25
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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, 2001
or
? Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from __________ to __________
Commission file number: 000-23701
SOUTHWEST ROYALTIES, INC. SOUTHWEST ROYALTIES
(Exact Name of Registrant as HOLDINGS, INC.
Specified in Its Charter) (Exact Name of Registrant
as
Specified in Its Charter)
Delaware Delaware
(State or Other Jurisdiction of (State or Other
Jurisdiction of
Incorporation or Organization) Incorporation or
Organization)
75-1917432 75-2724264
(I.R.S. Employer (I.R.S. Employer
Identification Number) Identification Number)
407 North Big Spring, Suite 300
Midland, Texas 79701
(Address of Principal Executive Offices) (Zip Code)
(915) 686-9927
Registrants' Telephone Number, Including Area Code:
Not Applicable
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check 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
such filing requirements for the past 90 days. Yes X No ___
Number of shares of common stock outstanding as of September 30, 2001 for
Southwest Royalties, Inc 100.
Number of shares of common and redeemable common stock outstanding as of
September 30, 2001 for Southwest Royalties Holdings, Inc 1,075,534.
SOUTHWEST ROYALTIES, INC.
SOUTHWEST ROYALTIES HOLDINGS, INC.
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 2001
(unaudited) and December 31, 2000 3
Consolidated Statements of Operations for the
three and nine months ended September 30, 2001
and 2000 (unaudited) 5
Consolidated Statements of Cash Flows for the three
and nine months ended September 30, 2001
and 2000 (unaudited) 7
Notes to Consolidated Financial Statements 10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 22
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 27
PART II - OTHER INFORMATION
Item 6. Reports on Form 8-K and Exhibits 28
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
September 30,December 31,
2001 2000
-----------------------
(unaudited)
ASSETS
- ---------------------------------------------------------
Current assets
Cash and cash equivalents $ 12,329 $ 17,217
Restricted cash 3,982 4,558
Accounts receivable, net of allowance of
$818 and $559, respectively 9,210 10,302
Receivables from related parties 1,733 1,941
Other current assets 4,200 3,166
------- -------
Total current assets 31,454 37,184
------- -------
Oil and gas properties, using the full cost
method of accounting
Proved 225,881 204,751
Unproved 1,042 625
------- -------
226,923 205,376
Less accumulated depletion, depreciation
and amortization 139,109 131,734
------- -------
Oil and gas properties, net 87,814 73,642
------- -------
Rental property, net 130,674 133,385
------- -------
Rental property - construction in progress 6,536 2,926
------- -------
Other property and equipment, net 4,493 4,612
------- -------
Other assets
Real estate investments 1,864 3,024
Deferred debt costs, net of accumulated
amortization of $7,787 and $5,698, respectively 5,043
7,043
Noncompete covenants, net of accumulated
amortization of $1,272 and $877, respectively 2,175
727
Other, net 2,121 1,258
------- -------
Total other assets 11,203 12,052
------- -------
Total assets $272,174 $ 263,801
======= =======
(continued)
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (continued)
(in thousands, except per share data)
September 30,December 31,
2001 2000
--------- -----------
(unaudited)
LIABILITIES, MINORITY INTEREST, REDEEMABLE
COMMON STOCK AND STOCKHOLDERS' EQUITY
- ---------------------------------------------------------
Current liabilities
Current maturities of long-term debt $147,129 $ 56,231
Accounts payable 6,664 7,045
Accounts payable to related parties 848 1,543
Accrued expenses 7,412 6,477
Accrued interest payable 7,558 4,612
------- -------
Total current liabilities 169,611 75,908
------- -------
Long-term debt 199,457 281,034
------- -------
Other long-term liabilities 1,296 1,645
------- -------
Redeemable common stock - 129,046 shares issued 8,290
8,290
------- -------
Stockholders' equity
Preferred stock - $1 par value; 5,000,000
shares authorized; none issued - -
Common stock - $.10 par value; 5,000,000 shares
authorized; 1,161,037 issued at September 30, 2001
and December 31, 2000 116 116
Additional paid-in capital 2,196 2,196
Accumulated deficit (104,431) (100,662)
Accumulated other comprehensive income:
Transition adjustment on implementation of
SFAS 133 net of reclassification to earnings
of $691 and none, respectively 339 -
Note receivable from an officer and stockholder (1,590)
(1,616)
Less: treasury stock - at cost; 214,549 shares
at September 30, 2001 and December 31, 2000 (3,110) (3,110)
------- -------
Total stockholders' deficit (106,480) (103,076)
------- -------
Total liabilities, redeemable common stock
and stockholders' equity $272,174 $ 263,801
======= =======
The accompanying notes are an integral part of these
consolidated financial statements.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2001 2000 2001 2000
------ ------ ------ ------
Operating revenues
Oil and gas $10,585 $14,955 $42,088 $39,297
Real estate 8,217 7,933 24,154 23,391
Other 54 118 187 291
------ ------ ------ ------
Total operating revenues 18,856 23,006 66,429 62,979
------ ------ ------ ------
Operating expenses
Oil and gas production 4,555 3,969 13,265 11,152
Real estate 4,978 4,558 14,390 13,714
General and administrative, net of
related party management and
administrative fees of $804, $798,
$2,384 and $2,467, respectively 1,032 1,242 3,145
3,243
Depreciation, depletion and
amortization 3,958 2,644 12,303 7,825
Other 53 165 179 754
------ ------ ------ ------
Total operating expenses 14,576 12,578 43,282 36,688
------ ------ ------ ------
Operating income 4,280 10,428 23,147 26,291
------ ------ ------ ------
Other income (expense)
Interest and dividend income 303 327 783 841
Interest expense (9,735) (10,922) (29,553) (32,398)
Other 1,664 405 1,944 1,030
------ ------ ------ ------
(7,768) (10,190) (26,826) (30,527)
------ ------ ------ ------
(continued)
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (continued)
(in thousands, except per share data)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
----------------- -----------------
2001 2000 2001 2000
------ ----- ----- -----
Income (Loss) before income taxes,
minority interest and extraordinary
item $ (3,488) $ 238 $ (3,679) $ (4,236)
Income tax benefit (provision) - - -
- -
--------- --------- --------- ---------
Income (Loss) before minority interest
and extraordinary item (3,488) 238 (3,679) (4,236)
Minority interest in subsidiaries,
net of tax (30) (33) (90) 1,139
--------- --------- --------- ---------
Income (Loss) before extraordinary
item (3,518) 205 (3,769) (3,097)
Extraordinary gain (loss) from
early extinguishment of debt - (1,374) -
12,622
--------- --------- --------- ---------
Net income (loss) $ (3,518) $ (1,169) $ (3,769) $ 9,525
========= ========= ========= =========
Income (Loss) per common share before
extraordinary item $ (3.27) $ .19 $(3.51) $
(2.88)
Extraordinary gain (loss) from
early extinguishment of debt - (1.27) -
11.74
--------- --------- --------- ---------
Income (loss) per common share $ (3.27) $ (1.08)$ (3.51) $
8.86
========= ========= ========= =========
Weighted average shares outstanding 1,075,534 1,075,868 1,075,534
1,075,868
========= ========= ========= =========
