Koil Energy Solutions, Inc. - Quarter Report: 2009 March (Form 10-Q)

ITEM 1.  FINANCIAL STATEMENTS

 

 

DEEP DOWN, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

		For the Three Months Ended
		March 31,
		2009				2008
Revenues		$	7,102,589			$	6,279,465
Cost of sales			4,798,788				3,931,555
Gross profit			2,303,801				2,347,910
Operating expenses:
Selling, general & administrative			2,843,776				1,879,409
Depreciation and amortization			406,097				125,803
Total operating expenses			3,249,873				2,005,212
Operating income (loss)			(946,072	)			342,698
Other income (expense):
Interest income			2,228				39,164
Interest expense			(48,344	)			(769,030	)
Other (expense) income			(2,910	)			28,355
Total other expense			(49,026	)			(701,511	)
Loss before income taxes			(995,098	)			(358,813	)
Benefit from income taxes			265,323				269,366
Net loss		$	(729,775	)		$	(89,447	)
Loss per share:
Basic		$	-			$	-
Weighted-average common shares outstanding			176,150,630				87,185,242
Diluted		$	-			$	-
Weighted-average common shares outstanding			176,150,630				87,185,242

See accompanying notes to unaudited consolidated financial statements.

 

 

2

---

 

 

 

 

3

---

DEEP DOWN, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1: General

Nature of Business

 

Deep Down, Inc., a Nevada corporation (“Deep Down”), is the parent company to its wholly-owned subsidiaries: Deep Down, Inc., a Delaware corporation (“Deep Down Delaware”), ElectroWave USA, Inc., a Nevada corporation (“ElectroWave”), since its acquisition effective April 2, 2007, Mako Technologies, LLC, a Nevada limited liability company (“Mako”), since its acquisition effective December 1, 2007, Flotation Technologies, Inc., a Maine corporation (“Flotation”), since its acquisition effective May 1, 2008 and Deep Down International Holdings, LLC since its formation in February 2009.

 

Deep Down Delaware provides installation management, engineering services, support services and storage management services for the subsea controls, umbilicals and offshore pipeline industries. Deep Down Delaware also fabricates component parts for subsea distribution systems and assemblies.

ElectroWave offers products and services in the fields of electronic monitoring and control systems for the energy, military, marine and commercial business sectors.

Mako serves the growing offshore petroleum and marine industries with technical support services and products vital to offshore petroleum production, through rentals of its remotely operated vehicles (“ROV”), topside and subsea equipment and diving support systems used in diving operations, maintenance and repair operations, offshore construction, and environmental/marine surveys.

Flotation engineers, designs and manufactures deepwater buoyancy systems using high-strength FlotecTM syntactic foam and polyurethane elastomers.  Flotation’s  product offerings include distributed buoyancy for flexible pipes and umbilicals, drilling riser buoyance modules, CoreTecTM drilling riser buoyancy modules, ROVitsTM buoyancy, Hydro-Float mooring buoys, StablemoorTM low-drag ADCP deployment solution, Quick-Loc™ cable floats, HardballTM umbilical floats, Flotec™ cable and pipeline protection, InflexTM polymer bend restrictors, and installation buoyancy of any size and depth rating.

 

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles (“GAAP”) for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three-month period ended March 31, 2009 are not necessarily indicative of the results that may be expected for the year ended December 31, 2009.  The balance sheet at December 31, 2008 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.

For further information, refer to the audited consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008 filed on March 16, 2009.

Reclassifications

Prior period information presented in these financial statements includes reclassifications which were made to conform to the current period presentation.  These reclassifications had no effect on our previously reported net income (loss) or stockholders' equity. For example, Deep Down reclassified a portion of total depreciation expense, $172,346, into Cost of sales from Operating expenses for the three months ended March 31, 2008. The remainder of depreciation expense for the three month period is reported in the Operating expenses section of the Statements of Operations.

Principles of Consolidation

The unaudited consolidated financial statements include the accounts of Deep Down and its wholly-owned subsidiaries after the elimination of significant intercompany balances and transactions.

