markets its products and services in most of the significant oil and gas producing areas in the world and is, therefore, subject to the risks customarily attendant to international operations and investments in foreign countries. These risks include nationalization, expropriation, war, acts of terrorism and civil disturbance, restrictive action by local governments, limitation on repatriation of earnings, change in foreign tax laws and change in currency exchange rates, any of which could have an adverse effect on either the Company's ability to manufacture its products in its facilities abroad or the demand in certain regions for the Company's products or both. To date, the Company has not experienced any significant problems in foreign countries arising from local government actions or political instability, but there is no assurance that such problems will not arise in the future. Interruption of the Company's international operations could have a material adverse effect on its overall operations. Revenues.Dril-Quip's revenues are generated from three sources: products, services and leasing. Product revenues are derived from the sale of drilling and production equipment. Service revenues are earned when the Company provides technical advisory assistance and rework and reconditioning services. Leasing revenues are derived from rental tools used during installation and retrieval of the Company's products and from leasing our forging facility. In 2020, the Company derived 70.9% of its revenues from the sale of its products, 20.7% of its revenues from services and 8.4% from leasing revenues, compared to 73.1%, 17.4% and 9.5% for products, services and leasing in 2019, respectively. During the latter part of 2019 we entered into an agreement to lease our forge facilities and equipment toAFGlobal Corporation , which also has an option to acquire those same assets. Service and leasing revenues generally correlate to revenues from product sales because increased product sales typically generate increased demand for technical advisory assistance services during installation and rental of running tools. However, customer stocking and destocking can affect the correlation between demand for services and product sales. The Company has substantial international operations, with approximately 66.7% of its revenues derived from foreign sales in 2020 and 65.0% in 2019. Substantially all of the Company's domestic revenue relates to operations in theU.S. Gulf of Mexico . Domestic revenue approximated 33.3% of the Company's total revenues in 2020 and 35.0% in 2019. Product contracts are typically negotiated and sold separately from service contracts. In addition, service contracts are not typically included in the product contracts or related sales orders and are not offered to the customer as a condition of the sale of the Company's products. The demand for products and services is generally based on worldwide economic conditions in the oil and gas industry and is not based on a specific relationship between the two types of contracts. Substantially all of the Company's sales are made on a purchase order basis. Purchase orders are subject to change and/or termination at the option of the customer. In case of a change or termination, the customer is required to pay the Company for work performed and other costs necessarily incurred as a result of the change or termination. Generally, the Company attempts to raise its prices as its costs increase. However, the actual pricing of the Company's products and services is impacted by a number of factors, including global oil prices, competitive pricing pressure, the level of utilized capacity in the oil service sector, maintenance of market share, the introduction of new products and general market conditions. The Company accounts for larger and more complex projects that have relatively longer manufacturing time frames on an over time basis. During 2020, there were 57 projects that were accounted for using the over time method, which represented approximately 33.2% of the Company's total revenues and 46.9% of the Company's product revenues. During 2019, there were 36 projects that were accounted for using the over time method, which represented approximately 20.5% of the Company's total revenues and 28.0% of the Company's product revenues. These percentages may fluctuate in the future. Revenues accounted for in this manner are generally recognized based upon a calculation of the percentage complete, which is used to determine the revenue earned and the appropriate portion of total estimated cost of sales. Accordingly, price and cost estimates are reviewed periodically as the work progresses, and adjustments proportionate to the percentage complete are reflected in the period when such estimates are revised. Losses, if any, are recorded in full in the period they become known. Amounts received from customers in excess of revenues recognized are classified as a current liability. See "Item 1A. Risk Factors-We may be required to recognize a charge against current earnings because of over time method of accounting." Cost of Sales. The principal elements of cost of sales are labor, raw materials and manufacturing overhead. Cost of sales as a percentage of revenues is influenced by the product mix sold in any particular period, costs from projects accounted for under the over time method, over/under manufacturing overhead absorption and market conditions. The Company's costs related to its foreign operations do not significantly differ from its domestic costs. Selling, General and Administrative Expenses. Selling, general and administrative expenses include the costs associated with sales and marketing, general corporate overhead, business development expenses, compensation expense, stock-based compensation expense, legal expenses and other related administrative functions. Engineering and Product Development Expenses. Engineering and product development expenses consist of new product development and testing, as well as application engineering related to customized products. The engineering and product development expenses during the years endedDecember 31, 2020 and 2019 were$18.9 million and$17.3 million , respectively. Impairment. During 2020, impairment losses consist of a full impairment of our goodwill balance of$7.7 million , which occurred in connection with our preparation and review of financial statements during the first quarter of 2020. No goodwill impairment losses were recorded for the year endedDecember 31, 2019 . 35
