DAYBREAK OIL & GAS, INC. - Quarter Report: 2012 August (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended August 31, 2012

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from  ______________  to  _______________

Commission File Number: 000-50107

DAYBREAK OIL AND GAS, INC.

(Exact name of registrant as specified in its charter)

(509) 232-7674

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  þ Yes  ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  þ Yes  ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ¨ Yes  þ No

At October 11, 2012 the registrant had 48,807,939 outstanding shares of $0.001 par value common stock.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

PART I

FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

DAYBREAK OIL AND GAS, INC.

Balance Sheets - Unaudited

The accompanying notes are an integral part of these unaudited financial statements.

3

DAYBREAK OIL AND GAS, INC.

Statements of Operations - Unaudited

The accompanying notes are an integral part of these unaudited financial statements.

4

DAYBREAK OIL AND GAS, INC.

Statements of Cash Flows - Unaudited

The accompanying notes are an integral part of these unaudited financial statements.

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DAYBREAK OIL AND GAS, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS

NOTE 1 — ORGANIZATION AND BASIS OF PRESENTATION:

Organization

Originally incorporated as Daybreak Uranium, Inc. under the laws of the State of Washington on March 11, 1955, the Company was organized to explore for, acquire, and develop mineral properties in the Western United States.  In March 2005, management of the Company decided to enter the oil and gas exploration and production industry.  On October 25, 2005, the Company shareholders approved a name change from Daybreak Mines, Inc. to Daybreak Oil and Gas, Inc. (referred to herein as “Daybreak” or the “Company”) to better reflect the business of the Company.

All of the Company’s oil and gas production is sold under contracts which are market-sensitive.  Accordingly, the Company’s financial condition, results of operations, and capital resources are highly dependent upon the prevailing market prices of, and demand for, oil and natural gas.  These commodity prices are subject to wide fluctuations and market uncertainties due to a variety of factors that are beyond the control of the Company.  These factors include the level of global demand for petroleum products, foreign supply of oil and gas, the establishment of and compliance with production quotas by oil-exporting countries, the relative strength of the U.S. dollar, weather conditions, the price and availability of alternative fuels, and overall economic conditions, both foreign and domestic.

Basis of Presentation

The accompanying unaudited interim financial statements and notes for the Company have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q for quarterly reports under Section 13 or 15 (d) of the Securities Exchange Act of 1934 (the “Exchange Act”).  Accordingly, they do not include all of the information and footnote disclosures normally required by accounting principles generally accepted in the United States of America for complete financial statements.

In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements have been included and such adjustments are of a normal recurring nature.  Operating results for the six months ended August 31, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2013.

These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 29, 2012.

Use of Estimates

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions.  These estimates and assumptions may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period.  Actual results could differ materially from those estimates. The accounting policies most affected by management’s estimates and assumptions are as follows:

·

The reliance on estimates of proved reserves to compute the provision for depreciation, depletion and amortization and to determine the amount of any impairment of proved properties;

·

The valuation of unproved acreage and proved oil and gas properties to determine the amount of any impairment of oil and gas properties;

·

Judgment regarding the productive status of in-progress exploratory wells to determine the amount of any provision for abandonment; and

·

Estimates regarding abandonment obligations.

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NOTE 2 — GOING CONCERN:

Financial Condition

The Company’s financial statements for the six months ended August 31, 2012 have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.  The Company has incurred net losses since entering the oil and gas exploration industry and as of August 31,  2012 has an accumulated deficit of $24,391,625 and a working capital deficit of $3,713,720 which raises substantial doubt about the Company’s ability to continue as a going concern.

Management Plans to Continue as a Going Concern

The Company continues to implement plans to enhance its ability to continue as a going concern.  Daybreak currently has a net revenue interest in 11 producing wells in its East Slopes Project located in Kern County, California (the “East Slopes Project”).  The revenue from these wells has created a steady and reliable source of revenue for the Company.  Daybreak’s average working interest in these wells is 40.15% and the average net revenue interest is 29.85% in these same wells.

The Company anticipates revenues will continue to increase as it participates in the drilling of more wells in the East Slopes Project.  Daybreak plans to continue its development drilling program at a rate that is compatible with its cash flow and funding opportunities.

In the last few years, the Company has disposed of properties in Alabama, Louisiana and Texas that impeded cash flow and growth in the East Slopes Project.  These actions have allowed the Company to move forward with a drilling and exploration program in Kern County, California.

The Company’s sources of funds in the past have included the debt or equity markets and, while the Company has experienced revenue growth from its oil properties, it has not yet established a positive cash flow on a company-wide basis.  It will be necessary for the Company to obtain additional funding from the private or public debt or equity markets in the future.  However the Company cannot offer any assurance that the Company will be successful in executing the aforementioned plans to continue as a going concern.

The Company’s financial statements as of August 31, 2012 do not include any adjustments that might result from the Company’s inability to implement or execute the plans to improve its ability to continue as a going concern.

NOTE 3 — RECENT ACCOUNTING PRONOUNCEMENTS:

There are no new accounting pronouncements issued or effective that have had, or are expected to have, a material impact on the Company’s financial statements.

NOTE 4 — CONCENTRATION OF CREDIT RISK:

Substantially all of the Company’s accounts receivable result from crude oil sales or joint interest billings to its working interest partners.  This concentration of customers and joint interest owners may impact the Company’s overall credit risk as these entities could be affected by similar changes in economic conditions as well as other related factors.  Accounts receivable are generally not collateralized.  There were no allowances for doubtful accounts at August 31, 2012 and February 29, 2012 as all joint interest owners have a history of paying their obligations.

At the Company’s East Slopes Project, there is only one buyer available for the purchase of oil production.  At August 31, 2012, this one customer represented 100% of crude oil sales receivable.

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NOTE 5 — OIL AND GAS PROPERTIES:

Oil and gas property balances at August 31, 2012 and February 29, 2012 are set forth in the table below.

NOTE 6 — ACCOUNTS PAYABLE:

On March 1, 2009, the Company became the operator for its East Slopes Project.  Additionally, the Company then assumed certain original defaulting partners’ approximate $1.5 million liability representing a 25% working interest in the drilling and completion costs associated with the East Slopes Project’s four earning wells.  The Company subsequently sold the same 25% working interest on June 11, 2009.  Of the $1.5 million default, $283,343 remains unpaid and is included in the August 31, 2012 accounts payable balance.

NOTE 7 —  SHORT-TERM AND LONG-TERM BORROWINGS:

Short-Term Notes Payable

On May 18, 2012, the Company entered into a loan agreement with Luberski, Inc. (“Luberski“) as lender and another party as co-borrower, pursuant to which the Company and the co-borrower together borrowed a principal amount of $1,500,000.  The Company received $719,062 with the remainder of the loan proceeds paid to the co-borrower.  The loan bears interest at a rate of 5% per month, has a term of 120 days, and may be prepaid at any time in part or in full without premium or penalty.  The loan calls for a minimum interest payment of $150,000.  The Company recognized $123,318 in deferred financing fees associated with this loan.  The loan is a joint and several obligation of the Company and the co-borrower, and is secured by the Company’s currently producing leases in Kern Country, California and certain personal property, accounts receivable and net profits of the co-borrower as well as a personal unconditional guarantee of the loan by the co-borrower’s sole managing member.  Either the Company’s or the co-borrower’s failure to repay the principal at maturity constitute an event of default.  Upon maturity of the loan, the Company and the co-borrower did not repay the loan in full.  The Company is currently in discussions with the lender regarding an extension and/or repayment of the loan in full.

On May 22, 2012 the Company paid Well Works, LLC, a Utah Limited Liability Company, $595,744 representing the outstanding principal balance and all interest and fees due in regards to the secured convertible promissory note between the Company and Well Works (the “Well Works Loan”) that was executed on September 17, 2010.  The security interest granted by Daybreak in favor of Well Works in the Company’s Kern County, California leases was terminated in connection with the payoff.