 

4

---

 

Accounts Receivable

Deep Down provides an allowance for doubtful accounts on trade receivables based on historical collection experience, the level of past due accounts and a specific review of each customer’s trade receivable balance with respect to their ability to make payments and expectations of future conditions that could impact the collectability of accounts receivable.  When specific accounts are determined to be uncollectable, they are expensed as bad debt expense in that period. At March 31, 2009 and December 31, 2008, Deep Down estimated its allowance for doubtful accounts to be $264,149 and $574,975, respectively. Bad debt expense totaled $60,000 and $3,949 for the three months ended March 31, 2009 and 2008, respectively.

Recently Issued Accounting Standards and Developments.

In June 2008, EITF 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” was issued. This standard triggers liability accounting on all options and warrants exercisable at strike prices denominated in any currency other than the Company’s functional currency or warrants with certain reset provisions to the strike price because of a “down-round” financing. This Issue is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. We adopted EITF 07-5 on January 1, 2009 and analyzed all of the outstanding warrants and none contained down-round reset exercise price provisions which would have precluded equity treatment.  Therefore, the adoption did not have a material impact on our financial position, results of operations or cash flows.

FASB Staff Position FSP No. 141(R)-1 Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies, (“FSP 141(R)-1”), issued in February 2009, amends the provisions in Statement 141(R) for the initial recognition and measurement, subsequent measurement and accounting, and disclosures for assets and liabilities arising from contingencies in business combinations. The FSP eliminates the distinction between contractual and non-contractual contingencies, including the initial recognition and measurement criteria in Statement 141(R) and instead carries forward most of the provisions in SFAS 141 for acquired contingencies. FSP 141(R)-1 is effective for contingent assets and contingent liabilities acquired in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Deep Down will integrate the provisions of this FSP as appropriate to future business combinations.

 

Note 2: Costs and Estimated Earnings in Excess of Billings on Uncompleted Contracts

The components of costs and estimated earnings in excess of billings on uncompleted contracts are summarized below:

 

		March 31, 2009				December 31, 2008
Costs incurred on uncompleted contracts		$	1,032,120			$	2,114,714
Estimated earnings			757,837				4,969,444
			1,789,957				7,084,158
Less: Billings to date			3,752,859				8,691,464
		$	(1,962,902	)		$	(1,607,306	)
Included in the accompanying consolidated balance sheets under the following captions:
Costs and estimated earnings in excess of billings on uncompleted contracts			165,454				707,737
Billings in excess of costs and estimated earnings on uncompleted contracts			(2,128,356	)			(2,315,043	)
		$	(1,962,902	)		$	(1,607,306	)

 

The asset balance of $165,454 at March 31, 2009 relates to several contracts that are projected to be completed during fiscal 2009. Deep Down has completed several of the included jobs subsequent to March 31, 2009, while other jobs are more long term in nature.

 

5

---

 

The asset balance of $707,737 at December 31, 2008 was related to a large contract that was completed during December 2008 except for the final documentation. This retention amount is in accordance with applicable provisions of engineering and construction contracts and became due upon completion of contractual requirements in January 2009. Deep Down had recognized approximately 90% of the related revenue based on the percentage-of-completion method as of December 31, 2008 and recognized the remainder in the first quarter of fiscal 2009.

The billings in excess of costs and estimated earnings on uncompleted contracts of $2,128,356 and $2,315,043 at March 31, 2009 and December 31, 2008, respectively, consisted mainly of a deposit on a large job that will be completed in fiscal year 2009.

Note 3: Acquisition

Purchase of Flotation Technologies, Inc.

On June 5, 2008, Deep Down completed the acquisition of Flotation, pursuant to the Stock Purchase Agreement entered into on April 17, 2008. Deep Down assumed effective control and dated the acquisition for accounting purposes on May 1, 2008. As such, the consolidated statement of operations includes the operating results of Flotation from May 1, 2008.

The acquisition of Flotation has been accounted for using the purchase method of accounting in accordance with Statement of Financial Accounting Standards (“SFAS”) 141, “Business Combinations” (“SFAS 141”) since Deep Down acquired substantially all of the assets, certain liabilities, employees, and business of Flotation.