The accompanying notes are an integral part of these
consolidated financial statements
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
----------------- -----------------
2001 2000 2001 2000
------ ----- ----- -----
Cash flows from operating activities
Net income (loss) $(3,518) $(1,169) $(3,769) $ 9,525
Adjustments to reconcile net income
(loss) to net cash provided by
operating activities:
Depreciation, depletion and
amortization 3,958 2,644 12,303 7,825
Noncash interest expense 1,667 2,314 5,201 7,492
Noncash reclassification of
unrealized gain (257) - (691) -
Noncash unrealized gain on
oil and gas hedges (412) - (115) -
Extraordinary (gain) loss from early
extinguishment of debt - 1,374 - (12,622)
Gain on sale of assets (1,049) (208) (1,115) (456)
Other noncash items - 153 - 492
Amortization of lease commissions 40 41 123
145
Bad debt expense 150 100 396 240
Minority interest (income) loss
of subsidiary - 33 - (1,139)
Changes in operating assets
and liabilities -
Accounts receivable 2,587 (2,178) 904 (4,664)
Other current assets 1,439 (736) 1,787 (1,205)
Accounts payable and accrued
expenses 865 2,153 (141) (195)
Change in restricted cash (765) 2,744 440 4,956
Accrued interest payable 3,354 3,202 2,946 2,998
------ ------ ------ ------
Net cash provided by operating
activities 8,059 10,467 18,269 13,392
------ ------ ------ ------
Cash flows from investing activities
Proceeds from sale of oil and
gas properties 6 162 53 498
Investment in oil and gas properties (5,737) (2,934) (21,600)
(6,744)
Purchase of other property and
equipment and rental property (1,991) (2,120) (5,636)
(6,419)
Purchase of other assets (406) (586) (2,597) (622)
Proceeds from sale of real estate
investments 662 410 874 1,053
Proceeds from sale of other assets 114 27 147
46
(continued)
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(in thousands)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
----------------- -----------------
2001 2000 2001 2000
------ ----- ----- -----
Proceeds from sale of other property
equipment and rental property $ 446 $ 7 $ 469 $
87
Change in restricted cash (393) (61) 136 (896)
Other 8 8 26 24
------ ------ ------ ------
Net cash used in investing activities (7,291) (5,087) (28,128)
(12,973)
------ ------ ------ ------
Cash flows from financing activities
Proceeds from borrowings 1,683 54,403 25,248 75,922
Payments on debt (450) (51,893) (19,481) (75,655)
Change in other long-term
liabilities (502) (2) (349) (47)
Deferred debt cost - (1,264) (447) (1,395)
Refund of debt issue costs - 1,500 - 1,500
Dividends paid to minority interest
owners - (30) - (90)
Purchase of minority interest of
subsidiary - (8) - (8)
Other - - - 1
------ ------ ------ ------
Net cash provided by financing
activities 731 2,706 4,971 228
------ ------ ------ ------
Net increase (decrease) in
unrestricted cash and cash
equivalents 1,499 8,086 (4,888) 647
Unrestricted cash and cash equivalents -
beginning of period 10,830 9,544 17,217 16,983
------ ------ ------ ------
Unrestricted cash and cash equivalents -
end of period $12,329 $17,630 $12,329 $17,630
====== ====== ====== ======
(continued)
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(in thousands)
(unaudited)
Three months ended Nine months ended
September 30, September 30,
----------------- -----------------
2001 2000 2001 2000
------ ----- ----- -----
Non-cash investing and financing activities
Deferred debt cost incurred $ - $ 1,000 $ - $ 1,000
Increase in other long-term
liabilities associated with
deferred debt costs $ - $ 500 $ - $ 500
Increase in accrued expenses
associated with deferred debt costs $ - $ 500 $ -
$ 500
Unrealized gain on oil and gas
commodity hedges-taken to other
comprehensive income $ - $ - $ 1,030 $ -
Note payable issued to fund
non-compete agreement $ - $ - $ 800 $ -
Supplemental disclosures of cash flow
information
Interest paid $ 4,714 $ 5,693 $21,406 $21,908
The accompanying notes are an integral part of these
consolidated financial statements
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Business
Southwest Royalties Holdings, Inc. ("SRH"), a Delaware corporation, was
formed in June 1997 to serve as a holding company for Southwest Royalties
Inc. ("Southwest"), Midland Red Oak Realty, Inc. ("Red Oak") (collectively,
the "Company") and an equity investment in Basic Energy Service, Inc.
("Basic") (formerly Sierra Well Services, Inc.). Each shareholder of
Southwest was issued one share in SRH for each share of Southwest stock
held. Prior to the formation of SRH, Red Oak and Basic were subsidiaries
of Southwest. Southwest paid a dividend of the shares it owned in Red Oak
and Basic to SRH. After the formation of SRH, Southwest and Red Oak became
subsidiaries of SRH and, as of July 1, 1997, Basic was deconsolidated.
Southwest is principally involved in the business of oil and gas
development and production, as well as organizing and serving as managing
general partner for various public and private limited partnerships engaged
in oil and gas development and production. Southwest is also the general
partner of Southwest Partners II and III, which own common stock in Basic.
Southwest sells its oil and gas production to a variety of purchasers, with
the prices it receives being dependent upon the oil and gas commodity
prices. Red Oak is principally involved in real estate investment and
development.
Principles of Consolidation
The consolidated financial statements include the accounts of SRH and
its subsidiaries. As of September 30, 2001, the Company owned 100% of
Southwest and 81% of Red Oak. As of September 30, 2001, Southwest had only
one subsidiary, Blue Heel Company ("Blue Heel"). Effective August 2000,
Midland Southwest Software ("MSS"), a former subsidiary of Southwest, was
merged into Southwest. Blue Heel holds a nominal interest in certain oil
and gas properties owned by Southwest.
As of September 30, 2001 Red Oak has 4 wholly owned subsidiaries, MRO
Management, Inc. ("MRO Management"), MRO Commercial, Inc. ("MRO
Commercial"), MRO N Cross, Inc. ("Northcross"), and MRO Southwest, Inc.
("MRO Southwest"). MRO Commercial, Northcross and MRO Southwest each hold
titles to certain real estate properties and are the borrowers under the
credit agreements related to such properties. These credit agreements are
non-recourse to Red Oak. MRO Management performs real estate management
services for Red Oak, MRO Commercial, Northcross, MRO Southwest and for
third party clients.
The consolidated financial statements include the Company's
proportionate share of the assets, liabilities, income and expenses of the
oil and gas limited partnerships for which Southwest serves as managing
general partner. Southwest accounts for its investments in Southwest
Partners II and III using the equity method, as they exercise significant
influence over the operations of these partnerships. All significant
intercompany transactions have been eliminated.
Estimates and Uncertainties
Preparation of the accompanying consolidated financial statements in
conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Cash and Cash Equivalents
The Company considers all highly liquid debt instruments purchased with
a maturity of three months or less to be cash equivalents. In addition,
the Company maintains its excess cash in several interest bearing accounts
in various financial institutions.
