Reflected in the comparison above are the effects in the first half of 2006 of:
| · | net cash provided by operations of $98.7 million |
| · | proceeds from disposals of property, plant and equipment of $34.3 million |
| · | proceeds from stock option and convertible debenture plans of $7.8 million |
| · | capital expenditures of $258.1 million |
| · | cash dividend payments of $38.5 million |
| · | debt repayments of $32.5 million |
Operating cash flows during the first half of 2006 were after a $178.8 million net investment in working capital during the period. Receivables increased by $91.4 million due primarily to recoverable hurricane-related survey and salvage costs and the impact of revenue growth. Inventories increased by $67.3 million due primarily to a growing manufacturing backlog. Non-cash or non-operating adjustments to net income during the first half of 2006 totaled $93.6 million and included deferred income taxes of $57.2 million and depreciation of $42.1 million.
Capital expenditures during the first half of 2006 included $38.1 million related to the construction of our third Tarzan Class jack-up rig, the Hank Boswell, $23.7 million related to construction of our fourth Tarzan Class jack-up rig and $89.8 million related to the construction of 12 new 2000 horsepower land rigs.
The Hank Boswell was recently relocated to our Sabine Pass, Texas facility for final outfitting, and delivery is scheduled for late September 2006. Another shipyard is constructing the hull of our fourth Tarzan Class jack-up and the rig should be completed during the third quarter of 2007. We currently expect to continue funding construction of our third and fourth Tarzan Class rigs from available cash, though we earlier applied under the Title XI program of U. S. Department of Transportation’s Maritime Administration (MARAD) for government-guaranteed financing for up to $176 million of the cost of these rigs on terms and conditions similar to those in our outstanding debt agreements.
In December 2005, our Board of Directors approved the construction of two of a new class of jack-up rig. The 240C will be equipped for high pressure/high temperature drilling in water depths of up to 400 feet and have more deck space, higher variable load, more drilling capacity (two million pound hook-load capability), more cantilever reach (up to 100 feet) and greater personnel capacity (108 man) than the 116-C. Each rig will cost approximately $165 million and will be constructed in Vicksburg, Mississippi with delivery expected in mid 2008 and early 2009. Capital expenditures during the first half of 2006 included $5.6 million related to the construction of our first two 240C jack-up rigs. We currently expect to continue funding construction with available cash, but will consider attractive financing alternatives.
We currently estimate that remaining 2006 capital expenditures will be between $230 million and $260 million, including approximately $20 million towards the completion of the Hank Boswell, $50-60 million towards the construction of our fourth Tarzan Class jack-up, $55-65 million towards the construction of our first 240C class jack-up and approximately $65 million towards the completion of our 12 new land rigs.
In October 2005, we sold our only semi-submersible rig for approximately $60 million in cash. Payment for the rig is scheduled to occur over a 15-month period ending in January 2007, at which point the title to the rig will transfer to the buyer. We retained ownership of much of the drilling equipment on the rig and will continue to provide a number of operating personnel under a separate services agreement. The transaction is being accounted for as a sales-type lease with the expected gain on the sale and imputed interest income deferred until the $14 million net book value of the rig had been recovered. At June 30, 2006, we had received payments totaling $35.6 million and included in assets the present value of expected future collections of $23.4 million. During the six months ended June 30, 2006, we recognized $20.1 million of gain on the sale and $1.5 million of interest income related to this agreement.
Our debt agreements contain provisions that require minimum levels of working capital and stockholders’ equity and limit the amount of long-term debt and, in the event of noncompliance, restrict investment activities, asset purchases and sales, lease obligations, borrowings and mergers or acquisitions. We were in compliance with each of these provisions at June 30, 2006. Our debt agreements also specify the minimum insurance coverage for our financed rigs. Upon our April 1, 2006 policy renewal, we determined that windstorm coverage meeting the requirements of our existing debt agreements was cost-prohibitive. We received from MARAD a waiver of any defaults related to insurance requirements through June 30, 2006. On August 8, 2006, we provided additional security to MARAD in return for an extension of the waiver. We have established a separate cash account containing the amount necessary to repay in full the outstanding Bob Palmer note, currently $156.1 million, and in which MARAD has a security interest. We are not obligated to repay the Bob Palmer note in advance of its scheduled maturity. In addition, we agreed to maintain at least $100 million of unrestricted cash. Finally, we agreed to restrictions on the use of certain insurance proceeds should we experience further losses. The waiver is in effect as long as these additional security provisions are in place. Each of the additional security provisions will be released by MARAD if we are able to obtain windstorm coverage that satisfies the requirements of our existing debt agreements.