The purchase price of Flotation was $23,941,554 and consisted of $22,100,000 cash and 1,714,286 shares of common stock valued at $0.83 per common share plus transaction costs of $296,904. In addition, warrants to purchase 200,000 shares of common stock at $0.70 per share were issued to an entity affiliated with the Selling Shareholders for the acquisition of the related technology. The warrants are exercisable at any time from June 3, 2009 through September 3, 2011 and include piggyback registration rights with respect to the underlying shares of common stock. Deep Down valued the warrants at $121,793 based on the Black-Scholes option pricing model. The purchase price may be adjusted upward or downward, dependant on certain working capital targets. Both parties are in preliminary negotiations concerning this adjustment and as of the current date, there has been no agreement as to the adjustment.

Deep Down sold 57,142,857 shares to accredited investors on June 5, 2008, for approximately $37,100,000 in net proceeds, at a price of $0.70 per share. Deep Down used $22,100,000 in proceeds from this Private Placement to fund the cash requirement of the Flotation acquisition.

Deep Down also issued 600,000 incentive common stock purchase options to employees of Flotation for their continued services with an exercise price of $1.15 per share. The employee options vest one-third of the original amount each year and may be exercised in whole or in part after vesting. Deep Down valued the options at $264,335 based on the Black-Scholes option pricing model, and will recognize the related compensation cost ratably over the requisite service period and not in the purchase price of the transaction.

The allocation of the purchase price was based on preliminary unaudited estimates.  Estimates and assumptions are subject to change upon the receipt of management’s review of audited final amounts and final tax returns. This final evaluation of net assets acquired will be offset by a corresponding change in goodwill and is expected to be complete within one year of the purchase date.

Unaudited pro-forma combined condensed financial statements

 

The unaudited pro-forma combined condensed financial statements are presented for informational purposes only and are not necessarily indicative of the results of operations that actually would have been achieved had each acquisition been consummated as of that time, nor are they intended to be a projection of future results.

 

6

---

 

The unaudited combined condensed pro-forma results were as follows:

The historical results of Deep Down for the three months ended March 31, 2009 contain the results for Flotation operations since its acquisition was effective May 1, 2008, thus the three months ending March 31, 2008 are presented as pro-forma. The weighted-average shares of stock used in computing basic and diluted per share amounts give effect to the 2,802,969 Mako shares issued on March 28, 2008 and the total of 58,857,143 common shares of Deep Down issued in June 2008, of which such amount 57,142,857 were issued in connection with the Private Placement and 1,714,286 were issued to Flotation’s prior shareholders, as if all these shares were issued January 1, 2008. Taxes are calculated on the pro-forma entries at Deep Down’s estimated combined effective rate of 37%.

 

The Unaudited Pro-Forma Combined Condensed Statements include the following pro-forma assumptions and entries for Flotation:

 

(a)	Recognition of stock-based compensation from employee stock options issued in connection with the acquisition of Flotation. Deep Down estimated $7,343 per month for the respective time periods.

 

(b)	Amortization of the intangible assets at a rate of $68,261 per month based on the remaining useful lives of the acquired assets.

 

(c)	Represents estimated income tax accruals for the historical income plus all pro-forma adjustments for the respective periods at Deep Down’s estimated combined effective rate of 37%. Flotation was an S-Corp, and as such did not accrue income taxes in its historical financial statements.

 

(d)

A total of 58,857,143 common shares of Deep Down were issued connected to Flotation and Private Placement; 57,142,857 in connection with the Private Placement, and 1,714,286 to former Flotation shareholders. These pro-forma amounts give effect as if shares were issued January 1, 2008. Additionally, 2,802,969 shares were issued to the Mako shareholders in connection with the final payment for that acquisition.

