Nine Energy Service, Inc. - Quarter Report: 2018 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2018

OR

FOR THE TRANSITION PERIOD FROM          TO            

Commission File Number: 001-38347

Nine Energy Service, Inc.

(Exact name of registrant as specified in its charter)

2001 Kirby Drive, Suite 200

Houston, TX 77019

(Address of principal executive offices) (zip code)

(281) 730-5100

(Registrant’s telephone number, including area code)

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.    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).    Yes  ☒    No  ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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  ☐  No  ☒

The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding at August 3, 2018, was 25,063,421.

TABLE OF CONTENTS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q (this “Quarterly Report”) contains forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control. All statements, other than statements of historical fact included in this Quarterly Report, regarding our strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this Quarterly Report, the words “could,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “may,” “continue,” “predict,” “potential,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words.

All forward-looking statements speak only as of the date of this Quarterly Report; we disclaim any obligation to update these statements unless required by law and we caution you not to place undue reliance on them. Although we believe that our plans, intentions and expectations reflected in or suggested by the forward-looking statements we make in this Quarterly Report are reasonable, we can give no assurance that these plans, intentions or expectations will be achieved.

We disclose important factors that could cause our actual results to differ materially from our expectations under Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017 (our “2017 Annual Report), Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Quarterly Report and Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2017 Annual Report. Important factors, some of which are beyond our control, that could cause actual results to differ materially from our historical results or those expressed or implied by these forward-looking statements include the following: the level of capital spending and well completions by the onshore oil and natural gas industry in North America; oil and natural gas commodity prices; general economic conditions; our ability to employ, or maintain the employment of, a sufficient number of key employees, technical personnel and other skilled and qualified workers; our ability to implement price increases or maintain existing prices on our services; conditions inherent in the oilfield services industry, such as equipment defects, liabilities arising from accidents or damage involving our fleet of trucks or other equipment, explosions and uncontrollable flows of gas or well fluids, and loss of well control; our ability to implement new technologies and services; seasonal and adverse weather conditions; and changes in laws or regulations regarding issues of health, safety and protection of the environment, including those relating to hydraulic fracturing, greenhouse gases and climate change.

These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

NINE ENERGY SERVICE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

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

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NINE ENERGY SERVICE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS)

(In thousands, except share data)

(Unaudited)

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

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NINE ENERGY SERVICE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands, except share data)

(Unaudited)

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

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NINE ENERGY SERVICE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of dollars)

(Unaudited)

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

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NINE ENERGY SERVICE, INC.

NOTES TO THE FINANCIAL STATEMENTS

(unaudited)

1. Description of business and organization

Nine Energy Service, Inc. (the “Company” or “Nine”), a Delaware corporation, is an oilfield services business that provides services integral to the completion of unconventional wells through a full range of tools and methodologies, and provides a range of production enhancement and well workover services.  The Company is headquartered in Houston, Texas.

On February 28, 2017, pursuant to the terms and conditions of a combination agreement dated February 3, 2017 (“Combination”) the Company merged with Beckman Production Services, Inc. (“Beckman”), and all of the issued and outstanding shares of Beckman common stock were converted into shares of common stock of Nine Energy Service, Inc.  Prior to the Combination, SCF-VII, L.P. had controlled a majority of the voting interests of Nine and Beckman since February 28, 2011 and July 31, 2012, respectively.  The merger of the entities into the combined Company was accounted for using reorganization accounting (i.e., “as if” pooling of interest) for entities under common control.

2. Summary of significant accounting policies

Basis of presentation

The accompanying condensed consolidated financial statements have not been audited by the Company’s independent registered public accounting firm, except that the Condensed Consolidated Balance Sheet at December 31, 2017 and the Condensed Consolidated Statements of Stockholders' Equity as of December 31, 2017, are derived from audited consolidated financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments necessary for the fair statement of the Company’s financial position, have been included. These condensed consolidated financial statements include all accounts of the Company.

These condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) for interim financial information. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for complete financial statements. Therefore, these condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2017, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017 filed with the SEC. The operating results for interim periods are not necessarily indicative of results that may be expected for any other interim period or for the full year.

Principles of consolidation

The condensed consolidated financial statements include the accounts of Nine and its wholly owned subsidiaries.  All inter-company balances and transactions have been eliminated in the consolidation.

Use of estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. These estimates are based on management’s best knowledge of current events and actions that the Company may undertake in the future. Such estimates include, but are not limited to, fair value assumptions used in purchase accounting and in analyzing goodwill, other intangibles and long-lived assets for possible impairment, useful lives used in depreciation and amortization expense, stock based compensation fair value, estimated realizable value on excess and obsolete inventories, deferred taxes and income tax contingencies and losses on accounts receivable. It is at least reasonably possible that the estimates used will change within the next year

Revenue recognition

The Company recognizes revenue for equipment, products and services based upon purchase orders, contracts or other persuasive evidence of an arrangement with the customer that include fixed or determinable prices and that do not include right of return or other similar provisions or other post-delivery obligations.  Revenue is recognized for products upon delivery, customer acceptance and when collectability is reasonably assured.  Revenue is recognized for services when they are rendered and collectability is reasonably assured.  

