Superior Drilling Products, Inc. - Quarter Report: 2018 September (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 September 30, 2018

[  ] 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)

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 24,550,979 shares of common stock, $0.001 par value, issued and outstanding as of November 9, 2018.

Superior Drilling Products, Inc.

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2018

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION.

Item 1. Financial Statements

Superior Drilling Products, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

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

Superior Drilling Products, Inc.

Condensed Consolidated Statements of Income

(Unaudited)

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

Superior Drilling Products, Inc.

Condensed Consolidated Statements Of Cash Flows

(Unaudited)

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

Superior Drilling Products, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2018

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Nature of Operations

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 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) Hard Rock Solutions, LLC (“HR” or “Hard Rock”).

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). We will remain an emerging growth company until the earliest of (i) the end of the fiscal year in which the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of June 30, (ii) the end of the fiscal year in which we have total annual gross revenues of $1.07 billion or more during such fiscal year, (iii) the date on which we issue more than $1.0 billion in non-convertible debt in a three-year period or (iv) January 1, 2020.

Revenue Recognition

We are a drilling and completion tool technology company and we generate revenue from the 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 also earn royalty fees under certain arrangements for the tools we sell.

Unaudited Interim Financial Presentation

These interim consolidated condensed financial statements for the three and nine months ended September 30, 2018 and 2017, 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 nine months ended September 30, 2018 are not necessarily indicative of the results of operations expected for the year ended December 31, 2018. 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, 2017 and 2016 and the notes thereto, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, 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.

Recently Issued Accounting Standards

In May 2014, the Financial Accounting Standards Board (the “FASB”) issued an accounting standards update for “Revenue from Contracts with Customers,” which supersedes the revenue recognition requirements in “Topic 605, Revenue Recognition.” This accounting standard update provides new guidance concerning recognition and measurement of revenue and requires additional disclosures about the nature, timing and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, FASB delayed the effective date one year, which is now effective for the Company’s fiscal year beginning January 1, 2019. The Company is currently evaluating the impact the pronouncement will have on the consolidated financial statements and related disclosure and will adopt this standard on January 1, 2019.

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 is currently evaluating the impact the pronouncement will have on the consolidated financial statements and related disclosure and will adopt this standard on January 1, 2020.

NOTE 2. LIQUIDITY

At September 30, 2018, we had a working capital deficit of approximately $1,200,000. The Company’s manufacturing facility is financed by a commercial bank loan mortgage with principal of $4,200,000 due February 15, 2019 (see Note 7 – Long-Term Debt). The classification of this debt from long-term to short-term resulted in a working capital deficit at September 30, 2018. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. We continue to expect to be cash flow positive in 2018. If we are unable to manage our working capital requirements and successfully refinance our commercial bank loan that is collateralized by our property, 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.

NOTE 3. INVENTORIES

Inventories are comprised of the following:

The Company recorded an impairment loss in the cost of sales of $41,396 in the first quarter of 2018 relating to steel inventory unrelated to the Company’s primary operations. During the second quarter of 2018, the Company sold this unrelated inventory to a third-party wholesaler for approximately $248,000. No gain or loss was recorded upon the sale.

NOTE 4. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment are comprised of the following:

Depreciation expense related to property, plant and equipment for the three and nine months ended September 30, 2018 was $330,806 and $985,183, respectively, and for the three and nine months ended September 30, 2017 was $296,170 and $910,232, respectively.

NOTE 5. INTANGIBLE ASSETS

Intangible assets are comprised of the following:

Amortization expense related to intangible assets for the three and nine months ended September 30, 2018 and September 30, 2017, was $611,667 and $1,835,000, 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 September 30, 2018, the Company reviewed the net balance of the intangible assets and determined no impairment was needed.

NOTE 6. 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, which included 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.

The interest rate on the note is 5.25%. We earned interest of $97,489 and $275,614 for the three and nine months ending September 30, 2018, respectively, and interest of $87,867 and $251,000 for the three and nine months ended September 30, 2017, respectively.

On August 8, 2017, the Board of Directors agreed to extend the terms of the Tronco loan to interest only payments due December 31, 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 balance of which is $7,367,212. The Company holds 8,267,860 shares as collateral for the Tronco note as of September 30, 2018. On April 27, 2018, the Company released the 530,725 restricted stock units we previously held as additional collateral for the Tronco note. The Company believes the market value of the 8,267,860 shares is sufficient collateral for the note.