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Restructuring and Other Charges. During 2020, restructuring and other charges consisted of inventory write-downs, severance charges, long-lived assets write-downs and other charges of$17.3 million ,$8.4 million ,$8.3 million , and$1.4 million , respectively. For the year endedDecember 31, 2019 , we incurred approximately$4.4 million of expenses primarily associated with professional fees related to our strategic restructuring and approximately$1.1 million in severance payout to our former Chief Operating Officer, pursuant to a separation agreement entered into with him during the first quarter of 2019. (Gain) Loss on Sale of Assets. Gain or loss on sale of assets consists of sales of certain property, plant and equipment. Gain on sale of assets for the year endedDecember 31, 2020 was$0.6 million , which consisted primarily of a gain on sale of our TIW Oklahoma facility. Gain on sale of assets for the year endedDecember 31, 2019 was$1.5 million . Foreign Currency Transaction (Gains) and Losses. Foreign currency transaction (gains) and losses result from a change in exchange rates between the functional currency and the currency in which a foreign currency transaction is denominated. The Company's foreign subsidiaries, whose functional currency is the local currency, conduct a portion of their operations inU.S. dollars. As a result, these subsidiaries hold significant monetary assets denominated inU.S. dollars. These monetary assets are subject to changes in exchange rates between theU.S. dollar and the local currency, which has resulted in pre-tax non-cash foreign currency loss of$2.3 million during the year endedDecember 31, 2020 and a pre-tax non-cash foreign currency gain of$1.6 million during the year endedDecember 31, 2019 . Income Tax Provision. Income tax benefit for 2020 was$31.3 million on a net loss before taxes of$62.0 million , resulting in an effective income tax rate of 50.4%. Income tax expense for 2019 was$8.7 million on net income before taxes of$10.4 million , resulting in an effective income tax rate of 83.5%. The Company's effective income tax rate fluctuates from theU.S. statutory tax rate based on, among other factors, changes in pretax income in jurisdictions with varying statutory tax rates, impact of valuation allowances, changes due to CARES Act legislation, foreign inclusions, changes in withholding tax reserves on undistributed earnings and other permanent differences related to the recognition of income and expense betweenU.S. GAAP and applicable tax rules. Reclassifications. We reclassified approximately$1.6 million and$1.0 million of foreign currency transaction gains for the years endedDecember 31, 2019 and 2018, respectively, from selling, general and administrative to foreign currency transaction (gains) and losses. These reclassifications did not have an impact on our Consolidated Statements of Income (Loss), Consolidated Balance Sheets, Consolidated Statements of Comprehensive Income (Loss), Consolidated Statements of Stockholders' Equity and Consolidated Statements of Cash Flows.
Results of Operations
The following table sets forth, for the periods indicated, certain consolidated statement of income data expressed as a percentage of revenues:
Year Ended December 31, 2020 2019 2018 Revenues: Products 70.9 % 73.1 % 68.9 % Services 20.7 17.4 18.8 Leasing 8.4 9.5 12.3 Total revenues 100.0 100.0 100.0 Cost of sales: Products 55.0 53.9 57.6 Services 10.3 8.8 9.7 Leasing 8.6 8.4 8.8 Total cost of sales 73.9 71.1 76.1 Selling, general and administrative 26.0 23.7
26.6
Engineering and product development 5.2 4.2
5.3
Impairments 2.1 -
10.0
Restructuring and other charges 9.7 1.1
15.6
Gain on sale of assets (0.2 ) (0.4 ) (1.6 ) Foreign currency transaction (gains) and losses 0.6 (0.4 ) (0.3 ) Total costs and expenses 117.3 99.3 131.7 Operating income (loss) (17.3 ) 0.7 (31.7 ) Interest income 0.6 1.9 2.1 Interest expense (0.2 ) (0.1 ) (0.1 ) Income (loss) before income taxes (16.9 ) 2.5 (29.7 ) Income tax provision (benefit) (8.6 ) 2.1 (5.0 ) Net income (loss) (8.3 )% 0.4 % (24.7 )% 36
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The following table sets forth, for the periods indicated, a breakdown of our products and service revenues:
Year Ended December 31, 2020 2019 2018 (In millions) Revenues: Products: Subsea equipment$ 206.4 $ 245.3 $ 209.1 Downhole tools 28.9 28.5 32.2 Surface equipment 12.8 19.4 19.6 Offshore rig equipment 10.7 10.1 4.1 Total products 258.8 303.3 265.0 Services 75.6 72.0 72.4 Leasing 30.6 39.5 47.2 Total revenues$ 365.0 $ 414.8 $ 384.6
Year Ended
