ITEM 1. BUSINESS.
Background
Tesco Corporation (“TESCO” or the “Company”) is a global leader in the design, manufacture and service delivery of technology based solutions for the upstream energy industry. We seek to change the way people drill wells by delivering safer and more efficient solutions that add real value by reducing the costs of drilling for and producing oil and gas. Our product and service offerings include proprietary technology, including TESCO CASING DRILLING® (“CASING DRILLING”), TESCO’s Casing Drive System (“CDS™” or “CDS”) and TESCO’s Multiple Control Line Running System (“MCLRS™” or “MCLRS”). TESCO® is a registered trademark in Canada and the United States. TESCO CASING DRILLING® is a registered trademark in the United States. CASING DRILLING® is a registered trademark in Canada and CASING DRILLING™ is a trademark in the United States. Casing Drive System™, CDS™, Multiple Control Line Running System™ and MCLRS™ are trademarks in Canada and the United States.
TESCO was created on December 1, 1993 through the amalgamation of Shelter Oil and Gas Ltd., Coexco Petroleum Inc., Forewest Industries Ltd. and Tesco Corporation. The amalgamated corporation continued under the name Tesco Corporation, which is organized under the laws of Alberta; Canada. Unless the context indicates otherwise, a reference in this Form 10-K to “TESCO”, “the Company”, “we” or “us” includes Tesco Corporation and its subsidiaries.
Our principal executive offices are located at 3993 West Sam Houston Parkway North, Suite 100, Houston, Texas 77043; our telephone number is (713) 359-7000; and our Internet website address is www.tescocorp.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and all amendments thereto, are available free of charge on our Internet website. These reports are posted on our website as soon as reasonably practicable after such reports are electronically filed in the United States (“U.S.”) with the U.S. Securities and Exchange Commission (“SEC”) and in Canada on the System for Electronic Document Analysis and Retrieval (“SEDAR”). Our Code of Conduct Policy is also posted on our website. Our common stock is traded on the Nasdaq Global Market under the symbol “TESO.” Until June 30, 2008, TESCO’s common stock was also traded on the Toronto Stock Exchange (“TSX”) under the symbol “TEO.” Effective June 30, 2008, we voluntarily delisted our shares from the TSX.
Reporting
By the end of 2006, we determined that we no longer qualified for foreign private issuer status related to periodic reporting of our financial results with the SEC. As a result, we were required to prepare and file our Annual Report on Form 10-K reporting our annual results for the year ended December 31, 2006 and file quarterly reports on Form 10-Q for our quarterly results thereafter. Also, at December 31, 2006, we began reporting our results in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Through December 31, 2007, we filed our financial statements with a reconciliation of our financial statements under U.S. GAAP to Canadian generally accepted accounting principles. This reconciliation is not included in the financial statements for the year ended December 31, 2008, as it is no longer required by Canada’s National Instrument 52-102, “Continuous Disclosure Obligations.” Although we are a U.S. registrant with the SEC, we are still organized under the laws of Alberta and are therefore subject to the Business Corporation Act (Alberta). We are also a reporting issuer (or the equivalent) in each of the provinces of Canada and are subject to securities legislation in each of those jurisdictions.
Effective January 1, 2006, we adopted the U.S. dollar as our reporting currency since a majority of our revenue is closely tied to the U.S. dollar, and reporting our results in U.S. dollars facilitates comparability to other oil and gas service companies. Unless indicated otherwise, all amounts stated in this Form 10-K are denominated in U.S. dollars. All references to US$ or to $ are to U.S. dollars and references to C$ are to Canadian dollars.
Index to Financial Statements Changing the reporting currency affects the presentation in our Consolidated Financial Statements, but not the underlying accounting records, which are maintained in the functional currency of our business units. The functional currency for our Canadian operations is the Canadian dollar; however the U.S. dollar became the functional currency in all other regions, effective January 1, 2006. The financial results for our Canadian operations have been translated into U.S. dollars as described in Note 2 of the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Segments
Our four business segments are: Top Drive, Tubular Services, CASING DRILLING and Research and Engineering. Historically, the Company organized its activities into three business segments: Top Drives, Casing Services and Research and Engineering. Effective December 31, 2008, we determined that the CASING DRILLING segment no longer met the criteria which allowed it to be aggregated with the Tubular Services segment and therefore changed the presentation of its Tubular Services activities and CASING DRILLING activities into two separate segments and the financial and operating data for the years ended December 31, 2006 through 2008 have been recast to be presented consistently with this structure.
The Top Drive business is comprised of top drive sales, top drive rentals and after-market sales and service. The Tubular Services business includes both our proprietary and conventional Tubular Services. The CASING DRILLING segment consists of our proprietary CASING DRILLING technology. The Research and Engineering (“R&E”) segment is comprised of our research and development activities related to our proprietary Tubular Services, CASING DRILLING technology and Top Drive model development. For financial information regarding each segment, including revenues from external customers and a measure of profit or loss, refer to Part II, Item 7 of this Form 10-K (Management’s Discussion and Analysis of Financial Condition and Results of Operation).
For segment operating results and geographic information, see Note 12 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Top Drive Segment
Our Top Drive segment sells equipment and provides services to drilling contractors and oil and gas operating companies throughout the world. We primarily manufacture top drives that are used in drilling operations to rotate the drill string while suspended from the derrick above the rig floor. We also provide rental top drives on a day-rate basis for land and offshore drilling rigs, and we provide after-market sales and support for our customers.
We offer for sale a range of portable and permanently installed top drive products that includes both hydraulically and electrically powered machines capable of delivering 400 to 1,350 horsepower, with a rated lifting capacity of 150 to 650 tons. With each top drive we sell, we offer the services of top drive technicians who provide customers with training, installation and support services. In response to market demand and requests from a specific client, in 2006 we commercialized a new alternating current (“AC”) electric top drive model, the EMI400, available with 150 and 250 ton load path configurations. A growing need for high performance, compact electric top drives installed on late-generation automated drilling rigs provided significant opportunity for the EMI machine. The EMI machine utilizes more standard commercial AC induction drive technology, allowing the end user to specify its preferred power electronics and motor combination and permitting us to select components from a larger vendor base.
In further response to market demand we developed two new compact top drive drilling systems: the hydraulic HXI system and the AC electric EXI system. We developed the HXI machine to meet demands from both our third party, largely drilling contractor client base and our rental fleet needs. The HXI is a new generation of our current hydraulic HMI system, incorporating a full suite of operational features and providing a
Index to Financial Statements
significant gain in performance at the quill. The HXI machine has a load path rating of 250 tons and has a 700 horsepower self-contained diesel driven hydraulic power unit. The EXI system is a completely new design and offers a full suite of operational features. We developed the EXI system in response to market demands for a high performance compact electric top drive system, commonly required on modern fast moving rigs frequently used in pad drilling operations. The EXI system has a load path rating of 350 tons, generates 600 horsepower at the quill and uses commercial AC induction drive technology, allowing for ease in rig interface and permitting the selection of components from a broad range of power electronics providers. We first commercialized the EXI and HXI machines in 2007 and they are now part of our standard global products offering.
During 2008, we commenced a revitalization project of our rental top drive fleet. We added 34 new HXI machines to our fleet during the year, in addition to selling them to our traditional customer base. We continue to offer the EXI system as a sale item only.
We also provide rental top drives on a day-rate basis for land and offshore drilling rigs, offering a range of systems that can be installed in practically any mast configuration, including workover rigs. Our rental fleet is composed principally of hydraulically powered top drive systems, with power ratings of 460 to 1,205 horsepower and load path ratings of 150 to 650 tons, each equipped with its own independent diesel engine driven hydraulic power unit. This unique combination permits a high level of portability and installation flexibility. Additionally, we have introduced our ECI top drive systems as a rental offering in the Western Europe/North Sea market.
Our top drive rental fleet is deployed strategically around the world to be available to customers on a timely basis. Top drive rental revenue from our customers was $112.0 million in 2008, $109.7 million in 2007 and $101.9 million in 2006. The geographic distribution of the 126-unit fleet at December 31, 2008 included the following regions (in order of the size of our rental fleet in each region): the United States, South America, Mexico, Asia Pacific, Canada, Russia and the Middle East. We expect international demand for our rental top drives to sustain better than U.S. demand in the near term. Thus, we may shift the location of our fleet units during 2009 to meet market demand, and will do so in a manner that minimizes disruptions to our rental operations.
We also provide top drive after-market sales and support to our customers on an ongoing basis and maintain regional stocks of high-demand parts, as well as trained field and shop service personnel to support both our own rental units and units owned by our customers.
Tubular Services Segment
Our Tubular Services business segment includes a substantial suite of proprietary offerings, as well as conventional casing and tubing running services. We offer our tubular services under the brand name Azimuth Tubular Services. Casing is steel pipe that is installed in the well bore of oil, gas or geothermal wells to maintain the structural and pressure integrity of the well bore, isolate water bearing surface sands, prevent communication between subsurface strata, and provide structural support of the wellhead and other casing and tubing strings in the well. Most operators and drilling contractors install casing using specialized service companies, like ours, who use specialized equipment and personnel trained for this purpose. Wells can have from 2 to 10 casing strings installed of various sizes.
We have expanded our presence in the tubular services market over the past several years. The first was the development of our proprietary technology, primarily Proprietary Casing Running Service (“PCRS”), which uses certain components of our CASING DRILLING technology, in particular the Casing Drive System (“CDS”), to provide a safer and more automated method for running casing and, if required, reaming the casing into the hole. The CDS is a tool which facilitates running and reaming casing into a well bore on any rig equipped with a top drive. PCRS can be used with any top drive and offers improved safety and efficiency over traditional methods by eliminating operations that are associated with high risk of personal injury. PCRS also increases the likelihood that the casing can be run to casing point on the first attempt, offers the ability to simultaneously rotate,
Index to Financial Statements
reciprocate and circulate the casing string as required, and requires fewer people on the rig for casing running operations. PCRS was initially launched in Canada in 2002, and has since expanded into our other regional markets.
These jobs encompass wells from vertical holes to high angle extended reach wells and include both onshore and offshore applications. We also offer installation service of deep water smart well completion equipment using our MCLRS (Multiple Control Line Running System) proprietary and patented technology. We believe this technology substantially improves the quality of the installation of high-end well completions.
During the second half of 2007, we acquired four businesses that provide conventional casing running and tubular services. One of these businesses was based in Colorado and serviced the Rockies region, including the Piceance basin, and the remaining three businesses were based in Alberta, Canada and serviced the northwest Alberta and northeast British Columbia regions. The combined purchase price of these acquisitions was approximately $21.5 million. All of these acquisitions were funded by draws under our revolving credit facility. These acquisitions expand and strengthen our position in these growing regions and provide expansion opportunities for our tubular service offerings. For a description of these acquisitions, see Note 4 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
CASING DRILLING Segment
Effective December 31, 2008, we began reporting our CASING DRILLING operations as a distinct operating segment. CASING DRILLING is a revolutionary method for drilling wells which allows them to be drilled with conventional oilwell casing, but in a manner that reduces both drilling time and the chance of unscheduled drilling events. CASING DRILLING also minimizes the use of conventional drill pipe and drill collars and the problems associated with their use.
In conventional drilling, the entire string of drill pipe must be removed from the hole each time a drill bit or item of downhole equipment must be replaced. To “trip” or remove and reconnect the drill pipe is a time-consuming process which leaves the hole exposed to a variety of potential well bore integrity problems. With CASING DRILLING, the well is not drilled with drill pipe; instead, it is drilled with the same standard oilwell casing that is normally inserted in the hole after completion of conventional drilling. The CASING DRILLING bottomhole assembly, comprising the drill bit and other downhole tools, such as drilling motors, rotary steerable drilling systems, measurement-while-drilling equipment and logging-while-drilling apparatus, are lowered on wireline, drill pipe or a tubing string inside the casing and latched to the bottom joint of casing, retaining the ability to maintain the circulation of drilling fluid at all times. In certain applications, the CASING DRILLING bottomhole assembly can be conveyed into the wellbore by use of the rig’s mud pumps. Tools are recovered in a similar fashion, by use of wireline, or alternatively drill pipe or a tubing string. Since the casing remains on bottom in the well at all times, wellbore integrity is preserved, and the risk of a well control incident is reduced. Because the well is cased as it is drilled, the potential for unintentional sidetracking is significantly reduced. The risk of tool loss in the hole is also reduced.
We began to provide CASING DRILLING as a fully commercial service in 2002 using specially designed rigs, through drilling service contracts with oil and gas operators. By the end of 2006, we sold all of our interests and obligations in rigs and changed our focus to providing CASING DRILLING services as our revenue stream. Through the end of 2008, we have drilled approximately 500 wells and 3 million feet of hole using this proprietary technology. Through the end of 2008, we have participated in the drilling of 21 wells where CASING DRILLING was used in conjunction with industry standard rotary steerable directional drilling technology. We anticipate that the integration of these technologies will develop into a valuable offering to the industry, particularly for high-end offshore applications.
Index to Financial Statements In 2005, we decided to discontinue providing CASING DRILLING services as a rig contractor and focus on providing CASING DRILLING project management services. As a result, we sold our drilling rigs in December 2005 and returned our leased rigs in late 2006. During 2007 and 2008, we did not provide CASING DRILLING services as a rig contractor, and we currently do not own or lease any drilling rigs.
Research and Engineering Segment
As a technology driven company, we continue to invest significantly in research and development activities, primarily related to our proprietary technologies in Tubular Services, CASING DRILLING and top drive model development.
Raw Materials
We procure raw materials and components from many different vendors located throughout the world. A portion of these components are electrical in nature, including permanent magnet motors, induction motors and drives. We also purchase hydraulic components, such as motors, from certain suppliers located in the United States. In order to manufacture many of our proprietary parts, we require substantial quantities of steel. During 2008, we experienced substantial inflationary pressure on steel, machined products and fabrications for our top drives. However, during 2008 we initiated a program to expand our sourcing of steel, machined products and fabrications from regions outside of North America, and entered into supply contracts in an effort to lower our manufacturing costs and reduce exposure to fluctuations in commodity pricing and labor, and to gain improvements in the manufacturing process.
We select our component sources from, and establish supply relationships with, vendors who are prepared to develop components and systems that allow us to produce high performance, reliable and compact machines. For both our electric and hydraulic top drive systems we source key components, such as AC motors, power electronics, and hydraulic systems, from vendors who have developed these components for commercial, often non-oilfield applications, and who have adapted them for service conditions specific to our applications. Consequently, our ability to maintain timely deliveries and to provide long term support of certain models may depend on the supply of these components and systems.
