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, 2005
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission file number 001-13439
DRIL-QUIP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE | 74-2162088 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
13550 HEMPSTEAD HIGHWAY
HOUSTON, TEXAS
77040
(Address of principal executive offices)
(Zip Code)
(713) 939-7711
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x
As of November 7, 2005, the number of shares outstanding of the registrant’s common stock, par value $.01 per share, was 17,664,427.
PART I—FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
DRIL-QUIP, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
December 31, 2004 | September 30, 2005 | |||||
(Unaudited) | ||||||
(In thousands) | ||||||
ASSETS | ||||||
Current assets: | ||||||
Cash and cash equivalents | $ | 5,159 | $ | 7,991 | ||
Trade receivables | 63,116 | 90,469 | ||||
Inventories | 110,763 | 137,093 | ||||
Deferred taxes | 7,231 | 10,160 | ||||
Prepaids and other current assets | 3,798 | 3,200 | ||||
Total current assets | 190,067 | 248,913 | ||||
Property, plant and equipment, net | 113,206 | 115,031 | ||||
Other assets | 292 | 464 | ||||
Total assets | $ | 303,565 | $ | 364,408 | ||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||
Current liabilities: | ||||||
Accounts payable | $ | 26,805 | $ | 41,368 | ||
Current maturities of long-term debt | 990 | 878 | ||||
Accrued income taxes | 2,982 | 6,402 | ||||
Customer prepayments | 8,311 | 6,788 | ||||
Accrued compensation | 6,296 | 7,290 | ||||
Other accrued liabilities | 6,967 | 9,171 | ||||
Total current liabilities | 52,351 | 71,897 | ||||
Long-term debt | 28,082 | 45,079 | ||||
Deferred taxes | 6,769 | 5,818 | ||||
Total liabilities | 87,202 | 122,794 | ||||
Commitments and contingencies | — | — | ||||
Stockholders’ equity: | ||||||
Preferred stock: | ||||||
10,000,000 shares authorized at $0.01 par value (none issued) | — | — | ||||
Common stock: | ||||||
50,000,000 shares authorized at $0.01 par value, 17,300,873 and 17,663,489 shares issued and outstanding at December 31, 2004 and September 30, 2005, respectively | 173 | 176 | ||||
Additional paid-in capital | 64,889 | 74,922 | ||||
Retained earnings | 145,162 | 166,013 | ||||
Foreign currency translation adjustment | 6,139 | 503 | ||||
Total stockholders’ equity | 216,363 | 241,614 | ||||
Total liabilities and stockholders’ equity | $ | 303,565 | $ | 364,408 | ||
The accompanying notes are an integral part of these statements.
2
DRIL-QUIP, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2004 | 2005 | 2004 | 2005 | |||||||||
(In thousands, except share data) | ||||||||||||
Revenues | $ | 58,222 | $ | 95,324 | $ | 164,521 | $ | 245,944 | ||||
Cost and expenses: | ||||||||||||
Cost of sales | 41,341 | 64,158 | 115,471 | 168,885 | ||||||||
Selling, general and administrative | 7,915 | 10,773 | 23,482 | 29,725 | ||||||||
Engineering and product development | 4,213 | 5,266 | 12,474 | 15,964 | ||||||||
53,469 | 80,197 | 151,427 | 214,574 | |||||||||
Operating income | 4,753 | 15,127 | 13,094 | 31,370 | ||||||||
Interest expense | 272 | 549 | 830 | 1,323 | ||||||||
Income before income taxes | 4,481 | 14,578 | 12,264 | 30,047 | ||||||||
Income tax provision | 1,231 | 4,736 | 3,677 | 9,196 | ||||||||
Net income | $ | 3,250 | $ | 9,842 | $ | 8,587 | $ | 20,851 | ||||
Earnings per share: | ||||||||||||
Basic | $ | 0.19 | $ | 0.56 | $ | 0.50 | $ | 1.19 | ||||
Diluted | $ | 0.19 | $ | 0.54 | $ | 0.50 | $ | 1.16 | ||||
Weighted average shares: | ||||||||||||
Basic | 17,293,373 | 17,663,489 | 17,293,373 | 17,526,792 | ||||||||
Diluted | 17,392,735 | 18,145,055 | 17,345,638 | 17,937,110 | ||||||||
The accompanying notes are an integral part of these statements.