 

7

---

 

Note 4: Property and Equipment

Property and equipment consisted of the following:

 

		March 31, 2009				December 31, 2008				Useful Life
Land		$	461,955			$	461,955			-
Building			3,204,836				3,201,301			7 - 36 years
Leasehold improvements			428,691				344,485			2 - 5 years
Furniture and fixtures			372,697				160,443			2 - 7 years
Vehicles and trailers			127,107				120,847			3 - 5 years
Equipment			3,955,561				3,897,475			2 - 10 years
Rental Equipment			4,892,232				4,694,681			7 - 10 years
Computer and office equipment			536,981				473,518			2 - 5 years
Construction in progress			2,935,282				2,130,068
Total			16,915,342				15,484,773
Less: Accumulated depreciation			(2,109,119	)			(1,685,577	)
Property and equipment, net		$	14,806,223			$	13,799,196

 

Depreciation expense for the three months ended March 31, 2009 and 2008 was $424,125 and $213,090, respectively.  For the three months ended March 31, 2009 and 2008, Deep Down recorded $345,179 and $172,346, respectively, of the total depreciation as Cost of Sales on the accompanying statements of operations.

Note 5: Intangible Assets and Goodwill

Amounts allocated to intangible assets are amortized on a straight-line basis over their estimated useful lives. Deep Down is in the process of finalizing the valuations of certain intangible assets related to the Flotation acquisition; consequently, the initial allocations of the respective purchase price amounts are preliminary and subject to change for a period of one year following the acquisitions, although management believes amounts are materially accurate as of March 31, 2009. Estimated intangible asset values, net of recognized amortization expense include the following:

 

			March 31, 2009												December 31, 2008
	Estimated Useful Life		Gross Carrying Value				Accumulated Amortization				Net Carrying Amount				Gross Carrying Value				Accumulated Amortization				Net Carrying Amount
Customer relationship	8-25 Years		$	3,515,000			$	(498,735	)		$	3,016,265			$	3,515,000			$	(403,131	)		$	3,111,869
Non-Compete Covenant	3-5 Years			1,334,000				(389,916	)			944,084				1,334,000				(293,916	)			1,040,084
Trademarks	25-40 Years			3,110,000				(103,847	)			3,006,153				3,110,000				(80,393	)			3,029,607
Technology	25 Years			11,209,000				(411,973	)			10,797,027				11,209,000				(299,880	)			10,909,120
Total			$	19,168,000			$	(1,404,471	)		$	17,763,529			$	19,168,000			$	(1,077,320	)		$	18,090,680

 

8

---

Note 6: Long-Term Debt

The following table summarizes long-term debt:

 

		March 31, 2009				December 31, 2008
Bank term loan		$	1,062,476			$	1,150,000
Secured bank loan			1,829,638				-
Other bank loans			13,065				15,087
Total bank debt			2,905,179				1,165,087
6% Subordinated Debenture			500,000				500,000
Capital lease obligation			424,271				436,300
Total long-term debt			3,829,450				2,101,387
Current portion of long-term debt			(471,015	)			(382,912	)
Long-term debt, net of current portion		$	3,358,435			$	1,718,475

 

Revolving credit line and term loan

On November 11, 2008, Deep Down entered into a Credit Agreement (the “Revolver”) with Whitney National Bank (“Whitney Bank”) as lender. The Revolver provides a commitment to lend to Deep Down of the lesser of $2,000,000 and 80% of eligible receivables (generally defined as current due accounts receivables in which the lender has a first priority security interest).  All of the commitment under the Revolver is also available in commitments for the lender to issue letters of credit for the benefit of Deep Down. On December 18, 2008, Deep Down entered into an amendment to the Revolver, (the “Term Loan”) with Whitney Bank which provides for the incurrence by Deep Down of a term loan in the principal amount of $1,150,000 under, and subject to the terms and conditions of, Deep Down’s secured credit agreement. Such Term Loan does not impact the availability under the Revolver.

Each of Deep Down’s subsidiaries has guaranteed the obligations of Deep Down under the Revolver and as such, Deep Down’s obligations in connection with the Revolver are secured by a first priority lien generally on all of their non real property assets. Under the Revolver, Deep Down is required to meet certain covenants and restrictions.  The financial covenants are reportable each quarter, beginning with the quarter ending March 31, 2009.  Financial covenants include maintaining total debt to consolidated EBITDA below 2.5 to 1, consolidated EBITDA to consolidated net interest expense and principal payments on the total debt greater than 1.5 to 1, and tangible net worth in excess of $20,000,000 as each term is defined in the Credit Agreement. Other covenants include limitations on issuance of common stock, liens, transactions with affiliates, additional indebtedness and permitted investments, among others.  Deep Down was in compliance with the financial covenants at March 31, 2009.