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Accounts receivable

The Company extends credit to customers in the normal course of business. Accounts receivable are carried at their estimated collectible amount. Trade credit is generally extended on a short-term basis; thus receivables do not bear interest, although a finance charge may be applied to amounts past due. The Company maintains an allowance for doubtful accounts for estimated losses that may result from the inability of its customers to make required payments. Such allowances are based upon several factors including, but not limited to, credit approval practices, industry and customer historical experience as well as the current and projected financial condition of the specific customer. Accounts receivable outstanding longer than contractual terms are considered past due. The Company writes off accounts receivable to the allowance for doubtful accounts when they become uncollectible. Any payments subsequently received on receivables previously written off are credited to bad debt expense.

Bad debt expense reflected net recoveries of $30,000 and $39,000 for the three months ended June 30, 2018 and 2017, respectively. Bad debt expense reflected net recoveries of $0.3 million and $10,000 for the six months ended June 30, 2018 and 2017, respectively. The allowance for doubtful accounts was $0.2 million and $0.6 million at June 30, 2018 and December 31, 2017, respectively.

Revenues for the three and six months ended June 30, 2018 included sales to one customer that individually represented 10% or more of total revenue. No customer accounted for 10% or more of total revenue for the three and six months ended June 30, 2017.

Inventories

Inventories, classified as finished goods, are stated at the lower of cost or net realizable value. Cost is determined on an average cost basis. The Company reviews its inventory balances and writes down its inventory for estimated obsolescence or excess inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. The reserves for obsolescence were $2.2 million and $2.9 million at June 30, 2018 and December 31, 2017, respectively.

Equity

In January 2018, there was an 8.0256 for 1 stock split immediately preceding the Company’s initial public offering (the “IPO”).  All shares and per share data reflect the effect of the stock split.

In January 2018, we completed our IPO of 8,050,000 shares of common stock (including 1,050,000 shares pursuant to an over-allotment option) at a price to the public of $23.00 per share. 

The aggregate gross proceeds of our IPO were $185.2 million.  After subtracting underwriting discounts and commissions of $12.5 million and offering expenses of approximately $4.4 million (paid in 2017 and 2018), we received net proceeds of approximately $168.3 million.  We used a portion of these net proceeds, together with $125.0 million of term loan borrowings under our credit facility, to fully repay the outstanding indebtedness under our former credit facilities.  Further, our credit agreement required that we use a portion of the proceeds from the over-allotment option to make a prepayment of the term loan borrowings of $9.7 million. The remainder of the net proceeds are being used for general corporate purposes. No payments, fees or expenses have been paid, directly or indirectly, to any of our officers, directors or their associates, holders of 10% or more of any class of our equity securities or other affiliates.

Stock-based compensation

The Company maintains the Nine Energy Service, Inc. 2011 Stock Incentive Plan, pursuant to which the Company provides stock-based compensation to certain of its employees. The Company measures employee stock-based compensation awards at fair value on the date they are granted to employees and recognizes compensation cost in its financial statements over the requisite service period. Compensation expense is recorded for restricted stock over the applicable vesting period based on the fair value of the stock on the date of grant. Options are issued with an exercise price equal to the fair value of the stock on the date of grant. Compensation expense is recorded for the fair value of the stock options, and is recognized over the period of the underlying security’s vesting schedule. Consideration paid on the exercise of stock options is credited to share capital and additional paid-in capital.

Fair value of the stock options is measured by use of the Black-Scholes pricing model. Restricted stock is valued at the closing market price the day prior to the grant date.  The following discusses the assumptions used related to the Black-Scholes pricing model.

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Expected life

The expected term of stock options represents the period the stock options are expected to remain outstanding and is based on the simplified method, which is the weighted average vesting term plus the original contractual term, divided by two.

Expected volatility

Expected volatility measures the amount that a stock price has fluctuated or is expected to fluctuate during a period. Prior to the IPO, the Company’s stock was not publicly traded and the Company determined volatility based on an analysis of the PHLX Oil Service Index that tracks publicly traded oilfield service stocks.  When there is sufficient trading history, the Company will use the historical volatility.  

Dividend yield

At the time of the issuance of the options, the Company did not expect to pay cash dividends in the foreseeable future. Therefore, a zero expected dividend yield was used in the valuation model.

Risk-free interest rate

The risk-free interest rate is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options.

Forfeitures

As a result of the adoption of ASU No. 2016-09, the Company elected to account for stock-based compensation forfeitures as they occur.

Fair value of common stock

Prior to the IPO, the value of the Company’s stock at the time of each option grant used to establish the strike price was estimated by management in accordance with an internal valuation model, and approved by the Company’s Board of Directors. The valuation model was based upon an average of cash flow and book value multiples of comparable companies. The comparable companies selected reflected the market’s view on key sector, geographic, and product type exposure that were similar to those that impacted the Company’s business. The value was further subject to judgmental factors such as prevailing market conditions, changes in the stock prices of other oilfield service companies and the overall outlook for the Company and its products in general.