3
DRIL-QUIP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine months ended September 30, | ||||||||
2004 | 2005 | |||||||
(In thousands) | ||||||||
Operating activities | ||||||||
Net income | $ | 8,587 | $ | 20,851 | ||||
Adjustments to reconcile net income to net cash provided by (used in) operating activities: | ||||||||
Depreciation and amortization | 8,663 | 10,048 | ||||||
Gain on sale of equipment | (61 | ) | (53 | ) | ||||
Deferred income taxes | (337 | ) | (3,907 | ) | ||||
Changes in operating assets and liabilities: | ||||||||
Trade receivables | (4,371 | ) | (29,716 | ) | ||||
Inventories, net | 4,418 | (29,694 | ) | |||||
Prepaids and other assets | 2,982 | 431 | ||||||
Trade accounts payable and accrued expenses | 1,568 | 20,977 | ||||||
Net cash provided by (used in) operating activities | 21,449 | (11,063 | ) | |||||
Investing activities | ||||||||
Purchase of property, plant and equipment | (13,178 | ) | (14,711 | ) | ||||
Proceeds from sale of equipment | 349 | 1,191 | ||||||
Net cash used in investing activities | (12,829 | ) | (13,520 | ) | ||||
Financing activities | ||||||||
Proceeds from revolving line of credit and long-term debt | — | 18,060 | ||||||
Principal payments on revolving line of credit and long-term debt | (12,181 | ) | (779 | ) | ||||
Proceeds from sale of stock related to stock option plan | — | 10,036 | ||||||
Net cash provided by (used in) financing activities | (12,181 | ) | 27,317 | |||||
Effect of exchange rate changes on cash activities | (174 | ) | 98 | |||||
Increase (decrease) in cash | (3,735 | ) | 2,832 | |||||
Cash at beginning of period | 8,325 | 5,159 | ||||||
Cash at end of period | $ | 4,590 | $ | 7,991 | ||||
The accompanying notes are an integral part of these statements.
4
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND PRINCIPLES OF CONSOLIDATION
Dril-Quip, Inc., a Delaware corporation (the “Company” or “Dril-Quip”) designs, manufactures, sells and services highly engineered offshore drilling and production equipment that is well suited for use in deepwater, harsh environment and severe service applications. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, wellhead connectors and diverters. Dril-Quip’s products are used by major integrated, large independent and foreign national oil and gas companies in offshore areas throughout the world. Dril-Quip also provides installation and reconditioning services and rents running tools for use in the installation and retrieval of its products.
The Company’s operations are organized into three geographic segments—Western Hemisphere (including North and South America; headquartered in Houston, Texas), Eastern Hemisphere (including Europe and Africa; headquartered in Aberdeen, Scotland) and Asia-Pacific (including the Pacific Rim, Southeast Asia, Australia, India and the Middle East; headquartered in Singapore). Each of these segments sells similar products and services and the Company has major manufacturing facilities in all three of its headquarter locations.
The condensed consolidated financial statements included herein have been prepared by Dril-Quip and are unaudited, except for the balance sheet at December 31, 2004, which has been derived from the audited financial statements at that date. In the opinion of management, the unaudited condensed consolidated interim financial statements include all adjustments, consisting solely of normal recurring adjustments, necessary for a fair presentation of the financial position as of September 30, 2005, the results of operations for each of the three and nine-month periods ended September 30, 2005 and 2004 and the cash flows for each of the nine-month periods ended September 30, 2005 and 2004. Although management believes the unaudited interim related disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in annual audited financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The results of operations and the cash flows for the nine-month period ended September 30, 2005 are not necessarily indicative of the results to be expected for the full year. The consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
2. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Some of the Company’s more significant estimates are those affected by critical accounting policies for revenue recognition, inventories and contingent liabilities as discussed more fully in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
5
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(UNAUDITED)
Cash and cash equivalents
Investments that have a maturity of three months or less from the date of purchase are classified as cash equivalents.
Inventories
Inventory costs are determined principally by the use of the first-in, first-out (FIFO) method, and are stated at the lower of cost or market. Inventory is valued principally using standard costs that are calculated based upon direct costs incurred and overhead allocations. Periodically, obsolescence reviews are performed on slow-moving inventories and reserves are established based on current assessments about future demands and market conditions. The inventory values have been reduced by a reserve for excess and obsolete inventories. Inventory reserves of $11.7 million and $9.3 million were recorded as of September 30, 2005 and 2004, respectively. If market conditions are less favorable than those projected by management, additional inventory reserves may be required.
Property, Plant and Equipment
Property, plant and equipment are carried at cost, with depreciation provided on a straight-line basis over their estimated useful lives.
Income Taxes
The Company accounts for income taxes using the liability method. Deferred income taxes are provided on income and expenses which are reported in different periods for income tax and financial reporting purposes.
Revenue Recognition
The Company delivers most of its products and services on an as-needed basis to its customers and records revenues as the products are shipped and as services are rendered. Allowances for doubtful accounts are determined generally on a case by case basis. Certain revenues are derived from long-term product contracts which generally require more than one year to fulfill. Revenues and profits on long-term product contracts are recognized under the percentage-of-completion method based on a cost-incurred basis. Losses, if any, on contracts are recognized when they become known. Contracts for long-term projects contain provisions for customer progress payments. Payments in excess of revenues recognized are included as a customer prepayment liability.
Foreign Currency
The financial statements of foreign subsidiaries are translated into U.S. dollars at current exchange rates except for revenues and expenses, which are translated at average rates during each reporting period. Translation adjustments are reflected as a separate component of stockholders’ equity and have no current effect on earnings or cash flows.
