ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Superior Drilling Products, Inc. is an innovative drilling and completion tool technology company providing cost saving solutions that drive production efficiencies for the oil and natural gas drilling industry. Our headquarters and manufacturing operations are located in Vernal, Utah. Our drilling solutions include the patented Drill-N-Ream® well bore conditioning tool (“Drill-N-Ream tool”) and the patented Strider™ Drill String Oscillation System technology (“Strider technology” or “Strider”). In addition, the Company is a manufacturer of Drill-N-Ream tools and refurbisher of PDC (polycrystalline diamond compact) drill bits for a leading oil field services company. We operate a state-of-the-art drill tool fabrication facility, where we manufacture solutions for the drilling industry, as well as customers’ custom products.
Our strategy for growth is to leverage our expertise in drill tool technology and precision machining in order to broaden our product offerings and solutions for the oil and gas industry. We believe through our patented technologies, as well as technologies under development, that we can offer the industry the solutions it demands to improve drilling efficiencies and reduce production costs.
In addition, in December 2020, the Company successfully obtained ISO 9000 certification and is now qualified to bid on projects in industries outside oil and gas. We believe that with this certification, and our history of supplying high quality parts to research and development departments operating in the aerospace industry, we can effectively execute our industry diversification strategy. We continue to maintain this certification, comply with the yearly audits, and are currently certified for 2023-2024.
In May 2023, we engaged Piper Sandler & Co. as our financial advisor to investigate a range of strategic alternatives with the intent to maximize shareholder value. We have not set a timetable for the conclusion of our review of potential alternatives.
Industry Trends and Market Factors
The Russia – Ukraine conflict is a global concern. The Company does not have any direct exposure to Russia or Ukraine through its operations, employee base, investments or sanctions. The Company does not receive goods or services sourced from those countries, does not anticipate any disruption in its supply chain and has no business relationships, connections to or assets in Russia, Belarus or Ukraine. No impairments to assets have been made due to the conflict. The global oil industry has been impacted by this situation, but the Company’s operations and business in the Middle East has not been disrupted to date. The increase in oil producing activities in the United States has benefitted the Company’s operations. We are unable at this time to know the full ramifications of the Russia – Ukraine conflict and its effects on our business.
The Israel conflict – We have not been directly impacted by the Israel-Hamas conflict. However, the historic volatility in the Middle East, including as a result of recent events in Israel and Gaza, may result in political instability and societal disruption could reduce overall demand for oil and natural gas, potentially putting downward pressure on demand for our services and causing a reduction in our revenue.
Inflationary and/or recessionary factors relating to the oil and gas industry may directly affect the Company’s operations. The increased demand for oil and gas production has benefited the Company’s operations. The Company is not immune to the effects of inflation on its labor requirements, supply chain and costs of revenues. The Company continues to monitor these economic trends as part of its strategic forward planning.
The total U.S. rig count as reported by Baker Hughes as of December 31, 2023 was 622 rigs, a decrease of 157 rigs from the rig count as of December 31, 2022.
The Middle East market began to improve during 2022 after a slow rebound from the COVID-19 impact. Total rig count in that region as of February 28, 2024 was 349 compared with 327 at the same time last year.
How We Generate our Revenue
We are a drilling and completion tool technology company. We generate revenue from the refurbishment, manufacturing, repair, rental and sale of drill string tools. Our manufactured products are produced in a standard manufacturing operation, even when produced to our customer’s specifications. We also earn royalty fees under certain arrangements for certain tools we sell.
Tool sales, rentals and other related revenue
Tool and Product Sales : Revenue for tool and product sales is recognized upon shipment of tools or products to the customer. Shipping and handling costs related to tool and product sales are recorded gross as a component of both the sales price and cost of the product sold.
Tool Rental : Rental revenue is recognized upon completion of the customer’s job for which the tool was rented. While the duration of the rental will vary by job and number of runs, these rentals are generally less than one month. The rental agreements are typically based on the price per run or footage drilled and do not have any minimum rental payments or term.
Other Related Revenue: We receive revenue from the repair of tools upon delivery of the repaired tool to the customer. We earn royalty commission revenue when our customer invoices their customer for the use of our tools.
Contract Services
Drill Bit Manufacturing and Refurbishment : We recognize revenue for our PDC drill bit services upon transfer of control, which we have determined to be upon shipment of the product. Shipping and handling costs related to refurbishing services are paid directly by the customer at the time of shipment. We also provide contracting manufacturing services to customers.
