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Superior Drilling Products, Inc. - Quarter Report: 2017 June (Form 10-Q)

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the Quarterly Period Ended June 30, 2017

 

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

 

Commission File Number: 001-36453

 

Superior Drilling Products, Inc.

(Exact name of registrant as specified in its charter)

 

Utah   46-4341605

(State or other jurisdiction

of incorporation or organization)

 

(IRS Employer

Identification No )

 

1583 South 1700 East

Vernal, Utah 84078

(Address of principal executive offices)

 

435-789-0594

(Issuer’s telephone number)

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, during the preceding 12 months (or such shorter period that the Registrant was required to file such report(s)), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] 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 [X] No [  ]

 

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

 

Large accelerated filer [  ] Accelerated filer [  ] Non-accelerated filer [  ] Smaller reporting company [X] Emerging growth company [X]

 

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 [X]

 

There were 24,197,148 shares of common stock, $0.001 par value, issued and outstanding as of August 11, 2017.

 

 

 

 
  

 

Superior Drilling Products, Inc.

FORM 10-Q

 

QUARTER ENDED JUNE 30, 2017

 

TABLE OF CONTENTS

 

  Page
   
PART I - FINANCIAL INFORMATION  
   
Item 1. Financial Statements  
   
Condensed Consolidated Balance Sheet (Unaudited) at June 30, 2017 and December 31, 2016 3
   
Condensed Consolidated Statements of Operations (Unaudited) for the three and six months ended June 30, 2017 and 2016 4
   
Condensed Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2017 and 2016 5
   
Notes to Condensed Consolidated Financial Statements (Unaudited) 6
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 11
   
Item 4. Controls and Procedures 18
   
PART II - OTHER INFORMATION  
   
Item 1. Legal Proceedings 19
   
Item 1A. Risk Factors 19
   
Item 6. Exhibits 22
   
Signatures 23

 

2
  

 

PART I - FINANCIAL INFORMATION.

 

Item 1. Financial Statements

 

Superior Drilling Products, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

 

   June 30, 2017   December 31, 2016 
ASSETS          
Current assets          
Cash  $1,300,891   $2,241,902 
Accounts receivable, net   2,875,130    1,038,664 
Prepaid expenses   77,589    76,175 
Inventories   1,285,738    1,167,692 
Asset held for sale   -    2,490,000 
Other current assets   

163,733

    13,598 
Total current assets   5,703,081    7,028,031 
Property, plant and equipment, net   8,630,237    9,068,359 
Intangible assets, net   7,356,111    8,579,444 
Related party note receivable   7,746,717    8,296,717 
Other noncurrent assets   15,954    15,954 
Total assets  $29,452,100   $32,988,505 
LIABILITIES AND SHAREHOLDERS’ EQUITY          
Current liabilities          
Accounts payable  $746,606   $1,066,514 
Accrued expenses   693,087    449,004 
Capital lease obligation   63,582    217,302 
Related party debt obligation   197,922    272,215 
Current portion of long-term debt, net of discounts   1,926,971    2,905,682 
Total current liabilities   3,628,168    4,910,717 
Other long term liability   -    820,657 
Long-term debt, less current portion, net of discounts   11,583,939    13,288,701 
Total liabilities   15,212,107    19,020,075 
Commitments and contingencies (Note 7)          
Shareholders’ equity          
Common stock - $0.001 par value; 100,000,000 shares authorized; 24,197,148 and 24,120,695 shares issued and outstanding, respectively   24,197    24,120 
Additional paid-in-capital   38,646,092    38,295,428 
Accumulated deficit   (24,430,296)   (24,351,118)
Total shareholders’ equity   14,239,993    13,968,430 
Total liabilities and shareholders’ equity  $29,452,100   $32,988,505 

 

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

 

3
  

 

Superior Drilling Products, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

 

 

    For the Three Months     For the Six Months  
    Ended June 30,     Ended June 30,  
    2017     2016     2017     2016  
                         
Revenue   $ 4,049,497     $ 1,114,469     $ 7,419,109     $ 2,559,095  
                                 
Operating costs and expenses                                
Cost of revenue     1,491,383       1,331,985       2,672,116       2,352,597  
Selling, general and administrative expenses     1,237,335       1,538,824       2,734,852       2,829,427  
Depreciation and amortization expense     899,373       1,200,085       1,837,395       2,446,967  
                                 
Total operating costs and expenses     3,628,091       4,070,894       7,244,363       7,628,991  
                                 
Operating income (loss)     421,406       (2,956,425 )     174,746       (5,069,896 )
                                 
Other income (expense)                                
Interest income     82,509       77,952       164,368       156,319  
Interest expense     (215,103 )     (377,063 )     (474,128 )     (728,075 )
Other income     -       52,225       43,669       108,951  
Gain on sale of assets     17,995       104,599       12,167       191,450  
Total other expense     (114,599 )     (142,287 )     (253,924 )     (271,355 )
                                 
Net income (loss)     306,807     $ (3,098,712 )   $ (79,178 )   $ (5,341,251 )
                                 
Basic income (loss) earnings per common share   $ 0.01     $ (0.18 )   $ 0.00     $ (0.31 )
Basic weighted average common shares outstanding     24,197,148       17,464,443       24,196,726       17,462,024  
Diluted income (loss) per common share   $ 0.01     $ (0.18 )   $ 0.00     $ (0.31 )
Diluted weighted average common shares outstanding     24,197,148       17,464,443       24,196,726       17,462,024  

 

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

 

4
  

 

Superior Drilling Products, Inc.

Condensed Consolidated Statements Of Cash Flows

(Unaudited)

 

   For the Six Months Ended 
   June 30, 
   2017   2016 
Cash Flows From Operating Activities          
Net loss  $(79,178)  $(5,341,251)
Adjustments to reconcile net loss to net cash used in operating activities:          
Depreciation and amortization expense   1,837,395    2,446,967 
Amortization of debt discount   40,110    69,768 
Share based compensation expense   350,741    376,785 
Write-off of Strider asset   -    361,903 
Gain on sale of assets   (12,167)   (191,450)
Changes in operating assets and liabilities:          
Accounts receivable   (1,836,466)   1,387,203 
Inventories   (118,046)   (17,514)
Prepaid expenses and other noncurrent assets   (151,549)   (86,281)
Other assets   -    (12,537)
Accounts payable and accrued expenses   (328,992)   134,691 
Other long term liabilities   (17,490)   - 
Net Cash Used in Operating Activities   (315,642)   (871,716)
Cash Flows From Investing Activities          
Purchases of property, plant and equipment   (141,137)   (315,101)
Proceeds from sale of fixed assets   2,483,921    294,242 
Net Cash Provided by (Used in) Investing Activities   2,342,784    (20,859)
Cash Flows From Financing Activities          
Principal payments on debt   (2,740,140)   (1,031,491)
Principal payments on related party debt   (74,293)   (44,662)
Principal payments on capital lease obligations   (153,720)   (133,403)
Proceeds received from debt borrowings   -    1,000,000 
Proceeds from sale of subsidiary   -    50,700 
Proceeds from payments on related party note receivable   -    22,534 
Debt issuance costs   -    (56,188)
Net Cash Used in Financing Activities   (2,968,153)   (192,510)
Net decrease in Cash   (941,011)   (1,085,085)
Cash at Beginning of Period   2,241,902    1,297,002 
Cash at End of Period  $1,300,891   $211,917 
Supplemental information:          
Cash paid for Interest  $460,842   $689,409 
Non-cash payment of other long term liability by offsetting related party note receivable  $550,000   $- 
Acquisition of equipment by issuance of note payable  $16,557   $- 

