<Page>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
/ / 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 1-8038
KEY ENERGY SERVICES, INC.
(Exact name of registrant as specified in its charter)
Maryland 04-2648081
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6 Desta Drive, Midland, Texas 79705
-----------------------------------------------------
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number including area code: (915) 620-0300
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No / /
Common Shares outstanding at November 12, 2002 - 128,288,527
<Page>
KEY ENERGY SERVICES, INC.
INDEX
<Table>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of
September 30, 2002 (unaudited) and June 30, 2002................ 3
Unaudited Consolidated Statements of
Operations for the Three Months Ended
September 30, 2002 and 2001..................................... 4
Unaudited Consolidated Statements of
Cash Flows for the Three Months Ended
September 30, 2002 and 2001..................................... 5
Unaudited Consolidated Statements of Comprehensive
Income (Loss) for the Three Months Ended
September 30, 2002 and 2001..................................... 6
Notes to Consolidated Financial Statements...................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations...................... 18
Item 3. Quantitative and Qualitative Disclosures about Market Risk.......... 23
Item 4. Controls and Procedures............................................. 26
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................... 27
Item 2. Changes in Securities and Use of Proceeds........................... 27
Item 3. Defaults Upon Senior Securities..................................... 27
Item 4. Submission of Matters to a Vote of Security Holders................. 27
Item 5. Other Information................................................... 27
Item 6. Exhibits and Reports on Form 8-K.................................... 27
Signatures ..................................................................... 28
</Table>
2
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KEY ENERGY SERVICES, INC.
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
SEPTEMBER 30,
2002 JUNE 30, 2002
------------- -------------
(UNAUDITED)
(THOUSANDS, EXCEPT SHARE DATA)
ASSETS
Current assets:
Cash and cash equivalents............................................................... $ 3,828 $ 54,147
Accounts receivable, net of allowance for doubtful accounts of $3,986 and $3,969,
respectively........................................................................... 140,511 117,907
Inventories............................................................................. 8,969 7,776
Prepaid expenses and other current assets............................................... 18,114 12,243
----------- -----------
Total current assets...................................................................... 171,422 192,073
----------- -----------
Property and equipment:
Well servicing equipment................................................................ 922,159 776,271
Contract drilling equipment............................................................. 123,568 124,191
Motor vehicles.......................................................................... 78,253 68,977
Oil and natural gas properties and other related equipment, successful efforts method... 44,479 44,439
Furniture and equipment................................................................. 44,835 38,979
Buildings and land...................................................................... 49,060 40,247
----------- -----------
Total property and equipment.............................................................. 1,262,354 1,093,104
Accumulated depreciation and depletion.................................................... (311,169) (284,204)
----------- -----------
Net property and equipment................................................................ 951,185 808,900
----------- -----------
Goodwill, net........................................................................... 320,550 201,069
Deferred costs, net..................................................................... 13,993 12,580
Notes and accounts receivable - related parties........................................ 712 274
Other assets............................................................................ 33,328 28,099
----------- -----------
Total assets.............................................................................. $ 1,491,190 $ 1,242,995
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable........................................................................ $ 21,090 $ 24,625
Other accrued liabilities............................................................... 57,452 49,465
Accrued interest........................................................................ 5,310 14,864
Current portion of long-term debt and capital lease obligations......................... 7,311 7,674
----------- -----------
Total current liabilities................................................................. 91,163 96,628
----------- -----------
Long-term debt, less current portion...................................................... 482,520 420,717
Capital lease obligations, less current portion........................................... 14,621 15,219
Deferred revenue.......................................................................... 9,223 10,001
Non-current accrued expenses.............................................................. 40,922 13,574
Deferred tax liability.................................................................... 160,630 149,990
Commitments and contingencies............................................................. - -
Stockholders' equity:
Common stock, $.10 par value; 200,000,000 shares authorized, 128,525,250 and
110,308,463 shares issued at September 30, 2002 and June 30, 2002, respectively........ 12,853 11,031
Additional paid-in capital.............................................................. 671,874 514,752
Treasury stock, at cost; 416,666 shares at September 30, 2002 and June 30, 2002......... (9,682) (9,682)
Accumulated other comprehensive loss.................................................... (47,156) (48,967)
Retained earnings....................................................................... 64,222 69,732
----------- -----------
Total stockholders' equity................................................................ 692,111 536,866
----------- -----------
Total liabilities and stockholders' equity................................................ $ 1,491,190 $ 1,242,995
=========== ===========
</Table>
SEE THE ACCOMPANYING NOTES WHICH ARE AN INTEGRAL PART OF THESE CONSOLIDATED
FINANCIAL STATEMENTS.
3
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KEY ENERGY SERVICES, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2002 2001
--------- ---------
(THOUSANDS, EXCEPT PER SHARE DATA)
REVENUES:
Well servicing.......................................................................... $ 184,887 $ 212,501
Contract well drilling.................................................................. 15,479 33,636
Other................................................................................... 1,701 3,100
--------- ---------
Total revenues............................................................................ 202,067 249,237
--------- ---------
COSTS AND EXPENSES:
Well servicing.......................................................................... 131,271 135,761
Contract drilling....................................................................... 10,957 21,188
Depreciation, depletion and amortization................................................ 25,802 17,869
General and administrative.............................................................. 26,008 15,147
Interest................................................................................ 11,262 11,949
Other expenses.......................................................................... 1,030 1,185
Gain on retirement of debt.............................................................. (10) (287)
--------- ---------
Total costs and expenses.................................................................. 206,320 202,812
--------- ---------
Income (loss) before income taxes......................................................... (4,253) 46,425
Income tax benefit (expense).............................................................. 1,616 (17,249)
--------- ---------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE................ (2,637) 29,176
Cumulative effect on prior years of a change in accounting principle, less applicable
income taxes of $1,761................................................................... (2,873) -
--------- ---------
NET INCOME (LOSS)......................................................................... $ (5,510) $ 29,176
========= =========
EARNINGS (LOSS) PER SHARE:
Basic - before cumulative effect of a change in accounting principle.................... $ (0.02) $ 0.29
Cumulative effect of a change in accounting principle, net of tax....................... (0.02) -
--------- ---------
Basic - after cumulative effect of a change in accounting principle..................... $ (0.04) $ 0.29
========= =========
Diluted - before cumulative effect of a change in accounting principle.................. $ (0.02) $0.28
Cumulative effect of a change in accounting principle, net of tax....................... (0.02) -
--------- ---------
Diluted - after cumulative effect of a change in accounting principle................... $ (0.04) $ 0.28
========= =========
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic................................................................................... 122,475 101,727
Diluted................................................................................. 122,475 103,829
</Table>
SEE THE ACCOMPANYING NOTES WHICH ARE AN INTEGRAL PART OF THESE CONSOLIDATED
FINANCIAL STATEMENTS
4
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KEY ENERGY SERVICES, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2002 2001
---------- ---------
(THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)....................................................................... $ (5,510) $ 29,176
ADJUSTMENTS TO RECONCILE NET INCOME (LOSS) TO NET CASH PROVIDED BY OPERATING
ACTIVITIES:............................................................................
