ITEM 1. BUSINESS
OVERVIEW
We are a diversified oilfield service company that provides products and services used primarily for the drilling, completion and production of oil and natural gas wells. We have operations in North America and select areas internationally. Since our formation in 1989, we have entered the following lines of business through acquisitions, and we have expanded our product and service offerings through a combination of acquisitions, internal growth and research and development:
- drilling related products and services, which include logging-while-drilling, or LWD, measurement-while-drilling, or MWD, directional drilling, rental tools (including drill pipe), down-hole drilling motors and drilling fluids; and
- completion and workover related products and services, which include cased-hole wireline logging and perforating, tubing conveyed perforating and associated rental equipment, polymers and specialty chemicals, rental tools (including tubing) and coiled tubing.
We focus on products and services that provide our customers with alternatives to the integrated services typically marketed by the major integrated oilfield service companies. We believe our business approach enables us to compete successfully against these larger oilfield service companies by:
- offering technologically advanced and cost effective products and services;
- focusing on niche markets in which leading market positions can be achieved;
- operating our business lines autonomously and marketing our product offerings independently;
- emphasizing customer service, responsiveness and reliability; and
- providing equity incentives to key management and operating personnel.
Our customers include major and independent oil and natural gas companies, drilling contractors and other oilfield service companies.
In this report, unless otherwise specified, "W-H" and "we," "our," "us" and "our company" refer to W-H Energy Services, Inc., a Texas corporation, and/or one or more of its subsidiaries. General information about us can be found at our internet website (www.whes.com). Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other reports and forms that we file with the U.S. Securities and Exchange Commission, or SEC, or that are filed with the SEC in respect of our company, such as Forms 3, 4 and 5, as well as any amendments and exhibits to the foregoing reports and forms, are available free of charge through our website as soon as reasonably practicable after we file them with, or furnish them to, the SEC.
Information regarding our corporate governance policies and guidelines, including our Corporate Governance Guidelines, Corporate Code of Business Conduct and Ethics, Financial Code of Ethics for Senior Officers, as well as the charters for the Audit, Compensation and Corporate Governance and Nominating Committees of our Board of Directors are also available on our internet website or in print to any shareholder who requests them.
Following is a discussion of our business lines, our strategy, our research and development initiatives and certain risks we face.
BUSINESSES
DRILLING RELATED PRODUCTS AND SERVICES
Our drilling related products and services segment provides a broad range of products and services used by oil and natural gas companies, drilling contractors and other oilfield service companies for the drilling of oil
and natural gas wells. Our drilling related products and services are used primarily in North America and select areas internationally. We currently are conducting operations onshore in Canada, Brazil, Europe, North Africa and the Middle East and offshore in the North Sea, the Persian Gulf, the Gulf of the Suez, the Mediterranean Sea and off the coast of Brazil. Our drilling related products and services segment includes the following business lines:
- LWD, MWD and directional drilling;
- down-hole drilling motors;
- rental tools (including drill pipe); and
- drilling fluids.
LWD, MWD and Directional Drilling. We are one of a few companies worldwide that currently has the technological capability to offer a full complement of LWD products and services. LWD tools provide real-time data about the physical properties of downhole formations such as pressure, porosity and permeability. In addition to indicating the possible presence of oil and natural gas, this data also assists in improving drilling performance.
Before the introduction of LWD technology, well formation data was typically obtained by lowering evaluation tools into the well with armored electro-mechanical cable, or wireline, from a truck on land or a skid unit offshore. Traditional open-hole wireline information can only be obtained after the well has been drilled or during the drilling process if drilling is halted and the drill string is removed from the well. An advantage that LWD has over traditional open-hole wireline logging is that costs are reduced because drilling rig downtime is minimized. These savings can be substantial for offshore jobs where day rates for drilling currently range from an average of about $25,000 per day in shallow waters to an average of about $160,000 per day in deep waters. In addition, the real-time information transmitted during the drilling process can assist in making drilling decisions such as altering the path of the well-bore to a point in the formation which, when compared with previously obtained seismic data, provides for enhanced recovery of oil and natural gas.
We also offer MWD products and services, which use down-hole electronic instruments to help locate and direct the drill bit to the intended target. This capability is particularly advantageous when drilling directional (non-vertical) wells, which represent an increasing percentage of overall drilling activity, particularly offshore. In order to drill a directional well, the driller must be able to determine the precise direction the drill bit is moving during the drilling operation. MWD tools assist the driller in making this determination by transmitting data to the surface enabling the driller to adjust the drilling path as necessary during the drilling process.
We provide directional drilling services in North America and in select areas internationally. Directional drilling involves directing the well-bore along a predetermined path to optimally recover oil and natural gas from a reservoir. These services are used to more accurately drill vertical wells and to drill deviated or directional wells (which deviate from vertical by a planned angle and direction), horizontal wells (which are sections of wells drilled perpendicular or nearly perpendicular to vertical) and extended reach wells (which are deviated over extended distances). We entered the directional drilling market in North America in October 2002 and believe that doing so has increased the domestic utilization of our MWD, LWD and down-hole drilling motor fleet. Prior to that time, we provided directional drilling services only in select areas of the Eastern Hemisphere.
Our LWD, MWD and directional drilling services are provided by our wholly owned subsidiary, PathFinder Energy Services, Inc. We market these services through an internal sales force. Our customers typically utilize these services on a per well or per project basis. We charge our customers for these services primarily on a per day rental basis.
Down-hole Drilling Motors. We are a supplier of down-hole drilling motors and a manufacturer of their replaceable parts. We provide down-hole drilling motors internally to PathFinder's directional drilling business
and to other oilfield service companies. Our drilling motors business is conducted by our two wholly owned subsidiaries, Drill Motor Services, Inc. and Dyna-Drill Technologies, Inc.
Drill Motor Services' rental product line consists of a wide range of sizes of down-hole drilling motors ranging from 1 11/16 inches to 11 1/2 inches in outside diameter for use at various drilling depths. The components of the drill motor are designed to operate at various speeds and torque levels and to withstand severe environmental conditions such as high temperatures, hard rock and abrasive drilling fluids.
Power sections and bearing packs for Dyna-Drill(R) down-hole drilling motors are manufactured by our subsidiary, Dyna-Drill Technologies. In addition to complementing our Drill Motor Services line of down-hole drilling motors, our manufacturing capability enables us to support our own motor lines and to provide manufacturing and repair services for other oilfield service companies. Dyna-Drill Technologies is one of only a limited number of companies worldwide that manufactures the power sections and bearing packs for down-hole drilling motors.
We typically charge our customers for the use of our rental fleet of drilling motors on the basis of hours of usage. We charge our customers for our manufactured motor components and repair services when products are shipped and services are completed. We market our down-hole drilling motors and services directly through our internal sales force.
Rental Tools (including drill pipe). We provide a broad range of rental equipment and tools for the drilling of oil and natural gas wells. Our rental equipment allows our customers, primarily oil and natural gas companies, the ability to have access to inventories of tools and other equipment without the cost of maintaining or storing that equipment in their own inventory. Our rental tool inventory includes:
- drilling equipment, such as large diameter drill pipe, heavy weight drill pipe, high torque drill pipe, drill collars and other required accessories;
- pressure control equipment, such as blowout preventers, high pressure valves, choke and kill manifolds and test pumps;
- down-hole tools, such as milling tools and casing scrapers;
- pipe handling equipment; and
- side entry subs and our patented lockdown lubricator system (described below under "Research and Development: Patents and Technologies").
We have various sizes of drill pipe and related handling tools, providing our customers with a wide range of drill pipe for drilling at a variety of well depths and conditions. In response to the growth in directional drilling, we have expanded our inventory of premium, high torque drill pipe, which also provides operators with the technical characteristics demanded by deeper wells and wells expected to encounter adverse conditions. We also offer all corresponding handling and sub-surface tools and pressure control equipment that support high torque drill pipe.
Our rental tool business is conducted by our wholly-owned subsidiaries Thomas Energy Services, Inc., through its Thomas Tools division, and Dutch, Inc. These rental tools and related services are marketed through our internal sales force. The majority of our equipment and tools are rented to our customers on a per day rental basis.
Drilling Fluids. Drilling fluid products are used to cool and lubricate the drill bit during drilling operations, to contain formation pressures and to suspend and remove rock cuttings from the borehole while maintaining the stability of the well-bore. We manufacture, package, transport, warehouse and wholesale drilling fluids and drilling fluid chemicals and additives. We also provide size reduction services of environmentally approved solids used in control of loss circulation and seepage. Our customers, which include retail drilling fluid companies, specialty fluid companies and other oilfield service companies, use our drilling fluid products throughout the world.
Our drilling fluid chemicals and additives are used in the production and maintenance of:
- water-based drilling fluids, which are the most widely used drilling fluids, having application in both land and offshore environments;
- oil-based drilling fluids, which are used primarily to drill water-sensitive shale and in drilling conditions where stuck pipe is more likely to occur; and
- synthetic-based drilling fluids, which are used where oil-based fluids are prohibited for environmental reasons, or where high performance and safety are an issue.
We manufacture a large portion of the drilling fluid products we wholesale, which enables us to manage the cost and maintain the proprietary nature of these products. Our drilling fluids business is conducted through our wholly owned subsidiaries, Integrity Industries, Inc., Grinding and Sizing Company, Inc. and Agri-Empresa, Inc. We market and sell these products through our internal sales force.
COMPLETION AND WORKOVER RELATED PRODUCTS AND SERVICES
Our completion and workover related products and services segment provides a broad range of products and services primarily to customers in and along the Gulf of Mexico. These products and services include:
- cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment and services;
- polymers and specialty chemicals;
- rental tools (including tubing); and
- coiled tubing.
Cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment and services. We provide cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment services to oil and natural gas companies. Cased-holes are wells that have been drilled and in which casing has been installed to stabilize the hole. Cased-holes typically are either ready to produce or are already producing oil and natural gas. The majority of our revenues from this business are generated by repeat business on existing wells. Consequently, this business typically provides more stable revenue during periods of reduced drilling activity. Our services include:
- Logging Services. Logging involves the gathering of down-hole information to identify various characteristics about the formation or zone to be produced. Logging services are performed by lowering armored electro-mechanical cable, or wireline, into a well from a truck on land or a skid unit offshore. These units contain instrumentation and computer equipment used to chart and record down-hole information.
- Perforating Services. Perforating involves creating a pathway for oil and natural gas to flow into a completed and cased well from a reservoir. Once a well has been drilled and cased and is ready for production, a perforating gun is lowered into the well using wireline and a shaped explosive charge is detonated in the zone from which production is desired. The resulting perforations in the casing allow oil and natural gas to flow into the casing where they are carried to the surface. Perforating is also used in wells that are already producing to improve the production rate of oil and natural gas. For example, perforating might be used to restore or improve production in a producing well that has become congested by sand or might be used to create production from a new zone once a deeper zone or formation has been depleted.
- Tubing Conveyed Perforating/Drill Stem Testing. Tubing conveyed perforating, or TCP, involves the use of drill pipe, tubing or coil tubing, to convey the perforating assembly to the required depth. Drill stem testing, or DST, is a method of determining the producing potential of a formation by allowing the formation fluids to flow into the borehole. The use of these tools together allows our customers to
evaluate and complete oil and gas wells in a more efficient and safer manner relative to conventional techniques.
- Rental Equipment and Services. Wireline rental equipment includes grease injector units, pipe recovery lubricators, air compressors, high pressure risers, wireline blow-out preventers and flanges.
We conduct our cased-hole wireline logging and perforating business through our wholly owned subsidiaries, Perf-O-Log, Inc. and E.M. Hobbs, L.P. Our wireline rental equipment is offered through our wholly owned subsidiary, Boyd's Bit Service, Inc. which conducts business as Boyd's Rental Tools. A wireline job typically involves the use by a skilled operator of a logging and perforating unit and certain specialized rental equipment at a customer's well site. We market these services through an internal sales force and our customers typically utilize these services on a per well basis. We charge our customers on a per day or per job basis.
Polymers and Specialty Chemicals. We produce polymers and specialty chemicals for niche applications related to completion and workover activities. Our polymers and specialty chemical products are sold to customers for use around the world.
Completion fluids are generally solids-free solutions with high specific gravities and are non-damaging to the producing formation. Oil and natural gas operators use completion fluids in combination with specialty chemical products to control bottom-hole pressures during the completion and workover phase of a well.
Our three classes of completion and workover related polymer and specialty chemical products are:
- oilfield products, which include:
- enhanced recovery chemicals;
- lubricants;
- well treating chemicals; and
- liquefied polymers;
- industrial products, which include:
- cleaners;
- lubricants; and
- environmentally sensitive solvents; and
- environmental remediation products.
We conduct our completion and workover related polymers and specialty chemicals business through our wholly owned subsidiaries, Integrity Industries and Agri-Empresa. We market and sell our polymers and specialty chemical products through an internal sales force.
Rental Tools (including tubing). We provide rental of premium tubing work strings, high pressure blowout preventers, flow iron packages, high pressure manifolds, tanks and tubing handling tools for conventional well remediation, as well as specialized equipment for snubbing and coiled tubing applications. Snubbing involves pushing pipe into the well against high well-bore pressures.
Our rental tool business is conducted by our wholly-owned subsidiary Thomas Energy Services, Inc., through its Thomas Tubing Specialists division. We market our rental tools through an internal sales force. Our customers typically utilize tools on a per well basis and we charge our customers for rental tools primarily on a per day rental basis.
Coiled Tubing. We provide coiled tubing conveyed well intervention services to oil and natural gas companies. A typical coiled tubing job involves the use of a coiled tubing unit by one or more skilled operators at a customer well site. We own and operate a fleet of coiled tubing units that are used in a variety of well-bore applications, including foam washing, acidizing, displacing, cementing, gravel packing and jetting. In addition
to these services, we use modeling software for coiled tubing applications to provide optimal job design and cost saving solutions for our customers.
Coiled tubing is one of the fastest growing segments of the well service industry today. In the Gulf of Mexico, where a large percentage of domestic natural gas reserves are located, the economics of coiled tubing operations are often far superior to the use of conventional workover rigs. The growth in deep well and horizontal drilling has increased the market for coiled tubing. Routine logging and down-hole tool manipulation in highly deviated and horizontal wells previously performed primarily with wireline can now be accomplished more efficiently utilizing coiled tubing services.