 

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

 

5
  

 

Superior Drilling Products, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2017

 

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization and Nature of Operations

 

Superior Drilling Products, Inc. (the “Company”, “SDPI”, “we”, “our” or “us”) is a drilling and completion tool technology company providing solutions for the oil and natural gas drilling industry. The Company, designs, engineers, manufactures, sells, and repairs drilling and completion tools.

 

Our subsidiaries include (a) Superior Drilling Solutions, LLC (previously known as Superior Drilling Products, LLC), a Utah limited liability company (“SDS”), together with its wholly owned subsidiary Superior Design and Fabrication, LLC, a Utah limited liability company (“SDF”), (b) Extreme Technologies, LLC, a Utah limited liability company (“ET”), (c) Meier Properties Series, LLC, a Utah limited liability company (“MPS”), (d) Meier Leasing, LLC, a Utah limited liability company (“ML”), and (e) HR.

 

Basis of Presentation

 

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated financial statements include the accounts of Superior Drilling Products Inc. and all of its wholly-owned subsidiaries. All significant intercompany accounts have been eliminated in consolidation. The Company does not have investments in any unconsolidated subsidiaries.

 

In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an emerging growth company can utilize the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for implementing new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to nonissuers. We have elected to delay such adoption of new or revised accounting standards, and as a result, we may not implement new or revised accounting standards on the relevant dates on which adoption of such standards is required for other issuer companies.

 

Subject to certain conditions set forth in the JOBS Act, as an emerging growth company, we intend to rely on certain of these exemptions, including without limitation, providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404 and implementing any requirement that may be adopted regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis). These exemptions will apply for a period of five years following the completion of our IPO although if the market value of our common stock that is held by nonaffiliates exceeds $700 million as of any June 30 before that time, we would cease to be an emerging growth company as of the following December 31.

 

Revenue Recognition

 

We are a drilling and completion tool technology company and we generate revenue from the refurbishment, manufacturing, repair, and sale of drilling and completion tools. Our manufactured products are produced in a standard manufacturing operation, even when produced to our customer’s specifications. We earn royalty commission revenue when our customer invoices their customer for the use of our tools. The Company may act as an agent by billing and collecting its customers’ tool rental revenue. When we are an agent for our customer, revenue is presented in the statement of operations on a net basis. At June 30, 2017, there was approximately $300,000 of accounts receivable and approximately $326,000 of accounts payable related to transactions we performed as an agent for our customer.

 

Unaudited Interim Financial Presentation

 

These interim consolidated condensed financial statements for the three and six months ended June 30, 2017 and 2016, and the related footnote disclosures included herein, are unaudited. However, in the opinion of management, these unaudited interim financial statements have been prepared on the same basis as the audited financial statements, and reflect all adjustments necessary to fairly state the results for such periods. The results of operations for the three and six months ended June 30, 2017 are not necessarily indicative of the results of operations expected for the year ended December 31, 2017. These interim consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the years ended December 31, 2016 and 2015 and the notes thereto, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, filed with the Securities and Exchange Commission (the “SEC”).

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results could differ from those estimates. Significant items subject to estimates and assumptions include the carrying amount and useful lives of property and equipment and intangible assets, impairment assessments, share-based compensation expense, and valuation allowances for accounts receivable, inventories, and deferred tax assets.

 

6
  

 

Accounting Standards

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (“ASU 2015-14”), which deferred the effective date of ASU 2014-09 for all entities by one year. The Company will adopt this guidance on January 1, 2019. ASU 2015-14 permits the use of either the retrospective or cumulative effect transition method. We have not yet selected a transition method nor has the effect of the standard on ongoing financial reporting been determined.

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases,” which introduces the recognition of lease assets and lease liabilities by lessees for all leases which are not short-term in nature. The new standard requires a modified retrospective transition for capital or operating leases existing at or entered into after the beginning of the earliest comparative period presented in the financial statements. The Company will adopt this guidance on January 1, 2019. The Company is currently evaluating the impact the pronouncement will have on the consolidated financial statements and related disclosure.

 

NOTE 2. INVENTORIES

 

Inventories is comprised of the following:

 

  

June 30,

2017 

  

December 31,

2016

 
Raw material  $1,043,037   $952,419 
Work in progress   134,363    90,017 
Finished goods   108,338    125,256 
   $1,285,738    $ 1,167,692 

 

NOTE 3. PROPERTY, PLANT AND EQUIPMENT

 

Property, plant and equipment are comprised of the following:

 

  

June 30,

2017 

  

December 31,

2016

 
Land  $880,416   $880,416 
Buildings   4,847,778    4,847,778 
Leasehold improvements   717,232    717,232 
Machinery and equipment   5,172,202    5,060,281 
Machinery under capital lease   2,322,340    2,322,340 
Furniture and fixtures   507,554    507,554 
Transportation assets   811,381    882,163 
    15,258,903    15,217,764 
Accumulated depreciation   (6,628,666)   (6,149,405)
   $8,630,237   $9,068,359 

 

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Depreciation expense related to property, plant and equipment for the three and six months ended June 30, 2017 was $287,706 and $614,062, respectively, and for the three and six months ended June 30, 2016 was $588,418 and $1,223,634, respectively.

 

NOTE 4. INTANGIBLE ASSETS

 

Intangible assets are comprised of the following:

 

  

June 30,

2017 

  

December 31,

2016

 
Developed technology  $7,000,000   $7,000,000 
Customer contracts   6,400,000    6,400,000 
Trademarks   1,500,000    1,500,000 
    14,900,000    14,900,000 
Accumulated amortization   (7,543,889)   (6,320,556)
   $7,356,111   $8,579,444 

 

Amortization expense related to intangible assets for the three and six months ended June 30, 2017 and June 30, 2016 was $611,667 and $1,223,333, respectively.