Foreign currency exchange transactions are recorded using the exchange rate at the date of the settlement. These amounts are included in selling, general and administrative costs in the consolidated statements of income.
Stock-Based Compensation
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting For Stock Based Compensation” (“SFAS No. 123”). Accordingly, no compensation cost has been recognized for stock options granted under the Company’s incentive plan.
6
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(UNAUDITED)
Under SFAS No. 123, pro forma information is required to reflect the estimated effect on net income and earnings per share as if the Company had accounted for the stock options using the fair value method. The fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
2002 | 2003 | 2004 | ||||||||
Risk free interest rate | 4.25 | % | 3.11 | % | No grants | |||||
Volatility of the stock price | .649 | .620 | ||||||||
Expected life of options (in years) | 5 | 5 | ||||||||
Expected dividend | 0.0 | % | 0.0 | % | ||||||
Calculated fair value per share | $ | 11.95 | $ | 8.22 |
Had compensation cost for the Company’s stock-based compensation plans been determined based on the fair value at the grant dates for awards consistent with the method available under SFAS No. 123, the Company’s net income and earnings per share for each of the three and nine month periods ended September 30, 2004, and 2005 would have been reduced to the pro forma amounts listed below.
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2004 | 2005 | 2004 | 2005 | |||||||||||||
(In thousands, except share data) | ||||||||||||||||
Net Income | ||||||||||||||||
As reported | $ | 3,250 | $ | 9,842 | $ | 8,587 | $ | 20,851 | ||||||||
Less: Compensation expense per SFAS No. 123, net of tax | (568 | ) | (414 | ) | (1,692 | ) | (1,267 | ) | ||||||||
Pro forma net income | $ | 2,682 | $ | 9,428 | $ | 6,895 | $ | 19,584 | ||||||||
Earnings per share | ||||||||||||||||
Basic | $ | 0.19 | $ | 0.56 | $ | 0.50 | $ | 1.19 | ||||||||
Diluted | $ | 0.19 | $ | 0.54 | $ | 0.50 | $ | 1.16 | ||||||||
Pro forma earnings per share | ||||||||||||||||
Basic | $ | 0.16 | $ | 0.53 | $ | 0.40 | $ | 1.12 | ||||||||
Diluted | $ | 0.15 | $ | 0.52 | $ | 0.40 | $ | 1.09 | ||||||||
There were no option grants during the nine months ended September 30, 2005.
Fair Value of Financial Instruments
The Company’s financial instruments consist primarily of cash and cash equivalents, receivables, payables and debt instruments. The carrying values of these financial instruments approximate their respective fair values as they are either short-term in nature or carry interest rates which approximate market rates.
Concentration of Credit Risk
Financial instruments which subject the Company to concentrations of credit risk consist principally of trade receivables. The Company grants credit to its customers, which operate primarily in the oil and gas industry. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company maintains reserves for potential losses and such losses have historically been within management’s expectations.
7
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(UNAUDITED)
Comprehensive Income
SFAS No. 130 establishes the rules for the reporting and display of comprehensive income and its components. SFAS No. 130 requires the Company to include unrealized gains or losses on foreign currency translation adjustments in other comprehensive income. Generally, gains are attributed to a weakening U.S. dollar and losses are the result of a strengthening U.S. dollar.
The following table provides comprehensive income for the periods indicated:
Three months ended September 30, | Nine months ended September 30, | ||||||||||||||
2004 | 2005 | 2004 | 2005 | ||||||||||||
(In thousands) | (In thousands) | ||||||||||||||
Net income | $ | 3,250 | $ | 9,842 | $ | 8,587 | $ | 20,851 | |||||||
Foreign currency translation adjustment | (317 | ) | (982 | ) | 538 | (5,636 | ) | ||||||||
Comprehensive income | $ | 2,933 | $ | 8,860 | $ | 9,125 | $ | 15,215 | |||||||
Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed considering the dilutive effect of stock options.
The net income used in the basic and dilutive earnings per share calculations is the same. The following table reconciles the number of common shares outstanding at September 30 of each year to the weighted average of common shares outstanding and the weighted average number of common and dilutive potential common shares outstanding for the purpose of calculating basic and diluted earnings per common share:
Three months ended September 30, | Nine months ended September 30, | |||||||
2004 | 2005 | 2004 | 2005 | |||||
(In thousands) | (In thousands) | |||||||
Number of common shares outstanding at end of period | 17,293 | 17,663 | 17,293 | 17,527 | ||||
Effect of using weighted average common shares outstanding | — | — | — | — | ||||
Weighted average basic common shares outstanding | 17,293 | 17,663 | 17,293 | 17,527 | ||||
Dilutive effect of common stock options | 100 | 482 | 53 | 410 | ||||
Weighted average diluted common shares outstanding | 17,393 | 18,145 | 17,346 | 17,937 | ||||
New Accounting Standards
In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151, Inventory Costs (SFAS 151). SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company believes that there will be no material effect on its financial statements upon adoption of this statement.
