SUPERIOR DRILLING PRODUCTS, INC. Overview
Superior Drilling Products, Inc. is an innovative drilling and completion tool technology company providing cost saving solutions that drive production efficiencies for the oil and natural gas drilling industry. Our headquarters and manufacturing operations are located inVernal, Utah . Our drilling solutions include the patented Drill-N-Ream® well bore conditioning tool ("Drill-N-Ream tool") and the patented Strider™ Drill String Oscillation System technology ("Strider technology" or "Strider"). In addition, the Company is a manufacturer and refurbisher of PDC (polycrystalline diamond compact) drill bits for a leading oil field services company. We operate a state-of-the-art drill tool fabrication facility, where we manufacture solutions for the drilling industry, as well as customers' custom products. Our strategy for growth is to leverage our expertise in drill tool technology and precision machining in order to broaden our product offerings and solutions for the oil and gas industry. We believe through our patented technologies, as well as technologies under development, that we can offer the industry the solutions it demands to improve drilling efficiencies and reduce production costs. With our recent AS9100D with ISO 9001:2015 certification there is opportunity to expand into new revenue streams that are decoupled from the upstream oil and gas industry, which can leverage our operating assets and mitigate the impact on our results of operations that is caused by the ongoing and unpredictable cyclic nature of energy markets.We believe that with this certification, and our history of supplying high quality parts to research and development departments operating in the aerospace industry, we can effectively execute our industry diversification strategy.
Industry Trends and Market Factors
The significant decline in oil demand due to COVID-19 coupled with a global over supply of oil drove down oil prices. This resulted in our customers announcing significant reductions to their capital expenditure budgets for 2020. This was evidenced by the significant decline inU.S. onshore rig counts. As ofDecember 31, 2020 ,U.S. onshore rig count was 351 rigs compared with 796 rigs as ofDecember 31, 2019 . We expect oil and gas related markets to continue to experience significant weakness in 2021. Despite these current challenges, the oil and gas industry is beginning to experience slight improvements including an increase in the number of active rigs in theU.S. from 2020 lows, and we expect additional rig count improvement to occur throughout the year, although likely not to pre-COVID levels. Worldwide military, political and economic events have contributed to oil and natural gas price volatility and are likely to continue to do so in the future. Although the Company has seen demand for its oil and gas related products and services inthe United States andCanada impacted by these industry conditions, we continue to aggressively market our drilling products. The oil and gas industry is increasingly using directional (e.g., horizontal) drilling in their exploration and production activities because of significantly improved recovery rates that can be achieved with these methods. With the rise of this type of drilling, traditional drill string tools used for vertical drilling do not necessarily provide the best performance or are not well suited for directional drilling. In addition, current and expected oil and natural gas prices combined with more technically challenging horizontal drilling has driven the demand for new technologies. We believe the value of our Drill-N-Ream tool has proven to provide significant operational efficiencies and costs savings for horizontal drilling activity and, combined with our low market penetration, provide us sales opportunities in soft as well as robust markets. How We Generate our Revenue We are a drilling and completion tool technology company. We generate revenue from the refurbishment, manufacturing, repair, rental and sale of drill string tools. Our manufactured products are produced in a standard manufacturing operation, even when produced to our customer's specifications. We also earn royalty fees under certain arrangements for certain tools we sell.
Tool sales, rentals and other related revenue
Tool and Product Sales: Revenue for tool and product sales is recognized upon shipment of tools or products to the customer. Shipping and handling costs related to tool and product sales are recorded gross as a component of both the sales price and cost of the product sold. Tool Rental: Rental revenue is recognized upon completion of the customer's job for which the tool was rented. While the duration of the rents vary by job and number of runs, these rents are generally less than one month. The rental agreements are typically based on the price per run or footage drilled and do not have any minimum rental payments or term. 26 Other Related Revenue: We receive revenue from the repair of tools upon delivery of the repaired tool to the customer. We earn royalty commission revenue when our customer invoices their customer for the use of our tools. Contract Services
Drill Bit Manufacturing and Refurbishment: We recognize revenue for our PDC drill bit services upon transfer of control, which we have determined to be upon shipment of the product. Shipping and handling costs related to refurbishing services are paid directly by the customer at the time of shipment. We also provide contracting manufacturing services to customers.