NOTE 7. LONG-TERM DEBT

Long-term debt is comprised of the following:

Real Estate Loans

Our manufacturing facility is financed by a commercial bank loan requiring monthly payments of approximately $43,000, including principal and interest. On August 1, 2018, we entered into an agreement with our lender to extend the due date of the commercial real estate loan from August 15, 2018 to February 15, 2019. The interest rate for the loan extension is 7.1%.

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 to Hard Rock. 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 $12,178 and $43,459 for the three and nine months ended September 30, 2018, respectively, and $19,657 and $59,766 for the three and nine months ended September 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 on January 15, 2020. We have made all the required principal and accrued interest payments related to the note for 2018. For 2019, we are required to pay $1,000,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2019. The remaining $2,000,000 balance of principal plus accrued interest on the Hard Rock Note is due on January 15, 2020.

NOTE 8. 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.

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 September 30, 2018, and our results of operations for the three and nine months ended September 30, 2018 and 2017. 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, 2017 and 2016, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, 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). We will remain an emerging growth company until the earliest of (i) the end of the fiscal year in which the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of June 30, (ii) the end of the fiscal year in which we have total annual gross revenues of $1.07 billion or more during such fiscal year, (iii) the date on which we issue more than $1.0 billion in non-convertible debt in a three-year period or (iv) January 1, 2020.

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:

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, 2017, and in our subsequent Exchange Act filings and the following:

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 based on current financial performance. 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” or “Strider”). In addition, the Company is a manufacturer and refurbisher of PDC (polycrystalline diamond compact) drill bits for a leading oil field services company. We operate a state-of-the-art drill tool fabrication facility, where we manufacture solutions for the drilling industry, as well as customers’ custom products.

We currently have three basic operations:

Our strategy for growth is to leverage our expertise in drill tool technology and precision machining in order to broaden our product offerings and solutions for the oil and gas industry. We believe through our patented technologies, as well as technologies under development, that we can offer the industry the solutions it demands to improve drilling efficiencies and reduce production costs.

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. He was also co-inventor of the Drill-N-Ream tool. We made a major strategic shift in 2016 to focus on our core competencies of innovation in manufacturing technologies, creation of solution for the upstream oil and gas industry, drilling tool fleet maintenance and repair and the development engineering and manufacture of new tools and technologies.

For the past 22 years, we have manufactured and refurbished PDC drill bits exclusively for Baker Hughes’s oilfield operations in the Rocky Mountain, California and Alaska regions, as well as other areas as needed to support their internal operations. Effective April 1, 2018, we entered into a new Vendor Agreement (the “Agreement”) with Baker Hughes Oilfield Operations LLC (“Baker Hughes”), replacing our former Vendor Agreement, which expired on March 31, 2018. Under the agreement, we will now serve an expanded market throughout the U.S., receive a base minimum volume in drill bit refurbishment and continue to provide our drill bit refurbishment services exclusively for Baker Hughes. The agreement has a four-year term and allows for modifications in the event of market deterioration. Either party has the right to cancel the agreement with 6-months’ notice.

We have been expanding our offerings and broadening our customer base and the end-users of our technologies by demonstrating our engineering, design and manufacturing expertise of down-hole drilling tools. In addition to the patented Drill-N-Ream tool, our products include the Strider technology, the V-Stream Advanced Conditioning System and the Dedicated Reamer Stinger. We have a pipeline of concepts of more horizontal drill string tools, each of which addresses a different technical challenge presented by today’s horizontal drilling designs. We are developing our relationships with our customers and the industry to understand the markets needs in order to develop new products and design enhancements to existing products in order to improve efficiency and safety and solve complex drilling tool problems.

We manufacture our solutions, as well as custom products, in our state-of-the-art drill tool fabrication facility where 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.

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

In May 2016, the Company entered into an agreement with Drilling Tools International (“DTI”), under which DTI had a requirement to purchase our Drill-N-Ream tool for their rental tool business and achieve market share requirements in order to maintain exclusive marketing rights for the Drill-N-Ream. DTI, has exclusive rights to market the Drill-N-Ream in the U.S. and Canada, both onshore and offshore. It must achieve defined market share goals with our tool that started in June 2017 and increase through the end of 2020. We receive revenue from DTI for tool sales, tool repairs and a royalty fee based on the tools usage. We are currently negotiating a new agreement and metrics with DTI to grow the market share of the Drill-N-Ream.

Also in 2016, the Company entered into a non-exclusive agreement with Baker Hughes to supply them with the Strider technology and related services. Tool shipments under the agreement are dependent upon the timing of the commercialization of the Strider technology. 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.

