Superior Drilling Products, Inc. - Quarter Report: 2020 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, 2020

[  ] 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)

Securities Registered Pursuant to Section 12(b) of the Exchange Act:

Securities Registered Pursuant to Section 12(g) of the Exchange Act: None

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 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 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 [  ]

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 25,617,486 shares of common stock, $0.001 par value, issued and outstanding as of November 6, 2020.

Superior Drilling Products, Inc.

FORM 10-Q

QUARTER ENDED September 30, 2020

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 Operations

(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, 2020

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. Our headquarters and manufacturing operations are located in Vernal, Utah. 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.

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.

Unaudited Interim Financial Presentation

These interim consolidated condensed financial statements for the three and nine months ended September 30, 2020 and 2019, 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, 2020 are not necessarily indicative of the results of operations expected for the year ended December 31, 2020. 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, 2019 and 2018 and the notes thereto, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, 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.

COVID-19

The COVID-19 pandemic-related reduction in energy demand and the dramatic decline in commodity prices that began in the first quarter of 2020 continued to cause disruptions and volatility in the second and third quarters of 2020. Sharp declines in crude oil and natural gas production along with reduced demand for refined products due to the economic shutdown in the wake of the pandemic affected our business in the second quarter, and we expect will continue to do so in the near term. Further, significant uncertainty remains regarding the duration and extent of the impact of the pandemic on the energy industry. See Note 2 – Liquidity.

Leases

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which requires assets and liabilities that arise from all leases to be recognized on the balance sheet for lessees and expanded financial statement disclosures for both lessees and lessors. We adopted the new standard effective January 1, 2020 and elected the modified retrospective transition method and as such, the comparative financial information will not be restated and will continue to be reported under the lease standard in effect during those periods. The adoption of this standard resulted in approximately $270,000 of additional assets and liabilities on our consolidated balance sheet representing the recognition of operating lease right-of-use assets and operating lease liabilities. Right-of-use assets represent the Company’s right to use an underlying asset for the lease term and lease liability represents the Company’s obligation to make lease payments arising from the lease, both of which are recognized based on the present value of the future minimum lease payments over the lease term at the commencement date. Leases with a lease term of 12 months or less at inception are not recorded on the condensed consolidated balance sheet and are expensed on a straight-line basis over the lease term in the condensed consolidated statement of operations. The interest rate implicit in lease contracts is typically not readily determinable. As a result, the Company utilizes an estimate of its incremental borrowing rate to discount lease payments, which reflects the fixed rate at which the Company believes it could borrow on a collateralized basis the amount of the lease payments in the same currency, for a similar term, in a similar economic environment. See Note 8 – Leases.

Significant Customers

For the nine months ended September 30, 2020, two customers represented 81% of our total revenue during the period. For the nine months ended September 30, 2019, two customers represented 94% of our total revenue during the period.

Significant Vendors

We had one vendor that represented 13.9% of our purchases for the nine months ended September 30, 2020. The vendor had approximately $72,000 in accounts payable at September 30, 2020 and purchases in the nine months of 2020 from this vendor totaled approximately $554,000. We had one vendor that represented 12% of our purchases for the nine months ended September 30, 2019. This vendor had approximately $218,000 in accounts payable at September 30, 2019 and purchases during the nine months of 2019 from this vendor totaled approximately $772,000.

Reclassifications

Certain prior year amounts have been reclassified to the balance sheet to conform to the current year presentation. The reclassifications were within accounts payable and accrued expenses and did not impact net income.

Recently Issued Accounting Standards

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). ASU 2016-13 changes the impairment model for most financial assets and certain other instruments, including trade and other receivables, and requires the use of a new forward-looking expected loss model that will result in the earlier recognition of allowances for losses. Early adoption is permitted and entities must adopt the amendment using a modified retrospective approach to the first reporting period in which the guidance is effective. For smaller reporting companies, as provided by Accounting Standards Update 2019-10, Financial Instruments - Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842), ASU 2016-13 is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2022. The adoption of ASU 2016-13 is currently not expected to have a material effect on our consolidated financial statements.

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (“Topic 740”) - Simplifying the Accounting for Income Taxes. ASU 2019-12 is intended to simplify accounting for income taxes. It removes certain exceptions to the general principles in Topic 740 and amends existing guidance to improve consistent application. ASU 2019-12 is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2020. The adoption of ASU 2019-12 is currently not expected to have a material effect on our consolidated financial statements.