Costs of Conducting Our Business
The principal elements of cost of sales for manufacturing, repair, rental and
sale of tools ("product") are the direct and indirect costs to manufacture,
repair and supply the product, including labor, materials, utilities, equipment
repair, lease expense related to our facilities, supplies and freight.
Selling, general and administrative expense is comprised of costs such as new
business development, technical product support, research and development costs,
compensation expense for general corporate operations including accounting,
human resources, risk management, etc., information technology expenses, safety
and environmental expenses, legal and professional fees and other related
administrative functions.
Other income (expense), net is comprised primarily of interest expense associated with outstanding borrowings net of interest income, gains (losses) of disposed assets and recovery of related party note receivable.
27 RESULTS OF OPERATIONS
The following table represents our condensed consolidated statement of operations for the periods indicated:
For the Years Ended December 31,
(in thousands) 2020 2019
Tool revenue $ 7,051 67 % $ 12,116 64 %
Contract services 3,420 33 % 6,881 36 %
Total revenue $ 10,471 100 % $ 18,997 100 %Operating costs and expenses 14,293 137 % 19,899 105 %
Loss from continuing operations (3,822 ) (36 )% (902 ) (5 )%
Other income 508 5 % (16 ) (0 )%
Income tax expense (115 ) (1 )% (18 ) (0 )%
Net loss $ (3,430 ) (32 )% $ (936 ) (5 )%
Material changes of certain items in our statements of operations included in our financial statements for the comparative periods are discussed below.
28 Revenue. Our revenue decreased approximately$8,526,000 , or 45%, to$10,471,000 . The decrease was a result of the COVID-19 pandemic induced decline in the demand for oil and gas which resulted in a significant reduction in drilling activity globally. Despite the decline in drilling activity, International revenue increased$565,000 or 43% to$1,880,000 .
Tool revenue was
Operating Costs and Expenses. Significant cost management efforts led to total operating costs and expenses declining approximately$5,605,000 , or 28%, during 2020 compared with 2019.
? Cost of revenue decreased approximately
decrease in sales and the impact of cost savings resulting from the Company's
reduction in force and the closing of our Abilene DNR tool repair center. As a
percentage of revenue, cost of revenue was 49% for the year ended
2020, and 43% for the year ended
? Selling, general and administrative expenses decreased approximately
cost reduction measures implemented by us in 2020 in an effort to offset the
reduction in revenue. These measures included headcount reductions, salary
reductions and the deferral of new product development initiatives.
? Depreciation and amortization expenses decreased approximately
due to lower amortization expense as a result of fully amortizing a portion of
intangible assets in May 2019 .
29
Other Income (Expenses). Other income and expense primarily consists of interest income, interest expense, loan forgiveness and gain/loss on disposition of assets.
? Interest income for the years 2020 and 2019 was approximately
? Interest expense for the years 2020 and 2019 was approximately
the reduction in the balance outstanding on the Hard Rock Note.
? The Company recognized
Loan and
the CARES Act.
? The Company recorded a loss on asset held for sale of
? The Company recorded a gain of approximately
2020, and a gain of approximately
? The Company recognized a recovery of related party note receivable in 2019.
Effective
receivable of
balance to
party note receivable in the form of a non-cash payment given in lieu of
making an annual restricted stock unit award to the CEO and COO and recorded a
recovery of the loan. The Company will continue to record recovery of related
party note receivable when consideration or payments on the loan are made in
the future.
