SUPERIOR DRILLING PRODUCTS: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL AND BUSINESS RESULTS (Form 10-K)
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 in Vernal, 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 in
U.S.onshore rig counts. As of December 31, 2020, U.S.onshore rig count was 351 rigs compared with 796 rigs as of December 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 the U.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 in the United Statesand Canadaimpacted 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, rental and other related income
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.
Cost of running 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 (expenses), net, consists primarily of interest expenses in connection with outstanding borrowings less interest income, gains (losses) on assets sold and the collection of promissory notes on related parties.
27 RESULTS OF OPERATIONS
The following table shows our abridged consolidated income statement for the specified periods:
For the Years Ended December 31, (in thousands) 2020 2019 Tool revenue
$ 7,05167 % $ 12,11664 % Contract services 3,420 33 % 6,881 36 % Total revenue $ 10,471100 % $ 18,997100 %
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 to certain items in our income statement that are 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 $565,000or 43% to $1,880,000.
Tool turnover 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 sales decreased by approx
Decline in sales and the impact of cost savings due to
Force reduction and closure of our Abilene DNR tool repair center. As a
percentage of sales, cost of sales amounted to 49% in the past year
2020 and 43% for the past year
? Selling and general administration costs have decreased by approx
Cost reduction measures that we implemented in 2020 to reduce the
Decrease in revenue. These measures included downsizing, salary
reductions and the deferral of new product development initiatives.
? Depreciation and amortization expenses have decreased by approx
due to lower amortization costs through complete amortization of part of
intangible assets in
May 2019. 29
Other income (expenses). Other income and expenses consist mainly of interest income, interest expenses, loan waivers and profit / loss from the sale of assets.
? The interest income for the years 2020 and 2019 amounted to approx.
? The interest expense for 2020 and 2019 was approx.
reducing the outstanding balance of the Hard Rock Note.
? The company has recognized
the CARES law.
? The company recorded a loss on assets held for sale of
? The company posted a profit of around
2020 and a profit of approx.
? In 2019, the company recorded a collection of borrower’s note receivables from related parties.
Debt note claim in the form of a instead of given
an annual allocation of restricted stock units to the CEO and COO and logged as
Reclaim the loan. The company will continue the recovery of appropriate
Debt note claim for consideration or payments on the loan in
Liquidity and capital resources
December 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 $1,500,000and we will further defer investment in new technology development, including our Strider technology. The Hard Rock Note had a remaining balance of $1,500,000as of December 31, 2020, accrues interest at 8.00% per annum and is fully payable on October 5, 2022. Under the amended terms of the Hard Rock Note, we are required to make the following remaining payments: accrued interest on January 5, April 5, July 5and October 5in 2021 and 2022; plus $750,000in principal on July 5, 2021with the remaining balance of principal and accrued interest on the Hard Rock Note due on October 5, 2022. Our Credit Agreement is comprised of $1,000,000Term Loan and $3,500,000Revolving Loan. As of December 31, 2020, we had $666,584outstanding on the Term Loan and $198,838outstanding 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 of December 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. At December 31, 2020, we had approximately $8,700of accrued interest. The interest rate for the Term Loan and the Revolving Loan is prime plus 2%. At December 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 ending December 31, 2020was 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 on February 20, 2023. On December 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 millionand simultaneously entered into a 15-year lease. After fees, the Company netted approximately $4.2 millionin proceeds of which $2.5 millionwas 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 of
December 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$ - $ 2,962Operating 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 related to our long-term debt.
(2) Refers to the sale-leaseback transaction that the company completed in December
2020. The contractual obligation does not include the residual value thereof
$2,160,242. See Note 10 - Financing Obligation to our consolidated financial statements.
The total outstanding balance of our borrower’s note loan liabilities less discounts on
Cash Flow Operating Cash Flows For 2020, net cash provided by our operating activities was approximately
$575,000. The Company had approximately $3,430,000of net loss, an approximately $2,505,000decrease in accounts receivable, depreciation and amortization expense of approximately $2,816,000, which were offset by an approximately $1,042,000increase in inventories and $933,000gain on forgiveness of the
PPP loan and SBA equipment loan. Investing Cash Flows For 2020, the Company used approximately
$222,000in investing activities for property, plant and equipment purchases primarily to increase tool repair capacity to support product expansion in the Middle East. This was offset by proceeds from the sale of fixed assets of approximately $150,000. 31 Financing Cash Flows
For 2020, the net cash inflow from our financing activities was approx
Off-balance sheet regulations
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 in
the United Statesand the Middle East. Approximately 82% of our revenue is from the United Statesand approximately 18% is from the Middle Eastfor the year ended December 31, 2020. For the year ended December 31, 2019, approximately 93% of our revenue was from the United Statesand approximately 7% was from the Middle 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 for
Baker Hughesand from DTI when we 1) sell the Drill-N-Ream tool, 2) repair the DNRtool, and 3) earn royalty on our customer's rental of the DNRtool 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
$0and $9,288at December 31, 2020and 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 of
December 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 $4,800and $79,200related to slow moving inventory in 2020 and 2019, respectively.
Property, plant and equipment
Tangible assets are valued at acquisition cost. Ordinary maintenance and repair costs are charged to operating expenses, while critical component replacements and major improvements are capitalized. Depreciation on property, plant and equipment is calculated using the straight-line method over the estimated useful life of the asset 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.
Promissory note claim to related parties party
January 2014, we entered into a Note Purchase and Sale Agreement under which we agreed to purchase a loan made to Tronco 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. On May 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 on December 31, 2017and 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 effective August 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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