Amendment to credit agreement and new loan agreement

On March 5, 2009, Deep Down’s wholly-owned subsidiary, Flotation, obtained loan proceeds in the principal amount of $1,840,000 pursuant to a loan agreement Flotation and Deep Down entered into with TD Bank, N.A. (“TD Bank”) as of February 13, 2009.  This loan agreement provides a further commitment to Flotation for advancement of principal in the amount of $320,000. Loans under the loan agreement are generally secured by Flotation’s operational premises in Biddeford, Maine under a mortgage and security agreement and a collateral assignment of leases and rents.  In connection with the loan agreement, TD Bank required that Deep Down enter into a debt subordination agreement that subordinated any debt Flotation owes to Deep Down other than accounts payable between them arising in the ordinary course of business.  Furthermore, as part of the loan agreement, TD Bank required a “negative pledge” that prohibits Flotation and Deep Down from granting security interests in Flotation’s personal property, other than such security interests granted in respect of Deep Down’s primary facility for borrowed money (as currently held with Whitney Bank). Deep Down is obligated to repay proceeds funded on March 5, 2009 based on a schedule of monthly installments of $13,007, with an initial payment on March 13, 2009 and a final payment of all remaining outstanding and unpaid principal and accrued interest in February 2016.  However, upon advancement of any portion of the $320,000 additional principal amount available under the loan agreement, TD Bank will recalculate the monthly installments to an amount that will fully amortize the then outstanding principal balance over a 20-year amortization schedule.

 

9

---

 

In connection with such loan for Flotation, Deep Down entered into a second amendment of its existing credit facility with Whitney Bank to permit such loan and the security and other arrangements relating to Flotation’s loan agreement.  The terms of the second amendment also included a guarantor’s consent and agreement, to be signed by each of Deep Down’s subsidiaries as guarantors of the obligations of Deep Down under such existing credit facility, that Whitney Bank required as a condition to the effectiveness of the second amendment. Additionally, Whitney Bank required that Deep Down International Holdings, LLC, a Nevada limited liability company and wholly-owned subsidiary of Deep Down formed in February 2009, enter into joinder agreements for the guaranty and security agreement arrangements generally required of Deep Down’s subsidiaries under the existing credit facility. Deep Down International Holdings, LLC currently has no material assets or operations.

Interest expense during the three months ended March 31, 2008

During the three months ended March 31, 2008, Deep Down amortized the discounts and deferred financing costs associated with the fair market value of warrants and the cash-based expenses related to third party fees and prepaid lender fees into interest expense over the life of a Credit Agreement using the effective interest rate method.  The discounts and deferred financing costs were associated with a secured credit agreement entered into in August 2007 and December 2007.  A total of $118,171 of debt discount and $56,915 of deferred financing costs were amortized into interest expense for the three months ended March 31, 2008.  Cash interest paid for the three months ended March 31, 2008 was $459,833 under the original stated terms of the note.

At March 31, 2008, upon the exchange of 500 shares of Series E Redeemable Exchangeable Preferred Stock (“Series E”) into a 6% subordinated debenture in the amount of $500,000, Deep Down recorded $113,589 in interest expense for the accretion of the Series E Preferred Stock up to face value.

Note 7: Stock-Based Compensation

Deep Down has a stock-based compensation plan - the 2003 Directors, Officers and Consultants Stock Option, Stock Warrant and Stock Award Plan (the “Plan”). Deep Down accounts for stock-based compensation expense under SFAS No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS No. 123(R)”). The exercise price of the options, as well as the vesting period, is established by Deep Down’s Board of Directors. The options granted under the Plan have vesting periods that range from immediate vesting to vesting over five years, and the contract terms of the options granted are up to ten years. Under the Plan, the total number of options permitted is 15% of issued and outstanding common shares. During the three months ended March 31, 2009, Deep Down granted 4,450,000 options and 2,350,000 shares of restricted stock. Based on the shares of common stock outstanding at March 31, 2009, there were approximately 10,990,000 options available for grant under the Plan as of that date.