Liquidity and Capital Resources
AtDecember 31, 2020 , we had working capital of approximately$1,300,000 . Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. Our operational and financial strategies include lowering our operating costs and capital spending to match revenue trends, accelerating collections of international receivables, and managing our working capital and debt to enhance liquidity. We will continue to work to grow revenue and manage costs to minimize negative net cash flow in 2021. If we are unable to do this, we may not be able to, among other things, (i) maintain our current general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements. We cannot provide any assurance that financing will be available to us in the future on acceptable terms. In addition, the significant decline in oil demand due to COVID-19, the instability of oil prices caused by geopolitical issues and over supply have resulted in the announcements by our customers and end users of our tools and technology of significant reductions to their capital expenditure budgets. Our expectation is that demand for our products and services will continue to be impacted in 2021 and potentially beyond; however, we are currently unable to estimate the full impact to our business, how long this significant drop in demand will last or the depth of the decline. We have minimal planned capital expenditures for 2021 of$1,500,000 and we will further defer investment in new technology development, including our Strider technology. The Hard Rock Note had a remaining balance of$1,500,000 as ofDecember 31, 2020 , accrues interest at 8.00% per annum and is fully payable onOctober 5, 2022 . Under the amended terms of the Hard Rock Note, we are required to make the following remaining payments: accrued interest onJanuary 5 ,April 5 ,July 5 andOctober 5 in 2021 and 2022; plus$750,000 in principal onJuly 5, 2021 with the remaining balance of principal and accrued interest on the Hard Rock Note due onOctober 5, 2022 . Our Credit Agreement is comprised of$1,000,000 Term Loan and$3,500,000 Revolving Loan. As ofDecember 31, 2020 , we had$666,584 outstanding on the Term Loan and$198,838 outstanding on the Revolving Loan. Amounts outstanding under the Revolving Loan at any time may not exceed the sum of: (a) up to 85% of accounts receivable or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect (less a dilution reserve as determined by AFS in its sole good faith discretion), plus (b) the lesser of (i) up to 50% of inventory or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect, or (ii) the inventory sublimit, minus (c) the borrowing base reserve as may be determined from time to time by AFS. Amounts outstanding on the Revolving Loan as ofDecember 31, 2020 , may not exceed$314,517 , which is based on a calculation applying 85% of accounts receivable and 50% of inventory. A collateral management fee is payable monthly on the used portion of the Revolving Loan and Term Loan. If our borrowings are less than$1,000,000 , we still pay interest as if we had borrowed$1,000,000 . AtDecember 31, 2020 , we had approximately$8,700 of accrued interest. The interest rate for the Term Loan and the Revolving Loan is prime plus 2%. AtDecember 31, 2020 , the interest rate for the Term Loan was 8.85%, which includes a 3.6% management fee rate. The effective interest rate for the Revolving Loan for the year endingDecember 31, 2020 was 11.35%. The obligations of the Company under the agreement are secured by a security interest in substantially all of the tangible and intangible assets of the Company, other than any assets owned by the Company that constitute real property (and fixtures affixed to such real property), certain excluded equipment, intellectual property, or aircraft. The Credit Agreement matures onFebruary 20, 2023 . OnDecember 7, 2020 , the Company closed a sale-leaseback agreement for its headquarters and manufacturing facilities. Under the terms of the transaction, the Company sold the property for$4.5 million and simultaneously entered into a 15-year lease. After fees, the Company netted approximately$4.2 million in proceeds of which$2.5 million was used to repay in full the outstanding mortgage on the property. Under the lease agreement, the Company has an option to extend the term of the lease and to repurchase the property. Due to this repurchase option, the Company was unable to account for the transfer as a sale under ASC Topic 842, Leases, and as such, the transaction is accounted for
as a financing transaction. 30 Contractual Obligations
The following table presents our contractual obligations as ofDecember 31, 2020 . Our obligations to make payments in the future may vary due to certain assumptions including the duration of our obligations and anticipated actions by third parties according to the following table (in thousands): 2021 2022 2023 2024 2025 Thereafter Total Debt (1)$ 1,384 $ 1,299 $ 156 $ 119 $ 4 $ -$ 2,962 Operating leases 82 15 8 - - - 105 Financial obligation (2) 312 316 321 326 331 1,432 3,038 Total$ 1,778 $ 1,630 $ 485 $ 445 $ 335 $ 1,432 $ 6,105
(1) Amounts represent the expected cash payments of principal and interest
amounts associated with our long-term debt obligations.