Depreciation, depletion and amortization................................................ 25,802 17,869
Amortization of deferred debt issuance costs, discount and premium...................... 967 905
Deferred income taxes................................................................... (1,616) 14,707
(Gain) loss on sale of assets........................................................... 145 (1,062)
Gain on retirement of debt.............................................................. (10) (287)
Cumulative effect on prior years of a change in accounting principle, net of tax........ 2,873 -
CHANGE IN ASSETS AND LIABILITIES, NET OF EFFECTS FROM ACQUISITIONS:
Increase in accounts receivable...................................................... (1,290) (7,900)
(Increase) decrease in other current assets.......................................... 5,035 (170)
Decrease in accounts payable, accrued interest and accrued expenses.................. (21,246) (1,988)
Other assets and liabilities......................................................... 2,727 (5,705)
---------- ---------
Net cash provided by operating activities............................................... 7,877 45,545
---------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures - well servicing................................................... (12,115) (11,911)
Capital expenditures - contract drilling................................................ (191) (8,154)
Capital expenditures - other............................................................ (4,286) (3,424)
Proceeds from sale of fixed assets...................................................... 82 3,416
Acquisitions - well servicing, net of cash acquired..................................... (98,093) (2,673)
Net cash used in investing activities................................................... (114,603) (22,746)
---------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of long-term debt............................................................. (1,211) (66,490)
Repayment of capital lease obligations.................................................. (2,387) (2,455)
Proceeds from long-term debt............................................................ 63,000 46,000
Debt issuance costs..................................................................... (2,355) -
Proceeds from exercise of stock options................................................. 447 541
Other................................................................................... (38) -
---------- ---------
Net cash provided by (used in) financing activities..................................... 57,456 (22,404)
---------- ---------
Effect of exchange rates on cash........................................................ (1,049) -
Net increase (decrease) in cash and cash equivalents.................................... (50,319) 395
Cash and cash equivalents at beginning of period........................................ 54,147 2,098
---------- ---------
Cash and cash equivalents at end of period.............................................. $ 3,828 $ 2,493
========== =========
</Table>
SEE THE ACCOMPANYING NOTES WHICH ARE AN INTEGRAL PART OF THESE CONSOLIDATED
FINANCIAL STATEMENTS.
5
<Page>
KEY ENERGY SERVICES, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2002 2001
---------- ---------
(THOUSANDS)
NET INCOME (LOSS)......................................................................... $ (5,510) $ 29,176
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Oil and natural gas derivatives adjustment, net of tax (See Note 7)..................... (344) 176
Amortization of oil and natural gas derivatives, net of tax (See Note 7)................ 210 (33)
Foreign currency translation gain (loss), net of tax.................................... 1,945 (23)
---------- ---------
COMPREHENSIVE INCOME (LOSS), NET OF TAX................................................... $ (3,699) $ 29,296
========== =========
</Table>
SEE THE ACCOMPANYING NOTES WHICH ARE AN INTEGRAL PART OF THESE CONSOLIDATED
FINANCIAL STATEMENTS.
6
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
1. SUMMARY OF SIGNFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Key Energy Services, Inc. (the
"Company", or "Key") and its wholly-owned subsidiaries as of September 30, 2002
and for the three month periods ended September 30, 2002 and 2001 are unaudited.
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 Form 10-Q pursuant to the rules and
regulations of the Securities and Exchange Commission. However, in the opinion
of management, these interim financial statements include all the necessary
adjustments to fairly present the results of the interim periods presented.
These unaudited interim consolidated financial statements should be read in
conjunction with the audited financial statements included in the Company's
Annual Report on Form 10-K for the fiscal year ended June 30, 2002. The results
of operations for the three month period ended September 30, 2002 are not
necessarily indicative of the results of operations for the full fiscal year
ending June 30, 2003.
RECLASSIFICATIONS
Certain reclassifications have been made to the consolidated financial
statements for the three months ended September 30, 2001 to conform to the
presentation for the three months ended September 30, 2002. The
reclassifications consist primarily of reclassifying certain items from
general and administrative expense to direct expenses, and reclassifying
gains (losses) on the retirement of debt as operating expenses rather than
extraordinary items in accordance with SFAS 145, which the Company adopted on
July 1, 2002 (See Note 11).
7
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KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
2. EARNINGS PER SHARE
The Company accounts for earnings per share based upon Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). Under
SFAS 128, basic earnings per common share are determined by dividing net
earnings applicable to common stock by the weighted average number of common
shares actually outstanding during the period. Diluted earnings per common share
is based on the increased number of shares that would be outstanding assuming
exercise of dilutive stock options and warrants and conversion of dilutive
outstanding convertible securities using the "as if converted" method.
<Table>
<Caption>
THREE MONTHS
ENDED SEPTEMBER 30,
-------------------------
2002 2001
--------- ----------
(THOUSANDS, EXCEPT
PER SHARE DATA)
BASIC EPS COMPUTATION:
NUMERATOR
Net income (loss) before cumulative effect of a change in
accounting principle.......................................... $ (2,637) $ 29,176
Cumulative effect of a change in accounting principle, net of
tax........................................................... (2,873) -
--------- ----------
Net income (loss).............................................. $ (5,510) $ 29,176
========= ==========
DENOMINATOR
Weighted average common shares outstanding..................... 122,475 101,727
--------- ----------
BASIC EPS:
Net income (loss) before cumulative effect of a change in
accounting principle.......................................... $ (0.02) $ 0.29
Cumulative effect of a change in accounting principle, net of
tax........................................................... (0.02) -
--------- ----------
Net income (loss).............................................. $ (0.04) $ 0.29
========= ==========
DILUTED EPS COMPUTATION:
NUMERATOR
Net income (loss) before cumulative effect of a change in
accounting principle.......................................... $ (2,637) $ 29,176
Cumulative effect of a change in accounting principle, net of
tax........................................................... (2,873) -
--------- ----------
Net income (loss).............................................. $ (5,510) $ 29,176
========= ==========
DENOMINATOR
Weighted average common shares outstanding:.................... 122,475 101,727
Warrants....................................................... - 577
Stock options.................................................. - 1,525
--------- ----------
122,475 103,829
--------- ----------
DILUTED EPS:
Net income (loss) before cumulative effect of a change in
accounting principle.......................................... $ (0.02) $ 0.28
Cumulative effect of a change in accounting principle, net of
tax........................................................... (0.02) -
--------- ----------
Net income (loss).............................................. $ (0.04) $ 0.28
========= ==========
</Table>
The diluted earnings per share calculations for the three months ended
September 30, 2001 excludes the effect of the potential exercise of stock
options of 1,463,000 and the potential
8
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
conversion of the Company's 5% Convertible Subordinated Notes because the
effects of such instruments on earnings per share would be anti-dilutive.
3. ACQUISITIONS
ACQUISITION OF Q SERVICES, INC.
On July 19, 2002, Key acquired Q Services, Inc. ("QSI") pursuant to an
Agreement and Plan of Merger dated May 13, 2002, as amended, by and among
Key, Key Merger Sub, Inc. and QSI. As consideration for the merger, the
Company issued approximately 17.1 million shares of its common stock to the
QSI shareholders and paid approximately $94.2 million in cash at the closing
to retire debt and preferred stock of QSI and to satisfy certain other
obligations of QSI. In addition to assuming the positive working capital of
QSI, the Comany incurred other direct acquisition costs and assumed certain
other liabilities of QSI, resulting in the Company recording an aggregate
purchase price of approximately $248 million. The value of those shares was
based on the closing price of the Key common stock on the closing date of
$8.75 per share. The results of QSI's operations have been included in the
consolidated financial statements since the closing date. Prior to the
acquisition, QSI was a privately held corporation conducting field
production, pressure pumping and other service operations in Louisiana, New
Mexico, Oklahoma, Texas and the Gulf of Mexico. The Company and QSI operate
in adjacent and/or overlapping locations and expect to realize future cost
savings and synergies in connection with the merger. The combination of the
companies formed the largest oil field trucking fleet in the United States
complementing the Company's well service rig fleet, which is the largest in
the world.