In December 2004, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 123R,Share-Based Payments. This statement is a revision of SFAS Statement No. 123,Accounting for Stock-BasedCompensation and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and its related
8
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(UNAUDITED)
implementation guidance. SFAS No. 123R addresses all forms of share based payment (“SBP”) awards including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. Under SFAS No. 123R, SBP awards result in a cost that will be measured at fair value on the awards’ grant date, based on the estimated number of awards that are expected to vest and will be reflected as compensation expense in the financial statements. In addition, this statement will apply to unvested options granted prior to the effective date.
This new standard is currently effective at the beginning of the fiscal year that begins after December 15, 2005. Dril-Quip, Inc. is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations and cash flows.
3. INVENTORIES
Inventories consist of the following:
December 31, 2004 | September 30, 2005 | |||||
(In thousands) | ||||||
Raw materials and supplies | $ | 17,815 | $ | 24,697 | ||
Work in progress | 16,247 | 38,343 | ||||
Finished goods | 76,701 | 74,053 | ||||
$ | 110,763 | $ | 137,093 | |||
9
DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(UNAUDITED)
4. GEOGRAPHIC AREAS
Three months ended September 30, | Nine months ended September 30, | |||||||||||||||
2004 | 2005 | 2004 | 2005 | |||||||||||||
(In thousands) | (In thousands) | |||||||||||||||
Revenues: | ||||||||||||||||
Western Hemisphere: | ||||||||||||||||
Products | $ | 20,323 | $ | 41,743 | $ | 58,250 | $ | 98,639 | ||||||||
Services | 4,216 | 7,871 | 14,606 | 20,944 | ||||||||||||
Intercompany | 9,240 | 15,235 | 26,801 | 36,149 | ||||||||||||
Total | $ | 33,779 | $ | 64,849 | $ | 99,657 | $ | 155,732 | ||||||||
Eastern Hemisphere | ||||||||||||||||
Products | $ | 22,608 | $ | 30,507 | $ | 61,272 | $ | 83,176 | ||||||||
Services | 3,272 | 4,835 | 10,494 | 12,586 | ||||||||||||
Intercompany | 265 | 51 | 1,051 | 592 | ||||||||||||
Total | $ | 26,145 | $ | 35,393 | $ | 72,817 | $ | 96,354 | ||||||||
Asia-Pacific | ||||||||||||||||
Products | $ | 6,643 | $ | 9,662 | $ | 16,895 | $ | 28,160 | ||||||||
Services | 1,160 | 706 | 3,004 | 2,439 | ||||||||||||
Intercompany | 568 | 1,132 | 1,439 | 2,225 | ||||||||||||
Total | $ | 8,371 | $ | 11,500 | $ | 21,338 | $ | 32,824 | ||||||||
Summary | ||||||||||||||||
Products | $ | 49,574 | $ | 81,912 | $ | 136,417 | $ | 209,975 | ||||||||
Services | 8,648 | 13,412 | 28,104 | 35,969 | ||||||||||||
Intercompany | 10,073 | 16,418 | 29,291 | 38,966 | ||||||||||||
Eliminations | (10,073 | ) | (16,418 | ) | (29,291 | ) | (38,966 | ) | ||||||||
Total | $ | 58,222 | $ | 95,324 | $ | 164,521 | $ | 245,944 | ||||||||
Income before taxes: | ||||||||||||||||
Western Hemisphere | $ | 758 | $ | 12,990 | $ | 2,183 | $ | 22,526 | ||||||||
Eastern Hemisphere | 1,692 | 532 | 4,993 | 1,516 | ||||||||||||
Asia-Pacific | 2,022 | 3,641 | 5,341 | 9,059 | ||||||||||||
Eliminations | 9 | (2,585 | ) | (253 | ) | (3,054 | ) | |||||||||
Total | $ | 4,481 | $ | 14,578 | $ | 12,264 | $ | 30,047 | ||||||||
September 30, | ||||||||
2004 | 2005 | |||||||
(In thousands) | ||||||||
Total Assets: | ||||||||
Western Hemisphere | $ | 160,006 | $ | 209,404 | ||||
Eastern Hemisphere | 94,468 | 126,775 | ||||||
Asia-Pacific | 27,359 | 34,194 | ||||||
Eliminations | (4,095 | ) | (5,965 | ) | ||||
$ | 277,738 | $ | 364,408 | |||||
10
Item 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following is management’s discussion and analysis of certain significant factors that have affected certain aspects of the Company’s financial position and results of operations during the periods included in the accompanying unaudited condensed consolidated financial statements. This discussion should be read in conjunction with the unaudited condensed consolidated financial statements included elsewhere herein, and with the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the annual consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
Overview
Dril-Quip designs, manufactures, sells and services highly engineered offshore drilling and production equipment that is well suited for use in deepwater, harsh environment and severe service applications. The Company designs and manufactures subsea equipment, surface equipment and offshore rig equipment for use by major integrated, large independent and foreign national oil and gas companies in offshore areas throughout the world. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, wellhead connectors and diverters. Dril-Quip also provides installation and reconditioning services and rents running tools for use in the installation and retrieval of its products.
