Item 1.
Business.
Overview
We are a diversified oilfield service company that provides products and services used in connection with the drilling and completion of oil and natural gas wells and the production of oil and natural gas. 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:
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drilling related products and services, which include logging-while-drilling, measurement-while-drilling, directional drilling, down-hole drilling motors, drilling fluids and rental tools; and
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completion and workover related products and services, which include cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment, coiled tubing, completion fluids and rental tools.
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:
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operating our business lines autonomously and marketing our product offerings independently;
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focusing on niche markets in which leading market positions can be achieved;
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emphasizing customer service, responsiveness and reliability; and
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offering technologically advanced and cost effective products and services.
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 our company can be found on our 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 risks related to our business.
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 the United States and select areas internationally. We are currently conducting international operations onshore in Canada, Brazil, Europe, North
Africa and the Middle East and offshore in the North Sea, the Gulf of Suez, the Mediterranean Sea and off the coast of Brazil. Our drilling related products and services segment includes the following business lines:
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logging-while-drilling, measurement-while-drilling, directional drilling and down-hole drilling motors;
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drilling fluids; and
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rental tools.
Logging-while-drilling, Measurement-while-drilling, Directional Drilling and Down-hole Drilling Motors. We are one of a few companies worldwide that currently has the technological capability to offer a full complement of logging-while-drilling products and services. Logging-while-drilling tools provide real-time data about the physical properties of downhole formations. In addition to indicating the possible presence of hydrocarbons, this data also assists in improving drilling performance.
Before the introduction of logging-while-drilling 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 logging-while-drilling has over traditional open-hole wireline logging is that costs are reduced because the logging-while-drilling tools accompany the drill string and downhole data is provided during drilling operations. Drilling rig downtime is thereby minimized. These savings can be substantial for offshore jobs where day rates for drilling currently range from an average of about $80,000 per day in shallow waters to an average of about $210,000 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 measurement-while-drilling products and services, which use down-hole tools 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. 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. Measurement-while-drilling 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 skilled personnel 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).
Our logging-while-drilling, measurement-while-drilling and directional drilling services are provided by our wholly-owned subsidiary, PathFinder Energy Services, Inc. (“PathFinder”). We market these services through an internal sales force. Our customers typically utilize these services on a per well or per project basis. We generally charge our customers for these services on a per day basis.
We are a supplier of down-hole drilling motors and a manufacturer of certain of their components and replacement 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 PathFinder Drilling Motors, a division of PathFinder, and Dyna-Drill Technologies, Inc., our wholly-owned subsidiary (“Dyna-Drill”).
PathFinder Drilling Motors’ rental product line consists of a wide range of sizes of down-hole drilling motors ranging from 11/16-inch to 11 1/2-inches in outside diameter for use at various drilling depths and down-hole environments. 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® down-hole drilling motors are manufactured by Dyna-Drill. In addition to complementing our PathFinder Drilling Motors 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 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.
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 solids that are added to drilling fluids to control 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:
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water-based drilling fluids, which are the most widely used drilling fluids, having application in both onshore and offshore environments;
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oil-based drilling fluids, which are used primarily to drill water-sensitive shale and in situations where stuck pipe is more likely to occur; and
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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 our drilling fluid products 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, Agri-Empresa, Inc., Grinding and Sizing Company, Inc., Integrity Industries, Inc. and Mt. Pulaski, Inc. We market and sell these products through our internal sales force.
Rental Tools. 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:
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drilling equipment, such as large diameter drill pipe, heavy weight drill pipe, high torque drill pipe, drill collars and other required accessories;
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pressure control equipment, such as blowout preventers, high pressure valves, choke and kill manifolds and test pumps;
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down-hole tools, such as milling tools and casing scrapers;
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pipe handling equipment; and
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side entry subs and our patented lockdown lubricator system.
We have various sizes of drill pipe and related handling tools, providing our customers with a wide range of equipment 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 drilling related rental tool business is conducted by our wholly-owned subsidiaries, Thomas Energy Services, Inc., (which conducts business as Thomas Tools), 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 basis.
Completion and Workover Related Products and Services
Our completion and workover related products and services segment provides a broad range of products and services used by oil and natural gas companies and other oilfield service companies for the completion and workover of oil and natural gas wells. Our completion and workover related products and services are used primarily in North America. These products and services include:
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cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment and services;
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coiled tubing;
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completion fluids; and
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rental tools.
Cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment and services. 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. Our services include:
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Logging Services. Logging involves the gathering of down-hole information to identify various characteristics about the formation or the well bore. 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.
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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, cased and is ready for production, a perforating gun is introduced 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.
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Tubing Conveyed Perforating/Drill Stem Testing. Tubing conveyed perforating involves the use of drill pipe, tubing or coil tubing, to convey the perforating assembly to the required depth. Drill stem testing 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 natural gas wells in a more efficient and safer manner relative to conventional techniques.
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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, Enertech Wireline Services, L.P. (formerly, E.M. Hobbs, L.P.) and Perf-O-Log, Inc. 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 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.
Coiled Tubing. A typical coiled tubing job involves the use of a coiled tubing unit and one or more pumping units which are operated by skilled personnel at a customer well site. We own and operate a fleet of coiled tubing units and associated equipment that are used in a variety of well-bore applications, including foam washing, acidizing, displacing, fishing, milling, drilling, 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 continues to be one of the fastest growing segments of the well service industry. For many applications, 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. Logging, milling and down-hole tool manipulation in highly deviated and horizontal wells previously performed with other equipment 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. 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.
Completion Fluids. We produce polymers and specialty chemicals for niche applications related to completion and workover activities. Completion fluids are generally solids-free solutions with high specific gravities that are designed not to damage 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 fluid products are sold to customers for use around the world.
Our three classes of completion and workover related fluid products are:
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oilfield products, which include:
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enhanced recovery chemicals;
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lubricants;
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well treating chemicals; and
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liquefied polymers;
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industrial products, which include:
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cleaners;
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lubricants; and
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environmentally sensitive solvents; and
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environmental remediation products.
We conduct our completion and workover related fluids business through our wholly-owned subsidiaries, Agri-Empresa, Inc. and Integrity Industries, Inc. We market and sell our completion fluids through an internal sales force.
Rental Tools. 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.
Our completion and workover related 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.
For a summary of our reportable segments and operations by geographical region as of and for the years ended December 31, 2006, 2005 and 2004, see Note 13 to our Consolidated Financial Statements, which information is incorporated herein by reference.
Strategy
Our strategy is to grow revenues, cash flow 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 2006, we spent approximately $17.2 million on research and development initiatives, and we plan to spend $23.0 million to $25.0 million on research and development in 2007. 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 the Growth of Select Emerging Markets. We believe that the longer-term domestic outlook will continue to reflect upward pressure on oil and natural gas prices as supply struggles to keep up with demand. As a result, we expect the domestic search for energy, and especially natural gas, to continue its recent growth trend, recognizing that there will be occasional interruptions in this trend when energy prices decline as a result of events such as an abnormally warm winter. Our response to this expectation is to expand our geographic coverage in North America. For example, we have made approximately $51.0 million in capital expenditures and commitments to open and equip a facility in southwestern Wyoming that we plan to use to increase our presence in the Rocky Mountain region. The Rocky Mountain facility will be completed during the first half of 2007 and will provide rental tools, coiled tubing and cased-hole wireline services. We are also further expanding products and services in the development of unconventional natural gas reservoirs such as coalbed methane, shale and tight gas.
Capitalize on Trends in More Mature Markets. 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 other remote 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, the North Sea and in the North American onshore market. 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 in these regions.
Capitalize on the Growth of Directional Drilling. A substantial portion of our drilling related products and services are designed for use in directional drilling. 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 our measurement-while-drilling and logging-while-drilling tools, 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 the larger oil and natural gas projects will increasingly be located in other countries. We will continue to seek to capitalize on this trend by increasing our market share in existing international locations and by selectively establishing new locations where we believe the geo-political risk and other market factors are acceptable. Our international operations consist primarily of our measurement-while-drilling and logging-while-drilling 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. Generally, we continue to market the products and services of these companies under their established names.
Research and Development: Technology Initiatives
We engage in research and development activities 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 $17.2 million, $16.3 million and $15.5 million for the years ended December 31, 2006, 2005 and 2004, respectively. While several of our subsidiaries conduct research and development at their facilities, our largest research and development effort is conducted by PathFinder through its research and development facility in Houston, Texas, where most of our logging-while-drilling, measurement-while-drilling and directional drilling technology is developed.