The following table summarizes the estimated fair value of the assets
acquired and liabilities assumed at the date of acquisition. The Company is
in the process of obtaining third-party valuations of certain non-current
accrued liabilities; thus, the allocation of the purchase price is subject to
refinement.
<Table>
<Caption>
AT JULY 19,
2002
-----------
(THOUSANDS)
Current assets....................................... $ 37,734
Property and equipment............................... 138,898
Intangible assets.................................... 3,243
Other assets......................................... 342
Goodwill............................................. 117,060
---------
Total assets acquired............................. 297,277
---------
Current liabilities.................................. 16,787
Capital lease obligations............................ 77
Non-current accrued expenses......................... 17,908
Deferred tax liability............................... 14,347
---------
Total liabilities assumed......................... 49,119
---------
Net assets acquired.................................. $ 248,158
=========
</Table>
9
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
The $3,243,000 of intangible assets consists of noncompete agreements
which have a weighted-average useful life of approximately three years. The
$117,060,000 of goodwill was allocated to the well servicing reporting
segment. Of that amount, $11,645,000 is expected to be deductible for income
taxes.
The following unaudited pro forma results of operations have been prepared
as though QSI had been acquired on July 1, 2001. Pro forma amounts are not
necessarily indicative of the results that may be reported in the future.
<Table>
<Caption>
THREE MONTHS ENDED
-----------------------
9/30/02 9/30/01
--------- ---------
(THOUSANDS, EXCEPT PER
SHARE AMOUNT)
Revenues.......................................................... $ 209,770 $ 307,391
Income (loss) before cumulative effect of a change in accounting
principle, net of tax............................................ (4,296) 34,488
Cumulative effect of a change in accounting principle, net of tax. (2,873) -
Net income (loss)................................................. (7,169) 34,488
Basic earnings (loss) per share................................... $ (0.06) $ 0.29
</Table>
In addition to the acquisition of QSI, during the three months ended
September 30, 2002, Key completed several small acquisitions for a total of
approximately $12,065,000, which consisted of a combination of cash and shares
of Key common stock. Each of the acquisitions made during such three-month
period was accounted for using the purchase method and the results of the
operations generated from the acquired assets are included in the Key's results
of operations as of the completion date of each acquisition. There were no
acquisitions by the Company during the three months ended September 30, 2001.
4. COMMITMENTS AND CONTINGENCIES
Various suits and claims arising in the ordinary course of business are
pending against the Company. Management does not believe that the disposition of
any of these items will result in a material adverse impact to the consolidated
financial position, results of operations or cash flows of the Company.
5. INDUSTRY SEGMENT INFORMATION
The Company's reportable business segments are well servicing and contract
drilling.
WELL SERVICING: The Company's operations provide well servicing (ongoing
maintenance of existing oil and natural gas wells), completions, workover
(major repairs or modifications necessary to optimize the level of production
from existing oil and natural gas wells) and production and well intervention
services (fluid hauling and fluid storage tank rental and fishing and rental
tools).
10
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KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
CONTRACT DRILLING: The Company provides contract drilling services for
major and independent oil companies onshore the continental United States,
Argentina and Ontario, Canada.
<Table>
<Caption>
WELL CONTRACT CORPORATE /
SERVICING DRILLING OTHER TOTAL
--------- --------- ----------- -----------
THREE MONTHS ENDED SEPTEMBER 30, 2002
Operating revenues...................................... $ 184,887 $ 15,479 $ 1,701 $ 202,067
Operating profit ....................................... 53,616 4,522 671 58,809
Depreciation, depletion and amortization................ 22,069 2,392 1,341 25,802
Interest expense........................................ 276 - 10,986 11,262
Net income (loss) before cumulative effect of a change
in accounting principle*............................... 8,962 262 (11,861) (2,637)
Identifiable assets..................................... 828,845 88,742 253,053 1,170,640
Capital expenditures (excluding acquisitions)........... 12,115 191 4,286 16,592
THREE MONTHS ENDED SEPTEMBER 30, 2001
Operating revenues...................................... $ 212,501 $ 33,636 $ 3,100 $ 249,237
Operating profit ....................................... 76,740 12,448 1,915 91,103
Depreciation, depletion and amortization................ 14,557 2,380 932 17,869
Interest expense........................................ 548 - 11,401 11,949
Net income (loss) before cumulative effect of a change
in accounting principle*............................... 34,259 5,735 (10,818) 29,176
Identifiable assets..................................... 676,410 101,161 290,112 1,067,683
Capital expenditures (excluding acquisitions)........... 11,911 8,154 3,424 23,489
</Table>
* Net income (loss) before cumulative effect of a change in accounting
principle for the contract drilling segment includes a portion of well
servicing general and administrative expenses allocated on a percentage of
revenue basis.
Operating revenues for the Company's foreign operations for the three
months ended September 30, 2002 and 2001 were $6.1 million and $12.1 million,
respectively. Operating profits for the Company's foreign operations for the
three months ended September 30, 2002 and 2001 were $1.4 million and $2.6
million, respectively. The Company had $41.1 million and $82.6 million of
identifiable assets as of September 30, 2002 and 2001, respectively, related to
foreign operations.
6. VOLUMETRIC PRODUCTION PAYMENT
In March 2000, Key sold a portion of its future oil and natural gas
production from Odessa Exploration Incorporated, its wholly owned subsidiary,
for gross proceeds of $20 million pursuant to an agreement under which the
purchaser is entitled to receive a portion of the production from certain oil
and natural gas properties over the six year period ending February 28, 2006 in
amounts starting at 10,000 barrels of oil per month and declining to 3,500
barrels of oil per month and starting at 122,100 Mmbtus of natural gas per month
and declining to 58,800 Mmbtus of natural gas per month. The total volume of the
forward sale is approximately 486,000 barrels of oil and 6,135,000 Mmbtus of
natural gas.
7. DERIVATIVE INSTRUMENTS
The Company utilizes derivative financial instruments to manage well
defined 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 only deals with reputable financial
11
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
institutions as counter-parties and anticipates 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.
The Company periodically hedges a portion of its oil and natural gas
production through collar and option agreements. The purpose of the hedges is to
provide a measure of stability in the volatile environment of oil and natural
gas prices and to manage exposure to commodity price risk under existing sales
commitments. The Company's risk management objective is to lock in a range of
pricing for expected production volumes. This allows the Company to forecast
future cash flows within a predictable range. The Company meets this objective
by entering into collar and option arrangements which allow for acceptable cap
and floor prices.
The Company does not enter into derivative instruments for any purpose
other than for economic hedging. The Company does not speculate using derivative
instruments. The Company has identified the following derivative instruments:
FREESTANDING DERIVATIVES. On May 25, 2001 the Company entered into an
option arrangement for a 12-month period beginning March 2002 whereby the
counter-party will pay if the price should fall below the floor index. On May 2,
2002 the Company entered into an option arrangement for a 12-month period
beginning March 2003 whereby the counter-party will pay if the price should fall
below the floor index. The Company desires a measure of stability to ensure that
cash flows do not fall below a certain level.