Short-Term (Related Party)

On June 20, 2011, the Company issued a $200,000 non-interest bearing note to the Company’s President and Chief Executive Officer.  The term of the note provided for repayment on or before June 30, 2011, or such date as may be agreed to by the Company and its President.  The Company and its President have agreed that repayment will be made upon the successful completion of long-term financing for the Company.  Proceeds from the note were used to meet the escrow requirement on a loan commitment from a third party that was announced in June 2011. The escrow requirement amount of $200,000 is reflected as an account receivable on the Company’s Balance Sheets and will be refunded to the Company upon closing of funding from the third party.

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On January 31, 2012, the Company issued a $35,100 non-interest bearing note to the Company’s President and Chief Executive Officer.  The term of the note provided for repayment on such date as may be agreed to by the Company and its President.  The Company and its President have agreed that repayment will be made upon the successful completion of long-term financing.  Proceeds from the note were used to pay an extension fee related to the Well Works Loan.

On August 21, 2012, the Company’s President and Chief Executive Officer loaned the Company $15,000 to reduce the outstanding balance on the Line of Credit with UBS Bank.  The loan is a non-interest bearing loan.  Repayment will be made upon the successful completion of long-term financing.

Long-Term Notes Payable

12% Subordinated Notes

On January 13, 2010, the Company commenced a private placement of 12% Subordinated Notes (“Notes”).  On March 16, 2010, the Company closed its private placement of Notes to 13 accredited investors resulting in total gross proceeds of $595,000.  Interest on the Notes accrues at 12% per annum, payable semi-annually.  The note principal is payable in full at the expiration of the term of the Notes, which is January 29, 2015.  Should the Board of Directors, on the maturity date, decide that the payment of the principal and any unpaid interest would impair the financial condition or operations of the Company, the Company may then elect a mandatory conversion of the unpaid principal and interest into the Company’s Common Stock at a conversion rate equal to 75% of the average closing price of the Company’s Common Stock over the 20 consecutive trading days preceding December 31, 2014.  A $250,000 Note was sold to a related party, the Company’s President and Chief Executive Officer.  The terms and conditions of the related party Note were identical to the terms and conditions of the other participants’ Notes.

In conjunction with the Notes private placement, a total of 1,190,000 common stock purchase warrants were issued at the rate of two warrants for every dollar raised through the private placement.  The warrants have an exercise price of $0.14 and expire on January 29, 2015.  The fair value of the warrants, as determined by the Black-Scholes option pricing model, was $116,557 using the following weighted-average assumptions: a risk free interest rate of 2.33%; volatility of 147.6%; and dividend yield of 0.0%.  The fair value of the warrants was recognized as a discount to debt and is being amortized over the term of the Notes using the effective interest method.  Amortization expense for the six months ended August 31, 2012 amounted to $10,673.  Unamortized debt discount amounted to $69,411 as of August 31, 2012.

NOTE 8 — LINE OF CREDIT:

The Company has an $890,000 credit line for working capital purposes with UBS Bank USA (“UBS”) established pursuant to a Credit Line Agreement dated October 24, 2011 that is secured by the personal guarantee of the Company’s President and Chief Executive Officer.  At August 31, 2012, the Line of Credit had an outstanding balance of $885,189.  Interest is payable monthly at a stated reference rate of 0.249% + 337.5 basis points.  The reference rate is based on the 30 day LIBOR (“London Interbank Offered Rate”) and is subject to change from UBS.

NOTE 9 — STOCKHOLDERS DEFICIT:

Series A Convertible Preferred Stock

The Company is authorized to issue up to 10,000,000 shares of $0.001 par value preferred stock.  The Company has designated 2,400,000 shares of the 10,000,000 preferred shares as “Series A Convertible Preferred Stock” (“Series A Preferred”), with a $0.001 par value.  The Series A Preferred can be converted by the shareholder at any time into three shares of the Company’s Common Stock.  During the six months ended August 31, 2012, there were 8,000 shares of Series A Preferred converted into 24,000 shares of the Company’s Common Stock by one shareholder.  At August 31, 2012, there were 898,565 shares of Series A Preferred issued and outstanding.

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Holders of Series A Preferred shares earn a 6% annual cumulative dividend based on the original purchase price of the shares.  Accumulated dividends do not bear interest and as of August 31, 2012, accumulated and unpaid dividends amounted to $1,216,827.  Dividends may be paid in cash or Common Stock at the discretion of the Company and are payable upon declaration by the Company’s Board of Directors.  Dividends are earned until the Series A Preferred is converted to Common Stock.  No payment of dividends has been declared as of August 31, 2012.

Dividends earned on the Series A Preferred for each fiscal year since issuance and the six months ended August 31, 2012 are set forth in the table below:

Common Stock

The Company is authorized to issue up to 200,000,000 shares of $0.001 par value Common Stock, of which 48,807,939 shares were issued and outstanding as of August 31, 2012.  For the six months ended August 31, 2012, there were 24,000 shares of the Company’s Common Stock issued due to the conversion of Series A Preferred Stock.  However, 3,830 shares of the Company’s Common Stock relating to the Company’s 2009 Restricted Stock and Restricted Stock Unit  Plan were returned to the Company during the six months ended August 31, 2012 as discussed in Note 11 below.

Common Stock Issued through Restricted Stock and Restricted Stock Unit Plan

On April 6, 2009, the Board approved the 2009 Restricted Stock and Restricted Stock Unit Plan (the “2009 Plan”) allowing the executive officers, directors, consultants and employees of the Company and its affiliates to be eligible to receive restricted stock and restricted stock unit awards.  Refer to the discussion in Note 11 for the issuances made under the 2009 Plan.

NOTE 10 — WARRANTS:

Warrants outstanding and exercisable as of August 31, 2012 are set forth in the table below:

10

There were no warrants issued or exercised during the six months ended August 31, 2012.  Additionally, there were no warrants that expired during the six months ended August 31, 2012.  The outstanding warrants as of August 31, 2012, have a weighted average exercise price of $0.68, a weighted average remaining life of 1.5 years, and an intrinsic value of $-0-.

NOTE 11 — RESTRICTED STOCK AND RESTRICTED STOCK UNIT PLAN:

On April 6, 2009, the Board of Directors of the Company approved the 2009 Restricted Stock and Restricted Stock Unit Plan (the “2009 Plan”) allowing the executive officers, directors, consultants and employees of the Company and its affiliates to be eligible to receive restricted stock and restricted stock unit awards (“Awards”).  Subject to adjustment, the total number of shares of the Company’s Common Stock that will be available for the grant of Awards under the 2009 Plan may not exceed 4,000,000 shares; provided, that, for purposes of this limitation, any stock subject to an Award that is forfeited in accordance with the provisions of the 2009 Plan will again become available for issuance under the 2009 Plan.

At August 31, 2012, a total of 2,992,340 shares of restricted stock had been awarded and remained outstanding under the 2009 Plan, and 2,615,255 of the shares had fully vested.  A total of 1,007,660 Common Stock shares remained available at August 31, 2012 for issuance pursuant to the 2009 Plan.  A summary of the 2009 Plan issuances is set forth in the table below:

⁽¹⁾

Does not include shares that were withheld to satisfy such tax liability upon vesting of a restricted award by a Plan Participant, and subsequently returned to the 2009 Plan.

⁽²⁾

Reflects the number of common shares that were withheld pursuant to the settlement of the number of shares with a fair market value equal to such tax withholding liability, to satisfy such tax liability upon vesting of a restricted award by a Plan Participant.

⁽³⁾

In accordance with the award, on April 7, 2012, 633,335 shares were vested.

⁽⁴⁾

In accordance with the award, on July 16, 2012, 8,335 shares were vested.

⁽⁵⁾

In accordance with the award, on July 16, 2012, 154,335 shares were vested and 1,915 shares were returned to the 2009 Plan.

⁽⁶⁾

In accordance with the award, on July 22, 2012, 8,335 shares were vested.