Some of our recently commercialized technologies include:
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PathMaker® 3-Dimensional Rotary Steerable (“3DRS”) technology for 8 1/2-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. This technology in the 8 1/2-inch borehole size will allow us to service smaller borehole diameters. Aspects of this technology are patented or patent-pending.
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Slim Array Wave Resistivity (SAWRtm) technology. This technology involves the use of proprietary tools and data analysis techniques to improve the reliability and quality of resistivity data as it relates to formation evaluation. Our SAWR technology operates by transmitting electromagnetic waves through the formation surrounding a well-bore. This new technology will allow us to service smaller borehole diameters. SAWR tools, along with the larger size Array Wave Resistivity tools, are capable of operating in high pressure and high temperature conditions (up to 25,000 psi and 350ºF). Aspects of this technology are patented or patent-pending.
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Slim Density Neutron Standoff Caliper (“SDNSC”) technology. Our density neutron technology is used to provide customers with more reliable information about the porosity of a formation and the diameter of the borehole. We recently commercialized our SDNSC to provide this service in smaller borehole diameters. Aspects of this technology are patent-pending.
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Matrix-3® tungsten carbide-based metal coating technology. These coatings improve 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.
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New generation of mud motor elastomer technology. This technology involves the incorporation of highly-resilient elastomers into the power section of mud motors. This technology delivers up to 70% more power and torque to mud motors. Aspects of this technology are patent pending.
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Pay Zone Inclination Gamma (PZIGtm) directional survey technology. This technology includes deployment of an independent drilling tool at or near the drill bit from which real-time directional survey and formation information can be obtained.
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Survivortm high-temperature/high pressure Dynamic Pressure Module (“QDPM”) technology. This technology measures the pressure and temperature of the drilling fluid in the drill pipe and annulus, providing valuable information regarding performance of the drilling equipment. Tools embodying this technology are designed for high pressure and high temperature conditions (up to 25,000 psi and 350ºF), and are operable in several borehole sizes. QDPM tools are compatible with our other Survivortm suites of tools, as well as with our other logging-while-drilling technologies, such as the SAWRtm and SDNSC technologies described above.
We plan to use research and development expenditures to continue to develop proprietary technologies targeted to give us a commercial advantage. Two of these technologies in development include:
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PathMaker® 3DRS technology for 9 7/8-inch and 6-inch borehole sizes. This technology is intended to be functionally substantially similar to the 8 1/2-inch PathMaker® 3DRS tool described above, except that these tools will be able to accommodate these borehole diameters. Aspects of this technology are patented and patent-pending. The 97/8-inch borehole size is targeted to be commercially available on a limited basis by late 2007.
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Azimuthal Density Neutron Standoff Caliper (“IDNSC”) technology. This technology is intended to enhance our current proven DNSC and Slim DNSC technology by providing an image of the inside of the borehole based on density measurements. The technology also generates reliable information about the porosity of a formation and the diameter of the borehole. Aspects of this technology are patent-pending. This technology is targeted to be commercially available on a limited basis by late 2007 or early 2008.
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 logging-while-drilling 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.
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. Insurance rates are subject to fluctuations. During the last five fiscal years our cost of insurance has increased substantially due principally to growth in our operations. 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.
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. The violation of such laws 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, including acts that were in compliance with applicable laws at the time they were performed.
We are subject to regulation under both the federal Clean Water Act of 1972, or the CWA, and the Oil Pollution Act of 1990, or the OPA. The CWA is the principal federal statute protecting navigable waters and adjoining shorelines from pollution. The CWA imposes specific requirements for pollution prevention and response measures. In conjunction with similar state laws the CWA imposes effluent limitations regulating the amount of pollutants that may be discharged from specific point sources into state waters and waters of the United States through a system of permitting, compliance and spill prevention program requirements. Under the OPA, the government has adopted requirements related to the prevention of oil spills and the liability for damages resulting from such spills into waters of the United States. The OPA imposes strict, joint and several liability on the owners or
operators of facilities or vessels, and/or the lessee or permittee of the area in which an offshore facility is located 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 and plans required under the CWA and OPA. We are currently updating our existing and or developing new spill prevention, control and countermeasure (SPCC) plans which are required under the CWA and OPA 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 these 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-137, americium-241, iridium, iodine, radium, californium-252 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, Inc. and Enertech Wireline Services, L.P., 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 State Health Services (Radiation Control Program), and the Mississippi Department of Health and Radiological Control, as well as an NRC license, that allow us to store and use these source materials in connection with our well logging activities in these three states and other agreement states, as well as offshore in federal waters. We believe that we are in compliance with the terms and conditions of our radioactive 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, 2006, 2005 and 2004, 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 logging-while-drilling and measurement-while-drilling tools and certain chemicals and additives used in producing our drilling fluids from various third-party suppliers. We have not experienced and do not foresee experiencing a shortage of any of these products. Lead times for most of these products have increased, however, during the last two to three years.
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 logging-while-drilling, measurement-while-drilling and directional drilling businesses include divisions of Baker Hughes, Halliburton, Schlumberger, and Weatherford International. In our rental tool business, our competitors range from small, independent oilfield service companies to much larger oilfield service companies such as Weatherford International. Competitors in our measurement-while-drilling, 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, 2006, 2005 and 2004 we had 2,959, 2,333 and 2,079 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.
Item 1A.
Item 1A.
Risk Factors.
Set forth below is a discussion of some of the risks that we face and that could affect our business and financial position for 2007 and beyond. However, they are not the only risks that we face. There may be additional risks that we do not presently know of or that we currently believe are immaterial which could also impair our business and financial position.
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 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 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, but not limited to, the ability of the Organization of Petroleum Exporting Countries to set and maintain production levels and prices for oil;
•
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 laws.
Demand for our completion and workover related products and services is less immediately affected by changing oil and natural gas prices and, thus, tends to be less directly impacted by the above factors than our drilling
related products and services. However, production activity typically decreases when oil and natural gas prices decline which could also adversely affect our completion and workover related 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. In addition, many of our insurance policies contain deductibles for which we are responsible.
Insurance rates for our industry have been subject to fluctuations during the last five years. 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. 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 logging-while-drilling and measurement-while-drilling 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 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 increased, 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.
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 attracting and retaining key employees.
We depend on attracting and retaining the services of key employees, including executive officers and directors. 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 2005, two major hurricanes affected the Gulf of Mexico, causing a suspension of oil and natural gas operations and significant damage to industry infrastructure.
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 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, require us to maintain certain financial ratios, including a leverage ratio and an interest coverage ratio, and a specified net worth. Our credit facility also limits the amount of capital expenditures we may make, limits the amount of debt we may 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 as 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 cash flows 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 cash flows from our subsidiaries to provide funding to meet our debt obligations and operating expenses. 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 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 6,900,075 shares of our common stock which have been and may in the future be issued under our stock
awards plans as restricted stock or upon the exercise of options. All of the shares issued upon exercise of these options and the shares of restricted stock upon vesting 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 real or perceived factors, including:
•
variations in our quarterly or annual results of operations;
•
variations in oil and natural gas prices and production/ inventory levels;
•
drilling activity levels 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. Our stock price may fluctuate due to current or expected changes in commodity prices, which are highly volatile.
Item 1B.
Item 1B.
Unresolved Staff Comments.
None.
Item 2.
Item 2.
Properties.
Our principal executive offices are located in Houston, Texas. We lease or own numerous service centers, shops and sales and administrative offices throughout the United States and in select areas internationally. We believe that we have good title to the properties that we own and that all of our leases are at competitive or market rates, and we 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. Based upon information currently available, management believes that the ultimate liability with respect to these proceedings and claims will not materially affect our consolidated results of operations or financial position.
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 2006.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market for, Holders of and Dividends on Common Equity
Our common stock is traded on the New York Stock Exchange under the symbol “WHQ”. The following table sets forth the high and low prices per share of our common stock as reported by the New York Stock Exchange.
As of February 14, 2007, there were 30,264,638 shares of our common stock outstanding, which were held by approximately 90 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, 2006:
(1)
Includes 75,000 shares of restricted stock issued to our President and Chief Executive Officer. The forfeiture restrictions lapsed in annual 25,000 share increments in May 2005 and May 2006, and the remaining forfeiture restrictions are scheduled to lapse in May 2007, assuming the continued employment of our President and Chief Executive Officer. These restricted shares do not have an exercise price; they have, thus, been excluded in calculating the weighted average exercise price.
(2)
Includes 117,000 shares of restricted stock issued to various employees and directors. The forfeiture restrictions are scheduled to lapse in annual 25% increments beginning in May 2007 assuming the continued employment of the individuals awarded the restricted stock. These restricted shares do not have an exercise price; they have, thus, been excluded in calculating the weighted average exercise price.