 

Annually, and more often as necessary, we will perform an evaluation of our intangible assets for indications of impairment. If indications exist, we will perform an evaluation of the fair value of the intangible assets and, if necessary, record an impairment charge. As of June 30, 2017, the Company reviewed the net balance of the intangible assets and determined no impairment was needed.

 

NOTE 5. RELATED PARTY NOTE RECEIVABLE

 

In January 2014, we entered into a Note Purchase and Sale Agreement under which we agreed to purchase a loan made to Tronco Energy Corporation (“Tronco”), a party related to us through common control, in order to take over the legal position as Tronco’s senior secured lender. That agreement provided that, upon our full repayment of the Tronco loan from the proceeds of the Offering, the lender would assign to us all of its rights under the Tronco loan, including all of the collateral documents. On May 30, 2014, we closed our purchase of the Tronco loan for a total payoff of $8.3 million, including principal, interest, and early termination fees. As a result of that purchase, we became Tronco’s senior secured lender, and as a result are entitled to receive all proceeds from sales of the Tronco-owned collateral, as discussed below.

 

8
  

 

In 2015, the Board of Directors agreed to extend the terms of the Tronco loan to interest only payments due on December 31, 2015 and 2016, with a balloon payment of all unpaid interest and principal due in full maturity on December 31, 2017. The related party note receivable is classified as long term in accordance with management’s estimate of realizability. The interest rate on the note is 4.25%. We earned interest of $81,650 and $163,733 for the three and six months ended June 30, 2017, respectively, and interest of $77,567 and $155,137 for the three and six months ended June 30, 2016, respectively.

 

On March 28, 2017, the Company and Tronco finalized an agreement with a third party and pursuant to this agreement, the third party acquired all of the Ohio assets of Tronco for $550,000. As Tronco’s senior secured lender, we agreed to release our lien and security interest on these assets in accordance with the agreement. The Company agreed to a non-cash receipt of the $550,000 from Tronco by reducing our bonus accrual liabilities, which was earned by the Meiers in 2014 but not paid, and was recorded in other long-term liability. As a result of this agreement, we reduced both the other long-term liability and the Tronco related party note receivable during the first quarter of 2017.

 

On August 8, 2017, the Board of Directors agreed to extend the terms of the Tronco loan to interest only payments due December 31, 2017, 2018, 2019, 2020, and 2021, with a balloon payment of all unpaid interest and principal due upon full maturity on December 31, 2022.

 

We have the direct legal right to enforce the collateral and guaranty agreements entered into in connection with the Tronco loan and to collect Tronco’ s collateral sales proceeds, in order to recover the loan purchase amount. The Tronco loan continues to be secured by the first position liens on all of Tronco assets, as well as by the guarantees of Troy and Annette Meier (the “Meier Guaranties”), which are directly payable to and legally enforceable by us. In addition, the Meiers have provided us with stock pledges in which they pledge all of their shares of our common stock held by their family entities (the “Meier Stock Pledge”), as collateral for the Meiers guaranties until full repayment of Tronco loan. The pledged shares, which are subject to insider timing requirements and volume limitations under Rule 144 of the Securities Act and required periodic black-out periods, are being held in third-party escrow until full repayment of the Tronco loan. The Company holds 8,267,860 shares and 530,725 restricted stock units as collateral for the Tronco note as of June 30, 2017.

 

NOTE 6. LONG-TERM DEBT

 

Long-term debt is comprised of the following:

 

  

June 30,

2017

  

December 31,

2016

 
Real estate loans  $4,642,880   $7,264,036 
Hard Rock Note, net of discount   7,884,705    7,846,497 
Machinery loans   600,721    684,921 
Transportation loans   382,604    398,929 
    13,510,910    16,194,383 
Current portion of long-term debt   (1,926,971)   (2,905,682)
Long-term debt, less current portion  $11,583,939   $13,288,701 

 

Real Estate Loans

 

Our manufacturing facility is financed by a commercial bank loan requiring monthly payments of approximately $39,000, including principal and interest at 5.25%. A lump sum principal payment of approximately $4.2 million is due at the maturity date of this loan on August 15, 2018.

 

On February 9, 2017, the Company sold real estate to Superior Auto Body (“SAB”), a related party, for the net proceeds of $2.5 million. The cash received from the sale was used to pay down the $2.5 million loan balance on the property. As part of the sale, the Company released 547,000 shares of the Meiers common stock from the collateral for the Tronco note (see Note 5 – Related Party Note Receivable).

 

9
  

 

Hard Rock Note

 

In 2014, the Company purchased all of the interests of Hard Rock Solutions, LLC (“Hard Rock”). Consideration consisted of $12.5 million paid in cash at closing and a $12.5 million seller’s note (the “Hard Rock Note”). The Hard Rock Note and subsequent amendments are secured by all of the patents, patents pending, other patent rights, and trademarks transferred in the closing of the Hard Rock acquisition. At issuance, the fair value of the Hard Rock Note was determined to be $11,144,000, which is less than the face value due to a below-market interest rate. The resulting discount of $1,356,000 will be amortized to interest expense using the effective interest method, totaling approximately $19,104 and $38,207 for the three and six months ended June 30, 2017, respectively.

 

On August 10, 2016, certain of our subsidiaries entered into an amended and restated note with the seller in our acquisition of Hard Rock. As amended and restated, the Hard Rock Note accrues interest at 5.75% per annum and matures and is fully payable on January 15, 2020. Under the current terms of the Hard Rock Note, we are required to make the following payments: accrued interest only on each of January 15, March 15, May 15 and July 15, 2017; $500,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2018, and $1,000,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2019. The remaining balance of principal of $2,000,000 and accrued interest on the Hard Rock Note are due on January 15, 2020. During 2017, we have made the accrued interest payments related to the note on January 15, 2017, March 15, 2017, May 15, 2017, and July 15, 2017 of $129,808, $74,356, $76,877, and $76,877, respectively.