Our coiled tubing business is conducted by our wholly owned subsidiary, Coil Tubing Services, L.L.C.
DISCONTINUED OPERATIONS
In March 2004, we committed to the divestiture of our maintenance and safety related products and services segment. Accordingly, this segment has been included in the Consolidated Statements of Operations and Comprehensive Income as discontinued operations and in the Consolidated Balance Sheets as assets and liabilities held for sale. In April 2004, we completed the sale of Well Safe, Inc., one of the two companies that formerly comprised the maintenance and safety related products and services segment, for cash consideration of $28.0 million. Additionally, in December 2004, we sold the remaining entity that formerly comprised this segment, Charles Holston, Inc., for consideration of $2.0 million, consisting of $1.0 million in cash and a $1.0 million subordinated promissory note due December 31, 2009. We sold Well Safe and Charles Holston pursuant to customary stock purchase agreements in which we made customary representations and warranties, agreed to customary covenants and agreed to indemnify the buyers of these businesses for certain matters, subject to certain caps, limitations and deductibles. These sales resulted in a loss of $5.1 million for the year ended December 31, 2004.
For a summary of our reportable segments and operations by geographical region as of and for the years ended December 31, 2004, 2003 and 2002, see Note 12 to our Consolidated Financial Statements, which information is incorporated herein by reference.
STRATEGY
Our strategy is to grow revenues and earnings by providing our customers with an alternative to the major integrated oilfield service companies while preserving our entrepreneurial culture. Our strategy consists of the following key components:
Provide Leading Technology Solutions to Our Customers. We believe technology is an important aspect of our business. Improving technology helps us provide our customers with more efficient and cost effective tools to find and produce oil and natural gas. In fiscal year 2004, we spent approximately $15.5 million on research and development initiatives, and we plan to spend approximately $18 million on these initiatives in 2005. We are committed to investing substantial time and resources in building our technology-based products and services. We believe our new products and services are among the best in the industry and will provide us with the opportunity to grow our business and service the needs of our customers.
Maintain a Diverse Source of Revenues within the Oilfield Services Industry. We believe that the value and stability of our company will be enhanced if we continue to broaden and diversify our revenue base, both operationally and geographically. We believe that the products and services provided by our completion and workover segment provide a measure of revenue stability during periods of low drilling activity when demand for our drilling related products and services is reduced. We have devoted substantial time and capital to accomplish this diversification of our business lines, both through organic growth and through acquisitions, and we expect to continue to do so in the future.
Capitalize on Trends in the Gulf of Mexico. We believe that many of the larger integrated oil and natural gas companies are increasingly focused on projects in the deeper waters of the Gulf of Mexico and in international locations. As a consequence, we believe that independent oil and natural gas companies are becoming more prominent players in exploration, development and production activity in the Gulf of Mexico,
especially in this areas' shallow waters. We believe that we have good working relationships with many of these independent oil and natural gas companies, and we plan to capitalize on these relationships to increase the utilization of our tools and personnel.
Capitalize on the Growth of Offshore and Directional Drilling. A substantial portion of our drilling related products and services are designed for use in directional drilling onshore and directional and vertical drilling offshore. While the overall level of drilling activity fluctuates based on the industry environment, we believe that the long-term trends in directional drilling are positive. We provide directional drilling services in North America and in select areas internationally. We believe that providing directional drilling services will continue to increase the utilization of some of our other products and services, such as MWD, LWD, down-hole drilling motors and rental tools.
Expand the Breadth and Scope of Our International Operations. Although our operations are focused primarily in the United States, we believe that larger oil and natural gas exploration and development projects are increasingly located in international locations. We will continue to seek to selectively capitalize on this trend in international locations where we offer LWD and MWD products and services, directional drilling services and down-hole drilling motors.
Selectively Acquire Complementary Businesses and Technologies. We expect to continue to pursue acquisitions of complementary businesses, which increase the technological base and expand the market reach of our product and service offerings. We intend to focus on acquisitions that expand our operations with new products and services, broaden our geographic scope, increase our market share and improve our ability to compete with the major integrated oilfield service companies. We also intend to provide management and key personnel of acquired businesses with stock-based incentives in our company and to continue to market these companies and technologies under their established names.
POTENTIAL LIABILITIES AND INSURANCE
Our industry involves a high degree of operational risk. Failure of equipment could result in property damage, personal injury, loss of life, environmental pollution and other damages for which we could be liable. Litigation arising from a catastrophic occurrence at a location where our equipment or services are used may result in our being named as a defendant in lawsuits asserting potentially large claims.
We maintain insurance policies providing coverage for risks that we believe are consistent with industry standards and that meet the requirements of our customers. We have deductibles under these policies in amounts we believe to be customary and reasonable. Although we believe that we maintain insurance coverages that are adequate in amount and type for the risks associated with our businesses, there is always a risk that our insurance may not be sufficient to cover any particular loss. In addition, our insurance does not provide coverage for all liabilities, including liability for some events involving pollution. Finally, insurance rates have recently been subject to increases and wide fluctuations, and, during the last five fiscal years our cost of insurance and deductibles have increased substantially. Changes in coverage, insurance markets and our industry, and events affecting our company, may result in future increases in our insurance costs and in higher deductibles and retentions.
RESEARCH AND DEVELOPMENT: TECHNOLOGY INITIATIVES
Several of our subsidiaries conduct research and development initiatives at their facilities. Our subsidiary Pathfinder Energy Services, Inc. maintains a research and development facility in Houston, Texas, at which most of our LWD, MWD and directional drilling technology is developed. We invest heavily in research and development in an effort to improve our existing product and service offerings and to satisfy customer demand for tools, products and services that will increase the efficiency of their operations. Our expenditures for research and development were $15.5 million, $11.2 million and $10.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Recently Commercialized Technologies. Some of our recently commercialized technologies include:
- PathMaker(R) 3-Dimensional Rotary Steerable, or 3DRS, technology for 12 1/4-inch borehole size. This technology facilitates full steering and propulsion of a drill string in any direction, with or without the use of a down-hole drilling motor, with real-time at-surface feedback as to the tool's performance and well placement. Aspects of this technology are patented or patent-pending.
- Array Wave Resistivity (AWR(TM)) technology. Tools and data analysis in this technology improve the precision and reliability of formation data obtained through the analysis of electromagnetic wave transmissions through the formation surrounding a well-bore. Aspects of this technology are patented or patent-pending.
- E-sonic(TM) acoustic tool technology. This technology enhances the precision and measurement quality of our proven and patented sonic formation evaluation technology.
- Matrix-3(TM) tungsten carbide-based metal coating technology. These coatings deliver improved resistance to wear, corrosion and impact to metal components used in drilling and other down-hole applications, such as motor bearings used in down-hole drilling motors. The coating process is a confidential process, developed independently in-house, based on proven tungsten carbide metallurgy and brazing technologies.
- Guardian(TM) sensor spool technology. This patented tool detects the precise location of pipe tool joints and connections during tripping, snubbing or removal of pipe through the well-bore, thereby allowing for increased safety and fewer equipment failures, while greatly enhancing operating efficiency.
- Pay Zone Inclination Gamma (PZIG(TM)) directional survey technology. This technology includes deployment of independent drilling subs at or near the drill bit, from which real-time directional survey and drill bit/subsurface formation information can be obtained.
- TWINNING(TM) passive ranging and well twinning technology. These are advanced MWD techniques that facilitate the drilling of a second well that follows the path of an existing well with high precision at a close but controlled distance, to assist in, for example, relief well drilling, or drilling of a "twin" well to complete as a producing well. Aspects of this technology are patented or patent-pending.
- Gyro MWD(TM) directional survey technology. This technology allows us to provide directional surveys while drilling in subterranean zones of high magnetic interference, such as below a multi-well platform.
- RX5(TM) rig site computer technology. This surface system enhances our ability to receive and interpret data received from down-hole sensors to provide timely and useful information to our customers about current subsurface conditions.
- GSX600(TM) polymeric loss circulation technology. This product, in development, when added to the drilling fluid system, seals porous formation zones and helps build a thin but tight filter caulk, thereby improving drilling performance.
- Tiger Paw(TM) isolation tool technology. This tool protects pressure control equipment above ground while high pressures are temporarily introduced into the well bore during, for example, fracturing operations.
Technologies in Development. Some of our technologies in development include:
- PathMaker(R) 3DRS technology for 8 1/2-inch borehole size. This technology will be functionally substantially similar to the 12 1/4-inch 3DRS technology described above that is now commercially available, except that the 8 1/2-inch tool will be able to accommodate a smaller borehole diameter. Aspects of this technology are patent-pending. This technology is targeted to be commercially available during the second half of 2005.
- Slim Density Neutron Standoff Caliper technology. This technology will allow our proven density neutron technology to be used to evaluate formation characteristics in smaller borehole diameters.
Aspects of this technology are patent-pending. This technology is targeted to be commercially available during the second half of 2005.
- Survivor(TM) high-temperature/high pressure technology. This technology will include a survey package and a data transmission system that are designed for especially demanding down-hole conditions (up to 3507 F and 25,000 psi). The Survivor(TM) tools will be configured to be compatible with other LWD technologies, such as the AWR(TM) and slim density neutron technologies described above.
- Slim Array Wave Resistivity technology. This technology will allow our new AWR(TM) technology described above to be used to evaluate formation characteristics in smaller borehole diameters.
- Azimuthally-enriched data technology. This technology will associate relative rotational position with other sensor data regarding the formation or subsurface conditions. The resulting data will enable us to provide increasingly sophisticated and useful information to our customers about the formation and/or current subsurface conditions. Aspects of this technology are patent-pending.
- Enhanced power section technology for down-hole drilling motors. This technology involves incorporating elastomer and non-elastomer materials into the manufacture of certain components of the power sections of our drilling motors. This technology also involves the introduction of new manufacturing techniques associated with use of these new materials. The resulting components will be more reliable, and will enhance the power capability, fluid compatibility, and resistance to high temperatures of power sections in drilling motors. Aspects of this technology are patent-pending.
Established Commercial Technologies. Some of our other established commercial technologies include:
- Drilling Formation Tester tool. This LWD tool obtains wireline-equivalent formation pressure data while drilling, offering time and cost savings over conventional formation pressure measurement by open-hole wireline equipment.
- Gravity MWD(R) directional survey technology. This patented technology eliminates the adverse impact of magnetic interference while conducting directional surveying, thereby reducing reliance on and the cost of conventional gyroscopic wireline surveys.
- Patented gravel pack service. This service provides operators of oil and natural gas wells with a more precise method of installing gravel packs with cased-hole wireline.
- Patented wireline side entry sub, patent-pending locking swivel, and patented wireline wear sleeve. All of these tools may be used, for example, in pipe recovery applications.
- Patented LLS(TM) lockdown lubricator system. This system, installed on a well-head above the blowout preventers, allows wireline operations to be conducted more safely and more cost effectively.
- Patented drilling fluid seepage control technology. This product, containing grape pumice, controls seepage when added to the drilling fluids system, but does not affect the electrical stability of the drilling fluid system. In some cases, the product actually enhances the drilling fluid system for a more homogenous fluid.
- Patented pelletizing technology. This process condenses bulky drilling fluid additives into pellet form. The pellet form reduces dust in handling, reduces transportation costs, and enables more rapid deployment of the material into the drilling fluid system.
- Ultralube II(TM) high performance lubricant technology. This lubricant allows the use of environmentally friendly water-based drilling fluid systems in deep or severe drilling environments where the drill string may encounter high torque resistance or drag. The lubricant also enhances the lubricity of oil-based and synthetic-based drilling fluids.
We own or have licenses to use various patents covering a variety of technologies embodied in our portfolio of products and services. Although in the aggregate these patents are of importance to us, we do not consider any single patent to be of a critical or essential nature. Some of our products and services enjoy brand
name recognition. We own trademarks in respect of these brands. Some of these trademarks are registered or are pending registration.
While we are developing and deploying many of our own technologies, our LWD business is still dependent upon technologies that we acquired when we acquired PathFinder. We have the right to use substantially all of these acquired technologies pursuant to worldwide, royalty-free, irrevocable license rights. We have the right to use a small number of these acquired technologies under licenses from other third party licensors. The terms of certain of these licenses may be subject to change if there is a change in control of our company.
We have employment or product revenue sharing agreements with a limited number of our employees who have been involved in the development of technologies that are important to our business. In general, these agreements provide that we must make payments to these employees based upon the amount of revenues generated by the products to which these employees contributed. In some cases, these agreements provide for acceleration of these payments upon the occurrence of specified events, such as a change in control of our company.
GOVERNMENT REGULATION
Our business is significantly affected by foreign, federal, state and local laws and regulations relating to the oil and natural gas industry, worker safety and environmental protection. Changes in these laws, including more stringent administrative regulations and increased levels of enforcement of these laws and regulations, could affect our business. We cannot predict the level of enforcement of existing laws and regulations or how these laws and regulations may be interpreted by enforcement agencies or court rulings or the effect changes in these laws and regulations may have on us or our businesses, our results of operations, our cash flows or our financial condition. We also are not able to predict whether additional laws and regulations will be adopted.
We depend on the demand for our products and services from oil and natural gas companies, drilling contractors and other oilfield service companies. This demand is affected by changing taxes, price controls and other laws and regulations relating to the oil and natural gas industry. The adoption of laws and regulations curtailing exploration and development drilling for oil and natural gas in our areas of operation for economic, environmental or other policy reasons could also adversely affect our operations by limiting demand for our products and services. We cannot determine the extent to which our future operations and earnings may be affected by new laws or legislation, new regulations or changes in existing laws, regulations or enforcement.
Some of our employees who perform services on offshore platforms and vessels are covered by the provisions of the Jones Act, the Death on the High Seas Act and general maritime law. These laws have the effect of making the liability limits established under state workers' compensation laws inapplicable to these employees and, instead, permit them or their representatives to pursue actions against us for damages from job-related injuries, with generally no limitations on our potential liability.