As of May 25, 2001, the Company had not documented the May 25, 2001 oil and
natural gas options as cash flow hedges and therefore has included income of
$768,000 for the increase in fair value of the asset as of June 30, 2001 in
other income. As of July 1, 2001, the Company documented these options as cash
flow hedges. As of May 2, 2002, the Company had documented the May 2, 2002 oil
and natural gas options as cash flow hedges. The Company recorded a net decrease
in derivative assets of approximately $163,000 during the three months ended
September 30, 2002.
EMBEDDED DERIVATIVES. The Company is party to a volumetric production
payment of which certain terms meet the definition of an embedded derivative
under SFAS 133. Effective July 1, 2000, the Company determined and documented
that the volumetric production payment is excluded from the scope of SFAS 133
under the normal purchases/sales exclusion as set forth in SFAS 138.
8. CONDENSED CONSOLIDATING FINANCIAL INFORMATION
The Company's senior notes are guaranteed by all of the Company's
subsidiaries (except for the foreign subsidiaries), all of which are
wholly-owned. The guarantees are joint and several, full, complete and
unconditional. There are currently no restrictions on the ability of the
subsidiary guarantors to transfer funds to the parent company.
The accompanying condensed consolidating financial information has been
prepared and presented pursuant to SEC Regulation S-X Rule 3-10 "Financial
Statements of Guarantors and
12
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
Issuers of Guaranteed Securities Registered or Being Registered." The
information is not intended to present the financial position, results of
operations and cash flows of the individual companies or groups of companies in
accordance with generally accepted accounting principles.
CONDENSED CONSOLIDATING BALANCE SHEETS
<Table>
<Caption>
SEPTEMBER 30, 2002
--------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
(THOUSANDS)
Assets:
Current assets................ $ 8,625 $ 150,435 $ 12,362 $ - $ 171,422
Net property and equipment.... 37,776 884,694 28,715 - 951,185
Goodwill, net................. 3,431 316,551 568 - 320,550
Deferred costs, net........... 13,993 - - - 13,993
Inter-company receivables..... 786,580 - - (786,580) -
Other assets.................. 19,779 14,260 1 - 34,040
--------- ----------- --------- ---------- -----------
Total assets.................... $ 870,184 $ 1,365,940 $ 41,646 $ (786,580) $ 1,491,190
========= =========== ========= ========== ===========
Liabilities and equity:
Current liabilities........... $ 35,507 $ 52,547 $ 3,109 $ - $ 91,163
Long-term debt................ 482,520 - - - 482,520
Capital lease obligations..... 1,421 13,200 - - 14,621
Inter-company payables........ - 752,813 33,767 (786,580) -
Deferred tax liability ....... 160,630 - - - 160,630
Other long-term liabilities... 14,283 35,862 - - 50,145
Stockholders' equity.......... 175,823 511,518 4,770 - 692,111
--------- ----------- --------- ---------- -----------
Total liabilities and
stockholders' equity........... $ 870,184 $ 1,365,940 $ 41,646 $ (786,580) $ 1,491,190
========= =========== ========= ========== ===========
</Table>
13
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
<Table>
<Caption>
JUNE 30, 2002
--------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
(THOUSANDS)
Assets:
Current assets................ $ 64,814 $ 117,140 $ 10,119 $ - $ 192,073
Net property and equipment.... 43,003 748,158 17,739 - 808,900
Goodwill, net................. 3,374 197,144 551 - 201,069
Deferred costs, net........... 12,580 - - - 12,580
Inter-company receivables..... 537,416 - - (537,416) -
Other assets.................. 21,593 6,780 - - 28,373
--------- ----------- --------- ---------- -----------
Total assets.................... $ 682,780 $ 1,069,222 $ 28,409 $ (537,416) $ 1,242,995
========= =========== ========= ========== ===========
Liabilities and equity:
Current liabilities........... $ 48,388 $45,427 $ 2,813 $ - $ 96,628
Long-term debt................ 420,717 - - - 420,717
Capital lease obligations..... 1,457 13,762 - - 15,219
Inter-company payables........ - 516,761 20,655 (537,416) -
Deferred tax liability ....... 149,990 - - - 149,990
Other long-term liabilities... 13,474 10,101 - - 23,575
Stockholders' equity.......... 48,754 483,171 4,941 - 536,866
--------- ----------- --------- ---------- -----------
Total liabilities and
stockholders' equity........... $ 682,780 $ 1,069,222 $ 28,409 $ (537,416) $ 1,242,995
========= =========== ========= ========== ===========
</Table>
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, 2002
--------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
(THOUSANDS)
Revenues........................ $ 46 $ 195,952 $ 6,069 $ - $ 202,067
Costs and expenses:
Direct expenses............... - 138,598 4,660 - 143,258
Depreciation, depletion and
amortization expense......... 793 24,622 387 - 25,802
General and administrative
expense...................... 11,104 14,540 364 - 26,008
Interest...................... 10,986 259 17 - 11,262
Gain on retirement of debt... (10) - - - (10)
--------- ----------- --------- ---------- -----------
Total costs and expenses........ 22,873 178,019 5,428 - 206,320
--------- ----------- --------- ---------- -----------
Income (loss) before income
taxes.......................... (22,827) 17,933 641 - (4,253)
Income tax (expense) benefit.... 8,674 (6,814) (244) - 1,616
--------- ----------- --------- ---------- -----------
Net income (loss) before
cumulative effect of a change
in accounting principle........ (14,153) 11,119 397 - (2,637)
Cumulative effect of a change
in accounting principle, net
of tax......................... - (2,873) - - (2,873)
--------- ----------- --------- ---------- -----------
Net income (loss)............... $ (14,153) $ 8,246 $ 397 $ - $ (5,510)
========= =========== ========= ========== ===========
</Table>
14
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, 2001
--------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
(THOUSANDS)
Revenues........................ $ 493 $ 236,641 $ 12,103 $ - $ 249,237
Costs and expenses:
Direct expenses............... - 148,631 9,503 - 158,134
Depreciation, depletion
and amortization expense..... 311 16,508 1,050 - 17,869
General and administrative
expense...................... 5,328 9,015 804 - 15,147
Interest...................... 11,401 205 343 - 11,949
Gain on retirement of debt.... (287) - - (287)
--------- ----------- --------- ---------- -----------
Total costs and expenses........ 16,753 174,359 11,700 - 202,812
--------- ----------- --------- ---------- -----------
Income (loss) before income
taxes.......................... (16,260) 62,282 403 - 46,425
Income tax (expense) benefit.... 6,041 (23,140) (150) - (17,249)
--------- ----------- --------- ---------- -----------
Net income (loss) before
cumulative effect of a change
in accounting principle........ (10,219) 39,142 253 - 29,176
Cumulative effect of a change
in accounting principle, net
of tax......................... - - - - -
--------- ----------- --------- ---------- -----------
Net income (loss)............... $ (10,219) $ 39,142 $ 253 $ - $ 29,176
========= =========== ========= ========== ===========
</Table>
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, 2002
---------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
---------- ------------ ------------- ------------ ------------
(THOUSANDS)
Net cash provided (used) by
operating activities........... $ (11,098) $ 15,043 $ 3,932 $ - $ 7,877
Net cash provided (used) in
investing activities........... (101,843) (10,813) (1,947) - (114,603)
Net cash provided (used) in
financing activities........... 59,671 (2,215) - - 57,456
Effect of exchange rate
changes on cash................ - - (1,049) - (1,049)
---------- ----------- --------- ---------- -----------
Net increase (decrease) in cash (53,270) 2,015 936 - (50,319)
Cash at beginning of period..... 52,742 (157) 1,562 - 54,147
---------- ----------- --------- ---------- -----------
Cash at end of period........... $ (528) $ 1,858 $ 2,498 $ - $ 3,828
========== =========== ========= ========== ===========
</Table>
15
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, 2001
---------------------------------------------------------------------------
PARENT GUARANTOR NON-GUARANTOR
COMPANY SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
---------- ------------ --------------- ------------ ------------
(THOUSANDS)
Net cash provided (used) by
operating activities........... $ 20,909 $ 25,818 $ (1,182) $ - $ 45,545
Net cash provided (used) in
investing activities........... (5,247) (17,383) (116) - (22,746)
Net cash provided (used) in
financing activities........... (19,957) (2,434) (13) - (22,404)
---------- ----------- --------- ---------- -----------
Net increase (decrease) in cash. (4,295) 6,001 (1,311) - 395
Cash at beginning of period.... 1,647 (2,005) 2,456 - 2,098
---------- ----------- --------- ---------- -----------
Cash at end of period........... $ (2,648) $ 3,996 $ 1,145 $ - $ 2,493
========== =========== ========= ========== ===========
</Table>
9. GOODWILL AND OTHER INTANGIBLE ASSETS - SFAS 142
The Company adopted Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets ("SFAS 142") on July 1, 2001. SFAS 142
eliminates the amortization for goodwill and other intangible assets with
indefinite lives. Intangible assets with lives restricted by contractual,
legal, or other means will continue to be amortized over their useful lives.