NOTE 2. LIQUIDITY

The significant decline in oil demand due to COVID-19, the instability of oil prices caused by geopolitical issues and production levels, and the limited availability of storage capacity, have together resulted in our customers announcing significant reductions to their capital expenditure budgets for 2020. Demand for our products and services has been severely impacted as a result, and management expects this to continue for the duration of 2020 and potentially beyond; however, we are currently unable to estimate the full impact to our business, how long this significant drop in demand will last or the depth of the decline.

In an effort to offset the reduction in revenue resulting from the weakened macroeconomic environment, we have implemented certain cost reduction measures during 2020. These measures included, but were not limited to, the following:

We have also entered into amended agreements with certain of our customers, reduced our planned capital expenditures for 2020 and decided to defer further investment in new technology development, including our Strider technology, for the foreseeable future. Management is working diligently with vendors to achieve amended price concessions and terms of our payables. We believe the U.S. onshore activity for the remainder of 2020 will remain at depressed levels and continue to be constrained.

We are working to minimize the decline in revenue by adding additional revenue streams and maintaining cost containment measures in order to be cash flow positive. We believe that our borrowing capacity, cash generated from operations and the proceeds of the Paycheck Protection Program (“PPP”) loan (see Note 9 – Long-Term Debt) will be sufficient to fund our operations for the next 12 months. To enhance liquidity, our operational and financial strategies include managing our operating costs, accelerating collections of international receivables, and reducing working capital requirements and restructuring our debt. If we are unable to do this, we may not be able to, among other things, (i) maintain our revised general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements. COVID-19 has also led to a significant disruption in the equity and debt capital markets, which could hinder our ability to raise new capital or obtain financing on acceptable terms. We cannot provide any assurance that financing will be available to us in the future on acceptable terms, if at all.

Additionally, in July 2020, the Company filed a Form S-3 Shelf Registration that will allow the Company to offer and sell, from time to time, up to $20,000,000 of securities.

NOTE 3. REVENUE

Our revenue is derived from short term contracts. Revenue is recognized when we satisfy a performance obligation by transferring control of the promised goods or services to our customers at a point in time, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. We also assess our customer’s ability and intention to pay, which is based on a variety of factors including our customer’s historical payment experience and financial condition. Payment terms and conditions vary, although terms generally include a requirement of payment within 30 days.

Revenue generally does not include right of return or other significant post-delivery obligations. Revenue is recognized net of any taxes collected from customers, which are subsequently remitted to governmental authorities. We elected to treat shipping and handling costs as a fulfillment cost instead of as a separate performance obligation. We recognize the cost for shipping and handling when incurred as an expense in cost of sales.

Performance Obligations

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer under Topic 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. The majority of our contracts with customers contain a single performance obligation to provide agreed-upon products or services. For contracts with multiple performance obligations, we allocate revenue to each performance obligation based on its relative standalone selling price. In accordance with Topic 606, we do not assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer.

All of our contracts are less than one year in duration. We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed.

Disaggregation of Revenue

Approximately 83% of our revenue was from the United States and approximately 17% was from the Middle East for the nine months ended September 30, 2020. For the nine months ended September 30, 2019, approximately 95% of our revenue was from the United States and approximately 5% was from the Middle East.

Tool Revenue

Tool and Product Sales: Revenue for tool and product sales is recognized upon shipment of tools or products to the customer. Shipping and handling costs related to tool and product sales are recorded gross as a component of both the sales price and cost of the product sold.

Tool Rental: Tool rental revenue is recognized upon completion of the customer’s job for which the tool was rented. While the duration of the rents vary by job and number of runs, these rents are generally less than one month. The rental agreements are typically based on the price per run or footage drilled and do not have any minimum rental payments or term.

Other Related Revenue: We receive revenue from the repair of tools upon delivery of the repaired tool to the customer. We earn royalty commission revenue when our customer invoices their customer for the use of our tools.

Contract Services

Drill Bit Manufacturing and Refurbishment: We recognize revenue for our PDC drill bit services upon transfer of control, which we have determined to be upon shipment. Shipping and handling costs related to refurbishing services are paid directly by the customer at the time of shipment.

Revenue disaggregated by revenue source are as follows:

Contract Costs

We do not incur any material costs of obtaining contracts.