We manufacture six distinct model series of top drive systems, using hydraulic, permanent magnet AC and induction AC technology. We believe that we are industry leaders in the development and provision of permanent magnet technology in both portable and permanently installed top drive systems. This technology provides very high power density, allowing for high performance and low weight. In smaller horsepower systems, we use AC induction technology and late generation power electronics. As a result of the customized nature of the motors used in our top drive products, our ability to supply certain of our AC electric top drive models depends upon the supply of certain AC motors and variable frequency drive technology obtained from a specific manufacturer. We attempt to minimize this with the development of supply agreements to maintain acceptable levels of ready components.
Seasonality
Our top drive rental business is subject to seasonal cycles, associated with winter-only, summer-only, dry-season or regulatory-based access to drilling locations. The most significant of these occur in Canada and Russia, where traditionally the first and fourth calendar quarters of each year are the busiest as the contractor fleet can access drilling locations that are only accessible when frozen. However, we feel we have limited exposure to this issue because as of December 31, 2008, approximately 10% of our top drive rental fleet operated in Canada and Russia.
In certain Asia Pacific and South American regions, we are subject to decline in activities due to seasonal rains. Further, seasonal variations in the demand for hydrocarbons and accessibility of certain drilling locations
Index to Financial Statements
in North America can affect our business, as our activity follows the active drilling rig count reasonably closely. We actively manage our highly mobile rental fleet around the world to minimize the impact of geographically specific seasonality.
Our Tubular Services and CASING DRILLING businesses are subject to seasonal cycles, primarily associated with winter-only, summer-only, dry-season or regulatory-based access to drilling locations. In Canada, many drilling locations are inaccessible except when frozen. In certain of our Asia Pacific and South American operations, we are subject to decline in activities due to seasonal rains.
Inventory
Our current manufacturing capacity has been expanded to meet our customer and internal demand and allows us to build 12 to 16 top drive units per month, depending on system complexity. The resulting increase in top drive units sold to customers has increased our installed base throughout the world, which has provided expansion opportunities for our after-market sales and service business. Additionally, with the exception of one major customer, we have seen a shift in market demand to larger, more complex units. More recently, during 2008 and in response to customer demand, we increased our production and sales of smaller top drive units that offer higher portability. We believe that our top drive business needs to maintain manufacturing inventory of two quarters of production to limit our exposure in the event that the sales market softens and allows us to effectively manage our supply chain and workforce. In addition, we must maintain additional inventory of long lead time items and semi-finished goods to support our after-market sales and service business and our manufacturing operations. In 2006, we initiated a Sales and Operational Planning program to balance market demand with inventory and our ability to supply top drives. In mid-2008, we initiated a Global Distribution Center (“GDC”) in order to more closely monitor our global parts inventory and to provide our operating locations with a centralized purchasing center. We believe the GDC will improve our purchasing power with suppliers and allow us to provide inventory parts to our customers around the world in a more expedient manner.
Although we manufacture the proprietary equipment used to provide CASING DRILLING and Tubular Services, these segments do not require levels of inventory and working capital as high as those required for the Top Drive segment.
Customers
Our customers for top drive sales and after-market sales and service include drilling contractors, rig builders and equipment brokers and occasionally, major and independent oil and gas companies and national oil companies who wish to own and manage their own top drive systems. Our customers for our rental fleet include drilling contractors, major and independent oil and gas companies and national oil companies. Demand for our top drive products depends primarily upon capital spending of drilling contractors and oil and gas companies and the level of drilling activity. Our top drive business is distributed globally with 55% of our top drive revenues generated in the North American markets (excluding Mexico) and 45% in international markets.
Our Tubular Services and CASING DRILLING customers also primarily consist of oil and gas operating companies, including major and independent companies, national oil companies and, on occasion, drilling contractors that have contractual obligations to provide tubular running and handling services. Demand for our Tubular Services and CASING DRILLING services strongly depends upon capital spending of oil and gas companies and the level of drilling activity. Our CASING DRILLING business is distributed globally: Approximately 58% of our 2008 CASING DRILLING revenues were generated in North American markets (excluding Mexico) and 42% were from international markets. Our Tubular Services business is primarily focused in the North American markets (excluding Mexico) where 78% of our 2008 Tubular Services revenues were generated with the remaining 22% from international markets.
Backlog
We believe top drive backlog is a leading indicator of how our business will be affected by changes in the global macro-economic environment. We consider a product sale order as backlog when the customer has signed
Index to Financial Statements
a purchase contract, submitted the purchase order and, if required by the purchase agreement, paid a non-refundable deposit. We experienced a strong order rate in 2008 and ended the year with a backlog of 65 top drive units, with a total value of $56.9 million, compared to a backlog of 38 units at December 31, 2007, with a total value of $39.2 million. Based upon the most recent changes in the economy, we expect a slower order rate in 2009 compared to our 2008 sales of 118 units. Over the last three years, our average revenue per top drive unit sale has increased due to a shift in market demand to larger, more complex units. However, we have recently seen an increase in the demand for smaller top drive units typically required for fast-moving new build rigs. We believe that for our top drive business, a backlog of two quarters of production is reasonable and allows us to effectively manage our supply chain and workforce, yet be responsive to our client base.
Revenue from services is recognized as the services are rendered, based upon agreed daily, hourly or job rates. Accordingly, we have no backlog for services.
Competitive Conditions
We were the first top drive manufacturer to provide portable top drives for land drilling rigs, thereby accelerating the growth of the onshore top drive market. According to recent industry data, approximately 60% of land drilling rigs are currently equipped with top drive systems, including the former Soviet Union and China where few rigs operate with top drives today. By contrast, approximately 95% of offshore rigs are equipped with top drives. In our estimation, significant further market potential exists for our top drive drilling system technology, including both portable and permanently installed applications. Further, where many top drive systems approach the end of their useful lives and are inefficient or may not have legacy parts available, we believe a market for replacement systems will be created. This represents an important opportunity for us.
Our top drives offer portability and flexibility, permitting drilling companies to conduct top drive drilling for all or any portion of a well. Our electric top drive systems utilize late-generation alternating current technology and a computerized Programmable Logic Control (“PLC”) system. The non-sparking and lightweight permanent magnet technology employed in our larger, high horsepower systems represents a significant technological advancement over more conventional electric top drives.
Our primary competitors in the sale of top drive systems are National Oilwell Varco, Inc. (“NOV”) and Canrig Drilling Technology Ltd., a subsidiary of Nabors Industries Ltd. We have the second largest third party installed base and are the number two global provider of top drives, following NOV in both measures. Of the three major top drive system providers, we are the only company that maintains a sizeable fleet of assets solely for the purposes of rental. Competition in the sale of top drive systems takes place primarily on the basis of the features and capacities of the equipment, the quality of the services and technical support offered, delivery lead time and, to a varying extent, price.
The conventional tubular services market consists principally of several large, global operators and a large number of small and medium-sized operators that typically operate in limited geographic areas where the market is highly fragmented. We have combined the purchased conventional businesses with our PCRS offering and deliver all tubular services through the Azimuth Tubular Services brand name. Our Azimuth business represents a significant entry into the global tubular services market. The largest global competitors in this market are Weatherford International, Ltd. (“Weatherford International”), Franks International, Inc. (“Franks”) and BJ Services Company. We estimate that we are the third largest provider of services in the global tubular services market based on revenue, with a market share of approximately 10%. Competition in the conventional tubular services market takes place primarily on the basis of the quality of the services offered, the quality and utility of the equipment provided, the proximity of the service provider and equipment to the work site and, to a certain extent, on price.
We are not currently aware of any commercially or technically viable direct competition for our proprietary CASING DRILLING retrievable process, services or products, although several of our competitors are known to
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have developed prototypes that are similar, and in some cases have deployed them in a field environment. We continue to be the only company offering customers a broad range of tool sizes and the possibility of using casing to drill directional wells combined with costly downhole equipment, while providing assurance that such equipment can readily be retrieved when the drilling is complete.
We believe the primary competition to our CASING DRILLING process is the traditional drill pipe drilling process and to a lesser extent other methods for casing while drilling that do not involve a retrievable bottom hole assembly. Such alternative methods of casing while drilling offer limited applications because of the cutting structure, and they cannot be combined with directional tools which facilitates the drilling of directional (i.e. non-vertical) wells. While we offer such alternative (i.e. non-retrievable) methods in addition to our proprietary CASING DRILLING process, we believe Weatherford International has the largest share of the non-retrievable portion of the market, although Baker Hughes is supplying an increasing number of EZCase™ bits (a trademark held by Baker Hughes) which our CASING DRILLING team is using on behalf of the operators.
We are aware of competitive technology similar to our Casing Drive System (“CDS”). We believe that we continue to be the market leader in this technology, based on our market share. Other companies offering similar technology include NOV, Weatherford International and Franks. Our CDS system is unique in its ability to be easily and quickly installed on any top drive system and we have the advantage of being able to offer skilled and trained personnel at the field level who have a specialized knowledge of top drive drilling system operations.
Intellectual Property
We pursue patent protection in appropriate jurisdictions for the innovations that have significant potential application to our core businesses. We hold patents and patent applications in the United States, Canada, Europe, Norway, and various other countries. We also hold rights, through patent license agreements, to other patented and/or patent pending technologies. Our patent portfolio currently includes 92 issued patents and in excess of 100 pending patent applications.
We generally retain all intellectual property rights to our technology through non-disclosure and technology ownership agreements with our employees, suppliers, consultants and other third parties with whom we do business.
The overall design of our portable top drive assembly is protected by patents that will continue in force for several more years. Various specific aspects of the design of the top drive and related equipment are also patented, including the torque track system that improves operational handling by absorbing the torque generated by our top drive.
Our CASING DRILLING method and retrievable apparatus are protected by patents that will continue in force for several more years. In addition, we have patents that protect the combination of the retrievable drill bit assembly with a rotary steerable tool. Our CDS is protected by patents on some of the gripping tools and on the “link tilt” system, which is a method used to handle casing.
We hold numerous patents related to the installation and utilization of certain accessories for casing for purposes of casing rotation. Various other related methods and tools are patent protected as well.
Please see Part I, Item 1A.
ITEM 1A. RISK FACTORS.
Our business, financial condition, results of operations and cash flows are subject to various risks, including the following:
The volatility and disruption of the capital and credit markets and adverse changes in the global economy may negatively impact our revenue, cash flows and earnings, and our ability to access financing.
The capital and credit markets have been experiencing extreme volatility and disruption for more than 12 months. Recent events have paralyzed credit markets and sparked a serious global banking crisis. Many economists foresee a slow and uncertain recovery of credit markets, and an emerging global recession.
While we intend to finance our operations with existing cash, cash flow from operations and borrowing under our existing credit facility, we may require additional financing to support our continued growth. However, due to the existing uncertainty in the capital and credit markets, access to capital may be limited on terms acceptable to us or at all.
Furthermore, many of our customers access the credit markets to finance their oil and natural gas drilling and production activity. Therefore, our customers may also reduce their drilling activity as a result of the current crisis in the global credit market. Companies that planned to finance exploration or development projects through the capital markets may be forced to curtail, reduce, postpone or delay drilling activity, and also may experience an inability to pay suppliers, including us. Such reductions or delays could negatively impact our revenues, cash flows and earnings.
The deteriorating global economic environment may impact industry fundamentals, and the potential decrease in demand for drilling rigs could cause the oil and gas industry to cycle into an extended downturn. Such a condition could have a material adverse impact on our business.
An extended deterioration in the global economic environment may impact fundamentals that are critical to our industry, such as the global demand for, and consumption of, oil and natural gas. Reduced demand for oil and natural gas generally results in lower oil and natural gas prices and may impact the economics of planned drilling projects, resulting in curtailment, reduction, delay or postponement for an indeterminate period of time. Any prolonged reduction in oil and natural gas prices will reduce oil and natural gas drilling and production activity and result in a corresponding decline in the demand for our products and services, which could adversely affect the demand for sales or rentals of our top drive units and for our Tubular Services and CASING DRILLING businesses.
Fluctuations in the demand for and prices of oil and gas could negatively impact our business.
Fluctuations in the demand for and prices of oil and gas impact the levels of drilling activity by our customers and potential customers. The prices are primarily determined by supply, demand, government regulations relating to oil and gas production and processing, and international political events, none of which can be accurately predicted. In times of declining activity, not only is there less opportunity for us to sell our products and services but there is increased competitive pressure that tends to reduce prices and therefore margins.
We face risks due to the cyclical nature of the energy industry and the corresponding credit risk of our customers.
Changing political, economic or military circumstances throughout the energy producing regions of the world can impact the market price of oil and gas for extended periods of time. As most of our accounts receivable are with customers involved in the oil and gas industry, any significant change in such circumstances could result in financial exposure in relation to affected customers.
Index to Financial Statements Any significant consolidation or loss of end-user customers could have a negative impact on our business.
Exploration and production company operators and drilling contractors have undergone substantial consolidation in the last few years. Additional consolidation is probable. In addition, many oil and gas properties could be transferred over time to different potential customers.
Consolidation of drilling contractors results in fewer end-users for our products and could result in the combined contractor standardizing its equipment preferences in favor of a competitor’s products.
In addition, merger activity among both major and independent oil and gas companies also affects exploration, development and production activity, as these consolidated companies attempt to increase efficiency and reduce costs. Generally, only the more promising exploration and development projects from each merged entity are likely to be pursued, which may result in overall lower post-merger exploration and development budgets. Moreover, some end-users prefer not to use relatively new products or premium products in their drilling operations.
The occurrence or threat of terrorist attacks could materially impact our business.
The occurrence or threat of future terrorist attacks could adversely affect the economies of the United States and other developed countries. A lower level of economic activity could result in a decline in energy consumption, which could cause a decrease in spending by oil and gas companies for exploration and development. In addition, these risks could trigger increased volatility in prices for crude oil and natural gas which could also adversely affect spending by oil and gas companies. A decrease in spending for any reason could adversely affect the markets for our products and thereby adversely affect our revenue and margins and limit our future growth prospects. Moreover, these risks could cause increased instability in the financial and insurance markets and adversely affect our ability to access capital and to obtain insurance coverage that we consider adequate or are required to obtain by our contracts with third parties.
Our revenues and earnings are subject to fluctuations period over period and are difficult to forecast.