Subsequent to the IPO, the stock value is the publicly traded share price at the time of grant.

Deferred financing costs

Deferred financing costs are amortized over the life of the related debt using the effective interest method. The Company expensed approximately $0.2 million and $0.4 million of deferred financing costs during the three months ended June 30, 2018 and 2017, respectively. The Company expensed approximately $1.0 million and $0.8 million of deferred financing costs during the six months ended June 30, 2018 and 2017, respectively, which amounts are included in interest expense in the Condensed Consolidated Statements of Income and Comprehensive Income (Loss). The expense included the write-offs of approximately $0.7 million and $0.1 million of deferred financing costs for the six months ended June 30, 2018 and 2017, respectively. The amount written off in the six months ended June 30, 2018 represents the deferred financing costs related to the debt that was outstanding at December 31, 2017 and paid fully in January 2018; the amount written off in the six months ended June 30, 2017 represents the portion of the deferred financing costs related to the reduction in the amount available in the revolving credit facilities. There were no write-offs of deferred financing costs in the three months ended June 30, 2018 and 2017.

Deferred financing costs of $1.4 million and $0.7 million at June 30, 2018 and December 31, 2017, respectively, are reported as a reduction of long-term debt (Note 5).

Recently issued accounting pronouncements

In May 2014, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update (‘‘ASU’’) No. 2014-09, Revenue from Contracts with Customers, which supersedes the current revenue recognition guidance. The ASU is based on the principle that revenue is recognized to depict the transfer of goods and services to customers in the amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing, and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and asset recognized from costs incurred to obtain or fulfill a contract. Although the

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new guidance was generally effective for fiscal years beginning after December 31, 2017, the Company plans to adopt for the fiscal years beginning after December 31, 2018, as an emerging growth company, using the modified retrospective approach. The Company is currently reviewing revenue contracts in preparation for adoption of the guidance as of January 1, 2019.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. Upon adoption of the new guidance, lessees are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. Although the new guidance will be generally effective for fiscal years beginning after December 15, 2018, the Company plans to adopt for fiscal years beginning after December 31, 2019, as an emerging growth company. The Company is currently evaluating the impacts of adoption of this guidance.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, in an effort to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments in this standard provide a screen to determine when an integrated set of assets and activities is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the integrated set of assets and activities is not a business. Although the new guidance is generally effective for fiscal years beginning after December 15, 2017, the Company plans to adopt for the fiscal years beginning after December 31, 2018, as an emerging growth company. Early adoption is allowed for transactions for which the acquisition date occurs before the issuance date or effective date of the amendments, only when the transaction has not been reported in financial statements that have been issued or made available for issuance and for transactions in which a subsidiary is deconsolidated or a group of assets is derecognized before the issuance date or effective date of the amendments. Entities will be required to apply the guidance prospectively when adopted. The Company is evaluating the impact this new pronouncement will have on the consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles—Goodwill and Other which simplifies the accounting for goodwill impairment by eliminating Step 2 of the current goodwill impairment test. In computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under the new standard, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of an operating unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the operating unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that operating unit. An entity still has the option to perform the qualitative assessment for an operating unit to determine if the quantitative impairment test is necessary. The new guidance should be adopted for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230)—Classification of Certain Cash Receipts and Cash Payment. This new guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice, including: debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, distributions received from equity method investees, beneficial interests in securitization transactions, and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. As an emerging growth company, the Company plans to adopt for fiscal years beginning after December 31, 2018. The Company is evaluating the financial statement implications of adopting ASU 2016-15.

3. Acquisitions and combinations

Beckman combination

On February 28, 2017, pursuant to the terms and conditions of a combination agreement dated February 3, 2017, the Company merged with Beckman and substantially all of the issued and outstanding shares of Beckman common stock were converted into shares of common stock of Nine Energy Service, Inc. at a ratio of 0.567154 Nine shares per Beckman share, other than 1.6% of Beckman shares paid in cash. Prior to the Combination, SCF-VII, L.P. had controlled a majority of the voting interests of Nine and Beckman since February 28, 2011 and July 31, 2012, respectively. The merger of the entities into the Company was accounted for using reorganization accounting (i.e., “as if” pooling of interest) for entities under common control (Note 1).

In conjunction with the Combination, other events occurred, including:

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4. Goodwill and intangible assets

The changes in the net carrying amount of the components of goodwill for the year ended December 31, 2017 and the six months ended June 30, 2018 are as follows:

At December 31, 2017, the Company performed its annual impairment test on each of its operating units and concluded that there was impairment at one operating unit in our Completion Solutions segment because its carrying value exceeded its estimated fair value, which resulted from declining profitability and deteriorating market conditions. The Company recognized a goodwill impairment loss of $31.5 million.  