Goodwill and other intangible assets not subject to amortization are tested
for impairment annually or more frequently if events or changes in
circumstances indicate that the asset might be impaired. SFAS 142 requires a
two-step process for testing impairment. First, the fair value of each
reporting unit is compared to its carrying value to determine whether an
indication of impairment exists. If impairment is indicated, then the fair
value of the reporting unit's goodwill is determined by allocating the unit's
fair value to its assets and liabilities (including any unrecognized
intangible assets) as if the reporting unit had been acquired in a business
combination. The amount of impairment for goodwill is measured as the excess
of its carrying value over its fair value. The Company completed its
assessment of goodwill impairment as of the date of adoption during the three
months ended December 31, 2001, as allowed by SFAS 142. The assessment did
not result in an indication of goodwill impairment.
Intangible assets subject to amortization under SFAS 142 consist of
noncompete agreements and patents. Amortization expense for noncompete
agreements is calculated using the straight-line method over the period of
the agreement, ranging from three to seven years. Amortization expense for
patents is calculated using the straight-line method over the useful life of
the patent, ranging from five to seven years.
The gross carrying amount of noncompete agreements subject to amortization
totaled approximately $17,999,000 and $11,727,000 at September 30, 2002 and June
30, 2002, respectively. Accumulated amortization related to these intangible
assets totaled approximately $7,351,000 and $6,130,000 at September 30, 2002 and
June 30, 2002, respectively. Amortization expense for the three months ended
September 30, 2002 and 2001 was approximately $1,261,000 and $400,000,
respectively. Amortization expense for the next five succeeding years is
estimated to be $3,727,000, $2,698,000, $1,986,000, $1,456,000 and $747,000,
respectively.
16
<Page>
KEY ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002 AND 2001
The gross carrying amount of patents subject to amortization totaled
approximately $2,213,000 at September 30, 2002. The Company acquired the
patents on July 16, 2002. Accumulated amortization related to these
intangible assets totaled approximately $72,000 at September 30, 2002.
Amortization expense for the three months ended September 30, 2002 was
approximately $72,000. Amortization expense for the next five succeeding
years is estimated to be $348,000, $348,000, $348,000, $348,000 and $325,000,
respectively.
The Company has identified its reporting segments to be well servicing
and contract drilling. Goodwill allocated to such reporting segments at
September 30, 2002 is $306,293,000 and $14,257,000, respectively. The change
in the carrying amount of goodwill for the three months ended September 30,
2002 of $119,481,000, respectively, relates principally to goodwill acquired
in connection with the acquisition of QSI and other well servicing assets
acquired during the period and the translation adjustment for Argentina.
10. ASSET RETIREMENT OBLIGATIONS - ADOPTION OF SFAS 143
On July 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 143, Accounting for Asset Retirement Obligations ("SFAS 143").
Adoption of SFAS 143 is required for all companies with fiscal years beginning
after June 15, 2002. The new standard requires the Company to recognize a
liability for the present value of all legal obligations associated with the
retirement of tangible long-lived assets and capitalize an equal amount as a
cost of the asset depreciating the additional cost over the estimated useful
life of the asset. The Company recorded additional costs, net of accumulated
depreciation, of approximately $4,372,000, a non-current liability of
approximately $9,005,000 and an after-tax charge of approximately $2,873,000 for
the cumulative effect on prior years for depreciation of the additional costs
and accretion expense on the liability related to expected abandonment costs of
its oil and natural gas producing properties and salt water disposal wells.
11. GAINS (LOSSES) ON RETIREMENT OF DEBT - ADOPTION OF SFAS 145
On July 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections ("SFAS 145"). The
provisions of SFAS 145 rescind Statement No. 4, which required all gains and
losses from extinguishment of debt to be aggregated and classified as an
extraordinary item, and instead requires that such gains and losses be
reported in operating income. The Company now records gains from the
extinguishment of debt in operating income and has reclassified such gains in
the financial statements for the three months ended September 30, 2001 to
conform to the presentation for the three months ended September 30, 2002.
12. SUBSEQUENT EVENT - SALE OF PRESSURE PUMPING BUSINESS
On October 31, 2002, the Company entered into a letter of intent to sell
its pressure pumping business to a privately held company for approximately
$40,000,000 in cash and notes. The Company expects the transaction to close
by January 31, 2003. This business was acquired as part of the Q Services
acquisition in July 19, 2002. Detailed terms of the sale are subject to final
negotiation of a definitive purchase and sale agreement.
17
<Page>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
NOTE REGARDING FORWARD - LOOKING STATEMENTS
The statements in this document that relate to matters that are not
historical facts are "forward-looking statements" within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. When used in this document and the documents incorporated by reference,
words such as "anticipate," "believe," "expect," "plan," "intend," "estimate,"
"project," "will," "could," "may," "predict" and similar expressions are
intended to identify forward-looking statements. Further events and actual
results may differ materially from the results set forth in or implied in the
forward-looking statements. Factors that might cause such a difference include:
- fluctuations in world-wide prices and demand for oil and natural gas;
- fluctuations in level of oil and natural gas exploration and
development activities;
- fluctuations in the demand for well servicing, contract drilling and
ancillary oilfield services;
- the existence of competitors, technological changes and developments
in the industry;
- the existence of operating risks inherent in the well servicing,
contract drilling and ancillary oilfield services; and
- general economic conditions, the existence of regulatory
uncertainties, and the possibility of political instability in any of
the countries in which Key does business, in addition to other matters
discussed herein.
The following discussion provides information to assist in the
understanding of the Company's financial condition and results of operations. It
should be read in conjunction with the consolidated financial statements and
related notes appearing elsewhere in this report.