Our operations are subject to numerous foreign, federal, state and local laws and regulations governing the manufacture, management and/or disposal of materials and wastes in the environment and otherwise relating to environmental protection. Numerous governmental agencies issue regulations to implement and enforce these laws which are often difficult and costly to comply with and the violation of which may result in the revocation of permits, issuance of corrective action orders and assessment of administrative, civil and even criminal penalties. For example, state and federal agencies have issued regulations implementing environmental laws that regulate environmental and safety matters, such as restrictions on the types, quantities and concentration of various substances that can be released into the environment in connection with specialty chemical manufacturing or other field service operations, remedial measures to prevent pollution arising from current and former operations and requirements for worker safety training and equipment usage. While our management believes that we are in compliance in all material respects with applicable environmental laws and regulations, there can be no assurance that future compliance with environmental laws and regulations will not have a material effect on us.
We generate wastes, including hazardous wastes, which are subject to the federal Resource Conservation and Recovery Act, or RCRA, and comparable state statutes. The U.S. Environmental Protection Agency and state agencies have limited the approved methods of disposal for some types of hazardous and non-hazardous wastes. Furthermore, it is possible that certain wastes handled by us in connection with our field service activities that currently are exempt from treatment as "hazardous wastes" may in the future be designated as "hazardous wastes" under RCRA or other applicable statutes and therefore be subject to more rigorous and costly operating and disposal requirements.
The federal Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, also known as the "Superfund" law and comparable state statutes impose liability, without regard to fault or legality of the original conduct, on classes of persons that are considered to have contributed to the release of a "hazardous substance" into the environment. These persons include the owner or operator of the disposal site or sites where the release occurred and companies that disposed of or arranged for the disposal of the hazardous substances at the site where the release occurred. Under CERCLA, these persons may be subject to strict joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment and for damages to natural resources, and it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment. We currently lease a number of properties upon which activities involving the handling of hazardous substances or wastes may have been conducted by third parties not under our control and prior to our occupation of the subject property. These properties may be subject to CERCLA, RCRA and analogous state laws in the future. Under these laws and implementing regulations, we could be required to remove or remediate previously discarded hazardous substances and wastes or property contamination that was caused by these third parties. These laws and regulations may also expose us to liability for our acts that were in compliance with applicable laws at the time the acts were performed.
We are subject to regulation under both the Federal Water Pollution Control Act, or FWPCA, and the Oil Pollution Act of 1990, or OPA. The FWPCA and analogous state laws impose restrictions and strict controls regarding the discharge of pollutants into state waters and waters of the United States. The FWPCA prohibits any discharge into waters of the United States except in strict conformance with permits issued by federal and state agencies. The OPA imposes a variety of regulations on "responsible parties" related to the prevention of oil spills and liability for damages resulting from such spills in waters of the United States. A "responsible party" includes the owner or operator of a facility or vessel, or the lessee or permittee of the area in which an offshore facility is located. The OPA imposes strict, joint and several liability on responsible parties for oil removal costs and a variety of public and private damages, including natural resource damages. Our management believes that we possess and are in material compliance with applicable permits required under the FWPCA. We are currently updating our existing or developing new spill prevention, control and countermeasure, or SPCC, plans which are required under the FWPCA for certain facilities that store oils. The SPCC regulations have been amended in recent years and their applicability is under consideration as each subsidiary evaluates its obligations under the regulations in light of the changing dynamics of the operations.
The Atomic Energy Act, which provides for the development and regulation of commercial nuclear power, authorizes the Nuclear Regulatory Commission, or NRC, to regulate radioactive "source material." The "source material" used in the conduct of our business includes cesium, americium(241), iridium, iodine, radium and cobalt. Under the Atomic Energy Act, the NRC has entered into cooperative agreements with the states of Texas, Louisiana, Mississippi and New Mexico that authorize those states to regulate and license the use of source material. Source material is used by several of our companies, including PathFinder, Perf-O-Log and E.M. Hobbs, in connection with logging exploratory and producing wells in those states. We have obtained licenses from the Louisiana Department of Environmental Quality, the Texas Department of Health and Radiological Control and the Mississippi Department of Health and Radiological Control, as well as reciprocity license from the NRC, that allow us to store and use these source materials in connection with our well logging activities in these three states and offshore in federal waters. We believe that we are in compliance with the terms and conditions of our source material licenses.
CUSTOMERS
Our customers include major and independent oil and natural gas companies, drilling contractors and other oilfield service companies operating in North America and select areas internationally. We provide services and equipment to a broad range of customers, and, therefore, we believe that we are not dependent on any single customer or group of customers. For the years ended December 31, 2004, 2003 and 2002, no single customer or group of affiliated customers accounted for 10% or more of our revenues. We typically enter into master service agreements with our customers. These agreements govern the terms of our relationship with our customers, but they generally do not create binding commitments on the part of our customers to use our services or on us to provide services.
SUPPLIERS
We obtain our coiled tubing units, wireline equipment and rental tools, certain parts and components of our drilling motors and LWD and MWD tools and certain chemicals and additives used in producing our drilling fluids from various third-party suppliers. We do not believe that any one supplier of these products is material to us. We have not experienced and do not foresee experiencing a shortage of any of these products.
COMPETITION
Drilling Related Products and Services. In this segment, we principally compete on the basis of product capability, reputation, quality, price, reliability, experience, availability and range of services offered. Competitors in our LWD, MWD and directional drilling businesses include divisions of Baker Hughes, Halliburton and Schlumberger. In our rental tool business, our competitors range from small, independent oilfield service companies to much larger oilfield service companies such as Weatherford International. In addition, many of our customers own and operate large inventories of equipment they might otherwise rent and have the ability to purchase additional equipment, as opposed to renting. Competitors in our MWD, directional drilling, down-hole drilling motors, drilling fluids and specialty chemicals businesses include both small and large independent oilfield service companies.
Completion and Workover Related Products and Services. In this segment, we principally compete on the basis of reputation, quality, price, reliability, experience, availability and range of services offered. Our competitors in this segment include the major integrated oilfield service companies and both small and large independent oilfield service companies.
EMPLOYEES
As of December 31, 2004, 2003 and 2002 we had 2,079, 1,795 and 1,383 employees, respectively. None of our employees are represented by a union or covered by a collective bargaining agreement. We believe that our relations with our employees are satisfactory.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND ACCURACY OF FORWARD LOOKING STATEMENTS
In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or the Exchange Act, that involve risks, uncertainties and assumptions. The words "believe," "expect," "plan," "intend," "estimate," "project," "will," "could," "may," and similar expressions are intended to identify forward-looking statements. Actual results may differ materially from the results discussed in the forward-looking statements as a result of important risk factors including, but not limited to, the risk factors discussed below. You should not place undue reliance on these forward-looking statements, which speak only of the date of this report. We undertake no obligation to publicly update such forward-looking statements to reflect events or circumstances after the date of this report.
RISKS RELATED TO OUR BUSINESS
Demand for our products and services depends on oil and natural gas industry activity and expenditure levels that are directly affected by trends in oil and natural gas prices.
Demand for our drilling related products and services is substantially dependent on the level of exploration, development and production activity of, and the corresponding capital spending by, oil and natural gas companies. Oil and natural gas companies typically reduce exploration and development activity during periods of low or volatile oil and natural gas prices. The markets for oil and natural gas historically have been volatile and are likely to continue to be so in the future. Prices for oil and natural gas are subject to large fluctuations in response to relatively minor changes in the supply of and demand for oil and natural gas, market uncertainty and a variety of other factors that are beyond our control. Any prolonged reduction in oil and natural gas prices will depress the level of exploration, development and production activity by our customers which will result in a decrease in the demand for our drilling related products and services and could have a material adverse effect on our financial condition or results of operations.
Factors affecting the prices of oil and natural gas include:
- the level of demand for oil and natural gas;
- worldwide political, military and economic conditions, including the ability of the Organization of Petroleum Exporting Countries to set and maintain production levels and prices for oil and potential political or economic uncertainties resulting from the threat or occurrence of terrorist attacks;
- oil and natural gas production/inventory levels;
- the policies of governments regarding the exploration for and production and development of their oil and natural gas reserves;
- global weather conditions;
- interest rates and cost of capital; and
- tax policies.
The production sector of the oil and natural gas industry, which utilizes our completion and workover related products and services, is less immediately affected by changing oil and natural gas prices and, thus, is less volatile than the exploration sector, which utilizes our drilling related products and services. However, producers likely would react to declining oil and natural gas prices by reducing expenditures, which could also adversely affect our completion and workover products and services segment.
Because many of our products and services are used in potentially hazardous applications and operations, our business is subject to risks associated with events that result in personal injuries, loss of life, damage to or destruction of property, equipment or the environment and suspension of operations.
Many of our products and services are used in potentially hazardous drilling, completion and production applications. These activities are dangerous and accidents can result in:
- personal injury;
- loss of life;
- damage to or destruction of property, equipment and the environment; and
- suspension of operations.
Litigation arising from a catastrophic occurrence at a location where our equipment or services are used may result, in the future, in our being named as a defendant in lawsuits asserting potentially large claims.
In addition, many of our employees who perform services on offshore platforms and vessels are covered by provisions of the Jones Act, the Death on the High Seas Act and general maritime law. These laws have the effect of making the liability limits established by state workers' compensation laws inapplicable to these
employees and, instead, permit them or their representatives to pursue actions against us for damages from job-related injuries, with generally no limitations on our potential liability.
The frequency and severity of these incidents affect our operating costs, insurability and relationships with customers, employees and regulators. Any increase in the frequency or severity of these incidents, or the general level of compensation awards resulting from these incidents, could affect our ability to obtain projects from oil and natural gas companies or insurance covering these incidents.
Unavailability of or costs associated with insurance could affect us adversely.
We maintain insurance policies providing coverage for risks that we believe are consistent with industry standards and that meet the requirements of our customers. However, our insurance may not be sufficient to cover any particular loss, and it does not provide coverage for all liabilities, including liability for some events involving pollution. In addition, many of our insurance policies contain deductibles for which we are responsible.
Insurance premiums for our industry have been subject to increases and large fluctuations during the last five years. As a result, the amount we are required to spend each year on insurance has increased, in some cases, substantially, and we expect that these increases will continue. We have sought to minimize these premium increases through increasing the size of our deductibles. Continuing increases in the costs of insurance could adversely affect our financial condition and results of operations. We may not be able to maintain adequate insurance at rates we consider commercially reasonable. The occurrence of an event not fully covered by insurance could have a material adverse effect on our financial condition or results of operations.
We may encounter difficulty in continuing to develop, produce and commercialize technologically advanced products and services.
Our customers continually demand new and improved products and services that increase the precision of and reduce the uncertainty associated with the exploration for and development of oil and natural gas. Many of our competitors are much larger and have greater research and development, financial and other resources than we do. If we are not able to develop commercially competitive products and services that we can offer at competitive prices in a timely manner, our financial condition and results of operations may be adversely affected. New product development is a lengthy and costly process and depends upon our ability to:
- foresee the needs of our customers and the new technologies likely to be introduced by our competitors;
- successfully design, test, manufacture, market and commercialize our own competing technologies; and
- obtain and maintain exclusive technology positions through patent and trade secret protection.
We may encounter resource constraints or technical or other difficulties that could delay the introduction of new products and services in the future. In addition, our competitors may introduce new products before we are able to, thereby possibly achieving a commercial advantage over us.
If we are unable to develop, produce and commercialize new products and services that we can offer to our customers at a competitive price, our financial position and results of operations could be adversely affected.
Our business could be adversely affected by disputes regarding intellectual property or our inability to obtain protection for technologies we develop.
Many of our operations, especially those dependent on our LWD and MWD products and services and specialty chemical sales, rely substantially on proprietary rights in technologies for which we hold licenses or patents. In addition, we are pursuing patent and trademark protection for our newly developed technologies and brands. The market success of our technologies will depend, in part, on our ability to obtain and enforce our proprietary rights in these technologies, to preserve rights in our trade secret and non-public information,
and to operate without infringing the proprietary rights of others. We rely on a combination of patent, trademark and trade secret laws and restrictions on disclosure of our proprietary information to protect our intellectual property rights. We also seek to obtain confidentiality agreements from our employees, consultants and business partners and control access to and distribution of our documentation and other forms of our proprietary information. It is possible that these measures may not:
- Prevent the challenge, invalidation, narrowing or circumvention of our existing patents;
- Prevent our competitors from independently developing similar products or services, duplicating our products or services, or designing around the patents owned by us;
- Prevent third-parties from enforcing patents against us that eventually limit our ability to do business in some areas of the market;
- Provide adequate protection for our intellectual property rights and technologies;
- Prevent disclosure of our trade secrets and know-how to third parties or the public; or
- Result in intellectual property rights adequate to protect our business from competition from foreign sources.
If any of our patents or other intellectual property rights are determined to be invalid or unenforceable, or if a court limits the scope of claims in a patent or fails to recognize our trade secret rights, our competitive advantages could be significantly reduced in the relevant technology, allowing competition for our customer base to increase. The resulting loss in revenues could adversely affect our operational results. In addition, unauthorized parties may attempt to obtain or use our proprietary technologies. Monitoring unauthorized use of our technology may be difficult and we cannot be certain that the steps that we have taken will prevent unauthorized use of our technology particularly in foreign countries or markets where the laws may not protect our proprietary rights as fully as in the United States.
Numerous patents have been issued to oilfield service companies covering a wide variety of products and services. Although we endeavor to avoid infringing the proprietary rights of others in bringing new technologies and brands to market, there can be no assurance that third parties will not make claims of infringement. Intellectual property litigation is inherently expensive, whether enforcing our own proprietary rights or defending against the infringement claims of others. If a commercially significant intellectual property dispute arises, we could incur substantial litigation costs or be subject to claims for damages or injunctive relief, the impact of which upon our business could be substantial.
Intense competition in our industry could adversely affect our results of operations.
We operate in highly competitive areas of the oilfield products and services markets. The volatility of oil and natural gas prices has led to a consolidation of a number of companies providing products and services similar to those we provide. As a result of these consolidations, many of our competitors are much larger and have greater research and development, marketing, distribution, financial and other resources than we do. If these or other of our competitors or new market entrants introduce new products or services with better features, performance, prices or other characteristics than our products and services, our financial condition or results of operations may be adversely affected. In addition, the intense competition in our industry could result in significant price competition that could have a material adverse effect on our results of operations and financial condition. Finally, competition among oilfield service and equipment providers is partly based on the provider's reputation for safety and quality. Although we believe that our reputation for safety and quality service is good, there can be no assurance that we will be able to maintain this reputation and, thus our competitive position.
The volatility of the oil and natural gas industry and the demanding nature of our work may affect our ability to attract and retain the skilled workers on which our operations depend.