Revenues. Revenues decreased by$49.8 million , or approximately 12.0%, to$365.0 million in 2020 from$414.8 million in 2019. The overall decrease in revenue was driven by decreased product revenues of$44.5 million and decreased leasing revenues of$8.9 million , partially offset by increased service revenues of$3.6 million . Product revenues decreased by approximately$44.5 million for the year endedDecember 31, 2020 compared to the same period in 2019 as a result of decreased revenues of$38.9 million in subsea equipment and$6.6 million in surface equipment, partially offset by increased revenues of$0.6 million in offshore rig equipment and$0.4 million in downhole tools. Total revenues decreased in the Eastern Hemisphere by$38.9 million , in the Western Hemisphere by$11.6 million , partially offset by increase in revenues inAsia-Pacific by$0.7 million . The Company's revenues were negatively impacted by customers requesting extensions on their deliveries, orders and projects being delayed, disruptions to supply chain and production output and an increase in the number of employees in quarantine. All of these negative impacts were attributable to both the COVID-19 pandemic and developments in the global oil markets. During the first quarter of 2020 as the COVID-19 pandemic outbreak began to affect the global markets, our revenues were negatively impacted by reduced productivity, customers requesting extension of their deliveries and supply chain disruptions. Although all regions were impacted to differing degrees, the initial impact earlier in the year was most felt in theAsia-Pacific region . Further, as a result of supply chain interruptions to our wellhead business inEurope we shifted our focus to pipe fabrication which invariably has lower gross margins. As the year progressed, the effects of the COVID-19 pandemic spread globally and continued to cause delays and disruptions to our production schedule. In the fourth quarter of 2020, as the COVID-19 cases began to rise again, we witnessed an increase of our plant workers requiring quarantine resulting in lower production output and consequently lower revenue compared to the prior year. Overall, stagnant demand and reduced productivity negatively impacted our revenue during the year as a result of the developments discussed in this section. In any given time period, the revenues recognized between the various product lines and geographic areas will vary depending upon the timing of shipments to customers, completion status of the projects accounted for under the over time accounting method, market conditions and customer demand. Service revenues increased by approximately$3.6 million resulting mainly from increased service revenues inAsia-Pacific of$4.9 million and in the Western Hemisphere of$2.9 million , partially offset by decreased service revenue in the Eastern Hemisphere of$4.2 million . The increase in service revenues inAsia-Pacific and the Western Hemisphere is due largely to the increases in technical advisory services and maintenance requests related to products delivered. Lower service revenues in the Eastern Hemisphere are attributable primarily to COVID-19 disruptions, including travel restrictions, and lower activity, which more than offset increased customer rework and conditioning activity during the period. Leasing revenues decreased by approximately$8.9 million for the year endedDecember 31, 2020 compared to the same period in 2019 mainly from decreased leasing revenues in the Eastern Hemisphere of$4.7 million , in the Western Hemisphere of$3.8 million and inAsia-Pacific of$0.4 million . The majority of the decrease in the Eastern and Western Hemispheres is related to decreased subsea rental tool utilization due to timing of customer exploration activity, COVID-19 related travel restrictions and the unfavorable developments in the global oil markets. The decrease inAsia-Pacific is mainly due to resolution of a one-time customer dispute on rental equipment. Cost of Sales. Cost of sales decreased by$25.3 million , or 8.6%, to$269.7 million for 2020 from$295.0 million for 2019. The decrease in costs of sales were mainly in line with the decrease in revenue for the year endedDecember 31, 2020 . Savings resulting from our business transformation were partially offset by higher COVID-19 related costs which included higher manufacturing overhead costs from staggered shifts, an increase in the number of employees in quarantine, supply chain disruptions, additional freight charges, more extensive cleaning and sanitization of workstations and, to a lesser extent unfavorable product mix. Overall, the COVID-19 disruptions and unfavorable product mix resulted in the increase in cost of sales as a percentage of revenue to 73.9% in 2020 from 71.1% in 2019. This was partially offset by savings resulting from leasing of our forge facility toAFGlobal Corporation in the fourth quarter of 2019 and continuing for the entire year in 2020. 37
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Selling, General and Administrative Expenses. For 2020, selling, general and administrative expenses decreased by approximately$3.4 million , or 3.4%, to$95.1 million from$98.4 million in 2019. The decrease was attributable mainly to workforce reductions as part of our global strategic transformation plan and the suspension of our short-term incentive plans and approximately$1.8 million related to accelerated vesting of restricted stock awards and$2.4 million related to continued vesting of performance share units pursuant to a separation agreement with our former Chief Operating Officer entered into during the first quarter of 2019. This was partially offset by higher legal expenses during 2020 related to an ongoing legal matter. Engineering and Product Development Expenses. For 2020, engineering and product development expenses increased by approximately$1.6 million , or 9.2%, to$18.9 million from$17.3 million in 2019. Engineering and product development expenses as a percentage of revenues increased to 5.2% in 2020 from 4.2% in 2019. This was due to increased activity required to support strategic growth initiatives tied to committed customer orders and our continued research and development efforts within the Subsea Productions Systems product line which resulted in theOffshore Technology Conference award for the VXTe product. Impairments. InMarch 2020 , the overall offshore market conditions declined primarily due to the COVID-19 pandemic and unfavorable developments in the global oil markets. This decline was evidenced by lower commodity prices, decline in expected offshore rig counts, decrease in our customers' capital budgets and potential delays or cancellations of contracts. As a result, an interim goodwill impairment analysis was performed in