The December 31, 2017 impairment test for the Production Solutions segment indicated that the estimated fair value calculation provided only 11% of cushion in relation to carrying value.  As a result, this segment’s goodwill, which totals $13.0 million, is susceptible to impairment risk from adverse economic conditions in the future.

During the six months ended June 30, 2018, there were no indications that impairment of goodwill had occurred. Goodwill by segment was unchanged from December 31, 2017.

The changes in the net carrying value of the components of intangible assets for the year ended December 31, 2017 and the six months ended June 30, 2018 are as follows:

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Amortization expense of $1.9 million and $3.8 million for the three and six months ended June 30, 2018, and $2.2 million and $4.4 million for the three and six months ended June 30, 2017, respectively, are related to cost of revenues, but reported separately as “Amortization of intangibles” in the Condensed Consolidated Statements of Income and Comprehensive Income (Loss).

5. Long-term debt

Long-term debt consists of the following:

As explained in Note 2, the Company completed its IPO in January 2018.  On September 15, 2017, in anticipation of the IPO, the Company completed negotiations of terms for a new Credit Facility (the “New Facility”) that became effective upon the consummation of the IPO.  All balances owed under the Legacy Nine and Legacy Beckman entities’ Credit Facilities (“the Legacy Facilities”) were paid in full immediately following funding of the IPO, and such Legacy Facilities are no longer in effect. The New Facility aggregates the Company’s collateral and security and recognizes the Company as a single combined entity. The New Facility consists of a Term Loan Facility of $125 million, amortizable at a quarterly rate of 2.5%, and a $50 million Revolving Credit Facility. The New Facility matures in July 2020. At June 30, 2018, the revolving credit facility had an undrawn borrowing capacity of $49.3 million, which is net of a $0.7 million outstanding letter of credit.

All of the obligations under the New Facility are secured by first priority perfected security interests (subject to permitted liens) in substantially all of the personal property of Nine and its domestic restricted subsidiaries, excluding certain assets. Nine Canada is not a borrower or guarantor under the Credit Agreement.

Loans to Nine and its domestic restricted subsidiaries under the New Facility may be base rate loans or LIBOR loans. The applicable margin for base rate and prime rate loans will vary from 1.50% to 2.75%, and the applicable margin for LIBOR loans will vary from 2.50% to 3.75%, in each case depending on Nine’s leverage ratio. Interest rates averaged 5.6% during the six months ended June 30, 2018. Nine is permitted to repay any amounts borrowed prior to the maturity date without any premium or penalty other than customary LIBOR breakage costs. In addition, a commitment fee of 0.50% per annum will be charged on the average daily unused portion of the revolving commitments. Such commitment fee is payable quarterly in arrears.

The New Facility’s credit agreement contains various affirmative and negative covenants, including financial reporting requirements and limitations on indebtedness, liens, mergers, consolidations, liquidations and dissolutions, sales of assets, dividends and other restricted payments, investments (including acquisitions) and transactions with affiliates. The credit agreement does not contain any financial covenants, other than a total leverage ratio, an asset coverage ratio and a fixed charge coverage ratio, each of which will be tested on a quarterly basis.

The Company was in compliance with all debt covenants under the New Facility as of June 30, 2018.

The fair value (level 2) of debt approximates book value, as its interest rates are variable and based on market rates.

6. Related Party Transactions

During 2014, in conjunction with an exercise of warrants to provide a capital infusion, the Company issued promissory notes totaling $2.5 million to both a former executive officer of the Company and a current manager of the Company.  The principal is due on June 30, 2019 (the “Maturity Date”).  Interest of 4% per annum is due and payable on the Maturity Date.  At each of June 30, 2018

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and December 31, 2017, the outstanding balance of the notes, including principal and unpaid interest, totaled $2.9 million.  Unpaid interest at each of June 30, 2018 and December 31, 2017 totaled $0.4 million.

As part of the acquisition of Crest in 2014, the Company issued promissory notes totaling $9.4 million to former owners of Crest, including Mr. Crombie, who is an executive officer of the Company.  The principal is due on June 30, 2019.  The interest rate is based on the prime rate, the federal funds rate or LIBOR, plus a margin to be determined in connection with the Company’s credit agreement, and is due quarterly. Mr. Crombie paid $1.8 million during 2016 to pay his promissory note in full.  At each of June 30, 2018 and December 31, 2017, the outstanding principal balance of the remaining promissory notes held by other former owners of Crest totaled $7.6 million.  Unpaid interest, included in “Prepaid expenses and other” in the Condensed Consolidated Balance Sheets, totaled $0.1 million and $8,000 at June 30, 2018 and December 31, 2017, respectively.

The Company leases office space, yard facilities and equipment, and purchases building maintenance services from entities owned by Mr. Crombie. Total lease expense and building maintenance expense was $0.4 million for each of the six months ended June 30, 2018 and 2017. There were payables to these entities of $13,000 at each of June 30, 2018 and December 31, 2017.  