(2) Relates to the sale-leaseback transaction the Company completed in December
2020. The contractual obligation does not include the residual value of this
property of $2,160,242 . See Note 10 - Financing Obligation to our
consolidated financial statements.
The aggregate outstanding balance of our notes payable obligations net of
discounts as of
Cash Flow Operating Cash Flows For 2020, net cash provided by our operating activities was approximately$575,000 . The Company had approximately$3,430,000 of net loss, an approximately$2,505,000 decrease in accounts receivable, depreciation and amortization expense of approximately$2,816,000 , which were offset by an approximately$1,042,000 increase in inventories and$933,000 gain on forgiveness of the
PPP loan and SBA equipment loan. Investing Cash Flows For 2020, the Company used approximately$222,000 in investing activities for property, plant and equipment purchases primarily to increase tool repair capacity to support product expansion in theMiddle East . This was offset by proceeds from the sale of fixed assets of approximately$150,000 . 31 Financing Cash Flows
For 2020, net cash provided by our financing activities was approximately
Off Balance Sheet Arrangements
None. Critical Accounting Policies The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. During the preparation of these financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions, including those discussed below. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of our analysis form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. While we believe that the estimates and assumptions used in the preparation of our consolidated financial statements are appropriate, actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated financial statements. Our estimates and assumptions are evaluated periodically and adjusted when necessary. Described below are the most significant policies we apply in preparing our consolidated financial statements, some of which are subject to alternative treatment under GAAP. We also describe the most significant estimates and assumptions we make in applying these policies. See Note 1 to our consolidated financial statements. Segment reporting is not applicable to us as we have a single, company-wide management team that administers the Company as a whole, rather than by discrete business units. While we have three business product lines and report the revenues by product line internally and externally, we do not capture expenses by product line and as such, we do not maintain complete separate financial statement information by product line. We evaluate our business performance as a single segment and we report as a single segment. We operate inthe United States and theMiddle East . Approximately 82% of our revenue is fromthe United States and approximately 18% is from theMiddle East for the year endedDecember 31, 2020 . For the year endedDecember 31, 2019 , approximately 93% of our revenue was fromthe United States and approximately 7% was from theMiddle East . Revenue Recognition We are a drilling and completion tool technology company and we generate revenue from the manufacturing, repair, rental and sale of drilling and completion tools. Our manufactured products are produced in a standard manufacturing operation, even when produced to our customer's specifications. We earn royalty commission revenue when our customer invoices their customer for the use of
the tools. Stock-Based Compensation Stock-based compensation is measured at the grant date, based on the fair value of the award, and is recognized ratably as an expense over the vesting period of the award. Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require the use of subjective assumptions, including the expected life of the stock-based payment awards and stock price volatility. Management uses the Black-Scholes option pricing model to value award grants and determine the related compensation expense. The assumptions used in calculating the fair value of stock-based payment awards represent management's best estimates, but the estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and management uses different assumptions, the Company's stock-based compensation expense could be materially different in the future. The Company expects to continue to grant stock-based awards in the future, and to the extent that the Company does, its actual stock-based compensation expense recognized in future periods will likely increase. Concentration of Credit Risk Substantially all of our revenue is derived from our refurbishing of PDC drill bits forBaker Hughes and from DTI when we 1) sell the Drill-N-Ream tool, 2) repair theDNR tool, and 3) earn royalty on our customer's rental of theDNR tool to the end user. 32