⁽⁷⁾

In accordance with the award, on July 22, 2012, 104,335 shares were vested and 1,915 shares were returned to the 2009 Plan.

For the six months ended August 31, 2012, the Company recognized compensation expense related to the above restricted stock grants of $13,693.  Unamortized compensation expense amounted to $28,378 as of August 31, 2012.

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NOTE 12 — INCOME TAXES:

Reconciliation between actual tax expense (benefit) and income taxes computed by applying the U.S. federal income tax rate and state income tax rates to income from continuing operations before income taxes is as follows:

Tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred liabilities are presented below:

At August 31, 2012, Daybreak had estimated net operating loss carryforwards for federal and state income tax purposes of $16,316,832, which will begin to expire, if unused, beginning in 2024.  The valuation allowance increased $217,504 for the six months ended August 31, 2012 and increased $535,710 for the year ended February 29, 2012.  Section 382 of the Internal Revenue Code places annual limitations on the Company’s net operating loss carryforward.

The above estimates are based on management’s decisions concerning elections which could change the relationship between net income and taxable income. Management decisions are made annually and could cause the estimates to vary significantly.

NOTE 13 — COMMITMENTS AND CONTINGENCIES:

Various lawsuits, claims and other contingencies arise in the ordinary course of the Company’s business activities.  While the ultimate outcome of any future contingency is not determinable at this time, management believes that any liability or loss resulting therefrom will not materially affect the financial position, results of operations or cash flows of the Company.

The Company received notice on July 16, 2012, that it was named as a defendant along with several other parties and up to 100 unnamed John Does in a civil lawsuit for damages for wrongful death, negligence, negligent entrustment, permissive use liability, negligent hiring and premises liability in the death of woman in rural California. The civil suit, case S-1500-CV-276772 SPC, was filed on May 30, 2012 with a summons issued on June 25, 2012, in Kern County, in the State of California, in the Superior Court of the State of California. While the outcome of this lawsuit cannot be predicted with certainty, management feels the lawsuit is totally without merit and expects to be eventually dismissed as a defendant from this lawsuit. Management does not expect this lawsuit to have a material adverse impact on our financial condition or results of operation.

The Company, as an owner or lessee and operator of oil and gas properties, is subject to various federal, state and local laws and regulations relating to discharge of materials into, and protection of, the environment.  These laws and regulations may, among other things, impose liability on the lessee under an oil and gas lease for the cost of pollution clean-up resulting from operations and subject the lessee to liability for pollution damages.  In some instances, the Company may be directed to suspend or cease operations in the affected area.  The Company maintains insurance coverage that is customary in the industry, although the Company is not fully insured against all environmental risks.

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The Company is not aware of any environmental claims existing as of August 31, 2012.  There can be no assurance, however, that current regulatory requirements will not change, or past non-compliance with environmental issues will not be discovered on the Company’s oil and gas properties.

NOTE 14 — SUBSEQUENT EVENTS:

As discussed in more detail in Note 7 of these Notes to the Unaudited Financial Statements, on May 18, 2012, the Company entered into a loan agreement with Luberski (“Luberski”) as lender and another party as co-borrower, pursuant to which the Company received $719,062 of the total principal amount of the loan of $1,500,000.  The loan is a joint and several obligation of the Company and the co-borrower, and is secured by the Company’s currently producing leases in Kern Country, California and certain personal property, accounts receivable and net profits of the co-borrower, as well as a personal unconditional guarantee of the loan by the co-borrower’s sole managing member. The loan has a term of 120 days and matured subsequent to the end of the quarterly period ended August 31, 2012. Upon maturity, the Company and the co-borrower did not repay the loan in full.  The Company is currently in discussions with the lender regarding an extension and/or repayment of the loan in full.  There can be no assurances that the Company and/or the co-borrower will be able to repay this loan, or that the lender will not institute foreclosure proceedings on the collateral securing the loan, which includes the Company’s currently producing leases.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement Regarding Forward-Looking Statements

Certain statements contained in our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) are intended to be covered by the safe harbor provided for under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act.

Some statements contained in this Form 10-Q report relate to results or developments that we anticipate will or may occur in the future and are not statements of historical fact.  All statements other than statements of historical fact contained in this MD&A report are inherently uncertain and are forward-looking statements.  Words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “will” and similar expressions identify forward-looking statements.  Examples of forward-looking statements include statements about the following:

·

Our future operating results;

·

Our future capital expenditures;

·

Our future financing;

·

Our expansion and growth of operations; and

·

Our future investments in and acquisitions of oil and natural gas properties.

We have based these forward-looking statements on assumptions and analyses made in light of our experience and our perception of historical trends, current conditions, and expected future developments.  However, you should be aware that these forward-looking statements are only our predictions and we cannot guarantee any such outcomes.  Future events and actual results may differ materially from the results set forth in or implied in the forward-looking statements.  Important factors that could cause actual results to differ materially from our expectations include, but are not limited to, the following risks and uncertainties:

·

General economic and business conditions;

·

Exposure to market risks in our financial instruments;

·

Fluctuations in worldwide prices and demand for oil and natural gas;

·

Our ability to find, acquire and develop oil and gas properties;

·

Fluctuations in the levels of our oil and natural gas exploration and development activities;

·

Risks associated with oil and natural gas exploration and development activities;

·

Competition for raw materials and customers in the oil and natural gas industry;

·

Technological changes and developments in the oil and natural gas industry;

·

Legislative and regulatory uncertainties, including proposed changes to federal tax laws, and climate change legislation, and potential environmental liabilities;

·

Our ability to continue as a going concern;

·

Our ability to secure financing under any commitments as well as additional capital to fund operations; and

·

Other factors discussed elsewhere in this Form 10-Q and in our public filings, press releases and discussions with Company management.

Should one or more of the risks or uncertainties described above or elsewhere in this Form 10-Q occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements.  We specifically undertake no obligation to publicly update or revise any information contained in any forward-looking statement or any forward-looking statement in its entirety, whether as a result of new information, future events, or otherwise, except as required by law.

All forward-looking statements attributable to us are expressly qualified in their entirety by this cautionary statement.

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Introduction and Overview

The following MD&A is management’s assessment of the historical financial and operating results of the Company for the three and six month periods ended August 31, 2012 and August 31, 2011 and of our financial condition as of August 31, 2012, and is intended to provide information relevant to an understanding of our financial condition, changes in our financial condition and results of operations and cash flows and should be read in conjunction with our unaudited financial statements and notes included elsewhere in this Form 10-Q and in our audited financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended February 29, 2012.  Unless otherwise noted, all of our discussion refers to continuing operations at our East Slopes Project in Kern County, California.

We are an independent oil and natural gas exploration, development and production company.  Our basic business model is to increase shareholder value by finding and developing oil and gas reserves through exploration and development activities and selling the production from those reserves at a profit.  To be successful, we must, over time, be able to find oil and gas reserves and then sell the resulting production at a price that is sufficient to cover our finding costs, operating expenses, administrative costs and interest expense, plus offer us a return on our capital investment.  A secondary means of generating returns can include the sale of either producing or non-producing lease properties.

We have a limited operating history of oil and gas production and minimal proven reserves, production and cash flow.  To date, we have had limited revenues and have not been able to generate sustainable positive earnings on a Company-wide basis.  Our management cannot provide any assurances that Daybreak will ever operate profitably.  As a result of our limited operating history, we are more susceptible to the numerous business, investment and industry risks that have been described in Item 1A. Risk Factors of our Annual Report on Form 10-K for the fiscal year ended February 29, 2012.

Our longer-term success depends on, among many other factors, the acquisition and drilling of commercial grade oil and gas properties and on the prevailing sales price for oil and natural gas along with associated operating expenses.  The volatile nature of the energy markets makes it difficult to estimate future prices of oil and natural gas; however, any prolonged period of depressed prices would have a material adverse effect on our results of operations and financial condition.