RESULTS OF OPERATIONS
The Company's results of operations for the first quarter of fiscal 2003
reflect the impact of a decline in industry conditions resulting from decreased
commodity prices (and its customers' perception that commodity prices may
decrease further) which in turn caused a decline in demand for the Company's
equipment and services.
THREE MONTHS ENDED SEPTEMBER 30, 2002 VERSUS THREE MONTHS ENDED SEPTEMBER 30,
2001
The Company's revenue for the quarter ended September 30, 2002 decreased
$47,170,000, or 19%, to $202,067,000 from $249,237,000 for the quarter ended
September 30, 2001 while net income for the quarter ended September 30, 2002
decreased $34,686,000, or 119%, to a net loss of $5,510,000, or ($0.04) per
share, from net income of $29,176,000, or $0.28
18
<Page>
per diluted share for the quarter ended September 30, 2001. The decrease in
revenues and net income is due to lower levels of activity and lower pricing
partially offset by the acquisition of QSI. Net income in the quarter ended
September 30, 2002 was also adversely affected by the cumulative effect of
the Company's mandatory adoption of SFAS 143, costs associated with the
integration of QSI, unusually high general liability costs and start-up costs
associated with the Company's new Egypt project.
OPERATING REVENUES
WELL SERVICING. Well servicing revenues decreased $27,614,000, or 13%, to
$184,887,000 for the three months ended September 30, 2002 from $212,501,000 for
the three months ended September 30, 2001. The decrease in revenues was
primarily due to a decline in activity and oilfield service rates partially
offset by the acquisition of QSI.
CONTRACT DRILLING. Contract drilling revenues decreased $18,157,000, or
54%, to $15,479,000 for the three months ended September 30, 2002 from
$33,636,000 for the three months ended September 30, 2001. The decrease in
revenues was primarily due to a decline in activity and drilling rig rates.
OPERATING EXPENSES
WELL SERVICING. Well servicing expenses decreased $4,490,000, or 3%, to
$131,271,000 for the three months ended September 30, 2002 from $135,761,000
for the three months ended September 30, 2001. The decrease was primarily due
to lower levels of activity partially offset by the acquisition of QSI,
higher insurance costs and start-up costs for the Company's new Egypt
project. Well servicing expenses, as a percentage of well servicing revenue,
increased to 71% for the three months ended September 30, 2002 from 64% for
the three months ended September 30, 2001
CONTRACT DRILLING. Contract drilling expenses decreased $10,231,000, or
48%, to $10,957,000 for the three months ended September 30, 2002 from
$21,188,000 for the three months ended September 30, 2001. The decrease was
primarily due lower levels of activity partially offset by higher insurance
costs. Well servicing expenses, as a percentage of well servicing revenue,
increased to 71% for the three months ended September 30, 2002 from 63% for
the three months ended September 30, 2001
DEPRECIATION, DEPLETION AND AMORTIZATION EXPENSE
The Company's depreciation, depletion and amortization expense increased
$7,933,000, or 44%, to $25,802,000 for the three months ended September 30, 2002
from $17,869,000 for the three months ended September 30, 2001. The increase is
due to the acquisition of QSI and capital expenditures during the prior year as
the Company continued major refurbishments of well servicing and contract
drilling equipment and its continued investment in technology.
GENERAL AND ADMINISTRATIVE EXPENSES
The Company's general and administrative expenses increased $10,861,000, or
72%, to
19
<Page>
$26,008,000 for the three months ended September 30, 2002 from $15,147,000
for the three months ended September 30, 2001. The increase was primarily due
to the acquisition of QSI and costs associated with the integration of QSI,
higher general liability costs and increases in personnel supporting
information technology functions. General and administrative expenses, as a
percentage of revenues, increased to 13% for the three months ended September
30, 2002 from 6% for the three months ended September 30, 2001.
INTEREST EXPENSE
The Company's interest expense decreased $687,000, or 6%, to $11,262,000
for the three months ended September 30, 2002 from $11,949,000 for the three
months ended September 30, 2001. The decrease was primarily due to a
reduction in the Company's long-term debt in the prior year and lower
interest rates. Included in interest expense was the amortization of debt
issuance costs of $943,000 and $738,000 for the three months ended September
30, 2002 and 2001, respectively.
GAIN ON RETIREMENT OF DEBT
During the three months ended September 30, 2002, the Company repurchased
$204,000 of its long-term debt at a discount and expensed related debt issuance
costs which resulted in a gain of $10,000. During the three months ended
September 30, 2001, the Company repurchased $53,277,000 of its long-term debt at
a discount and expensed related debt issuance costs which resulted in a gain of
$287,000. On July 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of
FASB Statement No. 13, and Technical Corrections ("SFAS 145"). The new standard
rescinds Statement No. 4, which required all gains and losses from
extinguishment of debt to be recorded as extraordinary items.
CUMULATIVE EFFECT ON PRIOR YEARS OF A CHANGE IN ACCOUNTING PRINCIPLE
On July 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 143, Accounting for Asset Retirement Obligations ("SFAS 143").
Adoption of SFAS 143 is required for all companies with fiscal years beginning
after June 15, 2002. The new standard requires the Company to recognize a
liability for the present value of all legal obligations associated with the
retirement of tangible long-lived assets and capitalize an equal amount as a
cost of the asset depreciating the additional cost over the estimated useful
life of the asset. The Company recorded an after-tax charge of approximately
$2,873,000 for the cumulative effect on prior years for depreciation of the
additional costs and accretion expense on the liability related to expected
abandonment costs related to its oil and natural gas producing properties and
salt water disposal wells.
INCOME TAXES
The Company's income tax benefit decreased $18,865,000 to a benefit of
$1,616,000 for the three months ended September 30, 2002 from an expense of
$17,249,000 for the three months ended September 30, 2001. The decrease in
income taxes is due to the decrease in pretax income. The Company's effective
tax rate for the three months ended September 30, 2002 and 2001 was 38% and 37%,
respectively. The effective tax rates are different from the statutory rate of
35% because of non-deductible expenses and the effects of state and local taxes.
20
<Page>
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically funded its operations, acquisitions, capital
expenditures and working capital requirements from cash flow from operations,
bank borrowings and the issuance of equity and long-term debt. The Company
believes that its current reserves of cash and cash equivalents, access to its
existing credit lines, access to capital markets and internally generated cash
flow from operations are and will be sufficient to finance the cash requirements
of its current and future operations.
CAPITAL EXPENDITURES
Capital expenditures for fiscal 2003 have been and will be directed
toward selectively refurbishing the Company's assets as business conditions
warrant. The Company will continue to evaluate opportunities to acquire or
divest assets or businesses to enhance the Company's primary operations. Such
capital expenditures, acquisitions and divestitures are at the discretion of
the Company and will depend on management's view of market conditions as well
as other factors.
LONG-TERM DEBT
SENIOR CREDIT FACILITY
On July 15, 2002, the Company entered into a Third Amended and Restated
Credit Agreement (the "New Senior Credit Facility"). The New Senior Credit
Facility consists of a $150,000,000 revolving loan facility with a $40,000,000
sublimit for letters of credit. The loans are secured by most of the tangible
and intangible assets of the Company. The revolving loan commitment will
terminate on July 15, 2005 and all revolving loans must be paid on or before
that date. The revolving loans bear interest based upon, at the Company's
option, the prime rate plus a variable margin of 0.00% to 0.75% or a Eurodollar
rate plus a variable margin of 1.25% to 2.75%. The New Senior Credit Facility
has customary affirmative and negative covenants including a maximum leverage
ratio, a minimum fixed charge coverage ratio and a minimum net worth, as well as
limitations on liens and indebtedness and restrictions on dividends,
acquisitions and dispositions.