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are generally due within 60 days of the invoice date. No interest is charged on past-due balances. We grant credit to our customers based upon an evaluation of each customer's financial condition. We periodically monitor the payment history and ongoing creditworthiness of our customers. An allowance for doubtful accounts is established at a level estimated by management to be adequate based upon various factors including historical experience, aging status of customer accounts, payment history and financial condition of our customers. The allowance for doubtful accounts was$0 and$9,288 atDecember 31, 2020 and 2019, respectively. Intangible Assets
Annually, and more often as necessary, we will perform an evaluation of our intangible assets for indications of impairment. If indications exist, we will perform an evaluation of the fair value of the intangible assets and, if necessary, record an impairment charge. As ofDecember 31, 2020 , the Company performed an evaluation of the intangible assets. Based on this assessment, we have determined no impairment was needed. Valuation of Inventories Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost, determined using the weighted-average cost method, or net realizable value. Finished goods inventories include raw materials, direct labor and production overhead. The Company regularly reviews inventories on hand and current market conditions to determine if the cost of finished goods inventories exceed current market prices and impairs the cost basis of the inventory accordingly. The Company wrote off$4,800 and$79,200 related to slow moving inventory in 2020 and 2019, respectively.
Property, Plant and Equipment
Property, plant and equipment is stated at cost. The cost of ordinary maintenance and repair is charged to operating expense, while replacement of critical components and major improvements are capitalized. Depreciation or amortization of property, plant and equipment, is calculated using the straight-line method over the asset's estimated useful life as follows:
Buildings and leasehold improvements 2-39 years
Machinery, equipment and rental tools 18 months -10 years
Office equipment, fixtures and software 3-7 years
Transportation equipment 5 - 30 years
Property, plant and equipment is reviewed for impairment on an annual basis or whenever events or changes in circumstances indicate the carrying value of an asset or asset group may not be recoverable. Indicative events or circumstances include, but are not limited to, matters such as a significant decline in market value or a significant change in business climate. An impairment loss is recognized when the carrying value of an asset exceeds the estimated undiscounted future cash flows from the use of the asset and its eventual disposition. The amount of impairment loss recognized is the excess of the asset's carrying value over its fair value. Assets to be disposed of are reported at the lower of the carrying value or the fair value less cost to sell. There were no impairment losses related to fixed assets during 2020 and 2019. Upon sale or other disposition of an asset, the Company recognizes a gain or loss on disposal measured as the difference between the net carrying value of the asset and the net proceeds received.
Related Party Note Receivable
InJanuary 2014 , we entered into a Note Purchase and Sale Agreement under which we agreed to purchase a loan made toTronco Energy Corporation ("Tronco"), a party related to us through common control, in order to take over the legal position as Tronco' s senior secured lender. That agreement provided that, upon our full repayment of the Tronco loan from the proceeds of our initial public offering, the lender would assign to us all of its rights under the Tronco loan, including all of the collateral documents. OnMay 30, 2014 , we closed our purchase of the Tronco loan for a total payoff of$8.3 million , including principal, interest, and early termination fees. The Meier Guaranties were determined not to be substantive based on GAAP that states that the substance of a personal guarantee depends on the ability of the guarantor to perform, the practicality of enforcing the guarantee, and the demonstrated intent to enforce the guarantee. Since the Company did not demonstrate intent by either enforcing the redemption of collateral or the guarantees by the borrowers to repay the loan when the related party note receivable was due and payable onDecember 31, 2017 and instead modified the loan by extending the payment term, the Company determined the guarantees are not substantive and therefore should not serve as the basis for concluding the loan is well secured and collateralized. As a result, the Company fully reserved the related party note receivable effectiveAugust 2017 . The Company continues to hold the 8,267,860 shares of the Company's common stock as collateral. The Company will record a recovery of the loan upon receiving repayment of the note, but there is no guarantee a full recovery of the loan will occur.
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