Our operations are focused on identifying and evaluating prospective oil and gas properties and funding projects that we believe have the potential to produce oil or gas in commercial quantities.  We are currently in the process of developing a multi-well oilfield project in Kern County, California.

Kern County, California (East Slopes Project)

The East Slopes Project is located in the southeastern part of the San Joaquin Basin near Bakersfield, California.  Since January 2009, we have participated in the drilling of 14 wells in this project.  Eleven of those wells have been successful and have been placed on production.  Drilling targets are porous and permeable sandstone reservoirs which exist at depths of 1,200 feet to 3,000 feet.

We currently have production from five reservoirs at our Sunday, Bear, Black, Ball and Dyer Creek locations.  The Sunday and Bear properties each have four producing wells.  The Black property is the smallest of all currently producing reservoirs, and we will most likely drill only one or two development wells at this property.  The Ball and Dyer Creek properties were put on production in late October 2010.  There are several other similar prospects on trend with the Bear, Black and Dyer Creek reservoirs exhibiting the same seismic characteristics.  Some of these prospects, if successful, would utilize the Company’s existing production facilities.  In addition to the current field development, there are several other exploratory prospects that have been identified from the seismic data, which we plan to drill in the future.  We plan to spend approximately $1,500,000 in new capital investments within the East Slopes Project area in the next 12 months.

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Producing Properties

Sunday Property

In November 2008, we made our initial oil discovery drilling the Sunday #1 well.  The well was put on production in January 2009.  Production is from the Vedder sand at approximately 2,000 feet.  During 2009, we drilled three development wells including one horizontal well.  The Sunday reservoir is estimated to be approximately 35 acres in size with the potential for at least three more development wells to be drilled in the future.  With the acquisition of an additional 16.67% working interest in the East Slopes Project in September 2010, we have a 41.67% working interest with a 29.0% net revenue interest (“NRI”) in the Sunday #1 well.  We continue to have a 37.5% working interest with a 27% NRI in each of the Sunday #2 and #3 wells.  We also have a 37.5% working interest with a 30.1% NRI in the Sunday #4H well.  We expect to drill at least one development well at this property during 2012.

Bear Property

In February 2009, we made our second oil discovery drilling the Bear #1 well, which is approximately one mile northwest of our Sunday discovery.  The well was put on production in May 2009.  Production is from the Vedder sand at approximately 2,200 feet.  In December 2009, we began a development program by drilling and completing the Bear #2 well.  In April 2010, we successfully drilled and completed the Bear #3 and the Bear #4 wells.  The Bear reservoir is estimated to be approximately 62 acres in size with the potential for at least five more development wells to be drilled in the future.  With the acquisition of an additional 16.67% working interest in the East Slopes Project in September 2010, we have a 41.67% working interest with a 29.0% NRI in each of the Bear wells in this property.  Effective April 24, 2012, the royalty interest on this property was reduced to encourage more drilling.  While our NRI on currently producing wells will remain unchanged, our new NRI for the next four wells drilled on this property will increase to 34.7%.  We expect to drill at least three development wells at this property during 2012.

Black Property

The Black property was acquired through a farm-in arrangement with a local operator.  The Black property is just south of the Bear property on the same fault system.  The Black #1 well was completed and put on production in January 2010.  Production is from the Vedder sand at 2,150 feet.  The Black reservoir is estimated to be approximately 13 acres in size with the potential for one or two development wells to be drilled in the future.  We have a 37.5% working interest with a 29.8% NRI in this property.  We expect to drill at least one development well at this property during 2012.

Sunday Central Processing and Storage Facility

The oil produced from our acreage is considered heavy oil.  The oil ranges from 14° to 16° API gravity.  All of our oil from the Sunday, Bear and Black properties is processed, stored and sold from the Sunday Central Processing and Storage Facility.  The oil must be heated to separate and remove water to prepare it to be sold.  We constructed these facilities during the summer and fall of 2009 and at the same time established electrical service for our field by constructing three miles of power lines.

Ball Property

The Ball #1-11 well was put on production in late October 2010.  Our 3-D seismic data indicates a reservoir approximately 38 acres in size with the potential for at least two development wells to be drilled in the future.  Production from the Ball #1-11 well is being processed at the Dyer Creek production facility.  In January 2012, we farmed out to a third party 50% of our working interest covering the Ball and Dyer Creek Fields.  In return, the third party will pay Daybreak’s share of the completed well cost on the next Ball well to be drilled.  We have a 41.67% working interest with a 34.69% NRI in the Ball #1-11 well. For wells in this field other than the Ball #1-11, we will have a 20.84% working interest with a 17.35% NRI.  We anticipate drilling at least one development well at this property after the permitting process has been completed, probably in 2013.

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Dyer Creek Property

The Dyer Creek #67X-11 (“DC67X”) well was also put on production in late October 2010.  This well is producing from the Vedder sand and is located to the north of the Bear property on the same trapping fault.  The Dyer Creek property has the potential for at least one development well in the future.  Production from the DC67X well is also being processed at the Dyer Creek production facility.  We have a 41.67% working interest with a 34.69% NRI in this property.  For wells other than the DC67X, we will have a 20.84% working interest with a 17.35% NRI.  We anticipate drilling at least one development well at this property probably in 2013.

Dyer Creek Processing and Storage Facility

The Dyer Creek Processing and Storage Facility serves the Ball and Dyer Creek properties and includes previously abandoned infrastructure that we have refurbished.  The oil produced into this facility has a similar API gravity to the oil at the Sunday production facility and the oil must also be heated to separate and remove water in preparation for sale.

Centralized Oil Processing and Storage Facilities

By utilizing the Sunday and Dyer Creek centralized production facilities our average operating costs have been reduced from over $40 per barrel to under $10 per barrel of oil for the six months ended August 31, 2012, partially due to certain credits that we received. Without these credits, our average operating costs were approximately $15 per barrel for the six months ended August 31, 2012. With these centralized facilities and having permanent electrical power available, we are ensuring that our operating expenses are kept to a minimum.

Exploration Properties

Breckenridge-Chimney Prospect

This prospect is located in the central portion of our acreage position.  The drilling targets are the Vedder and Eocene sands between 2,000 and 2,500 feet deep.  We plan to drill an exploratory well in 2012.  We estimate that the Breckenridge-Chimney prospect is 60 acres in size with a gross recoverable reserve potential of 1.5 million barrels of oil.  We have a 41.67% working interest in this prospect.

Bull Run Prospect

This prospect is located in the southern portion of our acreage position.  The drilling targets are the Etchegoin and Santa Margarita sands located between 800 and 1,200 feet deep.  We drilled an exploratory well on this prospect in December 2011 that was determined to be not viable for commercial production and the well was plugged and abandoned.  Utilizing the data received from this well, we expect to drill another exploratory well on this prospect during 2013.  The Bull Run wells will require a pilot steam flood and additional production facilities.  We estimate that the Bull Run prospect is 70 acres in size with a gross recoverable reserve potential of 873,000 barrels of oil.  We have a 41.67% working interest in this prospect.

Glide-Kendall Prospect

This prospect is also located in the southern portion of our acreage position.  The drilling targets are the Olcese and Eocene sands between 1,000 and 2,000 feet deep.  We plan to drill an exploratory well during 2013.  We estimate that the Glide Kendall prospect is 200 acres in size with a gross recoverable reserve potential of 1.8 million barrels of oil.  We have a 41.67% working interest in this prospect.

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Sherman Prospect

This prospect is located in the southern portion of our acreage position.  The drilling targets are the Olcese and Etchegoin sands between 1,000 and 2,000 feet deep.  We plan to drill an exploratory well in 2014.  We estimate that the Sherman Prospect is 100 acres in size with a gross recoverable reserve potential of 300,000 barrels of oil.  We have a 41.67% working interest in this prospect.

