SUPERIOR DRILLING PRODUCTS, INC. Introduction
The following discussion and analysis was prepared to supplement information contained in the accompanying financial statements and is intended to provide certain details regarding our financial condition as ofSeptember 30, 2020 , and our results of operations for the three and nine months endedSeptember 30, 2020 and 2019. It should be read in conjunction with the unaudited financial statements and notes thereto contained in this Quarterly Report on Form 10-Q (this "Quarterly Report") as well as our audited financial statements for the years endedDecember 31, 2019 and 2018, which were included in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2019 , which was filed with theSecurities and Exchange Commission (the "SEC"). Unless the context requires otherwise, references to the "Company" or to "we," "us," or "our" and other similar terms are toSuperior Drilling Products, Inc. and all of its subsidiaries.
Forward - Looking Statements
This Quarterly Report on Form 10-Q includes certain statements that may be deemed to be "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Statements contained in all parts of this document that are not historical facts are forward-looking statements that involve risks and uncertainties that are beyond the control of the Company. You can identify the Company's forward-looking statements by the words "anticipate," "estimate," "expect," "may," "project," "believe" and similar expressions, or by the Company's discussion of strategies or trends. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, no assurances can be given that these expectations will prove to be correct. These forward-looking statements include the following types of information and statements as they relate to the Company:
? future operations, financial results, business plans, cash flow and cash
requirements;
? scheduled, budgeted and other future capital expenditures;
? working capital requirements;
? the availability of expected sources of liquidity;
? the introduction into the market of the Company's future products;
? the market for the Company's existing and future products;
? the Company's ability to develop new applications for its technologies;
? the exploration, development and production activities of the Company's
customers;
? compliance with present and future environmental regulations and costsassociated with environmentally related penalties, capital expenditures,
remedial actions and proceedings;
? effects of potential legal proceedings; and
? changes in customers' future product and service requirements that may not be
cost effective or within the Company's capabilities.
13
These statements are based on assumptions and analyses in consideration of the Company's experience and perception of historical trends, current conditions, expected future developments and other factors the Company believes were appropriate in the circumstances when the statements were made. Forward-looking statements by their nature involve substantial risks and uncertainties that could significantly impact expected results, and actual future results could differ materially from those described in such statements. While it is not possible to identify all factors, the Company continues to face many risks and uncertainties. Among the factors that could cause actual future results to differ materially are the risks and uncertainties discussed under "Item 1A. Risk Factors" in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2019 , our subsequent filings with theSEC , and the following:
? the impact of COVID-19 on domestic and global economic conditions and the
future impact of such conditions on the oil and gas industry and the demand
for our services;
? the volatility of oil and natural gas prices;
? the cyclical nature of the oil and gas industry;
? availability of financing, flexibility in restructuring existing debt and
access to capital markets;
? our reliance on significant customers;
? consolidation within our customers' industries;
? competitive products and pricing pressures;
? our ability to develop and commercialize new and/or innovative drilling and
completion tool technologies;
? fluctuations in our operating results;
? our dependence on key personnel;
? costs of raw materials;
? our dependence on third party suppliers;
? unforeseen risks in our manufacturing processes;
? the need for skilled workers;
? our ability to successfully manage our growth strategy;
? unanticipated risks associated with, and our ability to integrate,
acquisitions;
? current and potential governmental regulatory actions in
regulatory actions and political unrest in other countries;
? terrorist threats or acts, war and civil disturbances;
? our ability to protect our intellectual property;
? impact of environmental matters, including future environmental regulations;
? implementing and complying with safety policies;
? breaches of security in our information systems and other cybersecurity risks;
? related party transactions with our founders; and ? risks associated with our common stock. 14
Many of such factors are beyond the Company's ability to control or predict. Any of the factors, or a combination of these factors, could materially affect the Company's future results of operations and the ultimate accuracy of the forward-looking statements. Management cautions against putting undue reliance on forward-looking statements or projecting any future results based on such statements or present or prior earnings levels. Every forward-looking statement speaks only as of the date of the particular statement, and the Company undertakes no obligation to publicly update or revise any forward-looking statement. Executive Summary
We innovate, design, engineer, manufacture, sell, and repair drilling and
completion tools in
We currently have three basic operations:
? Our PDC drill bit and other tool refurbishing and manufacturing service,
? Our emerging technologies business that manufactures the Drill-N-Ream tool,
our innovative drill string enhancement tool, the Strider technology and other
tools, and
? Our new product development business that conducts our research and
development, and designs our horizontal drill string enhancement tools, other
down-hole drilling technologies, and drilling tool manufacturing technologies.