On February 25, 2005, in conjunction with the sale of our aviation operations, we paid a special cash dividend of $.25 per common share to stockholders of record on February 9, 2005. On September 1, 2005, in conjunction with the sale of several non-core assets, we paid a special cash dividend of $.25 per common share to stockholders of record on August 17, 2005. On February 24, 2006, we paid a special cash dividend of $.25 per common share to stockholders of record on February 8, 2006. On May 2, 2006, we announced our intention to pay a regular quarterly dividend of $.10 per common share, the first of which was paid on May 26, 2006 to stockholders of record on May 12, 2006. At June 30, 2006, we had approximately $544 million of retained earnings available for distribution to stockholders under the most restrictive provisions of our debt agreements. On July 25, 2006, we announced a dividend of $.10 per common share payable on August 18, 2006 to stockholders of record on August 4, 2006.
We contributed $131.4 million to our defined benefit pension plans over the 2003 to 2005 period, including almost $90 million during 2005. Minimum contribution amounts are determined based upon actuarial calculations of pension assets and liabilities that involve, among other things, assumptions about long-term asset returns and interest rates. Similar calculations were used to estimate pension costs and obligations as reflected in our consolidated financial statements, which showed an accumulated other comprehensive loss resulting from unfunded pension liabilities of $83.7 million at December 31, 2005. We expect to make additional pension contributions over the next several years even if plan assets perform as expected, though our funding requirement during the remainder of 2006 is expected to be less than $3 million. Pending federal legislation aimed at strengthening underfunded pension plans could significantly increase and accelerate our future funding requirements. We currently estimate that our 2006 pension expense will increase by approximately $5 million or about 25% over the 2005 amount.
Based on current and anticipated near-term operating levels, we believe that operating cash flows together with existing working capital will be adequate to sustain planned capital expenditures and debt service and other requirements at least through the remainder of 2006. We currently have no other available credit facilities, but believe financing could be obtained if deemed necessary.
During the third quarter of 2005, Rowan lost four offshore rigs, including the Rowan-Halifax, and incurred significant damage on a fifth as a result of Hurricanes Katrina and Rita. Since that time, we have been conducting salvage operations. At June 30, 2006, we included in Receivables $56.5 million of costs incurred to locate the lost or damaged rigs, salvage related equipment, remove debris, wreckage and pollutants from the water, mark or clear navigational hazards and clear rights of way. We expect to incur additional costs in the near term to fulfill our salvage obligations in amounts that may exceed our expenditures to date. Such additional costs will depend on the extent and nature of work ultimately required and the duration thereof. Our insurance carriers have notified us that they are reserving their right to deny reimbursement for any costs incurred in wreck and debris removal activities that they believe are outside the scope of our coverage. Although we believe that we have adequate insurance coverage and will be reimbursed for costs incurred and to be incurred, it is possible that a portion of such costs will not be reimbursed, requiring a charge to future operations for any shortfall. On July 20, 2006, we filed a lawsuit styled Rowan Companies, Inc. vs. Certain Underwriters at Lloyd’s and Insurance Companies Subscribing to Cover Note ARS 4183 in the 215th Judicial District Court of Harris County, Texas. The lawsuit alleges, among other things, breach of contract and seeks a declaratory judgment. On August 8, 2006, the Company agreed to dismiss its lawsuit while the parties attempt to resolve the claims without litigation. If such an agreement cannot be reached, the underwriters have agreed that the Company may re-file its lawsuit in Harris County before the underwriters file suit.
We leased the Rowan-Halifax under a charter agreement that commenced in 1984 and was scheduled to expire in March 2008. The rig was insured for $43.4 million, a value that we believe satisfied the requirements of the charter agreement, and by a margin sufficient to cover the $6.3 million carrying value of our equipment installed on the rig. However, the owner of the rig has claimed that the rig should have been insured for its fair market value and is seeking recovery from us for compensation above the insured value. Thus, we have assumed no insurance proceeds related to the Rowan-Halifax and recorded a charge during 2005 for the full carrying value of our equipment. On November 3, 2005, we filed a declaratory judgment action styled Rowan Companies, Inc. vs. Textron Financial Corporation and Wilmington Trust Company as Owner Trustee of the Rowan-Halifax 116-C Jack-Up Rig in the 215th Judicial District Court of Harris County, Texas. Recent appraisals obtained by the owner indicate a fair market value of the rig in the range of $75-91 million.