We may not be able to find enough skilled workers to meet our needs, which could limit our growth. Business activity in the oil and natural gas industry historically decreases or increases with the price of oil and
natural gas. Even though the prices of oil and natural gas have recovered, industry-wide downsizing, resulting from low oil and natural gas prices in the late 1990s and industry consolidation, caused oilfield workers to look for and secure work in other industries and locations. The oil and natural gas industry has not fully recovered from the earlier employment migration away from the oil and natural gas industry. As a result, we may have problems finding enough skilled workers in the future.
In addition, we require skilled workers who can perform physically demanding work. As a result of the volatility of the oil and natural gas industry and the demanding nature of the work, workers may choose to pursue employment in fields that offer a more desirable and stable work environment at wage rates that are competitive with ours.
With a reduced pool of workers, it is possible that we will have to raise wage rates to attract workers from other fields and to retain or expand our current work force. If we are not able to increase our service rates to our customers to compensate for wage rate increases, our financial condition or results of operations may be adversely affected.
Our success depends on key members of our management, the loss of whom could disrupt our business operations.
We depend on the services of certain key employees, including executive officers and directors. The loss of the services of any of these key employees could disrupt our operations. We have employment agreements with certain key employees that contain non-compete provisions. Despite these agreements, we may not be able to retain these key employees and may not be able to enforce the non-compete provisions in their employment agreements.
Increases in the prices of raw materials could affect our results of operations.
Large amounts of steel are used in the manufacture of many of the products we use. Steel prices have increased significantly since the end of 2003, which has resulted in increased costs of these products for us and, in some cases, delays in our ability to obtain these products. In addition, we use raw materials in the production of our drilling fluid products. If we encounter difficulty in procuring or arranging for the transportation of these raw materials, and we are unable to pass corresponding cost increases on to our customers, our financial position and results of operations could be adversely affected.
Adverse weather conditions could result in fluctuations in our operating results.
Demand for our products and services in the Gulf of Mexico may be adversely affected by the hurricanes and other storms prevalent in the Gulf of Mexico and along the Gulf Coast during the summer and fall months. The threat of a hurricane or tropical storm in the vicinity of a drilling rig or production platform where we have personnel and equipment deployed often requires us to evacuate our personnel and equipment. An evacuation and the amount of time required to redeploy personnel and equipment after the threat of a storm has passed may result in significant downtime and lost revenues, especially in the case of a large storm. In addition, equipment that we are unable to remove from the path of a storm may be damaged, lost or destroyed. For example, during the third quarter of 2004, two major hurricanes affected the Gulf of Mexico, causing a suspension of oil and natural gas operations for several days, which had a negative impact on our results of operations during that period.
In the North Sea, demand for our products and services is also affected by periods of adverse weather, although the storms experienced in the North Sea typically do not require the evacuation of personnel and equipment.
As a result, our operating results may vary from quarter to quarter, depending upon factors outside of our control and full year results are not likely to be a direct multiple of any particular quarter or combination of quarters.
Compliance with environmental and other government regulations could adversely affect our business.
Our business is significantly affected by foreign, federal, state and local laws and regulations relating to:
- the oil and natural gas industry; and
- worker safety and environmental protection.
We depend on the demand for our products and services from oil and natural gas companies, drilling contractors and other oilfield service companies. This demand is affected by a variety of factors, including taxes, price controls and the adoption or amendment of laws and regulations. For example, the adoption of laws and regulations curtailing the exploration and development of oil and natural gas in our areas of operation for economic, environmental or other policy reasons could adversely affect our operations by limiting demand for our products and services.
The technical requirements of the foreign, federal, state and local laws and regulations affecting our businesses are becoming increasingly complex and stringent. For instance, some environmental laws may provide for "strict liability" for damages to natural resources or threats to public health and safety, rendering a party liable for environmental damage without regard to negligence or fault on the part of the party. Sanctions for noncompliance with these laws and regulations may include:
- revocation of permits;
- issuance of corrective action orders;
- assessment of administrative, civil or criminal penalties; and
- issuance of injunctions restricting or prohibiting our operations.
Some environmental laws provide for joint and several strict liability for remediation of spills and releases of hazardous substances. In addition, we may be subject to claims alleging personal injury or property damage as a result of alleged exposure to hazardous substances, as well as damage to natural resources. These laws and regulations also may expose us to liability for the conduct of, or conditions caused by, others, or for our acts that were in compliance with applicable laws at the time the acts were performed.
The concentration of our customers in the energy industry could materially and adversely affect our earnings.
Substantially all of our customers are in the energy industry. This concentration of customers may impact our overall exposure to credit risk, either positively or negatively, in that customers may be similarly affected by changes in economic and industry conditions. Many of our customers slow the payment of their accounts when industry conditions decline. We perform ongoing credit evaluations of our customers, but do not generally require collateral in support of our trade receivables.
A significant amount of our growth has occurred through the acquisition of existing businesses; however, future acquisitions may be difficult to integrate, may disrupt our existing businesses and may adversely affect our operating results.
We may acquire other companies, assets and product lines that complement or expand our existing business. Each acquisition, however, involves a number of risks. These risks include:
- the diversion of our management's attention from our existing businesses to integrate the operations and personnel of the acquired business;
- possible adverse effects on our operating results during the integration process; and
- our possible inability to achieve the intended objectives of the combination.
We may seek to finance an acquisition through borrowings under our credit facility or through the issuance of new debt or equity securities. If we should proceed with a relatively large cash acquisition, we could deplete a substantial portion of our financial resources to the possible detriment of our other operations.
Any future acquisitions could also dilute the equity interests of our shareholders, require us to write off assets for accounting purposes or create other undesirable accounting issues.
Our international operations may experience interruptions due to political and economic risks.
We operate our business and market our products and services in oil and natural gas producing areas outside the United States. We are, therefore, subject to the risks common in international operations and investments in foreign countries. These risks include:
- nationalization and expropriation;
- acts of terrorism, war and civil disturbances;
- restrictive actions by local governments;
- limitations on repatriation of earnings;
- changes in foreign tax laws; and
- changes in currency exchange rates and currency devaluations.
The occurrence of any of these events could have an adverse effect on regional demand for our products and services or our ability to provide our products and services in a particular region. An interruption of our international operations could have a material adverse effect on our results of operations and financial condition.
Our credit facility contains restrictive covenants that limit our financial and operational flexibility and our ability to pay dividends.
Our credit facility contains restrictive covenants that limit the incurrence of debt by our company or our subsidiaries, require us to maintain certain financial ratios, including a leverage ratio and a debt service coverage ratio, and a specified net worth. Our credit facility further limits the amount of capital expenditures we may make, limits the amount of debt we can incur outside the credit facility, limits the amount of future investments we may make, restricts our ability to pay dividends and restricts our ability to engage in certain business combination transactions. These restrictions may adversely affect our ability to conduct and expand our operations. For example, our business is capital intensive and requires specialized equipment. We may need to raise additional funds through public or private debt or equity financing to acquire new or additional equipment or for other purposes. Adequate funds may not be available when needed or may not be available on favorable terms. Even if adequate funds are available, our credit facility may restrict our ability to raise additional funds. If we are unable to raise capital, our financial condition and results of operations may be adversely affected.
As a holding company, we are dependent on dividends from our operating subsidiaries to pay our obligations.
We are a holding company with no business operations. Our only significant asset is the outstanding capital stock of our subsidiaries. As a result, we must rely on dividends from our subsidiaries to provide funding to meet our debt obligations and operating expenses. Before they can dividend funds to us, our subsidiaries must meet their own debt obligations, including payment of their trade payables. We currently intend to retain our earnings and cash flow for growth and general corporate expenditures and not to pay any dividends. Even if we decided to pay a dividend on or make a distribution in respect of our common stock, our subsidiaries may not be able to generate sufficient cash flow to pay a dividend or distribute funds to us. At present, we are restricted from paying dividends under our credit facility. Future credit facilities and other future debt obligations, as well as statutory provisions, may also limit our ability to pay dividends.
RISKS RELATED TO THE MARKET FOR OUR COMMON STOCK
The availability of shares of our common stock for future sale could depress our stock price.
Sales of a substantial number of shares of our common stock in the public market, or the perception that such sales might occur, could have a material adverse effect on the price of our common stock. We have registered the sale of 5,800,075 shares of our common stock which have been and may in the future be issued upon the exercise of options granted under our option plans. All of the shares issued upon exercise of these options will be freely tradable without restrictions or registration under the Securities Act of 1933, by persons other than our affiliates. Our affiliates would be able to sell these shares under Rule 144 after compliance with any lock-up agreement to which they are subject.
Our stock price could be extremely volatile as a result of the effect that variations in oil and natural gas prices and other factors beyond our control could have on the market price of our stock.
The market price of our common stock may be influenced by many factors, including:
- variations in our quarterly or annual results of operations;
- variations in oil and natural gas prices and production/ inventory levels;
- level of drilling activity worldwide;
- investor perceptions of us and other oilfield service companies, in general;
- general economic conditions and industry competition; and
- the liquidity of the market for our common stock.
These factors may cause the price of our common stock to fluctuate significantly.
In particular, the market price of our common stock may be influenced by variations in oil and natural gas prices because demand for our products and services is closely related to the prices of these commodities. This may cause our stock price to fluctuate with these underlying commodity prices, which are highly volatile.
ITEM 2.
ITEM 2. PROPERTIES
Our principal executive offices are located at 10370 Richmond Avenue, Suite 990, Houston, Texas 77042 and our telephone number is (713) 974-9071. Our businesses are conducted out of sales offices and facilities located throughout North America and in select areas internationally. Set forth below is a chart describing the locations of these sales offices and facilities:
With the exception of certain of our Lafayette and Houma, Louisiana and our Alice, Bridgeport, Snyder, Tyler and Corpus Christi, Texas facilities, which are owned, all of these sales offices and facilities are leased pursuant to operating leases for various terms. Some of these sales offices and facilities are leased from employees who were the former owners of our subsidiaries. We believe that all of our leases are at competitive or market rates and do not anticipate any difficulty in renewing these leases or in leasing suitable alternative space upon expiration of our current lease terms.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are from time to time a party or otherwise subject to legal proceedings, claims, investigations and other proceedings in the ordinary course of our business. These matters typically involve tort, workers compensation, commercial and infringement and other intellectual property claims. Where appropriate, we make provision for a liability with respect to these claims in our financial statements in accordance with generally accepted accounting principles. These provisions are reviewed periodically and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and events pertaining to a particular case. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us. It is possible, nevertheless, that our results of operations or financial position could be adversely affected by the resolution of one or more of these matters.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the fourth quarter of 2004.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange under the symbol "WHQ" where it began trading on August 6, 2003. Prior to that time, our common stock traded on the NASDAQ National Market under the symbol "WHES". The following table sets forth the high and low prices per share of our common stock as reported by the NASDAQ National Market through August 5, 2003 and as reported by the New York Stock Exchange since that date.
As of February 11, 2005, there were 27,884,153 shares of our common stock outstanding, which were held by approximately 137 record holders.
We have not declared or paid any cash dividends on our common stock since our initial public offering and do not intend to declare or pay any cash dividends on our common stock in the foreseeable future. Instead, we currently intend to retain our earnings, if any, to finance our business and for general corporate purposes. Furthermore, our credit facility restricts our ability to pay dividends. Please read "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" in Item 7 for a discussion of restrictions on our ability to pay dividends. Any future determination as to the declaration and payment of dividends will be at the discretion of our Board of Directors and will depend on then existing conditions, including our financial condition, results of operations, contractual restrictions, capital requirements, business prospects and other factors that our Board of Directors considers relevant.
EQUITY COMPENSATION PLANS
The table below provides information relating to our equity compensation plans as of December 31, 2004:
On March 29, 1999, prior to our initial public offering, we granted to Kenneth T. White, Jr., our Chairman, President and Chief Executive Officer, an option to purchase 900,900 shares of our common stock at a purchase price of $4.55 per share. The issuance of this option was approved by the Board of Directors but was not submitted to our shareholders for their approval. This option, which is fully vested, is exercisable by Mr. White at any time until March 29, 2009 and is not transferable. Upon Mr. White's death or disability, or the termination of his employment for any reason, this option will terminate and expire; although, Mr. White (or his estate or the person who acquires this option by will or the laws of descent or distribution or otherwise by the reason of Mr. White's death) may exercise this option for a period of three (3) months following any such event.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
Our selected consolidated financial information contained below is derived from our Consolidated Financial Statements and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Form 10-K. In particular, Note 3 to our Consolidated Financial Statements describes acquisitions consummated since January 1, 2003, which acquisitions could affect the year to year comparability of the information presented below.
The Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002 have been audited by PricewaterhouseCoopers LLP. The Consolidated Financial Statements for the years 2000 and 2001 were audited by Arthur Andersen LLP which has ceased operations.
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(1) Includes the write-off of approximately $3.1 million ($1.9 million, after tax) of non-cash financing costs associated with our previous credit facility.
(2) Includes the write-off of approximately $13.2 million of deferred financing costs and unamortized discount associated with debt that was repaid in 2000 with the net proceeds from our initial public offering and borrowings under a prior credit facility, reclassified in conjunction with the adoption of FAS 145 in January 2003.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Set forth below is a description of the matters that we consider to be important to understanding the results of our operations for each of the three years in the period ended December 31, 2004, and our capital resources and liquidity as of December 31, 2004 and 2003. Our discussion begins with an overview of the significant factors that have recently affected our company, including a discussion of industry market trends and management's perspectives regarding the opportunities and challenges we face during 2005 and beyond. Next, we analyze the results of our operations for the last three years. A summary follows of the critical accounting judgments and estimates that we have made which we believe are most important to an understanding of our MD&A and our consolidated financial statements, as well as a discussion of recently issued accounting pronouncements. Finally, we review our cash flows and liquidity, capital resources and contractual commitments.
The following discussion includes various forward-looking statements about the markets in which we operate, the demand for our products and services and our future results. These statements are based on certain assumptions that we believe are reasonable. For information about some of the risks that could cause actual results to differ from these forward looking statements, please refer to the section entitled "Item 1. Business -- Factors That May Affect Future Results and Accuracy of Forward-Looking Statements."
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes appearing elsewhere in this Form 10-K.