Restricted Cash
Restricted cash represents amounts required to be reserved in separate
accounts by financial lenders. Restricted cash accounts have been
established for the following purposes (in thousands):
September 30,December 31,
2001 2000
---- ----
Certificate of Deposits - Red Oak $ - $ 118
Tenant security deposits - Red Oak 582 536
Capital expenditures account - Red Oak 688 824
Tax and insurance reserve - Red Oak 1,840 2,034
Lockbox - Red Oak 222 160
Customer service reserve - Red Oak 10 12
Interest reserve - Red Oak - 115
Escrow fund - Southwest 640 759
----- ------
$ 3,982 $ 4,558
===== ======
Real Estate Revenue Recognition
The Company leases offices and retail shopping centers under
noncancelable operating leases. The Company reports base rental revenue
for financial statement purposes straight-line over the terms of the
respective leases. Accrued straight-line rents represent the amount that
straight-line rental revenue exceeds rents collected in accordance with the
lease agreements. Management, considering current information and events
regarding the tenants' ability to fulfill their lease obligations,
considers accrued straight-line rents to be impaired if it is probable that
the Company will be unable to collect all rents due according to the
contractual lease terms. If accrued straight-line rents associated with a
tenant are considered to be impaired, the amount of the impairment is
measured based on the present value of expected future cash flows.
Impairment losses, if any, are recorded through a loss on the write-off of
assets. Cash receipts on impaired accrued straight-line rents are applied
to reduce the remaining outstanding balance and as rental revenue,
thereafter.
Some leases provide for percentage rents based on the tenant's revenue.
Percentage rents are accrued monthly based on prior experience or current
tenant financial information. Some leases require tenants to reimburse the
Company for certain expenses of operating the property. Tenant
reimbursements are accrued and billed to the tenants monthly based on prior
experience or certain identifiable costs.
Concentrations of Credit Risk
The Company is subject to credit risk through oil and gas trade
receivables and real estate lease receivables. Although a substantial
portion of its customers' ability to pay is dependent upon conditions in
the oil and gas industry as well as general economic conditions, credit
risk is reduced due to a large customer base.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Commodity Hedging and Derivative Financial Instruments
The Company has only limited involvement with derivative financial
instruments and generally does not use them for trading purposes. They are
used to manage commodity price risks. The Company is exposed to credit
losses in the event of nonperformance by the counter-parties to its
commodity hedges. The Company anticipates, however, that such counter-
parties will be able to fully satisfy their obligations under the
contracts. The Company does not obtain collateral or other security to
support financial instruments subject to credit risk but monitors the
credit standing of the counter-parties.
Through December 31, 2000, premiums paid for commodity option contracts
which qualified as hedges under Statement of Accounting Standards ("SFAS")
No. 80 "Accounting for Futures Contracts", were amortized to oil and gas
sales over the term of the agreements. Unamortized premiums are included
in other assets in the consolidated balance sheet. Amounts receivable or
payable under the commodity option contracts are accrued as an increase or
decrease in oil and gas sales for the applicable periods. Effective
January 1, 2001, derivative financial instruments are accounted for in
accordance with SFAS 133 as amended by SFAS 138.
In June 1998, the Financial Accounting Standards Board ("FASB") issued
SFAS No.133, "Accounting for Derivative Instruments and Hedging
Activities." SFAS No. 133, as amended by SFAS No. 138, establishes
accounting and reporting standards for derivative instruments, including
certain derivative instruments embedded in other contracts, (collectively
referred to as derivatives) and for hedging activities. It requires an
entity to recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair
value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a
hedge of the exposure to changes in the fair value of the exposure to
variable cash flows of a forecasted transaction, or (c) a hedge of the
foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, an available-for-sale security, or a foreign
currency denominated forecasted transaction. Special accounting for
qualifying hedges allows a derivative's gains and losses to offset related
results on the hedged item in the Company's statement of operations. The
Company recorded a net transition adjustment gain of $1,030,000 in
accumulated other comprehensive income on January 1, 2001. The transition
adjustment is being amortized to oil and gas sales over the term of the
agreements.
Oil and Gas Properties
All of the Company's oil and gas properties are located in the United
States and are accounted for at cost under the full cost method. Under
this method, all productive and nonproductive costs incurred in connection
with the acquisition, exploration and development of oil and gas reserves
are capitalized. No gain or loss is recognized on the sale of oil and gas
properties unless nonrecognition would significantly alter the relationship
between capitalized costs and remaining proved reserves for the affected
amortization base. When gain or loss is not recognized, the amortization
base is reduced by the amount of sales proceeds.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Net capitalized costs of oil and gas properties, including the estimated
future costs to develop proved reserves, are amortized using the units of
revenue method, whereby the provision is computed on the basis of current
gross revenues from production in relation to future gross revenues, based
on current prices, from estimated production of proved oil and gas
reserves. Should the net capitalized costs net of related deferred income
taxes exceed the estimated present value of oil and gas reserves discounted
at 10% and adjusted for related income taxes, such excess costs would be
charged to expense in the Consolidated Statements of Operations.
It is reasonably possible that the estimates of anticipated future gross
revenues, the remaining estimated economic life of the product, or both
could change significantly in the near term due to the fluctuation of oil
and gas prices or production. Depletion estimates would also be affected
by such changes.
Management and service fees received for contractual arrangements, if
any, are treated as reimbursement of costs, offsetting the costs incurred
to provide those services, with any excess of fees over costs credited to
the full cost pool and recognized through lower cost amortization only as
production occurs.
Property and Equipment
Rental property and other property and equipment are stated at cost.
Repairs and maintenance are charged to expense as incurred, with additions
and improvements being capitalized. Upon sale or other retirement of
depreciable property, the cost and accumulated depreciation are removed
from the related accounts and any gain or loss is reflected in the
Consolidated Statements of Operations.
Depreciation is provided on the straight-line method based on the
estimated useful lives of the depreciable assets as follows:
Building and improvements 20 to 30 years
Rental property and improvements 5 to 30 years
Leasehold improvements 2 to 10 years
Machinery and equipment 3 to 5 years
Furniture and fixtures 3 to 5 years
Equipment under capital lease 3 to 5 years
Rental Property - Construction in Progress
All costs associated with construction in progress are capitalized and
subject to depreciation when each project is completed. Interest is
capitalized for construction in progress. The capitalized interest is
recorded as part of the asset to which it relates and is amortized over the
assets useful life. In 2001 and 2000 no interest costs were capitalized.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
In accordance with the provisions of SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of, the Company reviews its long-lived assets, excluding oil and gas
properties accounted for using the full cost method of accounting, and
certain identifiable intangibles for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. In this circumstance, the Company recognizes an impairment
loss for the amount by which the carrying amount of the asset exceeds the
estimated fair value of the asset.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Deferred Debt Costs
The Company capitalizes certain costs incurred in connection with
issuing debt. These costs are being amortized to interest expense on the
straight-line method over the term of the related debt.
Gas Balancing
The Company utilizes the sales method of accounting for over or under
deliveries of natural gas. Under this method, the Company recognizes sales
revenue on all natural gas sold.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated
future tax effects attributable to differences between the financial
statement carrying amount of existing assets and liabilities and their
respective tax basis. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled.
The effect on deferred tax assets and liabilities of a change in tax rate
is recognized in income in the period that includes the enactment date.
Deferred tax assets are reduced, if necessary, by a valuation allowance for
the amount of tax benefits that may not be realized.
SRH and its eligible subsidiaries file a consolidated U.S. federal
income tax return. Basic (through June 30, 1997) and Red Oak are
consolidated for financial reporting purposes, but beginning January 1,
1996, were not eligible to be included in the consolidated U.S. federal
income tax return. Separate provisions for income taxes have been
determined for these entities. Effective January 1, 2001 Red Oak has become
eligible to be included in the consolidated U.S. federal income tax return.