Our revenues and earnings may vary significantly from quarter to quarter depending upon:
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the level of drilling activity worldwide, as well as the particular geographic focus of the activity;
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the variability of customer orders, which are particularly unpredictable in international markets;
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the levels of inventories of our products held by end-users and distributors;
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the mix of our products sold or leased and the margins on those products;
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new products offered and sold or leased by us or our competitors;
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weather conditions or other natural disasters that can affect our operations or our customers’ operations;
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changes in oil and gas prices and currency exchange rates, which in some cases affect the costs and prices for our products;
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the level of capital equipment project orders, which may vary with the level of new rig construction and refurbishment activity in the industry;
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changes in drilling and exploration plans which can be particularly volatile in international markets;
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the variability of customer orders or a reduction in customer orders, which may leave us with excess or obsolete inventories; and
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the ability to manufacture and timely deliver customer orders, particularly in the top drive segment due to the increasing size and complexity of our models.
In addition, our fixed costs cause our margins to decrease when demand is low and service capacity is underutilized.
Index to Financial Statements Our debt and other financing obligations restrict our ability to take certain actions and require the maintenance of certain financial ratios; failure to comply with these requirements could result in acceleration of our debt.
Our debt and other financing obligations contain restrictive covenants. A breach of any of these covenants could preclude us or our subsidiaries from issuing letters of credit, from borrowing under our credit agreements and could accelerate our debt and other financing obligations and those of our subsidiaries. If this were to occur, we might not be able to repay such debt and other financing obligations.
Additionally, our credit agreements are collateralized by equity interests in our subsidiaries. A breach of the covenants under these agreements could permit the lenders to exercise their rights to foreclose on these collateral interests.
We have outstanding debt that is not contracted at market rates.
Our credit facility contains provisions for interest rates on borrowings and commitment fees that were established prior to the credit crisis and probably could not be replaced at the same value in today’s market. If we needed to replace our credit facility in today’s uncertain bank loan market, for any reason, including an event of default on our part, we may be unable to negotiate lending terms at the same rates, or for the same borrowing capacity, that we currently hold. Any change in the terms of our fees or borrowing capacity could adversely affect our liquidity and results of operations.
At this time it is difficult to forecast the future state of the bank loan market. As a result of the uncertain state of various financial institutions and the credit markets generally, we may be unable to maintain our current borrowing capacity in the event of bank or banks failure to fund any commitments under the current credit facility, and we may not be able to refinance our bank facility in the same amount and on the same terms as we currently hold, which could negatively impact our liquidity and results of operations.
We are exposed to risks associated with turmoil in the financial markets.
U.S. and global credit and equity markets have recently undergone significant disruption, making it difficult for many businesses to obtain financing on acceptable terms. In addition, equity markets are continuing to experience wide fluctuations in value. As a result, an increasing number of financial institutions and insurance companies have reported significant deterioration in their financial condition. If any of the significant lenders, insurance companies or other financial institutions are unable to perform their obligations under our credit agreements, insurance policies or other contracts, and we are unable to find suitable replacements on acceptable terms, our results of operations, liquidity and cash flows could be adversely affected. We also face challenges relating to the impact of the disruption in the global financial markets on other parties with whom we do business, such as our customers and vendors. The inability of these parties to obtain financing on acceptable terms could impair their ability to perform under their agreements with us and lead to various negative effects on the Company, including business disruption, decreased revenues and increases in bad debt write-offs. A sustained decline in the financial stability of these parties could have an adverse impact on our business and results of operations.
Concentration of our revenue and management in the United States involves risk.
In 2008 approximately 52% of our revenue was obtained from operations in the U.S. (compared to 61% during 2007). The concentration of revenue and management functions in the U.S. involves certain risks, including the following:
•
increased vulnerability to fluctuations in the U.S. economy; in particular, a severe economic downturn or prolonged recession in the U.S. could have a greater impact on our ability to do business than would otherwise be the case;
Index to Financial Statements
•
fluctuations in the valuation of the U.S. dollar during 2008, particularly in relation to the Canadian dollar, may negatively impact our financial results. Future devaluation of the U.S. dollar could increase our Canadian manufacturing costs and our cost of doing business outside of the U.S. in general and it may not be possible to raise the prices and rates we charge customers in U.S. dollars to compensate for these increased costs, or to hedge our exposure to devaluation of the U.S. dollar through currency swaps and other financial instruments; and
•
the U.S. limits the number of visas available to non-U.S. professionals and executives who wish to work in the U.S. The potential inability to obtain such a visa may prevent us from transferring our non-U.S. employees to the U.S., or may restrict our ability to recruit qualified international executives to fill management positions at our corporate headquarters.
Our foreign operations and investments involve special risks.
We sell products and provide services in parts of the world where the political and legal systems are very different from those in the United States and Canada. In places like Russia, Latin America, the Middle East and Asia/Pacific, we may have difficulty or extra expense in navigating the local bureaucracies and legal systems. We may face challenges in enforcing contracts in local courts or be at a disadvantage when we have a dispute with a customer that is an agency of the state. We may be at a disadvantage to competitors that are not subject to the same international trade and business practice restrictions that U.S. and Canadian law impose on us.
While diversification is desirable, it can expose us to risks related to cultural, political and economic factors of foreign jurisdictions which are beyond our control. As a general rule, we have elected not to carry political risk insurance against these risks. Such risks include:
•
loss of revenue, property and equipment as a result of hazards such as wars or insurrection;
•
the effects of currency fluctuations and exchange controls, such as devaluation of foreign currencies and other economic problems;
•
changes or interpretations in laws, regulations and policies of foreign governments, including those associated with changes in the governing parties, nationalization, and expropriation; and
•
protracted delays in securing government consents, permits, licenses, or other regulatory approvals necessary to conduct our operations.
We operate in an intensively competitive industry and if we fail to compete effectively our business will suffer.
Competitive risks may include decisions by existing competitors to attempt to increase market share by reducing prices and decisions by customers to adopt competing technologies. The drilling industry is driven primarily by cost minimization. Our strategy is aimed at reducing drilling costs through the application of new technology. Our competitors, many of whom have a more diverse product line and access to greater amounts of capital, have the ability to compete against the cost savings generated by our technology by reducing prices and by introducing competing technologies. Our competitors may also have the ability to offer larger bundles of products and services to customers that we do not offer. We have limited resources to sustain a prolonged price war and maintain the investment required to continue the commercialization and development of our new technologies.
To compete in our industry, we must continue to develop new technologies and products.
The markets for our products and services are characterized by continual technological developments and we have identified our products as providing technological advantages over other competitive products. As a result, substantial improvements in the scope and quality of product function and performance can occur over a
Index to Financial Statements
short period of time. If we are not able to develop commercially competitive products in a timely manner in response to changes in technology, our business may be adversely affected. Our future ability to develop new products depends on our ability to:
•
design and commercially produce products that meet the needs of our customers,
•
successfully market new products, and
•
obtain and maintain patent protection.
We may encounter resource constraints, technical barriers, or other difficulties that may delay introduction of new products and services in the future. Our competitors may introduce new products or obtain patents before we do and achieve a competitive advantage. Additionally, the time and expense invested in product development may not result in commercial applications.
For example, from time to time, we have incurred significant losses in the development of new technologies which were not successful for various commercial or technical reasons. If we are unable to successfully implement technological or research and engineering type activities, our growth prospects may be reduced and our future revenues may be materially and adversely affected. Moreover, we may experience operating losses after new products are introduced and commercialized because of high start-up costs, unexpected manufacturing costs or problems, or lack of demand.
We provide warranties on our products and if our products fail to operate properly our business will suffer.
We provide warranties as to the proper operation and conformance to specifications of the equipment we manufacture. Our products are often deployed in harsh environments including subsea applications. The failure of these products to operate properly or to meet specifications may increase our costs by requiring additional engineering resources and services, replacement of parts and equipment or monetary reimbursement to a customer. We have in the past experienced quality problems with raw material vendors, which required us to recall and replace certain equipment and components. We have also in the past received warranty claims and we expect to continue to receive them in the future. Such claims may exceed the reserve we have set aside for them. To the extent that we incur substantial warranty claims in any period because of quality issues with our products, our reputation, ability to obtain future business and earnings could be materially and adversely affected.
Our profitability is driven to a large extent by our ability to deliver the products we manufacture in a timely manner.
Disruptions to our production schedule may adversely impact our ability to meet delivery commitments. If we fail to deliver products according to contract terms, we may suffer financial penalties and a diminution of our commercial reputation and future product orders.
We rely on the availability of raw materials, component parts and finished products to produce our products.
We buy raw materials, components and precision machining or sub-assembly services from many different vendors located in Canada, the United States, Europe, Eastern Europe and the Middle East. The price and lead times for the forgings have increased along with the general increase of steel prices around the world. Further, uncertainty regarding compliance with certain material toughness specifications may make it necessary for us to order additional forgings to manufacture certain replacement parts. We also source a substantial amount of electrical components, including permanent magnet motors and drives as well as a substantial amount of hydraulic components, including hydraulic motors, from suppliers located in the U.S. The inability of suppliers to meet performance, quality specifications and delivery schedules could cause delays in manufacturing and make it difficult or impossible for us to meet outstanding orders or accept new orders for the manufacture of the affected equipment.
Index to Financial Statements The design of some of our equipment is based on components provided by specific sole source manufacturers.
Some of our products have been designed around components which are only available from one source of supply. In some cases, a manufacturer has developed or modified the design of a component at our request, and consequently we are the only purchaser of such items. If the manufacturer of such an item should go out of business or cease or refuse to manufacture the component in question, or raise the price of such components unduly, we may have to identify alternative components and redesign portions of our equipment. This could cause delays in manufacturing and make it difficult or impossible for us to meet outstanding orders or accept new orders for the manufacture of the affected equipment.
Our business requires the retention and recruitment of a skilled workforce and key employees, and the loss of such employees could result in the failure to implement our business plans.
As a technology-based company, we depend upon skilled engineering and other professionals in order to engage in product innovation and ensure the effective implementation of our innovative technology, especially CASING DRILLING. We compete for these professionals, not only with other companies in the same industry, but with oil and gas service companies generally and other industries. In periods of high energy and industrial manufacturing activity, demand for the skills and expertise of these professionals increases, which can make the hiring and retention of these individuals more difficult and expensive. Failure to recruit and retain such individuals may result in our inability to maintain a competitive advantage over other companies and loss of customer satisfaction.
The loss or incapacity of certain key employees for any reason, including our President and Chief Executive Officer, Julio M. Quintana, could have a negative impact on our ability to implement our business plan due to the specialized knowledge these individuals possess.
Our business relies on the skills and availability of trained and experienced trades and technicians to provide efficient and necessary services to us and our customers. Hiring and retaining such individuals are critical to the success of our business plan. Retention of staff and the prevention of injury to staff are essential in order to provide high level of service.
Our products and services are used in hazardous conditions, and we are subject to risks relating to potential liability claims.
Most of our products are used in hazardous drilling and production applications where an accident or a failure of a product can have catastrophic consequences. For example, the unexpected failure of a top drive to rotate a drill string during drilling operations could result in the loss of control over a well, leading to blowout and the discharge of pollutants into the environment. Damages arising from an occurrence at a location where our products are used have in the past and may in the future result in the assertion of potentially large claims against us.
While we attempt to limit our exposure to such risks through contracts with our customers, these measures may not protect us against liability for certain kinds of events, including blowouts, cratering, explosions, fires, loss of well control, loss of hole, damaged or lost drilling equipment, damage or loss from inclement weather or natural disasters, and losses resulting from business interruption. Our insurance coverage generally provides that we assume a portion of the risk in the form of a self-insured retention, and may not be adequate in risk coverage or policy limits to cover all losses or liabilities that we may incur. The occurrence of an event not fully insured or indemnified against, or the failure of a customer or insurer to meet its indemnification or insurance obligations, could result in substantial losses. Moreover, we may not be able in the future to maintain insurance at levels of risk coverage or policy limits that we deem adequate. Any significant claims made under our policies will likely cause our premiums to increase. Any future damages caused by our products or services that are not covered by insurance, are in excess of policy limits or are subject to substantial deductibles, could reduce the our earnings and cash available for operations.
Index to Financial Statements We have been party to patent infringement claims and we may not be able to protect or enforce our intellectual property rights.
In three separate actions, we were sued by VARCO I/P, Inc. (“Varco”), Franks International, Inc. (“Franks”) and Weatherford International, who have alleged that our CDS tool and other equipment and processes violate certain of their patents. See Part I, Item 3. (“Legal Proceedings”), below. We believe that these suits are without merit and we intend to continue to defend ourselves vigorously. In the event that we are not successful in defending ourselves in one or more of these matters, it may have a material adverse effect on our Tubular Services and CASING DRILLING segments and, therefore, on our business. In addition, in the future we may be subject to other infringement claims and if any of our products were found to be infringing, our consolidated financial results may be adversely affected.
Some of our products and the processes used to produce them have been granted U.S. and international patent protection, or have patent applications pending. Nevertheless, patents may not be granted from our applications and, if patents are issued, the claims allowed may not be sufficient to protect our technology. Recent changes in U.S. patent law may have the effect of making certain of our patents more likely to be the subject of claims for invalidation.
Our competitors may be able to independently develop technology that is similar to ours without infringing on our patents. This is especially true internationally where the protection of intellectual property rights may not be as effective. In addition, obtaining and maintaining intellectual property protection internationally may be significantly more expensive than doing so domestically. We may have to spend substantial time and money defending our patents. After our patents expire, our competitors will not be legally constrained from marketing products substantially similar to ours.
We are subject to legal proceedings and may, in the future, be subject to additional legal proceedings.
We are currently involved in legal proceedings described below in Part I, Item 3. “Legal Proceedings.” From time to time, we may become subject to additional legal proceedings which may include contract, tort, intellectual property, tax and other claims. We are also subject to complaints or allegations from former, current or prospective employees from time to time, alleging violations of employment-related laws. Lawsuits or claims could result in decisions against us which could have a material adverse effect on our financial condition, results of operations or cash flows.
Environmental compliance and remediation costs and the costs of environmental liabilities could exceed our estimates.
The energy industry is affected by changes in public policy, federal, state and local laws and regulations. The adoption of laws and regulations curtailing exploration and development drilling for oil and gas for economic, environmental and other policy reasons may adversely affect our operations due to our customers having limited drilling and other opportunities in the oil and gas exploration and production industry. The operations of our customers, as well as our properties, are subject to increasingly stringent laws and regulations relating to environmental protection, including laws and regulations governing air emissions, water discharges, waste management and workplace safety.