As of September 30, 2002, $62,000,000 was outstanding under the
revolving loan facility and approximately $30,797,000 of letters of credit
related to workers compensation insurance were outstanding. The Company
borrowed approximately $53,000,000 in July under the New Senior Credit
Facility in order to complete the acquisition of QSI. Since September 30,
2002, the Company has repaid $10,000,000 leaving $52,000,000 outstanding
under the revolving loan facility as of November 13, 2002.
8 3/8% SENIOR NOTES
On March 6, 2001, the Company completed a private placement of
$175,000,000 of 8 3/8% Senior Notes due 2008 (the "8 3/8% Senior Notes"). The
cash proceeds from the private placement, net of fees and expenses were used
to repay all of the remaining balance of the original term loan under the
Company's previous senior credit facility, and a portion of the revolving
loan facility then outstanding under the Company's previous senior credit
facility. On March 1, 2002, the Company completed a public offering of an
additional $100,000,000 of 8 3/8% Senior Notes due 2008 at 101.5% of par. The
cash proceeds from the public offering were used to repay all of the
remaining balance of the revolving loan facility
21
<Page>
under the Company's previous senior credit facility. The 8 3/8% Senior Notes
are senior unsecured obligations. The 8 3/8% Senior Notes are effectively
subordinate to the Company's secured indebtedness which includes borrowings
under the New Senior Credit Facility.
On and after March 1, 2005, the Company may redeem some or all of the
8 3/8% Senior Notes at any time at varying redemption prices in excess of par,
plus accrued interest. In addition, before March 1, 2004, the Company may redeem
up to 35% of the aggregate principal amount of the 8 3/8% Senior Notes with the
proceeds of certain sales of equity at 108.375% of par plus accrued interest.
At September 30, 2002, $275,000,000 principal amount of the 8 3/8% Senior
Notes remained outstanding.
14% SENIOR SUBORDINATED NOTES
On January 22, 1999, the Company completed the private placement of
150,000 units (the "Units") consisting of $150,000,000 of 14% Senior
Subordinated Notes due 2009 (the "14% Senior Subordinated Notes") and 150,000
warrants to purchase 2,173,433 shares of the Company's Common Stock at an
exercise price of $4.88125 per share (the "Unit Warrants"). The net cash
proceeds from the private placement were used to repay substantially all of
the remaining $148,600,000 principal amount (plus accrued interest) owed
under the Company's bridge loan facility arranged in connection with the
acquisition of Dawson Production Services, Inc. ("Dawson"). The 14% Senior
Subordinated Notes are subordinate to the Company's senior indebtedness,
which includes borrowings under the New Senior Credit Facility and the 8 3/8%
Senior Notes. The Unit Warrants have separated from the 14% Senior
Subordinated Notes and became exercisable on January 25, 2000. As of
September 30, 2002, 63,500 Unit Warrants had been exercised, producing
approximately $4,173,000 of proceeds to the Company and leaving 86,500 Unit
Warrants outstanding.
On and after January 15, 2004, the Company may redeem some or all of the
14% Senior Subordinated Notes at any time at varying redemption prices in excess
of par, plus accrued interest. In addition, before January 15, 2002, the Company
was allowed to redeem up to 35% of the aggregate principal amount of the 14%
Senior Subordinated Notes at 114% of par plus accrued interest with the proceeds
of certain sales of equity. At September 30, 2002, $97,500,000 principal amount
of the 14% Senior Subordinate Notes remain outstanding.
5% CONVERTIBLE SUBORDINATED NOTES
In late September and early October 1997, the Company completed a
private placement of $216,000,000 of 5% Convertible Subordinated Notes due
2004 (the "5% Convertible Subordinated Notes"). The 5% Convertible
Subordinated Notes are subordinate to the Company's senior indebtedness which
includes borrowings under the New Senior Credit Facility, the 14% Senior
Subordinated Notes and the 8 3/8% Senior Notes. The 5% Convertible
Subordinated Notes are convertible, at the holder's option, into shares of
the Company's common stock at a conversion price of $38.50 per share, subject
to certain adjustments.
During the quarter ended September 30, 2002, the Company repurchased
(and canceled) an additional $204,000 principal amount of the 5% Convertible
Subordinated Notes, leaving $49,747,000 outstanding as of September 30, 2002.
These repurchases resulted in gains of approximately $10,000.
22
<Page>
CRITICAL ACCOUNTING POLICIES
The Company follows certain significant accounting policies when preparing
its consolidated financial statements. A complete summary of these policies is
included in Note 1 to the consolidated financial statements included in the
Company's Annual Report on Form 10-K.
Certain of the policies require management to make significant and
subjective estimates which are sensitive to deviations of actual results from
management's assumptions. In particular, management makes estimates regarding
the fair value of the Company's reporting units in assessing potential
impairment of goodwill. In addition, the Company makes estimates regarding
future undiscounted cash flows from the future use of long-lived assets whenever
events or changes in circumstances indicate that the carrying amount of a
long-lived asset may not be recoverable.
In assessing impairment of goodwill, the Company has used estimates and
assumptions in estimating the fair value of its reporting units. Actual future
results could be different than the estimates and assumptions used. Events or
circumstances which might lead to an indication of impairment of goodwill would
include, but might not be limited to, prolonged decreases in expectations of
long-term well servicing and/or drilling activity or rates brought about by
prolonged decreases in oil or natural gas prices, changes in government
regulation of the oil and natural gas industry or other events which could
affect the level of activity of exploration and production companies.
In assessing impairment of long-lived assets other than goodwill where
there has been a change in circumstances indicating that the carrying amount of
a long-lived asset may not be recoverable, the Company has estimated future
undiscounted net cash flows from use of the asset based on actual historical
results and expectations about future economic circumstances including oil and
natural gas prices and operating costs. The estimate of future net cash flows
from use of the asset could change if actual prices and costs differ due to
industry conditions or other factors affecting the Company's performance.
RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS
Recently, the Financial Accounting Standards Board, ("FASB") issued
Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 establishes
requirements for financial accounting and reporting for costs associated with
exit or disposal activities. SFAS 146 is effective for exit or disposal
activities initiated after December 31, 2002. The Company is currently assessing
the impact of this standard on its consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Special Note: Certain statements set forth below under this caption
constitute "forward-looking statements". See "Note Regarding Forward-Looking
Statements" in Item 2 for additional factors relating to such statements.
The primary objective of the following information is to provide
forward-looking quantitative and qualitative information about the Company's
potential exposure to market risk.
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<Page>
The term "market risk" refers to the risk of loss arising from adverse changes
in foreign currency exchange, interest rates and oil and natural gas prices. The
disclosures are not meant to be precise indicators of expected future losses,
but rather indicators of reasonably possible losses. This forward-looking
information provides indicators of how the Company views and manages its ongoing
market risk exposures.