The Company provides services to Citation Oil & Gas Corp., an entity owned by Curtis F. Harrell, a director of the Company. The Company billed $0.5 million and $0.3 million for services provided to this entity during the six months ended June 30, 2018 and 2017, respectively. There was an outstanding receivable due from such entity of $0.1 million and $0.2 million as of June 30, 2018 and December 31, 2017, respectively.

The Company provides services in the ordinary course of business to EOG Resources, Inc. Gary L. Thomas, a director of the Company, acts as the President of EOG Resources, Inc. The Company generated revenue from EOG Resources, Inc. of $19.7 million and $16.8 million for the six months ended June 30, 2018 and 2017, respectively.

7. Commitments and contingencies

Litigation

From time to time, we have various claims, lawsuits and administrative proceedings that are pending or threatened with respect to personal injury, workers’ compensation, contractual matters and other matters. Although no assurance can be given with respect to the outcome of these and the effect such outcomes may have, we believe any ultimate liability resulting from the outcome of such claims, lawsuits or administrative proceedings, to the extent not otherwise provided for or covered by insurance, will not have a material adverse effect on our business, operating results or financial condition.

We have been named in the following proceeding:

Christina Sparks, et al v. Pioneer Natural Resources, et al., Filed in the District Court, 142nd Judicial District, Midland County, Texas. On August 31, 2017, an accident occurred while a five-employee crew of Big Lake Services, LLC, a subsidiary of Nine (“Big Lake Services”), was performing workover services at an oil and gas wellsite near Midland, Texas, operated by Pioneer Natural Resources, resulting in the death of a Big Lake Services employee, Juan De La Rosa. On December 7, 2017, a lawsuit was filed on behalf of Mr. De La Rosa’s minor children in the Midland County District Court against Pioneer Natural Resources, Big Lake Services, and Phillip Hamilton related to this accident. The petition alleges, among other things, that the defendants acted negligently, resulting in the death of Mr. De La Rosa.  On March 14, 2018, a plea in intervention was filed on behalf of Mr. De La Rosa’s parents, alleging similar claims.  The plaintiffs and intervenors are seeking money damages, including punitive damages.

We maintain insurance coverage against liability for, among other things, personal injury (including death), which coverage is subject to certain exclusions and deductibles. We tendered this matter to our insurance company for defense and indemnification of Big Lake Services and the other defendants. While we maintain such insurance policies with insurers in amounts and with coverage and deductibles that we, with the advice of our insurance advisors and brokers, believe are reasonable and prudent, we cannot assure you that this insurance will be adequate to protect us from all material expenses related to current or potential future claims for personal and property damage or that these levels of insurance will be available in the future at economical prices.

Self-insurance

The Company uses a combination of third party insurance and self-insurance for health insurance clams. The self-insured liability represents an estimate of the undiscounted ultimate cost of uninsured claims incurred as of the balance sheet date. The estimate is based on an analysis of trailing months of incurred medical claims to project the amount of incurred but not reported claims liability. The estimated liability for self-insured medical claims was $1.3 million at each of June 30, 2018 and December 31, 2017, respectively, and is included under the caption “Accrued liabilities” on the Condensed Consolidated Balance Sheets.

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Although the Company does not expect the amounts ultimately paid to differ significantly from the estimates, the self-insurance liability could be affected if future claims experience differs significantly from historical trends and actuarial assumptions.

Scorpion contingent liability

In connection with the acquisition of Scorpion in 2015, the Company recorded a liability for contingent consideration to be paid in shares of Company common stock and in cash, contingent upon quantities of Scorpion Composite Plugs^TM sold during 2016 and gross margin related to the product sales for three years following the acquisition.

The contingent consideration related to the Scorpion acquisition is reported at fair value, based on discounted cash flows.  Significant inputs used in the fair value measurement include estimated gross margin related to forecasted sales of the plugs, term of the agreement, and a risk adjusted discount factor.  

The revaluation gains and losses are included in “General and administrative expenses” in the Condensed Consolidated Statements of Income and Comprehensive Income (Loss). The following is a reconciliation of the beginning and ending amounts of contingent consideration obligation (level 3) related to the Scorpion acquisition for the six months ended June 30, 2018 and the year ended December 31, 2017:

Contingent liabilities related to the Scorpion acquisition include $3.4 million and $1.7 million reported in “Accrued expenses” at June 30, 2018 and December 31, 2017, respectively.  The liabilities related to Scorpion are expected to be paid by December 31, 2018.

8. Stockholders’ equity

Common stock issued

In January 2018, the Company completed its IPO of 8,050,000 shares of common stock (including 1,050,000 shares pursuant to an over-allotment option) at a price to the public of $23.00 per share pursuant to our registration statement on Form S‑1 (File 333‑217601), as amended and declared effective by the SEC on January 18, 2018 (the “Registration Statement”). 