Management has concluded that we maintained effective internal control over financial reporting as of December 31, 2008. If we discover a material weakness in the future, we may not be able to provide reasonable assurance regarding the reliability of our financial statements. As a result, investors could lose confidence in our reported results which could have a negative effect on the trading of our securities.
Effective internal control over financial reporting is necessary for us to provide reasonable assurance with respect to our financial reports. If we cannot provide reasonable assurance with respect to our financial reports, investors could lose confidence in our reported financial information, which could have a negative effect on the trading of our securities.
Index to Financial Statements Management determined that our internal controls over financial reporting were effective as of December 31, 2007 and 2008. Although we determined that our internal controls over financial reporting were effective, internal control over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls or fraud. Therefore, even effective internal controls over financial reporting can provide only reasonable assurance with respect to the preparation and fair presentation of financial statements.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
Index to Financial Statements
ITEM 2.
ITEM 2. PROPERTIES.
The following table details our principal facilities, including (i) all properties which we own, and (ii) those leased properties which serve as corporate or regional headquarters.
Location
Approximate
Square Footage
(Buildings)
Owned or
Leased
Description
Houston, Texas
26,549
Leased
Corporate headquarters.
Houston, Texas
67,820
Owned
Headquarters for North American operations in Top Drive, Tubular Services and CASING DRILLING segments, and our U.S. regional operations base which also provides equipment repair and maintenance for U.S. and certain overseas operations.
Kilgore, Texas
21,950
Owned
Regional operations base for the Tubular Services segment in East Texas and Northern Louisiana.
Lafayette, Louisiana
43,290
Owned
Regional operations base for the Tubular Services segment in southern Louisiana and the Gulf of Mexico.
Calgary, Alberta, Canada
36,900
Owned
Headquarters and operations base for Canadian operations, research and development, and certain other corporate functions.
Calgary, Alberta, Canada
85,000
Owned
Manufacturing of top drives and other equipment.
Buenos Aires, Argentina
4,344
Leased
Regional headquarters for Latin America, including Mexico.
Aberdeen, Scotland
10,915
Leased
Regional headquarters for Europe, including the former Soviet Union, and West Africa.
Dubai, United Arab Emirates
2,900
Leased
Regional headquarters for the Middle East, North Africa, and East Africa.
Jakarta, Indonesia
7,692
Leased
Regional headquarters for the Asia Pacific region, including India, China, Japan, Australia and New Zealand.
In addition, we lease operational facilities at five locations in Texas, one in Louisiana, three in Colorado, and one in each of Arkansas, Wyoming and Utah. Each of these locations supports operations in its local area, primarily for the Tubular Services segment.
Outside the U.S., we lease additional operating facilities at three locations in Alberta, Canada, as well as in Mexico, Venezuela, Colombia, Ecuador, Argentina, Brazil, Norway, Russia, Dubai, Singapore, Indonesia, Australia and New Zealand. The majority of these facilities support the Top Drive, Tubular Services and CASING DRILLING segments.
Our existing equipment and facilities are considered by management to be adequate to support our operations.
Index to Financial Statements
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In the normal course of our business, we are subject to legal proceedings brought by or against us and our subsidiaries. None of these proceedings involves a claim for damages exceeding ten percent of the current assets of TESCO and its subsidiaries on a consolidated basis.
The estimates below represent management’s best estimates based on consultation with internal and external legal counsel. There can be no assurance as to the eventual outcome or the amount of loss we may suffer as a result of these proceedings.
Varco filed suit against TESCO in April 2005 in the U.S. District Court for the Western District of Louisiana, alleging that our CDS infringes certain of Varco’s U.S. patents. Varco seeks past damages and an injunction against further infringement. We filed a countersuit against Varco in June 2005 in the U.S. District Court for the Southern District of Texas, Houston Division seeking invalidation of the Varco patents in question. In July 2006, the Louisiana case was transferred to the federal district court in Houston, and as a result, the issues raised by Varco have been consolidated into a single proceeding in which we are the plaintiff. We also filed a request with the U.S. Patent and Trademark Office (“USPTO”) for reexamination of the patents on which Varco’s claim of infringement is based. The USPTO accepted the Varco patents for reexamination, and the district court stayed the patent litigation pending the outcome of the USPTO reexamination. In May 2008, the USPTO issued an Action Closing Prosecution, agreeing with us and rejecting all of the Varco patent claims that we had contested. Varco may appeal this decision or seek other administrative remedies within the USPTO. The outcome and amount of any future financial impacts from this litigation are not determinable at this time.
Franks filed suit against TESCO in the United States District Court for the Eastern District of Texas, Marshall Division, on January 10, 2007, alleging that our Casing Drive System infringes two patents held by Franks. Franks seeks past damages and an injunction against further infringement. TESCO filed a response denying the Franks allegation and asserting the invalidity of its patents. In May 2008, Franks withdrew its claims with respect to one of the patents and in July 2008, TESCO filed a request with the USPTO for reexamination of the other patent. In September 2008, the USPTO ordered a reexamination of that patent. That reexamination will proceed in parallel with the civil lawsuit, unless the lawsuit is stayed to await the result of the reexamination. In January 2009, the USPTO issued its initial office action, finding preliminarily that all of the claims in the Franks patent at issue are invalid. Franks has until March 2009 to respond to this patent office action. The lawsuit is set for trial in May 2009. TESCO believes it has meritorious defenses to the allegations of infringement. However, in the event of an adverse ruling at trial that is not overturned on appeal, and assuming the USPTO does not ultimately invalidate or substantially modify the Franks patent at issue in the course of its pending reexamination, TESCO could be liable for past damages. The expert retained by Franks in this litigation has opined that reasonable past damages would be approximately $5.4 million. If the court finds infringement was willful, any award for past damages could be trebled. The court would also have the discretion to award prejudgment interest from 2002 in the event of an adverse ruling. We do not believe that an adverse result in this suit, including any appeals, is probable.
Weatherford International and Weatherford/Lamb Inc. (“Weatherford”) filed suit against TESCO in the United States District Court for the Eastern District of Texas, Marshall Division, on December 5, 2007, alleging that various TESCO technologies infringe ten different patents held by Weatherford. Weatherford seeks past damages and an injunction against further infringement. The TESCO technologies referred to in the claim include the CDS, the CASING DRILLING system and method, a float valve, and the locking mechanism for the controls of the tubular handling system. The Company has filed a general denial seeking a judicial determination that it does not infringe the patents in question and/or that the patents are invalid. In November, 2008, we filed requests with the USPTO, seeking invalidation of substantially all of the Weatherford patent claims in the suit. The trial is set for May 2011. The outcome and amount of any future financial impacts from this litigation are not determinable at this time.
Index to Financial Statements We have been advised by the Mexican tax authorities that they believe significant expenses incurred by our Mexican operations from 1996 through 2002 are not deductible for Mexican tax purposes. Between 2002 and 2008, formal reassessments disallowing these deductions were issued for each of these years, all of which we appealed to the Mexican court system. We have obtained final court rulings deciding all years in dispute in our favor, except for 1996 (discussed below), and 2001 and 2002, both of which are currently before the Mexican Tax Court. The outcome of such appeals is uncertain. However, we recorded an accrual of $0.3 million during 2008 for our anticipated exposure on these issues ($0.2 million related to interest and penalties was included in Other Income and $0.1 million was included in Income Tax Expense). We continue to believe that the basis for these reassessments was incorrect, and that the ultimate resolution of those outstanding matters that remain will likely not have a material adverse effect on our financial position, results of operations or cash flows.
In May 2002, we paid a deposit of $3.3 million with the Mexican tax authorities in order to appeal the reassessment for 1996. In 2007 we requested and received a refund of approximately $3.7 million (the original deposit amount of $3.3 million plus $0.4 million in interest). Therefore, in the third quarter of 2007 we reversed an accrual for taxes, interest and penalties ($1.4 million related to interest and penalties was included in Other Income and $0.7 million benefit in Income Tax Expense). With the return of the $3.3 million deposit, the Mexican tax authorities issued a resolution indicating that we were owed an additional $3.4 million in interest but this amount had been retained by the tax authorities to satisfy a second reassessment for 1996. We believe the second reassessment is invalid, and we appealed it to the Mexican Tax Court. In January 2009, the Tax Court issued a decision accepting our arguments in part, which is subject to further appeal. Due to uncertainty regarding the ultimate outcome, we have not recognized the additional interest in dispute as an asset.
In July 2006, we received a claim for withholding tax, penalties and interest related to payments over the periods from 2000 to 2004 in a foreign jurisdiction. We disagree with this claim and are currently litigating this matter. However, at June 30, 2006 we accrued our estimated pre-tax exposure on this matter at $3.8 million, with $2.6 million included in other expense and $1.2 million included in interest expense. During 2007 and 2008, we accrued an additional $0.2 million and $0.2 million, respectively, of interest expense related to this claim.
In August 2008, we received a claim in Mexico for $1.1 million in fines and penalties related to the exportation of certain temporarily imported equipment that remained in Mexico beyond the authorized time limit for its return. We disagree with this claim and are currently litigating the matter. The outcome of this litigation is uncertain.
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 2008.
Index to Financial Statements PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Our outstanding shares of common stock, without par, are traded on The Nasdaq Global Market (“NASDAQ”) under the symbol “TESO.” Until June 30, 2008, TESCO’s common stock was also traded on the Toronto Stock Exchange (“TSX”) under the symbol “TEO.” Effective June 30, 2008, the Company voluntarily delisted its shares from the TSX. The following table outlines the share price trading range and volume of shares traded by quarter for 2008 and 2007.
As of February 23, 2009, there were approximately 247 holders of record of TESCO common stock, including brokers and other nominees.
We have not declared or paid any dividends since 1993 and do not expect to declare or pay dividends in the near future. Any decision to pay dividends on our Common Shares will be made by our Board of Directors on the basis of our earnings, financial requirements and other relevant conditions existing at the time. Pursuant to our Amended and Restated Credit Agreement, we are currently prohibited from paying dividends to shareholders.
Index to Financial Statements Performance Graph
The following performance graph and table compares the yearly percentage change in the cumulative shareholder return for the five year period commencing on December 31, 2003 and ending on December 31, 2008 on our common shares (assuming a $100 investment was made on December 31, 2003) with the total cumulative return of the S&P TSX Composite Index and the Philadelphia Oil Service Sector Index (“OSX”) assuming reinvestment of dividends.
Index to Financial Statements
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
TESCO CORPORATION AND CONSOLIDATED SUBSIDIARIES
SELECTED CONSOLIDATED FINANCIAL DATA
NOTE: Our consolidated financial statements for the three years ended December 31, 2008, which are discussed in the following notes, are included in this Form 10-K under Item 8.
Index to Financial Statements
(a) Included in CASING DRILLING revenues for the years ended December 31, 2004, 2005 and 2006 are $10.1 million, $18.3 million and $9.0 million, respectively, of revenues from contract CASING DRILLING rig activities which were discontinued in late 2006. During the years ended December 31, 2007 and 2008, we did not provide contract drilling rig services.
(b) Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) to account for our stock-based compensation program. We elected to adopt the modified prospective application method provided by SFAS 123(R). Under SFAS No. 123(R), we use the same fair value methodology pursuant to SFAS 123 but we are required to estimate the pre-vesting forfeiture rate beginning on the date of grant. On January 1, 2006, the date we adopted SFAS No. 123(R), we recorded a one-time cumulative benefit of $0.2 million, after-tax, to record an estimate of future forfeitures on outstanding unvested awards at the date of adoption.
(c) Our management evaluates our performance based on non-GAAP measures, of which a primary performance measure is Adjusted EBITDA which consists of earnings (net income or loss) available to common shareholders before cumulative effect of accounting change, net interest expense, income taxes, non-cash stock compensation expense, non-cash impairments, depreciation and amortization and other non-cash items. This measure may not be comparable to similarly titled measures employed by other companies and is not a measure of performance calculated in accordance with U.S. GAAP. The measure should not be considered in isolation or as a substitute for operating income, net income or loss, cash flows provided by operating, investing or financing activities, or other cash flow data prepared in accordance with U.S. GAAP. The amounts included in the Adjusted EBITDA calculation, however, are derived from amounts included in the historical Consolidated Statements of Income data.
We believe Adjusted EBITDA is useful to an investor in evaluating our operating performance because it is widely used by investors in our industry to measure a company’s operating performance without regard to items such as income taxes, net interest expense, depreciation and amortization, and non-cash stock compensation expense which can vary substantially from company to company depending upon accounting methods and book value of assets, financing methods, capital structure and the method by which assets were acquired; it helps investors more meaningfully evaluate and compare the results of our operations from period to period by removing the impact of our capital structure (primarily interest) and asset base (primarily depreciation and amortization) and actions that do not affect liquidity (stock compensation expense) from our operating results; and it helps investors identify items that are within our operational control. Depreciation and amortization charges, while a component of operating income, are fixed at the time of the asset purchase in accordance with the depreciable lives of the related asset and as such are not a directly controllable period operating charge.
Adjusted EBITDA is derived from the Consolidated Statements of Income as follows (in millions):
(d) Net (Debt) Cash represents the amount that Cash and Cash Equivalents exceeds (or is less than) total Debt of the Company. Net (Debt) Cash is not a calculation based upon U.S. GAAP. The amounts included in the Net (Debt) Cash calculation, however, are derived from amounts included in the historical Consolidated Balance Sheets. In addition, Net (Debt) Cash should not be considered as an alternative to operating cash flows or working capital as a measure of liquidity. We have reported Net (Debt) Cash because we regularly review Net (Debt) Cash as a measure of the Company’s performance. However, the Net (Debt) Cash measure presented in this document may not always be comparable to similarly titled measures reported by other companies due to differences in the components of the calculation. Net (Debt) Cash is derived from the Consolidated Balance Sheets as follows (in millions):
Index to Financial Statements
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
FORWARD-LOOKING INFORMATION AND RISK FACTORS
This annual report on Form 10-K contains forward-looking statements within the meaning of Canadian and United States securities laws, including the United States Private Securities Litigation Reform Act of 1995. From time to time, our public filings, press releases and other communications (such as conference calls and presentations) will contain forward-looking statements. Forward-looking information is often, but not always, identified by the use of words such as “anticipate”, “believe”, “expect”, “plan”, “intend”, “forecast”, “target”, “project”, “may”, “will”, “should”, “could”, “estimate”, “predict” or similar words suggesting future outcomes or language suggesting an outlook. Forward-looking statements in this annual report on Form 10-K include, but are not limited to, statements with respect to expectations of our prospects, future revenues, earnings, activities and technical results.