connection with the preparation and review of financial statements during the first quarter of 2020. Based on this analysis, we fully impaired our goodwill balance of$7.7 million , all of which was in the Eastern Hemisphere reporting unit. For further information, see "Goodwill ," Note 8 of Notes to Consolidated Financial Statements. Restructuring and Other Charges. As a result of unfavorable market conditions primarily due to the COVID-19 pandemic and developments in the global oil markets, which triggered historically low crude oil prices and decreases in our customers' capital budgets, we incurred additional costs under our existing 2018 global strategic plan primarily focused on workforce reductions and to realign our manufacturing facilities during the first quarter of 2020. We recorded inventory write-downs, severance charges, long-lived asset write-downs and other charges of$35.4 million during the year 2020. During 2019, we incurred approximately$4.4 million of expenses primarily associated with professional fees related to our strategic restructuring and approximately$1.1 million in severance payout to our former Chief Operating Officer, pursuant to a separation agreement entered into with him during the first quarter of 2019. Gain on Sale of Assets. During 2020, gain on sale of assets was$0.6 million , which consisted primarily of a gain on sale of our TIW Oklahoma facility. During 2019, gain on sale of assets was$1.5 million , which consisted primarily of the sale of ourYoungsville, Louisiana manufacturing and services facility. Foreign Currency Transaction (Gains) and Losses. Foreign exchange loss for 2020 was$2.3 million as compared to a foreign exchange gain of$1.6 million for the same period in 2019. Income Tax Provision (Benefit). Income tax benefit for 2020 was$31.3 million on a loss before taxes of$62.0 million , resulting in an effective income tax rate of 50.4%. Income tax expense was different than theU.S. federal statutory income tax rate of 21% primarily due to the impact of recording the NOL benefit of the CARES Act, changes in accruals for undistributed earnings and foreign inclusions. Income tax expense in 2019 was$8.7 million on an income before taxes of$10.4 million , resulting in an effective tax rate of approximately 83.5%. The change in the effective income tax rate from 2019 to 2020 was primarily driven by the NOL benefit of the CARES Act legislation, increase in accruals for undistributed earnings, change in valuation allowance against the netU.S. deferred tax assets as well as those in various foreign countries, the mix of foreign income taxed at different statutory rates, an increase in non-taxable income, non-deductible expenses, foreign income inclusions and foreign tax credits.
Net Income (Loss). Net loss was approximately
Non-GAAP Financial Measures
We have performed a detailed analysis of the non-GAAP measures that are relevant to our business and its operations and determined that the appropriate unit of measure to analyze our performance is Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization, as well as other significant non-cash items and other adjustments for certain charges and credits). The Company believes that the exclusion of these charges and credits from these financial measures enables it to evaluate more effectively the Company's operations period over period and to identify operating trends that could otherwise be masked by excluded items. It is our determination that Adjusted EBITDA is a more relevant measure of how the Company reviews its ability to meet commitments and pursue capital projects. Adjusted EBITDA We calculate Adjusted EBITDA as one of the indicators to evaluate and compare the results of our operations from period to period by removing the effect of our capital structure from our operating structure and certain other items, including those that affect the comparability of operating results. This measurement is used in concert with operating income, its most directly comparable financial measure, and net cash from operating activities, which measures actual cash generated in the period. In addition, we believe that Adjusted EBITDA is a supplemental measurement tool used by analysts and investors to help evaluate overall operating performance, ability to pursue and service possible debt opportunities and analyze possible future capital expenditures. Adjusted EBITDA does not 38
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represent funds available for our discretionary use and is not intended to represent or to be used as a substitute for net income, as measured underU.S. generally accepted accounting principles. The items excluded from Adjusted EBITDA, but included in the calculation of reported net income, are significant components of the Consolidated Statements of Income (Loss) and must be considered in performing a comprehensive assessment of overall financial performance. Our calculation of Adjusted EBITDA may not be consistent with calculations of Adjusted EBITDA used by other companies.
The following table reconciles our reported net income to Adjusted EBITDA for each of the respective periods:
Year Ended December 31, 2020 2019 2018 (In thousands) Net income (loss)$ (30,768 ) $ 1,720 $ (95,695 ) Add: Interest income, net (1,510 ) (7,626 ) (7,749 ) Income tax provision (benefit) (31,281 ) 8,709 (19,294 ) Depreciation and amortization expense 32,389 34,020 35,312 Impairments 7,719 -
38,559
Restructuring and other charges (2) 40,480 4,396 60,043 Gain on sale of assets (587 ) (1,511 ) (6,198 ) Foreign currency loss (gain) 2,345 (1,630 ) (1,007 ) Stock compensation expense 12,914 15,721 13,459 Adjusted EBITDA (1)$ 31,701 $ 53,799 $ 17,430
(1) Adjusted EBITDA does not measure financial performance under GAAP and, accordingly, should not be considered as an alternative to net income as an indicator of operating performance. (2) Restructuring and other charges include legal expenses related to a non-recurring legal matter.