The aggregate gross proceeds of the Company’s IPO were $185.2 million. After subtracting underwriting discounts and commissions of $12.5 million and offering expenses of approximately $4.4 million (paid in 2017 and 2018), the Company received net proceeds of approximately $168.3 million.  The Company used a portion of these net proceeds, together with $125.0 million of term loan borrowings under the New Facility, to fully repay the outstanding indebtedness under its former credit facilities.  Further, the Company’s credit agreement required that it use a portion of the proceeds from the over-allotment option to make a prepayment of the term loan borrowings of $9.7 million. The remainder of the net proceeds are being used for general corporate purposes. No payments, fees or expenses have been paid, directly or indirectly, to any of the Company’s officers, directors or its associates, holders of 10% or more of any class of its equity securities or other affiliates.

Other issuances of common stock during the six months ended June 30, 2018 include 1.1 million shares related to unvested restricted stock.

9. Taxes

The Company’s effective income tax rate fluctuates based on, among other factors, changes in statutory tax rates, changes in pretax income and nondeductible items, and changes in valuation allowances.

The Company’s effective tax rate for the three and six months ended June 30, 2018 was 6.7% and 6.5%, compared with (0.3%) and (7.2%), for the three and six months ended June 30, 2017. The change in effective income tax rate for the three and six months ended June 30, 2018 was primarily attributable to changes in pre-tax book income and valuation allowance positions as well as tax liability in states where income is expected to exceed available net operating losses.   

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The Company recognized the income tax effects of Tax Reform in its audited financial statements included in the Company’s 2017 Annual Report on Form 10-K in accordance with Staff Accounting Bulletin No. 118, which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period during which Tax Reform was signed into law.  The guidance also provides for a measurement period of up to one year from the enactment date of Tax Reform for the Company to complete its accounting for the U.S. tax law changes.  As such, the Company’s 2017 financial results reflected the provisional estimate of the income tax effects of the Tax Reform.  No subsequent adjustments have been made to the amounts recorded as of December 31, 2017, which continue to represent a provisional estimate of the impact of Tax Reform.  The estimate of the impact of Tax Reform was based on certain assumptions and the Company’s current interpretation of Tax Reform. This estimate may change as the Company receives additional clarification and implementation guidance and as additional interpretations of Tax Reform become available.

10. Earnings per share

The following is a reconciliation from basic earnings (loss) per share to diluted earnings (loss) per share of the Company:

In thousands except for share and per share data.

For the three and six months ended June 30, 2017, the computation of diluted earnings (losses) per share excluded outstanding stock options and unvested restricted stock because their inclusion would be anti-dilutive as the Company was in a net loss position.  The average number of securities that were excluded from diluted earnings (losses) per share that would potentially dilute earnings per shares for the periods in which the Company experienced a net loss were as follows:

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11. Segment information

The Company has two reportable segments, Completion Solutions and Production Solutions.

The Completion Solutions segment consists primarily of cementing, completion tools, wireline and coiled tubing services, while the Production Solutions consists of rig-based well maintenance and workover services.

The Company’s reportable segments are strategic units that offer distinct products and services. They are managed separately since each business segment requires different marketing strategies. Operating segments have not been aggregated as part of a reportable segment. The Company evaluates the performance of its reportable segments based on adjusted gross profit. This segmentation is representative of the manner in which our Chief Operating Decision Maker and our Board of Directors view the business. We consider the Chief Operating Decision Maker to be the Chief Executive Officer.  

Summary financial data by segment follows. The amounts labeled “Corporate” relate to assets not allocated to the reportable segments.

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Revenues by country were as follows:

Long-lived assets by country were as follows:

12. Supplemental disclosures of cash flow information

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying unaudited consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report, together with the audited consolidated financial statements and notes thereto and Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our  2017 Annual Report.

This section contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in any forward-looking statement because of various factors, including those described in the section titled “Cautionary Note Regarding Forward-Looking Statements” in Part I, Financial Statements of this Quarterly Report and “Risk Factors” in Part I, Item 1A of the 2017 Annual Report.

Overview

We are a leading North American onshore completion and production services provider that targets unconventional oil and gas resource development. We partner with our E&P customers across all major onshore basins in both the U.S. and Canada to design and deploy downhole solutions and technology to prepare horizontal, multistage wells for production. We focus on providing our customers with cost-effective and comprehensive completion solutions designed to maximize their production levels and operating efficiencies. We believe our success is a product of our culture, which is driven by our intense focus on performance and wellsite execution as well as our commitment to forward-leaning technologies that aid us in the development of smarter, customized applications that drive efficiencies.

On February 28, 2017, we completed the Combination, pursuant to which all of the issued and outstanding shares of Beckman common stock were converted into shares of our common stock, other than 1.6% of Beckman shares paid in cash. Prior to the Combination, Beckman, a growth-oriented oilfield services company that provides a wide range of well service and coiled tubing services, was also an SCF Partners portfolio company. As a result, the Combination was accounted for using the reorganization accounting method for entities under common control. Under this method of accounting, the financial statements and the discussions herein include the operating results of Nine and Beckman. In this Quarterly Report, unless the context otherwise requires, the terms “Nine,” “we,” “us,” “our” and the “Company” refer to (i) Nine Energy Service, Inc. and its subsidiaries together with Beckman prior to the Combination and (ii) Nine Energy Service, Inc. and its subsidiaries after the Combination. For more information on the Combination, see Note 3—“Acquisitions and Combinations” in our audited financial statements.