Forward-looking statements and information are based on current beliefs as well as assumptions made by, and information currently available to, us concerning our anticipated financial performance, business prospects, strategies and regulatory developments. Although management considers these assumptions to be reasonable based on information currently available to it, they may prove to be incorrect. The forward-looking statements in this annual report on Form 10-K are made as of the date it was issued and we do not undertake any obligation to update publicly or to revise any of the included forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
By their very nature, forward-looking statements involve inherent risks and uncertainties, both general and specific, and risks that outcomes implied by forward-looking statements will not be achieved. We caution readers not to place undue reliance on these statements as a number of important factors could cause the actual results to differ materially from the beliefs, plans, objectives, expectations and anticipations, estimates and intentions expressed in such forward-looking statements.
These risks and uncertainties include, but are not limited to, changes in the global economy and credit markets, the impact of changes in oil and natural gas prices and worldwide and domestic economic conditions on drilling activity and demand for and pricing of our products and services, other risks inherent in the drilling services industry (e.g. operational risks, potential delays or changes in customers’ exploration or development projects or capital expenditures, the uncertainty of estimates and projections relating to levels of rental activities, uncertainty of estimates and projections of costs and expenses, risks in conducting foreign operations, the consolidation of our customers, and intense competition in our industry); and risks, including litigation risks, associated with our intellectual property and risks associated with the performance of our technology. These risks and uncertainties may cause our actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. When relying on our forward-looking statements to make decisions, investors and others should carefully consider the foregoing factors and other uncertainties and potential events. The forward-looking statements in this document are provided for the limited purpose of enabling current and potential investors to evaluate an investment in TESCO. Readers are cautioned that such statements may not be appropriate, and should not be used, for other purposes.
Copies of our Canadian public filings are available at www.tescocorp.com and at www.sedar.com. Our U.S. public filings are available at www.tescocorp.com and at www.sec.gov.
The following review of TESCO’s financial condition and results of operations should be read in conjunction with our financial statements and related notes included in this Form 10-K. Unless indicated otherwise, all dollar amounts in this annual report on Form 10-K are denominated in United States (U.S.) dollars. All references to US$ or to $ are to U.S. dollars and references to C$ are to Canadian dollars.
Certain reclassifications have been made to prior years’ presentation to conform to the current year presentation.
Index to Financial Statements OVERVIEW
Business
TESCO is a global leader in the design, manufacture and service delivery of technology based solutions for the upstream energy industry. We seek to change the way people drill wells by delivering safer and more efficient solutions that add real value by reducing the costs of drilling for and producing oil and gas. Our product and service offerings include proprietary technology, including TESCO CASING DRILLING® (“CASING DRILLING”), TESCO’s Casing Drive System (“CDS™” or “CDS”) and TESCO’s Multiple Control Line Running System (“MCLRS™” or “MCLRS”). TESCO® is a registered trademark in Canada and the United States. TESCO CASING DRILLING® is a registered trademark in the United States. CASING DRILLING® is a registered trademark in Canada and CASING DRILLING™ is a trademark in the United States. Casing Drive System™, CDS™, Multiple Control Line Running System™ and MCLRS™ are trademarks in Canada and the United States.
Our four business segments are: Top Drives, Tubular Services, CASING DRILLING and Research and Engineering. Historically, we organized our activities into three business segments: Top Drives, Casing Services and Research and Engineering. Effective December 31, 2008, we separated our Tubular Services activities from our CASING DRILLING business and our financial and operating data for the years ended December 31, 2006 through 2008 has been recast in this Annual Report on Form 10-K to be presented consistently with this structure.
The Top Drive business is comprised of top drive sales, top drive rentals and after-market sales and service. The Tubular Services business includes both our proprietary and conventional Tubular Services. The CASING DRILLING segment consists of our proprietary CASING DRILLING technology, and the Research and Engineering segment is comprised of our research and development activities related to our proprietary Tubular Services and CASING DRILLING technology and Top Drive model development. For a detailed description of these business segments, see Part I, Item 1. (Business), above.
Business Environment
Strong oil and gas drilling activity and a spike in oil and gas prices in mid-2008 continued to provide significant opportunities for us to expand our customer base. However, during the latter portion of the year, a global economic crisis hit the financial and credit markets which led to a significant global economic slowdown. Current conditions point to continued slow economic activity through 2009 with wide-ranging volatility in oil and gas prices. One of the key indicators of our business is the number of active drilling rigs and this number has varied widely in recent months. The average annual number of active drilling rigs (excluding rigs drilling in Russia or onshore China for which reliable estimates are not available) is as follows:
During 2008, North American average rig activity increased slightly with a spike in the summer months, but fell off sharply in December. We believe that 2009 will be a year in which drilling activity in the United States and Canada will decline sharply from 2008 levels, but that drilling activity in other areas of the world will sustain better than in the U.S.
Index to Financial Statements According to World Oil, drilling activity for the last three years has been and the forecast for 2009 is as follows:
* forecast released by World Oil on January 26, 2009
We believe that 2009 will be a year of uncertainty. The current outlook for the global economy varies daily, but generally points toward a sharp decline in the first half of 2009. In particular, the U.S. and Canadian rig activity is projected to decline 25-40% from 2008 levels. International demand is expected to sustain better than U.S. demand, but this is contingent on increased commodity pricing. We are committed to expanding our role as a leading service provider to the global drilling industry. All of our services and products are delivered through geographic business units to provide customers with a single point of contact for all of our products and services.
Outlook
Current global macro-economic conditions make any projections difficult and uncertain. However, we believe top drive backlog is a leading indicator of how our business will be affected by changes in the global macro-economic environment. We experienced a strong order rate in 2008 and ended the year with a backlog of 65 top drive units, with a total value of $56.9 million, compared to a backlog of 38 units at December 31, 2007, with a total value of $39.2 million. Based upon the most recent changes in the economy, we expect a slower order rate in 2009.
Over the last three years, our average revenue per top drive unit sale has increased due to a shift in market demand to larger, more complex units. However, we have recently seen an increase in the demand for smaller top drive units typically required for fast-moving new build rigs. We believe that for our top drive business, a backlog of two quarters of production is reasonable and allows us to effectively manage our supply chain and workforce, yet be responsive to our client base. Additionally, the mix of top drive unit sales may be changing.
We expect international demand for our rental top drives to sustain better than U.S. demand. Thus, we may shift the location of several fleet units during 2009 to meet market demand. We will re-route our units in a manner that minimizes disruptions to our rental operations.
In addition, our increased manufacturing capacity since mid-2006 (currently 12 to 16 top drive units per month, depending on system complexity) and top drive sales over the past several years expanded our installed base throughout the world, providing increased market stability and expansion opportunities for our after-market sales and service business. Accordingly, we expect continuing demand for our top drive after-market sales and services business, although a temporary decline for these services may occur as a result of the economic slowdown and the related decline in operating worldwide rig count.
Over the long term we believe that our top drive business needs to maintain manufacturing inventory of two quarters of production to limit our exposure to fluctuations in sales markets and to allow effective management
Index to Financial Statements
of our supply chain and workforce. In addition, we must maintain additional inventory of long lead time items and semi-finished goods to support our after-market sales and service business and our manufacturing operations. In 2006 we initiated a Sales and Operational Planning program to balance market demand with inventory and our ability to supply top drives. In mid-2008, we initiated a Global Distribution Center (“GDC”) in order to more closely monitor our global parts inventory and to provide our operating locations with a centralized purchasing center. We believe the GDC will improve our purchasing power with suppliers and allow us to provide inventory parts to our customers around the world in a more expedient manner.
We continue to develop relationships with new and existing customers in both our Tubular Services and CASING DRILLING segments. For Tubular Services, we expect our CDS proprietary casing business and MCLRS activities to remain flat or decrease slightly in 2009 compared to 2008 and our conventional activity to decline compared to 2008 as we continue to focus our efforts on the expansion of our proprietary service offerings. We continue to address the high cost structure of our North American Tubular Services business by optimizing personnel and assets in operating areas that provide the highest returns and by identifying low-performing areas. In addition, we continue to expand our tubular services activities in selected international locations to help increase our global footprint and to mitigate the U.S. economic downturn. With respect to our CASING DRILLING business, we plan to continue our investment and believe that its performance should improve in 2009 compared to 2008. During 2007 and 2008, we incurred substantial expenses to build our business infrastructure and expand our resource base globally in order to grow CASING DRILLING at a faster rate. We expect that these investments will yield growth in our CASING DRILLING revenues over the next several years.
As described in “Overview-Business Conditions,” our international business (as a percentage of revenue and operating income) has increased over the past two years. We intend to continue our focus on international opportunities, especially with the anticipated decline in drilling activity in the United States and Canada during 2009. The foregoing are “forward looking statements” and are subject to the cautionary statements in “Forward Looking Information and Risk Factors” at the beginning of this “Management’s Discussion and Analysis of Financial Condition and Operations.”
Index to Financial Statements RESULTS OF OPERATIONS
Years Ended December 31, 2008 and 2007
Revenue for the year ended December 31, 2008 was $534.9 million, compared to $462.4 million in 2007, an increase of $72.5 million, or 16%. This increase is primarily due to a $52.3 million increase in the Top Drive segment, a $12.4 million increase in CASING DRILLING revenues and a $7.8 million increase in the Tubular Services segment.
Operating Income for the year ended December 31, 2008 was $75.7 million, compared to $48.5 million in 2007, an increase of $27.2 million. This increase is primarily attributable to increased operating income in the Top Drive and in the Tubular Services segments, decreased losses from our CASING DRILLING segment and decreased costs in our Research and Engineering segment, partially offset by increased Corporate and Other expenses. Results for each business segment are discussed in further detail below.
Net Income for the year ended December 31, 2008 was $52.9 million, or $1.40 per diluted share, compared to $32.3 million in 2007, or $0.86 per diluted share, an increase of $20.6 million. This increase primarily results from increased operating income discussed above and a $3.3 million change in foreign currency (gains) losses from a loss of $2.9 million in 2007 to a gain of $0.4 million in 2008 due to the strengthening of the U.S. dollar during 2008, partially offset by a $0.8 million decrease in interest income due to interest received on a Mexican tax deposit during 2007.
Revenue and operating income by segment and net income for the years ended December 31, 2008 and 2007 were as follows (in thousands):
(1) At the end of 2008, we commenced the presentation of our Tubular Services business and CASING DRILLING as two separate segments. Accordingly, we have reclassified prior year revenues of
Index to Financial Statements
approximately $14.6 million and prior year operating losses of approximately $14.1 million from the former Casing Services segment to the CASING DRILLING segment to conform to current year presentation.
(2) At the end of 2007, we commenced the presentation of Tubular Services revenue according to two categories: conventional and proprietary. Prior to January 1, 2008, MCLRS and certain part sales and services were included with conventional services. However, since these activities use proprietary and patented technology, we now include them with our proprietary information. Accordingly, we have reclassified prior year revenues of approximately $15.3 million related to these sales from conventional to proprietary to conform to our current year presentation.
(3) We incur costs directly and indirectly associated with our revenues at a business unit level. Direct costs include expenditures specifically incurred for the generation of revenue, such as personnel costs on location or transportation, maintenance and repair, and depreciation of our revenue-generating equipment. Overhead costs, such as field administration and field operations support, are not directly associated with the generation of revenue within a particular business segment. In prior years, we allocated total overhead costs at a consolidated level based on a percentage of global revenues. During the current year, we were able to identify and capture, where appropriate, the specific operating segments in which we incurred overhead costs at the business unit level. Using this information, we have reclassified our prior year segment operating results to conform to the current year presentation. These reclassifications resulted in an increase of $12.3 million in operating income in the Top Drive segment and a corresponding decrease of $12.3 million in the Tubular Services segment for year ended December 31, 2007.
Top Drive Segment
Our Top Drive segment is comprised of top drive sales, after-market sales and support and top drive rental activities.
Revenues-Revenue for the year ended December 31, 2008 increased $52.3 million compared to 2007, primarily driven by a $36.6 million increase in top drive sales, a $13.4 million increase in top drive after-market support and a $2.3 million increase in top drive rental operations.
Revenues from top drive sales increased $36.6 million, or 29%, to $164.1 million as compared to 2007, primarily the result of the sale of 137 units in 2008 compared to 122 units during 2007. During 2008, we sold 137 top drive units, of which 118 were new units and 19 were used units. During 2007, we sold 122 top drive units, of which 102 were new units and 20 were used units. The selling price per unit varies significantly depending on the model, whether the unit was previously operated in our rental fleet and whether a power unit was included in the sale. When top drive units in our rental fleet are sold, the sales proceeds are included in revenues and the net book value of the equipment sold is included in cost of sales and services. Revenues related to the sale of used units sold in 2008 and 2007 were $20.1 million and $18.9 million, respectively.
In addition to selling top drive units, we provide after-market sales and service to support our installed base. Revenues from top drive after-market support increased $13.4 million, or 26%, to $65.3 million as compared to 2007, primarily due to the increase in our third party installed base and our efforts to expand this service.
Index to Financial Statements Revenues from top drive rental activities increased $2.3 million, or 2%, to $112.0 million as compared to 2007, primarily due to an increase in the number of operating days, slightly offset by a decline in standby revenues. The increase in rental days was due to the increased size and utilization rates for our rental fleet, but offset by downtime associated with used units being removed from operations to be prepared for sale. We sold 19 used units from our rental fleet in 2008, and added 35 units. We also experienced downtime between when the new units were manufactured and when the new units were mobilized for operations. The number of top drive operating days and average daily operating rates for 2008 and 2007 and the number of rental units in our fleet at year-end 2008 and 2007 were (in thousands):
We define an operating day as a day that a unit in our rental fleet is under contract and operating. We do not include stand-by days in our definition of an operating day.
A stand-by day is a day in which we are paid an amount, which may be less than the full contract rate, to have a top drive rental unit available to a customer but that unit is not operating. In 2008, stand-by revenues from rental operations decreased $1.1 million to $9.4 million due to increased operating demand for our top drive rental units.
Operating Income-Top Drive Operating Income for the year ended December 31, 2008 increased $27.6 million to $108.3 million compared to 2007. This increase was primarily driven by the increase in the number of top drive units sold in 2008 compared to 2007 (137 units in 2008 compared to 122 units in 2007), higher sales margins on our used top drive sales and growth in our high-margin aftermarket sales and services. Partially offsetting this increase in 2008 were lower margins in our rental business due to costs related to revitalizing our fleet in North America, start-up costs related to new contracts in certain international markets, particularly Mexico, and increased maintenance, refurbishment and recertification costs due to the high utilization of our rental fleet.
