Forward Looking Statements
This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (forward-looking statements) that involve certain risks and uncertainties. The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto appearing elsewhere in this report. Except for the historical information contained herein, any statements that refer to expectations, projections or other characterization of future events or circumstances, and especially those which include variations of the words “believes,” “intends,” “estimates,” “anticipates,” “expects,” “plans,” or similar words or variations thereof, are likely to be forward-looking statements, and as such, are likely to concern matters involving risk, uncertainty, unpredictability and other factors that could materially and adversely affect the outcome or results indicated by or inferred from the statements themselves. Such factors include, among others, the following: the risk that the working interests in the SAEC oil and gas properties and the operations of SA Oil may not be profitable; the risk that the Company will recognize losses from operations; the risk that all of the foregoing factors or other factors could cause fluctuations in the Company’s operating results and the price of the Company’s common stock; and other risks detailed in this quarterly report and from time to time in the Company’s other filings with the Securities and Exchange Commission. Therefore, the reader is advised that the following discussion should be considered in light of the discussion of risks and other factors contained in this quarterly report on Form 10-QSB and in the Company’s other filings with the Securities and Exchange Commission, and that no statements contained in the following discussion or in this Form 10-QSB should be construed as a guarantee or assurance of future performance or future results, and the reader is cautioned to not place undue reliance on such forward-looking statements. The forward-looking statements made herein are only made as of the date of this quarterly report on Form 10-QSB, and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.
General
On November 9, 2004, the Company, through its 80% owned subsidiary, Scottsdale Thompson Peak, LLC, sold the property located at 20225 North Scottsdale Road, Scottsdale, Arizona. The total sales price for the property was $31,400,000. Following the payment of debt service obligations and related interest due of $23,401,000, which were inclusive of a $20,000,000, 5.9% loan, a $2,500,000, 6% loan and a $1,800,000, 10% loan, and the payment of closing costs and pro-rations of $531,000, cash proceeds to Scottsdale Thompson Peak, LLC were $7,468,000. The Company’s 80% share of the net proceeds was $5,974,000. This transaction represents the sale of the Company’s real estate segment. See Note 3 to the accompanying unaudited condensed consolidated financial statements of the Company for additional information related to the sale of the discontinued operations.
The Company owns working interests in oil and gas properties primarily located in Oklahoma and Texas as discussed in Note 6 of the accompanying unaudited condensed consolidated financial statements of the Company.
Other than the transactions described above, the Company has no significant operations and there can be no assurance that the Company’s operations will be profitable. The Company’s future revenues and operating costs may fluctuate significantly due to any one factor and or a combination of factors, many of which are outside management’s control. Management has identified the most important risk factors that may affect operating results in the future as follows:
Oil and gas prices: Oil and gas prices are volatile. A decline in prices could adversely affect the Company’s financial position, financial results and cash flows. The Company’s revenues and operating results depend primarily upon the prices received for oil and gas products. Historically, the markets for oil and gas have been volatile and they are likely to continue to be volatile. The volatility of the energy markets makes it extremely difficult to predict future oil and gas price movements with any certainty.
Competition: Competition in the oil and natural gas industry is intense. Many competitors have greater financial and other resources than the Company.
Exploration and development drilling: Exploration and development drilling may not result in commercially productive reserves. The new wells that the Company may participate in may not be productive and the Company may not recover all or any portion of its investment in wells in which it participates. The cost of drilling, completing and operating a well is often uncertain, and cost factors can adversely affect the economics of a project.
Government and environmental regulations: The oil and gas industry is subject to regulation at the federal, state, and local level, and some of the laws, rules and regulations that govern the Company’s oil and gas activities may carry penalties for noncompliance. The existence of such laws and regulations has, to date, had no material adverse effect on the Company’s operations, and the cost of compliance has not been material. The requirements imposed by such laws and regulations are frequently changed and subject to interpretation and the Company is unable to predict the ultimate cost of compliance with these requirements or their effect on its future operations, capital expenditures, earnings or competitive position.