 

NOTE 7. COMMITMENTS AND CONTINGENCIES

 

We are subject to litigation that arises from time to time in the ordinary course of our business activities. We are not currently involved in any litigation which management believes could have a material effect on our financial position or results of operations, except as follows:

 

Del Rio Suit

 

In October 2013, Del-Rio Resources, Inc. (“Del-Rio”) filed suit, on its own behalf and derivatively on behalf of Philco Exploration, LLC (“Philco”), against the following co-defendants (a) Tronco Ohio, LLC and Tronco, (b) the lender on the Tronco loan, ACF Property Management, Inc. (p.k.a. Fortuna Asset Management, LLC,) (“ACF”), (c) Troy and Annette Meier personally, and several of their family trusts, (d) Meier Family Holding Company, LLC and Meier Management Company, LLC, and (e) SDS and MPS in the Eighth Judicial District Court, Uintah County, Utah Cause #130800125 (the “Suit”). On May 11, 2017, pursuant to a mediation proceeding, all of the plaintiffs and remaining defendants in the Suit executed a Settlement Agreement whereby each of the parties have released all of their claims against the other parties to the Suit without liability effective as of March 22, 2017. Such release includes the Company’s two subsidiaries that were a party to the Suit, SDS and MPS, as well as Troy and Annette Meier personally and all of their family trusts named as defendants in the Suit. As a result of the execution of the Settlement Agreement, a Stipulated Motion for Dismissal with Prejudice was filed with the Court which includes a form of Order of Dismissal with Prejudice (the “Court Order”). On May 15, 2017, the Court Order was executed by the judge and the Suit was formally dismissed with prejudice.

 

NOTE 8. RELATED PARTY TRANSACTIONS

 

In 2014, the Company issued notes payable to related parties in the amount of $2 million. The notes bear interest at 7.5% and were scheduled to mature on January 2, 2017. The Company made principal payments of $50,000 in January 2017 and $24,000 in May 2017. Based on an informal agreement, the Company will continue to reduce the balance on the note in 2017 against the interest due to the Company on the Tronco related party note receivable (see Note 5 – Related Party Note Receivable) instead of repaying the note.

 

10
  

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

Introduction

 

The following discussion and analysis was prepared to supplement information contained in the accompanying financial statements and is intended to provide certain details regarding our financial condition as of June 30, 2017, and our results of operations for the three and six months ended June 30, 2017 and 2016. It should be read in conjunction with the unaudited financial statements and notes thereto contained in this Quarterly Report on Form 10-Q (this “Quarterly Report”) as well as our audited financial statements for the years ended December 31, 2016 and 2015, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, which was filed with the Securities and Exchange Commission (the “SEC”).

 

Unless the context requires otherwise, references to the “Company” or to “we,” “us,” or “our” and other similar terms are to Superior Drilling Products, Inc. and all of its subsidiaries.

 

Jumpstart Our Business Startups Act of 2012

 

In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an emerging growth company can utilize the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for implementing new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to nonissuers. We have elected to delay such adoption of new or revised accounting standards, and as a result, we may not implement new or revised accounting standards on the relevant dates on which adoption of such standards is required for other issuer companies.

 

Subject to certain conditions set forth in the JOBS Act, as an emerging growth company, we intend to rely on certain of these exemptions, including without limitation, providing an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404 and implementing any requirement that may be adopted regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis). These exemptions will apply for a period of five years following the completion of our IPO, which occurred in May 2014, although if the market value of our common stock that is held by nonaffiliates exceeds $700 million as of any June 30 before that time, we would cease to be an emerging growth company as of the following December 31.

 

Forward - Looking Statements

 

This Quarterly Report on Form 10-Q includes certain statements that may be deemed to be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Statements contained in all parts of this document that are not historical facts are forward-looking statements that involve risks and uncertainties that are beyond the control of the Company. You can identify the Company’s forward-looking statements by the words “anticipate,” “estimate,” “expect,” “may,” “project,” “believe” and similar expressions, or by the Company’s discussion of strategies or trends. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, no assurances can be given that these expectations will prove to be correct. These forward-looking statements include the following types of information and statements as they relate to the Company:

 

  future operating results and cash flow;
     
  scheduled, budgeted and other future capital expenditures;
     
  working capital requirements;
     
  the availability of expected sources of liquidity;
     
  the transition of our business to primarily selling tools;
     
  the introduction into the market of the Company’s future products;
     
  the market for the Company’s existing and future products;
     
  the Company’s ability to develop new applications for its technologies;
     
  the exploration, development and production activities of the Company’s customers;
     
  compliance with present and future environmental regulations and costs associated with
     
  future operations, financial results, business plans and cash needs
     
  environmentally related penalties, capital expenditures, remedial actions and proceedings;
     
  effects of pending legal proceedings;
     
  changes in customers’ future product and service requirements that may not be cost effective or within the Company’s capabilities; and
     
  future operations, financial results, business plans and cash needs

 

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These statements are based on assumptions and analyses in consideration of the Company’s experience and perception of historical trends, current conditions, expected future developments and other factors the Company believes were appropriate in the circumstances when the statements were made. Forward-looking statements by their nature involve substantial risks and uncertainties that could significantly impact expected results, and actual future results could differ materially from those described in such statements.

 

While it is not possible to identify all factors, the Company continues to face many risks and uncertainties. Among the factors that could cause actual future results to differ materially are the risks and uncertainties discussed under “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 and the following:

 

  the volatility of oil and natural gas prices;
     
  the cyclical nature of the oil and gas industry;
     
  availability of financing, flexibility in restructuring existing debt and access to capital markets;
     
  consolidation within our customers’ industries;
     
  competitive products and pricing pressures;
     
  our reliance on significant customers;
     
  our limited operating history;
     
  fluctuations in our operating results;
     
  our dependence on key personnel;
     
  costs of raw materials;
     
  our dependence on third party suppliers;
     
  unforeseen risks in our manufacturing processes;
     
  the need for skilled workers;
     
  our ability to successfully manage our growth strategy;
     
  unanticipated risks associated with, and our ability to integrate, acquisitions;
     
  current and potential governmental regulatory actions in the United States and regulatory actions and political unrest in other countries;
     
  terrorist threats or acts, war and civil disturbances;
     
  our ability to protect our intellectual property;
     
  impact of environmental matters, including future environmental regulations;
     
  implementing and complying with safety policies;
     
  breaches of security in our information systems;
     
  related party transactions with our founders; and
     
  risks associated with our common stock

 

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Many of such factors are beyond the Company’s ability to control or predict. Any of the factors, or a combination of these factors, could materially affect the Company’s future results of operations and the ultimate accuracy of the forward-looking statements. Management cautions against putting undue reliance on forward-looking statements or projecting any future results based on such statements or present or prior earnings levels. Every forward-looking statement speaks only as of the date of the particular statement, and the Company undertakes no obligation to publicly update or revise any forward-looking statement.