We operate in two segments:

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How We Generate Revenue and the Costs of Conducting Our Business

We generate our revenues by providing completion and production services to E&P customers across all major onshore basins in both the U.S. and Canada. We primarily earn our revenues pursuant to work orders entered into with our customers on a job-by-job basis. We typically will enter into a Master Service Agreement (“MSA”) with each customer that provides a framework of general terms and conditions of our services that will govern any future transactions or jobs awarded to us. Each specific job is obtained through competitive bidding or as a result of negotiations with customers. The rate we charge is determined by location, complexity of the job, operating conditions, duration of the contract and market conditions. In addition to MSAs, we have entered into a select number of longer-term contracts with certain customers relating to our wireline and cementing services, and we may enter into similar contracts from time to time to the extent beneficial to the operation of our business. These longer-term contracts address pricing and other details concerning our services, but each job is performed on a standalone basis.

The principal expenses involved in conducting both our Completion Solutions and Production Solutions segments are labor costs, materials and freight, the costs of maintaining our equipment and fuel costs. Our direct labor costs vary with the amount of equipment deployed and the utilization of that equipment. Another key component of labor costs relates to the ongoing training of our field service employees, which improves safety rates and reduces employee attrition.

How We Evaluate Our Operations

We manage our operations through two business segments, Completion Solutions and Production Solutions, as described above. We evaluate the performance of these segments based on a number of financial and non-financial measures, including the following:

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Factors Affecting the Comparability of our Future Results of Operations to our Historical Results of Operations

Our future results of operations may not be comparable to our historical results of operations for the periods presented, primarily because the Company is now a publicly traded company.   We expect to incur direct, incremental G&A expenses as a result of being a publicly traded company, including, but not limited to, costs associated with hiring new personnel, annual and quarterly reports to stockholders, quarterly tax provision preparation, independent auditor fees, expenses relating to compliance with the rules and regulations of the SEC, listing standards of the NYSE and the Sarbanes-Oxley Act of 2002, investor relations activities, registrar and transfer agent fees, incremental director and officer liability insurance costs and independent director compensation. These direct, incremental G&A expenses are not included in our historical results of operations.

Industry Trends and Outlook

Our business depends to a significant extent on the level of unconventional resource development activity and corresponding capital spending of oil and natural gas companies onshore in North America. These activity and spending levels are strongly influenced by the current and expected oil and natural gas prices. Oil and natural gas prices declined significantly between the third quarter of 2014 and the first quarter of 2016. However, oil and natural gas prices have since gradually increased, a positive trend since the members of the Organization of Petroleum Exporting Countries and certain other oil-producing nations agreed to reduce their oil output in 2016. This price recovery has stimulated an increase in onshore North American completions activity, and if the current price environment holds or continues to improve, we expect a further increase in demand for our services. As the demand for our services and complexity of our jobs increase, we anticipate the ability to increase prices for our services, creating more favorable margins for the services we provide.

The increase in high-intensity, high-efficiency completions of oil and gas wells further enhances the demand for our services. We compete with a limited number of service companies for the most complex and technically demanding wells in which we specialize, which are characterized by extended laterals, increased stage spacing and cluster spacing and high proppant loads. These well characteristics lead to increased operating leverage and returns for us, as we are able to complete more jobs and stages with the same number of units and crews. Service providers for these projects are selected based on their technical expertise and ability to execute safely and efficiently, rather than only price.

Results of Operations

Results for the Three Months Ended June 30, 2018 Compared to the Three Months Ended June 30, 2017

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Revenue

Total revenue is comprised of revenue from Completion Solutions and Production Solutions. Revenue for the three months ended June 30, 2018 increased by $69.6 million, or 51%, to $205.5 million, from $135.9 million for the three months ended June 30, 2017. Both segments’ businesses depend, to a significant extent, on the level of unconventional resource development activity and corresponding capital spending of oil and natural gas companies onshore in North America, which in turn are strongly influenced by current and expected oil and natural gas prices, which showed improvement during 2017 and in the three months ended June 30, 2018.  During 2017, the closing price of oil reached a high of $60.46 per barrel and the closing price of natural gas reached a high of $3.71 per MMBtu. During the three months ended June 30, 2018, the closing price per barrel of oil reached $72.35, and the closing price of natural gas reached a high of $3.02 per MMBtu. The increase in revenue by reportable segment is discussed below.