In December 2017, the Company entered into an agreement with Weatherford U.S., L.P. (“Weatherford”) to launch a joint market development program to introduce our Drill-N-Ream tool in the Middle East. Under the development agreement, Weatherford and SDPI will demonstrate the Drill-N-Ream’s capabilities with large Middle East operators in Saudi Arabia, Kuwait and Oman. The program was extended through December 31, 2018. SDPI and Weatherford each employ a local resident Product Champion to execute the pilot test program of 18 Drill-N-Ream tools. Upon the technology being proven in the region, the parties plan to enter into a long-term commercial agreement.

Oil and Gas Drilling Industry

Overview

Drilling and completion of oil and gas wells are upstream operations in the oil and 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; Industry Volatility. Our business is highly dependent upon the vibrancy of the oil and gas drilling operations in the U.S. As we expand into international markets, we will become more subject to changes in the industry in the countries in which we operate, such as Saudi Arabia, Kuwait and Oman. 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.

The oil and natural gas industry has recovered from its low in January 2016 when prices were just about $26 per barrel to today’s prices of nearly $70 per barrel. Correspondingly, the U.S. rig count increased from its low 404 rigs in May of 2016 to 1,067 as of October 19, 2018. The rate of growth in rig count stabilized in July 2017 and has increased at a slower rate from then to approximately 1,068 rigs as of October 26, 2018. Production of oil and gas in the U.S. has increased to record levels and has grown at a faster rate than the increased rig count because of better rig technology and higher rates of productivity per rig. With the increase in market activity, we have seen an increase in demand for our product and services, although we have not seen an increase in pricing.

Advancing Production Technologies. The oil and gas industry is increasingly using directional (e.g., horizontal) drilling in their exploration and production activities because of significantly improved recovery rates that can be achieved with these methods. With the rise of this type of drilling, traditional drill string tools used for vertical drilling do not necessarily provide the best performance or are not well suited for directional drilling. In addition, current and expected oil and natural gas prices combined with more technically challenging horizontal drilling has driven the demand for new technologies. We believe the value of our Drill-N-Ream tool has proven to provide significant operational efficiencies and costs savings for horizontal drilling activity and, combined with our low market penetration, provide us sales opportunities in soft as well as robust markets. Early results of our Strider technology have also delivered a similar outcome.

RESULTS OF OPERATIONS

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

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

For the three months ended September 30, 2018, as compared with the three months ended September 30, 2017

Revenue. Our revenue increased approximately $318,000, during the three months ended September 30, 2018. Tool revenue increased $179,000 to $3,361,000 from approximately $3,182,000 in the prior-year period. Tool revenue in the third quarter of 2018 was comprised of approximately $1,655,000 of tool rental and sales revenue and approximately $1,706,000 of other related revenue. Tool revenue in the prior-year period was comprised of approximately $2,012,000 of tool rental and sales revenue and approximately $1,170,000 of other related revenue.

Tool revenue for the third quarter 2018 grew as a result of an increase in other related revenue, which includes royalty fees and repair of tools, which was driven by the increase in U.S. drilling activity from 2017 to 2018 and our distributor’s increase in market share. This increase was partially offset by a decline in tool sales/rental revenue.

Contract services revenue was approximately $1,404,000 for the three months ended September 30, 2018 compared with approximately $1,265,000 for the three months ended September 30, 2017. The increase in contract services revenue was due to an increase in drill bit refurbishment activity.

Operating Costs and Expenses. Total operating costs and expenses increased approximately $748,000 during the three months ended September 30, 2018 compared with the same period in 2017.

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

For the nine months ended September 30, 2018 as compared with the nine months ended September 30, 2017

Revenue. Our revenue increased approximately $2,899,000, or 24% as a result of the $3,024,000, or 38%, increase in tool revenue, which more than offset the decline in Contract Services. Tool revenue grew to $10,962,000 primarily due to the $2,127,000 increase in Other related revenue and the $897,000 increase in tool rental and sales. Tool rental and sales were approximately $6,153,000 and Other related revenue was approximately $4,809,000. Tool revenue for the nine months ended September 30, 2017 was approximately $7,938,000 which was comprised of approximately $5,257,000 of tool rental and sales revenue and approximately $2,681,000 of other related revenue.

Tool revenue for the nine months ended September 30, 2018 grew as a result of an increase in Drill-N-Ream purchases from our distributor, the increase in other related revenue, which was driven by the increase in U.S. drilling activity from 2017 to 2018 and our distributor’s increase in market share.