Sarbanes-Oxley: The enactment of the Sarbanes-Oxley Act of 2002 has led to increased compliance costs and additional burdens on management. Section 404 of the Sarbanes-Oxley Act of 2002, scheduled to be in effect for the Company’s fiscal year ending December 31, 2007, requires the Company’s management to assess the effectiveness of the Company’s internal controls over financial reporting and include an assertion in the Company’s annual report as to the effectiveness of the Company’s controls. The Company’s independent registered public accounting firm will be required to attest to whether management’s assessment of the effectiveness of the Company’s internal controls over financial reporting is fairly stated in all material respects and separately report on whether it believes management maintained, in all material respects, effective internal controls over financial reporting as of December 31, 2007. The Company expects that the adoption of Section 404 will require significant amounts of management time and resources, and will significantly increase the Company’s costs both internal and in the form of higher fees paid to its external auditors and other financial advisors, that may adversely impact the Company’s operating results.
Stock price volatility: The Company’s common shares are currently listed for public trading on the OTC Bulletin Board. The trading price of the Company’s common shares has been subject to wide fluctuations. Trading prices of the Company’s common shares may fluctuate in response to a number of factors, many of which will be beyond the Company’s control. The Company’s common stock’s small public float, extremely limited trading volume, and bid-asked trading price spread have limited the Company’s ability to use its common stock as acquisition currency and has significantly limited the ability of shareholders to sell their shares without also reducing the trading price of the common stock.
On January 31, 2006, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with JDMD Investments, L.L.C., an Arizona limited liability company (“JDMD”), Stratford Holdings Investment, L.L.C., an Arizona limited liability company (“Stratford Holdings”), and Stratford Acquisition, L.L.C., an Arizona limited liability company and a wholly-owned subsidiary of Stratford Holdings (“Stratford Acquisition” and together with JDMD and Stratford Holdings, the “Buyout Parties”), pursuant to which Stratford Acquisition will merge with and into the Company (the “Merger”), with the Company continuing as the surviving corporation.
Pursuant to the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of common stock of the Company (“Common Stock”), other than Common Stock owned by the Company or any wholly-owned subsidiary of the Company, by the Buyout Parties and by shareholders who properly exercise dissenters’ rights, will be converted into the right to receive $0.80 in cash per share, without interest. On April 20, 2006, the Company entered into an Amendment to Agreement and Plan of Merger (the “Amendment”) with the Buyout Parties. The Amendment amends the Merger Agreement. Pursuant to the terms of the Amendment, the consideration payable to each shareholder of the Company upon consummation of the Merger was increased from $0.80 per share to $0.90 per share. All other terms of the Merger Agreement remained the same. JDMD intends to finance the Merger through use of the Company’s cash reserves, which will become available immediately upon the effectiveness of the Merger, and other cash available to JDMD from its business activities unrelated to the Company.
This is a “going private” transaction. The Merger will extinguish all equity interests in the Company held by its public shareholders and will result in the Company being a wholly-owned subsidiary of Stratford Holdings. JDMD, as sole owner of Stratford Holdings, will be the beneficiary of the earnings and growth of the Company, if any, following the Merger and will bear the risks of any decrease in the value of the Company following the Merger.
Following the Merger, the Company’s common stock will no longer be publicly traded, and the Company will no longer file periodic reports with the Securities and Exchange Commission.
The Merger is conditioned upon, among other things, the affirmative vote of the holders of a majority of the outstanding unaffiliated shares of Common Stock (those not owned, directly or indirectly, by the Buyout Parties or their affiliates) and the affirmative vote of the holders of a majority of all outstanding shares of Common Stock (including those shares owned, directly or indirectly, by the Buyout Parties or their affiliates). Refer to the Company’s filings on Form 8-K dated January 31, 2006 and April 20, 2006, and filed with the Securities and Exchange Commission on February 1, 2006 and April 20, 2006, respectively, for additional information.