(3)
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 months following any such event. As of December 31, 2006, 345,000 of these options have not been exercised.
PERFORMANCE GRAPH
The graph below compares the total shareholder return on the Company’s Common Stock from December 31, 2001, to December 31, 2006, with the total return on the S&P 500 Index, the S&P 500 Oil & Gas (Equipment and Services) Index and the Dow Jones U.S. Oil Equipment & Services Index for the same period. The information in the graph is based on the assumption of (1) a $100 investment on December 31, 2001 at closing prices on December 31, 2001 and (2) reinvestment of all dividends.
COMPARISON OF 50 MONTH CUMULATIVE TOTAL RETURN
Among W-H Energy Services, Inc., the S&P 500 Index,
the S&P Oil & Gas Equipment & Services Index
and the Dow Jones U.S. Oil Equipment & Services Index
COMPARISON OF CUMULATIVE FIVE YEAR TOTAL RETURN
Item 6.
Item 6.
Selected Financial Data.
Our selected consolidated financial data set forth 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, 2004, which could affect the year to year comparability of the information presented below.
The Consolidated Financial Statements for the years ended December 31, 2006 and 2005 have been audited by Grant Thornton LLP. The Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002 were audited by PricewaterhouseCoopers LLP.
(1)
The 2004 amount 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)
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 our Selected Financial Data and our Consolidated Statements of Operations and Comprehensive Income for fiscal years ended on or before December 31, 2004 as discontinued operations. In April 2004, we completed the sale of Well Safe, Inc., one of the two companies that formerly comprised our maintenance and safety related products and services segment, for cash consideration of $28.0 million. Additionally, in December 2004, we sold Charles Holston, Inc., the remaining entity that formerly comprised this segment, for consideration of $2.0 million. These sales resulted in a loss of $5.1 million for the year ended December 31, 2004.
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, 2006, and our capital resources and liquidity as of December 31, 2006 and 2005. 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 2007 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 Management’s Discussion and Analysis 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 Business
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. 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 rental equipment and costs of products sold as well as general operational costs. As a result of increased demand and competition for skilled personnel, compensation costs to attract and retain employees have been increasing. 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, expectations 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 also depends on oil and natural gas production activity, which may be less immediately affected by changes in oil and natural gas prices.
In July 2001, exploration and development activity levels in the United States peaked and subsequently 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 consisted 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 this trend has continued through the third quarter of 2006. This increase, however, resulted 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 1,192, 1,383 and 1,649 for 2004, 2005 and 2006, respectively. Of these figures, land rigs comprised 1,095, 1,290 and 1,559, respectively, and offshore rigs comprised 97, 93 and 90, respectively, for the same periods.
We believe that the overall long-term outlook for domestic natural gas exploration and development activity remains positive. First, natural gas production has not kept pace with the significant increases in drilling activity in
2005 and 2006. Second, industrial gas consumption, electric power generation and a healthy economy continue to drive domestic natural gas demand. We believe that these factors will keep upward pressure on long-term natural gas prices. We do have a concern that when the current winter season ends we may see natural gas storage levels above historic norms. This could result in lower oil and natural gas prices and a decline in domestic drilling activity. However, we believe any slowdown that may occur would be short lived as long as the positive factors set forth above affecting long-term supply and demand remain in place. As a result, we are focusing our capital expenditure investments in locations which are attracting long-term investment in oil and natural gas exploration and development.
Drilling Related Products and Services
Revenue from our drilling related products and services segment constituted approximately 63% of our total 2006 consolidated revenue. Approximately 84% of our drilling segment revenue for 2006 was generated in the United States, including the Gulf of Mexico. The remaining 16% was generated in various international locations.
As the improvement in drilling activity in the United States has been onshore, we have sought to increase the content of our land-based services. In October 2002, in response to this developing trend, we made the strategic decision to enter the directional drilling business in North America. As a result of this decision and the growth in the United States land rig count, we have successfully leveraged our directional drilling business to effect an increase in the utilization of our measurement-while-drilling and logging-while-drilling tools and down-hole drilling motor fleet. The increased utilization of our measurement-while-drilling and logging-while-drilling tools and down-hole drilling motor fleet has helped to offset the slowdown in domestic offshore activity. Our logging-while-drilling revenues from the offshore market have outperformed the rig count numbers as a result of performing more jobs with a higher content of our services, improved pricing and an increase in our share of this market.
Outside of the United States, the North Sea remains our largest market segment. In 2007, we expect to see increasing drilling activity in the Middle East and a modest increase in activity levels in the North Sea.
A 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 substantial 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 2004, we began to market our PathMaker® 3-Dimensional Rotary Steerable line of tools with the introduction of our 12 1/4-inch PathMaker® tool. The 8 1/2-inch PathMaker® tool has been available on a limited commercial basis since the first quarter of 2006 with full commercial deployment of this tool occurring during the first quarter of 2007. Other sizes of the PathMaker® tools are currently in development. We expect commercialization of the 3-Dimensional Rotary Steerable technology to improve the utilization of our logging-while-drilling, measurement-while-drilling and directional drilling services, as our customers are increasingly requiring this type of technology as a prerequisite for submitting bids on a drilling project or contract.
Our PathFinder Survivortm series of logging-while-drilling and measurement-while-drilling tools designed for use in high pressure and high temperature conditions (up to 25,000 psi and 350ºF) continue to be successfully introduced on a commercial basis. In 2004, PathFinder introduced the first of the Survivortm tools with the commercialization of its dual frequency Array Wave Resistivity tool. The Survivortm tool series currently includes Survivortm HDS-1tm (a highly accurate directional survey tool), Survivortm DPMtm (Dynamic Pressure Module), Survivortm DNSCtm (4 3/4-inch O.D. Slim Density Neutron Standoff Caliper Tool) and Survivortm SAWRtm (4 3/4-inch O.D. dual frequency Slim Array Wave Resistivity Tool).
For a discussion of other technologies we have under development, please read “Item 1. Business - Research and Development: Technology Initiatives.”
Completion and Workover Related Products and Services
Our completion and workover related products and services segment provided approximately 37% of our total consolidated revenue for 2006. Revenues provided by this segment are almost entirely derived from the United States and the Gulf of Mexico. Demand for this segment’s products and services is less immediately affected by
changing oil and natural gas prices and, thus, tends to be less directly impacted than our drilling related products and services segment. However, production activity typically decreases when oil and natural gas prices decline, which could also adversely affect our completion and workover related products and services segment.
We have increased our revenue capacity in this segment through capital spending which, when combined with our acquisitions and strategic land-based expansion efforts, has strengthened and further diversified our operations. 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.
Geographic Expansion
We are currently working to establish a larger presence in the Rocky Mountain region of the United States, an expansion that is requiring an initial capital investment during 2006 and 2007 of approximately $51 million to build and equip new facilities (see Item 1. Business - Strategy). We have been providing limited services in this region and expect this facility to be completed during the first half of 2007.
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 our Selected Financial Data and our Consolidated Statements of Operations and Comprehensive Income for fiscal years ended on or before December 31, 2004 as discontinued operations. In April 2004, we completed the sale of Well Safe, Inc., one of the two companies that formerly comprised our maintenance and safety related products and services segment, for cash consideration of $28.0 million. Additionally, in December 2004, we sold Charles Holston, Inc., the remaining entity that formerly comprised this segment, for consideration of $2.0 million. These sales resulted in a loss of $5.1 million for the year ended December 31, 2004.
Results of Operations
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005
Revenues. Revenues increased by $260.4 million, or approximately 41%, to $894.8 million for the year ended December 31, 2006 from $634.4 million for the year ended December 31, 2005. This increase was primarily attributable to higher levels of activity and demand for certain of our products and services, additional revenue capacity from our capital expenditure investments and favorable pricing.
Revenues from our drilling related products and services increased by $154.7 million, or approximately 38%, to $563.9 million for the year ended December 31, 2006 from $409.2 million for the year ended December 31, 2005. We attribute the increase in revenues in this segment to:
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a 19% increase in the average number of rotary rigs operating in the United States, resulting in an increase in demand for our directional drilling services and technologically advanced services and tools, rental tools and drilling fluids products;
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our larger asset base resulting from our capital expenditure investments;
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improved pricing;
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an increase in our Gulf of Mexico market share, resulting from higher utilization of our existing logging-while-drilling tools and commercialization of certain of our new technologies discussed earlier; and
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recovery of activity levels in the Gulf of Mexico as the infrastructure damage caused by Hurricanes Katrina and Rita in 2005 was repaired; and
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onshore geographic expansion.