Contract Balances

Under our sales contracts, we invoice customers after our performance obligations have been satisfied, at which point payment is unconditional. Accordingly, our contracts do not give rise to contract assets or liabilities under ASC 606.

NOTE 4. INVENTORIES

Inventories are comprised of the following:

NOTE 5. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment are comprised of the following:

In 2019, the Company decided to sell the Company airplane and related hangar. Accordingly, these assets were reported as assets held for sale on our balance sheet as of December 31, 2019 at their carrying value, which was lower than the expected fair value less costs to sell. In February 2020, the Company sold the airplane for a gain of approximately $142,000. The Company recorded a $30,000 impairment related to the hangar in March 2020 and expects a sale of the hangar to be completed in the next 12 months.

Depreciation expense related to property, plant and equipment for the three and nine months ended September 30, 2020 was $401,592 and $1,259,398, respectively and for the three and nine months ended September 30, 2019 was $446,888 and $1,271,737, respectively.

NOTE 6. INTANGIBLE ASSETS

Intangible assets are comprised of the following:

Amortization expense related to intangible assets for the three and nine months ended September 30, 2020 was $291,667 and $875,000, respectively and for the three and nine months ended September 30, 2019 was $291,667 and $1,408,333, 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 September 30, 2020, the Company reviewed the net balance of the intangible assets and determined no impairment was needed.

NOTE 7. 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. Effective August 2017, the Company fully reserved the related party note receivable of $6,979,043, which reduced the related party note receivable balance to $0. The Company continues to hold the 8,267,860 shares of the Company’s common stock as collateral. The Company will record a recovery of the loan upon receiving repayment of the note or interest in other income. On July 7, 2020, the Company entered into an amended and restated loan agreement and note with Tronco changing the payment terms on the note. As amended, the interest rate on the note is fixed at 2% per annum. Interest only is due December 31, 2021 and 2022, with a balloon payment of all unpaid interest and principal due upon maturity on December 31, 2022.

NOTE 8. LEASES

The Company determines whether a contract is a lease, or contains a lease, at inception of the contract and whether that lease meets the classification criteria of a finance or operating lease. The Company discounts lease payments based on an estimate of its incremental borrowing rate as the Company’s leases do not provide a readily determinable implicit rate.

The Company leases certain facilities in Texas, Utah and Dubai under long-term operating leases with lease terms of one year to two years. Effective January 1, 2020, the Company adopted the provision of ASC 842 Leases.

The table below presents the lease related assets and liabilities recorded on the Company’s consolidated balance sheet as of September 30, 2020:

The lease expense and the cash paid under operating leases for the three and nine months ended September 30, 2020 was $26,827 and $141,817, respectively. At September 30, 2020, the weighted average remaining lease terms were 1.84 years and the weighted average discount rate was 7.25%.

The following is the aggregate future lease payments for operating leases as of September 30, 2020:

NOTE 9. LONG-TERM DEBT

Long-term debt is comprised of the following:

Real Estate Loans

On February 1, 2019, we signed a loan agreement for $3,129,861 refinancing our commercial bank loan which is secured by the land and buildings at our Vernal, Utah campus. We paid $1,000,000 towards the previous loan that was scheduled to mature on February 15, 2019, upon refinancing. The loan requires monthly payments of approximately $43,000, including principal and interest at 7.25%, and is secured by the land and buildings at our Vernal, Utah Campus. A balloon payment of approximately $2,500,000 is due upon maturity on February 15, 2021.

Hard Rock Note

In 2014, the Company purchased all of the interests of 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.

The Company paid $803,630 of principal and accrued interest on January 5, 2020, and $790,223 of principal and accrued interest on April 5, 2020. In April 2020, the Company amended and restated the Hard Rock Note. Under the amended terms of the Hard Rock Note, we are required to make principal payments of $750,000 plus accrued interest on July 5, 2021 and October 5, 2022. Interest accrues at a rate of 8% per annum. The Company paid $29,759 of accrued interest on July 5, 2020 and $30,247 of accrued interest on October 5, 2020. Accrued interest only payments will also be due on the fifth day of January, April and October 2021 and January, April and July 2022. The remaining principal balance of the Hard Rock Note is $1,500,000.