Both the market for offshore drilling and production equipment and services and the Company’s business are substantially dependent on the condition of the oil and gas industry and, in particular, the willingness of oil and gas companies to make capital expenditures on exploration, drilling and production operations offshore. Oil and gas prices and the level of offshore drilling and production activity have historically been characterized by significant volatility.
Revenues.Dril-Quip’s revenues are generated from two sources: products and services. Product revenues are derived from the sale of offshore drilling and production equipment and service revenues are earned when the Company provides installation and reconditioning services as well as rental running tools for installation and retrieval of its products. For the nine months ended September 30, 2005, the Company derived 85% of its revenues from the sale of its products and 15% of its revenues from services. Service revenues generally correlate to revenues from product sales because increased product sales generate increased revenues from installation services and rental running tools. Substantially all of Dril-Quip’s sales are made on a purchase order basis. Purchase orders are subject to change and/or termination at the option of the customer. In case of a change or termination, the customer is required to pay the Company for work performed and other costs necessarily incurred as a result of the change or termination.
The Company accounts for larger and more complex projects that have relatively longer manufacturing time frames on a percentage of completion basis. For the first nine months of 2005, five projects representing approximately 15% of the Company’s revenues were accounted for using percentage of completion accounting. This percentage may fluctuate in the future. Revenues accounted for in this manner are generally recognized on the ratio of costs incurred to the total estimated costs. Accordingly, price and cost estimates are reviewed periodically as the work progresses and adjustments proportionate to the percentage of completion are reflected in the period when such estimates are revised. Losses, if any, are recognized when they become known. Amounts billed to or received from customers in excess of revenues recognized are classified as a current liability.
Foreign sales represent a significant portion of the Company’s business. In the nine months ended September 30, 2005, the Company generated approximately 67% of its revenues from sales outside the United States. In this period, approximately 63% (on the basis of revenues generated) of all products sold were manufactured in the United States.
11
Cost of Sales.The principal elements of cost of sales are labor, raw materials and manufacturing overhead. Variable costs, such as labor, raw materials, supplies and energy, generally account for approximately two-thirds of the Company’s cost of sales. Fixed costs, such as the fixed portion of manufacturing overhead, constitute the remainder of the Company’s cost of sales. Cost of sales as a percentage of revenues is also influenced by the product mix sold in any particular quarter and market conditions. The Company’s costs related to its foreign operations do not significantly differ from its domestic costs.
Selling, General and Administrative Expenses.Selling, general and administrative expenses include the costs associated with sales and marketing, general corporate overhead, compensation expense, legal expenses, foreign currency transaction gains and losses, and other related administrative functions.
Engineering and Product Development Expenses.Engineering and product development expenses consist of new product development and testing, as well as application engineering related to customized products.
Income Tax Provision.Dril-Quip’s effective tax rate has historically been lower than the statutory rate due to benefits from research and development expenditures, foreign sales and foreign income tax rate differentials.
Results of Operations
The following table sets forth, for the periods indicated, certain statement of operations data expressed as a percentage of revenues:
Three months ended September 30, | Nine months ended September 30, | |||||||||||
2004 | 2005 | 2004 | 2005 | |||||||||
Revenues: | ||||||||||||
Products | 85.2 | % | 85.9 | % | 82.9 | % | 85.4 | % | ||||
Services | 14.8 | 14.1 | 17.1 | 14.6 | ||||||||
Total | 100.0 | 100.0 | 100.0 | 100.0 | ||||||||
Cost of sales | 71.0 | 67.3 | 70.2 | 68.7 | ||||||||
Selling, general and administrative expenses | 13.6 | 11.3 | 14.3 | 12.1 | ||||||||
Engineering and product development expenses | 7.2 | 5.5 | 7.6 | 6.5 | ||||||||
Operating income | 8.2 | 15.9 | 7.9 | 12.7 | ||||||||
Interest expense | 0.5 | 0.6 | 0.5 | 0.5 | ||||||||
Income before income taxes | 7.7 | 15.3 | 7.4 | 12.2 | ||||||||
Income tax provision | 2.1 | 5.0 | 2.2 | 3.7 | ||||||||
Net income | 5.6 | % | 10.3 | % | 5.2 | % | 8.5 | % | ||||
Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004.
Revenues. Revenues increased by $37.1 million, or approximately 63.7%, to $95.3 million in the three months ended September 30, 2005 from $58.2 million in the three months ended September 30, 2004. The net increase resulted primarily from increased product revenues in the Western Hemisphere, Asia-Pacific and the Eastern Hemisphere of $21.4 million, $3.0 million and $7.9 million, respectively. Service revenues increased by approximately $4.8 million with increased service revenues in the Western Hemisphere of $3.7 million and in the Eastern Hemisphere of $1.6, offset by decreased revenues in Asia-Pacific of $500,000. In general, the increase in revenues resulted from increased demand for the Company’s products realized on a worldwide basis as oil and gas companies have increased their levels of capital expenditures on exploration, drilling and production operations offshore.