Revenues from our completion and workover related products and services increased by $105.6 million, or approximately 47%, to $330.8 million for the year ended December 31, 2006 from $225.2 million for the year ended December 31, 2005. We attribute the increase in revenues in this segment to:
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higher demand for our tools and services as a result of an overall increase in activity levels;
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a rebound in offshore activity and a less active 2006 hurricane season;
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an increase in our cased-hole wireline and coiled tubing fleets and other capital expenditure investments;
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improved pricing; and
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onshore geographic expansion.
Cost of Revenues. Cost of revenues increased by $114.9 million, or approximately 32%, to $472.7 million for the year ended December 31, 2006 from $357.8 million for the year ended December 31, 2005. As a percentage of revenues, cost of revenues decreased to 53% for the year ended December 31, 2006 from 56% for the year ended December 31, 2005. The decrease in cost of revenues as a percentage of revenues was primarily due to a change in our revenue mix, improved utilization in both business segments and improved pricing. In particular, our revenue mix was affected by revenue increases in our higher margin logging-while-drilling, measurement-while-drilling, directional drilling, rental tools, wireline and coiled tubing operations. These margin improvements were partially offset by higher employee compensation expenses, start-up costs in the Middle East and Rocky Mountain region and other operational costs.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $38.3 million, or approximately 35%, to $147.2 million for the year ended December 31, 2006 from $108.9 million for the year ended December 31, 2005. The increase was primarily attributable to increased selling costs attributable to our revenue growth, other personnel costs related to expansion efforts within all of our business lines and higher share-based compensation expense due to adoption of SFAS No. 123R as of January 1, 2006. As a percentage of revenues, selling, general and administrative expenses were 16% and 17% for the years ended December 31, 2006 and 2005, respectively.
Warehouse Fire Related Costs. On April 17, 2005, a Houston warehouse facility operated by one of our subsidiaries was destroyed by a fire. For the year ended December 31, 2005, we reported $3.7 million in costs associated with this fire. This amount has been reflected in the Consolidated Statements of Operations and Comprehensive Income under the caption “Warehouse fire related costs” and as a reduction to operating income for the drilling segment in Footnote 13 “Operating Segments” for the year ended December 31, 2005.
Research and Development Expenses. Research and development expenses increased by $0.9 million, or approximately 6%, to $17.2 million for the year ended December 31, 2006 from $16.3 million for the year ended December 31, 2005. The costs incurred in 2006 were for development of various PathFinder technologies, including our PathMaker® 3-Dimensional Rotary Steerable line of tools.
Depreciation and Amortization. Depreciation and amortization increased by $6.1 million, or approximately 11%, to $62.7 million for the year ended December 31, 2006 from $56.6 million for the year ended December 31, 2005. This increase was principally the result of a larger depreciable asset base resulting from our capital expenditure investments.
Interest and Other Expense. Interest and other expense for the year ended December 31, 2006 was $8.9 million, a decrease of $1.9 million, or approximately 18%, from $10.8 million for the year ended December 31, 2005. This decrease was principally due to lower outstanding borrowings under our credit facility, partially offset by higher interest costs associated with rising interest rates. We recognized approximately $1.2 million in net gains in 2006 as decreases to interest expense during 2006 and we recognized $0.5 million in net losses in 2005 as increases to interest expense resulting from net payments to swap counterparties (discussed more fully under “Capital Resources”).
Provision for Income Taxes. Our effective income tax rates for the years ended December 31, 2006 and 2005 were 38% and 39%, respectively. We anticipate that our effective income tax rate for 2007 will range from 39% to 40% assuming no discrete tax items. The estimated increase in our effective tax rate in 2007 is principally
attributable to several factors including changes in valuation allowances in various jurisdictions and fluctuations in income across taxing jurisdictions with different tax rates.
Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004
Revenues. Revenues increased by $172.0 million, or approximately 37%, to $634.4 million for the year ended December 31, 2005 from $462.4 million for the year ended December 31, 2004. This increase was primarily attributable to higher demand for certain of our products and services, combined with the benefit of increased revenue capacity from our capital expenditures.
Revenues from our drilling related products and services increased by $106.4 million, or approximately 35%, to $409.2 million for the year ended December 31, 2005 from $302.8 million for the year ended December 31, 2004. We attribute the increase in revenues in this segment to:
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a 16% increase in the average number of rotary rigs operating in the United States, resulting in an increase in demand for our products and services;
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an increase in our Gulf of Mexico market share, resulting from higher utilization of our existing logging-while-drilling tools and commercialization of certain of our new technologies discussed earlier; and
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revenue capacity increases from our capital expenditure program.
Revenues from our completion and workover related products and services increased by $65.6 million, or approximately 41%, to $225.2 million for the year ended December 31, 2005 from $159.6 million for the year December 31, 2004. We attribute the increase in revenues in this segment to:
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the benefits experienced from our onshore geographic expansion;
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higher utilization of our rental equipment and services as a result of the overall increase in activity levels; and
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revenue capacity increases from our capital expenditure program.
Cost of Revenues. Cost of revenues increased by $87.9 million, or approximately 33%, to $357.8 million for the year ended December 31, 2005 from $269.9 million for the year ended December 31, 2004. As a percentage of revenues, cost of revenues decreased to 56% for the year ended December 31, 2005 from 58% for the year ended December 31, 2004. The decrease in cost of revenues as a percentage of revenues was primarily due to improved pricing, improved utilization and a change in our revenue mix.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $21.1 million, or approximately 24%, to $108.9 million for the year ended December 31, 2005 from $87.8 million for the year ended December 31, 2004. The increase was primarily attributable to increased personnel costs related to expansion efforts within all of our business lines. As a percentage of revenues, selling, general and administrative expenses decreased to 17% for the year ended December 31, 2005 from 19% for the year ended December 31, 2004.
Warehouse Fire Related Costs. On April 17, 2005, a Houston warehouse facility operated by one of our subsidiaries was destroyed by a fire. For the year ended December 31, 2005, we reported $3.7 million in costs associated with this fire, net of approximately $0.8 million in insurance reimbursements. This amount has been reflected in our Selected Financial Data and our Consolidated Statements of Operations and Comprehensive Income under the caption “Warehouse fire related costs” and in Footnote 13 “Operating Segments” as a reduction to operating income for the drilling segment for the year ended December 31, 2005.
Research and Development Expenses. Research and development expenses increased by $0.8 million, or approximately 5%, to $16.3 million for the year ended December 31, 2005 from $15.5 million for the year ended December 31, 2004. This increase was the result of increased research and development spending on our PathFinder technologies, including our PathMaker® 1/2-inch 3-Dimensional Rotary Steerable tool, our Slim Density Neutron Stand-off Caliper tool and other research and development initiatives.
Depreciation and Amortization. Depreciation and amortization increased by $10.9 million, or approximately 24%, to $56.6 million for the year ended December 31, 2005 from $45.7 million for the year ended December 31, 2004. This increase was largely the result of a larger depreciable asset base resulting from our capital expenditures.
Interest and Other Expense. Interest and other expense for the year ended December 31, 2005 was $10.8 million, a decrease of $0.2 million, or approximately 2%, from $11.0 million for the year ended December 31, 2004. This decrease was primarily due to our write-off, during the second quarter of 2004, of $3.1 million in deferred financing costs associated with the retirement of our previous credit facility during June of 2004 and a larger amount of debt in 2004, partially offset by higher interest costs associated with rising interest rates and our recognition of approximately $0.5 million in net losses in 2005 as increases to interest expense resulting from net payments to swap counterparties (discussed more fully under “Capital Resources”).
Provision for income taxes. Our effective income tax rate for the year ended December 31, 2005 was 39.0% as compared to 38.5% for the year ended December 31, 2004. The increase in the 2005 effective rate compared to 2004 was due to several factors including, but not limited to, changes in valuation allowances in various jurisdictions, ongoing and settled audits in foreign jurisdictions, and fluctuations in income across taxing jurisdictions with different tax rates.
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. Historically, we have not incurred material write-offs against the allowance for doubtful accounts that had not been adequately provided for. 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 9 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 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 large deductibles. In addition, our insurance policies may not cover certain types of claims. We determine whether to disclose and accrue for loss contingencies based on the coverages we maintain and our 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. Historically, our actual claims losses have not differed materially from our loss reserves.