 

Overview

 

Superior Drilling Products, Inc. (the “Company”, “SDPI”, “we”, “our” or “us”) is an innovative drilling and completion tool technology company providing cost saving solutions that drive production efficiencies for the oil and natural gas drilling industry. The Company innovates, designs, engineers, manufactures, sells, and repairs drilling and completion tools. Our drilling solutions include the patented Drill-N-Ream® well bore conditioning tool (“Drill-N-Ream tool”) and the patented Strider™ Drill String Oscillation System technology (“Strider technology”). In addition, the Company is a manufacturer and refurbisher of PDC (polycrystalline diamond compact) drill bits for a leading oil field services company. We operate a state-of-the-art drill tool fabrication facility, where we manufacture solutions for the drilling industry, as well as customers’ custom products. The Company’s strategy for growth is to leverage its expertise in innovative drill tool technology and precision machining in order to broaden its product offerings and solutions for the oil and gas industry.

 

We currently have three basic operations:

 

  Our PDC drill bit and other tool refurbishing and manufacturing service,
     
  Our emerging technologies business that manufactures the Drill-N-Ream tool, our innovative drill string enhancement tool, the Strider technology and other tools, and
     
  Our new product development business that conducts our research and development, and designs our horizontal drill string enhancement tools, other down-hole drilling technologies, and drilling tool manufacturing technologies.

 

From our headquarters in Vernal, Utah, we operate a technologically-advanced PDC drill bit refurbishing facility, as well as a state-of-the-art, high-tech drilling and completion tool engineering design and manufacturing operation. We manufacture our drill string enhancement tools, including the patented Drill- N-Ream tool and the patented Strider technology, and conduct our new product research and development from this facility.

 

Our co-founder, Troy Meier, developed the first commercially-viable process for refurbishing PDC drill bits after a successful 13-year career with a predecessor of Baker Hughes Inc. For the past 21 years, we have exclusively provided our PDC drill bit refurbishing services for the Rocky Mountain, California and Alaska regions of Baker Hughes’s oilfield operations. In addition, we have expanded our offerings and our customer base by demonstrating our engineering, design and manufacturing expertise to develop our own down-hole drilling tools. We continuously work with our customers to develop new products and enhancements to existing products, improve efficiency and safety, and solve complex drilling tool problems.

 

We employ a senior work force with specialized training and extensive experience related to drill bit refurbishing and tooling manufacturing. They produce our products and services using a suite of highly technical, purpose-built equipment, much of which we design and manufacture for our proprietary use. Our manufacturing equipment and products use advanced technologies that enable us to increase efficiency, enhance product integrity, improve efficiency and safety, and solve complex drilling tool problems.

 

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Oil and Gas Drilling Industry

 

Overview

 

Drilling and completion of oil and gas wells are upstream operations in the oil & gas industry served by the oilfield services group within the energy industry. The drilling industry is often segmented into the North American market and the International market. These markets share common exposure to the same macro environment, but also exhibit unique factors that drive the dynamics of each market.

 

Oilfield services companies drill the wells for hydrocarbon exploration and production (“E&P”) companies. Demand for onshore drilling is a function of the willingness of E&P companies to make operating and capital expenditures to explore for, develop and produce hydrocarbons. When oil or natural gas prices increase, E&P companies generally increase their capital expenditures, resulting in greater revenue and profits for both drillers and equipment manufacturers. Likewise, significant decreases in the prices of those commodities may lead E&P companies to reduce their capital expenditures, which decreases the demand for drilling equipment.

 

Trends in the Industry

 

Recent Rig Count Improvement and Stabilization; Industry Volatility. Our business is highly dependent upon the vibrancy of the oil and gas drilling operations in the U.S. Worldwide military, political and economic events have contributed to oil and natural gas price volatility and are likely to continue to do so in the future. Very soon after the completion of our initial public offering in late May 2014 and through early 2016, oil prices dramatically declined in the United States and as a result, the number of operating drill rigs was measurably reduced. The NYMEX-WTI oil price was as low as $26.19 in February 2016, while the NYMEX-Henry Hub natural gas price was as low as $1.49 per MMBtu in March 2016. The Baker Hughes weekly rotary rig count decreased over 70% from the high of 1,931 on September 13, 2014 to a historic low of 404 as of May 27, 2016.

 

During the downturn in 2015 and 2016, our business with Baker Hughes decreased measurablyas a result of the decline in drilling activity. This severely impacted both pricing and volume for drill bit refurbishment. We are contracted with Baker Hughes to serve the Rocky Mountain region that includes the Bakken shale formation in North Dakota. This region is higher cost production and as such, the drill rig count reduction was more dramatic than the overall U.S rig count decline. During the second half of calendar year 2016 and the first half of 2017, the U.S. rig count began to increase from the historic low in May 2016 to 954 as of August 4, 2017. With this increase in market activity, we have seen an increase in demand for our product and services, however we have not seen an increase in pricing. The rate of growth in rig count has stabilized in July 2017 and is expected to not increase at the same rate as it has over the last twelve months.

 

Advent of horizontal drilling requires new technologies. We believe the value of our Drill-N- Ream tool and Strider technology combined with our low market penetration provide us sales opportunities in soft as well as robust markets.

 

The oil and gas industry is increasingly using directional (e.g., horizontal) drilling in their exploration and production activities because of measurably improved recovery rates that can be achieved with these methods. With the rise of this type of drilling, traditional drill string tools used for vertical drilling do not necessarily provide the best performance or are not well suited for directional drilling.

 

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We believe that our Drill-N-Ream tool and Strider technology have proven to provide significant operational efficiencies and costs savings for horizontal drilling activity. In addition, we are developing additional technologies to take advantage of the oil and gas industry’s significant shift to horizontal/directional drilling and its resulting need for new drill string tools and technology.

 

We expect that with our extensive knowledge and experience in the oilfield industry, we can identify additional challenges with directional drilling, and then design and develop tools that will help our customers with their drilling challenges. Further development of additional drill string components, such as our Drill-N-Ream and Strider technology, will become increasingly important to our business as we continue to grow through both organic expansion and strategic acquisitions.

 

GE Oil & Gas to merge with Baker Hughes. In October 2016, GE Oil and Gas and Baker Hughes announced an agreement to combine their businesses. Currently, Baker Hughes is our sole customer for our bit refurbishment business and we do not know how this merger may impact our business. Despite this, we intend to continue developing our long-time relationship with Baker Hughes. In January 2016, the Company entered into an agreement with Baker Hughes to supply the Strider technology with our Open Hole Strider tool and related services to Baker Hughes. Tool shipments associated with the agreement are expected to begin in early 2018. The agreement has no set expiration date or minimum shipment requirement. It will remain in force until it is canceled by either us or Baker Hughes, as stipulated in the agreement. The Company’s current agreement with Baker Hughes regarding drill bit refurbishment expires in October 2017. The Company plans to review the agreement with its customer to determine its future opportunity.

 

RESULTS OF OPERATIONS

 

The following table represents our condensed consolidated statement of operations for the periods indicated:

 

    Three-Months Ended June 30,     Six-Months Ended June 30,  
(in thousands)   2017     2016     2017     2016  
Revenue   $ 4,049       100 %   $ 1,114       100 %   $ 7,419       100 %   $ 2,559       100 %
Operating costs and expenses     3,628       90 %     4,071       365 %     7,244       98 %     7,629       298 %
Income (loss) from continuing operations     421       (10 )%     (2,956 )     (265 )%     175         2%     (5,070 )     (198 )%
Other expense     (115 )     (3 )%     (142 )     (43 )%     (254 )     (3 )%     (271 )     (11 )%
Net income (loss)   $ 307       8 8%   $ (3,099 )     (278 )%   $ (79)       (1 )%   $ (209 )     (209 )%

 

Material changes of certain items in our statements of operations included in our financial statements for the comparative periods are discussed below.

 

During 2016, the Company changed its revenue model from primarily renting tools to primarily selling tools. In May 2016, the Company entered into a distribution agreement with Drilling Tools International, Inc., (“DTI”), under which they purchase our Drill-N-Ream tool for their rental tool business. As part of this agreement, DTI also hired much of our field sales team and the related vehicles associated with our previous rental tool business in the second half of 2016. In order to maintain exclusivity of the Drill-N-Ream Tool in the U.S. and Canada, the agreement required DTI to achieve 10% market share, defined as 10% of the average horizontal rig count in the 30 days prior to June 30, 2017. As a result of DTI’s successful efforts to achieve this 10% market share, our sales grew measurably when compared with the prior-year period.

 

For the three months ended June 30, 2017, as compared with the three months ended June 30, 2016

 

Revenue. Our revenue increased approximately $2,935,000, during the three months ended June 30, 2017 compared with the same period in 2016. Tool revenue for second quarter of 2017 was $2,486,000 which was comprised of approximately $1,609,000 of tool rental and sales revenue and approximately $877,000 of other related revenue. Other related revenue includes royalty fees, maintenance and repair of tools and agency fees. Tool revenue for second quarter of 2016 was approximately $850,000 and other related revenue was approximately $42,000 for the same period. Tool revenue in the second quarter of 2016 was comprised of rental tool revenue and tool sales. Tool revenue for the second quarter 2017 grew as a result of the increase in U.S. drilling activity from 2016 to 2017, and the Company’s shift in business model in May 2016 from a rental tool business to a tool sales business. Contract services revenue increased 600% to approximately $1,564,000 for the three months ended June 30, 2017 compared with approximately $223,000 for the same period in 2016 as a result of the increase in drilling activity in the first half of 2017 and the Company receiving overflow drill bit refurbishment work from outside its contracted territory.

 

Operating Costs and Expenses. Total operating costs and expenses decreased approximately $443,000 during the three months ended June 30, 2017 compared with the same period in 2016.

 

  Cost of revenue increased approximately $160,000 in the second quarter of 2017 compared with the prior-year period due to an increase in volume. As a percentage of revenue, cost of sales was 37%, compared with 120% in the prior year period.
     
  Selling, general and administrative expenses decreased approximately $301,000 for the three months ended June 30, 2017 compared with the same period in 2016. The decrease was due to a reduction in professional fees and research and development expense.
     
  Depreciation and amortization expense decreased approximately $301,000 primarily as a result of the Drill-N-Ream tool being reclassified from property, plant, and equipment to inventory in accordance with the Company’s shift from a rental tool business to a tool sales business, for the three months ended June 30, 2017 compared with the same period in 2016.

 

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Other Income (Expenses). Other income and expense primarily consists of rent income, interest income, interest expense and loss on disposition of assets.

 

  Other Income. There was no other income in the second quarter of 2017 due to the sale of SAB facilities in February 2017. As result of the sale, we will no longer receive this rental income.
     
  Interest Income. For the three months ended June 30, 2017 and 2016 interest income was approximately $82,000 and $78,000, respectively, and relates to interest received from the Tronco related party note receivable.
     
  Interest Expense. The interest expense for the three months ended June 30, 2017 and 2016 was approximately $215,000 and $377,000, respectively. The decline in interest expense was due primarily to principal payments associated with the Hard Rock Note.

 

For the six months ended June 30, 2017 as compared with the six months ended June 30, 2016

 

Revenue. Our revenue increased approximately $4,860,000, during the six months ended June 30, 2017 compared with the same period in 2016. Tool revenue for the six months ended June 30, 2017 was approximately $4,756,000 which was comprised of approximately $3,245,000 of tool rental and sales revenue and approximately $1,511,000 of other related revenue. Other related revenue includes royalty fees, maintenance and repair of tools and agency fees. Tool revenue for the six months ended June 30, 2016 was approximately $1,751,000 and other related revenue was approximately $95,000 for the same period. Tool revenue for the first six months of 2016 was comprised of rental tool revenue and tool sales. Tool revenue for the six months of 2017 grew as a result of the increase in U.S. drilling activity from 2016 to 2017, and the Company’s shift in business model in May 2016 from a rental tool business to a tool sales business. Contract services revenue increased 273% to approximately $2,663,000 for the six months ended June 30, 2017 compared with approximately $713,000 for the same period in 2016 as a result of the increase in drilling activity in for the first half of 2017.

 

Operating Costs and Expenses. Total operating costs and expenses decreased approximately $385,000 during the six months ended June 30, 2017 compared with the same period in 2016.

 

  Cost of revenue increased approximately $320,000 for the six months ended June 30, 2017 compared with the prior-year period due to an increase in volume. As a percentage of revenue, cost of sales was 36% compared with 92% in the prior year period.
     
  Selling, general and administrative expenses decreased approximately $95,000 for the six months ended June 30, 2017 compared with the same period in 2016. The decrease was due to restructuring the sales and marketing departments.
     
  Depreciation and amortization expense decreased approximately $610,000 primarily as a result of the Drill-N-Ream tool being reclassified from property, plant, and equipment to inventory in accordance with the Company’s shift from a rental tool business to a tool sales business, for the six months ended June 30, 2017 compared with the same period in 2016.

 

Other Income (Expenses). Other income and expense primarily consists of rent income, interest income, interest expense and loss on disposition of assets.

 

  Other Income. For the six months ended June 30, 2017 and 2016, other income was approximately $44,000 and $109,000, respectively. The decrease was the result of the sale of the SAB facilities in February 2017. As result of the sale, we will no longer receive this rental income. For the six months ended June 30, 2016, we received $108,951 rental from two real property leases, our SAB facilities and our Vernal campus.
     
  Interest Income. For the six months ended June 30, 2017 and 2016, interest income was approximately $164,000 and $156,000, respectively, and relates to interest received from the Tronco related party note receivable.
     