Credit Agreement

In February 2019, the Company entered into a Loan and Security Agreement (the “Credit Agreement”) with Austin Financial Services, Inc. (“AFS”). The Credit Agreement provides a $4,500,000 credit facility, which includes a $1,000,000 term loan (the “Term Loan”) and a $3,500,000 revolver (the “Revolving Loan”). As of September 30, 2020, $359,916 was outstanding on the Revolving Loan. Amounts outstanding under the Revolving Loan at any time may not exceed the sum of: (a) up to 85% of accounts receivable or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect (less a dilution reserve as determined by AFS in its sole good faith discretion), plus (b) the lesser of (i) up to 50% of inventory or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect, or (ii) the inventory sublimit, minus (c) the borrowing base reserve as may be determined from time to time by AFS. Amounts outstanding on the Revolving Loan as of September 30, 2020, may not exceed $511,791, which is based on a calculation applying 85% of accounts receivable and 50% of inventory. A collateral management fee is payable monthly on the used portion of the Revolving Loan and Term Loan. Even if our borrowings are less than $1,000,000, we still pay interest as if we had borrowed $1,000,000. At September 30, 2020, we had approximately $9,456 of accrued interest.

The Credit Agreement contains various restrictive covenants that, among other things, limit or restrict the ability of the borrowers to incur additional indebtedness; incur additional liens; make dividends and other restricted payments; make investments; engage in mergers, acquisitions and dispositions; make optional prepayments of other indebtedness; engage in transactions with affiliates; and enter into restrictive agreements. The Credit Agreement does not include any financial covenants. If an event of default occurs, the lenders are entitled to accelerate the advances made thereunder and exercise rights against the collateral. Borrowing under the Revolving Loan is classified as current debt as a result of the required lockbox arrangement and the subjective acceleration clause. At September 30, 2020, we were in compliance with the covenants in the Credit Agreement.

The interest rate for the Term Loan and the Revolving Loan is prime plus 2%. At September 30, 2020, the interest rate was 8.85%, which includes a 3.6% management fee rate. The obligations of the Company under the agreement are secured by a security interest in substantially all of the tangible and intangible assets of the borrowers, other than any assets owned by the Company that constitute real property (and fixtures affixed to such real property), certain excluded equipment, intellectual property, or aircraft. The Credit Agreement matures on February 20, 2023, subject to early termination pursuant to the terms of the agreement or extension as may be agreed by the parties.

Paycheck Protection Program

On April 21, 2020, the Company received loan proceeds of $891,600 under a promissory note from its existing commercial bank (the “PPP Loan”). The PPP, established as part of the CARES Act, provides for loans to qualifying businesses for amounts up to 2.5 times the average monthly payroll expenses of the qualifying business. The loans and accrued interest are forgivable after eight weeks as long as the borrower uses the loan proceeds for eligible purposes, including payroll, benefits, rent and utilities, and maintains its payroll levels.

The application for these funds required the Company to, in good faith, certify that the current economic uncertainty made the loan request necessary to support the ongoing operations of the Company. Some of the uncertainties related to the Company’s operations that are directly related to COVID-19 include, but are not limited to, the severity of the virus, the duration of the outbreak, governmental, business or other actions (which could include limitations on operations or mandates to provide products or services), impacts on the supply chain, and the effect on customer demand or changes to operations. In addition, the health of the Company’s workforce, and its ability to meet staffing needs to continue to build, repair and distribute drilling tools, and other critical functions, are uncertain and is vital to its operations.

The PPP Loan certification further requires the Company to take into account our current business activity and our ability to access other sources of liquidity sufficient to support ongoing operations in a manner that is not significantly detrimental to the business. The Company had approximately $341,000 of available credit under the Credit Agreement as of April 21, 2020. Further, the Company has a limited market capitalization and the Company’s shares have limited trading volume and as a result, the Company believes it met and continues to meet the certification requirements.

The term of the Company’s PPP Loan is two years. The annual interest rate on the PPP Loan is 1% and no payments of principal or interest are due during the six-month period beginning on the date of the PPP Loan.

NOTE 10. TOTAL EQUITY

A summary of changes in total equity for the nine months ended September 30, 2020 and 2019 is presented below:

On August 7, 2020, the Board of Directors recommended and the Company’s shareholders approved an additional 2,543,448 shares of the Company’s common stock to be added to the 2015 Incentive Plan. Subject to adjustment as provided in the 2015 Incentive Plan, the maximum aggregate number of shares of the Company’ s common stock that may be issued with respect to awards under the 2015 Incentive Plan is 5,536,353.