Impairment of long-lived assets
Our long-lived assets are carried on our financial statements based on their cost less accumulated depreciation. However, accounting standards require us to write down assets or groups of assets if they become impaired. If significant events or changes in circumstances indicate that the carrying value of an asset or asset group may not be recoverable, we perform a test of recoverability by comparing the carrying value of the asset or asset group to its undiscounted expected future cash flows. If cash flows cannot be separately and independently identified for a single asset, we will determine whether an impairment has occurred for the group of assets for which we can identify the projected cash flows. If the carrying values are in excess of undiscounted expected future cash flows, we measure any impairment by comparing the fair value of the asset or asset group to its carrying value. Fair value is typically determined by an internally developed discounted projected cash flow analysis of the asset or asset group. If the fair value of an asset or asset group is determined to be less than the carrying amount of the asset or asset group, an impairment in the amount of the difference is recorded in the period that the impairment indicator occurs.
Typical indicators that an asset may be impaired include:
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significant underperformance relative to expected historical or projected future operating results;
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significant changes in the manner of our use of the assets or the strategy for our overall business;
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significant negative industry or economic trends;
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significant decline in our stock price for a sustained period; and
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market capitalization relative to net book value.
If any of these or other indicators occurs, we review the asset to determine whether there has been an impairment. Several of these indicators are beyond our control, and we cannot predict with any certainty whether or not they will occur. In addition, determination of future cash flows requires us to make judgments and 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 or more frequently if indicators arise. 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 Notes 2 and 5 to the Consolidated Financial Statements for more information.
Recent Accounting Pronouncements
We adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment,” (“SFAS No. 123R”) as of January 1, 2006 using the modified prospective method in which compensation cost is recognized based (1) on the requirements of SFAS No. 123R for all share-based payments granted after January 1, 2006 and (2) on the requirements of SFAS No. 123 for all awards granted to employees prior to January 1, 2006 that remain unvested on January 1, 2006. For the year ended December 31, 2006, we recorded approximately $4.1 million of pretax expense relating to this pronouncement for nonvested share-based payments granted prior to January 1, 2006. See Notes 2 and 11 to the Consolidated Financial Statements for additional information.
In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the application of SFAS No. 109, Accounting for Income Taxes, by establishing a threshold condition that a tax position must meet for any part of the benefit of that position to be recognized in the financial statements. In addition to recognition, FIN 48 provides guidance concerning measurement, derecognition, classification and disclosure of tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006; accordingly, we will adopt FIN 48 effective as of January 1, 2007. Upon adoption, we estimate that a cumulative effect adjustment of up to $4 million will be charged to retained earnings to increase reserves for uncertain tax positions. The amount of the charge is subject to revision as management completes its analysis. Currently, we do not anticipate that the adoption of FIN 48 will have a material impact on our effective tax rate.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) AUG AIR-1 - Accounting for Planned Major Maintenance Activities. FSP AUG AIR-1 prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities because it results in the recognition of a liability in a period prior to the occurrence of the transaction or event obligating the entity. FSP AUG AIR-1 is effective for fiscal years beginning after December 15, 2006 and its guidance is applicable to entities in all industries. We will adopt the guidance in FSP AUG-AIR-1 as of January 1, 2007 and apply it retrospectively for all prior periods presented. As of December 31, 2006, we had accrued maintenance costs of approximately $6.0 million, a portion of which relates to maintenance and repair services provided as of that date. We are currently evaluating the impact that the adoption of this guidance will have on our financial position and results of operations.
In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 provides guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 established a dual approach that requires quantification of errors under two methods: (1) roll-over method which quantifies the amount by which the current year income statement is misstated, and (2) the iron curtain method which quantifies the error as the cumulative amount by which the current year balance sheet is misstated. In some situations, companies will be required to record errors that occurred in prior years even though those errors were immaterial for each year in which they arose. Companies may choose to either restate all previously presented financial statements or record the cumulative effect of such errors as an adjustment to retained earnings at the beginning of the period in which SAB 108 is applied. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of this pronouncement did not have an impact on our financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which is intended to increase consistency and comparability in fair value measurements by defining fair value, establishing a framework for measuring fair value and expanding disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will adopt SFAS 157 on January 1, 2008, and have not yet determined the impact, if any, on our consolidated financial statements.
Liquidity and Capital Resources
Our primary uses for cash are capital expenditures, working capital, 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 $218.1 million as of December 31, 2006 and $155.6 million as of December 31, 2005. Net cash provided by operating activities was $144.1 million for the year ended December 31, 2006 and $72.7 million for the year ended December 31, 2005. The increase in working capital and cash flow from operating activities was largely due to increases in activity levels across all business lines.
Net cash used in investing activities was $133.7 million for the year ended December 31, 2006 and $68.5 million for the year ended December 31, 2005. The increase in net cash used in investing activities was principally the result of increased capital expenditures which was partially offset by an increase in proceeds from sales of equipment, which are primarily lost-in-hole proceeds which represent funds we receive from a customer when our rental equipment is involuntarily damaged or lost in-hole. Additionally, we invested $8.7 million in 2006 and $2.5 million in 2005, net of cash acquired, to acquire businesses.
Net cash provided by financing activities was $15.7 million for the year ended December 31, 2006 and net cash used in financing activities was $3.9 million for the year ended December 31, 2005. Changes in net cash related to financing activities were principally the result of significantly higher proceeds from the exercise of stock options and the related tax benefits during 2006 as compared to 2005. The adoption of SFAS No. 123R in 2006 resulted in a decrease in reported cash flow from operating activities of $13.3 million offset by an increase in reported cash flow from financing activities of $13.3 million for the year ended December 31, 2006. For periods prior to the adoption of SFAS No. 123R, the excess tax benefits from the exercise of stock options were reported as cash flows from operating activities.
For the year ended December 31, 2006, we made capital expenditures, primarily for rental equipment of $153.8 million, which included expenditures for the replacement of rental equipment, including rental tools damaged or lost-in-hole. In addition, we incurred $17.2 million in research and development expenses for the year ended December 31, 2006.
Acquisitions
During 2006, we consummated one acquisition for total consideration of approximately $10.4 million, including cash of approximately $9.4 million ($8.7 million net of cash acquired) and 20,358 shares of our common stock. See Note 3 to the Consolidated Financial Statements for additional information.
Capital resources
We maintain a revolving credit facility with certain lenders to provide for our cash, liquidity and other borrowing needs. The credit facility provides for aggregate borrowings of up to $375.0 million and matures on May 5, 2010. As of December 31, 2006, we had an outstanding loan balance of $150.0 million and approximately $10.4 million in letters of credit issued under our credit facility, resulting in an available borrowing capacity on such date of approximately $214.6 million.
Amounts borrowed under our credit facility bear interest, at our election, at either a variable rate equal to LIBOR, plus a margin ranging from 1.0% to 2.0%, 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 zero to 1.0%, depending upon our leverage ratio. As of December 31, 2006, borrowings under our credit facility bore interest at approximately 6.4%.
Our credit facility is secured 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 an interest coverage ratio, and a specified net worth. Our credit facility 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, our ability to pay dividends and our ability to engage in certain business combination transactions. As of December 31, 2006, we are in compliance with the financial ratios and other limitations of the credit facility.
Our credit facility contains customary events of default, including payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to certain other indebtedness agreements in excess of specified amounts, certain events of bankruptcy and insolvency, judgments in excess of specified amounts, ERISA defaults, certain failures of guaranty or security documents supporting our credit facility to be in full force and effect and a change of control.
We entered into our credit facility in June 2004. We entered into a first amendment to our credit facility in May 2005 and a second amendment in February 2006. Financing costs associated with our original credit facility of approximately $1.6 million and financing costs associated with the first amendment of approximately $1.0 million will be ratably amortized to interest expense over the five year term of the credit facility. As a result of the approximate $160.0 million repayment of our previous credit facility in June 2004, we wrote off approximately $3.1 million in non-cash financing costs to interest expense during the second quarter of 2004. This amount represented financing costs that previously had been deferred.
The descriptions of our credit facility, as amended by the first amendment and second amendment, are qualified in their entirety by reference to the original credit facility which is filed as Exhibit 10.8 to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, the first amendment which is filed as Exhibit 10.8(a) to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005 and the second amendment which is filed as Exhibit 10.8(b) to our Annual Report on Form 10-K for the year ended December 31, 2005.
In May 2005, we entered into interest rate swap agreements with a total notional amount of $150.0 million related to our credit facility. Under these agreements, we receive interest at a floating rate equal to three-month LIBOR and pay interest at a fixed rate of 4.24%. The three-month LIBOR rate as of December 31, 2006 was approximately 5.4%.