During 2004, we learned that a unit of the U. S. Department of Justice (DOJ) is conducting a criminal investigation of environmental matters involving several of our offshore drilling rigs. We are cooperating with the investigation, including responding to the DOJ’s subpoenas for certain documentation regarding our operations.
The DOJ has a broad range of civil and criminal sanctions under environmental and other laws, which it may seek to impose against corporations and individuals in appropriate circumstances including, but not limited to, injunctive relief, fines (including multi-million dollar fines), penalties, modifications to business practices and compliance programs and other sanctions. Based on current information, we cannot predict what, if any, actions may be taken by the DOJ or other authorities or the effect any such actions may have on our consolidated financial statements.
During 2005, we learned that a unit of the DOJ is conducting an investigation of potential antitrust violations among helicopter transportation providers in the Gulf of Mexico. Our former aviation subsidiary, which was sold effective December 31, 2004, has received a subpoena in connection with the investigation. We have been contacted by the DOJ, but the purchaser has made a claim that we are responsible for any exposure it may have. We have disputed that claim.
We are involved in various other legal proceedings incidental to our businesses and are vigorously defending our position in all such matters. We believe that there are no known contingencies, claims or lawsuits that will have a material adverse effect on our financial position, results of operations or cash flows.
Critical Accounting Policies and Management Estimates.
Our significant accounting policies are outlined in Note 1 of the Notes to Consolidated Financial Statements included in our Form 10-K for the year ended December 31, 2005. These policies, and management judgments, assumptions and estimates made in their application, underlie reported amounts of assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. We believe that our most critical accounting policies and management estimates involve revenue recognition (primarily upfront service fees for equipment moves and modifications and long-term manufacturing projects), property and depreciation (particularly capitalizable costs, useful lives and salvage values) and pension and other postretirement benefit liabilities and costs (specifically assumptions used in actuarial calculations), as changes in such policies and/or estimates would produce significantly different amounts from those reported herein.
Revenue recognition. Our drilling contracts generally provide for payment on a day rate basis, and revenues are recognized as the work progresses with the passage of time. We frequently receive lump-sum payments at the outset of a drilling assignment as upfront service fees for equipment moves or modifications, and such payments (and related costs) are recognized as drilling revenues (and expenses) over the contract period. At June 30, 2006, we had deferred $55.7 million of revenues and $32.1 million of costs related to such upfront service fees, with such amounts related to mobilization and modification activities in connection with our four-rig Saudi Arabia contract.
We generally recognize manufacturing sales and related costs when title passes as products are shipped. Revenues from long-term manufacturing projects such as rigs and rig kits are recognized on the percentage-of-completion basis using costs incurred relative to total estimated costs. We do not recognize any estimated profit until such projects are at least 10% complete, though a full provision is made immediately for any anticipated losses. Total estimated costs are critical to this process and are therefore reviewed on a regular basis. At June 30, 2006, we had received $157.9 million of progress payments toward long-term manufacturing projects and had recognized $73.7 million of manufacturing revenues and $60.8 million of costs related to such projects on the percentage-of-completion basis.
Property and depreciation. We provide depreciation under the straight-line method from the date an asset is placed into service based upon estimated service lives ranging up to 40 years and salvage values ranging up to 20%. We continue to operate 14 offshore rigs that were placed into service during 1971-1986 and assigned lives ranging from 12 to 15 years. Our newest and most significant assets, the Super Gorilla and Tarzan Class rigs, which collectively comprise almost two-thirds of our property, plant and equipment carrying value, carry a 25-year service life.
Expenditures for new property or enhancements to existing property are capitalized and expenditures for maintenance and repairs are charged to operations as incurred. Capitalized cost includes labor expended during installation and, on newly constructed assets, a portion of interest cost incurred during the construction period. Long-lived assets are reviewed for impairment whenever circumstances indicate their carrying amounts may not be recoverable, such as following a sustained deficit in operating cash flows caused by a prominent decline in overall rig activity and average day rates.