  Interest Expense. The interest expense for the six months ended June 30, 2017 and 2016 was approximately $474,000 and $728,000, respectively. The decline in interest expense was due primarily to principal payments associated with the Hard Rock Note.

 

Liquidity

 

At June 30, 2017, we had working capital of approximately $2.1 million. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. In February 2017, the Company received approximately $2,483,000 related to the sale of the SAB facilities, and we used the proceeds to repay the mortgage related to the SAB property of approximately $2,500,000. Our operational and financial strategies include lowering our operating costs and capital spending to match revenue trends, managing our working capital and managing our debt to enhance liquidity. We will continue to work to grow revenue and review additional cost containment measures with the plan to continue to be cash flow positive in the second half of 2017. If we are unable to do this, we may not be able to, among other things, (i) maintain our current general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements. We cannot provide any assurance that financing will be available to us in the future on acceptable terms.

 

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Public Offering: On September 30, 2016, we priced a follow-on public offering of common stock at $1.00 per share. The transaction closed on October 5, 2016. Net of underwriting expenses of $452,500, stock offering expenses of $256,419, net proceeds were approximately $5.0 million. The Company used the proceeds to repay its $1 million bridge financing entered into the summer of 2016, Federal National Commercial Credit (“FNCC”) indebtedness of $868,000 and pay the remaining $500,000 plus accrued interest on the Hard Rock Note. We have used the remaining $2.6 million from the offering to service on going debt obligations, which include real property leases and equipment loans, as well as for general corporate purposes, including growth working capital. The Bridge Financing Agreement and the FNCC lending agreement were both terminated upon the repayment on October 5, 2016.

 

Hard Rock Note: On August 10, 2016, certain of our subsidiaries entered into an amended and restated note with the seller in our acquisition of Hard Rock Solutions, LLC (as so amended and restated, the “Hard Rock Note”). As amended and restated, the Hard Rock Note accrues interest at 5.75% per annum and matures on January 15, 2020. Under the current terms of the Hard Rock Note, we are required to make the following payments: accrued interest only on each of January 15, March 15, May 15 and July 15, 2017; $500,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2018, and $1,000,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2019. The remaining principal balance of $2,000,000 and accrued interest on the Hard Rock Note are due on January 15, 2020. During 2017, we have made the accrued interest payments related to the note on January 15, 2017, March 15, 2017, May 15, 2017 and July 15, 2017 of $129,808, $74,356, $76,877 and $76,877, respectively.

 

Cash Flow

 

Operating Cash Flows

 

For the six months ended June 30, 2017, net cash used by our operating activities was approximately $316,000. The Company had approximately $79,000 of net loss, approximately $1,836,000 increase in accounts receivable, a decrease in accounts payable and accrued expenses of approximately $329,000 and a decrease in depreciation and amortization expense of approximately $610,000.

 

Investing Cash Flows

 

For the six months ended June 30, 2017, net cash provided by our investing activities was approximately $2,343,000. The Company received approximately $2,483,000 related to the sale of the SAB facilities. The Company used approximately $141,000 in investing activities for property, plant and equipment purchases.

 

Financing Cash Flows

 

For the six months ended June 30, 2017, net cash used in our financing activities was approximately $2,968,000 primarily attributable to a $2,500,000 loan repayment related to the SAB property that was sold in February 2017.

 

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Critical Accounting Policies

 

The discussion of our financial condition and results of operations is based upon our consolidated condensed financial statements, which have been prepared in accordance with U.S. GAAP. During the preparation of our financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions, including those discussed below. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of our analysis form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. While we believe that the estimates and assumptions used in the preparation of our consolidated condensed financial statements are appropriate, actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated condensed financial statements. Our estimates and assumptions are evaluated periodically and adjusted when necessary. The more significant estimates affecting amounts reported in our consolidated condensed financial statements include, but are not limited to: revenue recognition, stock based compensation, determining the allowance for doubtful accounts, valuation of inventories, recoverability of long-lived assets, useful lives used in calculating depreciation and amortization, and valuation of intangible assets.

 

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a- 15(e) and 15d- 15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective as of June 30, 2017 due to certain material weaknesses.

 

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a possibility that a material misstatement in our interim financial statements will not be prevented or detected on a timely basis. During the course of our assessment, management identified that the Company has a lack of staffing and appropriate accounting expertise within its accounting department. Management believes the lack of accounting and financial personnel amounts to a material weakness in its internal control over financial reporting and their ability to adequately prepare financial statements and disclosures, and a lack of accounting expertise to appropriately apply GAAP for complex and non-routine transactions. As a result, at June 30, 2017 and on the date of this Report, its internal control over financial reporting is not effective.

 

To remediate these issues, management has retained the services of additional third party accounting personnel as well as to modify existing disclosure controls and procedures in a manner designed to ensure future compliance.

 

Changes in Internal Controls over Financial Reporting

 

None

 

Internal Controls and Procedures

 

This quarterly report does not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of the Company’ s registered public accounting firm due to a transaction period established by the rules of the Securities and Exchange Commission for newly public companies. Under these rules, we will not be required to include an attestation report for so for as long as we are an “emerging growth company” pursuant to the provisions of the JOBS Act.

 

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PART II

 

Item 1. Legal Proceedings

 

We are subject to litigation that arises from time to time in the ordinary course of our business activities. We are not currently involved in any litigation which management believes could have a material effect on our financial position or results of operations, except as follows:

 

In October 2013, Del-Rio Resources, Inc. (“Del-Rio”) filed suit, on its own behalf and derivatively on behalf of Philco Exploration, LLC (“Philco”), against the following co-defendants (a) Tronco Ohio, LLC and Tronco, (b) the lender on the Tronco loan, ACF Property Management, Inc. (p.k.a. Fortuna Asset Management, LLC,) (“ACF”), (c) Troy and Annette Meier personally, and several of their family trusts, (d) Meier Family Holding Company, LLC and Meier Management Company, LLC, and (e) SDS and MPS in the Eighth Judicial District Court, Uintah County, Utah Cause #130800125 (the “Suit”). On May 11, 2017, pursuant to a mediation proceeding, all of the plaintiffs and remaining defendants in the Suit executed a Settlement Agreement whereby each of the parties have released all of their claims against the other parties to the Suit without liability effective as of March 22, 2017. Such release includes the Company’s two subsidiaries that were a party to the Suit, SDS and MPS, as well as Troy and Annette Meier personally and all of their family trusts named as defendants in the Suit. As a result of the execution of the Settlement Agreement, a Stipulated Motion for Dismissal with Prejudice was filed with the Court which includes a form of Order of Dismissal with Prejudice (the “Court Order”). On May 15, 2017, the Court Order was executed by the judge and the Suit was formally dismissed with prejudice.