Reclassifications
Certain reclassifications have been made to the 2000 amounts to conform
to the 2001 presentation.
Income (loss) per share
Basic net income (loss) per share is computed by dividing income
available to common stockholders by the weighted average number of common
shares outstanding for the period. The computation of diluted net income
(loss) per share reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or
converted into common stock or resulted in the issuance of common stock
that would then share in the earnings of the entity. For 2001 and 2000,
the computation of diluted net income (loss) per share was antidilutive;
therefore, the amounts reported for basic and diluted net income (loss) per
share were the same.
Noncompete covenants
Noncompete covenants are carried at cost less accumulated amortization.
The covenants are being amortized over their contractual lives, generally
three to five years.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Interim Financial Statements
In the opinion of management, the unaudited consolidated financial
statements of the Company as of September 30, 2001 and 2000 include all
adjustments and accruals, consisting only of normal recurring accrual
adjustments, which are necessary for a fair presentation of the results for
the interim periods. These interim results are not necessarily indicative
of results for a full year.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted in this report
pursuant to the rules and regulations of the Securities and Exchange
Commission. These consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the 2000 Form 10-K of the Company.
2. Liquidity
The accompanying consolidated financial statements have been prepared on
a going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. The
consolidated financial statements do not include any adjustments relating
to the recoverability and classification of liabilities that might be
necessary should the Company be unable to continue as a going concern.
SRH has a highly leveraged capital structure with, approximately, $31.5
million of cash interest and $147.1 million of principal (net of a related
party note of $798,000 between Southwest and Red Oak) due within the next
twelve months. The majority, $14.0 million of cash interest and $147.1
million of principal (which includes the $798,000 related party note
between Southwest and Red Oak) due within the next twelve months, pertains
to Red Oak. Management is currently in the process of renegotiating the
terms of SRH's various obligations with its debt holders and/or attempting
to seek new lenders or equity investors. Additionally, management is
considering the disposition of certain assets in order to meet its
obligations.
There can be no assurance that SRH's debt-restructuring efforts will be
successful or that the debt holders will agree to a course of action
consistent with SRH's requirements in restructuring the obligations. Even
if such agreement is reached, it may require approval of other creditors of
SRH, none of which is assured. Furthermore, there can be no assurance that
the sales of assets can be successfully accomplished on terms acceptable to
SRH.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
3. Commitments and Contingencies
The Company is subject to extensive federal, state and local
environmental laws and regulations. These laws, which are constantly
changing, regulate the discharge of materials into the environment and may
require the Company to remove or mitigate the environmental effects of the
disposal or release of petroleum or chemical substances at various sites.
Environmental expenditures are expensed or capitalized depending on their
future economic benefit. Expenditures that relate to an existing condition
caused by past operations and that have no future economic benefits are
expensed. Liabilities for expenditures of a noncapital nature are expensed
when environmental assessment and/or remediation is probable and the costs
can be reasonably estimated.
In the normal course of its business, the Company is subject to pending
or threatened legal actions; in the opinion of management, any such matters
will be resolved without material effect on the Company's operations, cash
flows or financial position.
4. Long-term Debt
Long-term debt consists of the following (in thousands):
September 30,December 31,
2001 2000
----- -----
10.5% Senior Notes, interest payable semi-annually due
October 15, 2004, net of discount of $788 and $945,
respectively $122,897 $122,740
Revolving Loan Facility with variable rate interest,
due August 2003. Collateralized by oil and gas
properties 49,970 50,000
Variable Rate Notes Payables:
Variable notes due July 2001, accrued interest due and
payable monthly at 8.7% at December 31, 2000 with
additional 1% payable in cash or additional
notes beginning July 1, 1998
Net of discount of $0 and $279, respectively -
17,802
Variable notes due December 2001, accrued interest due
and payable monthly at 7.1% and 8.9% at
September 30, 2001 and December 31, 2000, with
additional 1.5% payable in cash or additional
notes beginning January 1, 1999
Net of discount of $222 and $1,222, respectively 36,146
33,373
Variable notes due July 2002, interest at 8.6% and 10.4%
at September 30, 2001 and December 31, 2000, accrued
interest due and payable monthly beginning July 1, 1999
Net of discount of $1,172 and $2,491, respectively 106,269
103,690
Variable notes due November 2002, interest at 8.0% at
September 30, 2001, principal and interest due
and payable monthly beginning July 10, 2001 19,720 -
Other 11,584 9,660
------- -------
346,586 337,265
Less current maturities, net of discount of $1,394 and
$1,500 147,129 56,231
------- -------
$199,457 $281,034
======= =======
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
10.5% Senior Notes
In October 1997, the Company issued $200 million aggregate principal
amount of 10.5% Senior Notes due October 15, 2004 (the "Notes"). The Notes
were sold at a discount and interest is payable April 15 and October 15 of
each year, commencing April 15, 1998. The Notes are general unsecured
senior obligations of the Company and rank equally in right of payment with
all other senior indebtedness of the Company and senior in right of payment
of all existing future subordinated indebtedness of the issuer. Net
proceeds from the issuance of the Notes were used primarily to repay
existing debt of approximately $84 million, purchase oil and gas properties
for approximately $72 million, purchase additional stock in Red Oak for
approximately $10 million, invest $1.7 million in an affiliate, with the
remaining balance used for working capital.
The Indenture imposes certain limitations on the ability of the Company
and its restricted subsidiaries to, among other things, incur additional
indebtedness or issue disqualified capital stock, make payments in respect
to capital stock, enter into transactions with affiliates, incur liens,
sell assets, change the nature of its business, merge or consolidate with
any other person and sell, lease, transfer or otherwise dispose of
substantially all of its properties or assets. The indenture requires the
issuer to repurchase notes under certain circumstances with the excess cash
of certain asset sales. The limitations are subject to a number of
important qualifications and exceptions. The issuer must report to the
Trustee on compliance with such limitations on a quarterly basis.
Revolving Loan Facility
In December 1999, Southwest entered into a Revolving Loan Facility with
Bank One Texas, N.A., which provided a borrowing base of $50 million with a
maturity date of December 29, 2000. Funds from the Revolving Loan Facility
may be used for working capital and other general corporate purposes,
including the repurchase of a portion of Southwest's outstanding 10.5%
Senior Notes due 2004. Advances on the Revolving Loan Facility bear
interest at the option of Southwest, based on the prime rate of Bank One
Texas, N.A. (8.5% at December 31, 1999) plus one fourth of one percent
(.25%), when the borrowing base usage is equal to or greater than 80% or
zero percent (0%) when the borrowing base usage is less than 80% or, a
Eurodollar rate (substantially equal to the London InterBank Offered Rate
("LIBOR")) plus 1.25% up to 2.0% based on the borrowing base usage
percentage. The Revolving Loan Facility is secured by no less than 85% of
Southwest's oil and gas properties. As of December 31, 1999 Southwest had
drawn $35.0 million. The remaining $15.0 million was drawn in January
2000.
The Revolving Loan Facility imposes certain limitations on the ability
of Southwest to, among other things, incur additional indebtedness or issue
disqualified capital stock, make payments in respect to capital stock,
enter into transactions with affiliates, incur liens, sell assets, change
the nature of its business, merge or consolidate with any other person and
sell, lease, transfer or otherwise dispose of substantially all of its
properties or assets. The Revolving Loan Facility required Southwest to
establish a sinking fund account with an initial deposit of $3.5 million.