OVERVIEW OF OUR PRODUCTS AND SERVICES
We provide drilling related products and services and completion and workover related products and services to major and independent oil and natural gas companies, drilling contractors and other oilfield service companies. The majority of our revenues are generated from charging our customers day rates, based on the number of days our products and services are used, for the use of our equipment or for the provision of services by our personnel. We also sell certain products used in the exploration for and production of oil and natural gas and receive revenues from our customers in connection with these sales. Our primary expenses are salaries for our personnel and the costs associated with expendable parts and supplies, research and development, repair and maintenance of equipment and costs of products sold as well as general operational costs. A detailed description of the products and services that we provide, the manner in which we market these products and services and the way in which we charge our customers for these products and services is contained under "Item 1. Business -- Businesses."
Prices for oil and natural gas are subject to large fluctuations in response to relatively minor changes in the supply of and demand for oil and natural gas, market uncertainty and a variety of other factors. Any prolonged increase or decrease in oil and natural gas prices affects the levels of exploration, development and production activity as well as the entire health of the oil and natural gas industry. Demand for our drilling related products and services is directly affected by the level of exploration, development and production activity of, and the corresponding capital spending by, oil and natural gas companies. Demand for our completion and workover related products and services depends more on oil and natural gas production activity, which is less immediately affected by changes in oil and natural gas prices.
DRILLING RELATED PRODUCTS AND SERVICES
Revenue from our drilling related products and services segment constituted approximately 65% of our total 2004 consolidated revenue. Approximately 83% of our drilling segment revenue for 2004 was generated in the United States, including the Gulf of Mexico. The remaining 17% was generated in various international locations. In July 2001, exploration and development activity levels in the United States peaked and began to decline primarily as a result of lower natural gas prices. This decline continued through April 2002, at which point the United States drilling rig count levels reached a low of 738, which was comprised of 110 offshore rigs and 628 land rigs. As natural gas prices climbed and remained relatively strong, rig count levels began to recover in 2003 and continued throughout 2004. This increase, however, resulted entirely from an increase in
land-based rigs. According to statistics published by Baker Hughes, the average number of rotary rigs operating in the United States was 830, 1,032 and 1,192 for 2002, 2003 and 2004, respectively. Of these figures, land rigs comprised 717, 924 and 1,095, respectively, and offshore rigs comprised 113, 108 and 97, respectively, for the same periods.
The recovery in exploration and development activity levels in the United States has impacted our revenue and earnings generated in this market. Although the overall rig count in the United States has increased, the offshore rig count, where we experience our highest operating margins, declined approximately 11% from the 2003 average. However, the offshore rig count did improve modestly during the fourth quarter of 2004, increasing about 6% as compared to the prior quarter. This slight increase in offshore activity has carried into early 2005. Whether this improvement will continue throughout 2005 is unclear at this time. We do believe that the overall outlook for domestic natural gas exploration and development activity remains positive as natural gas production continues to decline. This factor should keep upward pressure on natural gas prices.
Outside of the United States, the North Sea remains our largest drilling segment market. According to statistics published by Baker Hughes, the number of rotary rigs operating in the North Sea declined from an average of 67 in January 2002 to an average of 35 in December 2004, after having reached a low of 31 in July 2004. We expect only a marginal increase in activity levels in the North Sea in the near term.
As the primary area of improvement in drilling activity has been onshore, the importance of improving our market share for land-based services became critical. As we started to see this trend developing, in October 2002, we made a strategic decision to enter the directional drilling business in North America. As a result of this decision and the growth of the United States land rig count, we have successfully leveraged our new directional drilling business to affect an increase in the utilization of our MWD and down-hole drilling motor fleet. The increased utilization of our MWD and down-hole drilling motor fleet has helped to offset decreases in utilization of our higher margin LWD fleet, which is primarily driven by the United States offshore rig count.
Another key challenge that our drilling related products and services segment faces is the demand by our customers for more efficient and technologically advanced services and tools. We have invested a substantial amount of our time and capital into developing and commercializing technologies that are of value to our customers and that enable us to compete effectively with the major integrated oilfield service companies. During the third quarter of 2004, we began to market our 12 1/4" 3-Dimensional Rotary Steerable (3DRS) technology. We expect commercialization of the 3DRS technology to improve the utilization of our LWD, MWD and directional drilling services, as our customers are increasingly requiring this type of technology as a prerequisite for a drilling project or contract. We are currently developing an 8 1/2" 3DRS tool and we expect to be able to offer this tool on a commercial basis during the second half of 2005.
Introduction of our Array Wave Resistivity (AWR) technology is the first of our next generation of LWD tools that are designed to withstand high pressure and high temperature well conditions. We believe that our AWR tools provide a more robust and accurate resistivity measurement. Tools and data analysis in this technology improve the precision and reliability of formation data obtained through the analysis of electromagnetic wave transmissions through the formation surrounding a well-bore.
These technologies were the first to be developed since we acquired PathFinder in March 1999. For a discussion of other technologies we have under development, please read "Item 1. Business-Research and Development and Patents and Technologies."
COMPLETION AND WORKOVER RELATED PRODUCTS AND SERVICES
Our completion and workover related products and services segment provided approximately 35% of our total consolidated revenue for 2004. Revenues provided by this segment are almost entirely derived from the United States and the Gulf of Mexico. While revenues from this segment are affected by the level of oil and natural gas prices, activity in this segment is only modestly affected by drilling activity (see the discussion under Drilling Related Products and Services above). As a result, our completion and workover segment has provided stability during prolonged downturns in drilling activity.
We have increased our revenue capacity in this segment through capital spending in 2002, 2003 and 2004, which, when combined with our acquisitions, has strengthened and further diversified the operations of the Company. Continued growth in this segment will be dependent upon, among other factors, industry activity levels, prices of oil and natural gas, our capital expenditure program and our ability to attract and retain qualified service personnel and field engineers required to operate the specialized equipment used in this business.
DISCONTINUED OPERATIONS
In March 2004, we committed to the divestiture of our maintenance and safety related products and services segment. Accordingly, this segment has been included in the Consolidated Statements of Operations and Comprehensive Income as discontinued operations and in the Consolidated Balance Sheets as assets and liabilities held for sale. In April 2004, we completed the sale of Well Safe, Inc., one of the two companies that formerly comprised the maintenance and safety related products and services segment, for cash consideration of $28.0 million. Additionally, in December 2004, we sold the remaining entity that formerly comprised this segment, Charles Holston, Inc., for consideration of $2.0 million, consisting of $1.0 million in cash and a $1.0 million subordinated promissory note due December 31, 2009. We sold Well Safe and Charles Holston pursuant to customary stock purchase agreements in which we made customary representations and warranties, agreed to customary covenants and agreed to indemnify the buyers of these businesses for certain matters, subject to certain caps, limitations and deductibles. These sales resulted in a loss of $5.1 million for the year ended December 31, 2004.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2004 COMPARED TO THE YEAR ENDED DECEMBER 31, 2003
Revenues. Revenues increased by $95.2 million, or approximately 26%, to $462.4 million for the year ended December 31, 2004 from $367.2 million for the year ended December 31, 2003. This increase was attributable to increases in capacity driven by capital expenditures, higher demand for certain of our products and services, particularly drilling/completion fluids, land-based MWD and directional drilling services, cased-hole wireline and coiled tubing, as well as the revenue contributions of Hydracoil, Inc., Dutch, Inc. and Continental Directional Corp., which were acquired in the fourth quarter 2003.
Revenues from our drilling related products and services increased by $60.7 million, or approximately 25%, to $302.8 million for the year ended December 31, 2004 from $242.1 million for the year ended December 31, 2003. This increase was primarily attributable to increases in capacity driven by capital expenditures, the growth of our North American directional drilling business, enhanced by the increase in land-based drilling activity levels in the United States, increased demand for our drilling fluids and rental tool products and the impact of the acquisitions that we consummated during the fourth quarter of 2003.
Revenues from our completion and workover related products and services increased by $34.5 million, or approximately 28%, to $159.6 million for the year ended December 31, 2004 from $125.1 million for the year ended December 31, 2003. This increase was the result of increases in capacity driven by capital expenditures, higher utilization of our coiled tubing and cased-hole wireline fleet, demand for our completion fluids and the impact of the acquisitions that we consummated during the fourth quarter of 2003.
Cost of Revenues. Cost of revenues increased by $60.8 million, or approximately 29%, to $269.9 million for the year ended December 31, 2004 from $209.1 million for the year ended December 31, 2003. As a percentage of revenues, cost of revenues increased to 58% for the year ended December 31, 2004 from 57% for the year ended December 31, 2003. The increase in cost of revenues as a percentage of revenues was due to increased insurance costs and our revenue mix. In particular, our revenue mix was affected by sales increases in our lower margin fluids products and land-based directional drilling services.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $16.7 million, or approximately 23%, to $87.8 million for the year ended December 31, 2004 from $71.1 million for the year ended December 31, 2003. The increase was primarily attributable to the operating
expenses associated with the businesses we acquired in the fourth quarter of 2003 and during 2004, as well as increased personnel costs related to expansion efforts within our directional drilling business and corporate compliance initiatives as mandated by law. As a percentage of revenues, selling, general and administrative expenses remained flat at 19% for the year ended December 31, 2004 relative to the year ended December 31, 2003.
Research and Development Expense. Research and development expenses increased by $4.3 million, or approximately 38%, to $15.5 million for the year ended December 31, 2004 from $11.2 million for the year ended December 31, 2003. This increase was the result of increased research and development spending on our PathFinder technologies, including our 3DRS and AWR tools and other research and development initiatives.
Depreciation and Amortization. Depreciation and amortization increased by $9.7 million, or approximately 27%, to $45.7 million for the year ended December 31, 2004 from $36.0 million for the year ended December 31, 2003. This increase was the result of depreciation associated with our continued capital expenditures, as well as additional depreciation and amortization due to our acquisitions.
Interest and Other Expense. Interest and other expense for the year ended December 31, 2004 was $11.0 million, an increase of $2.8 million, or approximately 34%, from $8.2 million for the year December 31, 2003. This increase was primarily due to the $3.1 million write-off of non-cash financing costs related to our previous credit facility, offset by a reduction in our effective interest rate during the second half of 2004.
Net Income. Net income for the year ended December 31, 2004 was $17.9 million, a decrease of $1.4 million, or approximately 7% from $19.3 million reported for the year ended December 31, 2003.
YEAR ENDED DECEMBER 31, 2003 COMPARED TO THE YEAR ENDED DECEMBER 31, 2002
Revenues. Revenues increased by $81.4 million, or approximately 28%, to $367.2 million for the year ended December 31, 2003 from $285.8 million for the year ended December 31, 2002. This increase was attributable to higher demand for products and services in each of our operating segments, as well as the full year effect of revenue contributions of Boyd's Bit Service, Inc., which was acquired in August 2002 and E. M. Hobbs, L.P., which was acquired in November 2002.
Revenues from our drilling related products and services increased by $36.9 million, or approximately 18%, to $242.1 million for the year ended December 31, 2003 from $205.2 million for the year ended December 31, 2002. This increase was primarily attributable to our entry into the directional drilling business in North America in October 2002, enhanced by the increase in land-based drilling activity levels in the United States.
Revenues from our completion and workover related products and services increased by $44.5 million, or approximately 55%, to $125.1 million for the year ended December 31, 2003 from $80.6 million for the year ended December 31, 2002. This increase was the result of increases in capacity driven by capital expenditures, increases in activity levels, higher utilization of our coiled tubing and cased-hole wireline fleet and increased demand for our completion fluids, as well as the full year's impact of the Boyd's and Hobbs acquisitions.
Cost of Revenues. Cost of revenues increased by $51.9 million, or approximately 33%, to $209.1 million for the year ended December 31, 2003 from $157.2 million for the year ended December 31, 2002. As a percentage of revenues, cost of revenues increased to 57% for the year ended December 31, 2003 from 55% for the year ended December 31, 2002. The increase in cost of revenues, as a percentage of revenues, was due to the continued effects of softness in pricing, increased insurance costs and the greater contribution to our consolidated revenues from lower margin products and services, primarily from our drilling fluids businesses.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $14.4 million, or approximately 25%, to $71.1 million for the year ended December 31, 2003 from $56.7 million for the year ended December 31, 2002. The increase was primarily attributable to additional expenses related to the operations of Boyd's and Hobbs, which were acquired during the second half of 2002 and increased personnel costs related to expansion efforts within our coiled tubing and directional drilling
business lines. We also experienced increased corporate costs to comply with the Sarbanes-Oxley Act of 2002 and incurred expenses associated with our move from the NASDAQ National Market to the New York Stock Exchange. As a percentage of revenues, selling, general and administrative expenses decreased to 19% for the year ended December 31, 2003 from 20% for the year ended December 31, 2002.
Research and Development Expense. Research and development expenses increased by $1.2 million, or approximately 12%, to $11.2 million for the year ended December 31, 2003 from $10.0 million for the year ended December 31, 2002. This increase was the result of continued research and development spending on our PathFinder technologies, including 3DRS and AWR and other research and development initiatives.
Depreciation and Amortization. Depreciation and amortization increased by $6.9 million, or approximately 24%, to $36.0 million for the year ended December 31, 2003 from $29.1 million for the year ended December 31, 2002. This increase was the result of depreciation associated with our continued capital expenditures, as well as additional depreciation and amortization due to our acquisitions.
Interest and Other Expense. Interest and other expense for the year ended December 31, 2003 was $8.2 million, an increase of $1.5 million, or approximately 22%, from $6.7 million for the year December 31, 2002. This increase was primarily due to the increase in the amounts outstanding under our credit facility.
Net Income. Net income for the year ended December 31, 2003 was $19.3 million, an increase of $3.0 million, or approximately 18%, from $16.3 million reported for the year ended December 31, 2002.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of our consolidated financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, based on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The most significant areas involving management judgment and estimates are described below. Actual results may differ from these estimates under different assumptions or conditions.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We extend credit to customers and other parties in the normal course of business. We regularly review outstanding receivables and provide for estimated losses through an allowance for doubtful accounts. In evaluating the level of established reserves, we make judgments regarding our customers' ability to make required payments, economic events and other factors. As the financial condition of these parties change, circumstances develop or additional information becomes available, adjustments to the allowance for doubtful accounts may be required. In the event we were to determine that a customer may not be able to make required payments, we would increase the allowance through a charge to income in the period in which that determination is made. See Note 2 to the Consolidated Financial Statements for further discussion.