Tubular Services Segment
Revenues-Revenues for the year ended December 31, 2008 increased $7.8 million to $166.5 million as compared to 2007. The increase in revenue reflects an increase of approximately $21.3 million, or 32%, in proprietary revenues, offset by a 13.5 million, or 15%, decrease in conventional casing running revenues as we shift our focus to gaining market share and market acceptance of our proprietary product offerings.
Tubular services proprietary revenue is principally generated from our casing and tubing business utilizing our proprietary casing running technology and the sale of our CDS units and related equipment. Additionally, our proprietary Tubular Service business includes the installation service of deep water smart well completion equipment using our MCLRS, a proprietary and patented technology which improves the quality of the installation of high-end well completions. Prior to January 1, 2008, MCLRS and certain part sales and services were included with conventional services. Since MCLRS is a proprietary and patented technology, we now include this and related activity with our proprietary information. Accordingly, we have reclassified prior year revenues related to MCLRS from conventional to proprietary. Our proprietary tubular services business generated revenue of $87.1 million in 2008, an increase of $21.4 million, or 32%, from 2007, which is primarily due to our proprietary job activity as our job count increased from 1,406 in 2007 to 1,971 in 2008. The proprietary job count increase is a reflection of our increased utilization of our CDS tools. In addition, our
Index to Financial Statements
proprietary Casing Drive System fleet which increased from 177 units at December 31, 2007 to 239 units at December 31, 2008. Our revenues related to the sale of CDS and related equipment decreased by approximately $5.7 million from 2007. MCLRS revenues also decreased $5.2 million to $7.8 million in 2008 compared to 2007 as we focused our services on international opportunities.
Our conventional Tubular Service business provides equipment and personnel for the installation of tubing and casing, including power tongs, pick-up/lay-down units, torque monitoring services, connection testing services and power swivels for new well construction and in work-over and re-entry operations. Our conventional Tubular Services business generated revenue of $79.4 million in 2008, a decrease of $13.5 million from 2007, primarily due to our shift in job focus from conventional to proprietary services. During 2008, we continued to gain market acceptance of our services that use our proprietary and patented technology.
Operating Income-Tubular Services’ operating income for the year ended December 31, 2008 decreased $1.7 million to $22.0 million compared to 2007. The decrease was primarily driven by increased depreciation expenses and fuel prices. Our operating income was also affected by costs associated with closing some non-producing districts and the start-up costs of international projects. As the industry moves toward mechanized drilling technology, we expect the market for our conventional service offerings will be replaced by demand for our proprietary offerings.
CASING DRILLING Segment
Revenues-Revenues for 2008 were $27.0 million compared to $14.6 million in 2007, an increase of $12.4 million or 86%. The revenue increase in 2008 was attributable to significant international revenue growth in both Latin America and the Middle East as well as continued revenue growth in North America.
Operating Income-CASING DRILLING’s operating loss for the year ended December 31, 2008 decreased $1.5 million to $12.6 million compared to $14.1 million in 2007. Operating margins improved from a loss of 97% in 2007 to a loss of 47% in 2008, primarily due to increased revenues earned. We continue to establish the infrastructure needed to supply our CASING DRILLING services in locations around the world. As we continue to build a global market for this business and gain critical mass, we expect to realize improved margins.
Research and Engineering Segment
Research and Engineering’s operating expenses are comprised of our activities related to the design and enhancement of our top drive models and proprietary equipment and were $11.0 million for 2008, a decrease of $1.0 million from 2007’s operating expenses of $12.0 million. This decrease is primarily due to normalization of expenditures from 2007, when we focused on development and market production of a new generation of hydraulic and electric top drives. We continue to invest in the commercialization and enhancements of our proprietary technologies.
Corporate and Other
Corporate and Other is primarily comprised of the corporate level general and administrative expenses and corporate level selling and marketing expenses. Corporate and Other’s operating loss for the year ended December 31, 2008 increased $1.2 million to a $31.0 million loss compared to 2007. This increase is primarily due to a $0.5 million in legal expenses due to the status of our ongoing legal cases, and a $1.7 million increase in salaries and incentive compensation based on the company’s improved financial performance, partially offset by decreased computer expenses.
Index to Financial Statements Net Income
Interest Expense- Interest expense for 2008 increased $0.2 million compared to the previous year. During the year ended December 31, 2008, average daily debt balances were $67.8 million, approximately $18.3 million higher than 2007. This increase was a result of increased debt, an increase in amortization of financial items due to credit facility fees and an increase in interest for tax contingencies, but was partially offset by a 225-basis point decrease in the weighted average interest rate during the current year due to market conditions, resulting in slightly higher interest expense during the current year period.
Interest Income-Interest income for 2008 decreased $0.8 million to $0.3 million due to $0.4 million in interest received on a Mexico tax deposit during 2007.
Foreign Exchange (Gains) Losses-Foreign exchange (gains) losses increased $3.3 million from a loss of $2.9 million in 2007 to a gain of $0.4 million in 2008. This change is primarily due to the comparative weakening of the Canadian dollar between the two periods, offset by a $0.8 million loss on settling certain foreign currency contracts during 2008. During the year ended December 31, 2007, we entered into a series of 25 bi-weekly foreign currency forward contracts with notional amounts aggregating C$43.8 million. During 2008, we terminated these bi-weekly foreign currency forward contracts and recognized a loss of $0.6 million. We replaced them with 14 foreign monthly currency forward contracts that we subsequently terminated during 2008, recognizing a loss from inception of $0.2 million. We were not party to foreign currency forward contracts as of December 31, 2008. For further discussion regarding our foreign exchange losses, please see Part II, Item 7A, of this Form 10-K (Quantitative and Qualitative Disclosures About Market Risk).
Other Income-Other Income includes non-operating income and expenses, including investment activities. Following is a detail of the significant items that are included in Other (Income) Expense for 2008 and 2007 (in thousands):
For a description of these items, see Notes 2, 8 and 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Income Taxes-TESCO is an Alberta, Canada corporation. We conduct business and are taxable on profits earned in a number of jurisdictions around the world. Our income tax expense is provided based on the laws and
Index to Financial Statements
rates in effect in the countries in which operations are conducted or in which TESCO and/or its subsidiaries are considered residents for income tax purposes. Income tax expense as a percentage of pre-tax earnings fluctuates from year to year based on the level of profits earned in each jurisdiction in which we operate and the tax rates applicable to such profits.
Our effective tax rate for 2008 was 27% compared to 24% in 2007. The 2008 effective tax rate reflects a $0.8 million benefit from the generation of Canadian research and development credits, offset by a $1.2 million charge related to a reduction in deferred tax assets attributable to decreasing Canadian federal statutory tax rates. The effective tax rate for the year ended December 31, 2008 is lower than the Canadian statutory tax rate due to earnings generated in jurisdictions with statutory tax rates that are lower than the Canadian statutory tax rate and the effects of certain legal entity restructurings.
No provision is made for taxes that may be payable on the repatriation of accumulated earnings in our foreign subsidiaries on the basis that these earnings will continue to be used to finance the activities of these subsidiaries.
For a further description of income tax matters, see Note 8 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Years Ended December 31, 2007 and 2006
Revenue for the year ended December 31, 2007 was $462.4 million, compared to $386.2 million in 2006, an increase of $76.2 million, or 20%. This increase is primarily due to increased activities in the Top Drive segment, particularly top drive sales and after-market sales and support due to the substantial increase in the top drive unit sales and increased activity in the Tubular Services and CASING DRILLING segments. Included in CASING DRILLING revenues for 2006 is $9.0 million from contract CASING DRILLING activities which were discontinued in 2006.
Operating Income for the year ended December 31, 2007 was $48.5 million, compared to $60.9 million in 2006, a decrease of $12.4 million. This decrease is primarily attributable to decreased operating income in Tubular Services, increased losses in our CASING DRILLING business, increased costs in our Research and Engineering segment and increased selling, general and administrative expenses which were partially offset by increased operating income from Top Drives. Results for each business segment are discussed in further detail below.
Net Income for the year ended December 31, 2007 was $32.3 million, or $0.86 per diluted share, compared to $30.5 million in 2006, or $0.83 per diluted share, an increase of $1.8 million. Other than the changes in Operating Income discussed above, in 2007 we benefited from a $3.4 million benefit related to 2006 return to accrual adjustments as a result of filing our Canadian, U.S. and other foreign tax returns and the reversal of $1.4 million in accrued interest and penalties related to the favorable resolution of a Mexico tax claim, partially offset by a $1.8 million foreign exchange loss related to the U.S. dollar receivables held by our Canadian operations and the weakening of the U.S. dollar during the period, a $1.7 million charge related to a reduction in deferred tax assets attributable to reduced statutory tax rates for Canadian federal taxes and a $1.2 million loss related to the expiration of the Turnkey E&P warrants. Additionally, our 2006 Net Income included an accrual of $2.6 million related to a withholding taxes and penalties related to payments over the period from 2000 to 2004 in a foreign jurisdiction, an interest expense accrual of $1.2 million in 2006 arising out of a claim for foreign withholding tax on payments made over the period from 2000 to 2004 and a $1.6 million charge related to a reduction in deferred tax assets attributable to reduced statutory tax rates for both Canadian federal and provincial (Alberta) taxes.
Index to Financial Statements Revenue and operating income by segment and net income for the years ended December 31, 2007 and 2006 were as follows (in thousands):
(1) At the end of 2008, we commenced the presentation of our Tubular Services business and CASING DRILLING as two separate segments. Accordingly, we have reclassified 2007 and 2006 revenues of approximately $14.6 million and $23.7 million, respectively, and prior year operating losses of approximately $14.1 million and $6.7 million, respectively, from the former Casing Services segment to the CASING DRILLING segment to conform to our current year presentation.
(2) At the end of 2007, we commenced the presentation of Tubular Services revenue according to two categories: conventional and proprietary. Prior to January 1, 2008, MCLRS and certain part sales and services were included with conventional services. However, since these activities use proprietary and patented technology, we now include them with our proprietary information. Accordingly, we have reclassified 2007 and 2006 revenues of approximately $15.3 million and $0.9 million, respectively, related to these sales from conventional to proprietary to conform to our current year presentation.
(3) We incur costs directly and indirectly associated with our revenues at a business unit level. Direct costs include expenditures specifically incurred for the generation of revenue, such as personnel costs on location or transportation, maintenance and repair, and depreciation of our revenue-generating equipment. Overhead costs, such as field administration and field operations support, are not directly associated with the generation of revenue within a particular business segment. In prior years, we allocated total overhead costs at a consolidated level based on a percentage of global revenues. During 2008, we were able to identify and capture, where appropriate, the specific operating segments in which we incurred overhead costs at the business unit level. Using this information, we have reclassified our 2007 and 2006 segment operating results to conform to the current year presentation. This reclassification resulted in an increase of $12.3 million and $2.0 million in operating income in the Top Drive segment for 2007 and 2006, respectively, and a corresponding decrease of $12.3 million and $2.0 million in the Tubular Services segment for 2007 and 2006, respectively.
Index to Financial Statements Top Drive Segment
Our Top Drive segment is comprised of top drive sales, after-market sales and support and top drive rental activities.
Revenues-Revenue for the year ended December 31, 2007 increased $70.0 million compared to 2006, primarily driven by a $46.1 million increase in top drive sales, a $16.1 million increase in top drive after-market support and a $7.8 million increase in top drive rental operations.
Revenues from top drive sales increased $46.1 million, or 57%, to $127.6 million as compared to 2006, primarily the result of the sale of 122 units in 2007 compared to 94 units during 2006. During 2007, we sold 122 top drive units, of which 102 were new units and 20 were used units. During 2006, we sold 94 top drive units, of which 86 were new units and eight were used units. The selling price per unit varies significantly depending on the model, whether the unit was previously operated in our rental fleet and whether a power unit was included in the sale. When top drive units in our rental fleet are sold, the sales proceeds are included in revenues and the net book value of the equipment sold is included in cost of sales and services. Revenues related to the sale of used units sold in 2007 and 2006 were $18.9 million and $6.7 million, respectively.
In addition to selling top drive units, we provide after-market sales and service to support our installed base. Revenues from top drive after-market support increased $16.1 million, or 45%, to $51.9 million as compared to 2006, primarily due to the increase in our third party installed base and our efforts to expand this service.
Revenues from top drive rental activities increased $7.8 million, or 8%, to $109.7 million as compared to 2006, primarily due to higher average rental rates offset by a decrease in the number of operating days, but offset by downtime associated with used units being removed from operations to be prepared for sale. We sold 8 used units from our rental fleet in 2007, and added 13 units. We also experienced downtime between when the new units were manufactured and when the new units were mobilized for operations. The number of top drive operating days and average daily operating rates for 2007 and 2006 and the number of rental units in our fleet at year-end 2007 and 2006 were:
We define an operating day as a day that a unit in our rental fleet is under contract and operating. We do not include stand-by days in our definition of an operating day.
A stand-by day is a day in which we are paid an amount, which may be less than the full contract rate, to have a top drive rental unit available to a customer but that unit is not operating. In 2007, stand-by revenues from rental operations decreased $4.2 million to $10.5 million due to increased operating demand for our top drive rental units.
Operating Income-Top Drive Operating Income for the year ended December 31, 2007 increased $13.9 million to $80.7 million compared to 2006. This increase was primarily driven by the increase in the number of top drive units sold in 2007 compared to 2006 (122 units in 2007 compared to 94 units in 2006), higher sales margins on our used top drive sales and the reversal of $2.2 million in warranty reserves, partially offset by increased manufacturing costs of our top drives and lower margins in our rental business due to costs related to reallocating our fleet from North American markets to international markets, start-up costs related to new contracts in certain international markets, particularly Mexico, and increased maintenance, refurbishment and recertification costs due to the high utilization of our rental fleet. Our increased manufacturing costs were
Index to Financial Statements
primarily driven by the weakening of the U.S. dollar, as a majority of our manufacturing costs are incurred in Canadian dollars, and increased costs associated with the disruption of installing a new planning system in our manufacturing plant earlier in the year and the introduction of the two new “X” series top drives into production. The reversal of certain of our warranty reserve in 2007 relates to reserves originally provided in 2005 related to load path parts of certain equipment sold to customers and used in our rental fleet and in 2006 to correct technical problems with our EMI 400 top drives as substantially all of our warranty work was completed at December 31, 2007. For further description of the reversal of certain warranty reserves, see Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Tubular Services Segment
Revenues-Revenues for the year ended December 31, 2007 increased $15.4 million to $158.7 million as compared to 2006. The increase in revenue reflects increased activity in both conventional and proprietary casing running services, primarily in North America. Our proprietary tubular services business generated revenue of $65.7 million in 2007, an increase of $26.9 million, or 69%, from 2006, which is primarily due to our proprietary job activity as our job count increased from 1,134 in 2006 to 1,406 in 2007. Our revenues related to the sale of CDS and related equipment was approximately the same between the two periods. The proprietary job count increase is a reflection of our proprietary Casing Drive System™ fleet which increased from 155 units at December 31, 2006 to 177 units at December 31, 2007.