Southwest is to transfer monthly one-twelfth of the annual interest
payments on the 10.5% Senior Notes beginning December 31, 1999 into this
sinking fund account for the purpose of making interest payments on the
10.5% Senior Notes.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Southwest successfully completed a refinancing of their Revolving Loan
Facility in the amount of $50.0 million on August 17, 2000 with a new
lender. The Amended and Restated Loan and Security Agreement allows for a
prime rate of interest (9.50% at December 31, 2000) plus one and one-half
percent (1.5%). The new lender continues to impose the above noted
limitations, however, the sinking fund requirement was eliminated.
Southwest was able to extend the due date from December 29, 2000 to August
17, 2003. Southwest, in recording the refinancing of the Revolving Loan
Facility, recorded an extraordinary loss from early extinguishment of debt
in the amount of approximately $1.4 million.
Variable Rate Notes Payable
In June 1998, MRO N Cross, Inc., a wholly owned subsidiary of Red Oak
negotiated two notes payable in the amount of $13.5 million, net of a $2
million discount, and $2.5 million. The $13.5 million note was used for the
acquisition of rental property in the amount of $12.9 million with the
remaining $600,000 to be used for capital improvements to the rental
property purchased. The $2.5 million note was reserved for capital
improvements to the rental property purchased and had been utilized as of
June 30, 2001. The notes were collateralized by the property purchased.
The notes were paid in full as of June 30, 2001.
In June 2001, MRO N Cross, Inc., a wholly owned subsidiary of Red Oak
negotiated a note payable in the amount of $22.1 million. The initial
funding of $18.8 million was utilized to retire the existing debt on the
collateralized property. The additional $3.3 million will be funded as
necessary to make capital improvements to the property.
In December 1998, MRO Commercial, Inc., a wholly owned subsidiary of Red
Oak negotiated two notes payable in the amount of $21.7 million, net of a
$4 million discount, and $9.7 million. The $21.7 million note was used for
the acquisition of a retail shopping center and the funding of various
escrow balances. The $9.7 million note is for capital improvements to the
rental property purchased and had been utilized as of June 30, 2001. The
notes are collateralized by the property purchased.
In June 1999, MRO Southwest, Inc., a wholly owned subsidiary of Red Oak
negotiated two notes payable in the amount of $97.5 million and $8.0
million, net of discounts of $5.3 million. Borrowings for both notes accrue
interest in arrears at a rate per annum equal to the greater of 8.6% or
LIBOR plus 360 basis points. The interest rate includes a servicing fee of
.10%. Approximately $91.4 million of the $97.5 million note was used to
retire existing debt on properties contributed to MRO Southwest by Red Oak,
$1.5 million was deposited into various restricted cash accounts and the
remaining proceeds were used for general corporate purposes. The $8.0
million note is for capital improvements to rental property and $6.3
million has been utilized as of September 30, 2001. The notes are
collateralized by the properties owned by MRO Southwest.
The real estate notes impose certain restrictive covenants including
restrictions on the incurrence of additional indebtedness, dissolution,
termination or liquidation of all or substantially all of the assets,
changes in the legal structure of the assets, making any loans or advances
to any third party and commingling its assets with the assets of any of its
affiliates or of any other person or entity.
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
Extinguishment of Debt
In January of 2000, Southwest purchased approximately 19%, or
approximately $38.4 million original face amount, of its 10.5% Senior Notes
with the proceeds from the aforementioned Revolving Loan Facility.
Southwest paid approximately $23.0 million, including all fees, to purchase
the 10.5% Senior Notes and wrote off approximately $980,000 of deferred
loan issue costs and approximately $349,000 of the original issue discount
to recognize a $14.1 million extraordinary gain on the purchase of the
Notes. The tax benefit of $6.0 million recognized in 2000 results from the
reversal of a portion of the Company's deferred tax asset valuation
allowance. In accordance with Statement of Financial Accounting Standards
("SFAS") No. 109, none of this amount is allocated to the extraordinary
gain. The extraordinary gain per share is approximately $13.01.
On August 17, 2000, Southwest refinanced their Revolving Loan Facility
and recorded an extraordinary loss from early extinguishment of debt in the
amount of approximately $1.4 million. There is no income tax benefit
recognized on the extraordinary loss. The extraordinary loss per share is
approximately $(1.27).
Aggregate maturities of all long-term debt as of December 31, 2000 are
as follows (in thousands):
2001 $ 57,731
2002 106,688
2003 52,791
2004 123,731
2005 408
Thereafter 853
-------
342,202
Less unamortized discount 4,937
-------
$337,265
=======
Aggregate maturities of all long-term debt as of September 30, 2001 are
as follows (in thousands):
For the twelve
months ended
--------------
September 30, 2002 $148,523
September 30, 2003 73,780
September 30, 2004 1,240
September 30, 2005 124,268
September 30, 2006 103
Thereafter 854
-------
348,768
Less unamortized discount 2,182
-------
$346,586
=======
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
5. Lines of Business
The Company operates in two major segments: Oil and Gas Activities (oil
and gas acquisition, development, exploration and production, as well as
organizing and serving as managing general partner for various public and
private limited partnerships engaged in oil and gas development and
production) and Real Estate Investment and Management (owns and manages
retail shopping centers and office buildings). Other items include
eliminations, computer service and the holding Company. Effective August
2000, Midland Southwest Software ("MSS") a 100% wholly owned software
subsidiary was merged into Southwest.
Three months ended Nine months ended
September 30, September 30,
------------------ -----------------
2001 2000 2001 2000
----- ----- ----- -----
(in thousands) (in thousands)
(unaudited) (unaudited)
Operating Revenue
Oil and gas $ 10,593 $14,965 $42,115 $39,326
Real estate 8,217 7,933 24,154 23,391
Other and eliminations 46 108 160 262
------- ------ ------ ------
$ 18,856 $23,006 $66,429 $62,979
======= ====== ====== ======
Operating profit (loss)
Oil and gas $ 3,178 $ 9,074 $19,418 $22,351
Real estate 1,143 1,785 3,853 4,918
Other and eliminations (41) (431) (124) (978)
------- ------ ------ ------
$ 4,280 $10,428 $23,147 $26,291
======= ====== ====== ======
Interest Expense
Oil and gas $ 4,868 $ 5,528 $14,714 $16,837
Real Estate 4,876 5,404 14,867 15,592
Other and eliminations (9) (10) (28) (31)
------- ------ ------ ------
$ 9,735 $10,922 $29,553 $32,398
======= ====== ====== ======
Depreciation, depletion and
amortization
Oil and gas $ 2,391 $ 1,394 $ 7,720 $ 4,161
Real Estate 1,541 1,222 4,506 3,555
Other and eliminations 26 28 77 109
------- ------ ------ ------
$ 3,958 $ 2,644 $12,303 $ 7,825
======= ====== ====== ======
Capital expenditures
Oil and gas $ 5,737 $ 2,934 $21,600 $ 6,744
Oil and gas, other 109 162 304 294
Real Estate 1,882 1,957 5,332 6,046
Other - 1 - 79
------- ------ ------ ------
$ 7,728 $ 5,054 $27,236 $13,163
======= ====== ====== ======
SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
September 30, December 31,
2001 2000
---------- ----------
Identifiable assets
Oil and gas $ 126,809 $ 119,357
Real estate 149,850 151,231
Other and eliminations (4,485) (6,787)
------- -------
$ 272,174 $ 263,801
======= =======
6. Comprehensive Income
Comprehensive income consists of net income (loss), as reflected on the
consolidated statement of operations, and other gains and losses affecting
stockholders' equity that are excluded from net income (loss). The Company
recorded other comprehensive income during the first quarter of 2001.