Our strategy for growth is to expand our global market penetration of our current drill tool technology and 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, as well as other industries that require precision machining and quality. We believe through our patented technologies, as well as technologies under development, that we can offer the oil and gas industry the solutions it demands to improve drilling efficiencies and reduce production costs.
Recent Developments and Trends
Our business and operations have been adversely affected by and are expected to continue to be adversely affected by the COVID-19 pandemic. The COVID-19 pandemic greatly reduced global oil demand as social distancing and travel restrictions were implemented across the world. The timeline and potential magnitude of the COVID-19 outbreak and its consequences are currently unknown. The continuation or amplification of this virus could continue to more broadly affectthe United States and global economy, including the demand for oil and gas. Further disrupting the oil and gas industry was the lifting by theOrganization of the Petroleum Exporting Countries ("OPEC") of supply curtailments. This resulted in an increase in the global supply of oil in an environment of rapidly contracting demand. As a result, the price of oil declined significantly inApril 2020 as storage capacity became limited. Overall, the significant decline in oil demand due to COVID-19 coupled with a global over supply of oil drove down oil prices. This has resulted in our customers announcing significant reductions to their capital expenditure budgets for 2020. This is evidenced by the significant decline inU.S. onshore rig counts from the beginning of the year. At the end of 2019, theU.S. onshore rig count as reported byBaker Hughes was 781 rigs. As ofSeptember 30, 2020 , theU.S. onshore rig count was 266 rigs compared with 855 rigs as ofSeptember 30, 2019 . We expect oil and gas related markets to continue to experience significant weakness for the remainder of 2020 and into 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 third quarter lows, and we expect additional rig count improvement to occur
into year-end. The reduction of theU.S. onshore rig count has negatively affected our results of operations as our business is highly dependent upon the vibrancy of the oil and gas drilling operations in theU.S. In an effort to offset the reduction in revenue resulting from the weakened macroeconomic environment, we have implemented certain cost reduction measures during 2020. These measures included, but were not limited to, the following: ? 20% reduction of the base salary beginning inApril 2020 and a 40% salary
deferral beginning in
Officer, Chief Operating Officer, and Chief Financial Officer;
? 20% reduction in the base salaries beginning in April 2020 and a 20%
deferral of base salaries beginning in October 2020 of certain
non-executive officers of the Company;
? 20% reduction in fees to be paid beginning in April 2020 and a 40%
deferral of fees beginning in
the
? 5% to 10% reduction in salaries beginning in
of salaries beginning in
team and salaried workforce;
? 43% reduction of the Company's workforce; and
? Closure of our West Texas repair facility in July 2020 .