Our conventional Tubular Service business provides equipment and personnel for the installation of tubing and casing, including power tongs, pick-up/lay-down units, torque monitoring services, connection testing services and power swivels for new well construction and in work-over and re-entry operations. Our Conventional Tubular Services business generated revenue of $92.9 million in 2007, a decrease of $11.5 million from 2006, primarily due to our shift in job focus from conventional to proprietary services.
Operating Income-Tubular Services’ operating income for the year ended December 31, 2007 decreased $9.4 million to $23.7 million compared to 2006. The decrease in Tubular Services’ 2007 operating income compared to 2006 was primarily driven by an increased cost base, including labor and benefit costs, resulting from competitive pressures in the industry and increased costs associated with the expansion of our Tubular Services businesses throughout the world.
CASING DRILLING Segment
Revenues-CASING DRILLING revenue in 2007 was $14.6 million compared to $23.7 million in 2006. Included in CASING DRILLING revenues for 2006 is $9.0 million in revenues from contract CASING DRILLING rig activities which were discontinued in late 2006. As of December 31, 2006, we no longer provide contract drilling rig services. Our 2007 CASING DRILLING revenues were approximately equal to those in 2006 excluding the 2006 CASING DRILLING revenues related to our contract drilling rig activities. Included in our 2007 CASING DRILLING revenues was $1.0 million for mobilization efforts for an offshore Norway project which has been indefinitely suspended.
Operating Income-CASING DRILLING’s operating loss for the year ended December 31, 2007 increased $7.4 million to a loss of $14.1 million compared to a loss of $6.7 million in 2006. The increase in CASING DRILLING’s 2007 operating loss compared to 2006 was primarily driven by an increased cost base and increased costs associated with the build-up of resources for our CASING DRILLING business throughout the world. As we increased our revenues we expect our margins to substantially improve.
Research and Engineering Segment
Research and Engineering’s operating loss is comprised of our activities related to the design and enhancements of our top drive models and proprietary equipment and was $12.0 million for 2007, an increase of
Index to Financial Statements
$6.0 million from 2006. This increase is primarily due to expenditures related to the development and market introduction of a new generation of hydraulic and electric top drives in the summer of 2007 and additional product development activity focusing on the commercialization and enhancement of existing proprietary technologies in our Tubular Services and CASING DRILLING businesses.
Corporate and Other
Corporate and Other is primarily comprised of the corporate level general and administrative expenses and corporate level selling and marketing expenses. Corporate and Other’s operating loss for the year ended December 31, 2007 increased $3.4 million to a $29.8 million loss compared to 2006. This increase is primarily due to the professional fees incurred in the first quarter of 2007 as a result of our transition from a foreign private issuer to a U.S. reporting company, the various issues and events related to the delayed filing of our initial Annual Report on Form 10-K for the year ended December 31, 2006, the increased auditing fees associated with our initial year of testing our internal controls pursuant to Section 404 of the Sarbanes Oxley Act, costs associated with the restatements of our quarterly results for the second and third quarters of 2006 and the costs associated with our self-initiated review of the Company’s stock option practices and related accounting. Corporate and Other’s operating loss includes bad debt expense (benefit) which was $1.2 million for 2007 and ($1.7) million for 2006. The 2006 bad debt benefit reflects the collection of a receivable previously written off when the customer filed for bankruptcy in 2003.
Net Income
Interest Expense-Interest expense for 2007 decreased $0.2 million primarily due to interest expense in 2006 including an accrual of $1.2 million arising out of a claim for foreign withholding tax on payments made over the period from 2000 to 2004 (see Note 10 to the Consolidated Financial Statements) partially offset by interest expense related to higher average debt levels during 2007.
Interest Income-Interest income for 2007 decreased $0.1 million to $1.2 million primarily due to lower average cash balances on hand as compared to 2006 during 2007.
Foreign Exchange Losses-Foreign exchange losses increased $1.8 million to $2.9 million primarily due to the weakening of the U.S. dollar during 2007 against the Canadian dollar related to an increase in U.S. dollar net receivables held by our Canadian operations.
Index to Financial Statements Other (Income) Expense-Other (Income) Expense includes non-operating income and expenses, including investment activities. Following is a detail of the significant items that are included in Other (Income) Expense for 2007 and 2006 (in thousands):
For a description of these items, see Notes 2, 8 and 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Income Taxes-TESCO is an Alberta, Canada corporation. We conduct business and are taxable on profits earned in a number of jurisdictions around the world. Our income tax expense is provided based on the laws and rates in effect in the countries in which operations are conducted or in which TESCO and/or its subsidiaries are considered residents for income tax purposes. Income tax expense as a percentage of pre-tax earnings fluctuates from year to year based on the level of profits earned in each jurisdiction in which we operate and the tax rates applicable to such profits.
Our effective tax rate for 2007 was 24% compared to 44% in 2006. The 2007 effective tax rate reflects a $3.4 million benefit related to 2006 return to accrual adjustments as a result of our Canadian, U.S. and other foreign tax returns and a $0.8 million benefit primarily related to the favorable resolution of a Mexico tax claim offset by a $1.7 million charge related to a reduction in deferred tax assets attributable to reduced statutory tax rates for Canadian federal taxes. Our 2007 effective tax rate also includes a $1.5 million benefit related to the release of the valuation allowance established against the foreign tax credits generated in 2006, which was offset by a valuation allowance established against foreign tax credits generated in 2007 and a valuation allowance established against 2007 losses of certain foreign subsidiaries. The 2006 effective tax rate was higher than the federal statutory rate primarily due to a $1.6 million charge related to a reduction in deferred tax assets attributable to Canadian tax law changes which incrementally reduced the statutory tax rates for both Canadian federal and provincial (Alberta) taxes.
The benefit related to filing our 2006 U.S. federal and state tax returns was $2.2 million and was primarily due to an allocation of 2006 earnings between our U.S. subsidiary and U.S. branch in the preparation of our tax returns. Because this allocation was not performed in the preparation of our 2006 income tax provision, such benefit should have been recorded in 2006. We believe that the effect of recording this tax adjustment in 2007 instead of 2006 is immaterial to both the current year and prior year financial statements taken as a whole.
No provision is made for taxes that may be payable on the repatriation of accumulated earnings in our foreign subsidiaries on the basis that these earnings will continue to be used to finance the activities of these subsidiaries.
For a further description of income tax matters, see Note 8 to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
Index to Financial Statements QUARTERLY PERIOD ENDED DECEMBER 31, 2008
Revenues and operating income by business segment and net income for each of the three month periods ended December 31, 2008, September 30, 2008 and December 31, 2007 were (in thousands):
(1) At the end of 2008, we commenced the presentation of our Tubular Services business and CASING DRILLING as two separate segments. Accordingly, we have reclassed revenues for the three months ended September 30, 2008 and December 31, 2007 of approximately $6.5 million and $6.3 million, respectively, and operating losses for the three months ended September 30, 2008 and December 31, 2007 of approximately $3.1 million and $2.2 million, respectively, from the former Casing Services segment to the CASING DRILLING segment to conform to our current year presentation.
(2) At the end of 2007, we commenced the presentation of Tubular Services revenue according to two categories: conventional and proprietary. Prior to January 1, 2008, MCLRS and certain parts sales and services were included with conventional services. However, since these activities use proprietary and patented technology, we now include them with our proprietary information. Accordingly, we have reclassified revenues of approximately $2.7 million related to these activities from conventional to proprietary for the three months ended December 31, 2007 to conform to our current year presentation.
(3) We incur costs directly and indirectly associated with our revenues at a business unit level. Direct costs include expenditures specifically incurred for the generation of revenue, such as personnel costs on location or transportation, maintenance and repair, and depreciation of our revenue-generating equipment. Overhead costs, such as field administration and field operations support, are not directly associated with the generation of revenue within a particular business segment. In prior years, we allocated total overhead costs at a consolidated level based on a percentage of global revenues. During the current year, we were able to identify and capture, where appropriate, the specific operating segments in which we incurred overhead costs at the business unit level. Using this information, we have reclassified our prior year segment
Index to Financial Statements
operating results to conform to the current year presentation. This reclassification resulted in an increase of $5.5 million in operating income in the Top Drive segment and a corresponding decrease of $5.5 million in the Tubular Services segment for the three months ended December 31, 2007.
Quarterly Period Ended December 31, 2008 Compared to Quarterly Period Ended September 30, 2008
Revenue for the three months ended December 31, 2008 was $139.4 million, compared to $140.0 million for the three months ended September 30, 2008, a decrease of $0.6 million, due to a decrease of $0.7 million in the Top Drive segment, partially offset by an increase of $0.2 million in the Tubular Services segment. CASING DRILLING revenues were approximately the same across the periods.
Operating income for the three months ended December 31, 2008 was $16.9 million, compared to $25.4 million for the three months ended September 30, 2008, a decrease of $8.5 million, or 34%, primarily attributable to a $6.0 million decrease in the Top Drive business segment and a $2.3 million decrease in the Tubular Services segment.
Net income for the three months ended December 31, 2008 was $12.0 million, compared to $17.6 million for the three months ended September 30, 2008, a decrease of $5.6 million, or 32%. This decrease was primarily the result of lower operating income and an increase in the effective tax rate, partially offset by increased foreign exchange gains during the three months ended December 31, 2008.
Top Drive Segment
The decrease in the Top Drive segment revenues is primarily the result of decreased revenues from used top drive sales and aftermarket support activities. During the three months ended December 31, 2008, we sold 38 top drive units (37 new units and 1 used unit) as compared to 38 units (32 new units and 6 used units) during the three months ended September 30, 2008. Typically, used units sold from our rental fleet generate higher income due to their lower carrying values on our balance sheet. Of the new top drive units sold during the three months ended December 31, 2008, 13 units were smaller units that typically earn smaller profits, compared to 11 units of this type sold during the three months ended September 30, 2008. During the three months ended December 31, 2008 we delivered 8 units to our rental fleet.
Our top drive rental revenues increased $2.0 million compared to the three months ended September 30, 2008 resulting from increased prices for units rented in North America during the three months ended December 31, 2008. This increase was partially offset by a 3% decrease in operating days, due to the time lag that occurred when used units sold from the rental fleet were prepared for sale and prior to the time that the new replacement units were mobilized for operations.
Top Drive operating income decreased $6.0 million primarily due to a decreased number of used top drive sales and a margin decrease due to the sale of smaller new top drive units discussed above.
Tubular Services Segment
The increase in the Tubular Services segment revenues was primarily attributable to an increase of $2.3 million, or 10%, in proprietary revenues. This increase resulted from an increased number of proprietary jobs performed from 496 jobs last quarter to 540 during the three months ended December 31, particularly in North America. The increase in the number of jobs during the three months ended December 31, 2008 was due in part to projects that were delayed from the three months ended September 30, 2008 because of Hurricanes Gustav and Ike. The increase in proprietary revenues was mostly offset by a $2.0 million decrease in conventional revenues as we continue to shift the focus of our business to our proprietary product offerings.
Tubular Services operating income decreased $2.3 million, or 32%, primarily due pricing pressures during the three months ended December 31, 2008 that resulted in decreased margins, while our labor, fuel and maintenance costs increased due to the increase in the volume of work performed.
Index to Financial Statements CASING DRILLING Segment
Our CASING DRILLING revenues were essentially unchanged between the two periods, with revenues of $6.4 million for the three months ended December 31, 2008 and $6.5 million for the three months ended September 30, 2008.
We recognized $0.4 million in additional losses during the three months ended December 31, 2008 in our CASING DRILLING business compared to the previous quarter. This was a result of flat revenues and increased maintenance, freight, travel and depreciation expenses as we worked to expand our global product offering.
Research and Engineering Segment
R&E expenses for the three months ended December 31, 2008 increased $0.3 million to $2.9 million compared to the three months ended September 30, 2008, in part due to $0.2 million in patent fees incurred during the three months ended December 31, 2008. The remaining $0.2 million increase was due to an increase in product development work.
Corporate and Other
Corporate and Other expenses decreased $0.4 million to $8.0 million for the three months ended December 31, 2008 compared to $8.4 million for the three months ended September 30, 2008 due to a $1.3 million decrease in incentive compensation related to lower quarterly earnings, offset by a $0.7 million increase in compensation expense.
Net Income
Net income for the three months ended December 31, 2008 was $12.0 million, compared to $17.6 million for the three months ended September 30, 2008, a decrease of $5.6 million, or 32%. This decrease is primarily due to the decrease in operating income discussed above and an increase in the effective tax rate from 27% during the three months ended September 30, 2008 to 31% during the three months ended December 31, 2008, slightly offset by increased foreign exchange gains recognized during the three months ended December 31, 2008 due to the strengthening of the U.S. dollar.
Quarterly Period Ended December 31, 2008 Compared to Quarterly Period Ended December 31, 2007
Revenue for the three months ended December 31, 2008 was $139.4 million, compared to $124.4 million for the three months ended December 31, 2007, an increase of $15.0 million or 12%, due to an increase of $12.3 million in the Top Drive segment and a $2.7 million increase in the Tubular Services segment. CASING DRILLING segment revenues remained the same for both periods.
Operating income for the three months ended December 31, 2008 was $16.9 million, compared to $13.3 million for the three months ended December 31, 2007, an increase of $3.5 million, or 27%. This increase is primarily due to an increase of $5.6 million in the Top Drive segment, offset by a decrease of $1.2 million in the CASING DRILLING segment and additional Corporate and Other expenses of $1.1 million.
Net income for the three months ended December 31, 2008 was $12.0 million, compared to $6.6 million for the three months ended December 31, 2007, an increase of $5.4 million, or 82%. This increase was primarily the result of higher operating income and increased foreign exchange gains, partially offset by an increase in the effective tax rate during the three months ended December 31, 2008.