Tobias Prospect

This prospect is also located in the central portion of our acreage position.  The drilling targets are the Vedder and Eocene sands between 2,000 and 2,500 feet deep.  We plan to drill an exploratory well in 2013.  We estimate that the Tobias prospect is 60 acres in size with a gross recoverable reserve potential of 700,000 barrels of oil.  We have a 41.67% working interest in this prospect.

Production, Revenue and LOE

Our net sales volume, revenue and lease operating expenses (“LOE”) by quarter for the East Slopes Project for the last five quarters ended August 31, 2012 are set forth in the following table:

* During the three months ended August 31, 2012, the Company received certain credits on production expenses related to dehydration expense and property taxes on mineral valuations totaling $38,537, that resulted in lower than normal production expenses for the quarter.

Encumbrances

The Company’s debt obligations, pursuant to a loan agreement entered into by and among Luberski, Inc., a California corporation, as lender, and the Company and RTG Steel Company, LLC, an Arizona limited liability company, as co-borrowers, are secured by mortgages on the Sunday, Bear, Black, Ball and Dyer Creek Properties.  For further information on the loan agreement refer to the discussion under the caption “Short-Term Borrowings” in this MD&A.

Results of Operations – Three Months Ended August 31, 2012 compared to the Three Months Ended August 31, 2011

Revenues.  Monthly revenues are derived entirely from the sale of our share of oil production.  We realized the first revenue from producing wells in our East Slopes Project during February 2009.  The price we receive for oil sales is based on prices quoted on the New York Mercantile Exchange (“NYMEX”) for spot West Texas Intermediate (“WTI”) Cushing, OK contracts, less deductions that vary by grade of crude oil sold. Historically, the sale price we receive for California oil sales has been less than the quoted WTI price.  However, since March of 2011, we have been receiving a premium for our California oil in comparison to the WTI price.  For the three months ended August 31, 2012 the average monthly WTI price was $88.11 and the average monthly sale price was $93.34, resulting in a premium that was 5.9% higher than the average monthly WTI price.  For the three months ended August 31, 2011, the average monthly WTI price was $93.30 and the average monthly sale price was $98.69 resulting in a premium that was 5.8% higher than the average monthly WTI price.

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For the three months ended August 31, 2012, revenues decreased $82,535 or 24.9% to $249,149 in comparison to revenues of $331,684 for the three months ended August 31, 2011.  The average monthly sale price of a barrel of oil for the three months ended August 31, 2012 was $93.34 in comparison to $98.69 for the three months ended August 31, 2011.  The decrease of $5.35 or 5.3% in the average monthly sale price of a barrel of oil accounted for $17,918 or 21.7% of the revenue decrease for the three months ended August 31, 2012.

Production for the three months ended August 31, 2012 was from 11 wells for a total of 906 well days in comparison to production from 11 wells with a total of 1,005 well days for the three months ended August 31, 2011.  Due to repair and maintenance issues on the Bear #1 and Bear #3 wells, these wells only produced for 82 and 6 days, respectively, during the three months ended August 31, 2012.

Our net share of production for the three months ended August 31, 2012 was 2,669 barrels of oil in comparison to 3,362 barrels for the three months ended August 31, 2011.  The decrease in production of 692 barrels or 20.6% for the three months ended August 31, 2012 in comparison to the three months ended August 31, 2011 was due to repair and maintenance issues on the two wells referenced above in addition to the normal production decline in our oil wells.  The decline in production accounted for $64,617 or 78.3% of the decrease in revenues for the three months ended August 31, 2012.  A table of our revenues for the three months ended August 31, 2012 and 2011 is set forth below:

Operating Expenses.  Total operating expenses for the three months ended August 31, 2012 decreased by $167,882 or 31.5% to $364,696 in comparison to $532,578 for the three months ended August 31, 2011.  Decreases occurred in all expense categories including production expenses; exploration and drilling; depreciation, depletion and amortization (“DD&A”) and general and administrative (“G&A”) expenses. Operating expenses for the three months ended August 31, 2012 and 2011 are set forth in the table below:

Production expenses include expenses directly associated with the generation of oil and gas revenues, road maintenance and well workover expenses.  For the three months ended August 31, 2012, these expenses decreased by $57,132 or 96.7% to $1,939 in comparison to $59,071 for the three months ended August 31, 2011.  Approximately $38,537 of the decrease in production expenses is directly related to recognition of certain credits we received relating to dehydration expenses and property taxes on minerals valuation during the three months ended August 31, 2012. Production expenses are directly related to the number of wells that were producing during the three months ended August 31, 2012 and 2011, our percentage of working interest ownership in those wells.  Production expenses represented approximately 0.5% of total operating expenses.

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Exploration and drilling expenses include geological and geophysical (“G&G”) expenses as well as leasehold maintenance and dry hole expenses.  For the three months ended August 30, 2012 these expenses decreased $9,179 or 30.6%, to $20,807 in comparison to $29,986 for the three months ended August 31, 2011.  Exploration and drilling expenses for the three months ended August 31, 2012, decreased primarily as a result of the expiration of certain leases that were not renewed.  Exploration and drilling expenses represented approximately 5.7% of total operating expenses.

DD&A expense relating to equipment, proven reserves and property costs, along with impairment are another component of operating expenses.  DD&A expense decreased $15,183 or 20.2% to $60,154 for the three months ended August 31, 2012 in comparison to $75,337 for the three months ended August 31, 2011 primarily due to a larger proven reserve base used in the DD&A calculation and lower production levels. DD&A expense represented approximately 16.5% of total operating expenses.

G&A expenses include the salaries of six employees, including management.  Other items included in our G&A expenses are legal and accounting expenses, director fees, stock compensation, investor relations fees, travel expenses, insurance, Sarbanes-Oxley (“SOX”) compliance expenses and other administrative expenses necessary for an operator of oil and gas properties as well as in running a public company.  For the three months ended August 31, 2012, G&A expenses decreased $86,387 or 23.5% to $281,797 in comparison to $368,184 for the three months ended August 31, 2011.  Significant decreases were realized in accounting and legal ($38,220) and management and employee salaries.  Management and employee salaries, which comprised 59.3% of our G&A expense and stock compensation decreased $45,234 or 21.3% for the three months ended August 31, 2012 in comparison to the three months ended August 31, 2011.  These categories were responsible for $83,454 in aggregate of the decrease in G&A expenses in comparison to the three months ended August 31, 2011.  For the three months ended August 31, 2012 and 2011, we received, as Operator, administrative overhead reimbursement of $9,628 and $16,436, respectively, for the East Slopes Project, which was used to directly offset certain employee salaries.  We are continuing a program of reducing all of our G&A costs wherever possible.  G&A costs represented 77.3% of total operating expenses for the three months ended August 31, 2012.

Interest income for the three months ended August 31, 2012 decreased $40 to $119 compared to $159 for the three months ended August 31, 2011, due to lower average cash balances.

Interest expense for the three months ended August 31, 2012 increased $83,246 to $141,993 in comparison to $58,747 for the three months ended August 31, 2011.  This increase was primarily from the amortization of loan origination fees related to the Luberski loan.

Due to the nature of our business, as well as the relative immaturity of the Company, we expect that revenues, as well as all categories of expenses, will continue to fluctuate substantially on a quarter-to-quarter and year-to-year basis.  Production expenses will fluctuate according to the number and percentage ownership of producing wells, as well as the amount of revenues being contributed by such wells.  Exploration and drilling expenses will be dependent upon the amount of capital that we have to invest in future development projects, as well as the success or failure of such projects.  Likewise, the amount of DD&A expense and impairment expense will depend upon the factors cited above and the size of our reserve base.  G&A expenses will also fluctuate based on our current requirements, but will generally tend to increase as we expand the business operations of the Company.

Results of Operations – Six Months Ended August 31, 2012 compared to the Six Months Ended August 31, 2011

Revenues.  For the six months ended August 31, 2012, the average monthly WTI price was $94.74 and the average monthly sale price was $100.27 resulting in a premium that was 5.5% higher than the average monthly WTI price.  For the six months ended August 31, 2011, the average monthly WTI price was $98.86 and the average monthly sale price was $103.74 resulting in a premium that was 4.9% higher than the average monthly WTI price.