Contractual obligations
The following table aggregates information about our contractual cash obligations (in thousands) as of December 31, 2006:
(1)
Purchase obligations represent orders to purchase various rental equipment, inventory items and other supplies that have not yet been delivered.
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 rental 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 $180.0 million in 2007, including expenditures for the Rocky Mountain region facilities and related equipment, and will make research and development expenditures of approximately $23.0 million to $25.0 million in 2007.
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 operating, capital expenditure, 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 8 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. Our market risk could arise from changes in interest rates and foreign currency exchange rates. We have utilized, and may continue to utilize, derivative and other financial instruments to manage these market risks. We have not entered into derivative or other financial instruments for trading or speculative purposes.
Interest Rate Risk. We are subject to market risk exposure related to changes in interest rates. To manage this risk, we have entered into interest rate swap agreements with a total notional amount of $150.0 million related to our credit facility. Under these agreements, we receive interest at a floating rate equal to three-month LIBOR and pay interest at a fixed rate of 4.24%. Assuming our current level of borrowings and considering the effect of the interest rate swap agreements, a 100 basis point increase in the LIBOR-based interest rate we pay under our credit facility would have had no impact on our net interest expense for the year ended December 31, 2006.
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 common stock. The market price of our common stock may be influenced by many factors including real or perceived 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.
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.
None.
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 provide reasonable assurance 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, 2006, 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, 2006 was effective.
Our management’s assessment of the effectiveness of our internal control over external financial reporting in accordance with generally accepted accounting principles as of December 31, 2006 has been audited by Grant Thornton 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, 2006.
Other Matters. During the quarterly period ended December 31, 2006, 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.
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
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 ended December 31, 2006.
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 ended December 31, 2006.
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 ended December 31, 2006 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, and Director Independence.
Information required by this item is hereby incorporated by reference to the sections entitled “Certain Relationships and Related Transactions” and “Election of Directors” 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 ended December 31, 2006.
Item 14.
Item 14.
Principal Accounting 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 ended December 31, 2006.
PART IV
Item 15.
Item 15.
Exhibits 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.
The Exhibit Index, which index follows page of this report and is incorporated herein by reference, sets forth a list of those exhibits filed herewith, and 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 28th day of February, 2007.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Shareholders of W-H Energy Services, Inc.
We have audited the accompanying consolidated balance sheets of W-H Energy Services, Inc. (a Texas corporation) and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, shareholders’ equity, and cash flows for the years then ended. 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 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of W-H Energy Services, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board Statement No. 123(R), Share-Based Payments, on a modified prospective basis as of January 1, 2006.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of W-H Energy Services, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 26, 2007, expressed an unqualified opinion that W-H Energy Services, Inc. and subsidiaries maintained effective internal control over financial reporting and an unqualified opinion on management’s assessment of the effectiveness of internal control over financial reporting.
GRANT THORNTON LLP
Houston, Texas
February 26, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
W-H Energy Services, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing in Item 9A, that W-H Energy Services, Inc. (a Texas corporation) and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The management of W-H Energy Services, Inc. and its subsidiaries 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 an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit 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. Our audit included 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 considered 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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) 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 (3) 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.
In our opinion, management’s assessment that W-H Energy Services, Inc. and its subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by COSO. Also in our opinion, W-H Energy Services, Inc. and its subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of W-H Energy Services, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, shareholders’ equity, and cash flows for the years then ended, and our report dated February 26, 2007 expressed an unqualified opinion on those consolidated financial statements.
GRANT THORNTON LLP
Houston, Texas
February 26, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
W-H Energy Services, Inc.:
In our opinion, the consolidated statements of income and comprehensive income, of shareholders’ equity and of cash flows for the year ended December 31, 2004 present fairly, in all material respects, the results of operations and cash flows of W-H Energy Services, Inc. and its subsidiaries (the Company) for the year 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 audit. We conducted our audit 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 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 audit provides a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Houston, Texas
March 11, 2005
W-H ENERGY SERVICES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these financial statements.
W-H ENERGY SERVICES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(In thousands, except per share amounts)
The accompanying notes are an integral part of these financial statements.
W-H ENERGY SERVICES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands)
The accompanying notes are an integral part of these financial statements.
W-H ENERGY SERVICES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
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 in connection with the drilling and completion of oil and natural gas wells and the production of oil and natural gas. W-H has the following primary lines of business: (1) drilling related products and services, which include logging-while-drilling, measurement-while-drilling, directional drilling, down-hole drilling motors, drilling fluids and rental tools; and (2) completion and workover related products and services, which include cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment, coiled tubing, completion fluids and rental tools.
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 also depends 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. Other risk factors include, but are not limited to, risks associated with (1) W-H’s ability to develop and commercialize competitive tools and technologies, (2) explosions, spills, fires and other accidents, (3) the competitive nature of W-H’s business, (4) the cost and availability of insurance, (5) the ability to attract and retain skilled employees and managers and (6) weather conditions in offshore markets.
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. 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 Charles Holston, Inc., the remaining entity that formerly comprised this segment, for consideration of $2.0 million. 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)
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 relies upon credit approval, balance limitation and monitoring procedures to control credit use on trade accounts receivable. W-H 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 rental equipment that is involuntarily damaged or lost down-hole are reflected as revenues, with the resulting carrying value of the related rental equipment charged to cost of revenues.
Proceeds from sales of equipment, including sales of equipment involuntarily damaged or lost down-hole, are reported as cash inflows from investing activities in the accompanying consolidated statements of cash flows. For the years ended December 31, 2006, 2005 and 2004, proceeds from sales of equipment involuntarily damaged or lost down-hole were $27.9 million, $20.8 million and $15.3 million, respectively. For the years ended December 31, 2006, 2005 and 2004, the gain on sales of equipment involuntarily damaged or lost down-hole was $20.0 million, $13.7 million and $9.3 million, respectively.
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 carrying value of long-lived assets whenever changes in circumstances indicate the carrying amount of such assets may not be recoverable. If necessary, W-H measures 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. There have been no significant events or changes in circumstances indicating that the carrying value of W-H’s long-lived assets may not be recoverable; therefore, no adjustments were made to the carrying value of long-lived assets during the three years ended December 31, 2006.
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 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. W-H performed the required assessments in accordance with SFAS No. 142 for the three years ended December 31, 2006, which resulted in W-H recording no goodwill impairment expense.
Debt Issue Costs
Other assets includes 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 in June 2004, 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, as amended, totaled approximately $2.6 million, and are amortized ratably to interest expense over the remaining 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 sells products to customers and recognizes the related revenue as items are shipped from its facilities. Proceeds from customers for the cost of
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
oilfield rental equipment that is involuntarily damaged or lost down-hole are reflected as revenues. For the years ended December 31, 2006, 2005 and 2004, proceeds from sales of equipment involuntarily damaged or lost down-hole included in revenues were $27.9 million, $20.8 million and $15.3 million, respectively.
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, 2006, 2005 and 2004, research and development costs were $17.2 million, $16.3 million and $15.5 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.
On May 18, 2005, W-H entered into interest rate swap agreements with a total notional amount of $150.0 million related to its credit facility. The interest rate swap agreements have been designated as and qualify as cash flow hedging instruments. The interest rate swap agreements are fully effective, and have resulted in no gain or loss due to ineffectiveness being recorded in net income in the Consolidated Statement of Operations and Comprehensive Income. W-H records the fair values of the interest rate swap agreements on its Consolidated Balance Sheet. See Note 7 to the Consolidated Financial Statements for more information.
With the exception of the operating leases on real property and automobile leases discussed in Note 8 to the Consolidated Financial Statements, W-H has no off-balance sheet debt or other off-balance sheet financing arrangements.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Accounting for Share-Based Compensation
Through December 31, 2005, 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,” 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 SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation:
In calculating the amount of the deduction in the table above, 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, 2005 and 2004: risk-free interest rates between 3.9% and 4.6%; dividend rates of zero; expected lives between 5.6 years and 6.7 years; and expected volatilities between 49.6% and 50.7%.
In December 2004, the Financial Accounting Standards Board issued SFAS 123(R), “Share-Based Payment,” a revision of SFAS 123. In March 2005, the SEC issued Staff Bulletin No. 107 regarding its interpretation of SFAS 123R. Under SFAS 123R and SAB 107, W-H expenses the grant-date fair value of stock options and other equity-based compensation issued to employees. W-H adopted SFAS 123R as of January 1, 2006 using the modified prospective method in which compensation cost is recognized based (1) on the requirements of SFAS 123R for all share-based payments granted after January 1, 2006 and (2) on the requirements of SFAS 123 for all awards granted to employees prior to January 1, 2006 that remain unvested on January 1, 2006.