INCOME TAXES
Deferred tax assets and liabilities are recognized for the difference between the book basis and tax basis of our net assets. In providing for deferred taxes, we consider current tax regulations, estimates of future taxable income and available tax planning strategies. We believe that our earnings during the periods when the temporary differences become deductible will be sufficient to realize the related future income tax benefits. In certain cases where projected results indicate that realization is not likely, we have established a valuation allowance to reduce deferred tax assets to estimated realizable value.
In assessing the need for a valuation allowance, we estimate future taxable income, considering the feasibility of ongoing tax planning strategies and the realizability of tax loss carry-forwards. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event we were to determine that we would not be able to realize all or a portion of our deferred tax assets in the future, we would reduce such amounts through a charge to income in the period in which that determination is made. Conversely, if we were to determine that we would be able to
realize our deferred tax assets in the future in excess of the net carrying amounts, we would decrease the recorded valuation allowance through an increase to income in the period in which that determination is made. See Note 8 to the Consolidated Financial Statements for further discussion.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If we ultimately determine that payment of these amounts is unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be.
INSURANCE RESERVES
We maintain insurance coverage for various aspects of our business and operations and retain a portion of losses that occur through the use of deductibles. We are subject to legal proceedings and claims from time to time, the outcomes of which are subject to significant uncertainty. Although we maintain policies of insurance that cover claims asserted against our company, many of our policies provide for deductibles. In addition, our insurance policies may not cover certain types of claims, such as those involving pollution. We determine whether to disclose and accrue for loss contingencies based on the coverages we maintain and on an assessment of whether the risk of loss is remote, reasonably possible, or probable. While we make these judgments with the advice of legal counsel and our insurers, these judgments are inherently subjective. As claims develop and additional information becomes available, adjustments to loss reserves may be required.
IMPAIRMENT OF LONG-LIVED ASSETS
We assess our long-term assets for impairment whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Factors considered important, which could trigger an impairment review, include the following:
- Significant underperformance relative to expected historical or projected future operating results;
- Significant changes in the manner of our use of the assets or the strategy for our overall business;
- Significant negative industry or economic trends;
- Significant decline in our stock price for a sustained period; and
- Market capitalization relative to net book value.
Our determination of impairment of long-lived assets, if any, requires estimates of undiscounted future cash flows. Actual impairment charges, if any, are recorded using an estimate of discounted future cash flows. The determination of future cash flows requires estimates based upon the most recent market and operating data for the applicable asset at the time the estimate is made, and such estimates can change based on market conditions, technological advances in the industry or changes in regulations governing the industry.
GOODWILL AND INTANGIBLE ASSETS
Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment testing. The identification and measurement of goodwill impairment involves the estimation of the fair value of reporting units. The estimates of fair value of reporting units are based on the best information available as of the date of the assessment, which primarily incorporate management assumptions about expected future cash flows but are also based on other valuation techniques. Future cash flows can be affected by changes in industry or market conditions or the rate and extent to which anticipated synergies or cost savings are realized with newly acquired entities. Although no goodwill impairment has been recorded to date, there can be no assurances that future goodwill impairments will not occur. See Note 5 to the Consolidated Financial Statements for further discussion.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 123R "Share-Based Payment" (SFAS 123R). This statement revises SFAS No. 123, supercedes APB No. 25, and requires companies to recognize the cost of employee stock options and other awards of stock-based compensation based on the fair value of the award as of the grant date. Currently this type of compensation expense is not reflected in our Consolidated Statements of Operations and Comprehensive Income. The effective date of this pronouncement is as of the beginning of the first interim or annual period that begins after June 15, 2005. We have adopted the requirements of SFAS 123R effective January 1, 2005. As a result of the implementation of SFAS 123R, we expect to incur stock-based compensation expense totaling approximately $0.6 million in the first quarter of 2005.
In December 2004, the FASB published the following two final FASB Staff Positions, effective immediately. FAS 109-1, "Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004," giving guidance on applying FASB Statement No. 109, Accounting for Income Taxes, to the tax deduction on qualified production activities provided by the American Jobs Creation Act of 2004. FAS 109-2 "Accounting and Disclosure Guidance for that Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" provides guidance on the Act's repatriation provision. We are in the process of reviewing the FAS 109-1 and FAS 109-2; however, at this time, we do not believe that the adoption of FAS 109-1 or FAS 109-2 will have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2004, the FASB Emerging Issues Task Force, or EITF, reached a consensus in applying the conditions in Paragraph 42 of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets, in Determining Whether to Report Discontinued Operations" (EITF 03-13). Evaluation of whether operations and cash flows have been eliminated depends on whether (1) continuing operations and cash flows are expected to be generated, and (2) the cash flows, based on their nature and significance, are considered direct or indirect. This consensus should be applied to a component that is either disposed of or classified as held for sale in fiscal periods beginning after December 15, 2004. We do not believe that the adoption of EITF 03-13 will have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs--An Amendment of ARB No. 43, Chapter 4" (SFAS No. 151). SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005 and is required to be adopted by us in the first quarter of fiscal 2006, beginning on January 1, 2006. We are currently evaluating the effect that the adoption of SFAS No. 151 will have on our consolidated financial position, results of operations and cash flows but do not expect SFAS No. 151 to have a material impact.
LIQUIDITY AND CAPITAL RESOURCES
Our primary uses for cash are working capital, capital expenditures, research and development expenditures, acquisitions and principal and interest payments on indebtedness. Our primary sources of liquidity are cash reserves, cash generated by operations and amounts available to be drawn under our revolving credit facility. To the extent our cash requirements exceed our sources of liquidity, we will be required to fund our cash requirements through other means, such as through debt and equity financing activities or we will be required to curtail our expenditures.
CASH FLOW
Working capital was $121.6 million as of December 31, 2004 and $89.4 million as of December 31, 2003, net of discontinued operations. Net cash provided by operating activities was $41.2 million for the year ended December 31, 2004 and $35.6 million for the year ended December 31, 2003. The increase in working capital and cash flow from operating activities was principally attributable to higher operating levels across our business segments.
Net cash used in investing activities was $70.7 million for the year ended December 31, 2004 and $64.9 million for the year ended December 31, 2003. Net cash used in investing activities was principally the result of capital expenditures, offset by lost-in-hole proceeds which represent funds we receive from a customer when one of our tools is involuntarily damaged or lost down-hole.
Net cash provided by financing activities was $3.1 million for the year ended December 31, 2004 and $27.2 million for the year ended December 31, 2003. Changes in net cash related to financing activities were primarily the result of borrowings and repayments under our credit facility, which is described below.
For the year ended December 31, 2004, we made capital expenditures of $82.4 million, primarily for rental tool inventory, LWD and MWD tools, wireline equipment and coil tubing units, including expenditures for the replacement of equipment lost-in-hole. In addition, we made $15.5 million in research and development expenditures for the year ended December 31, 2004.
ACQUISITIONS
During 2004, we consummated two acquisitions in the completion and workover segment for total consideration of approximately $4.0 million, resulting in goodwill of approximately $1.3 million.
CAPITAL RESOURCES
On June 30, 2004, we closed on a $237.5 million revolving credit facility that matures on June 30, 2009. As of December 31, 2004, we had an outstanding loan balance of $180.8 million and approximately $5.6 million in letters of credit issued under our credit facility, resulting in an available borrowing capacity of approximately $51.1 million.
Our credit facility bears interest, at our election, at either a variable rate equal to LIBOR, plus a margin ranging from 1.5% to 2.5% depending upon our leverage ratio, or an alternate base rate equal to the higher of (1) the prime rate or (2) the federal funds rate plus 0.5%, plus a margin ranging from 0.5% to 1.5% depending upon our leverage ratio. As of December 31, 2004, we had elected to pay interest on our outstanding borrowings at LIBOR plus the then applicable margin of 2.0%.
Our credit facility is collateralized by a lien on substantially all of our property and assets, a pledge of all of the capital stock of our domestic subsidiaries and a pledge of not greater than 65% of the capital stock of each of our top tier foreign subsidiaries. In addition, our credit facility is guaranteed by all of our domestic subsidiaries. Our credit facility requires, among other things, that we maintain certain financial ratios, including a leverage ratio and a debt service coverage ratio, and a specified net worth. Our credit facility further limits the amount of capital expenditures we may make, the amount of debt we may incur outside of the credit facility, the amount of future investments we may make, the ability to pay dividends and the ability to engage in certain business combination transactions.
As a result of the approximate $160.0 million repayment of our previous credit facility, we wrote off approximately $3.1 million in financing costs that had previously been deferred. This write-off has been included in the Consolidated Statements of Operations and Comprehensive Income as interest expense. Additionally, financing costs associated with our new credit facility were approximately $1.6 million, which will be ratably amortized to interest expense over the five year term of the credit facility.
CONTRACTUAL OBLIGATIONS
The following table aggregates information about our contractual cash obligations (in thousands) as of December 31, 2004:
FUTURE CAPITAL REQUIREMENTS
We anticipate that acquisitions of complementary companies, assets and product lines will continue to play an important role in our business strategy. While there are currently no unannounced agreements or ongoing negotiations for the acquisition of any material businesses or assets, such transactions can be effected quickly and may occur at any time. Likewise, we will continue to need to make capital expenditures for tools and equipment and to make research and development expenditures to maintain and improve the quality of our products and services. We currently estimate that we will make capital expenditures of approximately $75 million in 2005 and will make research and development expenditures of approximately $18 million in 2005.
We believe that our internally generated cash flow, combined with access to our credit facility will be sufficient to meet the liquidity requirements necessary to fund our operations, capital expenditure requirements, research and development and debt service requirements for at least the next 12 months. However, our ability to maintain our credit facility and the sufficiency of our internally generated cash flow can be impacted by economic conditions outside of our control.
The continuation of our acquisition strategy will require substantial capital. We currently intend to finance future acquisitions through issuances of our equity or debt securities and through borrowings under our credit facility. Using debt to complete acquisitions could substantially limit our operational and financial flexibility and using stock could dilute the ownership interests of our existing shareholders. The extent to which we will be able or are willing to use our common stock to make acquisitions will depend on its market value from time to time and the willingness of potential sellers to accept it as full or partial payment. If we are unable to obtain additional capital on acceptable terms, we may be unable to grow through acquisitions.
OFF BALANCE SHEET ARRANGEMENTS
With the exception of operating leases on real property and automobile leases discussed in Note 7 of our consolidated financial statements, we have no off-balance sheet debt or other off-balance sheet financing arrangements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risks. Market risk is the potential loss arising from adverse changes in market prices and rates. We have not entered into derivative or other financial instruments. Our market risk could arise from changes in interest rates and foreign currency exchange rates.
Interest Rate Risk. We are subject to market risk exposure related to changes in interest rates. Assuming our current level of borrowings, a 100 basis point increase in interest rates under these borrowings would have increased our interest expense by approximately $1.8 million for the year ended December 31, 2004 and $1.8 million for the year ended December 31, 2003.
Foreign Currency Exchange Risk. Our earnings and financial position are affected by foreign exchange rate fluctuations. We currently do not hedge against foreign currency translation risks and we believe that foreign currency exchange risk is unlikely to be significant to our operations.
Stock Price Volatility. Our ability to raise capital at a reasonable cost of capital is, in part, affected by the market price of our stock. The market price of our stock may be influenced by many factors including variations in our earnings, variations in oil and natural gas prices, the level of exploration, development and production activity of, and the corresponding capital spending by, our customers, investor perceptions of us and other oilfield service companies and the liquidity of the market for our common stock.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements, together with the notes thereto and our independent registered public accounting firm's reports thereon appear on pages through of this Annual Report on Form 10-K and are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures. We maintain disclosure controls and procedures, which are controls and procedures designed to ensure that the information we are required to disclose in the reports we file with the SEC is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Based on an evaluation of our disclosure controls and procedures as of the end of the period covered by this report conducted by our management, with the participation of our Chief Executive Officer and Chief Financial Officer, our Chief Executive Officer and Chief Financial Officer believe that these controls and procedures are effective to ensure that we are able to collect, process and disclose the information we are required to disclose in the reports we file with the SEC within the required time periods.
Management's Report on Internal Control over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed under the supervision of our Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2004, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an assessment of the effectiveness of our internal control over financial reporting based on the framework established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Based on this assessment, our management has determined that our internal control over financial reporting as of December 31, 2004 was effective.
Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report appearing elsewhere in this Annual Report on Form 10-K, which expresses unqualified opinions on our management's assessment and on the effectiveness of our internal control over financial reporting as of December 31, 2004.
During the quarterly period ended December 31, 2004, there were no changes in our internal control over financial reporting that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent and/or
detect all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this item is hereby incorporated by reference to the sections entitled "Information About Directors" and "Executive Officers of the Company" in our definitive proxy statement to be filed with the SEC pursuant to the Exchange Act within 120 days of the end of our fiscal year on December 31, 2004.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this item is hereby incorporated by reference to the sections entitled "Director Compensation" and "Executive Compensation" of our definitive proxy statement to be filed with the SEC pursuant to the Exchange Act within 120 days of the end of our fiscal year on December 31, 2004.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required by this item is hereby incorporated by reference to the section entitled "Principal Shareholders" of our definitive proxy statement to be filed with the SEC pursuant to the Exchange Act within 120 days of the end of our fiscal year on December 31, 2004 and under the heading "Equity Compensation Plans" in Item 5 of this Annual Report on Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this item is hereby incorporated by reference to the section entitled "Certain Relationships and Related Transactions" of our definitive proxy statement to be filed with the SEC pursuant to the Exchange Act within 120 days of the end of our fiscal year on December 31, 2004.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required by this item is hereby incorporated by reference to the section entitled "Audit Committee Report" of our definitive proxy statement to be filed with the SEC pursuant to the Exchange Act within 120 days of the end of our fiscal year on December 31, 2004.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a)(1 and 2) Financial Statements and Financial Statement Schedules. Our consolidated financial statements, together with the notes thereto and our independent accountants' reports thereon appear on pages through of this Annual Report on Form 10-K. An index to such financial statements appears on page, and such index is incorporated herein by reference. All schedules not filed herewith for which provision is made under SEC Regulation S-X have been omitted as not applicable or not required or the information required has been included in the notes to our consolidated financial statements.