Liquidity and Capital Resources
Cash Flows
Cash flows provided by (used in) operations by type of activity were as follows: Year Ended December 31, 2020 2019 2018 (In thousands) Net cash provided by (used in) operating activities$ (21,088 ) $ 14,678 $ 45,503 Net cash used in investing activities (5,628 ) (8,471 ) (15,173 ) Net cash used in financing activities (25,183 ) (24,572 ) (99,199 ) (51,899 ) (18,365 ) (68,869 ) Effect of exchange rate changes on cash activities (1,092 ) (789 ) (6,211 ) Decrease in cash and cash equivalents$ (52,991 ) $ (19,154 ) $ (75,080 ) Statements of cash flows for entities with international operations that are local currency functional exclude the effects of the changes in foreign currency exchange rates that occur during any given year, as these are non-cash changes. As a result, changes reflected in certain accounts on the Consolidated Statements of Cash Flows may not reflect the changes in corresponding accounts on the Consolidated Balance Sheets. The primary liquidity needs of the Company are (i) to fund capital expenditures to improve and expand facilities and manufacture additional running tools, (ii) to fund working capital and (iii) to fund the repurchase of the Company's shares. The Company's principal source of funds is cash flows from operations. As ofDecember 31, 2020 , the Company had availability of$40.2 million under the ABL Credit Facility. The Company may use its liquidity for, among other things, the support of the Company's research and development efforts, the funding of key projects and spending required by any upturn in the Company's business and the pursuit of possible acquisitions. Net cash used in operating activities in 2020 increased by approximately$35.8 million primarily due to increases resulting from the change in operating assets and liabilities of$49.0 million and an increase in net loss of$32.5 million . This was partially offset by$45.7 million of non-cash movements which included an increase in impairment, restructuring and other charges of$42.9 million , of which,$35.2 million is related to the write-down of inventory and long-lived assets and$7.7 million is related to the impairment of goodwill. 39
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The change in operating assets and liabilities during 2020 resulted in a$49.0 million decrease in cash as compared to the change in operating assets and liabilities during 2019. The$35.9 million increase in prepaids and other assets was primarily due to the CARES Act and other tax benefits recognized due to losses incurred in various foreign jurisdictions. The decrease in accounts payable and accrued expenses of$35.7 million was mainly related to lower material purchases and suspension of our short-term incentive plan during the year. Trade receivables increased by$20.3 million primarily due to lower global collections which was impacted by delays in customer collections due to their remote working arrangements which impacted our ability to collect. As such, we have subsequently collected approximately$20.0 million in the first half ofJanuary 2021 related to the customer collection delays from the fourth quarter of 2020. The increase in inventory of$14.3 million was mainly due to delays in shipments due to COVID-19 pandemic related disruptions and the strategic stocking program activity related to our downhole tools and subsea tree businesses. Unbilled receivables decreased by$57.2 million mainly due to the timing difference on our milestone billing, which is offset by an increase in trade receivables, and progress on the projects that are accounted for on an over time basis. Net income (loss) changed by$32.5 million to a net loss of$30.8 million in 2020 from a net income of$1.7 million in 2019. Net income (loss) changed by$97.4 million to a net income of$1.7 million in 2019 from net loss of$95.7 million in 2018. The reasons for the changes in net income or losses are set forth in the "Results of Operations" section above. Net cash provided by operating activities in 2019 decreased by approximately$30.8 million from 2018 primarily due to decreases resulting from the change in non-operating assets and liabilities of$90.0 million and operating assets and liabilities of$38.2 million , partially offset by a decreased net loss of$97.4 million between 2019 and 2018. Decreases in the change in non-operating assets and liabilities of$90.0 million primarily related to decreases in impairment, restructuring and other non-cash charges of$98.4 million , partially offset by a lower gain on sale of equipment of$4.7 million and a change in deferred income taxes of$4.7 million . Decreases in the change in operating assets and liabilities of$38.2 million related to change in inventory of$64.0 million and change in trade receivables, net and unbilled receivables of$34.4 million , partially offset by change in accounts payable and accrued expenses of$34.1 million and change in prepaid and other assets of$26.1 million . Net cash used in investing activities decreased by approximately$2.8 million due to increased proceeds related to sales of assets, partially offset by increased capital expenditures related to rental tools and machinery and equipment in the Western Hemisphere. Capital expenditures by the Company were$11.9 million ,$11.5 million and$32.1 million in 2020, 2019 and 2018, respectively. Capital expenditures in 2020 included$5.1 million for rental tools,$3.9 million for machinery and equipment and other expenditures of$2.9 million . Capital expenditures in 2020 were primarily for rental tools to support our current and recently developed products, our downhole tools segment and machinery and equipment required for the consolidation of our manufacturing facilities from the Eastern Hemisphere to the Western Hemisphere. Capital expenditures in 2019 were primarily$3.0 million for facilities, machinery and equipment,$2.4 million for rental tools and other expenditures of$6.1 million . Capital expenditures in 2018 were comprised of$14.0 million for facilities,$2.9 million for machinery and equipment,$12.6 million for rental tools and other expenditures of$2.6 million .