Cost of Sales.Cost of sales increased by $22.8 million, or approximately 55.2%, to $64.2 million for the three months ended September 30, 2005 from $41.3 million for the same period in 2004. As a percentage of
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revenues, cost of sales were approximately 67.3% and 71.0% for the three-month periods ending September 30, 2005 and 2004, respectively. The reduction in cost of sales as a percentage of revenues resulted primarily from manufacturing efficiencies realized from the increased utilization of the Company’s manufacturing facilities, pricing and changes in product mix.
Selling, General and Administrative Expenses.For the three months ended September 30, 2005, selling, general and administrative expenses increased by $2.9 million or approximately 36.1%, to $10.8 million from $7.9 million in the 2004 period. The increase in selling, general and administrative expenses was primarily due to increased labor and overhead expenses resulting from increased staffing levels in the areas of sales, administration and finance. The Company experienced approximately $330,000 in foreign currency transaction losses in the third quarter of 2005 versus approximately $197,000 in foreign currency transaction gains in the third quarter of 2004. Selling, general and administrative expenses as a percentage of revenues declined from 13.6% in 2004 to 11.3% in 2005.
Engineering and Product Development Expenses.For the three months ended September 30, 2005, engineering and product development expenses increased by $1.1 million or approximately 25% to $5.3 million from $4.2 million in the same period of 2004. This was primarily due to increased headcount and the corresponding increased salary expenses related to new product development. Engineering and product development expenses as a percentage of revenues declined from 7.2% in 2004 to 5.5% in 2005.
Interest Expense.Interest expense for the three months ended September 30, 2005 was $549,000 as compared to interest expense of $272,000 for the three-month period ended September 30, 2004. This change resulted primarily from higher interest rates and additional borrowing during the period ended September 30, 2005 under the Company’s unsecured revolving line of credit as compared to borrowings during the period ended September 30, 2004.
Income tax provision.Income tax expense for the three months ended September 30, 2005 was $4.7 million on income before taxes of $14.6 million, resulting in an effective tax rate of approximately 32%. Income tax expense for the three months ended September 30, 2004 was $1.2 million on income before taxes of $4.5 million, resulting in an effective tax rate of approximately 27%. This increase in the effective tax rate reflects a lower percentage of earnings in foreign jurisdictions with lower tax rates.
Net Income.Net income was approximately $9.8 million for the three months ended September 30, 2005 and $3.3 million for the same period in 2004, for the reasons set forth above.
Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004.
Revenues. Revenues increased by $81.4 million, or approximately 49.5%, to $245.9 million in the nine months ended September 30, 2005 from $164.5 million for the nine months ended September 30, 2004. The net increase resulted primarily from increased product revenues in the Western Hemisphere, Asia-Pacific and the Eastern Hemisphere of $40.4 million, $11.3 million and $21.9 million, respectively. Service revenues increased by approximately $7.8 million with increased service revenues in the Western Hemisphere of $6.3 million and in the Eastern Hemisphere of $2.1 million, offset by decreased revenues in Asia-Pacific of $600,000. In general, the increase in revenues resulted from increased demand for the Company’s products realized on a worldwide basis as oil and gas companies have increased their levels of capital expenditures on exploration, drilling and production operations offshore.
Cost of Sales.Cost of sales increased by $53.4 million, or approximately 46.3%, to $168.9 million for the nine months ended September 30, 2005 from $115.5 million for the same period in 2004. As a percentage of revenues, cost of sales were approximately 68.7% and 70.2% for each of the nine-month periods ending September 30, 2005 and 2004, respectively. The reduction in cost of sales as a percentage of revenues resulted primarily from manufacturing efficiencies realized from the increased utilization of the Company’s manufacturing facilities, pricing and changes in product mix.
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Selling, General and Administrative Expenses.For the nine months ended September 30, 2005, selling, general and administrative expenses increased by approximately $6.2 million or 26.6%, to $29.7 million from $23.5 million in the 2004 period. The increase in selling, general and administrative expenses was primarily due to increased labor and overhead expenses resulting from increased staffing levels in the areas of sales, administration and finance. The Company experienced approximately $16,000 in foreign currency transaction gains during the nine months ended September 30, 2005 versus approximately $516,000 in foreign currency transaction gains during the nine months ended September 30, 2004. Selling, general and administrative expenses as a percentage of revenues declined from 14.3% in 2004 to 12.1% in 2005.
Engineering and Product Development Expenses.For the nine months ended September 30, 2005, engineering and product development expenses increased by $3.5 million, or approximately 28% to $16.0 million from $12.5 million in the same period of 2004. This was primarily due to increased headcount and the corresponding increased salary expenses related to new product development. Engineering and product development expenses as a percentage of revenues declined from 7.6% in 2004 to 6.5% in 2005.