Also on  August 7, 2020, the Board of Directors granted 259,765 restricted stock units to Troy Meier, Chairman and Chief Executive Officer, 199,219 restricted stock units to Annette Meier, President and Chief Operating Officer, 140,625 restricted stock units to Chris Cashion, Chief Financial Officer, and 87,891 restricted stock units to each of the three independent members of the Board of Directors. In addition, the Board of Directors authorized 675,000 restricted stock units to be granted to employees of the company other than Mr. and Mrs. Meier and Mr. Cashion.  These restricted stock units will vest over three years from the date of grant.

NOTE 11. GEOGRAPHICAL OPERATIONS INFORMATION

The following summarizes revenue by geographic location:

The following summarizes net property, plant and equipment by geographic location:

NOTE 12. COMMITMENTS AND CONTINGENCIES

We are subject to litigation that arises from time to time in the ordinary course of our business activities. In February 2019, the Company filed a patent infringement lawsuit in the United States District Court for the Western District of Louisiana Lafayette Division asserting Stabil Drill Specialties, LLC (“Stabil Drill”) infringed on our patent that covers the Company’s well bore conditioning tool, the Drill-N-Ream. The lawsuit was subsequently moved from Louisiana to the United States District Court for the Southern District of Texas, Houston Division. The court ordered the Company to serve discovery requests upon Stabil Drill and gave Stabil Drill deadlines to respond and produce documents and permit product inspection. Stabil Drill filed a motion for summary judgement and the Company responded and cross-moved for patent infringement. The parties are awaiting the judge’s decision. On October 1, 2020, Superior Energy Services, Stabil Drill’s parent company, filed for bankruptcy, which may result in a delay in the resolution of this litigation. We cannot predict the outcome of this matter, but our legal costs could have a material effect on our financial position or results of operations in future periods. We are not currently involved in any other 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, 2020, and our results of operations for the three and nine months ended September 30, 2020 and 2019. 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, 2019 and 2018, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, 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.

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, 2019, our subsequent filings with the SEC, 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 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.

Executive Summary

We innovate, design, engineer, manufacture, sell, and repair drilling and completion tools in the United States, Canada, Middle East and Eastern Europe.

We currently have three basic operations:

Our strategy for growth is to expand our global market penetration of our current drill tool technology and 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, as well as other industries that require precision machining and quality. We believe through our patented technologies, as well as technologies under development, that we can offer the oil and gas industry the solutions it demands to improve drilling efficiencies and reduce production costs.

Recent Developments and Trends

Our business and operations have been adversely affected by and are expected to continue to be adversely affected by the COVID-19 pandemic. The COVID-19 pandemic greatly reduced global oil demand as social distancing and travel restrictions were implemented across the world. The timeline and potential magnitude of the COVID-19 outbreak and its consequences are currently unknown. The continuation or amplification of this virus could continue to more broadly affect the United States and global economy, including the demand for oil and gas.

Further disrupting the oil and gas industry was the lifting by the Organization of the Petroleum Exporting Countries (“OPEC”) of supply curtailments. This resulted in an increase in the global supply of oil in an environment of rapidly contracting demand. As a result, the price of oil declined significantly in April 2020 as storage capacity became limited.

Overall, the significant decline in oil demand due to COVID-19 coupled with a global over supply of oil drove down oil prices. This has resulted in our customers announcing significant reductions to their capital expenditure budgets for 2020. This is evidenced by the significant decline in U.S. onshore rig counts from the beginning of the year. At the end of 2019, the U.S. onshore rig count as reported by Baker Hughes was 781 rigs. As of September 30, 2020, the U.S. onshore rig count was 266 rigs compared with 855 rigs as of September 30, 2019. We expect oil and gas related markets to continue to experience significant weakness for the remainder of 2020 and into 2021. Despite these current challenges, the oil and gas industry is beginning to experience slight improvements including an increase in the number of active rigs in the U.S. from third quarter lows, and we expect additional rig count improvement to occur into year-end.