Contract services revenue was approximately $3,803,000 compared with approximately $3,928,000 for the nine months ended September 30, 2017. The decrease in contract services revenue was the result of a reduction in manufacturing custom orders.

Operating Costs and Expenses. Total operating costs and expenses increased approximately $2,248,000 during the nine months ended September 30, 2018 compared with the same period in 2017.

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

Liquidity

At September 30, 2018, we had a working capital deficit of approximately $1,200,000. The Company’s manufacturing facility is financed by a commercial bank loan mortgage with principal of $4,200,000 due February 15, 2019 (see Note 7 – Long-Term Debt). The classification of this debt from long-term to short-term resulted in a working capital deficit at September 30, 2018.

Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. We continue to expect to be cash flow positive in 2018. If we are unable to manage our working capital requirements and successfully refinance our commercial bank loan that is collateralized by our property, 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.

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 on January 15, 2020. We have made all the required principal and accrued interest payments related to the note for 2018. For 2019, we are required to pay $1,000,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2019. The remaining $2,000,000 balance of principal plus accrued interest on the Hard Rock Note is due on January 15, 2020.

Cash Flow

Operating Cash Flows

For the nine months ended September 30, 2018, net cash provided by our operating activities was approximately $3,970,000. The Company had approximately $1,299,000 of net income and approximately $244,000 increase in prepaid expenses and other assets, which was offset by a decrease in accounts payable and accrued expenses of approximately $429,000.

Investing Cash Flows

For the nine months ended September 30, 2018, net cash used in our investing activities was approximately $183,000 and related to property, plant and equipment purchases.

Financing Cash Flows

For the nine months ended September 30, 2018, net cash used in our financing activities was approximately $1,887,000 and related to principal payments on debt.

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 effective as of September 30, 2018.

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 as long as we are an “emerging growth company” pursuant to the provisions of the JOBS Act.

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.

Item 1A. Risk Factors

We may be unable to maintain adequate liquidity and make payments on our debt.

At September 30, 2018, we had a working capital deficit of approximately $1,200,000. The Company’s manufacturing facility is financed by a commercial bank mortgage loan with principal of $4,200,000 due February 15, 2019. If we are unable to refinance the mortgage, the bank could foreclose on our property.

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, we are required to pay equal principal payments totaling $4,000,000 (plus accrued interest) on each of January 15, March 15, May 15 and July 15, 2019, with the remaining $2,000,000 balance of principal and accrued interest on the Hard Rock Note due on January 15, 2020. We have made all the required principal and accrued interest payments related to the note for 2018. For 2019, we are required to pay $1,000,000 in principal plus accrued interest on each of January 15, March 15, May 15 and July 15, 2019. If we are unable to make the payments required, we could lose our rights to market the Drill-N-Ream.

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 debt to enhance liquidity. 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 2018.

We expect to be cash flow positive in 2018. 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. In order to make our debt payments in 2018, 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.

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.

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.

We are required to make remaining payments on the Hard Rock Note of $4.0 million (plus accrued interest) for 2019, with the balance of $2.0 million due on maturity in January 2020. We have a commercial bank mortgage loan with principal of $4,200,000 due in February 2019. In addition, we are required to make monthly payments of approximately $68,000 on our other indebtedness.

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.

Our customer base is concentrated and the loss of, or nonperformance by, one or more of our significant customers, or our failure to expand our channels to market and further commercialize could cause our revenue to decline substantially.

We have two large customers that currently comprise 95% of our total revenue. It is likely that we will continue to derive a portion of our revenue from a relatively small number of customers in the future. If a major customer decided not to continue to use our services or significantly reduces its drilling plans, or if we are unable to expand our channels to market or further commercialize, our revenue would decline and our operating results and financial condition could be harmed. In addition, we are subject to credit risk due to the concentration of our customer base. Any increase in the nonpayment of and nonperformance by our counterparties, either as a result of changes in financial and economic conditions or otherwise, could have a material effect on our business, results of operations and financial condition and could adversely affect our liquidity.

Possible new tariffs could have a material adverse effect on our business.

The United States has recently announced the implementation of new tariffs on imported steel, and is also considering tariffs on additional items. There is a concern that the imposition of additional tariffs by the United States could result in the adoption of additional tariffs by other countries as well. Any resulting trade war could negatively impact the global market for oil field products and services and could have a significant adverse effect on our business. While it is too early to predict how the recently enacted tariffs on steel will impact our business, the imposition of tariffs on items we import from other countries could increase our costs and could result in lowering our gross margin on products sold.

Item 6. Exhibits

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

** Furnished herewith.

* Filed herewith.

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.