Repurchase of
During the year endedDecember 31, 2020 , the Company purchased 808,389 shares at an average price of$30.91 per share totaling approximately$25.0 million . All repurchased shares have been cancelled as ofDecember 31, 2020 . Refer to "Item 5 - Market for Registrant's Common Stock, Related Stockholder Matters and Issuer Purchases ofEquity Securities " for further discussion. OnFebruary 26, 2019 , the Company announced that the Board of Directors had authorized a new stock repurchase program under which the Company is authorized to repurchase up to$100 million of its common stock. The repurchase program has no set expiration date. Repurchases under the program will be made through open market purchases, privately negotiated transactions or plans, instructions or contracts established under Rule 10b5-1 under the Exchange Act. The manner, timing and amount of any purchase will be determined by management based on an evaluation of market conditions, stock price, liquidity and other factors. The program does not obligate the Company to acquire any particular amount of common stock and may be modified or superseded at any time at the Company's discretion. During the year endedDecember 31, 2019 , the Company purchased 615,940 shares at an average price of$43.12 per share totaling approximately$26.6 million . All repurchased shares were subsequently cancelled. OnJuly 26, 2016 , the Board of Directors authorized a stock repurchase plan under which the Company was authorized to repurchase up to$100 million of its common stock. During the year endedDecember 31, 2018 , the Company purchased, and subsequently cancelled, 1,991,206 shares for$100.0 million . The repurchase plan was completed onOctober 19, 2018 . All repurchased shares were subsequently cancelled. 40
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Table of Contents Contractual Obligations The following table presents the long-term contractual obligations of the Company's leases and the related payments in total and by year as ofDecember 31, 2020 : Twelve months ended December 31, 2020 Operating Finance Leases Leases Total (In thousands) 2021$ 1,376 $ 149 $ 1,525 2022 1,125 54 1,179 2023 870 26 896 2024 625 20 645 2025 602 - 602 After 2025 4,654 - 4,654 Total lease payments 9,252 249 9,501 Less: interest 2,297 15 2,312
Present value of lease liabilities
In addition to the above, the Company has issued purchase orders in the ordinary course of business for the purchase of goods and services. These purchase orders are enforceable and legally binding. However, none of the Company's purchase obligations call for deliveries of goods or services for time periods in excess of one year. The Company believes that cash generated from operations plus cash on hand will be sufficient to fund operations, working capital needs and anticipated capital expenditure requirements for the next twelve months at current activity levels. However, if work activity increases, we expect further working capital investment will be required.
Asset Backed Loan (ABL) Credit Facility
OnFebruary 23, 2018 , the Company, as borrower, and the Company's subsidiariesTIW Corporation andHoning, Inc. , as guarantors, entered into a five-year senior secured revolving credit facility (the "ABL Credit Facility") withJPMorgan Chase Bank, N.A ., as administrative agent, and other financial institutions as lenders with total commitments of$100.0 million , including up to$10.0 million available for letters of credit. The maximum amount that the Company may borrow under the ABL Credit Facility is subject to the borrowing base, which is based on a percentage of eligible accounts receivable and eligible inventory, subject to reserves and other adjustments. As ofDecember 31, 2020 , the availability under the ABL Credit Facility was$40.2 million , after taking into account the outstanding letters of credit of approximately$1.0 million issued under the facility. For additional information on the ABL Credit Facility, see "Asset Backed Loan (ABL) Credit Facility," Note 14 of Notes to Consolidated Financial Statements.
Backlog
Backlog typically consists of firm customer orders ofDril-Quip products for which a purchase order, signed contract or letter of award has been received, satisfactory credit or financing arrangements exist and delivery is scheduled. Historically, the Company's revenues for a specific period have not been directly related to its backlog as stated at a particular point in time. The Company believes that its backlog should help mitigate the impact of negative market conditions; however, slow recovery in the commodity prices or an extended downturn in the global economy or future restrictions on, or declines in, oil and gas exploration and production could have a negative impact on the Company and its backlog. The Company's product backlog was approximately$195.7 million atDecember 31, 2020 and$272.5 million atDecember 31, 2019 . The backlog at the end of 2020 represents a decrease of approximately$76.8 million , or 28.2%, from the end of 2019. The Company's backlog balance during 2020 was negatively impacted by a decrease in the number of new product bookings due to the outbreak of the COVID-19 pandemic resulting in a depressed global economic environment that led to weakness in oil prices and decreases in our customers' capital budgets. In addition, we had approximately$11.3 million in cancellations during the year. 41
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The following table represent the change in backlog.