Pension and other postretirement benefit liabilities and costs. As previously mentioned, our pension and other postretirement benefit liabilities and costs are based upon actuarial computations that reflect our assumptions about future events, including long-term asset returns, interest rates, annual compensation increases, mortality rates and other factors. Key assumptions for 2006 include discount rates ranging from 5.56% to 5.68%, an expected long-term rate of return on pension plan assets of 8% and annual healthcare cost increases ranging from 10% in 2006 to 5% in 2011 and beyond. The assumed discount rate is based upon the average yield for Moody’s Aa-rated corporate bonds and the rate of return assumption reflects a probability distribution of expected long-term returns that is weighted based upon plan asset allocations. A 1-percentage-point decrease in the assumed discount rate would increase our recorded pension and other postretirement benefit liabilities by approximately $60 million, while a 1% change in the expected long-term rate of return on plan assets would change annual net benefits cost by approximately $2.8 million. A 1-percentage-point increase in the assumed healthcare cost trend rate would increase 2006 other benefits costs by $0.5 million.
Our adoption, effective January 1, 2006, of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, as amended, which requires the measurement and recognition of stock-based compensation expense based upon grant date fair value, reduced our net income during the six months ended June 30, 2006 by approximately $1.9 million or $.02 per share. Prior to 2006, we used the intrinsic value method of accounting for stock-based employee compensation pursuant to Accounting Principles Board Opinion No. 25. We estimate that use of the fair value method would have reduced reported amounts of net income and net income per share by approximately $1.7 million, or $.01 per share for the six months ended June 30, 2005.
Our adoption, effective January 1, 2006, of Statement of Financial Accounting Standards No. 151, “Inventory Costs”, which clarifies the distinction between costs that are allocable to inventory and those that are expensed as incurred, did not materially impact our financial position or results of operations.
Financial Accounting Standards Board Interpretation (FIN) No. 48, issued in June 2006, clarifies the measurement and financial statement recognition of the effects of tax positions taken or expected to be taken in a tax return. We are currently evaluating the provisions of FIN 48 but do not expect our adoption, effective January 1, 2007, to materially affect our financial position or results of operations.
This report contains forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including, without limitation, statements as to the expectations, beliefs and future expected financial performance of Rowan that are based on current expectations and are subject to certain risks, trends and uncertainties that could cause actual results to differ materially from those projected by us. Among the factors that could cause actual results to differ materially are the following: oil, natural gas and other commodity prices; the level of offshore expenditures by energy companies; energy demand; the general economy, including interest rates and inflation; weather conditions in our principal operating areas; and environmental and other laws and regulations. Details of these and other risks have been disclosed in Rowan’s filings with the U. S. Securities and Exchange Commission - see Part II, Item IA of this Quarterly Report on Form 10-Q.
Rowan believes that its exposure to risk of earnings loss due to changes in market interest rates is not significant. The Company’s outstanding debt at June 30, 2006 was comprised as follows: $337.8 million of fixed-rate notes bearing a weighted average annual interest rate of 4.57% and $245.0 million of floating-rate notes bearing a weighted average annual interest rate of 5.52%. In addition, virtually all of the Company’s transactions are carried out in U. S. dollars. Thus, Rowan’s foreign currency exposure is not material. Fluctuating commodity prices materially affect Rowan’s future earnings only to the extent that they influence demand for the Company’s products and services. Rowan does not hold or issue derivative financial instruments.
The Company’s management has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer, along with the Company’s Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2006.
Our management is responsible for establishing and maintaining internal control over financial reporting (ICFR). Our internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations, and therefore can only provide reasonable assurance with respect to financial statement preparation and presentation.
On March 15, 2006, our management reported that the Company did maintain effective ICFR as of December 31, 2005 within the context of the framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). No change has occurred since that date that management believes has materially affected, or is reasonably likely to materially affect, the Company’s IFCR.
During the third quarter of 2005, Rowan lost four offshore rigs, including the Rowan-Halifax, and incurred significant damage on a fifth as a result of Hurricanes Katrina and Rita. Since that time, the Company has been conducting salvage operations. At June 30, 2006, Rowan included in Receivables $56.5 million of costs incurred to locate the lost or damaged rigs, salvage related equipment, remove debris, wreckage and pollutants from the water, mark or clear navigational hazards and clear rights of way. The Company expects to incur additional costs in the near term to fulfill its salvage obligations in amounts that may exceed its expenditures to date. Such additional costs will depend on the extent and nature of work ultimately required and the duration thereof. Rowan’s insurance carriers have notified the Company that they are reserving their right to deny reimbursement for any costs incurred in wreck and debris removal activities that they believe are outside the scope of its coverage. Although the Company believes that it has adequate insurance coverage and will be reimbursed for costs incurred and to be incurred, it is possible that a portion of such costs will not be reimbursed, requiring a charge to future operations for any shortfall. On July 20, 2006, the Company filed a lawsuit styled Rowan Companies, Inc. vs. Certain Underwriters at Lloyd’s and Insurance Companies Subscribing to Cover Note ARS 4183 in the 215th Judicial District Court of Harris County, Texas. The lawsuit alleges, among other things, breach of contract and seeks a declaratory judgment. On August 8, 2006, the Company agreed to dismiss its lawsuit while the parties attempt to resolve the claims without litigation. If such an agreement cannot be reached, the underwriters have agreed that the Company may re-file its lawsuit in Harris County before the underwriters file suit.