Prior to the date that the Company’s shareholders approve and adopt the Merger Agreement and the Merger, the Board of Directors is permitted to engage in discussions and negotiations with a third party regarding a competing acquisition offer if: (a) the Board determines in good faith that any such competing offer is a superior alternative to the Merger; (b) the Board reasonably determines in good faith that Board’s fiduciary duties under Arizona law require discussions to be conducted with the third party; and (c) the Company provides Stratford Holdings with written notice of the competing offer and the material terms of such offer. The Board of Directors is permitted by the Merger Agreement to withdraw its recommendation of the Merger Agreement and the Merger only if it: (a) reasonably determines in good faith, after consultation with and taking into account the advice of its outside legal counsel, that such action is necessary in order for the Board to comply with its fiduciary duties under Arizona law; and (b) has given notice of its intention to withdraw its recommendation, and has not received an offer from Stratford Holdings within five business days which matches or exceeds the competing acquisition offer.
There can be no assurance that the Company will consummate the Merger and such failure to consummate the Merger could negatively impact the market price of the Company’s common stock.
The risks described above are not the only risks and uncertainties that may negatively impact the Company’s business or its operating results. Additional risks and uncertainties not presently known to the Company may also impair the Company’s business operations, operating results or financial condition.
Critical Accounting Policies and Estimates
The consolidated balance sheet and consolidated statements of income have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires the Company to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to oil and gas interests, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. The Company accrues production income and expense based upon historical performance, costs, and prices received for oil and gas. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. Future adverse changes in market conditions or poor operating results could result in losses or an inability to recover the carrying value of our oil and gas interests, thereby possibly requiring an impairment charge in the future.
The investments in oil and gas properties are operated by unaffiliated entities (“Operators”) who are responsible for drilling, administering and producing activities for leases jointly owned by working interest owners pursuant to the terms of the applicable Operating Agreements. The Company’s portion of exploration, drilling, and equipment and capital expenditures relating to the wells are advanced and billed by Operators through authorization for expenditures. The Company’s portion of operating expenditures relating to the wells are billed monthly by the Operators through joint interest billings.
The Company utilizes the successful efforts method of accounting for its oil and gas properties. Under this method all costs associated with productive wells are capitalized while nonproductive exploration costs are expensed. Capitalized costs relating to proven properties are depleted using the straight-line method over a period of five to seven years.
Capitalized costs of individual properties abandoned or retired are charged to accumulated depletion, depreciation and amortization. Proceeds from sales of individual properties are credited to property costs. No gain or loss is recognized until the entire basis of all of the properties is sold or abandoned.
Liquidity and Capital Resources
At March 31, 2006, the Company had $6,342,000 in available cash resources. A significant amount of the cash available at March 31, 2006 was generated from the one-time sale of the Property held by the Company’s 80% subsidiary, STP. Proceeds to the Company from the sale of the Property by STP were $5,974,000.
During the three months ended March 31, 2006, the Company, through its wholly-owned subsidiary, SAEC, elected to participate proportionately in the drilling of one new development well with costs paid by the Company of $41,000. Funds for the development drilling came from Company cash. Future costs to complete the development well, should it prove to be a producing property, will be approximately $16,000 and will be funded with Company cash. Also, during the three months ended March 31, 2006, the Company paid $42,000 in additional development drilling costs on three development wells in which the Company had elected to participate proportionately during 2005. Future costs to complete the three development wells should they prove to be producing properties, will be approximately $105,000 and will be funded with Company cash. In addition, the Company paid $35,000 for equipment on five producing wells.
The Company maintains its excess cash funds in interest-bearing deposits, which at times exceed the amount insured by the Federal Deposit Insurance Corporation. The Company has not sustained any losses as a result of maintaining its excess cash funds in such interest bearing deposits and does not expect to do so in the future. The Company believes that its current cash and cash equivalents will be sufficient to meet its forecasted operating cash needs for 2006.
Results of Operations - Three Month Period Ended March 31, 2006, Compared with Three Month Period Ended March 31, 2005
The Company reported net income of $13,000 and $19,000 for the three month periods ended March 31, 2006 and 2005, respectively.
Oil and Gas Revenues. For the three months ended March 31, 2006, oil and gas revenues were $380,000, increasing $111,000, or 41% from $269,000 for the three months ended March 31, 2005. Oil and gas revenues accounted for 85% and 87% of the total revenues from operations for the three month periods ended March 31, 2006 and 2005, respectively. The increasing oil and gas prices are the primary factor in the increase in revenues. Additional production volumes, primarily due to positive drilling results for development properties in which the Company elected to participate, also contributed to the increase.
Separately, the SA Oil properties generated $199,000 and $156,000 in revenue for the three months ended March 31, 2006 and 2005, respectively. The working interests in the SAEC oil and gas properties generated $177,000 and $110,000 in revenue for the three months ended March 31, 2006 and 2005, respectively. The SARC oil and gas properties generated $4,000 and $3,000 in revenues for the three months ended March 31, 2006 and 2005, respectively.
Oil and gas activities are the major part of the Company’s continuing operations. The Company sells its gas in the spot market, which is highly seasonal and volatile. Oil prices will continue to be affected by world markets and conditions.
Interest and Other Income. Interest and other income increased from $39,000 for the three months ended March 31, 2005 to $65,000 for the three months ended March 31, 2006. The increase is a result of higher interest rates being received in 2006 on the Company’s cash accounts.
General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related benefits, office rent, legal and accounting fees, and other administrative costs incurred in our office. General and administrative expenses increased 73%, from $139,000 for the three months ended March 31, 2005 to $240,000 for the three months ended March 31, 2006. The increase is primarily due to legal and accounting costs of $99,000 related to the Merger Agreement (see Note 2 - Going- Private Proposal).
Depreciation, Depletion and Amortization. Depreciation, depletion and amortization expense increased from $78,000 for the three months ended March 31, 2005 to $94,000 for the three months ended March 31, 2006. The increase in expense of $16,000 for the three months ended March 31, 2006 is due primarily to the additional depletion expense of $15,000 recognized on eight SAEC development wells completed subsequent to March 31, 2005 and an increase of $1,000 in amortization on intangible drilling costs capitalized for the SAEC properties.
Oil and Gas Operations. Oil and gas operations expense increased from $72,000 for the three months ended March 31, 2005 to $98,000 for the three months ended March 31, 2006. The increased expense for the three months ended March 31, 2006 resulted primarily from higher field operating expenses from an expanded number of properties and higher maintenance costs.
Discontinued Operations. As previously discussed above in Note 3, a real estate Property was sold by STP to Holualoa, effective November 9, 2004 and has been accounted for as a discontinued operation and therefore there are no results of operations for the three month periods ending March 31, 2006 and 2005.
Related Party Transactions
Related party transactions are discussed in Note 7 of the accompanying unaudited condensed consolidated financial statements of the Company.
Capital Requirements
During the three months ended March 31, 2006, the Company utilized $118,000 in cash to fund development costs and capital additions for the oil and gas interests, as discussed in Note 6. Future costs to complete the four development wells, should they prove to be producing properties, will be approximately $121,000 and will be funded from Company cash.
Other than the capital requirements described above, the Company does not have any material plans for future capital expenditures at the present time.
Impact of Inflation
Inflation has not had a significant impact on the Company’s results of operations.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements as defined by Item 303(c) of Regulation S-B.
Our Chief Executive Officer, our President and our Controller, based on the evaluation of our disclosure controls and procedures (as defined in rules 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended) required by paragraph (b) of Rule 13a-15 or Rule 15d-15, have concluded that, as of March 31, 2006 our disclosure controls and procedures were effective to ensure that the information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information was accumulated and communicated to our Chief Executive Officer, our President and our Controller, in a manner that allowed for timely decisions regarding disclosure.
During the three months ended March 31, 2006, there was no change in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Responses to Items 1 through 5 are omitted since these items are not applicable.