The reduction of the U.S. onshore rig count has negatively affected our results of operations as our business is highly dependent upon the vibrancy of the oil and gas drilling operations in the U.S. In an effort to offset the reduction in revenue resulting from the weakened macroeconomic environment, we have implemented certain cost reduction measures during 2020. These measures included, but were not limited to, the following:

We have also entered into amended agreements with certain of our customers as discussed below in more detail, reduced our planned capital expenditures for 2020 and decided to defer further investment in new technology development, including our Strider technology, for the foreseeable future. Management is working diligently with vendors to achieve amended price concessions and terms of our payables. We believe the U.S. onshore activity for the remainder of 2020 will remain at depressed levels and continue to be constrained. We will continue to actively monitor the situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, partners, suppliers, and stakeholders, or as required by federal, state, or local authorities.

We have placed a priority on protecting our employees during this pandemic while continuing to provide essential services to our customers. We operate under an emergency response plan specific to the global pandemic. This plan is reviewed and revised quarterly based on the latest federal and state government information provided, best practice, and consultation with local health departments. This plan includes disinfecting on a regular basis, the elimination of overlap between shifts, and a strict procedure for handling potential cases within the processes outlined in the Families First Coronavirus Response Act. Employees are also required to perform self-health evaluations at the start of every shift. These measures continue to act as a barrier to the spread of the virus on company property and among its employees. To date, these precautions have had an immaterial impact on the normal costs associated with our operations.

Effective April 1, 2020, the Company through its Hard Rock subsidiary entered into a First Amendment to Amended and Restated Distribution Agreement (the “DTI Amendment”) with Drilling Tools International, Inc. (“DTI”), amending the agreement between Hard Rock and DTI dated August 30, 2016. Under the DTI Amendment, all charges for repair rates the Company provides to DTI are reduced by 10%. These rate changes are applicable through September 30, 2020, unless extended on, or prior to, the expiration date by mutual written agreement. The Company hopes to extend the DTI Agreement prior to year-end 2020.

Effective May 1, 2020, we entered into a First Amendment to Vendor Agreement (the “Baker Hughes Amendment”) with Baker Hughes Oilfield Operations LLC (“Baker Hughes”), amending their existing Vendor Agreement dated April 1, 2018. Under the Baker Hughes Amendment, we may engage in other activity not related to or in competition with the business of Baker Hughes to the extent that such other activity shall not be considered a breach of the Vendor Agreement. Also, under the Baker Hughes Amendment, charges for repair rates that we provide to Baker Hughes are reduced by 10%. Lastly, Baker Hughes agreed to remove the exclusivity restrictions that prevented us from providing drill bit repair for other entities, which broadens our market opportunity.

CONSOLIDATED RESULTS OF OPERATIONS

Three and Nine Months Ended September 30, 2020 Compared with the Three and Nine Months Ended September 30, 2019

The following table represents summary consolidated operating results 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. Comparisons are to the prior-year period unless stated otherwise.

Three Months Ended September 30, 2020 Compared with the Three Months Ended September 30, 2019

Revenue. Our revenue decreased approximately $3,529,000 or 70%. The revenue decline was driven primarily by a 73% decrease in the U.S. land rig count resulting from the global impact of the COVID-19 pandemic, which was partially offset by a $141,000, or 49% increase, in International revenue to $429,000. The Company’s U.S. revenue declined 77%, from reduced drill bit repair and tool sales reflecting the dramatic slowdown in the U.S. drilling activity in the quarter. Contract services revenue decreased approximately $1,525,000, or 81%, to $357,000. Tool revenue was $1,191,000, down 65% or $2,004,000, from the prior-year period reflecting the positive impact of International activity.

Operating Costs and Expenses. Total operating costs and expenses decreased approximately $2,210,000 for the 2020 three-month period.

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

Nine Months Ended September 30, 2020 Compared with the Nine Months Ended September 30, 2019

Revenue. Our revenue decreased approximately $5,726,000 or 39% to $8,930,000. The decrease is a result of the COVID-19 pandemic induced decrease in the demand of oil and gas leading to a reduction in drilling activity in the United States. Partially offsetting this decline was an increase of $843,000, or more than double, in International revenue to $1,542,000.

Tool revenue was $6,147,000, down 33% or $3,065,000, from the prior-year period. Contract services revenue decreased approximately $2,661,000, or 49%, to $2,782,000.

Operating Costs and Expenses. Total operating costs and expenses decreased approximately $3,880,000 for the 2020 nine-month period.