The Company leased the Rowan-Halifax under a charter agreement that commenced in 1984 and was scheduled to expire in March 2008. The rig was insured for $43.4 million, a value that Rowan believes satisfied the requirements of the charter agreement, and by a margin sufficient to cover the $6.3 million carrying value of Rowan equipment installed on the rig. However, the owner of the rig has claimed that the rig should have been insured for its fair market value and is seeking recovery from Rowan for compensation above the insured value. Thus, Rowan has assumed no insurance proceeds related to the Rowan-Halifax and recorded a charge during 2005 for the full carrying value of our equipment. On November 3, 2005, the Company filed a declaratory judgment action styled Rowan Companies, Inc. vs. Textron Financial Corporation and Wilmington Trust Company as Owner Trustee of the Rowan-Halifax 116-C Jack-Up Rig in the 215th Judicial District Court of Harris County, Texas. Recent appraisals obtained by the owner indicate a fair market value of the rig in the range of $75-91 million.
During 2004, the Company learned that a unit of the U. S. Department of Justice (DOJ) is conducting a criminal investigation of environmental matters involving several of Rowan’s offshore drilling rigs. The Company is cooperating with the investigation, including responding to the DOJ’s subpoenas for certain documentation regarding its operations.
The DOJ has a broad range of civil and criminal sanctions under environmental and other laws, which it may seek to impose against corporations and individuals in appropriate circumstances including, but not limited to, injunctive relief, fines (including multi-million dollar fines), penalties, modifications to business practices and compliance programs and other sanctions. Based on current information, the Company cannot predict what, if any, actions may be taken by the DOJ or other authorities or the effect any such actions may have on Rowan’s consolidated financial statements.
During 2005, the Company learned that a unit of the DOJ is conducting an investigation of potential antitrust violations among helicopter transportation providers in the Gulf of Mexico. Rowan’s former aviation subsidiary, which was sold effective December 31, 2004, has received a subpoena in connection with the investigation. The Company has not been contacted by the DOJ, but the purchaser has made a claim that Rowan is responsible for any exposure it may have. The Company has disputed that claim.
The Company is involved in various other legal proceedings incidental to its businesses and is vigorously defending its position in all such matters. The Company believes that there are no known contingencies, claims or lawsuits that will have a material adverse effect on Rowan’s financial position, results of operations or cash flows.
You should carefully consider the risk factors set forth in our Part I, Item IA. of our Annual Report on Form 10-K for the year ended December 31, 2005 before deciding to invest in Rowan Common Stock.
The Company did not repurchase any shares of its outstanding common stock during the first quarters of 2006 or 2005. Under the terms of a Share Repurchase Program begun in June 1998, the Company was authorized, at March 31, 2006, to buy back up to approximately 1.5 million shares of its common stock.
On February 25, 2005, in conjunction with the sale of our aviation operations, we paid a special cash dividend of $.25 per common share to stockholders of record on February 9, 2005. On September 1, 2005, in conjunction with the sale of several non-core assets, we paid a special cash dividend of $.25 per common share to stockholders of record on August 17, 2005. On February 24, 2006, we paid a special cash dividend of $.25 per common share to stockholders of record on February 8, 2006. On May 2, 2006, we announced our intention to pay a regular quarterly dividend of $.10 per common share, the first of which was paid on May 26, 2006 to stockholders of record on May 12, 2006.
At June 30, 2006, Rowan had approximately $544 million of retained earnings available for distribution to stockholders under the most restrictive provisions of our debt agreements. On July 25, 2006, we announced a dividend of $.10 per common share payable on August 18, 2006 to stockholders of record on August 4, 2006.
The following is a list of Exhibits filed with this Form 10-Q:
