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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR THE QUARTER ENDED MARCH 31, 2004
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF EXCHANGE ACT
COMMISSION FILE NO. 0-12185
DAUGHERTY RESOURCES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
PROVINCE OF BRITISH COLUMBIA NOT APPLICABLE
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
120 PROSPEROUS PLACE, SUITE 201
LEXINGTON, KENTUCKY 40509-1844
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (859) 263-3948
Number of shares outstanding of each of the issuer's classes of common equity,
as of the latest practicable date.
TITLE OF CLASS OUTSTANDING AT MAY 5, 2004
COMMON STOCK 14,236,830
Transitional Small Business Disclosure Format. Yes [ ] No [X]
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DAUGHERTY RESOURCES, INC.
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS:
Review Engagement Report.................................................................................... 2
Condensed Consolidated Balance Sheets - March 31, 2004 (unaudited) and December 31, 2003................... 3
Condensed Consolidated Statement of Operations and Deficit - Three months ended
March 31, 2004 and 2003 (unaudited)...................................................................... 4
Condensed Consolidated Statement of Cash Flows - Three months ended
March 31, 2004 and 2003 (unaudited)...................................................................... 5
Notes to Condensed Consolidated Financial Statements........................................................ 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............. 15
ITEM 3. CONTROLS AND PROCEDURES............................................................................ 22
PART II. OTHER INFORMATION................................................................................. 23
1
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REVIEW ENGAGEMENT REPORT
To the Directors of
DAUGHERTY RESOURCES, INC.
We have reviewed the condensed consolidated balance sheet of DAUGHERTY
RESOURCES, INC. as at March 31, 2004 and the condensed consolidated statements
of operations and deficit and cash flows for the three months then ended. Our
review was made in accordance with generally accepted standards for review
engagements in Canada and the United States of America and accordingly consisted
primarily of enquiry, analytical procedures and discussion related to
information supplied to us by the Company.
A review does not constitute an audit and, consequently, we do not express an
audit opinion on these condensed consolidated financial statements.
Based on our review, nothing has come to our attention that causes us to believe
that these condensed consolidated financial statements are not, in all material
respects, in accordance with Canadian generally accepted accounting principles.
We have previously audited, in accordance with auditing standards generally
accepted in Canada and the United States of America, the consolidated balance
sheet as at December 31, 2003 and the related consolidated statements of
operations and deficit and cash flows for the year then ended (not presented
herein) and, in our report dated March 16, 2004, we expressed an unqualified
opinion on those financial statements. In our opinion, the information set forth
in the accompanying consolidated balance sheet as of December 31, 2003 is fairly
stated in all material respects in relation to the consolidated balance sheet
from which it has been derived.
/S/ KRAFT, BERGER, GRILL, SCHWARTZ, COHEN & MARCH LLP
KRAFT, BERGER, GRILL, SCHWARTZ, COHEN & MARCH LLP
CHARTERED ACCOUNTANTS
Toronto, Ontario
May 12, 2004
2
DAUGHERTY RESOURCES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(U.S. FUNDS)
MARCH 31, DECEMBER 31,
2004 2003
------------- --------------
(UNAUDITED)
ASSETS
Current assets:
Cash....................................................................... $ 15,388,208 $ 22,594,993
Subscriptions receivable................................................... -- 2,335,009
Accounts receivable........................................................ 759,048 503,177
Prepaid expenses and other current assets.................................. 812,702 773,415
Loans to related parties (Note 4).......................................... 140,780 140,780
------------- --------------
Total current assets..................................................... 17,100,738 26,347,374
Bonds and deposits........................................................... 99,000 99,000
Oil and gas properties (Note 2).............................................. 22,460,993 16,369,859
Property and equipment (Note 3).............................................. 2,103,234 2,054,088
Loans to related parties (Note 4)............................................ 482,741 517,940
Investments (Note 5)......................................................... 119,081 119,081
Deferred financing costs (Note 6)............................................ 106,713 247,923
Goodwill (Note 7)............................................................ 313,177 313,177
------------- --------------
Total assets........................................................... $ 42,785,677 $ 46,068,442
============= ==============
LIABILITIES
Current liabilities:
Accounts payable........................................................... 2,257,275 1,445,603
Accrued liabilities........................................................ 3,676,596 2,865,045
Income taxes payable....................................................... 184,866 144,450
Customers' drilling deposits............................................... 2,987,600 10,162,600
Long term debt, current portion (Note 8)................................... 401,932 397,722
------------- --------------
Total current liabilities................................................ 9,508,269 15,015,420
Future income taxes.......................................................... 700,369 257,647
Long term debt (Note 8)...................................................... 3,162,788 4,739,387
------------- --------------
Total liabilities...................................................... 13,371,426 20,012,454
------------- --------------
SHAREHOLDERS' EQUITY
Capital stock (Note 9)
Authorized:
5,000,000 Preferred shares, non-cumulative, convertible
100,000,000 Common shares
Issued:
12,736,905 Common shares (December 31, 2003 - 10,676,030)................ 44,142,617 36,244,623
21,100 Common shares held in treasury, at cost....................... (23,630) (23,630)
Paid-in capital - options and warrants........................ 1,150,145 1,140,321
To be issued:
140,744 Common shares (December 31, 2003 - 1,403,335)................. 601,162 5,917,958
------------- --------------
45,870,294 43,279,272
Deficit...................................................................... (16,456,043) (17,223,284)
------------- --------------
Total shareholders' equity............................................. 29,414,251 26,055,988
------------- --------------
Total liabilities and shareholders' equity........................... $ 42,785,677 $ 46,068,442
============= ==============
See Notes to Condensed Consolidated Financial Statements.
3
DAUGHERTY RESOURCES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND DEFICIT
(U.S. FUNDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
------------- --------------
REVENUE
Contract drilling................................................................ $ 14,326,125 $ 8,033,000
Oil and gas production........................................................... 791,289 529,004
Gas transmission and compression................................................. 448,468 268,850
------------- --------------
Total revenue.................................................................. 15,565,882 8,830,854
------------- --------------
DIRECT EXPENSES
Contract drilling................................................................ 10,104,648 3,395,165
Oil and gas production........................................................... 277,708 316,014
Gas transmission and compression................................................. 399,866 108,189
------------- --------------
Total direct expenses.......................................................... 10,782,222 3,819,368
------------- --------------
GROSS PROFIT........................................................................ 4,783,660 5,011,486
------------- --------------
OTHER INCOME (EXPENSES)
Selling, general and administrative.............................................. (3,185,518) (2,692,215)
Compensation from options and warrants........................................... (30,074) (153,600)
Depreciation, depletion and amortization......................................... (253,129) (179,080)
Interest expense................................................................. (89,168) (82,453)
Interest income.................................................................. 86,862 28,828
Other, net....................................................................... 7,746 (3,754)
------------- --------------
Total other income (expenses).................................................. (3,463,281) (3,082,274)
------------- --------------
INCOME BEFORE INCOME TAXES.......................................................... 1,320,379 1,929,212
------------- --------------
INCOME TAX EXPENSE
Current.......................................................................... 110,416 256,235
Future........................................................................... 442,722 475,865
Benefit realized on loss carried forward......................................... -- (732,100)
------------- --------------
553,138 --
------------- --------------
NET INCOME.......................................................................... 767,241 1,929,212
DEFICIT, beginning of period........................................................ (17,223,284) (20,883,424)
------------- --------------
DEFICIT, end of period.............................................................. $ (16,456,043) $ (18,954,212)
============= ==============
NET INCOME PER SHARE
Basic............................................................................ $ 0.06 $ 0.33
============= ==============
Diluted.......................................................................... $ 0.05 $ 0.24
============= ==============
WEIGHTED AVERAGE COMMON
SHARES OUTSTANDING:
Basic............................................................................ 12,052,183 5,862,502
============= ==============
Diluted.......................................................................... 15,633,855 8,295,832
============= ==============
See Notes to Condensed Consolidated Financial Statements.
4
DAUGHERTY RESOURCES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. FUNDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
------------- --------------
OPERATING ACTIVITIES
Net income....................................................................... $ 767,241 $ 1,929,212
Adjustments to reconcile net income to
net cash used in operating activities:
Incentive bonus paid in common shares.......................................... -- 236,130
Compensation from options and warrants......................................... 30,074 153,600
Depreciation, depletion and amortization....................................... 253,129 179,080
Notes issued in kind for interest on long term debt............................ 37,202 --
Loss (gain) on sale of assets.................................................. (4,600) 3,795
Future income taxes............................................................ 442,722 --
Changes in assets and liabilities:
Subscriptions receivable..................................................... 2,335,009 --
Accounts receivable.......................................................... (255,871) 18,948
Prepaid expenses and other current assets.................................... (39,287) 237,126
Accounts payable............................................................. 811,672 287,497
Accrued liabilities.......................................................... 811,551 1,190,019
Income taxes payable......................................................... 40,416 --
Customers' drilling deposits................................................. (7,175,000) (5,905,000)
------------- --------------
Net cash used in operating activities.......................................... (1,945,742) (1,669,593)
------------- --------------
INVESTING ACTIVITIES
Proceeds from sale of assets..................................................... 4,600 3,245
Purchase of property and equipment............................................... (115,146) (375,806)
Additions to oil and gas properties, net......................................... (6,266,134) (1,556,934)
------------- --------------
Net cash used in investing activities.......................................... (6,376,680) (1,929,495)
------------- --------------
FINANCING ACTIVITIES
Decrease in loans to related parties............................................. 35,199 21,865
Proceeds from issuance of common shares.......................................... 1,103,308 149,188
Proceeds from issuance of long term debt......................................... -- 1,065,500
Payments of long term debt....................................................... (22,870) (53,347)
------------- --------------
Net cash provided by financing activities...................................... 1,115,637 1,183,206
------------- --------------
Change in cash...................................................................... (7,206,785) (2,415,882)
Cash, beginning of period........................................................... 22,594,993 7,031,307
------------- --------------
Cash, end of period................................................................. $ 15,388,208 $ 4,615,425
============= ==============
SUPPLEMENTAL DISCLOSURE
Interest paid....................................................................... $ 43,314 $ 104,578
Income taxes paid................................................................... 70,000 --
SUPPLEMENTAL SCHEDULE OF NONCASH
INVESTING AND FINANCING ACTIVITIES
Common shares issued in settlement of accounts payable.............................. -- 114,126
Common shares issued upon conversion of notes....................................... 1,457,640 --
See Notes to Condensed Consolidated Financial Statements.
5
DAUGHERTY RESOURCES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004
(UNAUDITED)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) General. The accompanying unaudited condensed consolidated financial
statements of Daugherty Resources, Inc., a British Columbia corporation (the
"Company"), have been prepared in accordance with generally accepted accounting
principles in Canada and the United States of America. In the opinion of
management, the accompanying unaudited condensed consolidated financial
statements reflect all adjustments (consisting of normal recurring adjustments)
necessary to fairly present the Company's condensed consolidated financial
position at March 31, 2004 and its condensed consolidated results of operations
and cash flows for the interim periods presented. The condensed consolidated
financial statements should be read in conjunction with the Company's
consolidated financial statements and related notes included in its Annual
Report on Form 10-KSB for the year ended December 31, 2003.
(b) Basis of Consolidation. The Company's condensed consolidated financial
statements include the accounts of Daugherty Petroleum, Inc. ("DPI"), a Kentucky
corporation wholly owned by the Company, and the accounts of Sentra Corporation
("Sentra"), a Kentucky corporation wholly owned by DPI. DPI conducts all of the
Company's oil and gas drilling and production operations, and Sentra owns and
operates natural gas distribution facilities in Kentucky. The condensed
consolidated financial statements also reflect DPI's interests in a total of 24
drilling programs that it has sponsored and managed since 1996 to conduct
drilling operations on its prospects (the "Drilling Programs"). DPI maintains
combined interests as both general partner and an investor in the Drilling
Programs ranging between 25.75% and 66.67%. The Company accounts for those
interests using the proportionate consolidation method, combining DPI's share of
assets, liabilities, income and expenses of the Drilling Programs with those of
its separate operations. All material inter-company accounts and transactions
for the interim periods presented in the condensed consolidated financial
statements have been eliminated on consolidation.
(c) Estimates. The preparation of 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
disclosure of contingent assets and liabilities as of the balance sheet date and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Material estimates are
particularly significant as they relate to oil and gas reserve data, which
require estimates of future production volumes in determining the carrying value
of the Company's proved reserves.
(d) Change in Accounting Policy. Effective January 1, 2004, the Company
adopted the fair value provisions of Canadian Institute of Chartered
Accountants ("CICA") Handbook Section 3870, "Stock-Based Compensation and Other
Stock-Based Payments" and related interpretations for the recognition and
measurement of compensation costs associated with employee stock options. See
Note 9 - Capital Stock.
(e) Reclassification. Certain amounts reported in the condensed
consolidated financial statements for interim period in 2003 have been
reclassified to conform with the presentation in the current period.
NOTE 2. OIL AND GAS PROPERTIES
Capitalized costs and accumulated depreciation, depletion and amortization
("DD&A") relating to the Company's oil and gas producing activities, all of
which are conducted within the continental United States, are summarized below.
MARCH 31, 2004 DECEMBER 31,
------------------------------------------------- 2003
ACCUMULATED --------------
COST DD&A NET NET
-------------- -------------- ------------- --------------
Proved oil and gas properties............... $ 22,040,595 $ (2,575,438) $ 19,465,157 $ 14,053,881
Unproved oil and gas properties............. 777,879 -- 777,879 657,879
Wells and related equipment................. 2,478,346 (260,389) 2,217,957 1,658,099
-------------- ------------- ------------- --------------
Total oil and gas properties................ $ 25,296,820 $ (2,835,827) $ 22,460,993 $ 16,369,859
============== ============= ============= ==============
6
NOTE 3. PROPERTY AND EQUIPMENT
The following table presents the capitalized costs and accumulated
depreciation for the Company's property and equipment as of March 31, 2004.
MARCH 31, 2004 DECEMBER 31,
----------------------------------------------- 2003
ACCUMULATED ------------
COST DEPRECIATION NET NET
----------- ------------ ----------- ------------
Land......................................... $ 12,908 $ -- $ 12,908 $ 12,908
Building improvements........................ 20,609 (3,567) 17,042 17,547
Machinery and equipment...................... 1,132,129 (247,264) 884,865 857,726
Office furniture and fixtures................ 43,289 (18,131) 25,158 26,220
Computer and office equipment................ 329,090 (92,172) 236,918 206,748
Vehicles and aircraft........................ 1,165,950 (239,607) 926,343 932,939
----------- ----------- ----------- -----------
Total property and equipment................. $ 2,703,975 $ (600,741) $ 2,103,234 $ 2,054,088
=========== =========== =========== ===========
NOTE 4. LOANS TO RELATED PARTIES
Loans to related parties represent loans receivable from certain
shareholders and officers of the Company, payable monthly from production
revenues for periods ranging from five to ten years, with a balloon payment at
maturity. The loans receivable from shareholders aggregated $452,092 at March
31, 2004 and $487,291 at December 31, 2003. These loans bear interest at 6% per
annum and are collateralized by ownership interests in Drilling Programs. The
loans receivable from officers totaled $171,429 at March 31, 2004 and December
31, 2003. These loans are non-interest bearing and unsecured.
NOTE 5. INVESTMENTS
The Company has investments of $119,081 in three series of bonds issued by
the City of Galax, Virginia Industrial Development Authority. The bonds bear
interest at rates ranging from 7% to 8.25% per annum, with maturity dates of
July 1, 2004 and July 1, 2010. Although the bonds have a face value of $154,040,
they are carried at cost on the Company's consolidated financial statements in
accordance with accounting principles generally accepted in Canada. Under
accounting principles generally accepted in the United States, the investments
are reportable at fair value, with unrealized gains and losses excluded from
earnings and reported as a separate component of shareholders' equity. As of
March 31, 2004 and December 31, 2003, the estimated market value of the bonds
was $36,970. See Note 14 - United States Accounting Principles.
NOTE 6. DEFERRED FINANCING COSTS
The Company incurred financing costs of $601,886 during 2003 in connection
with the issuance of $5,000,000 principal amount of its 7% convertible notes due
September 5, 2008. These costs were initially capitalized and were expected to
be amortized ratably over the life of the notes. During the fourth quarter of
2003, $2,800,000 principal amount of the notes were converted into common shares
and added to equity, net of $318,087, representing a proportionate amount of the
original financing costs. Additional notes in the principal amount of $1,301,721
were converted into common shares in the first quarter of 2004 and added to
equity, net of proportionate financing costs of $129,081. Accumulated
amortization for the remaining financing costs aggregated $48,005 at March 31,
2004. See Note 9 - Capital Stock.
NOTE 7. GOODWILL
In connection with the acquisition of DPI in 1993, the Company recorded
goodwill of $1,789,564, which was amortized over ten years on a straight-line
basis. Unamortized goodwill at December 31, 2001 was $313,177. At the beginning
of 2002, the Company adopted CICA Handbook Section 3062, "Goodwill and Other
Intangible Assets," which is the Canadian equivalent of Statement of Financial
7
Accounting Standards ("SFAS") No. 142 for accounting standards generally
accepted in the United States of America. Under the adopted standard, goodwill
is no longer amortized but is instead tested for impairment upon adoption and at
least annually thereafter. The annual test may be performed any time during the
year, but must be performed at the same time in each subsequent year. Based on
analyses of its recorded goodwill performed in October 2002 and 2003, the
Company determined that no impairment charges were required. Accordingly,
accumulated amortization of goodwill remained at $1,476,387 as of March 31, 2004
and December 31, 2003.
NOTE 8. LONG TERM DEBT
(a) Credit Facility. The Company maintains a credit facility with KeyBank
NA of up to $10 million, subject to semi-annual borrowing base determinations by
the bank. At March 31, 2004, the borrowing base was $2,675,000. Borrowings under
the facility bear interest payable monthly at 1.25% above the bank's prime rate,
amounting to 5.25% at March 31, 2004. The facility is secured by liens on all
corporate assets, including a first mortgage on oil and gas interests and
pipelines, as well as an assignment of major production and transportation
contracts. Borrowings under the facility totaled $252,046 at March 31, 2004 and
December 31, 2003.
(b) Convertible Notes. The Company has issued a series of convertible
notes in private placements to finance a substantial part of its drilling
activities. The notes are convertible by the holders into the Company's common
stock at fixed rates (subject to anti-dilution adjustments) and are generally
redeemable by the Company at 100% of their principal amount plus accrued
interest through the date of redemption. The terms of the notes are summarized
below.
SHARES
PRINCIPAL AMOUNT OUTSTANDING AT ISSUABLE AT
---------------------------------- MARCH 31, 2004
MARCH 31, DECEMBER 31, CONVERSION UPON
TITLE OF NOTES 2004 2003 PRICE CONVERSION
- --------------------------------- ------------- ------------ ---------- --------------
10% Convertible Notes
due May 1, 2007............... 605,500 740,500 1.50 403,666
8% Convertible Notes
due April 10, 2008............ 770,625 770,625 1.90 405,592
8% Convertible Notes
due May 1, 2008............... 350,000 500,000 2.25 155,555
7% Convertible Notes
due September 5, 2008......... 1,040,369 2,304,888 4.50 231,193
------------- ------------ ---------
Total......................... $ 2,766,494 $ 4,316,013 1,196,006
============= ============ =========
The Company's 7% Convertible Notes due September 5, 2008 listed above were
originally issued during September 2003 in the aggregate principal amount of
$5,000,000 (the "Institutional Notes"). Interest on the Institutional Notes is
payable quarterly in cash or additional Institutional Notes ("PIK Notes") and
must be paid in PIK Notes through September 30, 2004. PIK Notes aggregating
$142,090 were issued as of March 31, 2004.
(c) Acquisition Debt. The Company issued a note in the principal amount of
$854,818 to finance its 1986 acquisition of mineral property on Unga Island,
Alaska. The debt is repayable without interest in monthly installments of $2,000
and is secured by liens on the acquired property and related buildings and
equipment. Although the purchase agreement for the acquisition provides for
royalties at 4% of net smelter returns or other production revenues, the
property has remained inactive. The acquisition debt is recorded at its
remaining face value of $408,818 at March 31, 2004 and $414,818 at December 31,
2003.
8
(d) Miscellaneous Debt. The following table summarizes the Company's other
outstanding debt obligations at March 31, 2004 and December 31, 2003.
PRINCIPAL AMOUNT OUTSTANDING AT
-------------------------------
MARCH 31, DECEMBER 31,
TERMS OF DEBT 2004 2003
- ---------------------------------------------------------------------------- --------- ------------
Notes issued to finance equipment and vehicles, payable monthly in various
amounts through 2005, with interest ranging from 8.68% to 9.5% per annum,
collateralized by the acquired equipment and vehicles................... $ 15,893 $ 23,451
Loan payable to unaffiliated company, bearing interest
at 10% per annum payable quarterly, collateralized
by assets of subsidiary guarantor....................................... 64,779 64,779
Note payable to unaffiliated individual, payable in
60 installments of $1,370, together with interest at 8%
per annum, through 2005................................................. 16,653 20,397
Loans payable to various banks, payable monthly in
various amounts, together with interest at rates ranging
from 4% to 9.75% per annum, through 2005,
collateralized by receivables and various vehicles...................... 40,037 45,605
--------- ---------
Total...................................................................... $ 137,362 $ 154,232
========= =========
(e) Total Long Term Debt. The following table sets forth the Company's
total long term debt and current portion at March 31, 2004 and December 31,
2003.
PRINCIPAL AMOUNT OUTSTANDING AT
-------------------------------
MARCH 31, DECEMBER 31,
2004 2003
------------- -------------
Total long term debt (including current portion)......................... $ 3,564,720 $ 5,137,109
Less current portion..................................................... 401,932 397,722
------------- -------------
Total long term debt..................................................... $ 3,162,788 $ 4,739,387
============= =============
NOTE 9. CAPITAL STOCK
(a) Preferred and Common Shares. The Company has 5,000,000 authorized
shares of preferred stock, none of which were outstanding at March 31, 2004 or
December 31, 2003. The following table reflects transactions involving the
Company's common stock during the reported periods.
9
NUMBER OF
COMMON SHARES ISSUED SHARES AMOUNT
- ------------------------------------------------------------------------- ---------- -------------
Balance, December 31, 2002............................................... 5,505,670 $ 24,589,797
Issued for cash....................................................... 950,000 2,460,450
Issued to employees as incentive bonus................................ 360,500 364,680
Issued upon exercise of stock options and warrants.................... 1,018,131 1,904,164
Issued upon conversion of preferred shares............................ 625,448 1,784,493
Issued upon conversion of convertible notes........................... 2,069,393 4,976,913
Issued for settlement of accounts payable............................. 146,888 164,126
---------- -------------
Balance, December 31, 2003............................................... 10,676,030 36,244,623
Issued for cash....................................................... 1,303,335 5,417,958
Issued upon exercise of stock options and warrants.................... 311,604 1,022,396
Issued upon conversion of convertible notes........................... 445,936 1,457,640
---------- -------------
Balance, March 31, 2004.................................................. 12,736,905 $ 44,142,617
========== =============
COMMON SHARES TO BE ISSUED
Contract settlement...................................................... 100,000 $ 500,000
Exercised options and warrants........................................... 40,744 101,162
---------- -------------
Balance at March 31, 2004................................................ 140,744 $ 601,162
========== =============
PAID IN CAPITAL - OPTIONS AND WARRANTS
Balance, December 31, 2002............................................... $ 763,635
Issued................................................................ 376,686
-------------
Balance, December 31, 2003............................................... 1,140,321
Issued................................................................ 30,074
Exercised............................................................. (20,250)
-------------
Balance, March 31, 2004.................................................. $ 1,150,145
=============
During 2003, the Company completed two institutional private placements of
its common stock, issuing 900,000 shares at $2.85 per share for $2,565,000 in
June 2003 and an additional 1,303,335 shares at $4.50 per share for $5,865,000
at year end. A portion of the proceeds from the second equity financing were
received immediately after year end, resulting in all of the 1,303,335 common
shares subscribed in the financing being classified as capital stock to be
issued at December 31, 2003. All were issued in the first week of January 2004
upon receipt of the subscription proceeds.
(b) Stock Options. The Company maintains two stock option plans for the
benefit of its directors, officers, employees and, in the case of the second
plan, its consultants and advisors. The first plan, adopted in 1997, provides
for the grant of options to purchase up to 600,000 common shares at prevailing
market prices, vesting over a period of up to five years and expiring no later
than six years from the date of grant. The second plan, adopted in 2001,
provides for the grant of options to purchase up to 3,000,000 common shares at
prevailing market prices, expiring no later than ten years from the date of
grant.
During 2003, the Company adopted a new incentive stock award and stock
option plan, subject to approval of its shareholders. If approved, the plan will
provide for the grant of stock awards and stock option grants for an aggregate
of up to 4,000,000 common shares to its officers, directors and consultants, as
determined by the compensation committee of its board of directors.
10
The exercise prices of options outstanding at March 31, 2004 range from
$1.00 to $5.00 per share, and their weighted average remaining contractual life
is 3.82 years. The following table reflects transactions involving the Company's
stock options during 2003 and the first quarter of 2004.
WEIGHTED AVERAGE
STOCK OPTIONS ISSUED EXERCISABLE EXERCISE PRICE
- ----------------------------------------------- --------- ----------- ----------------
Balance, December 31, 2002..................... 1,585,210 1,585,210 1.30
---------
Issued(1)................................... 400,000 1.02
Exercised................................... (820,879) 1.17
Expired..................................... (45,000) 5.00
--------- -------
Balance, December 31, 2003..................... 1,119,331 1,119,331 1.10
---------
Issued(2)................................... 1,385,000 4.03
Exercised................................... (50,743) 1.00
--------- -------
Balance, March 31, 2004........................ 2,453,588 1,068,588 $ 2.75
========= ========= =======
- ------------------
(1) Granted to employees under stock option plans, exercisable through
January 2, 2008 at an exercise price of $1.02 per share.
(2) Granted to employees and directors under stock option plans,
exercisable at $4.03 per share and vesting in increments under
specified conditions.
In accounting for stock options, the Company follows the retroactive
method under CICA Handbook Section 3870. See Note 1 - Summary of Significant
Accounting Policies. For fiscal years beginning before December 15, 2003, the
statement permits compensation costs for stock options to be measured by the
intrinsic value method of accounting similar to the method prescribed by APB
Opinion No. 25, "Accounting for Stock Issued to Employees," with pro forma
disclosure of net income and earnings per share as if the fair value accounting
method had been applied. For fiscal years beginning after December 15, 2003, the
statement requires the fair value method of accounting for stock options
consistent with the recognition and measurement provisions of SFAS Nos. 123 and
148, "Accounting for Stock-Based Compensation," with retroactive restatement of
prior periods to reflect fair value accounting. For the three months ended March
31, 2004, this resulted in the recognition of $30,074 for compensation cost of
options and warrants.
Under the fair value method, employee stock options are valued at grant
date using the Black-Scholes valuation model, and the compensation cost is
recognized ratably over the vesting period. For the three months ended March 31,
2004 and 2003, the fair value estimates for each option grant assumed a risk
free interest rate of 4.5%, a dividend yield of 0%, a theoretical volatility of
0.30 and an expected life ranging from one to five years based on the option's
vesting provisions. Adoption of fair value accounting for stock options to
replace the intrinsic value method previously followed by the Company resulted
in the restatement of net income and income per share for the three months ended
March 31, 2003 as reflected in the table below, with related adjustments to the
deficit as previously reported since 1995.
INTRINSIC FAIR
VALUE VALUE
METHOD METHOD
----------- ----------
(PREVIOUSLY (RESTATED)
REPORTED)
THREE MONTHS ENDED MARCH 31, 2003
Net income......................................... $ 2,082,812 $ 1,929,212
Net earnings per share
Basic............................................ 0.36 0.33
Fully diluted.................................... 0.25 0.24
Weighted average fair value of options granted..... -- --
AS OF DECEMBER 31, 2003
Deficit............................................ 16,306,049 17,223,284
11
(c) Common Stock Purchase Warrants. The Company has issued common stock
purchase warrants in various financing transactions. The exercise prices of
warrants outstanding at March 31, 2004 range from $1.03 to $5.65 per share, and
their weighted average remaining contractual life is 1.40 years. The following
table reflects transactions involving the Company's common stock purchase
warrants during 2003 and the quarter of 2004.
WEIGHTED AVERAGE
COMMON STOCK PURCHASE WARRANTS ISSUED EXERCISABLE EXERCISE PRICE
- ----------------------------------------------- --------- ----------- ----------------
Balance, December 31, 2002..................... 2,559,901 2,559,901 2.76
---------
Issued in financing transactions(1)......... 916,453 5.12
Issued for consulting services(2)........... 175,000 1.55
Exercised................................... (317,831) 2.40
--------- --------
Balance, December 31, 2003..................... 3,333,523 3,333,523 3.43
---------
Exercised................................... (260,861) 3.65
--------- --------
Balance, March 31, 2004........................ 3,072,662 3,072,662 $ 3.38
========= ========= ========
- ------------------
(1) Expiring from June 13, 2006 through December 31, 2008
(2) Expiring from April 3, 2004 through April 2, 2008.
NOTE 10. INCOME PER SHARE
(a) Basic. Income per share is calculated using the weighted average
number of shares outstanding during the period. The following table sets forth
the weighted average of common shares outstanding for the reported periods.
WEIGHTED AVERAGE
REPORTING PERIOD COMMON SHARES OUTSTANDING
- ---------------------------------- -------------------------
Three months ended March 31, 2004 12,052,183
Three months ended March 31, 2003 5,862,502
(b) Fully Diluted. The Company follows CICA Handbook Section 3500,
"Earnings per Share." The statement requires the presentation of both basic and
diluted earnings per share ("EPS") in the statement of operations, using the
"treasury stock" method to compute the dilutive effect of stock options and
warrants and the "if converted" method for the dilutive effect of convertible
instruments. For the three months ended March 31, 2004, the assumed exercise of
outstanding stock options and warrants and conversion of outstanding convertible
notes would have a dilutive effect on EPS because their exercise or conversion
prices were below the average market price of the common stock during the
period. For the three months ended March 31, 2003, the assumed conversion of
preferred stock would also have a dilutive effect on EPS. The following table
sets forth the computation of basic and dilutive EPS for the three months ended
March 31, 2004 and 2003.
12
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
------------- --------------
NUMERATOR:
Net income as reported for basic EPS................................................ $ 767,241 $ 1,929,212
Adjustments to income for diluted EPS............................................... 48,039 31,868
------------- --------------
Net income for diluted EPS....................................................... $ 815,280 $ 1,961,080
============= ==============
DENOMINATOR:
Weighted average shares for basic earnings per share................................ 12,052,183 5,862,502
Effect of dilutive securities:
Stock options.................................................................... 1,082,535 602,063
Warrants......................................................................... 1,019,569 37,200
Conversion of debt instruments................................................... 1,479,568 1,540,551
Conversion of preferred shares................................................... -- 253,516
------------- --------------
Adjusted weighted average shares and assumed conversions for EPS.................... 15,633,855 8,295,832
============= ==============
Basic EPS........................................................................... $ 0.06 $ 0.33
============= ==============
Diluted EPS......................................................................... $ 0.05 $ 0.24
============= ==============
NOTE 11. EMPLOYEE BENEFIT PLAN
On October 1, 2003, the Company established a salary deferral plan under
section 401(k) of the Internal Revenue Code. The plan allows all eligible
employees to defer up to 15% of their annual compensation through contributions
to the plan, with matching contributions by the Company up to 3% of the
participating employees' compensation, plus half of their plan contributions
between 3% and 5% of annual compensation. The deferrals accumulate on a tax
deferred basis until a participating employee withdraws the funds allowable
based on a vesting schedule. The Company's matching contributions to the plan
aggregated $17,310 for the quarter ended March 31, 2004.
NOTE 12. RELATED PARTY TRANSACTIONS
(a) General. Because the Company operates through its subsidiaries and
affiliated Drilling Programs, its holding company structure causes various
agreements and transactions in the normal course of business to be treated as
related party transactions. It is the Company's policy to structure any
transactions with related parties only on terms that are no less favorable to
the Company than could be obtained on an arm's length basis from unrelated
parties. Significant related party transactions not disclosed elsewhere in these
notes are summarized below.
(b) Drilling Programs. DPI invests in sponsored Drilling Programs on
substantially the same terms as unaffiliated investors, contributing capital in
proportion to its partnership interest. DPI also maintains a 1% interest as
general partner in each Drilling Program, resulting in a combined interest of at
least 25.75% in each Drilling Program organized as a limited partnership and up
to 66.67% in each Drilling Program organized as a joint venture. The agreements
for both the limited partnership and joint venture Drilling Programs generally
provide for specified increases in DPI's program interests, up to 15% of the
total program interests, after program distributions reach "payout," which
ranges from 100% to 110% of partners' investment. The partnership agreements
also provide for each Drilling Program to enter into turkey drilling contracts
with DPI for all wells to be drilled by that Drilling Program. The portion of
profit on drilling contracts attributable to DPI's ownership interest in the
Drilling Programs has been eliminated on consolidation for the interim periods
presented in the Company's condensed consolidated financial statements. The
following table sets forth the total revenues recognized from the performance of
turnkey drilling contracts with sponsored Drilling Programs for the reported
periods.
REPORTING PERIOD DRILLING CONTRACT REVENUE
- ----------------------------------------- -------------------------
Three months ended March 31, 2004........ $ 14,326,125
Three months ended March 31, 2003........ 8,033,000
13
NOTE 13. SEGMENT INFORMATION
The Company has two reportable segments based on management responsibility
and key business operations. The following table presents summarized financial
information for the Company's business segments.
THREE MONTHS ENDED
MARCH 31,
-------------------------------
2004 2003
------------- --------------
REVENUE:
Oil and gas development............................................................. $ 15,565,882 $ 8,830,854
Corporate........................................................................... -- --
------------- --------------
Total............................................................................ 15,565,882 8,830,854
------------- --------------
DD&A:
Oil and gas development............................................................. 219,000 161,467
Corporate........................................................................... 34,129 17,613
------------- --------------
Total............................................................................ 253,129 179,080
------------- --------------
INTEREST EXPENSE:
Oil and gas development............................................................. 13,291 37,858
Corporate........................................................................... 75,877 44,595
------------- --------------
Total............................................................................ 89,168 82,453
------------- --------------
NET INCOME (LOSS):
Oil and gas development............................................................. 992,195 2,595,392
Corporate........................................................................... (224,954) (666,180)
------------- --------------
Total............................................................................ 767,241 1,929,212
------------- --------------
CAPITAL EXPENDITURES:
Oil and gas development............................................................. 6,342,898 1,807,473
Corporate........................................................................... 38,382 125,267
------------- --------------
Total............................................................................ $ 6,381,280 $ 1,932,740
============= ==============
MARCH 31, DECEMBER 31,
2004 2003
------------- --------------
IDENTIFIABLE ASSETS:
Oil and gas development............................................................. $ 26,033,000 $ 29,702,445
Corporate........................................................................... 16,752,677 16,365,997
------------- --------------
Total............................................................................ $ 42,785,677 $ 46,068,442
============= ==============
NOTE 14. UNITED STATES ACCOUNTING PRINCIPLES
(a) Differences Reflected in Consolidated Financial Statements. The
Company follows accounting principles generally accepted in Canada ("Canadian
GAAP"), which are different in some respects than accounting principles
generally accepted in the United States of America ("U.S. GAAP"). The only
differences that affect the Company's consolidated financial statements for the
reported periods involve the adoption of fair value accounting for stock options
described in Note 9, which would not be required until 2005 under U.S. GAAP, and
the accounting treatment of the Company's investment in municipal bonds
described in Note 5. Under Canadian GAAP, the decline in value of the Company's
long-term investment in these bonds is not being written-down to their estimated
realizable value. Under U.S. GAAP, this investment would be classified as
available-for-sale in accordance with SFAS No. 115, and would be reported at
fair value, with unrealized gains and losses excluded from earnings and reported
as a separate component of shareholders' equity, as other comprehensive income.
For the three months ended March 31, 2004 and 2003, there were no changes in
bond values. Therefore, other comprehensive income under U.S. GAAP was the same
as net income under Canadian GAAP for the periods presented.
(b) Recent Accounting Pronouncements. Recent accounting pronouncements
followed by the Company under U.S. GAAP are summarized below.
14
(i) SFAS No. 148. SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," was issued in December 2002 to amend
the transition and disclosure provisions of SFAS No. 123. Effective January 1,
2004, the Company adopted the statement to account for its employee stock
options under the fair market value method. See Note 9 - Capital Stock.
(ii) Financial Accounting Standards Board Interpretation ("FIN") No.
45. FIN No. 45, issued in November 2002, expands previously issued accounting
guidance and disclosure requirements for certain guarantees. It requires
companies to recognize an initial liability for the fair value of an obligation
assumed by issuing a guarantee. The provision for initial recognition and
measurement of the liability will be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The adoption of FIN No.
45 is not expected to have a material impact on the Company's condensed
consolidated financial statements.
(iii) SFAS No. 149. SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities," was issued in April 2003 to
amend and clarify accounting for hedging activities and derivative instruments,
including certain derivative instruments embedded in other contracts. The
statement is effective for contracts entered into or modified after September
30, 2003 and is not expected to have a material impact on the Company's
condensed consolidated financial statements.
(iv) SFAS No. 150. SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity," was issued in
May 2003. It establishes standards for classifying and measuring certain
financial instruments with characteristics of both debt and equity. It requires
many financial instruments previously classified as equity to be reclassified as
liabilities and is generally effective for financial instruments entered into or
modified after May 31, 2003 and otherwise at the beginning of the first interim
period beginning after June 15, 2003. The statement is not expected to have a
material impact on the Company's condensed consolidated financial statements.
NOTE 15. SUBSEQUENT EVENT
In April 2004, the Company completed an institutional private placement of
its common stock, issuing 975,000 shares at $5.98 per share for $5,832,450.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Daugherty Resources, Inc. (the "Company") is an independent energy and
natural resources company focused on natural gas development and production in
the Appalachian Basin, primarily in eastern Kentucky. Through our wholly owned
subsidiary, Daugherty Petroleum, Inc. ("DPI"), and DPI's interests in sponsored
drilling partnerships (the "Drilling Programs"), we actively acquire and develop
natural gas interests in our core operating areas. DPI also constructs and
maintains gas gathering systems for our wells, owns and operates natural gas
distribution facilities in Kentucky through its wholly owned subsidiary, Sentra
Corporation ("Sentra"), and owns inactive gold and silver prospects in Alaska.
Our principal and administrative offices are located at 120 Prosperous Place,
Suite 201, Lexington, Kentucky 40509, near our core operating areas. Our common
stock is traded on the Nasdaq SmallCap Market under the symbol "NGAS," and we
maintain a website with information about us at www.ngas.com.
We commenced oil and gas operations in 1993 with the acquisition of DPI
and have sponsored 24 separate Drilling Programs through the date of this
report. We plan to seek shareholder approval at our 2004 annual meeting for a
change in our corporate name to "NGAS Resources, Inc." The new name is intended
to reflect our focus on natural gas development and production. Since we are
commonly associated with the NGAS acronym from its use as the Nasdaq trading
symbol for our common stock and the Internet address of our website, we expect
to adopt the name change throughout our organization, with a view to building a
consistent and recognizable corporate identity. Unless otherwise indicated,
references in this report to "we," "our" or "us" include the Company as well as
DPI and its interests in the Drilling Programs and Sentra.
STRATEGY
We have structured our business to achieve capital appreciation through
growth in our natural gas reserves, production, cash flow and earnings per
share. Our strategy for continuing to realize our operational and financial
objectives emphasizes several components. Each is aimed at positioning us to
capitalize on natural gas development opportunities in our core operating areas
and long range pricing expectations for this commodity.
- Acceleration of Drilling Operations. Historically, we have relied
almost exclusively on development drilling for production and
reserve growth, concentrating on geographic areas of the Appalachian
Basin where we have established expertise and little competition
from major independent energy companies. To help finance our
drilling initiatives, we sponsor and manage Drilling Programs for
private investors, historically contributing 25% of total program
capital raised by each limited partnership Drilling Program and up
to 66.67% of joint venture Drilling Program capital. Since 1999, we
drilled 220 natural gas wells though our Drilling Programs without a
dry hole, including 89 gross (26.7680 net) wells in 2003 and 53
gross (19.9380 net) wells in the first quarter of 2004. We intend to
sponsor and manage Drilling Programs for up to 140 new wells in 2004
and to increase our ownership interest in new programs to at least
30%.
- Acquisition of Additional Drilling Prospects. Over the last two
years, we acquired oil and gas drilling rights covering
approximately 100,000 acres on the southeastern edge of the Big
Sandy Gas Field, extending 41 miles through our primary operating
areas in eastern Kentucky (the "Leatherwood Prospect"), as well as
and gas leases covering 9,400 acres on the north side of the Pine
Mountain Fault System near the Leatherwood Prospect (the "Straight
Creek Field"). As coal reserves are exhausted in the region, the
lapse or relinquishment of the coal companies' competing mineral
claims opens a window of opportunity for extending our acreage
position to additional properties with significant unproved gas
development potential as well as established infrastructure. We plan
to concentrate on assembling additional former coal producing
acreage for exploratory prospects relatively close to fields with
gas production histories and pipelines. By conducting initial
drilling operations on these higher risk prospects through specially
tailored joint venture Drilling Programs and retaining majority
ownership interests, we expect to expand our inventory of
development locations with lower risk profiles for subsequent
Drilling Programs, while adding to our proved reserves, both
developed and undeveloped.
16
- Adherence to Disciplined Drilling for Predictable Results. Most of
our natural gas wells are drilled to relatively shallow total depths
from 2,600 to 4,500 feet, generally encountering five distinct and
predictable pay zones. This disciplined approach helps reduce
drilling risks, as reflected in our 100% success rate since 1999. We
complete and produce our wells from multiple pay zones whenever
possible, eliminating the costs and complexities of deferred
completions with behind-pipe gas. As of March 31, 2004, we operated
a total of 390 natural gas wells, primarily in the Appalachian
Basin. While our wells typically produce at modest initial volumes
and pressures, they also demonstrate low annual decline rates, often
producing for 20 - 25 years or more.
- Concentration on Core Properties for Control of Drilling and
Production Costs. By managing our sponsored Drilling Programs, we
control drilling and production operations on our properties, while
sharing drilling and production costs with our partners and
providing efficiencies that help reduce those costs. We also benefit
from the quality of the natural gas produced from our core
properties. Known as "dry, sweet" gas, our production not only has a
high energy content but also has virtually no water, nitrogen,
sulfur or other impurities. This reduces our production costs and
our well maintenance expenses.
- Acquisition of Producing Properties. The purchase of third party
production offers a means in addition to drilling for accelerating
our growth, while capitalizing on our experience as a regional
operator. Our acquisition criteria for producing properties include
reserve life, profit enhancement potential, geographic concentration
and working interest levels permitting operation of acquired
properties. In addition to acquisitions for our own account, we may
begin to sponsor production programs modeled on our structure for
Drilling Programs to acquire producing natural gas wells meeting
defined criteria from unaffiliated operators in our core geographic
areas. If implemented, this strategy would provide us with
additional vehicles for increasing our stake in Appalachian Basin
gas reserves and production.
- Monetization of Gold and Silver Properties. We stopped exploration
work on our Alaskan gold and silver properties in 1996 based on
operating and commodity pricing considerations. The properties have
remained dormant since that time, and we elected to write off their
carrying value for accounting purposes in 2000, when the market
price of gold was below $285 per ounce. In view of recent
improvements in gold prices, we plan to increase our efforts to
monetize our interests in these properties by seeking a joint
venture partner to either provide funds for developing the prospects
or to acquire them from us.
FINANCING ACTIVITIES
During the last five years, we have funded a substantial part of our
capital expenditures with proceeds from private placements of our common stock
and convertible notes, including equity financings for $8,430,000 and
convertible note financings for $8,236,125 in 2003. Participants in our
convertible note financings elected to convert $5,295,000 of their notes into
2,069,393 shares of our common stock during 2003, with an additional $1,586,721
principal amount of the notes converted into 445,936 common shares in the first
quarter of 2004. During April 2004, we raised an additional $5,832,450 in an
institutional private placement of our common stock, issuing 975,000 shares at
$5.98 per share. See "Liquidity and Capital Resources" below. Our proceeds from
these financings have been allocated primarily to our construction of new
gathering systems and our investments in sponsored Drilling Programs.
DRILLING OPERATIONS
Drilling Program Structure. Most of our Drilling Programs are limited
partnerships structured to minimize drilling risks and optimize tax advantages
for private investors. To develop exploratory prospects with higher risk
profiles, we generally rely on smaller, specialized Drilling Programs structured
as joint ventures with strategic and industry partners or other suitable
investors. At the commencement of operations, drilling rights for specified
wells are assigned by DPI to each Drilling Program, which enters into turnkey
drilling contracts with DPI for drilling and completion of the wells. Each
turnkey contract establishes the price to drill and complete specified wells. We
are responsible for any drilling and completion costs exceeding the contract
price, and we are entitled to any surplus if the contract price exceeds our
costs.
We contribute capital to each Drilling Program in proportion to our
initial ownership interest, and we share program distributions in the same
ratio. We also maintain a 1% interest as general partner of each Drilling
Program,
17
and we are entitled to specified increases in our program interests, up to 15%
of the total program interests, after program distributions reach "payout,"
which ranges from 100% to 110% of partners' investment. We bear all selling
costs for Drilling Program financings and all overhead and administrative costs
for program operations. Our recovery of these expenses is limited to our share
of program distributions and any cost savings we achieve under our turnkey
drilling contracts, net of our proportionate share of that surplus.
Drilling Program Financings. During 2003, we raised outside capital of
$19,329,750 for our limited partnership Drilling Programs and $2,950,00 for
joint venture Drilling Programs. As of the date of this report, we have held
initial closings for an ongoing private placement of interests in the first 2004
limited partnership Drilling Program with contributed capital of $7,800,000 from
outside investors. DPI will have a 30.7% interest in the Drilling Program, which
has entered into turnkey drilling contracts for 37 wells as of that date.
Drilling Results. The following table shows the number of gross and net
development and exploratory wells we drilled during the 2003 and the first
quarter of 2004. Gross wells are the total number of wells in which we have a
working interest. Net wells reflect our working interests in wells drilled
through our Drilling Programs, without giving effect to any reversionary
interest we may subsequently earn in those programs. Productive wells listed
below include wells that were drilled and successfully tested in at least one
primary pay zone but were awaiting construction of gathering systems prior to
completion at the end of the reported period.
DEVELOPMENT WELLS EXPLORATORY WELLS
-------------------------------- ------------------------------
PRODUCTIVE DRY PRODUCTIVE DRY
------------------- ----- ------------------ -----
GROSS NET GROSS GROSS NET GROSS
----- ------- ----- ----- ------- -----
Year ended December 31, 2003.......... 79 20.1013 -- 10 6.6667 --
Quarter ended March 31, 2004.......... 38 9.9380 -- 15 10.0000 --
Well Characteristics. Our proved reserves, both developed and undeveloped,
are concentrated in the Appalachian Basin in eastern Kentucky, one of the oldest
and most prolific natural gas producing areas in the United States.
Historically, wells in this area generally produce between 200 to 450 million
cubic feet natural gas over a reserve life of up to 25 years. The natural gas in
this area is also known for being environmentally friendly in the sense that
wells produce virtually no water or other impurities with the gas production.
This helps us minimize production (lifting) costs. In addition, the average
energy (or Btu) value of the natural gas produced in this area is substantially
higher than normal pipeline quality gas, ranging from 1,100 to 1,229 million
British thermal units ("MBtu") per thousand cubic feet ("Mcf") of gas
production. Our gas sales contracts generally provide upward adjustments to
index based pricing for our natural gas with an energy value above 1,000 MBtu
per Mcf, enhancing our near term cash flows and contributing to the long term
returns on our investments in these properties.
RESULTS OF OPERATIONS
Quarters Ended March 31, 2004 and 2003 Total revenues for the quarter
ended March 31, 2004 were $15,565,882, an increase of 76% from $8,830,854 in the
same quarter last year. Our revenue mix for the first quarter of 2004 was 92%
contract drilling, 5% oil and gas production and 3% natural gas transmission and
compression. For the comparable quarter of 2003, our total revenues were derived
91% from contract drilling, 6% from oil and gas production and 3% from natural
gas transmission and compression activities.
Contract drilling revenues were $14,326,125 for the first quarter of 2004,
up 78% from $8,033,000 in the comparable quarter of 2003. This reflects both the
size and the timing of Drilling Program financings, from which we derive
substantially all our contract drilling revenues. Upon the closing of Drilling
Program financings, DPI receives most of the net proceeds as customers' drilling
deposits under turnkey drilling contracts with the programs. We recognize
revenues from drilling operations on the completed contract method as the wells
are drilled, rather than when funds are received. Drilling operations for our
year-end 2003 limited partnership Drilling Program and our joint venture
Drilling Program for the Leatherwood Prospect were ongoing during the first
quarter of 2004, when we drilled 53 gross (19.9380 net) natural gas wells, all
of which have been completed as producers or successfully tested in at least one
primary pay zone as of the date of this report.
18
Production revenues were $791,289 for the first quarter of 2004, an
increase of 50% from $529,004 in the comparable quarter of 2003. This primarily
reflects an increase of 19% in our average sales price of natural gas (before
certain transportation charges) to $5.51 per Mcf in the first quarter of 2004
from $4.62 per Mcf in the corresponding quarter of 2003. It also reflects a 30%
increase in our production volumes to 144,107 Mcfe in the first quarter of 2004
from 111,142 Mcfe in the same quarter last year. Our growth in production
volumes resulted from new wells brought on line since the end of March 2003. The
improvement in average sales price for our natural gas is consistent with a
market-wide rebound in natural gas prices that began in the third quarter of
2002. Principal purchasers of our natural gas production are gas marketers and
transmission companies with facilities near our producing properties. During the
first quarter of 2004, approximately 40% of our natural gas production was sold
under fixed-price contracts and the balance primarily at prices determined
monthly under formulas based on prevailing market indices.
Gas transmission and compression revenues were $448,468 during the first
quarter of 2004, up 67% from $268,850 in the comparable quarter of 2003. This
primarily reflects increased reliance on our own gathering systems for our new
wells, generating transmission and compression revenues from the Drilling
Programs holding the working interests in those wells. During the first quarter
of 2004, we extended our natural gas gathering systems for new wells and began
construction of a new system for the Straight Creek Field. Our gas transmission
and compression revenues for the first quarter of 2004 also reflect a
contribution of $140,970 from Sentra's gas utility sales, up 22% from $115,752
in the same quarter last year.
Total direct expenses increased by 182% to $10,782,222 for the first
quarter of 2004 compared to $3,819,368 for the first quarter of 2003. Our direct
expense mix for the current reported quarter was 94% contract drilling, 3% oil
and gas production and 4% natural gas transmission and compression. For the
comparable quarter of 2003, our total direct expenses were incurred 89% in
contract drilling, 8% in oil and gas production and 3% in natural gas
transmission and compression.
Contract drilling expenses were $10,104,648 during the first quarter of
2004, an increase of 198% from $3,395,165 in the same quarter last year,
reflecting the substantial level of drilling activities on behalf of our
sponsored Drilling Programs, as well as an increase of approximately 800 feet in
the average depth of our new wells. The greater depth of these wells adds
incrementally to the variable costs paid to outside contractors and to well
completion complexities and expenditures. The greater depth also adds to steel
casing requirements, prices for which increased by approximately 15% in the
first quarter of 2004, with further price increases anticipated on an industry
wide basis throughout the year. In response to these developments, we plan to
increase the price established for drilling and completing new wells under
turnkey drilling contracts with future Drilling Programs.
Production expenses decreased 12% to $277,708 in the first quarter of
2004, compared to $316,014 in the same quarter last year, reflecting economies
of scale and field operating efficiencies. As a percentage of oil and gas
production revenues, production expenses decreased to 35% in the first quarter
of 2004 from 60% in the same quarter last year. The improved margin reflects
both revenue growth driven by higher natural gas prices in the first quarter of
2004 and a greater allocation of our field operating resources for accelerated
drilling activities.
Gas transmission and compression expenses in the first quarter of 2004
were $399,866, an increase 270% from $108,189 in the same quarter last year. As
a percentage of gas transmission and compression revenues, these expenses
increased to 89% in the current reported quarter from 40% in the first quarter
of 2003. Gas transmission and compression expenses do not reflect capitalized
costs of $584,647 in the first quarter of 2004 for extensions of our gas
gathering systems and compression capacity required to bring new wells on line.
Selling, general and administrative ("SG&A") expenses were $3,185,518 in
the first quarter of 2004, an increase of 18% from $2,696,215 in the same
quarter last year, primarily reflecting the timing and extent of our selling and
promotional costs for sponsored Drilling Programs. The higher SG&A expenses for
the first quarter of 2004 also reflect costs for supporting expanded operations
as a whole, including additions to our staff and technology infrastructure as
well as increased salary and other employee related expenses. With the expansion
of our operations, we also achieved various economies of scale, reflected by a
decrease in SG&A expenses as a percentage of total revenues to 20% in the
current reported quarter compared to 31% in the first quarter of 2003.
19
Beginning in 2004, we adopted the fair value method of accounting for
employee stock options, with retroactive prior period restatement to reflect
this method instead of the intrinsic value method we previously followed. Under
the new method, employee stock options are valued at the grant date using the
Black-Scholes valuation model, and the compensation cost is recognized ratably
over the vesting period. We recognized compensation expense of $30,074 in the
first quarter of 2004 and restated our results for the first quarter of 2003 to
record a compensation charge of $153,600 under the fair value method.
Depreciation, depletion and amortization ("DD&A") increased 41% to
$253,129 in the first quarter of 2004 from $179,080 in the same quarter of 2003.
The increase in DD&A expense reflects additions to oil and gas properties, gas
gathering systems and related equipment.
Interest expense for the first quarter of 2004 was $89,168, up 8% from
$82,453 in the first quarter of 2003. Although we reduced our total outstanding
debt substantially since March 2003, the slight increase in current period
interest primarily reflects the repayment of borrowings under our credit
facility with proceeds from convertible notes bearing higher rates. See
"Liquidity and Capital Resources" below.
We recognized income tax expense of $553,138 in the first quarter of 2004,
of which $442,722 was recorded as a future tax liability. Our current income tax
expense for the first three months of 2004 was reduced to $110,416, primarily
from our proportionate share of intangible drilling costs from our Leatherwood
Prospect joint venture Drilling Program. In view of our full utilization of all
loss carryforwards at the DPI level in 2003, we plan to reduce our income tax
liability in future periods by increasing our allocation of intangible drilling
costs from new Drilling Programs.
We realized net income of $767,241 for the first quarter of 2004, compared
to $1,929,212 realized in the first quarter of 2003, reflecting the foregoing
factors. Basic earnings per share were $0.06 based on 12,052,183 weighted
average common shares outstanding in the first quarter of 2004, compared to
$0.33 based on 5,862,502 weighted average common shares outstanding in the same
quarter last year.
The results of operations for the quarter ended March 31, 2004 are not
necessarily indicative of results to be expected for the full year.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. Net cash provided by our operating activities in the first
quarter of 2004 was $1,525,768 before working capital adjustments. After
accounting for changes in assets and liabilities for the period, net cash of
$1,945,742 was used in operating activities, primarily reflecting a decrease of
$7,175,000 in customers' drilling deposits under turnkey drilling contracts with
sponsored Drilling Programs. Our cash position during the first three months of
2004 was decreased by the use of $6,376,680 of net cash in investing activities.
Funds used in investing activities were comprised primarily of $6,266,134 in net
additions to our oil and gas properties, as well as $115,146 in the purchase of
property and equipment. The decrease in our cash position from operating and
financing activities during the first quarter of 2004 was partially offset by
net cash of $1,115,637 from financing activities, consisting primarily of
proceeds from the exercise of stock options and warrants. As a result of these
activities, cash and cash equivalents decreased from $22,594,993 as of December
31, 2003 to $15,388,208 at March 31, 2004.
As of March 31, 2004, we had working capital of $7,592,469, compared to
working capital of $11,331,954 at the end of 2003. This reflects wide
fluctuations in our current assets and liabilities from the timing of customers'
deposits and expenditures under turnkey drilling contracts with our Drilling
Programs. Since these fluctuations are normalized over relatively short time
periods, we generally do not consider working capital to be a reliable measure
of liquidity. Any working capital deficits at the end of future reporting
periods are not expected to have an adverse effect on our financial condition or
results of operations.
Capital Resources. Our business involves significant capital requirements.
The rate of production from oil and gas properties generally declines as
reserves are depleted. Without successful development activities, our proved
reserves will decline as oil and gas is produced from our proved developed
reserves. Our long term performance and profitability is dependent not only on
developing existing oil and gas reserves, but also on our ability to find or
acquire additional reserves on terms that are economically and operationally
advantageous. To fund our ongoing reserve development and acquisition
activities, we have relied on a combination of cash flows
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from operations, bank borrowings and private placements of our convertible notes
and equity securities, as well as participation by outside investors in our
sponsored Drilling Programs.
During 2003, we completed two institutional private placements of common
stock, issuing 900,000 shares at $2.85 per share for $2,565,000 in June 2003 and
an additional 1,303,335 shares at $4.50 per share for $5,865,000 at year end. A
portion of the proceeds from the second equity financing were received
immediately after year end, resulting in their classification as subscriptions
receivable. In April 2004, we completed a third institutional private placement
of our common stock, issuing 975,000 shares at $5.98 per share for $5,832,450.
The proceeds from these equity financings and from convertible note financings
described below have been allocated primarily to construction of gas gathering
lines and our investments in sponsored Drilling Programs, which also raised
$22,279,750 from private investors during 2003 and $2,100,000 during the first
quarter of 2004. See "Drilling Operations - Drilling Program Financings" above.
We have issued five separate series of convertible notes since 2002 in the
aggregate principal amount of $8,656,125, including $3,236,125 principal amount
of convertible notes issued in the first six months of 2003 and $5,000,000
principal amount of convertible notes issued to institutional investors (the
"Institutional Notes") in September 2003. The notes bear interest at rates
ranging from 7% to 10% per annum. The notes of each series are convertible at
the option of the holders into our common stock at prices ranging from $0.85 to
$4.50 per share and are generally redeemable at the option of the Company at
100% of their principal amount plus accrued interest through the date of
redemption. As a result of note conversions totaling $5,295,000 in 2003 and
$1,586,721 in the first quarter of 2004, the aggregate principal amount of our
convertible notes outstanding at March 31, 2004 was reduced to $2,766,494.
The Institutional Notes issued in September 2003 have several features not
provided under prior note financings. Interest on the Institutional Notes at 7%
per annum is payable quarterly in cash or additional Institutional Notes ("PIK
Notes") and must be paid in PIK Notes through September 30, 2004. We issued PIK
Notes aggregating $142,090 as of March 31, 2004. We have the right to repay any
unconverted Institutional Notes at maturity either in cash or in common shares
valued for that purpose at 90% of their prevailing market price. As of March 31,
2004, Institutional Notes in the aggregate principal amount of $4,101,721 had
been converted into common shares at the original conversion price, leaving
$1,040,369 principal amount of the Institutional Notes and PIK Notes
outstanding.
In addition to our outstanding convertible notes, we maintain a credit
facility with KeyBank NA of up to $10 million, subject to semi-annual borrowing
base determinations by the bank. Since July 2003, the borrowing base has been
$2,675,000. Borrowings under the facility bear interest payable monthly at 1.25%
above the bank's prime rate, amounting to 5.25% at March 31, 2004. The facility
is secured by liens on all corporate assets, including a first mortgage on oil
and gas interests and pipelines, as well as an assignment of major production
and transportation contracts. Borrowings under the facility totaled $252,046 at
March 31, 2004 and December 31, 2003.
Our remaining long term debt outstanding at March 31, 2004, including the
current portions, aggregated $408,818 on a secured note issued in 1986 for the
acquisition of our mineral property in Alaska and $137,362 on miscellaneous
obligations incurred to finance various property and equipment acquisitions. Our
ability to repay this acquisition debt as well as our bank debt and any
convertible notes that are not converted prior to maturity will be subject to
our future performance and prospects as well as market and general economic
conditions. We may be dependent on additional financing to repay our outstanding
long term debt at maturity.
Our future revenues, profitability and rate of growth will continue to be
substantially dependent on the demand and market price for natural gas. Future
market prices for natural gas will also have a significant impact on our ability
to maintain or increase our borrowing capacity, to obtain additional capital on
acceptable terms and to continue attracting investment capital to Drilling
Programs. The market price for natural gas is subject to wide fluctuations in
response to relatively minor changes in supply and demand, market uncertainty
and a variety of other factors that are beyond our control.
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We expect our cash reserves, cash flow from operations and funds available
under our credit facility to provide adequate working capital to meet our
capital expenditure objectives through the fourth quarter of 2004, including our
anticipated contributions to Drilling Programs and potential sponsorship of
production acquisition programs. See "Business - Drilling Programs" and " -
Producing Activities - Production Purchase Initiatives." To fully realize our
financial goals for growth in revenues and reserves, we will continue to be
dependent on the capital markets or other financing alternatives as well as
continued participation by investors in future Drilling Programs.
RELATED PARTY TRANSACTIONS
Because we operate through subsidiaries and affiliated Drilling Programs,
our holding company structure causes various agreements and transactions in the
normal course of business to be treated as related party transactions. It is our
policy to structure any transactions with related parties only on terms that are
no less favorable to the Company than could be obtained on an arm's length basis
from unrelated parties. Significant related party transactions are summarized in
Notes 4 and 12 of the footnotes to the accompanying condensed consolidated
financial statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
General. The preparation of financial statements requires management to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosure of contingent assets
and liabilities. On an ongoing basis, management evaluates its estimates,
including evaluations of any allowance for doubtful accounts and impairment of
long-lived assets. Management bases its estimates on historical experience and
on various other assumptions it believes to be reasonable under the
circumstances. The results of these evaluations form a basis for making
judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Although actual results may differ from
these estimates under different assumptions or conditions, management believes
that its estimates are reasonable and that actual results will not vary
significantly from the estimated amounts.
The following critical accounting policies relate to the more significant
judgments and estimates used in the preparation of the condensed consolidated
financial statements.
Allowance for Doubtful Accounts. We maintain an allowance for doubtful
accounts when deemed appropriate to reflect losses that could result from
failures by customers or other parties to make payments on our trade
receivables. The estimates of this allowance, when maintained, are based on a
number of factors, including historical experience, aging of the trade accounts
receivable, specific information obtained on the financial condition of
customers and specific agreements or negotiated amounts with customers.
Impairment of Long-Lived Assets. Our long-lived assets include property
and equipment and goodwill. Long-lived assets with an indefinite life are
reviewed at least annually for impairment, while other long-lived assets are
reviewed whenever events or changes in circumstances indicate that carrying
values of these assets are not recoverable.
FORWARD LOOKING STATEMENTS
This report includes forward looking statements within the meaning of
Section 21E of the Exchange Act relating to anticipated operating and financial
performance, business and financing prospects, developments and results of our
operations. Actual performance, prospects, developments and results may differ
materially from anticipated results due to economic conditions and other risks,
uncertainties and circumstances partly or totally outside our control, including
operating risks inherent in oil and gas development and producing activities,
fluctuations in market prices of oil and natural gas, changes in future
development and production costs and uncertainties in the availability and cost
of capital. Words such as "anticipated," "expect," "intend," "plan" and similar
expressions are intended to identify forward looking statements, all of which
are subject to these risks and uncertainties.
ITEM 3. CONTROLS AND PROCEDURES
Our management, with the participation or under the supervision of our
Chief Executive Officer and Chief Financial Officer, is responsible for
establishing and maintaining disclosure controls and procedures and internal
control over financial reporting for the Company in accordance with the
requirements of the Exchange Act. Our
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Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures and our internal control over financial reporting as of December 31,
2003. Based on their evaluation, they have concluded that the controls and
procedures are effective. They also determined that there were no changes in our
controls or procedures during the first quarter of 2004 that have materially
affected or are reasonably likely to materially affect our internal control of
financial reporting.
Our disclosure controls and procedures have been designed to ensure that
material information about our business and operations is accumulated, recorded
and communicated to our Chief Executive Officer and Chief Financial Officer as
appropriate to make timely decisions on required public disclosure. They are
also intended to provide a framework for making sure that all information
required to be disclosed in our current and periodic reports under the Exchange
Act is processed and publicly reported by us within the prescribed time periods
for our filing of those reports with the SEC.
Our internal controls over financial reporting are designed to provide
reasonable assurances on the reliability of our financial reporting and the
preparation of our financial statements for external purposes in accordance with
generally accepted accounting principles. They include policies and procedures
for maintaining reasonably detailed records that accurately and fairly reflect
all our business transactions and dispositions of assets, for ensuring that
receipts and expenditures are made only in accordance with management
authorizations and for providing reasonable assurance on the prevention or
timely detection of any unauthorized acquisition, use or disposition of our
assets that could have a material effect on our financial statements.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- ---------- ------------------------------------------------------------------
3.1 Memorandum and Articles for Catalina Energy & Resources Ltd., a
British Columbia corporation, dated January 31, 1979 (incorporated
by reference to Exhibit 3[a] to its Registration Statement on Form
10 [File No. 0-12185], filed May 25, 1984).
3.2 Certificate for Catalina Energy & Resources Ltd., a British
Columbia corporation, dated November 27, 1981, changing the name
of Catalina Energy & Resources Ltd. to Alaska Apollo Gold Mines
Ltd. (incorporated by reference to Exhibit 3[b] to its
Registration Statement on Form 10 [File No. 0-12185] filed May 25,
1984).
3.3 Certificate of Change of Name for Alaska Apollo Gold Mines Ltd., a
British Columbia corporation, dated October 14, 1992, changing the
name of Alaska Apollo Gold Mines Ltd. to Daugherty Resources,
Inc., and changing its authorized capital stock to 6,000,000
shares of common stock, without par value (incorporated by
reference to Exhibit 3[c] to Amendment No. 1 to its Annual Report
on Form 10-K [File No. 0-12185] for the year ended December 31,
1993).
3.4 Altered Memorandum of Daugherty Resources, dated September 9,
1994, changing its authorized capital stock to 20,000,000 shares
of common stock, without par value (incorporated by reference to
Exhibit 3[d] to Amendment No. 1 to its Annual Report on Form 10-K
[File No. 0-12185] for the year ended December 31, 1993).
3.5 Altered Memorandum of Daugherty Resources, dated June 30, 1999,
changing its authorized capital stock to 100,000,000 shares of
common stock, without par value, and 5,000,000 shares of preferred
stock, without par value, and accompanying Special Resolution
setting forth the terms of preferred shares (incorporated by
reference to Exhibit 3[a] to its Current Report on Form 8-K [File
No. 0-12185] dated October 25, 1999).
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10.1 1997 Stock Option Plan of Daugherty Resources (incorporated by
reference to Exhibit 10[a] to its Annual Report on Form 10-K [File
No. 0-12185] for the year ended December 31, 2002).
10.2 2001 Stock Option Plan of Daugherty Resources (incorporated by
reference to Exhibit 10[b] to its Annual Report on Form 10-K [File
No. 0-12185] for the year ended December 31, 2002).
10.3 2003 Incentive Stock and Stock Option Plan of Daugherty Resources.
10.4 Form of Common Stock Purchase Warrant dated June 13, 2003 issued
pursuant to Securities Purchase Agreement dated as of June 10,
2003 among Daugherty Resources, Inc. and the investors named
therein (incorporated by reference to Exhibit 10.1 to the Current
Report on Form 8-K [File No. 0-12185] of Daugherty Resources dated
June 13, 2003).
10.5 Form of 7% Convertible Promissory Note dated as of September 5,
2003 issued pursuant to the Securities Purchase Agreement dated as
of September 5, 2003 among Daugherty Resources, Inc. and the
investors named therein (incorporated by reference to Exhibit 10.2
to the Current Report on Form 8-K [File No. 0-12185] of Daugherty
Resources dated September 5, 2003).
10.6 Form of Common Stock Purchase Warrant dated September 5, 2003
issued pursuant to Securities Purchase Agreement dated as of
September 5, 2003 among Daugherty Resources, Inc. and the
investors named therein (incorporated by reference to Exhibit 10.3
to the Current Report on Form 8-K [File No. 0-12185] of Daugherty
Resources dated September 9, 2003).
10.7 Form of Common Stock Purchase Warrant dated December 31, 2003
issued pursuant to Securities Purchase Agreement dated as of
December 31, 2003 between Daugherty Resources, Inc. and the
investors named therein (incorporated by reference to Exhibit 10.3
to the Current Report on Form 8-K [File No. 0-12185] of Daugherty
Resources dated January 2, 2003).
10.8 Form of Common Stock Purchase Warrant dated April 29, 2004 issued
pursuant to Securities Purchase Agreement dated as of April 27,
2004 among Daugherty Resources, Inc. and the investors named
therein (incorporated by reference to Exhibit 10.4 to the Current
Report on Form 8-K [File No. 0-12185] of Daugherty Resources dated
September 9, 2003).
10.9 Form of Change of Control Agreement dated as of February 25, 2004
between Daugherty Resources and each of William S. Daugherty,
William G. Barr III, D. Michael Wallen and Michael P. Windisch
10.10 Form of Indemnification Agreement dated as of February 25, 2004
between Daugherty Resources and each of William S. Daugherty,
William G. Barr III, D. Michael Wallen and Michael P. Windisch
10.11 Form of Long Term Incentive Agreement dated as of February 25,
2004 between Daugherty Resources and each of William S. Daugherty,
William G. Barr III, D. Michael Wallen and Michael P. Windisch
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934, as amended.
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934, as amended.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted under Section 906 of the Sarbanes-Oxley
Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted under Section 906 of the Sarbanes-Oxley
Act of 2002.
(b) Reports on Form 8-K.
None
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DAUGHERTY RESOURCES, INC.
Date: May 14, 2004 By: /s/ William S. Daugherty
---------------------------------------
William S. Daugherty
Chief Executive Officer
(Duly Authorized Officer)
(Principal Executive Officer)
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