 

Item 1A. Risk Factors

 

Due to reduced commodity prices and the unprecedented rapid decline in the rig count during 2015 and 2016 to historic lows, we had measurably lower operating cash flows. As a result of this situation coupled with pending payments required on our indebtedness, we may be unable to maintain adequate liquidity and make payments on our debt.

 

At December 31, 2016, we had working capital of approximately $2.1 million. During 2015 and into 2016, our principal sources of liquidity were cash flow from operations and our $3 million credit facility with Federal National Commercial Credit (“FNCC”). In addition, on August 5, 2016, we completed the $1 million bridge financing to provide us with liquidity until we could close the public offering described below. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. Given the current environment of the oil and gas industry, our revenue dramatically declined in 2015 and 2016.

 

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On September 30, 2016, we priced a public offering of common stock at $1.00 per share. The transaction closed on October 5, 2016. Net of underwriting and stock offering expenses of approximately $709,000, proceeds to the Company were approximately $5.0 million. The Company used the proceeds to pay off the $1 million Bridge Financing and its $868,000 indebtedness with FNCC, as well as for general corporate purposes, including working capital.

 

As amended and restated effective August 10, 2016, the Hard Rock Note accrues interest at 5.75% per annum and matures and is fully payable on January 15, 2020. Under the current terms of Hard Rock Note, and after the payment described below, we are required to make the following payments: accrued interest on each of January 15, March 15, May 15 and July 15, 2017, $500,000 (plus accrued interest) on each of January 15, March 15, May 15 and July 15, 2018, and $1,000,000 (plus accrued interest) on each of January 15, March 15, May 15 and July 15, 2019, with the remaining balance of principal and accrued interest on the Hard Rock Note due on January 15, 2020. During 2017, we made the accrued interest payments related to the note on January 15, 2017, March 15, 2017, May 15, 2017, and July 15, 2017 of $129,808, $74,356, $76,877 and $76,877, respectively.

 

At June 30, 2017, we had working capital of approximately $2.1 million. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. Our operational and financial strategies include lowering our operating costs and capital spending to match revenue trends, managing our working capital and managing our debt to enhance liquidity. For example, to conserve cash, we implemented a salary for stock options program during the first quarter of 2016 for senior management and our board of directors. With the success we are having with our distributor agreement with DTI and the opportunity with our new CTS tool, we believe we should have sufficient capital to support our opportunities in 2017. However, we may need additional capital to support additional growth. We cannot provide any assurance that financing will be available to us in the future on acceptable terms.

 

We will continue to work to grow revenue and review additional cost cutting measures with the goal to be cash flow positive in 2017. If we are unable to do this, we may not be able to, among other things, (i) maintain our current general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements.

 

Failure to generate sufficient revenue to make payments on the Hard Rock Note could result in our loss of the patents securing such note.

 

The Hard Rock Note is secured by all of the patents, patents pending, other patent rights, and the Drill-N-Ream trademark purchased in the Hard Rock acquisition (the “Drill-N-Ream Collateral”). If we do not have the funds necessary to make the future payments under the Hard Rock Note and fail to make any payments as required thereunder, and we are unsuccessful in amending or restructuring the payment terms, the holder of the Hard Rock Note could conduct a foreclosure sale on the Drill-N-Ream Collateral in order to apply the proceeds thereof toward repayment of the Hard Rock Note and all foreclosure costs, and our subsidiary Superior Drilling Solutions, LLC would be liable for any shortfall or receive any excess from the sales proceeds. The failure to retain and use the Drill-N-Ream Collateral in our business could cause a significant loss of our investment and might have a material adverse effect on our financial condition and results of operation, as well as our ability to grow our drill string tool business.

 

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Our level of indebtedness could adversely affect our future ability to raise additional capital to fund growth, limit our ability to react to changes in our business or our industry and place us at a competitive disadvantage.

 

As noted above, we are required to make payments on the Hard Rock Note of accrued interest only in 2017, $2.0 million (plus accrued interest) in 2018 and $4.0 million (plus accrued interest) for 2019, with the balance due on maturity in January 2020. Interest will continue to accrue on the Hard Rock Note based on the $1,000,000 value of the shares of common stock until such shares are registered. In addition, we are required to make monthly payments of approximately $135,000 on our other indebtedness. During 2017, we made the accrued interest payments related to the note on January 15, 2017, March 15, 2017, May 15, 2017, and July 15, 2017 of $129,808, $74,356, $76,877 and $76,877, respectively. During the year ending December 31, 2016, we paid interest of $769,582 and a principal payment of $2,000,000 on the Hard Rock Note, of which $1,000,000 was paid in stock. In addition, we issued 700,000 restricted shares of common stock on August 10, 2016 (having an agreed per share value of $1.43, or $1,000,000 in the aggregate) as payment for the remaining $1,000,000 required principal payment.

 

Our level of debt and debt service requirements could have important consequences. For example, it could (i) result in a foreclosure upon our key assets, (ii) increase our vulnerability to general adverse economic and industry conditions, (iii) limit our ability to fund future capital expenditures and working capital, to engage in future acquisitions or development activities, or to otherwise realize the value of our assets and opportunities fully because of the need to dedicate a substantial portion of our cash flow from operations to payments on our debt, (iv) increase our cost of borrowing, (v) restrict us from making strategic acquisitions or causing us to make non-strategic divestitures, (vi) limit our flexibility in planning for, or reacting to, changes in our business or industry in which we operate, placing us at a competitive disadvantage compared with our competitors who are less leveraged and (vii) impair our ability to obtain additional financing in the future.

 

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Item 6. Exhibits

 

The exhibits listed below are filed as part of this report:

 

Exhibit No.   Description
     
31.1*   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for G. Troy Meier.
     
31.2*   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for Christopher D. Cashion.
     
32**   Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for G. Troy Meier and Christopher D. Cashion.**
     
101.INS *   XBRL Instance
     
101.XSD *   XBRL Schema
     
101.CAL *   XBRL Calculation
     
101.DEF *   XBRL Definition
     
101.LAB *   XBRL Label
     
101.PRE *   XBRL Presentation

 

** Furnished herewith.

* Filed herewith.

 

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SIGNATURES

 

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

 

  SUPERIOR DRILLING PRODUCTS, INC.
     

August 11, 2017

By:  /s/ G. TROY MEIER
   

G. Troy Meier, Chief Executive Officer

(Principal Executive Officer)

     

August 11, 2017

By: /s/ CHRISTOPHER CASHION
    Christopher Cashion, Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)

 

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