Completion Solutions:  Completion Solutions segment revenue increased by $70.0 million, or 61%, to $185.1 million for the three months ended June 30, 2018 from $115.1 million for the three months ended June 30, 2017 due to a significant increase in completions activity and increased pricing in response to the improvement of industry conditions. The increase in demand and price for our services resulted from our customers increasing their North American capital expenditures and drilling and completing more new wells in the three months ended June 30, 2018 as compared to the three months ended June 30, 2017. Wireline revenue increased 97% from the three months ended June 30, 2018 to the three months ended June 30, 2017; total wireline stages completed increased 62% due to the increase in overall market activity. Completion tools revenue increased 64%, reflecting a 110% increase in stages; completion tools revenue per stage fell 22% due to transition from a higher volume of plugs sold versus sleeves, reflective of the market change. Cementing revenue increased by 34% due to a 10% increase in job count and improved pricing. Coiled Tubing Services revenue increased 54% on a 27% increase in total jobs.

Production Solutions:  Production Solutions segment revenue decreased by $0.4 million, or 2%, to $20.4 million for the three months ended June 30, 2018 from $20.7 million for the three months ended June 30, 2017. Rig activity, measured in hours worked, decreased 8%, but was offset by improved pricing, an increase in non-rig work and third-party costs charged to customers.

Cost of Revenues

Cost of revenues for the three months ended June 30, 2018 increased by $52.0 million, or 47%, compared to the three months ended June 30, 2017. The increase was a result of an increase in revenue-generating activity related to improvement in the oil and gas

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market. Materials installed in wells and consumed while performing services increased by $24.2 million. Compensation and benefits increased by $19.9 million and other costs, mostly related to improved levels of activity, increased by $7.9 million.

Completion Solutions:  Completion Solutions segment cost of services for the three months ended June 30, 2018 increased by $49.6 million, or 51%, when compared to the three months ended June 30, 2017. The increase was driven primarily by the increased level of activity. Costs related to materials installed in wells and consumed while performing services increased by $24.1 million, and other activity-driven costs increased by $7.4 million. Additionally, compensation and benefits were $18.0 million higher, as headcount was increased in response to the increase in revenue and forecasted activity increases.      

Production Solutions:  Production Solutions segment cost of services for the three months ended June 30, 2018 increased by $2.4 million, or 16%, when compared to the three months ended June 30, 2017. Compensation and benefits increased by $1.9 million, due in part to reinstatement of previous salary reductions. Other costs increased by $0.5 million, due to increased materials consumed while performing services and other increases related to activity.

Adjusted Gross Profit (Excluding Depreciation and Amortization)

Completion Solutions:  Adjusted gross profit (excluding depreciation and amortization) increased $20.4 million, to $39.1 million, for the three months ended June 30, 2018 compared to adjusted gross profit (excluding depreciation and amortization) of $18.7 million for the three months ended June 30, 2017 as a result of the factors described above under “Revenue” and “Cost of Revenues.”

Production Solutions:  Adjusted gross profit (excluding depreciation and amortization) decreased $2.7 million, to $2.8 million, for the three months ended June 30, 2018 compared to $5.5 million for the three months ended June 30, 2017 as a result of the factors described above under “Revenue” and “Cost of Revenues.”

General and Administrative Expenses

General and administrative expenses increased by $4.1 million, to $16.1 million, for the three months ended June 30, 2018 from $12.0 million for the three months ended June 30, 2017. The increase was higher primarily due to employee and other costs related to the level of business activity and expenses related to our IPO and being a public company. Additionally, there was a $0.5 million increase for revaluation of the contingent liability related to the purchase of Scorpion. General and administrative expenses as a percentage of revenue were 8% for the three months ended June 30, 2018, compared with 9% for the three months ended June 30, 2017.  

Depreciation

Depreciation expense for the three months ended June 30, 2018 decreased by $0.4 million, to $13.2 million, from $13.6 million for the three months ended June 30, 2017. The decrease resulted primarily from the disposal of equipment.

Amortization of Intangibles

Amortization of intangibles decreased by $0.3 million for the three months ended June 30, 2018 compared to the three months ended June 30, 2017. The decrease resulted from the write-off of intangibles in one of the Completions Solutions operating units during 2017.

Interest Expense

Interest expense was $1.8 million for the three months ended June 30, 2018, a decrease of $2.1 million from the three months ended June 30, 2017. The decline was a result of the reduction in debt following the IPO in January 2018 and funding of the New Facility.

Taxes

The Company’s effective income tax rate fluctuates based on, among other factors, changes in statutory tax rates, changes in pretax income and nondeductible items, and changes in valuation allowances.

The Company’s effective tax rate for the three months ended June 30, 2018 was 6.7%, compared with (0.3%) for the three months ended June 30, 2017. The change in effective income tax rate for the three months ended June 30, 2018 was primarily attributable to changes in pre-tax book income and valuation allowance positions as well as tax liability in states where income is expected to exceed available net operating losses. 

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Adjusted EBITDA

Adjusted EBITDA was $30.6 million for the three months ended June 30, 2018 as compared with $15.7 million for the three months ended June 30, 2017, an increase of 95%. The Adjusted EBITDA increase is primarily due to the changes in revenues and expenses discussed above.  See “Non-GAAP Financial Measures” below for further explanation.

Results for the Six Months Ended June 30, 2018 Compared to the Six Months Ended June 30, 2017