Costs of Conducting Our Business
Cost of revenue is comprised of direct and indirect costs to manufacture, repair and supply our products, including labor, materials, utilities, equipment repair, lease expense related to our facilities, supplies and freight.
Selling, general and administrative expense is comprised of costs such as new business development, technical product support, research and development costs, compensation expense for general corporate operations including accounting, human resources, risk management, etc., information technology expenses, safety and environmental expenses, legal and professional fees and other related administrative functions.
Other income (expense), net is comprised primarily of interest expense associated with outstanding borrowings net of interest income, impairment of asset held for sale and losses on disposition of assets.
RESULTS OF OPERATIONS
The following table represents our consolidated statement of operations for the periods indicated:
Year Ended December 31,
Revenue
Tool Revenue
Contract Services
Total Revenue
Operating cost and expenses
Cost of revenue
Selling, general, and administrative expenses
Depreciation and amortization expense
Total operating cost and expenses
Operating income
Other income (expense)
Interest income
Interest expense
Recovery of related party note receivable
Impairment on asset held for sale
Loss on disposition of assets
Loss on extinguishment of debt
Total other income (expense)
Income before income taxes
Income tax (expense)/benefit
Net income
Comparison of the years ended December 31, 2023 and 2022
Revenue
Our revenue increased approximately $1,876,000, or 10%, for the year ended December 31, 2023 compared with the year ended December 31, 2022. The increase was driven by an approximately $1,209,000, or 10%, increase in tool revenue compared with the prior year reflecting the strong market share of the DNR in the U.S. and expansion of our business in the Middle East. Revenue in the Middle East contributed approximately $884,000, or approximately 73%, of the increase in tool revenue. Contract services revenue increased by $667,000, or 10%, over the prior year, primarily due to expansion of services for our major customer.
Operating Costs and Expenses
Cost of Revenue
Cost of revenue decreased approximately $135,000, or 2%, for the year ended December 31, 2023 compared with the year ended December 31, 2022. The decrease in cost was impacted by the utilization of capacity to build rental tools owned by us. Additional savings were obtained from lowering domestic headcount costs during the fourth quarter of 2023. International cost of revenue increased 20% due to higher costs in freight and travel. Increase in cost of revenue was driven by the increase in bit refurbishment.
Selling, general and administrative expenses
Selling, general and administrative expenses increased approximately $2,315,000, or 32%, for the year ended December 31, 2023 compared to the year ended December 31, 2022. The increase was a result of higher payroll and benefits for building the Middle East team along with an increase in travel and increased legal fees pertaining to the patent infringement lawsuit. Patent infringement legal expenses increased approximately $600,000 in 2023 compared to 2022.
Depreciation and amortization expenses
Depreciation and amortization expenses decreased approximately $147,000, or 10%, for the year ended December 31, 2023 compared with the year ended December 31, 2022. The decrease was due to intellectual property intangible reaching its full amortization.
Other Income (Expenses)
Interest Income
Interest income increased approximately $34,000, or 128%, for the year ended December 31, 2023 compared to the year ended December 31, 2022. The increase was due to an increase in interest rates earned on the average cash balance held in interest bearing accounts.
Interest Expense
Interest expense increased approximately $ 117,000, or 20%, for the year ended December 31, 2023 compared to the year ended December 31, 2022. The increase in interest expense was mainly due to a new term loan at 8.18% interest.
Recovery of related party note receivable
Recovery of related party note receivable was approximately $350,000 for the year ended December 31, 2023 pertaining to partial recovery of the related party note receivable (See Critical Accounting Policies and Estimates – Relates Party Note Receivable). There was no such recovery for the year ended December 31, 2022.
Impairment on Asset Held for Sale
There was no such impairment on asset held for sale for the year ended December 31, 2023. In December 2022, the Company entered into an agreement to sell certain equipment, which closed in January 2023. As such, management made adjustments to reflect the fair value of this equipment as of December 31, 2023.
Loss on Disposition of Assets
Loss on disposition of assets was $70,664 for the year ended December 31, 2023.