Under the Black-Scholes option-pricing model, W-H estimated volatility using only its historical share price performance over the expected life of the option. Under SFAS No. 123R, however, W-H estimates expected volatility using a blend of implied volatility based on market-traded options on W-H’s common stock and historical volatility of W-H’s common stock over the contractual life of the options. Results of prior periods do not reflect any restated amounts and W-H had no cumulative effect adjustment upon adoption of SFAS No. 123R under the modified prospective method. For awards with service conditions and a graded vesting schedule only, W-H
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
recognizes compensation expense on a straight-line basis over the requisite service period for the entire award. W-H’s policy is to issue new shares of common stock to satisfy stock option exercises or grants of restricted shares.
For the year ended December 31, 2006, the adoption of SFAS No. 123R decreased W-H’s reported operating income and income before income taxes by approximately $4.1 million, reported net income by $2.7 million and reported basic and diluted net earnings per share by $0.09 per share. The share-based compensation expense is reported in cost of revenues or selling, general and administrative expense based on the classification of the optionees’ cash compensation expenses. The adoption of SFAS No. 123R resulted in a decrease in reported cash flow from operating activities of $13.3 million offset by an increase in reported cash flow from financing activities of $13.3 million for the year ended December 31, 2006. W-H’s adoption of SFAS No. 123R did not affect operating income, income before income taxes, net income, cash flow from operations, cash flow from financing activities or basic and diluted net earnings per share for the years ended December 31, 2005 and 2004.
The fair value of each option award made after December 31, 2005 will be estimated on the date of grant using a binomial lattice-based option valuation model, which incorporates ranges of assumptions for inputs. The assumptions will be determined as follows:
•
the expected volatility will be a blend of implied volatility based on market-traded options on W-H’s common stock and historical volatility of W-H’s stock over the contractual life of the options;
•
historical data will be used to estimate option exercise and employee termination behavior within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected life of options granted will be derived from the output of the option valuation model and represents the period of time the options are expected to be outstanding; and
•
the risk-free interest rate will be based on the U.S. Treasury yield curve in effect at the time of grant for periods within the contractual life of the option.
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. For the years ended December 31, 2006, 2005 and 2004, the translation adjustments were a gain of $1.6 million, a loss of $1.7 million and a gain of $0.9 million, respectively, and are reflected as foreign currency translation adjustments in the consolidated statements of operations and comprehensive income.
Earnings per Share
Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period as adjusted for the dilutive effect of stock options and restricted shares. For the year ended December 31, 2006, there were no anti-dilutive stock options, therefore, the effect of all stock options were included in the diluted earnings per share calculation. For the years ended December 31, 2005 and 2004, 2,382 and 1,404,661 shares, respectively were excluded from the calculation because the exercise price of the underlying stock options exceeded the average price of our common stock for the applicable period.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following reconciles basic and diluted weighted average shares outstanding (in thousands):
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the application of SFAS No. 109, Accounting for Income Taxes, by establishing a threshold condition that a tax position must meet for any part of the benefit of that position to be recognized in the financial statements. In addition to recognition, FIN 48 provides guidance concerning measurement, derecognition, classification and disclosure of tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006; accordingly, W-H will adopt FIN 48 effective as of January 1, 2007. Upon adoption, W-H estimates that a cumulative effect adjustment of up to $4.0 million will be charged to retained earnings to increase reserves for uncertain tax positions. The amount of the charge is subject to revision as management completes its analysis. Currently, W-H does not anticipate that the adoption of FIN 48 will have a material impact on its effective tax rate.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) AUG AIR-1 - Accounting for Planned Major Maintenance Activities. FSP AUG AIR-1 prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities because it results in the recognition of a liability in a period prior to the occurrence of the transaction or event obligating the entity. FSP AUG AIR-1 is effective for fiscal years beginning after December 15, 2006 and its guidance is applicable to entities in all industries. W-H will adopt the guidance in FSP AUG-AIR-1 as of January 1, 2007 and apply it retrospectively for all prior periods presented. As of December 31, 2006, W-H had accrued maintenance costs of approximately $6.0 million, a portion of which relates to maintenance and repair services provided as of that date. W-H is currently evaluating the impact that the adoption of this guidance will have on its financial position and results of operations.
In September 2006, the Securities and Exchange Commission staff issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 provides guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 established a dual approach that requires quantification of errors under two methods: (1) roll-over method which quantifies the amount by which the current year income statement is misstated, and (2) the iron curtain method which quantifies the error as the cumulative amount by which the current year balance sheet is misstated. In some situations, companies will be required to record errors that occurred in prior years even though those errors were immaterial for each year in which they arose. Companies may choose to either restate all previously presented financial statements or record the cumulative effect of such errors as an adjustment to retained earnings at the beginning of the period in which SAB 108 is applied. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of this pronouncement did not have an impact on W-H’s financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which is intended to increase consistency and comparability in fair value measurements by defining fair value, establishing a framework for measuring fair value and expanding disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. W-H will adopt SFAS 157 on January 1, 2008, and has not yet determined the impact, if any, on its consolidated financial statements.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
Acquisitions
On July 24, 2006, a wholly-owned subsidiary of W-H acquired Mt. Pulaski Products, Inc., including its related companies (“Mt. Pulaski”). Mt. Pulaski supplies products used in various industrial applications including drilling fluids. Total consideration for this acquisition of approximately $10.4 million included $9.4 million in cash and 20,358 shares of W-H common stock. W-H recognized goodwill of $5.8 million related to this acquisition.
During 2005, W-H acquired Madden Systems, Inc. (“Madden”) to enhance the technology of W-H’s operating companies that offer wireline logging services. Total consideration for this acquisition of $3.5 million included $2.5 million in cash and 31,422 shares of W-H common stock. W-H recognized intangible assets of approximately $2.6 million, including trade secret technology of $2.1 million and goodwill of approximately $0.5 million.
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 consists of the following (in thousands):
The components of inventories are as follows (in thousands):
During the year ended December 31, 2006, one of W-H’s subsidiaries increased its inventory reserve due to changes in its valuation of slow-moving inventory items.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Net property and equipment consists of the following (in thousands):
Construction-in-progress relates to the construction of the Rocky Mountain region facilities and includes capitalized interest of approximately $0.2 million. Depreciation expense charged to operations totaled approximately $61.8 million, $55.4 million, and $44.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Other intangibles, included in other assets, net, consist of the following (in thousands):
Amortization expense charged to operations totaled approximately $0.9 million, $1.2 million, and $1.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Estimated aggregate amortization of intangible assets (in thousands) for the next 5 years is as follows:
Accrued liabilities consist of the following (in thousands):
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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, 2005 and 2006 were as follows (in thousands):
6.
Credit Facility:
W-H maintains a revolving credit facility with certain lenders to provide for its cash, liquidity and other borrowing needs. The credit facility provides for aggregate borrowings of up to $375.0 million and matures on May 5, 2010. As of December 31, 2006, W-H had an outstanding loan balance of $150.0 million and approximately $10.4 million in letters of credit issued under its credit facility, resulting in an available borrowing capacity on such date of approximately $214.6 million.
Amounts borrowed under the credit facility bear interest, at W-H’s election, at either a variable rate equal to LIBOR, plus a margin ranging from 1.0% to 2.0%, 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 zero to 1.0%, depending upon W-H’s leverage ratio. As of December 31, 2006, borrowings under the credit facility bore interest at approximately 6.4%.
The credit facility is secured by a lien on substantially all of W-H’s property and assets, a pledge of all 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, the credit facility is guaranteed by all of W-H’s domestic subsidiaries. The credit facility requires, among other things, that W-H maintain certain financial ratios, including a leverage ratio and an interest coverage ratio, and a specified net worth. The credit facility 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 of W-H to pay dividends and the ability of W-H to engage in certain business combination transactions. As of December 31, 2006, W-H is in compliance with the financial ratios and other limitations of the credit facility.
W-H entered into its credit facility in June 2004. W-H entered into a first amendment to its credit facility in May 2005 and a second amendment in February 2006. Financing costs associated with W-H’s original credit facility of approximately $1.6 million and financing costs associated with the first amendment of approximately $1.0 million will be ratably amortized to interest expense over the five year term of the credit facility. As a result of the repayment of W-H’s previous credit facility, W-H wrote off approximately $3.1 million in non-cash financing costs to interest expense during 2004. This amount represented financing costs that previously had been deferred.
7.