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

Liquidity and Capital Resources

At September 30, 2020, we had a working capital deficit of approximately $2,600,000. 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, accelerating collections of international receivables, and managing our working capital and debt to enhance liquidity. We will continue to work to grow revenue and manage costs to minimize negative net cash flow in 2020. 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.

In addition, the significant decline in oil demand due to COVID-19, the instability of oil prices caused by geopolitical issues and over supply have resulted in the announcements by our customers and end users of our tools and technology of significant reductions to their capital expenditure budgets. Our expectation is that demand for our products and services will be severely impacted for the duration of 2020 and potentially beyond; however, we are currently unable to estimate the full impact to our business, how long this significant drop in demand will last or the depth of the decline. We have also reduced our planned capital expenditures for 2020 and we have decided to defer further investment in new technology development, including our Strider technology.

The Hard Rock Note has a remaining balance of $1,500,000 as of September 30, 2020, accrues interest at 8.00% per annum and is fully payable on October 5, 2022. Under the amended terms of the Hard Rock Note, we are required to make the following remaining payments: accrued interest on January 5, April 5, July 5 and October 5 in 2021 and 2022; plus $750,000 in principal on July 5, 2021 with the remaining balance of principal and accrued interest on the Hard Rock Note due on October 5, 2022.

Our commercial bank loan is secured by our Vernal, Utah campus. The loan requires monthly payments of approximately $43,000, including principal and interest at 7.25%, and a balloon payment of $2,500,000 is due upon maturity on February 15, 2021. We have been in active discussions regarding the extension of this loan.

Our Credit Agreement is comprised of $1,000,000 Term Loan and $3,500,000 Revolving Loan. As of September 30, 2020, we had $749,998 outstanding on the Term Loan and $359,916 outstanding on the Revolving Loan. Amounts outstanding under the Revolving Loan at any time may not exceed the sum of: (a) up to 85% of accounts receivable or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect (less a dilution reserve as determined by AFS in its sole good faith discretion), plus (b) the lesser of (i) up to 50% of inventory or such lesser percentage as AFS in its sole discretion may deem appropriate if it determines that there has been a material adverse effect, or (ii) the inventory sublimit, minus (c) the borrowing base reserve as may be determined from time to time by AFS. Amounts outstanding on the Revolving Loan as of September 30, 2020, may not exceed $511,791, which is based on a calculation applying 85% of accounts receivable and 50% of inventory. A collateral management fee is payable monthly on the used portion of the Revolving Loan and Term Loan. If our borrowings are less than $1,000,000, we still pay interest as if we had borrowed $1,000,000. At September 30, 2020, we had approximately $9,456 of accrued interest.

The interest rate for the Term Loan and the Revolving Loan is prime plus 2%. At September 30, 2020, the interest rate was 8.85%, which includes a 3.6% management fee rate. The obligations of the Company under the agreement are secured by a security interest in substantially all of the tangible and intangible assets of the Company, other than any assets owned by the Company that constitute real property (and fixtures affixed to such real property), certain excluded equipment, intellectual property, or aircraft. The Credit Agreement matures on February 20, 2023.

Cash Flows

Nine Months Ended September 30, 2020 Compared with the Nine Months Ended September 30, 2019

Net cash provided by operating activities was $1,268,788 and $1,221,440 for the nine months ended September 30, 2020 and 2019, respectively. The primary reason for the improvement was due to a $4,234,073 decrease in accounts receivable.

Net cash used in investing activities was $36,642 for the nine months ended September 30, 2020 and related to property, plant and equipment purchases for tools to support international expansion, which was offset by the sale of the Company airplane. Net cash used in investing activities was $392,691 for the nine months ended September 30, 2019, and related to property, plant and equipment purchases mostly for tools to support international expansion.

Net cash used in financing activities was $1,036,790 and $2,301,560 for the nine months ended September 30, 2020 and 2019, respectively. Principal payments on debt were offset by proceeds of debt borrowings in both periods.

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, revenue, 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: 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, 2020.