Year Ended December 31, 2020 2019 2018 (In thousands) Beginning Backlog$ 272,537 $ 269,968 $ 207,303 Bookings: Product (1) 191,301 367,365 342,474 Service 75,577 72,018 72,414 Leasing 30,562 39,509 47,160 Cancellation/Revision adjustments (11,280 ) (61,015 ) (11,675 ) Translation adjustments 1,926 (502 ) (3,082 ) Total Bookings 288,086 417,375 447,291 Revenues: Product 258,834 303,279 265,052 Service 75,577 72,018 72,414 Leasing 30,562 39,509 47,160 Total Revenue 364,973 414,806 384,626 Ending Backlog (1)$ 195,650 $ 272,537 $ 269,968 (1) The backlog data shown above includes all bookings as ofDecember 31, 2020 , including contract awards and signed purchase orders for which the contracts would not be considered enforceable or qualify for the practical expedient under ASC 606. As a result, this table will not agree to the disclosed performance obligations of$58.1 million as ofDecember 31, 2020 , within "Revenue Recognition," Note 4 of Notes to Consolidated Financial Statements. The Company expects to fill approximately 70% to 80% of theDecember 31, 2020 product backlog byDecember 31, 2021 . The remaining backlog atDecember 31, 2020 consists of longer-term projects which are being designed and manufactured to customer specifications requiring longer lead times. See "Item 1A. Risk Factors-Our backlog is subject to unexpected adjustments and cancellations and is, therefore, an uncertain indicator of our future revenues and earnings." Geographic Segments The Company's operations are organized into three geographic segments-Western Hemisphere (includingNorth and South America ; headquartered inHouston, Texas ), Eastern Hemisphere (includingEurope andAfrica ; headquartered inAberdeen, Scotland ) andAsia-Pacific (including thePacific Rim ,Southeast Asia ,Australia ,India and theMiddle East ; headquartered inSingapore ). Each of these segments sells similar products and services, and the Company has manufacturing facilities in all three of its regional headquarter locations as well as in Macae,Brazil . Revenues for each of these segments are dependent upon the ultimate sale of products and services to the Company's customers. For information on revenues by geographic segment, see "Geographic Segments," Note 16 of Notes to Consolidated Financial Statements.
Currency Risk
The Company has operations in various countries around the world and conducts business in a number of different currencies other than theU.S. dollar, principally the British pound sterling, Mexican pesos and the Brazilian real. Our significant foreign subsidiaries may also have monetary assets and liabilities not denominated in their functional currency. These monetary assets and liabilities are exposed to changes in currency exchange rates which may result in non-cash gains and losses primarily due to fluctuations between theU.S. dollar and each subsidiary's functional currency. The Company generally attempts to minimize its currency exchange risk by seeking international contracts payable in local currency in amounts equal to the Company's estimated operating costs payable in local currency and inU.S. dollars for the balance of the contracts. The Company had, net of income taxes, a transaction loss of$1.9 million in 2020, a transaction gain of$1.3 million in 2019 and a transaction gain of$0.8 million in 2018. There is no assurance that the Company will be able to protect itself against such fluctuations in the future. The Company has put in place an active cash management process to convert excess foreign currency and concentrate this cash in certain of our holding company bank accounts to minimize foreign currency risk and increase investment income. The Company conducts business in certain countries that limit repatriation of earnings. Further, there can be no assurance that the countries in which the Company currently operates will not adopt policies limiting repatriation of earnings in the future. The Company also has significant investments in countries other thanthe United States , principally its manufacturing operations inScotland ,Singapore ,Brazil and, to a lesser extent,Norway . The functional currency of these foreign operations is the local currency except forSingapore , where theU.S. dollar is used. Financial statement assets and liabilities in the functional currency are translated at the end of the period exchange rates. Resulting translation adjustments are reflected as a separate component of stockholders' equity and have no current effect on earnings or cash flow. 42
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Table of Contents Critical Accounting Policies The Company's discussion and analysis of its financial condition and results of operations are based on the Company's consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted inthe United States of America . The preparation of the consolidated financial statements requires the Company to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. The Company believes the following accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements. Revenue Recognition Product revenues
The Company recognizes product revenues from two methods:
• product revenues are recognized over time as control is transferred to the
customer; and
• product revenues from the sale of products that do not qualify for the over
time method are recognized as point in time.
Revenues recognized under the over time method
The Company uses the over time method on long-term project contracts that have the following characteristics:
• the contracts call for products which are designed to customer specifications;
• the structural designs are unique and require significant engineering and
manufacturing efforts generally requiring more than six months in duration;
• the contracts contain specific terms as to milestones, progress billings
and delivery dates;
• product requirements cannot be filled directly from the Company's standard
inventory; and
• the Company has an enforceable right to payment for any work completed to
date and the enforceable payment includes a reasonable profit margin.
For each project, the Company prepares a detailed analysis of estimated costs, profit margin, completion date and risk factors which include availability of material, production efficiencies and other factors that may impact the project. On a quarterly basis, management reviews the progress of each project, which may result in revisions of previous estimates, including revenue recognition. The Company calculates the percentage complete and applies the percentage to determine the revenues earned and the appropriate portion of total estimated costs to be recognized. Losses, if any, are recorded in full in the period they become known. Historically, the Company's estimates of total costs and costs to complete have approximated actual costs incurred to complete the project. Under the over time method, billings may not correlate directly to the revenue recognized. Based upon the terms of the specific contract, billings may be in excess of the revenue recognized, in which case the amounts are included in customer prepayments as a liability on the Consolidated Balance Sheets. Likewise, revenue recognized may exceed customer billings in which case the amounts are reported in unbilled receivables. Unbilled revenues are expected to be billed and collected within one year. AtDecember 31, 2020 and 2019, unbilled receivables included$96.5 million and$83.2 million of unbilled receivables related to products accounted for using over time method of accounting, respectively. For the year endedDecember 31, 2020 , there were 57 projects representing approximately 33.2% of the Company's total revenues and approximately 46.9% of its product revenues, and 36 projects during 2019 representing approximately 20.5% of the Company's total revenues and approximately 28.0% of its product revenues, which were accounted for using over time method of accounting.