We have also entered into amended agreements with certain of our customers as discussed below in more detail, reduced our planned capital expenditures for 2020 and decided to defer further investment in new technology development, including our Strider technology, for the foreseeable future. Management is working diligently with vendors to achieve amended price concessions and terms of our payables. We believe theU.S. onshore activity for the remainder of 2020 will remain at depressed levels and continue to be constrained.We will continue to actively monitor the situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, partners, suppliers, and stakeholders, or as required by federal, state, or local authorities. We have placed a priority on protecting our employees during this pandemic while continuing to provide essential services to our customers. We operate under an emergency response plan specific to the global pandemic. This plan is reviewed and revised quarterly based on the latest federal and state government information provided, best practice, and consultation with local health departments. This plan includes disinfecting on a regular basis, the elimination of overlap between shifts, and a strict procedure for handling potential cases within the processes outlined in the Families First Coronavirus Response Act. Employees are also required to perform self-health evaluations at the start of every shift. These measures continue to act as a barrier to the spread of the virus on company property and among its employees. To date, these precautions have had an immaterial impact on the normal costs associated with our operations. EffectiveApril 1, 2020 , the Company through itsHard Rock subsidiary entered into a First Amendment to Amended and Restated Distribution Agreement (the "DTI Amendment") withDrilling Tools International, Inc. ("DTI"), amending the agreement betweenHard Rock and DTI datedAugust 30, 2016 . Under the DTI Amendment, all charges for repair rates the Company provides to DTI are reduced by 10%. These rate changes are applicable throughSeptember 30, 2020 , unless extended on, or prior to, the expiration date by mutual written agreement. The Company hopes to extend the DTI Agreement prior to year-end 2020. EffectiveMay 1, 2020 , we entered into a First Amendment to Vendor Agreement (the "Baker Hughes Amendment") withBaker Hughes Oilfield Operations LLC ("Baker Hughes"), amending their existing Vendor Agreement datedApril 1, 2018 . Under the Baker Hughes Amendment, we may engage in other activity not related to or in competition with the business of Baker Hughes to the extent that such other activity shall not be considered a breach of the Vendor Agreement. Also, under the Baker Hughes Amendment, charges for repair rates that we provide to Baker Hughes are reduced by 10%. Lastly, Baker Hughes agreed to remove the exclusivity restrictions that prevented us from providing drill bit repair for other entities, which broadens our market opportunity. 15
CONSOLIDATED RESULTS OF OPERATIONS
Three and Nine Months Ended
The following table represents summary consolidated operating results for the
periods indicated:
Three-Months Ended September 30, Nine-Months Ended September 30,
(in thousands) 2020 2019 2020 2019
Tool revenue 1,191 77 % 3,195 65 % 6,147 69 % 9,212 63 %
Contract services 357 23 % 1,881 37 % 2,782 31 % 5,444 37 %
Total Revenue $ 1,547 100 % $ 5,076 100 % 8,929 100 % 14,656 100 %
Operating costs and expenses 3,094 200 % 5,303 104 % 11,307 127 % 15,187 104 %
Loss from operations (1,546 ) (100 )% (227 ) (4 )% (2,378 ) (27 )% (531 ) (4 )%
Other expense (85 ) (5 )% (191 ) (4 )% (291 ) (3 )% (530 ) (4 )%
Income tax expense (100 ) (6 )% - - (106 ) (1 )% - -
Net loss $ (1,731 ) (111 )% $ (418 ) (8 )% (2,775 ) (31 )% (1,061 ) (7 )%
Material changes of certain items in our statements of operations included in our financial statements for the comparative periods are discussed below. Comparisons are to the prior-year period unless stated otherwise.
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Three Months Ended
Revenue. Our revenue decreased approximately$3,529,000 or 70%. The revenue decline was driven primarily by a 73% decrease in theU.S. land rig count resulting from the global impact of the COVID-19 pandemic, which was partially offset by a$141,000 , or 49% increase, in International revenue to$429,000 . The Company'sU.S. revenue declined 77%, from reduced drill bit repair and tool sales reflecting the dramatic slowdown in theU.S. drilling activity in the quarter. Contract services revenue decreased approximately$1,525,000 , or 81%, to$357,000 . Tool revenue was$1,191,000 , down 65% or$2,004,000 , from the prior-year period reflecting the positive impact of International activity.
Operating Costs and Expenses. Total operating costs and expenses decreased
approximately
? Cost of revenue decreased approximately
the impact of cost savings resulting from the Company's reduction in force. As
a percentage of revenue, cost of revenue was 56% and 41% of revenue for the
three months ended
? Selling, general and administrative expenses decreased approximately
to
period. The decrease was due to cost reduction measures implemented by us in
2020 given the significant reduction in our revenue related to market
conditions, including COVID-19.