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Total revenues for the six months ended August 31, 2012 decreased $199,919 or 28.1% to $512,122 in comparison to revenues of $712,041 for the six months ended August 31, 2011.  The average monthly sale price of a barrel of oil for the six months ended August 31, 2012 was $100.27 in comparison to $103.74 for the six months ended August 31, 2011.  The decrease of $3.47 or 3.5% in the average sale price of a barrel of oil accounted for $23,743 or 11.9% of the revenue decrease for the six months ended August 31, 2012.

Production for the six months ended August 31, 2012 was from 11 wells for a total of 1,907 well days in comparison to production from 11 wells with a total of 2,000 well days for the six months ended August 31, 2011.  Our net share of production for the six months ended August 31, 2012 was 5,107 barrels of oil in comparison to 6,864 barrels for the six months ended August 31, 2011.  The decrease in production of 1,757 barrels or 25.6% was due to repair and maintenance issues on the two wells referenced above and the normal production decline in our wells. The decline in production accounted for $176,177 or 88.1% of the revenue decrease for the six months ended August 31, 2012.  A table of our revenues for the six months ended August 31, 2012 and 2011 is set forth below:

Operating Expenses.  Total operating expenses for the six months ended August 31, 2012 decreased by $175,562 or 17.4% in comparison to the six months ended August 31, 2011.  Decreases occurred in all expense categories including production expenses; exploration and drilling; DD&A; and G&A.  Operating expenses for the six months ended August 31, 2012 and 2011 are set forth in the table below:

Production expenses for the six months ended August 31, 2012 decreased by $56,211 or 56.3% to $43,632 in comparison to $99,843 for the six months ended August 31, 2011.  Approximately $38,537 of the decrease in production expenses is directly related to recognition of certain credits we received relating to dehydration expenses and property taxes on minerals valuation during the six months ended August 31, 2012. Production expenses are directly related to the number of wells that were producing during the six months ended August 31, 2012 and 2011, our percentage of working interest ownership in those wells.  Production expenses represented approximately 5.2% of total operating expenses.

Exploration and drilling expenses decreased by $19,238 or 34.5% to $36,550 for the six months ended August 31, 2012 in comparison to $55,788 for the six months ended August 31, 2011.  Exploration and drilling expenses for the six months ended August 31, 2012, decreased primarily as a result of the expiration of certain leases that were not renewed.  Exploration and drilling expenses represented approximately 4.4% of total operating expenses.

DD&A and impairment expenses for the six months ended August 31, 2012 decreased $35,788 or 23.1% to $119,120 in comparison to $154,908 for the six months ended August 31, 2011, primarily due to a larger proven reserve base used in the DD&A calculation and lower production levels.  DD&A expenses represented approximately 14.3% of total operating expenses.

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G&A expenses include the salaries of six employees, including management.  Other items included in our G&A are legal and accounting expenses, director fees, stock compensation, investor relations fees, travel expenses, insurance, SOX compliance expenses and other administrative expenses necessary for an operator of oil and gas properties as well as well as in running a public company.  G&A expense decreased $64,325, or 9.2% to $633,991 for the six months ended August 31, 2012 in comparison to $698,316 for the six months ended August 31, 2011.  A significant decrease of $75,217 was realized in management and employee salaries for the six months ended August 31, 2012. Management and employee salaries, which comprised 53.8% of our G&A expense and stock compensation decreased due to the elimination of the Sr. Vice President – Exploration position and also certain stock grants being fully amortized during the six months ended August 31, 2012.  For the six months ended August 31, 2012 and 2011, we received, as Operator, administrative overhead reimbursement of $19,309 and $32,486, respectively, for the East Slopes Project which was used to directly offset certain employee salaries.  We are continuing a program of reducing all of our G&A costs wherever possible.  G&A costs represented 76.1% of total operating expenses for the six months ended August 31, 2012.

Interest income for the six months ended August 31, 2012 decreased $105 or 32.0% to $223 in comparison to $328 for the six months ended August 31, 2011 due to lower average cash balances.

Interest expense increased $113,742 to $231,184 for the six months ended August 31, 2012 compared to $117,442 for the six months ended August 31, 2011, primarily due amortization of loan origination fees related to the Luberski loan.

Due to the nature of our business, as well as the relative immaturity of the Company, we expect that revenues, as well as all categories of expenses, will continue to fluctuate substantially on a quarter-to-quarter and year-to-year basis.  Production costs will fluctuate according to the number and percentage ownership of producing wells, as well as the amount of revenues being contributed by such wells.  Exploration and drilling expenses will be dependent upon the amount of capital that we have to invest in future development projects, as well as the success or failure of such projects.  Likewise, the amount of DD&A expense and impairment costs will depend upon the factors cited above and the size of our reserve base.  G&A costs will also fluctuate based on our current requirements, but will generally tend to increase as we expand the business operations of the Company.

Liquidity and Capital Resources

Our primary financial resource is our oil reserves base.  Our ability to fund a future capital expenditure program is dependent upon the level of prices we receive from oil sales, the success of our exploration and development program in Kern County, California, and the availability of capital resource financing.  We plan to spend approximately $1,500,000 in new capital investment within the East Slopes Project area in the current fiscal year.  Factors such as changes in operating margins and the availability of capital resources could increase or decrease our ultimate level of expenditures during the current fiscal year.

Our business is capital intensive.  Our ability to grow is dependent upon favorably obtaining outside capital and generating cash flows from operating activities necessary to fund our investment activities.  There is no assurance that we will be able to achieve profitability.  Since our future operations will continue to be dependent on successful exploration and development activities and our ability to seek and secure capital from external sources, should we be unable to achieve sustainable profitability this could cause any equity investment in the Company to become worthless.

Major sources of funds in the past for us have included the debt or equity markets.  While we have experienced revenue growth from operations in Kern County, California, we will have to rely on these capital markets to fund future operations and growth.  Our business model is focused on acquiring exploration or development properties as well as existing production.  Our ability to generate future revenues and operating cash flow will depend on successful exploration, and/or acquisition of oil and gas producing properties, which will require us to continue to raise equity or debt capital from outside sources.

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We continue to seek additional financing for our planned exploration and development activities.  We plan to obtain financing through various methods, including issuing debt securities, equity securities, bank debt, or combinations of these instruments which could result in dilution of existing security holders and increased debt and leverage.  No assurance can be given that we will be able to obtain funding under any loan commitments or any additional financing on favorable terms, if at all.  Sales of interests in our assets may be another source of cash flow.

We have repositioned Daybreak to better meet our corporate goals and objectives by disposing of assets that impeded our cash flow and growth in the East Slopes Project.  In the last few years, we have disposed of properties in Alabama, Louisiana and Texas.  These actions have allowed us to move forward with our drilling and exploration program in Kern County.

The Company’s financial statements for the six months ended August 31, 2012 have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.  We have incurred net losses since entering the oil and gas exploration industry and as of August 31, 2012 have an accumulated deficit of $24,391,625 and a working capital deficit of $3,713,720, which raises substantial doubt about our ability to continue as a going concern.

Changes in our capital resources at August 31, 2012 in comparison to February 29, 2012 are set forth in the table below:

We maintain our cash balance by increasing or decreasing our exploration and drilling expenditures as limited by availability of cash from operations, investments and financing.  Our cash balances were $4,787 and $73,392 as of August 31, 2012 and February 29, 2012, respectively. The decrease of $68,605 was due to meeting financial commitments from ongoing operations as well as G&A expenses.

Our working capital deficit increased $492,344 to $3,713,720 at August 31, 2012 in comparison to a deficit of $3,221,376 at February 29, 2012. We have not yet been able to generate sufficient cash flow to cover all of our G&A and interest expenses.  This is the primary factor for the increase in our working capital deficit. We anticipate an increase in our cash flow from our East Slope operations in Kern County, California during the current fiscal year due to additional drilling that is scheduled to occur.