(3) Index of Exhibits
See Index of Exhibits, which index is incorporated herein by reference, for a list of those exhibits filed herewith, which index also includes and identifies management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(b)(10)(iii) of Regulation S-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
W-H ENERGY SERVICES, INC.
By: /s/ KENNETH T. WHITE, JR. ------------------------------------ Kenneth T. White, Jr. Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 11th day of March, 2005.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of W-H Energy Services, Inc.:
We have completed an integrated audit of W-H Energy Services, Inc.'s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
CONSOLIDATED FINANCIAL STATEMENTS
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of W-H Energy Services, Inc. and its subsidiaries (the Company) at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
INTERNAL CONTROL OVER FINANCIAL REPORTING
Also, in our opinion, management's assessment, included in "Management's Report on Internal Control over Financial Reporting" appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control -- Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP
Houston, Texas March 11, 2005
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
The accompanying notes are an integral part of these financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS ORGANIZATION
DESCRIPTION OF COMPANY
W-H Energy Services, Inc., a Texas corporation, and its subsidiaries (collectively, "W-H") is a diversified oilfield service company that provides products and services used primarily for the drilling, completion and production of oil and natural gas wells. W-H has the following primary lines of business: (i) drilling related products and services, which include logging-while-drilling, measurement-while-drilling, directional drilling, rental tools (including drill pipe), down-hole drilling motors and drilling fluids; and (ii) completion and workover related products and services, which include cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment, polymers and specialty chemicals, rental tools (including tubing) and coiled tubing.
W-H's business depends in large part on the conditions in the oil and natural gas industry and specifically on the amount of capital spending by its customers. Any prolonged increase or decrease in oil and natural gas prices affects the levels of exploration, development and production activity, as well as the entire health of the oil and natural gas industry. Changes in prices could have a material effect on W-H's results of operations and financial condition, particularly with respect to its drilling related products and services segment. Demand for W-H's drilling related products and services is directly affected by the level of exploration, development and production activity of, and the corresponding capital spending by, oil and natural gas companies. Demand for W-H's completion and workover related products and services depends more on oil and natural gas production activity, which is less immediately affected by changes in oil and natural gas prices. Prices for oil and natural gas are subject to large fluctuations in response to relatively minor changes in the supply of and demand for oil and natural gas, market uncertainty and a variety of other factors that are beyond W-H's control. Any prolonged reduction in oil and natural gas prices may depress the level of exploration, development and production activity. Lower levels of activity result in a corresponding decline in the demand for W-H's drilling related products and services which could have a material adverse effect on its revenues and profitability. However, since W-H's completion and workover related products and services are less commodity price sensitive than its drilling related products and services, they continue to provide stability during prolonged downturns in drilling activity. Other risk factors include, but are not limited to, competition, risks relating to W-H's acquisition strategy, risks relating to acquisition financing and reliance on key personnel.
DISCONTINUED OPERATIONS
In March 2004, W-H committed to the divestiture of its maintenance and safety related products and services segment. Accordingly, this segment has been included in the Consolidated Statements of Operations and Comprehensive Income as discontinued operations and in the Consolidated Balance Sheets as assets and liabilities held for sale. In April 2004, W-H completed the sale of Well Safe, Inc., one of the two companies that formerly comprised the maintenance and safety related products and services segment, for cash consideration of $28.0 million. In December 2004, W-H sold the remaining entity, Charles Holston, Inc., that formerly comprised this segment, for consideration of $2.0 million, consisting of $1.0 million in cash and a $1.0 million subordinated promissory note due December 31, 2009. These sales resulted in a loss of $5.1 million for the year ended December 31, 2004. This loss is included as a component of discontinued operations in the accompanying Consolidated Statements of Operations and Comprehensive Income. Summary financial results for this segment are as follows:
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
W-H sold Well Safe and Charles Holston pursuant to customary stock purchase agreements in which it made customary representations and warranties, agreed to customary covenants and agreed to indemnify the buyers of these businesses for certain matters, subject to certain caps, limitations and deductibles.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION AND PRESENTATION
The accompanying consolidated financial statements include the accounts of W-H and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current presentation.
CASH AND CASH EQUIVALENTS
W-H considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
ACCOUNTS RECEIVABLE
Accounts receivable have a concentration of credit risk in the oil and natural gas industry. W-H performs continuing credit evaluations of its customers and generally does not require collateral.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
W-H extends credit to customers and other parties in the normal course of business. W-H regularly reviews outstanding receivables and provides for estimated losses through an allowance for doubtful accounts. In evaluating the level of established reserves, W-H makes judgments regarding its customers' ability to make required payments, economic events and other factors. As the financial condition of these parties change, circumstances develop or additional information becomes available, adjustments to the allowance for doubtful accounts may be required. In the event W-H was to determine that a customer may not be able to make required payments, W-H would increase the allowance through a charge to income in the period in which that determination is made.
INVENTORIES
Inventories are stated at the lower of cost or market, determined on a first-in, first-out basis. Inventories consist primarily of equipment, parts, raw materials and supplies. W-H assesses the realizability of its inventories based upon specific usage and future utility. A charge to results of operations is taken when factors that would result in a need for a reduction in the valuation, such as excess or obsolete inventory, are noted.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Expenditures for major additions and improvements are capitalized while minor replacements, maintenance and repairs, which do not improve or extend the life of such assets, are charged to operations as the services are provided. Disposals are removed at cost, less accumulated depreciation, and any resulting gain or loss is reflected in the accompanying consolidated statements of operations and comprehensive income. Proceeds from customers for the cost of oilfield rental equipment that is involuntarily damaged or lost down-hole are reflected as revenues, with the resulting carrying value of the related equipment charged to cost of revenues.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Depreciation is calculated using the straight-line method over the estimated useful lives of the depreciable assets. Leasehold improvements are amortized over the shorter of their useful lives or the term of the lease. The useful lives of the major classes of property and equipment are as follows:
REALIZATION OF LONG-LIVED ASSETS
W-H evaluates the recoverability of assets not held for sale by measuring the carrying amount of the assets against the estimated undiscounted future cash flows associated with them. If such evaluations indicate that the future undiscounted cash flows of certain long-lived assets are not sufficient to recover the carrying value of such assets, the assets are adjusted to their fair values. Based on these evaluations, there were no adjustments to the carrying value of long-lived assets in 2004, 2003 or 2002.
GOODWILL AND OTHER INTANGIBLES
Goodwill represents the excess of the aggregate price paid by W-H in acquisitions over the fair market value of the tangible and identifiable intangible net assets acquired. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets", separable intangible assets that are not deemed to have indefinite lives will be amortized over their useful lives.
Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized but are reviewed annually (or more frequently if indicators arise) for impairment. According to SFAS No. 142, companies are required to identify their reporting units and determine the aggregate carrying values and fair values of all such reporting units. If the carrying value of a reporting unit exceeds its relative fair value, SFAS No. 142 requires that a second impairment test be performed. This second step requires the comparison of the implied fair value of the reporting unit goodwill to its related carrying value, both of which must be measured by the company at the same point in time each year. Any initial loss resulting from a goodwill impairment test must be recorded as a change in accounting principle. W-H performed the required assessments in accordance with SFAS No. 142 for the years ended December 31, 2004, 2003 and 2002, which resulted in W-H recording no goodwill impairment expense.
DEBT ISSUE COSTS
Other assets include debt issue costs related to W-H's revolving credit facility. W-H amortizes these costs as interest expense over the scheduled maturity period of the debt. As a result of the repayment of its prior credit facility, W-H expensed approximately $3.1 million of the unamortized debt financing costs as interest expense during the year ended December 31, 2004. Financing costs associated with W-H's current credit facility were approximately $1.6 million, which will be ratably amortized to interest expense over the five year term of the credit facility. See Note 6 to the Consolidated Financial Statements for further discussion.
REVENUE RECOGNITION
W-H provides rental equipment and services to its customers on a day/hourly rate basis and recognizes the related revenue on a per-day/hourly basis as the work progresses. W-H also provides products to
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
customers and recognizes the related revenue as items are shipped from its facilities. Proceeds from customers for the cost of oilfield rental equipment that is involuntarily damaged or lost down-hole are reflected as revenues.
COST OF REVENUES
The primary components of cost of revenues are those salaries, expendable supplies, repairs and maintenance, costs of products sold and general operational costs that are directly associated with the services W-H performed for or products sold by W-H to its customers.
RESEARCH AND DEVELOPMENT
Research and development costs primarily represent salaries of research personnel and their related expenditures. Such activities are expensed when incurred. For the years ended December 31, 2004, 2003 and 2002, research and development costs were $15.5 million, $11.2 million and $10.0 million, respectively.
INCOME TAXES
W-H utilizes the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying values of existing assets and liabilities and their respective tax bases based on enacted tax rates.
W-H recognizes liabilities for anticipated tax issues based on its estimate of whether, and the extent to which, additional taxes will be due. These liabilities are adjusted accordingly as information on the associated tax issues becomes available.
USE OF ESTIMATES AND ASSUMPTIONS
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
FINANCIAL INSTRUMENTS
W-H considers the fair value of all financial instruments (primarily long-term debt) not to be materially different from their carrying values at the end of each fiscal year based on management's estimate of W-H's ability to borrow funds under terms and conditions similar to those of W-H's existing debt.
With the exception of the operating leases on real property and automobile leases discussed in Note 7 of the consolidated financial statements, W-H has no off-balance sheet debt or other off-balance sheet financing arrangements. W-H has not entered into derivative or other financial instruments.
ACCOUNTING FOR STOCK-BASED COMPENSATION
Through December 31, 2004, W-H accounted for all stock-based employee compensation plans under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," (APB No. 25) and related interpretations. Under APB No. 25, no stock-based employee costs are reflected in net income, as all options granted under those plans had an exercise price equal to or in excess of the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share as if W-H had applied the fair value recognition provisions of
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), to stock-based employee compensation:
The fair value of each option was estimated on the date of grant using the Black-Scholes option valuation model. The following assumptions were used for the historical option grants in the years ended December 31, 2004, 2003 and 2002: risk-free interest rates of between 3.8%-5.0%; dividend rates of zero; expected lives of between 5.9 and 8.6 years and expected volatilities of 50.7%-65.9%. The 3,745,192 options outstanding as of December 31, 2004 have a remaining weighted average contractual life of 6.8 years.
The Black-Scholes option valuation model and other existing models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of and are highly sensitive to subjective assumptions including expected stock price volatility. W-H's stock options have characteristics significantly different from those of traded options and changes in the subjective input assumptions can materially affect the fair value estimate.
As discussed more fully in "Recent Accounting Pronouncements" below, W-H adopted the requirements of FASB Statement 123R effective January 1, 2005.
FOREIGN CURRENCY TRANSLATIONS
The operations of foreign locations were translated into U.S. dollars based on the current exchange rates at the respective balance sheet dates and the weighted-average rates during each year for the statements of operations and comprehensive income. The translation adjustments were a gain of $0.9 million, $3.2 million and $4.2 million for the years ended December 31, 2004, 2003 and 2002, respectively, and are reflected as foreign currency translation adjustments in the consolidated statements of operations and comprehensive income for the years ended December 31, 2004, 2003 and 2002.
EARNINGS PER SHARE
Basic earnings per share excludes dilution and is computed by dividing income from continuing/discontinued operations available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed considering the dilutive effect of stock options and restricted shares. For the years ended December 31, 2004, 2003 and 2002, shares resulting from the assumed exercise of outstanding options and restricted shares of 673,341, 752,672 and 1,010,919,
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
respectively, were added to the denominator because the inclusion of such shares would be dilutive. For the years ended December 31, 2004, 2003 and 2002, additional shares resulting from the assumed exercise of outstanding options and restricted shares of 1,404,661, 1,495,925 and 912,337, respectively, were excluded from the computation of diluted earnings per share, because the inclusion of such shares would be anti-dilutive.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 123R "Share-Based Payment" (SFAS 123R). This statement revises SFAS No. 123, supercedes APB No. 25, and requires companies to recognize the cost of employee stock options and other awards of stock-based compensation based on the fair value of the award as of the grant date. Currently, this type of compensation expense is not reflected in W-H's Consolidated Statements of Operations and Comprehensive Income. The effective date of this pronouncement is as of the beginning of the first interim or annual period that begins after June 15, 2005. W-H plans to adopt the requirements of SFAS 123R effective January 1, 2005.
In December 2004, the FASB published the following two final FASB Staff Positions, effective immediately. FAS 109-1, "Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004," giving guidance on applying FASB Statement No. 109, Accounting for Income Taxes, to the tax deduction on qualified production activities provided by the American Jobs Creation Act of 2004. FAS 109-2 "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" provides guidance on the Act's repatriation provision. W-H is in the process of reviewing the FAS 109-1 and FAS 109-2; however, at this time W-H does not believe that the adoption of FAS 109-1 or FAS 109-2 will have a material impact on its consolidated financial position, results of operations or cash flows.
In November 2004, the FASB Emerging Issues Task Force (EITF) reached a consensus in applying the conditions in Paragraph 42 of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets, in Determining Whether to Report Discontinued Operations" (EITF 03-13). Evaluation of whether operations and cash flows have been eliminated depends on whether (1) continuing operations and cash flows are expected to be generated, and (2) the cash flows, based on their nature and significance, are considered direct or indirect. This consensus should be applied to a component that is either disposed of or classified as held for sale in fiscal periods beginning after December 15, 2004. W-H does not believe that the adoption of EITF 03-13 will have a material impact on its consolidated financial position, results of operations or cash flows.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs -- An Amendment of ARB No. 43, Chapter 4" (SFAS No. 151). SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify the accounting for abnormal amounts of idle facility expense, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005 and is required to be adopted by W-H in the first quarter of fiscal 2006, beginning on January 1, 2006. W-H is currently evaluating the effect that the adoption of SFAS No. 151 will have on its consolidated financial position, results of operations and cash flows but do not expect SFAS No. 151 to have a material impact.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. ACQUISITIONS
During 2004, W-H consummated two acquisitions in the cased-hole wireline business of its completion and workover segment for total consideration of approximately $4.0 million, resulting in goodwill of approximately $1.3 million.
During the fourth quarter of 2003, W-H made the following acquisitions:
DUTCH, INC.