INTEREST RATE RISK
At September 30, 2002, the Company had long-term debt and capital lease
obligations outstanding of $504,452,000. Of this amount $420,586,000, or 83%,
bears interest at fixed rates as follows:
<Table>
<Caption>
Balance at
September 30, 2002
------------------
(Thousands)
8 3/8% Senior Notes Due 2008..................................... $ 276,383
14% Senior Subordinated Notes Due 2009........................... 94,333
5% Convertible Subordinated Notes Due 2004....................... 49,747
Other (rates approximate 8.0%)................................... 123
---------
$ 420,586
=========
</Table>
The remaining $83,866,000 of debt and capital lease obligations outstanding
as of September 30, 2002 bears interest at floating rates which averaged
approximately 4.32% at September 30, 2002. A 10% increase in short-term interest
rates on the floating-rate debt outstanding at September 30, 2002 would equal
approximately 43 basis points. Such an increase in interest rates would increase
Key's fiscal 2003 interest expense by approximately $400,000 assuming borrowed
amounts remain outstanding.
The above sensitivity analysis for interest rate risk excludes accounts
receivable, accounts payable and accrued liabilities because of the short-term
maturity of such instruments.
FOREIGN CURRENCY RISK
During fiscal 2002, the Argentine government suspended the law tying the
Argentine peso to the U.S. dollar at the conversion ratio of 1:1 and created
a dual currency system in Argentina. The Company's net assets of its
Argentina subsidiary is based on the U.S. dollar equivalent of such amounts
measured in Argentine pesos as of December 31, 2001. Assets and liabilities
of the Argentine operations were translated to U.S. dollars at September 30,
2002 using the applicable free market conversion ratio of 3.7:1 and will be
translated at future dates using the applicable free market conversion ratio
on such dates. Key's net earnings and cash flows from its Argentina
subsidiaries were tied to the U.S. dollar for the six months ended December
31, 2001 and are based on the U.S. dollar equivalent of such amounts measured
in Argentine pesos for periods after December 31, 2001. Revenues, expenses
and cash flow will be translated using the average exchange rates during the
periods after December 31, 2001.
The change in the Argentine peso to the U.S. dollar exchange rate since
December 31, 2001 has reduced stockholders' equity by $46,340,000, through a
charge to other comprehensive loss, through September 30, 2002.
24
<Page>
Key's net assets, net earnings and cash flows from its Canadian subsidiary
are based on the U.S. dollar equivalent of such amounts measured in Canadian
dollars. Assets and liabilities of the Canadian operations are translated to
U.S. dollars using the applicable exchange rate as of the end of a reporting
period. Revenues and expenses are translated using the average exchange rate
during the reporting period.
A 10% change in the Canadian-to-U.S. Dollar exchange rate would not be
material to the net assets, net earnings or cash flows of the Company.
Key's net assets, net earnings and cash flows from its subsidiary
operating in Egypt are based on the U.S. dollar. Foreign currency
transactions are included in determination of net income for the period.
COMMODITY PRICE RISK
Key's major market risk exposure for its oil and natural gas production
operations is in the pricing applicable to its oil and natural gas sales.
Realized pricing is primarily driven by the prevailing worldwide price for crude
oil and spot market prices for natural gas. Pricing for oil and natural gas
production has been volatile and unpredictable for several years.
The Company periodically hedges a portion of its oil and natural gas
production through collar and option agreements. The purpose of the hedges is to
provide a measure of stability in the volatile environment of oil and natural
gas prices and to manage exposure to commodity price risk under existing sales
commitments. The Company's risk management objective is to lock in a range of
pricing for expected production volumes. This allows the Company to forecast
future earnings within a predictable range. The Company meets this objective by
entering into collar and option arrangements which allow for acceptable cap and
floor prices.
As of September 30, 2002, Key had oil and natural gas price put options
in place, as detailed in the following table. The total fiscal 2003 hedged
oil and natural gas volumes represent approximately 40% and 32%,
respectively, of expected 2003 calendar year total production. A 10%
variation in the market price of oil or natural gas from their levels at
September 30, 2002 would have no material impact on the Company's net assets,
net earnings or cash flows (as derived from commodity option contracts).
The following table sets forth the future volumes hedged by year and the
weighted-average strike price of the option contracts at September 30, 2002:
<Table>
<Caption>
MONTHLY VOLUMES
--------------- STRIKE PRICE
NATURAL PER BBL/MMBTU
OIL GAS ----------------
(BBLS) (MMBTU) TERM FLOOR CAP FAIR VALUE
----- ------ ----------------- ------- --- ----------
At September 30, 2002
Oil Put........... 5,000 - Mar 2002-Feb 2003 $ 22.00 - $ 3,000
Oil Put........... 4,000 - Mar 2003-Feb 2004 $ 21.00 - $ 72,000
Gas Put........... - 75,000 Mar 2002-Feb 2003 $ 3.00 - $ 10,000
</Table>
(The strike prices for the oil puts are based on the NYMEX spot price for West
Texas Intermediate; the strike price for the natural gas put is based on the
Inside FERC-El Paso Permian spot price.)
25
<Page>
ITEM 4. CONTROLS AND PROCEDURES
Within the 90 day period prior to the filing date of this Quarterly Report
on Form 10-Q, the Company, under the supervision, and with the
participation, of its management, including its principal executive officer
and principal financial officer, performed an evaluation of the design and
operation of the Company's disclosure controls and procedures (as defined
in Securities and Exchange Act Rule 13a-14(c)). Based on that evaluation,
the Company's principal executive officer and principal financial officer
concluded that such disclosure controls and procedures are effective to
ensure that material information relating to the Company, including its
consolidated subsidiaries, is accumulated and communicated to the Company's
management and made known to the principal executive officer and principal
financial officer, particularly during the period for which this periodic
report was being prepared.
No significant changes were made in the Company's internal controls or in
other factors that could significantly affect these controls subsequent to
the date the controls were evaluated as discussed above.
26
<Page>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
10.1* Second Amended and Restated Credit Agreement dated as of July 15,
2002, among the Registrant, the several lenders from time to time
parties thereto, PNC Bank, National Association, as
Administrative Agent, PNC Capital Markets, Inc., and Wells Fargo
Bank (Texas), as Co-Lead Arrangers and Credit Lyonnais New York
Bank, Lehman Commercial Paper, Inc., and Royal Bank of Canada, as
the Documentation Agents.
10.2* Second Amendment to Second Amended and Restated Employment
Agreement dated October 28, 2002 between the Registrant and
Francis D. John.
99.1* Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
- ----------
* Filed herewith.
(b) Reports on Form 8-K
The Company filed the following reports on Form 8-K during the quarter
ended June 30, 2002:
(i) Current Report on Form 8-K dated July 16, 2002 filed to report the new
senior credit facility and updated guidance on the quarter and fiscal
year ended June 30, 2002.
(ii) Current Report on Form 8-K dated August 2, 2002 filed to report the
acquisition of Q Services, Inc.
27
<Page>
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.
KEY ENERGY SERVICES, INC.
Dated: November 14, 2002 By /s/ Francis D. John
---------------------
President and Chief Executive Officer
Dated: November 14, 2002 By /s/ Royce W. Mitchell
---------------------
Chief Financial Officer
28
<Page>
I, Francis D. John, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Key Energy Services,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors:
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
29
<Page>
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: November 14, 2002 By /s/ Francis D. John
-------------------
Francis D. John
Chief Executive Officer
30
<Page>
I, Royce W. Mitchell, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Key Energy Services,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of the
this quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors:
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
31
<Page>
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Dated: November 14, 2002 By /s/ Royce W. Mitchell
---------------------
Royce W. Mitchell
Chief Financial Officer
32