Restricted Stock

On March 23, 2009, Deep Down granted 2,350,000 restricted shares to executives and employees which vest on March 23, 2011, provided such respective recipient remains employed with Deep Down on such date. The shares were valued at a price of $0.124 based on the closing price of common stock on the preceding business day, March 20, 2009. The shares vest on the second anniversary of the grant date, and Deep Down is amortizing the related stock-based compensation of $291,400 over the two-year requisite service period. For the three months ended March 31, 2009 and 2008, Deep Down recognized a total of $66,525 and $31,500, respectively, in stock-based compensation related to all outstanding shares of restricted stock; the unamortized portion of the estimated fair value of restricted stock is $508,375 at March 31, 2009.

The following table summarizes Deep Down’s restricted stock activity for the three months ended March 31, 2009:

 

		Restricted Shares				Weighted-Average Grant Price				Aggregate Intrinsic Value
Outstanding at December 31, 2008			1,200,000			$	0.42
Grants			2,350,000			$	0.12
Outstanding at March 31, 2009			3,550,000			$	0.22			$	-

10

---

Stock Option Activity During 2009

During the three months ended March 31, 2009, Deep Down granted an aggregate of 4,450,000 stock options to various employees with exercise prices of $0.124, reflecting the common stock closing price on the business date before the grant. The fair value of such options was approximately $395,160 based on the Black-Scholes option pricing model, using the following input values:

 

Dividend yield	0%
Risk free interest rate	1.69%
Expected life of options	3 years
Expected volatility	88.50%

Summary of Stock Options

Deep Down is expensing all stock options on a straight-line basis over the requisite expected service periods. The total stock-based compensation expense for stock options for the three months ended March 31, 2009 and 2008 was $79,140 and $73,662, respectively.  Additionally, during the three months ended March 31, 2009, Deep Down revised the estimated rate of forfeitures to 30% from 0% based on the history of stock option cancellations and management’s estimates of expected future forfeiture rates. This change in estimate resulted in a cumulative reduction of $116,246 during the three months ending March 31, 2009. The unamortized portion of the estimated fair value of outstanding stock options was $1,151,177 at March 31, 2009.

The following table summarizes Deep Down’s stock option activity for the three months ended March 31, 2009:

 

		Shares Underlying Options				Weighted- Average Exercise Price				Weighted- Average Remaining Contractual Term (in years)				Aggregate Intrinsic Value (In-The-Money)
Outstanding at December 31, 2008			8,066,667			$	0.96				2.3			$	-
Grants			4,450,000				0.12
Exercises			-				-
Cancellations & Forfeitures			(116,667	)			0.50
Outstanding at March 31, 2009			12,400,000			$	0.66				2.7			$	160,200
Exerciseable at March 31, 2009			2,666,666			$	0.93				2.4			$	-

The following summarizes Deep Down’s outstanding options and their respective exercise prices at March 31, 2009:

 

Exercise Price		Shares Underlying Options
$   0.10 - 0.49		4,550,000
$   0.50 - 0.69		3,600,000
$   0.70 - 0.99		450,000
$   1.00 - 1.29		800,000
$   1.30 - 1.50		3,000,000
		12,400,000

11

---

Note 8: Warrants

A summary of warrant transactions follows. The aggregate intrinsic value is based on the closing price of $0.16 on March 31, 2009.

 

		Shares Underlying Warrants				Weighted- Average Exercise Price				Weighted- Average Remaining Contractual Term (in years)				Aggregate Intrinsic Value (In-The-Money)
Outstanding at December 31, 2008			638,812			$	0.78
Outstanding at March 31, 2009			638,812			$	0.78				3.8			$	-
Exerciseable at March 31, 2009			438,812			$	0.82				3.8			$	-

The following summarizes Deep Down’s outstanding warrants and their respective exercise prices at March 31, 2009:

 

Exercise Price		Shares Underlying Warrants
$   0.70 - 0.99		520,000
$              1.01		118,812
		638,812

Note 9: Commitments and Contingencies

Litigation

Deep Down is from time to time involved in legal proceedings arising from the normal course of business. As of the date of this report, Deep Down is not currently involved in any material legal proceedings except as noted below.