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 SEC 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 a “smaller reporting company” as defined in Rule 12b-2 of the Exchange 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. In February 2019, the Company filed a patent infringement lawsuit in the United States District Court for the Western District of Louisiana Lafayette Division asserting Stabil Drill Specialties, LLC (“Stabil Drill”) infringed on our patent that covers the Company’s well bore conditioning tool, the Drill-N-Ream. The lawsuit was subsequently moved from Louisiana to the United States District Court for the Southern District of Texas, Houston Division. The court ordered the Company to serve discovery requests upon Stabil Drill and gave Stabil Drill deadlines to respond and produce documents and permit product inspection. Stabil Drill filed a motion for summary judgement and the Company responded and cross-moved for patent infringement. The parties are awaiting the judge’s decision. On October 1, 2020, Superior Energy Services, Stabil Drill’s parent company, filed for bankruptcy, which may result in a delay in the resolution of this litigation. We cannot predict the outcome of this matter, but our legal costs could have a material effect on our financial position or results of operations in future periods. We are not currently involved in any other litigation which management believes could have a material effect on our financial position or results of operations.

Item 1A. Risk Factors

As of the date of this filing, the Company remains subject to the risk factors previously disclosed in Part I, Item 1A “Risk Factors” in our 2019 Annual Report on Form 10-K. The risk factors below updates or expands upon those risk factors.

The outbreak of the recent coronavirus (“COVID-19”) has had, and is expected to continue to have, depending on the duration of the pandemic, a significant impact on our business, financial condition and results of operations due to its effect on the oil and gas industry.

The impact of COVID-19 and measures to prevent its spread are expected to continue to impact our results, operations, cash flows and liquidity.

We expect the impact of these disruptions, including the extent of their adverse impact on our financial and operational results, will be dictated by the length of time that such disruptions continue.

Demand for our products and services is declining as our customers continue to revise their capital budgets downwards and swiftly adjust their operations in response to lower commodity prices. Our customers may not be unable to meet existing payment or other obligations to us. To address the situation, we have been forced to take several actions, including reductions in salaries for officers and fees for independent directors, a reduction in our total workforce and the indefinite postponement of the development of new technology by us and elimination of any activity not necessary to conduct our business. Such a further spread or outbreak could also negatively impact the business and operations of third party service providers who perform critical services for our business

Given the uncertainty around the extent and timing of the potential future spread or mitigation of COVID-19 and around the imposition or relaxation of protective measures, we cannot reasonably estimate the impact on our future results of operations, cash flows or financial condition.

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

At September 30, 2020, we had working capital deficit of approximately $2,600,000. 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, accelerating collections of international receivables, and managing our working capital and debt to enhance liquidity.

While we believe that our borrowing capacity and cash generated from operations will be sufficient to fund our operations for the next twelve months, our operational and financial strategies include managing our operating costs, working capital and debt to enhance liquidity. We will continue to work to grow revenue and review additional cost containment measures. 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.

On May 6, 2020, certain subsidiaries the Company amended and restated the Hard Rock Note with the seller in the acquisition of Hard Rock Solutions, LLC. As amended, the Hard Rock Note accrues interest at 8.00% per annum and matures and is now fully payable on October 5, 2022. Under the amended terms of the Hard Rock Note, we are required to make the following payments: accrued interest on each July 5, October 5, January 5, and April 5 in 2021 and 2022; and $750,000 (plus accrued interest) on July 5, 2021 with the remaining balance of principal and accrued interest on the Hard Rock Note due on October 5, 2022. If we are unable to make the payments required, we could lose our rights to market the Drill-N-Ream.

Our Credit Agreement is comprised of $1,000,000 Term Loan and $3,500,000 Revolving Loan. As of September 30, 2020, we had $749,998 outstanding on the Term Loan and $359,916 outstanding on the Revolving Loan. If we are unable to make required payments under the Credit Agreement, we would be in default thereunder, which would permit the holders of the indebtedness to accelerate the maturity thereof, unless we are able to obtain, on a timely basis, a necessary waiver or amendment. Any waiver or amendment may require us to revise the terms of the Credit Agreement which could increase the cost of our borrowings, require the payment of additional fees, and adversely impact the results of our operations. Upon the occurrence of any event of default that is not waived, the lenders could elect to exercise any of their available remedies, which include the right to not lend any additional amounts or, in the event we have outstanding indebtedness under the Credit Agreement, to declare any outstanding indebtedness, together which any accrued interest and other fees, to be immediately due and payable. If we are unable to repay the outstanding indebtedness, if any, under the Credit Agreement when due, the lenders would be permitted to proceed against their collateral and this could have a material adverse effect on our business and financial condition.

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.