In December 2003, W-H acquired Dutch, Inc. ("Dutch"), which provides rental tools to drilling, completion and production businesses through its sole location in Broussard, Louisiana. W-H acquired Dutch for consideration consisting of $9.2 million in cash, of which $1.85 million is being held in escrow for a period of two years to satisfy certain types of indemnification claims that W-H is permitted to make under the purchase and sale agreement.
CONTINENTAL DIRECTIONAL CORPORATION
In November 2003, W-H acquired Continental Directional Corporation ("Continental"). Continental, headquartered in Nisku, Alberta, provides directional drilling services in Western Canada, a market that W-H's directional drilling business did not previously serve. Consideration for this acquisition was approximately $3.1 million in cash and short-term payable and 51,016 shares of W-H common stock, of which 25,513 shares are being held in escrow for a period of eighteen months to satisfy certain type of indemnification claims that W-H is permitted to make under the purchase and sale agreement.
HYDRACOIL, INC.
In November 2003, W-H acquired HydraCoil, Inc. ("HydraCoil"). The acquisition of HydraCoil extends the geographic reach of W-H's cased-hole logging and perforating services into the North Texas market. Consideration for this acquisition was approximately $3.0 million in cash and 58,823 shares of W-H common stock, of which 44,118 shares are being held in escrow for a period of between two and three years to satisfy certain types of indemnification claims that W-H is permitted to make under the purchase and sale agreement.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The aggregate purchase price and estimated aggregate fair market value of the net assets acquired with the businesses acquired in 2003 are as follows (in thousands):
Unaudited proforma consolidated financial information for these acquisitions have not been included as the results were not material to current operations.
4. DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS
Activity in W-H's allowance for doubtful accounts for the years ended December 31, 2004, 2003 and 2002, consists of the following (in thousands):
The components of inventories as of December 31, 2004 and 2003 are as follows (in thousands):
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Net property and equipment as of December 31, 2004 and 2003, consists of the following (in thousands):
Depreciation expense charged to operations totaled approximately $44.5 million, $35.2 million and $28.4 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Goodwill and other intangibles as of December 31, 2004 and 2003, consist of the following (in thousands):
Amortization expense charged to operations totaled approximately $1.2 million, $0.8 million and $0.7 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Estimated aggregate amortization of intangible assets (in thousands) for the next 5 years is as follows:
Accrued liabilities as of December 31, 2004 and 2003, consist of the following (in thousands):
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. GOODWILL:
The changes in the carrying amount of goodwill for each of W-H's reportable business segments for the years ended December 31, 2003 and 2004 were as follows (in thousands):
6. DEBT:
Long-term debt as of December 31, 2004 and 2003 consists of the following (in thousands):
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CREDIT FACILITY
On June 30, 2004, W-H closed on a $237.5 million revolving credit facility (the "Credit Facility") that matures on June 30, 2009. As of December 31, 2004, W-H had an outstanding loan balance of $180.8 million and approximately $5.6 million in letters of credit issued under the Credit Facility, resulting in an available borrowing capacity of approximately $51.1 million.
The Credit Facility bears interest, at W-H's election, at either a variable rate equal to LIBOR, plus a margin ranging from 1.5% to 2.5% depending upon W-H's leverage ratio, or an alternate base rate equal to the higher of (1) the prime rate or (2) the federal funds rate plus 0.5%, plus a margin ranging from 0.5% to 1.5% depending upon W-H's leverage ratio. As of December 31, 2004, W-H had elected to pay interest on its outstanding borrowings at LIBOR plus the then applicable margin of 2.0%.
W-H's Credit Facility is collateralized by a lien on substantially all of W-H's property and assets, a pledge of all of the capital stock of W-H's domestic subsidiaries and a pledge of not greater than 65% of the capital stock of each of W-H's top tier foreign subsidiaries. In addition, W-H's Credit Facility is guaranteed by all of W-H's domestic subsidiaries. The Credit Facility requires, among other things, that we maintain certain financial ratios, including a leverage ratio and a debt service coverage ratio, and a specified net worth. The Credit Facility further limits the amount of capital expenditures W-H may make, the amount of debt W-H may incur outside of the Credit Facility, the amount of future investments W-H may make, the ability to pay dividends and the ability to engage in certain business combination transactions.
As a result of the repayment of W-H's previous Credit Facility, W-H wrote off approximately $3.1 million in financing costs that had previously been deferred. This write-off has been included in the Consolidated Statements of Operations and Comprehensive Income as interest expense. Additionally, financing costs associated with this Credit Facility were approximately $1.6 million, which will be ratably amortized to interest expense over the five year term of the Credit Facility.
CONVERTIBLE SUBORDINATED NOTES
In connection with the CTS acquisition in 2001, W-H issued $4.5 million in 9% convertible subordinated notes to eight of the individuals from whom CTS was acquired as partial consideration for the acquisition. The notes were paid in full in January 2004.
7. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
W-H leases certain real property and automobiles under operating leases that expire at various dates through 2014. Rental expense under operating leases was approximately $8.2 million, $7.6 million and $6.2 million for the years ended December 31, 2004, 2003 and 2002, respectively. Future minimum lease payments under non-cancelable operating leases are as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
EMPLOYMENT AGREEMENTS
W-H has entered into employment agreements with its corporate officers. Under these agreements, each officer receives a set base salary, subject to adjustment, an annual discretionary bonus based on specific objectives to be determined by the compensation committee, an automobile or automobile allowance and certain fringe benefits as may be available to such executive officers. The agreements are for original terms of two to three years, with certain automatic renewal provisions and contain non-competition agreements. The agreements also contain a termination clause, which requires a two-year payment (2.5 years in the case of W-H's Chief Executive Officer) based on the officer's salary and historical bonus amounts received, in the event of termination without cause or certain change of control events.
W-H also has employment agreements with certain non-corporate officers. The agreements are for original terms of two to three years and provide for severance pay in the event of involuntary termination.
LITIGATION
W-H is from time to time a party or otherwise subject to legal proceedings, claims, investigations and other proceedings in the ordinary course of their business. These matters typically involve tort, workers compensation, commercial and infringement and other intellectual property claims. Where appropriate, W-H makes provision for a liability with respect to these claims in its financial statements in accordance with generally accepted accounting principles. These provisions are reviewed periodically and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and events pertaining to a particular case. Litigation is inherently unpredictable. However, W-H believes that it has valid defenses with respect to the legal matters pending against it. It is possible, nevertheless, that W-H's results of operations or financial position could be adversely affected by the resolution of one or more of these matters.
8. INCOME TAXES
The components of W-H's income tax provision are as follows (in thousands):
The United States and foreign components of income before income taxes are as follows (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The total provision for income taxes differs from an amount computed at the statutory rate as follows (in thousands):
The significant components of the deferred tax assets and liabilities as of December 31, 2004 and 2003, are as follows (in thousands):
Applicable U.S. deferred income taxes and related foreign dividend withholding taxes have not been provided on approximately $0.9 million of undistributed earnings and profits of the company's foreign subsidiaries. W-H considers such earnings to be permanently reinvested outside the United States. It is not practicable to estimate the amount of deferred income taxes associated with these unremitted earnings.
As of December 31, 2004, W-H had deferred tax assets of $8.0 million relating to $0.5 million of federal net operating loss ("NOL") carry-forwards, $0.4 million of credit carry-forwards, $23.0 million of state NOL carry-forwards and $6.9 million of foreign NOL carry-forwards. The federal NOL carry-forwards expire in
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2019. Foreign losses related to the United Kingdom and Netherlands do not expire; however, our Norwegian NOL carry-forwards expire in 2013 and 2014. State NOL carry-forwards expire beginning in 2005 until 2019. The NOL and credit carry-forwards can be used to reduce W-H's federal, state and foreign income taxes payable in future years. W-H's ability to realize the entire benefit of its deferred tax assets requires that W-H achieve certain future earnings levels prior to the expiration of its NOL carry-forwards.
Valuation allowances have been established for uncertainties in realizing the benefit of tax loss and credit carry-forwards. While W-H expects to realize the net deferred tax assets, changes in future taxable income or in tax laws may alter this expectation. W-H could be required to record an additional valuation allowance against certain or all of its remaining deferred tax assets if market conditions deteriorate or future earnings are below current estimates. As of December 31, 2004, approximately $0.9 million of the valuation allowance relates to state net operating loss carry-forwards and $1.0 million relates to foreign net operating loss and credit carry-forwards. The valuation allowance decreased approximately $2.0 million in 2004, increased $1.2 million in 2003 and decreased approximately $0.9 million in 2002. The $2.0 million decrease in 2004 was primarily due to release of the valuation allowance on the federal NOL and foreign tax credits. It is now expected that the federal NOL will be fully utilized and because of the passage of new tax legislation, the foreign tax credit carry-forward period has been extended. As such, management expects the company to be able to fully utilize the foreign tax credits. Additional amounts were also provided on current foreign and state losses, in jurisdictions where management does not believe W-H will be able to utilize in future periods.
W-H recognizes liabilities for anticipated tax issues based on its estimate of whether, and the extent to which, additional taxes will be due. These liabilities are adjusted accordingly as information on the associated tax issues becomes available. As of December 31, 2004 and 2003, amounts reserved for such contingencies were $7.2 million and $5.2 million, respectively.
9. RELATED-PARTY TRANSACTIONS
LEASE AGREEMENT
One of W-H's subsidiaries leases its facilities from a W-H officer. For each of the years ended December 31, 2004, 2003 and 2002, W-H paid the officer $108,000 for such annual lease costs.
TRANSACTIONS WITH PENNY-FARTHING PRESS, INC.
W-H's Chairman, President and Chief Executive Officer is the owner of Penny-Farthing Press Inc. ("PFP"), a publishing company, which occasionally performs services for W-H and several of its subsidiaries. In 2004 and 2003, W-H did not make any payments to PFP for services. In 2002, W-H made payments to PFP for graphic design and other services of approximately $28,000. During the same periods, PFP made payments to W-H of approximately $38,000, $38,000 and $30,000, respectively, primarily for rental of office space.
10. SHAREHOLDERS' EQUITY
STOCK OPTIONS
In May 2004, W-H's shareholders approved an amendment to W-H's stock option plan (the "1997 Option Plan") to increase the number of authorized shares to 4,900,000 to be issued under the 1997 Option Plan. Each option granted under the 1997 Option Plan contains such terms and conditions as may be approved by the compensation committee (the "Committee"). The options currently outstanding under the 1997 Option Plan vest ratably over a four-year period, commencing on the grant date, in 25% increments after each year of service has been completed and will expire ten years from the date the options were granted. The terms of such options also provide that if an optionee's employment terminates for any reason, the option may be
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
exercised during the three month period following such termination, but only to the extent vested at the time of such termination. As of December 31, 2004, 3,005,192 options were outstanding under this plan.
Additionally, on March 29, 1999, W-H issued 900,900 options to its chief executive officer under a separate non-statutory option plan. These options have a 10-year term and an exercise price of $4.55 per share. As of December 31, 2004, the remaining unexercised options to purchase 740,000 shares of common stock had vested.
A summary of W-H's stock option activity for the years ended December 31, 2002, 2003 and 2004 is as follows:
The following table summarizes information about stock options outstanding at December 31, 2004:
In January 2000, W-H issued options to purchase 190,575 shares of common stock to employees. W-H recorded deferred stock compensation totaling approximately $1.5 million for the options granted in the first quarter of 2000. The deferred stock compensation was amortized over the four-year vesting period of the individual stock options issued. The fair value of the common stock on the date of grant was determined based on a third-party valuation and taking into consideration certain industry and company-specific factors. During
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
each of the years ended December 31, 2004, 2003 and 2002, W-H recognized $ -- , $0.4 million and $0.4 million, respectively, in compensation expense relating to these options.
RESTRICTED COMMON STOCK
On May 12, 2004, W-H's shareholders approved the grant of 75,000 shares of restricted common stock to W-H's Chairman, President and Chief Executive Officer. Deferred stock compensation of approximately $1.3 million generated by this issuance has been recorded in shareholders' equity and is being amortized to compensation expense under the provisions of FASB issued Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans -- and interpretation of APB Opinions No. 15 and 25." During the year ended December 31, 2004, W-H recognized $0.5 million in compensation expense relating to this restricted stock issuance.
11. 401(K) PLAN
W-H maintains a 401(k) plan that enables employees to contribute up to specified percentages of their annual compensation. W-H may contribute a matching amount for each participant equal to a discretionary percentage determined annually by W-H. W-H may also contribute additional amounts at its sole discretion. W-H matching contributions were approximately $2.2 million, $1.2 million and $0.8 million for the years ended December 31, 2004, 2003 and 2002, respectively.
12. OPERATING SEGMENTS
Management has elected to aggregate its business unit segments based on the differences in each segment's customers, the products and services offered and other economic characteristics. Based on these requirements, management has identified the following reportable segments: (i) drilling related products and services and (ii) completion and workover related products and services. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies.
DRILLING RELATED PRODUCTS AND SERVICES
The drilling related products and services segment provides products and services used by oil and natural gas companies, drilling contractors and other oilfield service companies for the drilling of oil and natural gas wells. These products and services are used primarily throughout North America and in selected areas internationally. This segment includes the following business lines: (i) LWD; (ii) MWD; (iii) directional drilling; (iv) down-hole drilling motors; (v) rental tools (including drill pipe) and (vi) drilling fluids.
COMPLETION AND WORKOVER RELATED PRODUCTS AND SERVICES
The completion and workover related products and services segment provides products and services primarily to customers onshore in the Gulf Coast region and offshore in the Gulf of Mexico. These products and services include: (i) cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment; (ii) polymers and specialty chemicals; (iii) rental tools (including tubing) and (iv) coiled tubing.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SUMMARY INFORMATION
W-H recognizes revenues, cost of revenues, selling, general and administrative expense, research and development expense and depreciation and amortization expense by segment. Interest expense and other income (expense) are not monitored by segment. Summarized information for W-H's reportable segments is contained in the following tables (in thousands):
As of and for the year ended December 31, 2004:
As of and for the year ended December 31, 2003:
As of and for the year ended December 31, 2002:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
W-H operates in the United States, the North Sea and other geographic regions. The following is summary information by geographic region (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. INTERIM FINANCIAL INFORMATION (UNAUDITED)
The following is a summary of consolidated interim information for the years ended December 31, 2004 and 2003 (amounts in thousands, except per share data):
EXHIBIT INDEX
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* filed herewith