At March 31, 2009, Deep Down was in the arbitration process with the former stockholders of Flotation Technologies, Inc. regarding the proper calculation of the “Cash Price Adjustment” pursuant to the Stock Purchase Agreement by and between Deep Down, Flotation Technologies, Inc. and its former stockholders dated April 17, 2008. Any purchase price adjustment will be allocated to the goodwill balance once the preliminary estimates are finalized.  No changes to this potential contingency existed at May 11, 2009.

 

In connection with the Private Placement in June 2008, Deep Down filed an initial Registration Statement on Form S-1 on July 21, 2008 to register the 57,142,857 shares issued in the offering. Pursuant to the Registration Rights Agreement, Deep Down was obligated to have the Registration Statement declared effective by September 3, 2008, the “Required Effective Date”, or the Company would be required to pay liquidated damages to the Selling Shareholders in the Private Placement for each day following the Required Effective Date, until but excluding the date the Commission declares the Registration Statement effective. Deep Down evaluated this obligation under the Registration Rights Agreement for liability treatment under FASB Statement No. 5, “Accounting for Contingencies” (“SFAS 5”) and Financial Statement Staff Position (FSP) EITF 00-19(2) “Accounting for Registration Payment Arrangements” and determined that the registration rights met the definition of a liability under the authoritative guidance, and at December 31, 2008  reserved $1,212,120 in potential damages under terms of the Private Placement for the 90-day period from September 4 to December 3, 2008. Deep Down obtained an opinion from legal counsel allowing removal of the related stock’s restrictive legend under Rule 144, which was deemed to be equivalent, and thus satisfied the registration rights requirements.

 

12

---

 

The SEC declared the Registration Statement on Form S-1 effective on April 16, 2009.  Pursuant to section 7.1 (c) of the Registration Rights Agreement and based on opinion of counsel, as of March 31, 2009 Deep Down’s management has adjusted the liquidated damages reserve to 47 days, or $626,040. Deep Down recorded the reduction during the three months ended March 31, 2009 and initiated payment to the Selling Shareholders subsequent to that date.

Operating Leases

Deep Down leases certain offices, facilities, equipment and vehicles under non-cancelable operating and capital leases expiring at various dates through 2016.

Letters of Credit

Certain customers require Deep Down to post a bank letter of credit (“LC”) guarantee. These LCs assure Deep Down’s creditors that they will perform under terms of the contract and with associated vendors and subcontractors. In the event of default, the creditor may demand payment from the bank under an LC. There was no significant expense related to LCs for the three months ended March 31, 2009. Deep Down was contingently liable for secured and unsecured LCs of $135,855 as of March 31, 2009, which is offset by restricted cash in the same amount.

In December 2008, Deep Down amended the credit agreement with Whitney Bank as more fully described in Note 6. The amended credit agreement provides for LCs. Deep Down executed an irrevocable transferrable standby LC with a customer for $1,107,456 in the normal course of business during the three months ended March 31, 2009. This standby LC reduces the borrowing capacity under the Whitney Bank Revolver.

Note 10:  Related Party Transactions

 

Deep Down leases all buildings, structures, fixtures and other improvements at the Channelview, Texas location from JUMA, LLC, a limited-liability company (“JUMA”) owned by Ronald E. Smith, President and CEO and a director of Deep Down and Mary L. Budrunas, a Vice President and Corporate Secretary of Deep Down. The base rate of $15,000 per month is payable to JUMA through September 1, 2011, together with all costs of maintaining, servicing, repairing and operating the premises, including insurance, utilities and property taxes.

During the three months ended March 31, 2009, Deep Down executed a memorandum of understanding to purchase these assets from JUMA for approximately $2,600,000 which is expected to include an assumption of bank debt in the approximate amount of $1,800,000. Deep Down received a third party appraisal of the property in the amount of $3,100,000. Deep Down made earnest-money deposit payments during the three months ended March 31, 2009 totaling $470,000 to Ronald E. Smith, which are included in Other Assets on the accompanying balance sheets as of March 31, 2009.

13

---