Liquidity and Capital Resources
At December 31, 2023, we had working capital of approximately $4,939,000. Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. Our operational and financial strategies include managing our operating costs and capital spending to reflect revenue trends, accelerating collections of international receivables, and controlling our working capital and debt to enhance liquidity. We will continue to work to grow revenue and manage costs and expect to be cash flow positive in 2024. If we are unable to do this, we may not be able to, among other things, (i) maintain our current general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements. We cannot provide any assurance that financing will be available to us in the future on acceptable terms.
Loan Agreement
On July 28, 2023, the Company entered into a Loan Agreement (the “Loan Agreement”) among Vast Bank, National Association, as lender (the “Lender”), and various subsidiaries of the Company as guarantors (the “Guarantors”).
The Loan Agreement provides for borrowings with the following facilities (collectively, the “Loans”):
Revolving Line: The lesser of $750,000 or the borrowing base, which is currently 50% of eligible inventory as calculated under the Loan Agreement (“Revolving Line”), which matures on July 28, 2025.
Term Loan: $1,719,200 term loan (the “Term Loan”), which matures on July 28, 2028.
The interest rate per annum applicable to the Revolving Line is the greater of (a) Prime plus 1.00% and (b) 7.50%, which was 8% at December 31, 2023. The interest rate per annum applicable to the Term Loan is 8.18%. Payments of principal and interest monthly on the Term Loan, and interest only on the Revolving Line, commenced on August 28, 2023. The balance of principal and interest on both Loans will be due upon maturity, if not sooner repaid. The Company may prepay and/or repay the Loans, in whole or in part, at any time without premium or penalty, subject to certain conditions. The balance of the Revolving Line and Term Loan totaled approximately $0 and $1,602,000 as of December 31, 2023, respectively.
The Loan Agreement contains customary covenants limiting, among other things, the incurrence of additional indebtedness, the creation of liens, mergers, consolidations, liquidations and dissolutions, sales of assets, dividends and other payments in respect of equity interests, acquisitions, investments, loans and guarantees, subject, in each case, to customary exceptions, thresholds and baskets. The Loan Agreement also includes certain financial covenants which include a current assets/liabilities ratio, a debt service coverage ratio and a leverage ratio, as defined in the Loan Agreement. The Loan Agreement also contains customary events of default. As of December 31, 2023, the Company was in compliance with all covenants.
The Company’s obligations under the Loan Agreement are guaranteed by the Guarantors, and the obligations of the Company and any Guarantors are secured by a perfected first priority security interest in substantially all of the existing and future personal property of the Company and each Guarantor, subject to certain exceptions as noted in the Loan Agreement.
Business Manager Agreements
In connection with entering into the Loan Agreement, the Company entered into Business Manager Agreements for the purchase by the Lender of certain domestic and international accounts receivable of the Company. The face amount of the accounts under each agreement that may be purchased cannot exceed $2,500,000 under the domestic agreement and $2,000,000 under the international agreement. The service charge associated with the purchases is 1.25% under the domestic agreement and 2.0% under the international agreement. There are additional charges if accounts are not paid within 45 days. The Business Manager Agreements include recourse arrangements, which require the Company to repurchase transferred accounts receivable that remain unpaid for a specified period of time. The accounts are secured by a security interest in the accounts receivable in all of the Company’s present and after-acquired accounts receivable of the customers as defined in the agreements.
Generally, at the transfer date, the Company receives cash equal to 90% of the value of the sold domestic accounts receivable and 60% of the value of the sold international accounts receivable, less the service charge. The remaining balance is held back as a reserve. The reserve balance is carried at fair value, which is remeasured monthly to take into account activity during the period (the Company’s interest in newly-transferred receivables and collections on previously transferred receivables), as well as changes in estimates of future interest rates and anticipated credit losses. Fluctuations in interest rates and revised estimates of credit losses were zero as of December 31, 2023. The carrying amount of the reserve was $169,139 as of December 31, 2023 and is classified within cash and restricted cash on the consolidated balance sheet.
During the year ended December 31, 2023, the Company sold receivables having an aggregate face value of $4,211,786 in exchange for cash proceeds of $4,150,932. Service fees for the period totaled $83,109, which are initially recorded as prepaids in the consolidated balance sheets and amortized over 45 days. The Company recognized expense of $83,337 related to the service fees for both the year ended December 31, 2023 which is included in interest expense in the consolidated statements of operations. The outstanding principal amount of the receivables sold under this facility amounted to $307,310 as of December 31, 2023.