During the six months ended August 31, 2012, we reported an operating loss of $321,171 in comparison to an operating loss of $296,814 for the six months ended August 31, 2011.  This increase in the operating loss of $24,357 or 8.2% from the comparative six months ended August 31, 2011 was due to lower revenues resulting from lower prices for oil sold and a decrease in production due to the natural decline in our wells.

Since entering the oil and gas exploration industry, we have incurred recurring losses with periodic negative cash flow and have depended on external financing and the sale of oil and gas assets to sustain our operations.  A net loss of 552,132 was reported for the six months ended August 31, 2012 in comparison to a net loss of $413,928 for the six months ended August 31, 2011.  The increase in the net loss of $138,204 for the six months ended August 31, 2012 was primarily due to a decrease of $199,919 in revenue generated from oil sales.

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Cash Flows

Changes in the net funds provided by and (used in) our operating, investing and financing activities are set forth in the table below:

Cash Flow Provided by Operating Activities

Cash flow from operating activities is derived from the production of our oil and gas reserves and changes in the balances of receivables, payables or other non-oil property asset account balances.  For the six months ended August 31, 2012, we had a positive cash flow from operating activities of $62,529, in comparison to a positive cash flow of $89,319 for the six months ended August 31, 2011.  This decrease in positive cash flow of $26,790 or 30.0% was primarily the result of a decrease of $199,919 in our revenue for the six months ended August 31, 2012.  Variations in cash flow from operating activities may impact our level of exploration and development expenditures.

Cash Flow (Used in) Investing Activities

Cash flow from investing activities is derived from changes in oil and gas property and Other Assets account balances.  Cash used in investing activities for the six months ended August 31, 2012 was $131,134, in comparison to $128,258 for the six months ended August 31, 2011.  This increase of $2,876 or 2.2% in cash used in investing activities was primarily a result of ongoing infrastructure improvements that occurred during the six months ended August 31, 2012.

Cash Flow Provided by Financing Activities

Cash flow from financing activities is derived from changes in long-term account balances or in equity account balances excluding retained earnings.  For the six months ended August 31, 2012 and August 31, 2011, we had no net change in financing activities.  The following is a summary of cash flows provided by, and used in, the Company’s financing activities.

Short-Term Borrowings

On May 18, 2012, the Company entered into a Loan Agreement (the “Loan”) with Luberski, Inc., a California corporation, as lender, and RTG Steel Company, LLC, an Arizona limited liability company, as co-borrower (“RTG”), pursuant to which the Company and RTG together borrowed a principal amount of $1,500,000. Daybreak received $719,062 with the remainder of the Loan proceeds paid to RTG. The Loan bears interest at a rate of 5% per month, has a term of 120 days, and may be prepaid at any time in part or in full without premium or penalty.  The Loan calls for a minimum interest payment of $150,000.00.  The Loan is a joint and several obligation of Daybreak and RTG, and is secured by the Company’s currently producing leases in Kern Country, California and certain personal property, accounts receivable and net profits of RTG as well as a personal unconditional guarantee of the loan by RTG’s sole managing member.  The proceeds of the Loan were used to repay in full, effective May 22, 2012, all amounts outstanding and owed in regards to the Secured Convertible Promissory Note between the Company and Well Works, LLC that was executed on September 17, 2010.  Either the Company’s or the co-borrowers’ failure to repay the principal at maturity will constitute an event of default.  Upon maturity of the loan, the Company and the co-borrower did not repay the loan in full.  The Company is currently in discussions with the lender regarding an extension and/or repayment of the loan in full.  There can be no assurances that the Company or the co-borrower will be able to repay the loan, or that the lender will not institute foreclosure proceedings on our currently producing leases.  

On May 22, 2012 the Company paid Well Works, LLC, a Utah Limited Liability Company, $595,744 representing the outstanding principal balance and all interest and fees due in regards to the secured convertible promissory note between the Company and Well Works (the “Well Works Loan”) that was executed on September 17, 2010.  The security interest granted by Daybreak in favor of Well Works in the Company’s Kern County, California leases was terminated in connection with the payoff.

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Line of Credit

During the year ended February 29, 2012, the Company entered into an $890,000 credit line for working capital purposes with UBS Bank USA (“UBS”), established pursuant to a Credit Line Agreement dated October 24, 2011 that is secured by the personal guarantee of our President and Chief Executive Officer.  At August 31, 2012, the Line of Credit had an outstanding balance of $885,189.  Interest is payable monthly at a stated reference rate of 0.249% + 337.5 basis points and totaled $16,285 for the six months ended August 31, 2012.  The reference rate is based on the 30 day LIBOR (“London Interbank Offered Rate”) and is subject to change from UBS.

Short-Term Borrowings (Related Party)

On June 20, 2011, we issued a $200,000 non-interest bearing note to our President and Chief Executive Officer.  The term of the note provided for repayment on or before June 30, 2011, or such other date as may be agreed to by Daybreak and our President.  Daybreak and our President have agreed that repayment will be made upon the successful completion of long-term financing.  Proceeds from the note were used to meet the escrow requirement on a loan commitment from a third party that was announced in June 2011.  The escrow requirement amount of $200,000 is reflected as an account receivable on the Company’s Balance Sheets and will be refunded to the Company upon closing of funding from the third party.

On January 31, 2012, the Company issued a $35,100 non-interest bearing note to the Company’s President and Chief Executive Officer.  The term of the note provided for repayment on such other date as may be agreed to by the Company and its President.  The Company and its President have agreed that repayment will be made upon the successful completion of long-term financing.  Proceeds from the note were used to pay an extension fee related to the Well Works Loan.

On August 21, 2012, the Company’s President and Chief Executive Officer loaned the Company $15,000 to reduce the outstanding balance on the Line of Credit with UBS Bank.  The loan is a non-interest bearing loan.  Repayment will be made upon the successful completion of long-term financing.

Long-Term Borrowings

12% Subordinated Notes

The Company’s 12% Subordinated Notes (“the Notes”) issued pursuant to a March 2010 private placement, resulted in $595,000 in gross proceeds to the Company and accrue interest at 12% per annum, payable semi-annually on January 29th and July 29th.  The note principal is payable in full at the expiration of the term of the Notes, which is January 29, 2015.  In conjunction with the Notes private placement, a total of 1,190,000 common stock purchase warrants were issued at a rate of two warrants for every dollar raised through the private placement.  The warrants have an exercise price of $0.14 and expire on January 29, 2015.  The fair value of the warrants, as determined by the Black-Scholes option pricing model, was $116,557 using the following weighted average assumptions: a risk free interest rate of 2.33%; volatility of 147.6%; and dividend yield of 0.0%.  The fair value of the warrants was recognized as a discount to debt and is being amortized over the term of the Notes using the effective interest method.  Amortization expense for the six months ended August 31, 2012 amounted to $10,673.  Unamortized debt discount amounted to $69,411 as of August 31, 2012.

Daybreak has ongoing capital commitments to develop certain leases pursuant to their underlying terms.  Failure to meet such ongoing commitments may result in the loss of the right to participate in future drilling on certain leases or the loss of the lease itself.  These ongoing capital commitments may also cause us to seek additional capital from sources outside of the Company.  The current uncertainty in the credit and capital markets, and the economic downturn, may restrict our ability to obtain needed capital.

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Restricted Stock and Restricted Stock Unit Plan

On April 6, 2009, the Board approved the 2009 Restricted Stock and Restricted Stock Unit Plan (the “2009 Plan”) allowing the executive officers, directors, consultants and employees of Daybreak and its affiliates to be eligible to receive restricted stock and restricted stock unit awards. Subject to adjustment, the total number of shares of Daybreak’s common stock that will be available for the grant of awards under the 2009 Plan may not exceed 4,000,000 shares; provided, that, for purposes of this limitation, any stock subject to an award that is forfeited in accordance with the provisions of the 2009 Plan will again become available for issuance under the 2009 Plan.