? Depreciation and amortization expense decreased approximately
to $693,000 .
Other Income (Expenses). Other income and expense primarily consists of interest income, interest expense, loan forgiveness and gain/loss on disposition of assets.
? Interest expense for the three months ended
approximately
of an approximate
Note.
? The Company recognized
of the CARES Act.
Nine Months Ended
Revenue. Our revenue decreased approximately$5,726,000 or 39% to$8,930,000 . The decrease is a result of the COVID-19 pandemic induced decrease in the demand of oil and gas leading to a reduction in drilling activity inthe United States . Partially offsetting this decline was an increase of$843,000 , or more than double, in International revenue to$1,542,000 .
Tool revenue was
Operating Costs and Expenses. Total operating costs and expenses decreased
approximately
? Cost of revenue decreased approximately
decrease in sales and the impact of cost savings resulting from the Company's
reduction in force. As a percentage of revenue, cost of revenue was 48% for
the nine months ended
? Selling, general and administrative expenses decreased approximately
prior-year period. The decrease was primarily due to cost reduction measures
implemented by us in 2020 in an effort to offset the reduction in revenue.
? Depreciation and amortization expenses decreased approximately
decreased due to lower amortization expense as a result of fully amortizing a
portion of intangible assets in May 2019 .
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 nine months ended
income was approximately
? Interest expense for the nine months ended
approximately
expense was due primarily to the reduction in the balance outstanding on the
? The Company recognized
of the CARES Act.
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Liquidity and Capital Resources
AtSeptember 30, 2020 , we had a working capital deficit of approximately$2,600,000 . 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 2020. 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 be severely impacted for the duration of 2020 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 also reduced our planned capital expenditures for 2020 and we have decided to defer further investment in new technology development, including our Strider technology. The Hard Rock Note has a remaining balance of$1,500,000 as ofSeptember 30, 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 commercial bank loan is secured by ourVernal, Utah campus. The loan requires monthly payments of approximately$43,000 , including principal and interest at 7.25%, and a balloon payment of$2,500,000 is due upon maturity onFebruary 15, 2021 . We have been in active discussions regarding the extension of this loan. Our Credit Agreement is comprised of$1,000,000 Term Loan and$3,500,000 Revolving Loan. As ofSeptember 30, 2020 , we had$749,998 outstanding on the Term Loan and$359,916 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 ofSeptember 30, 2020 , may not exceed$511,791 , 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 . AtSeptember 30, 2020 , we had approximately$9,456 of accrued interest. The interest rate for the Term Loan and the Revolving Loan is prime plus 2%. AtSeptember 30, 2020 , the interest rate was 8.85%, which includes a 3.6% management fee rate. 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 . 18 Cash Flows
Nine Months Ended
Net cash provided by operating activities was$1,268,788 and$1,221,440 for the nine months endedSeptember 30, 2020 and 2019, respectively. The primary reason for the improvement was due to a$4,234,073 decrease in accounts receivable. Net cash used in investing activities was$36,642 for the nine months endedSeptember 30, 2020 and related to property, plant and equipment purchases for tools to support international expansion, which was offset by the sale of the Company airplane. Net cash used in investing activities was$392,691 for the nine months endedSeptember 30, 2019 , and related to property, plant and equipment purchases mostly for tools to support international expansion. Net cash used in financing activities was$1,036,790 and$2,301,560 for the nine months endedSeptember 30, 2020 and 2019, respectively. Principal payments on debt were offset by proceeds of debt borrowings in both periods. Critical Accounting Policies The discussion of our financial condition and results of operations is based upon our consolidated condensed financial statements, which have been prepared in accordance withU.S. GAAP. During the preparation of our 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 condensed 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 condensed financial statements. Our estimates and assumptions are evaluated periodically and adjusted when necessary. The more significant estimates affecting amounts reported in our consolidated condensed financial statements include, but are not limited to: stock based compensation, determining the allowance for doubtful accounts, valuation of inventories, recoverability of long-lived assets, useful lives used in calculating depreciation and amortization, and valuation of intangible assets.
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