Financing Obligation Liability
On December 7, 2020, the Company closed a sale-leaseback agreement for its headquarters and manufacturing facilities. Under the terms of the transaction, the Company sold the property for $4.45 million and simultaneously entered into a 15-year lease. After fees, the Company netted approximately $4.26 million in proceeds of which $2.64 million was used to repay in full the outstanding mortgage on the property. Under the lease agreement, the Company has an option to extend the term of the lease and to repurchase the property. Due to this repurchase option, the Company was unable to account for the transfer as a sale under ASC Topic 842, Leases, and as such, the transaction is a failed sale-leaseback that is accounted for as a financing transaction.
Machinery Loans
The Company financed the purchase of machinery and equipment in July 2022. The term of the loan is 5 years and matures in July 2027. The loan has an interest rate of 5.50%. The balance of the equipment loan totaled $620,176 as of December 31, 2023.
Insurance Loan
In June 2023, the Company financed insurance premiums with a loan agreement. In September 2023, an additional amount for insurance premiums was added to the loan. The loan matures in March 2024. The balance of the insurance loan totaled $196,693 as of December 31, 2023.
The Company had no off balance sheet arrangements.
Cash Flow
Year Ended December 31,
Net cash provided by operating activities
Net cash used in investing activities
Net cash (used in) provided by financing activities
Net (decrease) increase in cash and restricted cash
Operating Cash Flows
For the year ended December 31, 2023, net cash provided by operating activities was approximately $3,194,000. The Company had approximately $7,436,000 of net income, and a $2,577,000 increase in non-cash expenses, offset by a $437,000 decrease in working capital accounts.
Investing Cash Flows
For the year ended December 31, 2023, net cash used in investing activities was approximately $3,391,000, primarily related to purchases of property, plant and equipment.
Financing Cash Flows
For the year ended December 31, 2023, net cash provided by financing activities was approximately $710,000, primarily related to proceeds from debt borrowings of approximately $2,901,000, offset by principal payments on debt of approximately $2,306,000.
Critical Accounting Policies and Estimates
The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. During the preparation of these financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions, including those discussed below. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of our analysis form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. While we believe that the estimates and assumptions used in the preparation of our consolidated financial statements are appropriate, actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated financial statements. Our estimates and assumptions are evaluated periodically and adjusted when necessary. Described below are the most significant policies we apply in preparing our consolidated financial statements, some of which are subject to alternative treatment under GAAP. We also describe the most significant estimates and assumptions we make in applying these policies. See Note 1 to our consolidated financial statements.
Accounts Receivable and Allowance for Credit Losses
Accounts receivable are generally due within 60 days and 90 days of the invoice date for domestic and international customers, respectively. No interest is charged on past-due balances. We grant credit to our customers based upon an evaluation of each customer’s financial condition. We periodically monitor the payment history and ongoing creditworthiness of our customers. An allowance for credit losses is established at a level estimated by management to be adequate based upon various factors including historical experience, aging status of customer accounts, payment history and financial condition of our customers. The allowance for credit losses was $0 at both December 31, 2023 and 2022.
Substantially all of our revenue is derived from our refurbishing of PDC drill bits for Baker Hughes and from DTI when we 1) sell the Drill-N-Ream tool, 2) repair drilling bits and the Drill-N-Ream tool, and 3) earn royalty on our customer’s rental of the Drill-N-Ream tool to the end user. Internationally our revenue is derived from the rental of our Drill-N-Ream tool to large oilfield service companies. While our credit risk is concentrated, all of our customers have historically had excellent payment history. Management monitors accounts receivable collections on a weekly basis.
The Company analyzes each customer’s length of time a receivable is outstanding, geographical location, and any potential economic conditions that could cause concern for credit instability. On a weekly basis, this data is reviewed, and a determination made if there are potential concerns for losses. This historical data, geographical location, review of current economic conditions, and the current receivables helps establish a forecast for credit risk.
Related Party Note Receivable
In January 2014, we entered into a Note Purchase and Sale Agreement under which we agreed to purchase a loan made to Tronco Energy Corporation (“Tronco”), a party related to us through common control, in order to take over the legal position as Tronco’s senior secured lender. That agreement provided that, upon our full repayment of the Tronco loan from the proceeds of our initial public offering, the lender would assign to us all of its rights under the Tronco loan, including all of the collateral documents. On May 30, 2014, we closed our purchase of the Tronco loan for a total payoff of $8.3 million, including principal, interest, and early termination fees.