We believe that awards of this type further align the interests of our employees and our shareholders by providing significant incentives for these employees to achieve and maintain high levels of performance.  Restricted stock and restricted stock units also enhance our ability to attract and retain the services of qualified individuals.

At August 31, 2012, a total of 2,992,340 shares of restricted stock had been awarded and remained outstanding under the 2009 Plan, and 2,615,255 of the shares had fully vested.  A total of 1,007,660 Common Stock shares remained available at August 31, 2012 for issuance pursuant to the 2009 Plan.  A summary of the 2009 Plan issuances is set forth in the table below:

⁽¹⁾

Does not include shares that were withheld to satisfy such tax liability upon vesting of a restricted award by a Plan Participant, and subsequently returned to the 2009 Plan.

⁽²⁾

Reflects the number of common shares that were withheld pursuant to the settlement of the number of shares with a fair market value equal to such tax withholding liability, to satisfy such tax liability upon vesting of a restricted award by a Plan Participant.

⁽³⁾

In accordance with the award, on April 7, 2012, 633,335 shares were vested.

⁽⁴⁾

In accordance with the award, on July 16, 2012, 8,335 shares were vested.

⁽⁵⁾

In accordance with the award, on July 16, 2012, 154,335 shares were vested and 1,915 shares were returned to the 2009 Plan.

⁽⁶⁾

In accordance with the award, on July 22, 2012, 8,335 shares were vested.

⁽⁷⁾

In accordance with the award, on July 22, 2012, 104,335 shares were vested and 1,915 shares were returned to the 2009 Plan.

For the six months ended August 31, 2012, the Company recognized compensation expense related to the above restricted stock grants of $13,693.  Unamortized compensation expense amounted to $28,378 as of August 31, 2012.

Summary

We are continuing to execute the Company’s business plan of developing Daybreak’s acreage position in Kern County, California.  The Company will continue to focus our efforts on drilling both development and exploration wells in the current fiscal year as cash flow and funding allow. Along with stable oil prices, the increase in production from new wells will increase our net cash flow from operations.

We continue to seek additional financing for our planned exploration and development activities.  We plan to obtain financing through various methods, including issuing debt securities, equity securities, bank debt, or combinations of these instruments which could result in dilution to existing security holders and increased debt and leverage.  No assurance can be given that we will be able to obtain funding under any loan commitments or any additional financing on favorable terms, if at all.

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Critical Accounting Policies

Refer to Daybreak’s Annual Report on Form 10-K for the fiscal year ended February 29, 2012.

Off-Balance Sheet Arrangements

As of August 31, 2012, we did not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partners that have been, or are reasonably likely to have, a material effect on our financial position or results of operations.

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a smaller reporting company, we are not required to provide the information otherwise required by this Item.

ITEM 4.  CONTROLS AND PROCEDURES

Management’s Evaluation of Disclosure Controls and Procedures

As of the end of the reporting period, August 31, 2012, an evaluation was conducted by Daybreak management, including our President and Chief Executive Officer, who is also serving as our interim principal finance and accounting officer, as to the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(e) of the Exchange Act.  Such disclosure controls and procedures are designed to ensure that information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported within required time periods specified by the SEC rules and forms.  Additionally, it is vital that such information is accumulated and communicated to our management, including our President and Chief Executive Officer, in a manner to allow timely decisions regarding required disclosures.  Based on that evaluation, our management concluded that our disclosure controls were effective as of August 31, 2012.

Changes in Internal Control over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting during the three months ended August 31, 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Limitations

Our management does not expect that our disclosure controls or internal controls over financial reporting will prevent all errors or all instances of fraud.  A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.

Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls.  The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and any design may not succeed in achieving its stated goals under all potential future conditions.

Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.  Because of the inherent limitation of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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PART II

OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

See Note 13 of the Notes to the Unaudited Financial Statements.

ITEM 1A.  RISK FACTORS

The following risk factors could affect our financial performance or could cause actual results to differ materially from estimates contained in our forward-looking statements and update the Risk Factors included in our Annual Report on Form 10-K for the fiscal year ended February 29, 2012.  In evaluating all forward-looking statements, you should specifically consider various factors that may cause actual results to vary from those contained in the forward-looking statements.  Except as set forth below, there have been no material changes to the risks previously disclosed in our “Risk Factors” described in Part 1, Item 1A, of the Annual report on Form 10-K for the year ended February 29, 2012, as filed with the U.S. Securities and Exchange Commission on May 25, 2012, and available at www.sec.gov.

The amount of our outstanding indebtedness continues to increase and our ability to make payments towards such indebtedness could have adverse consequences on future operations.

Our outstanding indebtedness at August 31, 2012 was approximately $4,870,000, which was comprised of a variety of short term notes payable and related party notes payable; a line of credit, trade payables and 12% Subordinated Notes.  The level of indebtedness affects our operations in a number of ways.  We will need to use a portion of our cash flow to pay principal and interest and meet payables commitments, which will reduce the amount of funds we will have available to finance our operations.  This lack of funds could limit our flexibility in planning for or reacting to changes in our business and the industry in which we operate and could limit our ability to make funds available for other purposes, such as future exploration, development or acquisition activities.  Our ability to meet our debt service obligations and reduce our total indebtedness will depend upon our future performance.  Our future performance, in turn, is dependent upon many factors that are beyond our control such as general economic, financial and business conditions.  We cannot guarantee that our future performance will not be adversely affected by such economic conditions and financial, business and other factors.

The Luberski Loan referenced in the MD&A under the “Cash Flow from Financing Activities” section of this 10-Q report is secured by a Mortgage, Deed of Trust, Assignment of Production, Security Agreement and Financing Statement on the Sunday and Bear leases in the Company’s East Slopes Project.  If the lender were to institute foreclosure proceedings upon our leases securing this loan, the Company would lose two of its primary leases.

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ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On July 25, 2012, the Company issued 24,000 shares of Common Stock to an accredited investor pursuant to the terms of a Daybreak private placement offering held in July 2006, during which the accredited investor received shares of Daybreak Series A Convertible Preferred Stock, the terms of which are disclosed in the Company’s Amended and Restated Articles of Incorporation.  Each share of Series A Convertible Preferred Stock can be converted by the shareholder at any time into three shares of the Company’s Common Stock.  Pursuant to the terms of the Series A Convertible Preferred Stock, the Common Stock was issued to the accredited investor upon the conversion of 8,000 shares of Series A Convertible Preferred Stock by the accredited investor, in reliance on an exemption from registration provided by Section 3(a)(9) of the Securities Act of 1933 relating to securities exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange.

As of August 31, 2012, 31 accredited investors have converted 501,200 Series A Convertible Preferred shares into 1,503,600 shares of Daybreak Common Stock.  At August 31, 2012, there were 898,565 Series A Convertible Preferred shares outstanding, held by accredited investors that had not been converted into the Company’s Common Stock.  The table below shows the conversions of Series A Convertible Preferred that have occurred since the Series A Convertible Preferred was first issued in July 2006.

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ITEM 6.  EXHIBITS

The following Exhibits are filed as part of the report:

Exhibit

Number

Description

31.1⁽¹⁾

Certification of principal executive and principal financial officer as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1⁽¹⁾

Certification of principal executive and principal financial officer as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS⁽²⁾   

XBRL Instance Document

101.SCH⁽²⁾  

XBRL Taxonomy Schema

101.CAL⁽²⁾  

XBRL Taxonomy Calculation Linkbase

101.DEF⁽²⁾   

XBRL Taxonomy Definition Linkbase

101.LAB⁽²⁾  

XBRL Taxonomy Label Linkbase

101.PRE⁽²⁾   

XBRL Taxonomy Presentation Linkbase

⁽¹⁾

Filed herewith

⁽²⁾

Furnished herewith

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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