Interest Rate Swap Agreements
On May 18, 2005, W-H entered into interest rate swap agreements with a total notional amount of $150.0 million related to its credit facility. Under these agreements, W-H receives interest at a floating rate equal to three month LIBOR and pays interest at a fixed rate of 4.24%. The interest rate swap agreements have been designated as and qualify as cash flow hedging instruments. The interest rate swap agreements are fully effective,
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and have resulted in no gain or loss due to ineffectiveness being recorded in net income in the Consolidated Statement of Operations and Comprehensive Income. For the years ended December 31, 2006 and 2005, W-H recognized net gains of $1.2 million and net losses of $0.5 million, respectively, to interest expense resulting from net payments to the swap counterparties. W-H has recorded the fair value of the interest rate swap agreements on its Consolidated Balance Sheet, which was in aggregate an asset of $3.7 million and $3.1 million at December 31, 2006 and 2005, respectively, based on the fair value of the instruments. As of December 31, 2006, W-H anticipates that approximately $1.6 million of this asset will be recognized as gains resulting in reductions to interest expense during 2007.
8.
Commitments and Contingencies
Operating Leases
W-H leases certain real property and automobiles under operating leases that expire at various dates through 2014. Additionally, W-H rents various equipment under short-term, cancelable arrangements. Rental expense under operating leases and short-term rentals was approximately $37.7 million, $25.5 million and $21.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. Future minimum lease payments under non-cancelable operating leases are as follows (in thousands):
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 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 and other key employees. The agreements are for original terms of two to three years and provide for severance pay upon the occurrence of certain events including 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 its 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 impact of negotiations, settlements, rulings, advice of legal counsel and events pertaining to a particular case. Litigation is inherently
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
unpredictable. Based upon information currently available, management believes that the ultimate liability with respect to these proceedings and claims will not materially affect W-H’s consolidated results of operations or financial position.
9.
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):
The total provision for income taxes differs from an amount computed at the statutory federal income tax rate as follows (in thousands):
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The significant components of the deferred tax assets and liabilities are as follows (in thousands):
U.S. deferred income taxes and related foreign dividend withholding taxes have not been provided on the 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, 2006, W-H had deferred tax assets of $6.2 million relating to $1.6 million of credit carry-forwards, $20.4 million of state net operating loss (“NOL”) carry-forwards and $16.3 million of foreign NOL carry-forwards. Foreign losses do not expire. State NOL carry-forwards expire beginning in 2007 until 2021. 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, 2006, the valuation allowance relates principally to foreign NOL’s. The valuation allowance increased approximately $1.4 million in 2006, increased approximately $0.3 million in 2005, and decreased approximately $2.0 million in 2004. The $2.0 million decrease in 2004 was primarily due to release of the valuation allowance on the federal NOL and foreign tax credits. The increase in 2005 and 2006 related principally to amounts provided on foreign NOL’s in jurisdictions where management does not believe W-H will be able to utilize the losses 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
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
becomes available. As of December 31, 2006 and 2005, amounts reserved for such contingencies were $6.2 million and $5.2 million, respectively.
10.
Related-Party Transactions
One of W-H’s subsidiaries leases its facilities from a W-H officer. For each of the years ended December 31, 2006, 2005 and 2004, W-H paid the officer $108,000 for such annual lease costs.
An additional W-H subsidiary leases its facilities from a company that is partially owned by a W-H officer. For the years ended December 31, 2006, 2005 and 2004, W-H paid the company approximately $372,000, $312,000 and $90,000, respectively for such annual lease costs.
W-H’s Chairman, President and Chief Executive Officer is the owner of a publishing company which made payments to W-H of approximately $59,000, $42,000 and $38,000 for the years ended December 31, 2006, 2005 and 2004, respectively, primarily for rental of office space.
11.
Shareholders’ Equity
Stock options
On May 10, 2006, W-H’s shareholders approved W-H’s 2006 Stock Awards Plan (the “2006 Plan”). Under the 2006 Plan, W-H may grant equity-based awards including stock options, stock appreciation rights, restricted stock, restricted stock units, performance units and other stock-based awards. An aggregate of 1,100,000 shares of W-H’s common stock are reserved for issuance under the plan, subject to adjustments as described in the plan. The number of shares reserved for issuance will be reduced only by the number of shares of common stock delivered in payment or settlement of awards. Any shares of common stock issued in connection with restricted stock, restricted stock units, performance units or other full value awards will count against the limit of reserved shares as 1.7 shares of common stock for every one share of common stock issued. Shares of common stock issued in connection with other types of awards will be counted against the limit of reserved shares as one share of common stock for every one share of common stock issued. Each award granted under the 2006 Plan is subject to such terms and conditions as the compensation committee of W-H’s Board of Directors may approve.
Under the 2006 Plan, W-H is no longer permitted to issue new awards under its 1997 Stock Option Plan (the “1997 Plan”). As of December 31, 2006, options to purchase 1,606,904 shares of W-H’s common stock were outstanding under the 1997 Plan. 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 their respective grant dates. The terms of each option also provide that if an optionee’s employment terminates for any reason, the option may be exercised during the three-month period following such termination, but only to the extent vested at the time of such termination.
On March 29, 1999, prior to its initial public offering, W-H issued options to purchase 900,900 shares of W-H’s common stock 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, 2006, the remaining unexercised options to purchase 345,000 shares of common stock were vested.
As of December 31, 2006, there was approximately $5.6 million of total unrecognized compensation cost related to nonvested stock option awards that is expected to be recognized over a weighted-average period of 1.8 years. The intrinsic value for stock options is defined as the difference between the current market value and the grant price. During the year ended December 31, 2006, cash received from options exercised was approximately $17.4 million, and the excess tax benefit from share-based compensation totaled approximately $13.3 million.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of W-H’s stock option activity for the three years ended December 31, 2006 is as follows:
The following table summarizes information about stock options outstanding at December 31, 2006:
Restricted Stock
On May 31, 2006, W-H awarded a total of 117,000 shares of restricted stock under the 2006 Plan to certain employees and directors. The restricted stock vests ratably over a four-year period, commencing on the grant date, in 25% increments after each year of service has been completed. The fair value of the restricted stock issued was approximately $6.6 million, and is being recognized as compensation expense over the four-year vesting period. 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. For the years ended December 31, 2006, 2005 and 2004, W-H recognized $1.2 million, $0.5 million and $0.5 million in compensation expense relating to restricted stock awards.
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of W-H’s restricted stock from December 31, 2005 to December 31, 2006 is as follows:
The total grant-date fair value of restricted stock vested during the year ended December 31, 2006 was approximately $0.4 million. As of December 31, 2006, there was approximately $5.7 million of total unrecognized compensation cost related to nonvested restricted stock awards that is expected to be recognized over a weighted-average period of 3.4 years.
12.
401(k) Plan
W-H maintains a 401(k) plan that enables employees to defer up to specified percentages of their annual compensation and contribute such amount to the plan. 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 $4.8 million, $2.7 million and $2.2 million for the years ended December 31, 2006, 2005 and 2004, respectively.
13.
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: (1) drilling related products and services and (2) 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 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 select international areas. This segment includes the following business lines: (1) logging-while-drilling; (2) measurement-while-drilling; (3) directional drilling; (4) down-hole drilling motors; (5) drilling fluids and (6) rental tools.
Completion and Workover Related Products and Services
The completion and workover segment provides products and services primarily to customers onshore in the United States and offshore in the Gulf of Mexico. These products and services include: (1) cased-hole wireline logging, perforating, tubing conveyed perforating and associated rental equipment; (2) coiled tubing; (3) completion fluids and (4) rental tools.
W-H ENERGY SERVICES, INC.
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, 2006:
As of and for the year ended December 31, 2005:
As of and for the year ended December 31, 2004:
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)
The following presents property and equipment, net, by geographic region (in thousands):
14.
Interim Financial Information (Unaudited)
The following is a summary of consolidated interim information for the years ended December 31, 2006 and 2005 (amounts in thousands, except per share data):
W-H ENERGY SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
15.
Subsequent Events
On January 18, 2007, W-H acquired a distributor of drilling fluids products for cash consideration of approximately $4.9 million. On February 15, 2007, W-H acquired a directional drilling company for total consideration of approximately $14.7 million including cash of $10.8 million and 90,556 shares of W-H common stock.
On February 7, 2007, W-H awarded a total of 52,000 shares of restricted stock under the 2006 Plan to certain employees, including 20,000 shares awarded to W-H’s Chairman, President and Chief Executive Officer. The fair value of the restricted stock issued was approximately $2.3 million and will be recognized as compensation expense over the vesting periods ranging from 31 months to 48 months.
EXHIBIT INDEX
*
filed herewith