The Meier Guaranties were determined not to be substantive based on GAAP that states that the substance of a personal guarantee depends on the ability of the guarantor to perform, the practicality of enforcing the guarantee, and the demonstrated intent to enforce the guarantee. Since the Company did not demonstrate intent by either enforcing the redemption of collateral or the guarantees by the borrowers to repay the loan when the related party note receivable was due and payable on December 31, 2017 and instead modified the loan by extending the payment term, the Company determined the guarantees are not substantive and therefore should not serve as the basis for concluding the loan is well secured and collateralized. As a result, the Company fully reserved the related party note receivable effective August 2017.
On March 31, 2023, the Company entered into a fourth amended and restated loan agreement and note with Tronco to extend the maturity date of the principal to March 31, 2033. As amended, the interest rate on the note is fixed at 2.8% per annum and provides for principal and accrued interest payments in the amount of $750,000 annually on March 31, 2024 through 2032, with the balance of all remaining outstanding principal and accrued interest due on March 31, 2033. In the event the average closing price for the Company’s common stock for 10 consecutive trading days is equal to or greater than $3.00 per share, Tronco shall pay fifty percent of the then outstanding principal balance together with all accrued, unpaid interest within ten days of the date on which the 10-day trading average first equals or exceeds $3.00. In the event the average closing price for 10 consecutive trading days is $4.00 per share or greater, Tronco shall pay the entire outstanding principal balance together with all accrued, unpaid interest within ten (10) days of the date on which the 10-day average first equals or exceeds $4.00. In addition, in the event of a sale of all or substantially all of the assets or a controlling equity interest in the Company, Tronco and the Meiers must utilize the proceeds received from such sale to pay the entire outstanding principal balance on the note receivable together with all accrued, interest. On March 24, 2023, there was a principal and interest payment of $350,262 which was reflected as a recovery of related party note receivable in other income and expense on the condensed consolidated statements of operations. The Tronco note balance, including accrued interest, was approximately $6,706,000 and $6,884,000 as of December 31, 2023 and 2022, respectively, which is fully reserved. The Company continues to hold the 8,267,860 shares of the Company’s common stock as collateral. The Company will record a recovery of the loan upon receiving repayment of the note, but there is no guarantee a full recovery of the loan will occur.
Government Grant
The Company applied for and received a grant award of up to $750,000 from the State of Utah’s Manufacturing Modernization Grant Program. The program helps develop manufacturing industry in the state. Current GAAP has no specific authoritative guidance on the accounting for government assistance received by business entities. However, Accounting Standard Codification (“ASC”) 105 describes the decision-making framework for determining the guidance to apply when guidance is not specified by GAAP. ASC 105 points to IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, and ASC 958-605, Not-for-Profit Entities - Revenue Recognition, that require conditions of the grant to be met in order to recognize the income.
During 2022, the Company met the conditions of the grant and, therefore, recorded the initial grant funding totaling $675,000 as deferred income on the balance sheet, as portions of the grant are approved by the State of Utah. Income will be recognized on a straight-line basis over the life of the asset once all project requirements, such as employee training and installation of the equipment, have been completed.
Income Taxes and Valuation Allowance for Deferred Tax Assets
The Company recognizes an asset or liability for the deferred tax consequences of all temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years when the reported amounts of the asset or liabilities are recovered or settled and for operating loss carry forwards. These deferred tax assets and liabilities are measured using the enacted tax rates that will be in effect when the differences are expected to reverse and the carry forwards are expected to be realized.
In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that the deferred tax assets will be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, carryback potential if permitted under the tax law, and results of recent operations. The realization of deferred tax assets is primarily dependent upon earnings in federal and various state and local jurisdictions.
We consider a number of factors to reliably estimate future taxable income so we can determine the extent of our ability to realize net operating loss (“NOL”), foreign tax credits, realized capital loss and other carryforwards. These factors include forecasts of future income for each of our businesses and actual and planned business and operational changes, both of which include assumptions about future macroeconomic and company-specific conditions and events. We subject the forecasts to stresses of key assumptions and evaluate the effect on tax attribute utilization. If certain future operating results do not meet current expectations it could cause us to establish an additional valuation allowance on our deferred tax assets.