Interest Expense.Interest expense for the nine months ended September 30, 2005 was $1.3 million as compared to interest expense of $830,000 for the nine-month period ended September 30, 2004. This change resulted primarily from higher interest rates and additional borrowing during the period ended September 30, 2005 under the Company’s unsecured revolving line of credit as compared to borrowings during the period ended September 30, 2004.
Income tax provision. Income tax expense for the nine months ended September 30, 2005 was $9.2 million on income before taxes of $30.0 million, resulting in an effective tax rate of approximately 31%. Income tax expense for the nine months ended September 30, 2004 was $3.7 million on income before taxes of $12.3 million, resulting in an effective tax rate of approximately 30%. This increase in the effective tax rate reflects a lower percentage of earnings in foreign jurisdictions with lower tax rates.
Net Income.Net income was approximately $20.9 million for the nine months ended September 30, 2005 and $8.6 million for the same period in 2004, for the reasons set forth above.
Liquidity and Capital Resources
The primary liquidity needs of the Company are (i) to fund capital expenditures to improve and expand facilities and manufacture additional rental running tools and (ii) to fund working capital. The Company’s principal sources of funds are cash flows from operations and bank indebtedness.
Net cash provided by (used in) operating activities was approximately ($11.1 million) and $21.4 million for the nine months ended September 30, 2005 and 2004, respectively. The decline in cash flow from operating activities was principally due to increased working capital requirements attributable to inventory and trade receivables offset by net income, trade accounts payable and accrued expenses.
Capital expenditures by the Company were $14.7 million and $13.2 million for the nine months ended September 30, 2005 and 2004, respectively. This increase was primarily due to expenditures for land and facilities at the Company’s wholly owned subsidiary in Macae, Brazil and cost associated with running tools. Borrowing on the Company’s revolving line of credit was $17.9 million during the nine month period ended September 30, 2005 compared to payments of $11.2 million on the facility during the same period in 2004. Principal payments on long-term debt were $779,000 for the nine month period ended September 30, 2005 versus principal payments of $981,000 on long-term debt during the same period in 2004. Long-term debt borrowing totaled $160,000 during the first nine months of 2005. There was no long-term debt borrowing during the first nine months of 2004.
The Company has a credit facility with Guaranty Bank, FSB providing an unsecured revolving line of credit of up to $65 million. At the option of the Company, borrowing under this facility bears interest at either a rate
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equal to LIBOR (London Interbank Offered Rate) plus 1.5% or the Guaranty Bank base rate. The facility calls for quarterly interest payments and terminates on June 1, 2009. The facility also contains certain covenants including maintaining minimum tangible net worth levels and not exceeding specified funded debt amounts. The Company is in compliance with all loan covenants. As of September 30, 2005, the Company had drawn down $41.8 million under this facility for operating activities and capital expenditures.
Dril-Quip (Europe) Limited has a credit agreement with the Bank of Scotland dated March 21, 2001 in the original amount of U.K. Pounds Sterling 3.7 million (approximately U.S. $6.5 million). Borrowing under this facility bears interest at the Bank of Scotland base rate, which was 4.5% at September 30, 2005, plus 1%, and is repayable in 120 equal monthly installments, plus interest. Substantially all of this facility was used to finance capital expenditures in Norway. The outstanding balance of this facility at September 30, 2005 was approximately U.S. $3.9 million. The facility is secured by land and buildings in Aberdeen, Scotland and contains no restrictive financial covenants.
The Company believes that cash generated from operations plus cash on hand and its existing line of credit will be sufficient to fund operations, working capital needs and anticipated capital expenditure requirements in 2005. Cash needs may also be met by issuing securities in the capital markets. However, any significant future declines in hydrocarbon prices could have a material adverse effect on the Company’s liquidity. Should market conditions result in unexpected cash requirements, the Company believes that additional borrowing from commercial lending institutions would be readily available and more than adequate to meet such requirements.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is currently exposed to certain market risks related to interest rate changes and fluctuations in foreign exchange rates. The Company does not believe that these risks are material. The Company does not engage in any material hedging transactions, forward contracts or currency trading which could be subject to market risks inherent to such transactions.
Foreign Exchange Rate Risk
Through its subsidiaries, the Company conducts a portion of its business in currencies other than the United States dollar, principally the British pound sterling. The Company has not experienced significant transaction gains or losses associated with changes in currency exchange rates and does not anticipate such exposure to be material in the future. There is no assurance that the Company will be able to protect itself against currency fluctuations in the future.
Interest Rate Risk
As described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” the Company has entered into two credit facilities or loans that require the Company to pay interest at a floating rate. These floating-rate obligations expose the Company to the risk of increased interest expense in the event of increases in the short-term interest rates. Based upon the September 30, 2005 balance of approximately $45.7 million related to these floating rate obligations, each 1.0% rise in interest rates would result in additional annual interest expense to the Company of approximately $457,000, or $114,000 per quarter.