Revenues recognized under the point in time method
Revenues from the sale of standard inventory products, not accounted for under the over time method, are recorded at the point in time that the customer obtains control of the promised asset and the Company satisfies its performance obligation. This point in time recognition aligns with when the product is available to the customer, which is when the Company typically has a present right to payment, title transfers to the customer, the customer or its carrier has physical possession and the customer has significant risks and rewards of ownership. The Company may provide product storage to some customers. Revenues for these products are recognized at the point in time that control of the product transfers to the customer, the reason for storage is requested by the customer, the product is separately identified, the product is ready for physical transfer to the customer and the Company does not have the ability to use or direct the use of the product. This point in time typically occurs when the products are moved to storage. We receive payment after control of the products has transferred to the customer.
Service revenues
The Company recognizes service revenues from two sources:
• technical advisory assistance; and 43
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Table of Contents • rework and reconditioning of customer-ownedDril-Quip products.
The Company generally does not install products for its customers, but it does provide technical advisory assistance.
The Company normally negotiates contracts for products, including those accounted for under the over time method, and services separately. For all product sales, it is the customer's decision as to the timing of the product installation as well as whetherDril-Quip running tools will be purchased or rented. Furthermore, the customer is under no obligation to utilize the Company's technical advisory assistance services. The customer may use a third party or their own personnel. The contracts for these services are typically considered day-to-day. Rework and reconditioning service revenues are recorded using the over time method based on the remaining steps that need to be completed as the refurbishment process is performed. The measurement of progress considers, among other things, the time necessary for completion of each step in the reconditioning plan, the materials to be purchased, labor and ordering procedures. We receive payment after the services have been performed by billing customers periodically (typically monthly).
Leasing revenues
The Company earns leasing revenues from the rental of running tools and rental of its forging facility. Revenues from the rental of running tools are recognized within leasing revenues on a day rate basis over the lease term, which is generally between one to three months. Leasing revenue from the rental of our forging facility is recognized on a straight-line basis over the expected life of the lease. Inventories Inventory costs are determined principally by the use of the first-in, first-out (FIFO) costing method and are stated at the lower of cost or net realizable value. Company manufactured inventory is valued principally using standard costs, which are calculated based upon direct costs incurred and overhead allocations and approximate actual costs. Inventory purchased from third-party vendors is principally valued at the weighted average cost.
Inventory Reserves
Periodically, obsolescence reviews are performed on slow moving and excess inventories and reserves are established based on current assessments about future demands and market conditions. The Company determines the reserve percentages based on an analysis of stocking levels, historical sales levels and future sales forecasts anticipated for inventory items by product type. The inventory values have been reduced by a reserve for slow moving and excess inventories of$82.1 million and$71.0 million as ofDecember 31, 2020 and 2019, respectively. If market conditions are less favorable than those projected by management, additional inventory reserves may be required.
For goodwill an assessment for impairment is performed annually or when there is an indication an impairment may have occurred.Goodwill is not amortized but rather tested for impairment annually onOctober 1 or when events occur or circumstances change that would trigger such a review. The impairment test entails an assessment of qualitative factors to determine whether it is more likely than not that an impairment exists. If it is more likely than not that an impairment exists, then a quantitative impairment test is performed. Impairment exists when the carrying amount of a reporting unit exceeds its fair value. We complete our annual impairment test for goodwill using an assessment date ofOctober 1 . An interim goodwill impairment analysis was performed in connection with the preparation and review of financial statements during the first quarter of 2020. Based on this analysis, we fully impaired our goodwill balance of$7.7 million , all of which was in the Eastern Hemisphere reporting unit.Goodwill was reviewed for impairment by comparing the carrying value of each of our reporting unit's net assets, including allocated goodwill, to the estimated fair value of the reporting unit. We determine the fair value of our reporting units using a discounted cash flow approach. We selected this valuation approach because we believe it, combined with our best judgment regarding underlying assumptions and estimates, provides the best estimate of fair value for each of our reporting units. Determining the fair value of a reporting unit requires the use of estimates and assumptions. Such estimates and assumptions include revenue growth rates, future operating margins, the weighted average cost of capital ("discount rates"), a terminal growth value and future market conditions, among others. We believe that the estimates and assumptions used in our impairment assessments are reasonable. If the reporting unit's carrying value is greater than its calculated fair value, we recognize a goodwill impairment charge for the amount by which the carrying value of goodwill exceeds its fair value. In 2019, we performed an analysis of our goodwill, and as a result of our qualitative assessment no impairment was recorded. See "Item 1A. Risk Factors" for a more detailed discussion ofGoodwill impairment during the year.
Off-Balance Sheet Arrangements
The Company has no derivative instruments and no off-balance sheet hedging or financing arrangements, contracts or operations.
New Accounting Standards
The information set forth under Note 3 of Notes to Consolidated Financial Statements under the caption "New Accounting Standards" is incorporated herein by reference.
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