Total comprehensive income for the nine months ended September 30, 2001 is
as follows (in thousand):
Net income (loss) $(3,769)
Other comprehensive income, net of tax:
Transition adjustment on implementation of
SFAS 133 - January 1, 2001 1,030
Reclassification of transition adjustment (691)
-----
Other comprehensive income 339
-----
Comprehensive income (loss) $(3,430)
=====
7. Related Party Transactions
An affiliate of the Company issued a Notice to Stockholders of
Preemptive Rights dated May 21, 2001. Three individuals, two of whom are
officers of the Company, contributed $110,000 toward the purchase of 5,500
shares of stock from the affiliate using the Company as both purchaser and
holder of the stock via a Purchase Right Agreement dated June 6, 2001. The
transferability of the shares is restricted by the Stockholders' Agreement
dated December 21, 2000 according to Article 4 which states that the shares
are not transferable until the seventh anniversary of the date of said
Stockholders' Agreement and until such time as the cancellation of the
Pledge Agreement dated October 14, 1997 by and among SRH and State Street
Bank, as Trustee. Therefore, the Company recorded a long-term liability
for the 5,500 shares held on behalf of the three individuals in the
purchase price amount of $110,000. The 5,500 shares are recorded in other
assets at September 30, 2001.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
General
Southwest Royalties Holdings, Inc., a Delaware corporation, was formed
in 1997 to serve as a holding company for Southwest Royalties, Inc.,
Midland Red Oak Realty, Inc. and an equity investment in Basic Energy
Services, Inc. SRH is an independent oil and gas company engaged in the
acquisition, development and production of oil and gas properties,
primarily in the Permian Basin of West Texas and southeastern New Mexico,
through its wholly-owned subsidiary, Southwest. Since 1983, Southwest has
grown primarily through selective acquisitions of producing oil and gas
properties, both directly and through the oil and gas partnerships it
manages. SRH also owns and manages real estate properties through its
subsidiary, Red Oak.
Results of Operations
Three months and nine months ended September 30, 2001 compared to three
months and nine months September 30, 2000
The following table summarizes production volumes, average sales prices
and period-to- period comparisons for the Company's oil and gas operations,
including the effect on revenues, for the periods indicated:
Three months ended Nine months ended
September 30, September 30,
------------------- -------------------
2001 2000 2001 2000
----- ----- ----- -----
(in thousands) (in thousands)
(unaudited) (unaudited)
Production volumes:
Oil and condensate (MBbls) 317 312 944
928
Natural gas (MMcf) 1,305 1,213 3,769 3,605
Average sales prices:
Oil and condensate (per Bbl) $ 23.72 $ 30.36 $ 26.51
$ 27.85
Natural gas (per Mcf) $ 2.30 $ 4.37 $ 4.40 $ 3.64
Revenues. Revenues for the Company decreased 18% to $18.9 million for
the three months ended September 30, 2001 and increased 5% to $66.4 million
for the nine months ended September 30, 2000, as compared to $23.0 million
and $63.0 million for the same periods in 2000.
Oil and gas revenues decreased 29% to $10.6 million for the three months
ended September 30, 2001 and increased 7% to $42.1 million for the nine
months ended September 30, 2001, as compared to $15.0 million and $39.3
million for the same periods in 2000. The decrease in oil and gas revenues
for the three months ended September 30, 2001 is due primarily to a
decrease in oil and gas prices and was partially offset by increases in
both oil and gas production. The increase in oil and gas revenues for the
nine months ended September 30, 2001 is due to increases in both oil and
gas production as well as an increase in gas prices which were partially
offset by a decrease in oil prices.
Oil and gas production increased 4% to 5,815 BOEPD for the three months
ended September 30, 2001 and 3% to 5,758 BOEPD for the nine months ended
September 30, 2001 as compared to 5,590 BOEPD and 5,580 BOEPD for the same
periods in 2000.
Real estate revenues increased 4% to $8.2 million for the three months
ended September 30, 2001 and 3% to $24.2 million for the nine months ended
September 30, 2001, as compared to $7.9 million and $23.4 million for the
same periods in 2000.
Other Operating revenues decreased 54% to $0.1 million for the three
months ended September 30, 2001 and 36% to $0.2 million for the nine months
ended September 30, 2001, as compared to $0.1 million and $0.3 million for
the same periods in 2000. The decrease is due primarily to cut backs in
computer outsourcing services provided by Southwest.
Operating Expenses. Operating expenses, before general and
administrative expense and depreciation, depletion and amortization,
increased 10% to $9.6 million for the three months ended September 30, 2001
and 9% to $27.8 million for the nine months ended September 30, 2001, as
compared to $8.7 million and $25.6 million for the same periods in 2000.
Oil and gas operating expense increased approximately 15% to $4.6
million for the three months ended September 30, 2001 and 19% to $13.3
million for the nine months ended September 30, 2001, as compared to $4.0
million and $11.2 million for the same periods in 2000. The increase in
oil and gas operating expenses for the three and nine month periods ended
September 30, 2001 is due primarily to bringing higher lifting cost wells
back on line and to work over expense and repairs associated with
maintaining and/or increasing existing production. The average operating
expense increased 10% to $8.52 per BOE for the three months ended September
30, 2001 and 16% to $8.44 per BOE for the nine months ended September 30,
2001 from $7.72 and $7.29 per BOE for the same periods in 2000.
Real estate operating expense increased 9% to $5.0 million for the three
months ended September 30, 2001 and 5% to $14.4 million for the nine months
ended September 30, 2001, as compared to $4.6 million and $13.7 million for
the same periods in 2000. The increase is due primarily to the purchase of
two additional property management companies in 2001.
Other operating expense decreased 68% to $0.1 million for the three
months ended September 30, 2001 and 76% to $0.2 million for the nine months
ended September 30, 2001, as compared to $0.2 million and $0.8 million for
the same periods in 2000. The decrease is due to cut backs in computer
outsourcing services provided by Southwest.
General and Administrative ("G&A") Expense. G&A expense for the Company
decreased 17% to $1.0 million for the three months ended September 30, 2001
and approximately 3% to $3.1 million for the nine months ended September
30, 2001, as compared to $1.2 million and $3.2 million for the same periods
in 2000.
Oil and gas G&A expense remained constant at $0.5 million for the three
months ended September 30, 2001 and $1.7 million for the nine months ended
September 30, 2001, as compared to $0.5 and $1.7 million for the same
periods in 2000. Oil and gas G&A expense per BOE decreased 15% to $.88 for
the three months ended September 30, 2001 and remained constant at $1.09
per BOE for the nine months ended September 30, 2001, as compared to 1.03
per BOE and 1.09 per BOE for the same periods in 2000.
Real estate G&A expense increased 51% to $0.6 million for the three
months ended September 30, 2001 and 17% to $1.4 million for the nine months
ended September 30, 2001, as compared to $0.4 million and $1.2 million for
the same periods in 2000. The increase is due primarily to the purchase of
two additional property management companies in 2001.
Other G&A expense decreased 100% for both the three and nine months
ended September 30, 2001, from $0.3 million for the three and nine months
ended September 30, 2000. The decrease is due to cut backs in computer
outsourcing services provided by Southwest.
Depreciation, Depletion and Amortization ("DD&A") Expense. DD&A expense
for the Company increased 50% to $4.0 million for the three months ended
September 30, 2001 and 57% to $12.3 million for the nine months ended
September 30, 2001, as compared to $2.6 million and $7.8 million for the
same periods in 2000.
Oil and gas DD&A increased 71% to $2.4 million for the three months
ended September 30, 2001 and 83% to $7.7 million for the nine months ended
September 30, 2001, as compared to $1.4 million and $4.2 million for the
same periods in 2000. Depletion, which comprises the largest percentage
of DD&A, is calculated using the units of revenue method of amortization.
This method is calculated by dividing current period gross revenues by the
total estimated future gross revenues and multiplying the resulting
percentage by the net book value of the oil and gas properties being
depleted. The current period gross revenues are the result of the average
commodity prices actually received during the amortization period. Future
gross revenues are based on the commodity prices being received on the date
of the reserve estimate. Therefore large fluctuations between actual
average prices received during the amortization period and the prices
received on the date of the reserve estimate can result in large increases
or decreases in the computation of depletion expense for the period. The
average price received for oil and gas for the nine months ended September
30, 2001 was $26.51 per bbl of oil and $4.40 per mcf of gas as opposed to
the prices required to be used in determining the future gross revenues in
the reserve estimate of $22.40 per bbl of oil and $2.10 per mcf of gas; a
difference of 18% in the price per bbl of oil and 110% in the price per mcf
of gas. Oil and gas depletion expense on a BOE basis, increased 72% to
$4.25 per BOE for the three months ended September 30, 2001 and 88% to
$4.69 per BOE for the nine months ended September 30, 2001, as compared to
$2.47 per BOE and $2.49 per BOE for the same periods in 2000.
Real estate DD&A expense increased 26% to $1.5 million for the three
months ended September 30, 2001 and 27% to $4.5 million for the nine months
ended September 30, 2001, as compared to $1.2 million and $3.6 million for
the same periods in 2000. The increase in DD&A expense for the three and
nine months ended September 30, 2001 is due to the impact of capitalized
improvements and amortization of noncompete agreements associated with the
acquisition of two property management company's in 2000 and 2001.
Interest Expense. Interest expense for the Company decreased 11% to $9.7
million for the three months ended September 30, 2001 and 9% to $29.6
million for the nine months ended September 30, 2001, as compared to $10.9
million and $32.4 million for the same periods in 2000.
Oil and gas interest expense decreased 12% to $4.9 million for the three
months ended September 30, 2001 and 13% to $14.7 million for the nine
months ended September 30, 2001, as compared to $5.5 million and $16.8
million for the same periods in 2000. The reduction is due primarily to the
decreases in the prime rate associated with Southwest's $50 million
Revolving Loan Facility and the reduction of the deferred debt costs being
amortized due to the refinance of the Revolving Loan Facility in August of
2000.
Real estate interest expense decreased 10% to $4.9 million for the three
months ended September 30, 2001 and 5% to $14.9 million for the nine months
ended September 30, 2001, as compared to $5.4 million and $15.6 million for
the same periods in 2000. The reduction is due primarily to the decreases
in the prime rates associated with Red Oak's variable rate notes.
Other Income. Other income increased 311% to $1.7 million for the three
months ended September 30, 2001 and 89% to $1.9 million for the nine months
ended September 30, 2001, as compared to $0.4 million and $1.0 million for
the same periods in 2000. The increases are due primarily to payments
received on oil and gas hedges at Southwest.
Net Income (Loss). Due to the factors described above, net loss for the
Company was $3.5 million for the three months ended September 30, 2001 and
$3.8 million for the nine months ended September 30, 2001, as compared to a
net loss of $1.2 million and net income $9.5 million for the same periods
in 2000. Included in net income for the nine months ended September 30,
2000, is a net extraordinary gain of approximately $12.7 million associated
with the repurchase of approximately 19% of the original issue, $200
million face 10.5% Senior Notes and the refinancing of Southwest's
Revolving Loan Facility. Included in the net loss for the three months
ended September 30, 2001 was an extraordinary loss of approximately $1.4
million associated with the refinancing of Southwest's Revolving Loan
Facility.
Net income at Southwest was approximately $0.0 million for the three
months ended September 30, 2001 and $4.4 million for the nine months ended
September 30, 2001, as compared to $2.0 million and $18.0 million for the
same periods in 2000.
Real estate net losses were $3.5 million for the three months ended
September 30, 2001 $10.3 million for the nine months ended September 30,
2001 as compared $3.2 million and $9.5 million for the same periods in
2000.
Liquidity and Capital Resources
Funding for the Company's business activities has historically been
provided by operating cash flows, bank borrowings, debt issuances, reserve-
based financings and sales of equity. Any future capital expenditures,
other than those with previously arranged and set-aside lines of financing,
will most likely require additional equity or financing and will be
dependent upon financing arrangements available at the time. The
significant decrease in oil and gas prices experienced during the last
quarter of 1997 and extending through the first half of 1999, severely
limited cash flow from operations, depleted working capital and rendered
most other financing sources unavailable, or if available, on very
unattractive terms to Southwest. With the upturn in commodity prices that
began in the last half of 1999 and continued through the first half of
2001, Southwest's operating cash flows improved allowing for the investment
of capital expenditures. However, Southwest's cash flows are highly
dependent on commodity prices and, beginning in the 3rd quarter of 2001,
commodity prices began to fall precipitously. Based on current commodity
prices, Southwest's ability to generate cash flow from operations is very
limited thereby creating an inability to invest in capital projects to
maintain or increase production at current levels for the foreseeable
future.
SRH has a highly leveraged capital structure with, approximately, $31.5
million of cash interest and $147.1 million of principal (net of a related
party note of $798,000 between Southwest and Red Oak) due within the next
twelve months. The majority, $14.0 million of cash interest and $147.1
million of principal (which includes the $798,000 related party note
between Southwest and Red Oak) due within the next twelve months, pertains
to Red Oak. Management is currently in the process of renegotiating the
terms of SRH's various obligations with its debt holders and/or attempting
to seek new lenders or equity investors. Additionally, management is
considering the disposition of certain assets in order to meet its
obligations.
There can be no assurance that SRH's debt-restructuring efforts will be
successful or that the debt holders will agree to a course of action
consistent with SRH's requirements in restructuring the obligations. Even
if such agreement is reached, it may require approval of other creditors of
SRH, none of which is assured. Furthermore, there can be no assurance that
the sales of assets can be successfully accomplished on terms acceptable to
SRH.
SRH, Red Oak and Southwest regularly pursue and evaluate
recapitalization strategies and acquisition opportunities (including
opportunities to engage in mergers, consolidations or other business
combinations) and at any given time may be in various stages of evaluating
such opportunities. SRH has engaged Friedman, Billings, Ramsey and Co.,
Inc. to explore all strategic options for the company, including a
potential recapitalization.
Net Cash Provided By Operating Activities
Net cash provided by operating activities was $8.1 million and $18.3
million for the three and nine months ended September 30, 2001,
respectively, as compared to net cash provided by operating activities of
$10.5 million and $13.4 million for the same periods in 2000. The decrease
in cash provided by operating activities, is primarily attributable to
decreased oil and gas commodity prices and increased operating costs for
both the real estate and the oil and gas businesses, such as electrical
pumping costs, drilling costs, and work-over rig expenses.
Based on current commodity prices, Southwest may be unable to maintain
certain debt covenants, including its interest coverage ratio and will
probably need to obtain waivers or restructure its Revolving Loan Facility.
Based on Red Oak's current debt structure, Red Oak will not be able to
generate sufficient cash flow from operations without restructuring its
debt or selling assets.
Net Cash Used In Investing Activities
Net cash used in investing activities by the Company were $7.3 million
and $28.1 million for the three and nine months ended September 30, 2001,
as compared to net cash used in investing activities of $5.1 million and
$13.0 million for the comparable periods in 2000. Purchase of oil and gas
properties and developmental drilling, as well as capital improvements to
Real Estate holdings, were the primary uses of funds in 2001 and in 2000.
The following table sets forth capital expenditures, including
acquisitions, made by Southwest during the periods indicated.
Three months Ended Nine months Ended
September 30, September 30,
------------------ ----------------
2001 2000 2001 2000
----- ----- ----- -----
(in thousands)
Oil and gas properties
Development $ 3,383 $ 2,631 $13,303 $ 5,464
Exploration 390 242 661 449
Acquisitions 1,964 61 7,636 831
------ ----- ------ ------
Total $ 5,737 $ 2,934 $21,600 $ 6,744
====== ===== ====== ======
Based on current commodity prices, SRH has stopped all non-contractual
capital expenditures at Southwest for oil and gas development projects.
This budget is subject to change based on financial strategies currently
being developed, including hedging strategies, divestitures and debt
restructuring, as well as the level of oil and gas prices in the future.
SRH has budgeted $3.8 million, for the remainder of 2001, in capital
improvements on Real Estate holdings at Red Oak. The capital improvements
will be funded through additional borrowings on existing notes. This
budget is subject to change based on financial strategies currently being
developed which include the sale of non-strategic assets and debt
restructurings.
Net Cash Provided by Financing Activities.
Net cash provided by the Company's financing activities was $0.7 million
and $5.0 million for the three and nine months ended September 30, 2001 and
$2.7 million and $0.2 million for the same periods in 2000, respectively.
For the three months ended September 30, 2001, proceeds from borrowings
were $1.7 million and were used to fund capital improvements on Real Estate
holdings. For the nine months ended September 30, 2001, proceeds from
borrowings were $25.2 million and were used to fund payments on debt of
$19.0 million and to fund capital improvements on Real Estate holdings.
Other Issues
Derivative Instruments and Hedging Activities.
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No.133, "Accounting
for Derivative Instruments and Hedging Activities." SFAS No. 133, as
amended by SFAS No. 138, establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded
in other contracts, (collectively referred to as derivatives) and for
hedging activities. It requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial position and
measure those instruments at fair value. If certain conditions are met, a
derivative may be specifically designated as (a) a hedge of the exposure to
changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to changes in the
fair value of the exposure to variable cash flows of a forecasted
transaction, or (c) a hedge of the foreign currency exposure of a net
investment in a foreign operation, an unrecognized firm commitment, an
available-for-sale security, or a foreign currency denominated forecasted
transaction. Special accounting for qualifying hedges allows a
derivative's gains and losses to offset related results on the hedged item
in the Company's statement of operations. The Company recorded a net
transition adjustment gain of $1.0 million in accumulated other
comprehensive income on January 1, 2001. The transition adjustment is being
amortized to oil and gas sales over the term of the agreements. The
Company recorded a net gain of $115,000 to adjust the carrying value of its
oil and gas derivatives to fair market value of $3.2 million as of
September 30, 2001.
Recent Accounting Pronouncements
In July of 2001, the Financial Accounting Standards Boards (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 141
"Business Combinations", which requires that all business combinations
initiated after June 30, 2001 be accounted under the purchase method of
accounting. The Company regularly pursues and evaluates recapitalization
strategies and acquisition opportunities (including opportunities to engage
in mergers, consolidations or other business combinations) and at any given
time may be in various stages of evaluating such opportunities. The
company is assessing the impact, if any, of this FASB in relation to any
such recapitalization strategies and acquisition opportunities.
Additionally, in July of 2001, the FASB issued SFAS No. 142 "Goodwill
and Other Intangible Assets", which requires that goodwill no longer be
amortized to earnings, but instead be reviewed for impairment. The Company
is currently assessing the impact of SFAS No. 142, which must be adopted in
the first quarter of 2002.
Also, the FASB has voted to issue SFAS No. 143 "Accounting for Asset
Retirement Obligations", which establishes requirements for the removal-
type costs associated with asset retirements. The Company is currently
assessing the impact of SFAS No. 143, which must be adopted in the first
quarter of 2003.
In October 2001, FASB issued SFAS No. 144 "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" which
addresses financial accounting and reporting for the impairment or disposal
of long-lived assets. SFAS No. 144 superseded SFAS No. 121 and the
accounting and reporting provisions of APB Opinion No. 30. SFAS No. 144 is
effective for fiscal years beginning after December 15, 2001. SRH is
currently in the process of evaluating the impact that SFAS No. 144 will
have on its financial position and results of operations, if any.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The information included in "Quantitative and Qualitative Disclosures
About Market Risk" in Item 7A of SRH's 2000 Form 10-K is incorporated
herein by reference. Such information includes a description of SRH's
potential exposure to market risks, including commodity price risk and
SRH's interest rate risk. As of September 30, 2001, there have been no
material changes in SRH's market risk exposure from that disclosed in the
2000 Form 10-K.
PART II - OTHER INFORMATION
ITEM 6. REPORTS ON FORM 8K AND EXHIBITS
Reports on Form 8-K
None.
Exhibits
The following instruments and documents are included as Exhibits to this
Report. Exhibits incorporated by reference are so indicated by
parenthetical information.
Exhibit Number Description
-------------- ------------
None
SIGNATURES
SOUTHWEST ROYALTIES, INC.
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereto duly authorized.
SOUTHWEST ROYALTIES, INC.
By: /s/ H. H. Wommack, III
---------------------------------------
H.H. Wommack, III, Chairman, President,
Chief Executive Officer, and Director
Date: November 26, 2001
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ H.H. Wommack, III
---------------------------
H. H. Wommack, III Chairman/President/
Chief Executive Officer November 26, 2001
/s/ Bill E. Coggin
---------------------------
Bill E. Coggin Vice President/Chief
Financial Officer November 26, 2001
/s/ H. Allen Corey
---------------------------
H. Allen Corey Director/Secretary November 26, 2001
SIGNATURES
SOUTHWEST ROYALTIES HOLDINGS, INC.
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereto duly authorized.
SOUTHWEST ROYALTIES HOLDINGS, INC.
By: /s/ H. H. Wommack, III
---------------------------------------
H.H. Wommack, III, Chairman, President,
Chief Executive Officer, and Director
Date: November 26, 2001
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- -----
/s/ H.H. Wommack, III
---------------------------
H. H. Wommack, III Chairman/President/
Chief Executive Officer November 26, 2001
/s/ Bill E. Coggin
---------------------------
Bill E. Coggin Vice President/Chief
Financial Officer November 26, 2001
/s/ H. Allen Corey
---------------------------
H. Allen Corey Director/Secretary November 26, 2001