Item 4. CONTROLS AND PROCEDURES
In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company’s Co-Chief Executive Officers
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and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2005 to provide reasonable assurance that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
“Management’s Annual Reports on Internal Control over Financial Reporting” appears on page 22 of the 2004 annual report on Form 10-K.
There has been no change in the Company’s internal controls over financial reporting that occurred during the nine months ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.
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PART II—OTHER INFORMATION
Item 1.Legal Proceedings.
The Company is involved in a number of legal actions arising in the ordinary course of business. Although no assurance can be given with respect to the ultimate outcome of such legal actions, in the opinion of management, the ultimate liability with respect thereto will not have a material adverse effect on the Company’s financial position.
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3.Defaults Upon Senior Securities.
None.
Item 4.Submission of Matters to a Vote of Security Holders.
None.
Item 5.Other Information.
FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides safe harbor provisions for forward-looking information. Certain of the statements contained in this Form 10-Q are forward-looking statements. All statements, other than statements of historical facts, included in this Form 10-Q that address activities, events or developments that the Company expects, projects, believes or anticipates will or may occur in the future are forward-looking statements. Forward-looking statements can be identified by the use of words such as “believes,” “intends,” “may,” “should,” “could,” “anticipates,” “expected” or comparable terminology, or by discussions of strategies or trends. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Forward-looking statements relate to matters such as:
• | future operating results and cash flow; |
• | scheduled, budgeted and other future capital expenditures; |
• | working capital requirements; |
• | the availability of expected sources of liquidity; |
• | the market for Company products; |
• | the exploration and production activities of Company customers; |
• | effects of pending legal proceedings; and |
• | future operations, financial results, business plans and cash needs. |
The Company has based these statements on assumptions and analyses in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it 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
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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 following:
• | the volatility of oil and natural gas prices; |
• | the cyclical nature of the oil and gas industry; |
• | uncertainties associated with the United States and worldwide economies, including those due to political tensions in the Middle East and elsewhere; |
• | current and potential governmental regulatory actions in the United States and regulatory actions and political unrest in other countries; |
• | operating interruptions (including explosions, fires, weather-related incidents, mechanical failure, unscheduled downtime, labor difficulties, transportation interruptions, spills and releases and other environmental risks); |
• | the Company’s reliance on product development; |
• | technological developments; |
• | the Company’s dependence on key employees and skilled machinists, fabricators and technical personnel; |
• | the Company’s reliance on sources of raw materials; |
• | control by certain stockholders; |
• | impact of governmental regulation and environmental matters; |
• | competitive products and pricing pressures; |
• | reliance on significant customers; |
• | creditworthiness of our customers; |
• | access to capital markets; and |
• | war and terrorist acts. |
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. These forward-looking statements are not guarantees of our future performance, and the Company’s actual results and future developments may differ materially from those projected in 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.
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Item 6.
The following exhibits are filed herewith:
Exhibit No. | Description | |||
*3.1 | — | Restated Certificate of Incorporation of the Company (Incorporated herein by reference to Exhibit 3.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)). | ||
*3.2 | — | Bylaws of the Company (Incorporated herein by reference to Exhibit 3.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)). | ||
*4.1 | — | Certificate of Designations for Series A Junior Participating Preferred Stock (Incorporated herein by reference to Exhibit 3.3 to the Company’s Report on Form 10-Q for the Quarter ended September 30, 1997. (SEC File No. 1-13439)) | ||
*4.2 | — | Form of certificate representing Common Stock (Incorporated herein by reference to Exhibit 4.1 the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)). | ||
*4.3 | — | Registration Rights Agreement among the Company and certain stockholders (Incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)). | ||
*4.4 | — | Rights Agreement between the Company and ChaseMellon Shareholders Services, L.L.C., as rights agent (Incorporated herein by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)). | ||
*10.1 | — | Form of Indemnification Agreement (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on October 17, 2005 (SEC File No. 1-13439)). | ||
31.1 | — | Rule 13a-14(a)/15d-14(a) Certification of Larry E. Reimert. | ||
31.2 | — | Rule 13a-14(a)/15d-14(a) Certification of Gary D. Smith. | ||
31.3 | — | Rule 13a-14(a)/15d-14(a) Certification of J. Mike Walker. | ||
31.4 | — | Rule 13a-14(a)/15d-14(a) Certification of Jerry M. Brooks. | ||
32.1 | — | Section 1350 Certification of Larry E. Reimert. | ||
32.2 | — | Section 1350 Certification of Gary D. Smith. | ||
32.3 | — | Section 1350 Certification of J. Mike Walker. | ||
32.4 | — | Section 1350 Certification of Jerry M. Brooks. |
* | Incorporated herein by reference as indicated. |
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SIGNATURE
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.
DRIL-QUIP, INC. | ||
By: | /s/ JERRY M. BROOKS | |
Jerry M. Brooks, Chief Financial Officer (Principal Accounting Officer and Duly Authorized Signatory) |
Date: November 9, 2005
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