Top Drive Segment
The increase in the Top Drive segment revenues is primarily the result of increased average new top drive sales prices, the increase in used units sold and increased aftermarket support activities. During the three months
Index to Financial Statements
ended December 31, 2008, we sold 38 top drive units (37 new units and 1 used unit) as compared to 29 units (20 new units and 9 used units) during the three months ended December 31, 2007. The increase in new top drive unit sales was in response to strong market demand. Our top drive rental revenues increased $1.4 million due to increased day rates; operating days were approximately the same for the two periods.
Top Drive operating income increased $5.6 million primarily due to increased top drive sales as discussed above, partially offset by lower rental margins. These lower margins resulted from increased refurbishment and maintenance costs associated with the high utilization of our rental fleet during the current year period and refurbishment costs associated with the preparation of certain used top drive units for sale.
Tubular Services Segment
Our Tubular Services segment revenues increased $2.6 million between the two periods. The increase in our proprietary revenues of $12.0 million was associated with a 42% increase in our proprietary casing running services and a $1.3 million increase in CDS parts sales compared to the same period last year. The decrease in conventional revenues of $9.4 million was due to our shift from conventional to proprietary work.
Tubular Services operating income decreased $0.2 million, or 4%, primarily due to increased depreciation expenses and fuel prices in 2008.
CASING DRILLING Segment
Revenues for CASING DRILLING remained relatively the same at $6.4 million for the three months ended December 31, 2008 compared to $6.3 million for the same period last year.
CASING DRILLING’s operating loss increased $1.2 million, or 57%, to a loss of $3.4 million compared to the same period in 2007. This increased loss is primarily due to increased labor and depreciation costs as we expand this business.
Research and Engineering Segment
R&E expenses for the three months ended December 31, 2008 were $2.9 million, compared to $3.5 million for the three months ended December 31, 2007 primarily due to decreased product development activities on our top drive models during the current year period.
Corporate and Other
Corporate and Other expenses increased to $8.0 million for the three months ended December 31, 2008 as compared to $6.8 million for the three months ended December 31, 2007. This increase is primarily due to a $0.6 million increase in compensation expense from the same period in 2007.
Net Income
Net income for the three months ended December 31, 2008 was $12.0 million, compared to $6.6 million for the three months ended December 31, 2007, an increase of $5.4 million, or 82%. This increase is primarily due increased operating income discussed above and a $1.2 million loss in 2007 from the expiration of the Turnkey warrants.
LITIGATION AND CONTINGENCIES
In the normal course of our business, we are subject to legal proceedings brought by or against us and our subsidiaries. As described in Part I, Item 3 of this Form 10-K (Legal Proceedings) and in Notes 8 and 10 of the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and
Index to Financial Statements
Supplementary Data), we are currently subject to litigation regarding certain competitor patents and regarding taxes in Mexico. Our estimates of exposure related to this litigation represent our best estimates based on consultation with internal and external legal counsel. There can be no assurance as to the eventual outcome or the amount of loss we may suffer as a result of these proceedings. We do not believe that any such proceedings, either individually or in the aggregate, will have a material adverse effect on our consolidated financial position, results of operations or cash flows.
LIQUIDITY AND CAPITAL RESOURCES
Our net cash and cash equivalents or debt position as of December 31, 2008 and 2007 was as follows (in thousands):
The decrease in Net Debt during 2008 was primarily due to using our cash provided by operations to reduce our outstanding debt balances by $31.2 million. We have reported Net Debt because we regularly review Net Debt as a measure of our performance. However, the measure presented in this document may not always be comparable to similarly titled measures reported by other companies due to differences in the components of the measurement.
On December 21, 2007, we and our existing lenders entered into an amended and restated credit agreement (the “Amended Credit Agreement”) to provide up to $145 million in revolving loans including up to $15 million of swingline loans (collectively, the “Revolver”) and a term loan which had a balance of $20.0 million as of December 31, 2007 with required quarterly payments through October 31, 2009. The Amended Credit Agreement has a term of five years and all outstanding borrowings on the Revolver will be due and payable on June 5, 2012. In March 2008, we entered into a second amendment to the Amended Credit Agreement in order to increase the limit on permitted capital expenditures during the quarters ending March 31, June 30 and September 30, 2008 from 70% to 85% of consolidated EBITDA (as defined in the Amended Credit Agreement). Amounts available under the Revolver are reduced by letters of credit issued under the Amended Credit Agreement not to exceed $20 million in the aggregate of all undrawn amounts and amounts that have yet to be disbursed under all existing letters of credit. Amounts available under the swingline loans may also be reduced by letters of credit or by means of a credit to a general deposit account of the applicable borrower. As of December 31, 2008, we had $5.5 million in letters of credit outstanding under our credit facility and $100.1 million available under the Revolver.
The Amended Credit Agreement contains covenants that we consider usual and customary for an agreement of this type, including a leverage ratio, a minimum net worth, and a fixed charge coverage ratio. Pursuant to the terms of the Amended Credit Agreement, we are prohibited from incurring any additional indebtedness outside the existing Credit Facility, in excess of $15 million, paying cash dividends to shareholders and other restrictions which are standard to the industry. The Amended Credit Agreement is secured by substantially all our assets. All of our direct and indirect material subsidiaries in the United States and Canada are guarantors of any borrowings under the Amended Credit Agreement. Additionally, our capital expenditures are limited to 70% of consolidated EBITDA plus net proceeds from asset sales. The capital expenditure limit decreases to 60% of consolidated EBITDA plus net proceeds from asset sales for fiscal quarters ending after June 30, 2010. In March 2008, we entered into a second amendment to the Amended Credit Agreement in order to increase the limit on permitted capital expenditures during the quarters ending March 31, June 30 and September 30, 2008 from 70% to 85% of consolidated EBITDA (as defined in the Amended Credit Agreement).
Index to Financial Statements As of December 31, 2008, we believe that we are in compliance with our debt covenants in the Amended Credit Agreement. For further description of the Amended Credit Agreement, see Note 6 to the Consolidated Financial Statements in this Form 10-K (Financial Statements and Supplementary Data).
Outstanding borrowings under our revolving credit facility were $39.4 million and the outstanding balance on our term loan was $10.0 million as of December 31, 2008. Our credit facility is maintained by a syndicate of seven banks, none of which have indicated any insolvency issues to us.
Our investment in working capital, excluding cash and current portion of long term debt, decreased $14.4 million to $134.9 million at December 31, 2008 from $149.3 million at December 31, 2007. The decrease during 2008 was primarily attributable to reductions in our inventory, offset by a decrease in our accounts payable.
Our manufacturing capacity has been expanded to meet our customer and internal demand and allows us to build 12 to 16 top drive units per month, depending on system complexity. The resulting increase in top drive units sold to customers has increased our installed base throughout the world, which has provided expansion opportunities for our after-market sales and service business. Additionally, excluding one customer, we have seen a shift in market demand to larger, more complex units. These factors have driven our increase in inventory levels. We believe that our top drive business needs to maintain manufacturing inventory of two quarters of production to limit our exposure in the event that the sales market softens and allows us to effectively manage our supply chain and workforce. In addition, we must maintain additional inventory of long lead time items and semi-finished goods to support our after-market sales and service business and our manufacturing operations. In 2006 we initiated a Sales and Operational Planning program to balance market demand with inventory and our ability to supply top drives. In mid-2008, we initiated a Global Distribution Center (“GDC”) in order to more closely monitor our global parts inventory and to provide our operating locations with a centralized purchasing center. We believe the GDC will improve our purchasing power with suppliers and allow us to provide inventory parts to our customers around the world in a more expedient manner. Based on current market activity, we believe that 2009 new unit sales will be somewhat less than 2008, but that our after-market services will sustain better due to the size of our installed base around the globe. We intend to manage our current production levels in response to demand fluctuations.
Following is the calculation of working capital, excluding cash and current portion of long term debt, at December 31, 2008 and 2007 (in thousands):
During 2008, our capital expenditures were $79.3 million, primarily related to the revitalization of our rental top drive fleet, additions of proprietary tubular services equipment in the Tubular Services segment and additions of proprietary equipment in the CASING DRILLING segment. We project our capital expenditures for 2009 to be approximately $40 to $50 million. In 2008, we established a top drive fleet revitalization initiative, under which we sold 19 top drives and replaced them with 35 new units. The planned decrease from our 2008 capital spending levels is directly related to the completion of this project, along with our 2009 strategy to judiciously apply our capital spending in markets that will perform in spite of the worldwide economic slowdown.
Index to Financial Statements We believe that during 2009, cash generated from operations and amounts available under our existing credit facilities will be sufficient to fund our working capital needs and capital expenditures.
Contractual Obligations
The following is a summary of our significant future contractual obligations by year as of December 31, 2008 (in thousands):
Future interest payments were forecast based upon the applicable rates in effect at December 31, 2008 of 1.99% for the Secured Revolver and 4.44% for the Term Loan.
Major Customers and Credit Risk
Our accounts receivable are principally with major international and state oil and gas service and exploration and production companies and are subject to normal industry credit risks. We perform ongoing credit evaluations of customers and grant credit based upon past payment history, financial condition and anticipated industry conditions. Customer payments are regularly monitored and a provision for doubtful accounts is established based upon specific situations and overall industry conditions. Many of our customers are located in international areas that are inherently subject to risks of economic, political and civil instabilities, which may impact our ability to collect those accounts receivable.
For the years ended December 31, 2008, 2007 and 2006, no single customer represented more than 10% of total revenue.
ENVIRONMENTAL MATTERS
We are subject to numerous environmental, legal, and regulatory requirements related to our operations worldwide. In the United States, these laws and regulations include, among others:
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the Comprehensive Environmental Response, Compensation, and Liability Act;
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the Resources Conservation and Recovery Act;
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the Clean Air Act;
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the Federal Water Pollution Control Act; and
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the Toxic Substances Control Act.
In addition to the federal laws and regulations, states and other countries where we do business may have numerous environmental, legal, and regulatory requirements by which we must abide. We evaluate and address the environmental impact of our operations by assessing and remediating contaminated properties in order to avoid future liabilities and complying with environmental, legal, and regulatory requirements. On occasion, we are involved in specific environmental claims, including the remediation of properties we own or have operated, as well as efforts to meet or correct compliance-related matters. Our Quality, Health, Safety and Environment group has programs in place to maintain environmental compliance and to prevent the occurrence of environmental contamination.
Index to Financial Statements We do not expect costs related to these remediation activities to have a material adverse effect on our consolidated financial position, results of operations or cash flows. During 2008, the Company listed for sale a building and land located in Canada. The Company incurred approximately $0.9 million in soil remediation costs to prepare the property for sale; these costs have been capitalized and are reported as an increase in the property’s net book value as of December 31, 2008. Other than these expenditures, we did not incur any material costs in 2008, 2007 or 2006 as a result of environmental protection requirements, nor do we anticipate environmental protection requirements to have any material financial or operational effects on our capital expenditures, earnings or competitive position in future years.
TRANSACTIONS WITH RELATED PARTIES
Turnkey E & P Inc.
Robert M. Tessari is Chairman of the Board and President of Turnkey E & P Inc. (“Turnkey”) and serves on our Board of Directors and was our founder and former Chief Executive Officer and Chief Technology Officer. On November 16, 2007, TESCO, Turnkey and Mr. Tessari entered into a Consulting Agreement and Intellectual Property Rights Assignment (the “Consulting Agreement”), effective as of July 16, 2007. The Agreement provides that Turnkey will make Mr. Tessari available to provide consulting services to us from time to time and provide reasonable assistance in testing and developing our products and services. The term of the Consulting Agreement is for three years from its effective date and shall thereafter automatically renew for successive one year terms unless any party gives 180 days’ written notice of termination prior to the renewal date. As consideration, Turnkey will (i) be reimbursed for all reasonable, ordinary and necessary expenses incurred by Mr. Tessari and (ii) will receive preferred customer pricing on our products as follows:
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For purchased products for Turnkey’s internal use, Turnkey shall receive preferred customer pricing equal to the lesser of (a) our direct cost plus ten percent (10%) or (b) eighty-five percent (85%) of the lowest price charged to another one of our customers that is not an affiliate. In the event Turnkey can demonstrate that it can build a consumable product of ours at a substantially lower cost than ours, Turnkey may offer to us the right to provide such product at such lower price. If we choose not to provide such product at such price, Turnkey may manufacture such product and pay us a royalty of 10% of Turnkey’s manufacturing cost.
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For rented products for Turnkey’s internal use, the preferred customer day rate pricing shall be calculated as the sum of (a) our direct manufacturing cost of the product divided by 730 plus (b) 10%. Turnkey guarantees a minimum of 200 rental days per year for each rented product.
In addition, in the event that Turnkey proposes development of a product or service (the “New Technology”) that we do not want to design, test and/or commercialize, Turnkey shall have a limited, nonexclusive, nontransferable license to develop, manufacture and use the New Technology for its own internal purposes. If we subsequently decide to manufacture the New Technology, we shall give notice to Turnkey, and Turnkey shall thereafter be obliged to purchase any additional products containing the New Technology from us at the prices set forth above. In that event, we shall repay Turnkey three times the documented development cost of the New Technology. All intellectual property rights in any way related to inventions made or conceived or reduced to practice within the oilfield services field pursuant to the Consulting Agreement will belong to us. During 2008 and 2007, Turnkey purchased $1.0 million and $0.7 million, respectively, of products and services from us pursuant to the Consulting Agreement. In November 2008, Turnkey filed for protection under Chapter 11 of the U.S. Bankruptcy Code. As a result, we recognized bad debt expense of $0.4 million associated with a write-off of accounts receivable due to us from Turnkey.
During 2007 prior to the effective date of the Consulting Agreement discussed above and during 2006, Turnkey purchased other CASING DRILLING-related and other services and equipment from us in the amount of $1.9 million and $2.2 million, respectively. The prices we charged Turnkey prior to July 16, 2007 were on terms similar to those that we charge other third parties. After that date, Turnkey was charged rates as specified
Index to Financial Statements
in the Consulting Agreement. Also, during 2006, we provided drilling rigs to our CASING DRILLING customers which we had leased from a third party. The crews for these drilling rigs were provided to us by Turnkey pursuant to a Rig Personnel Supply Agreement. Turnkey charged us $5.1 million to supply these drilling rig crews in 2006 which represents the actual cost incurred by Turnkey plus a 15% markup. The Rig Personnel Supply Agreement terminated in late 2006. However, pursuant to that agreement, TESCO has since indemnified Turnkey for $0.5 million in third party claims arising under that agreement. Prior to the effective date of the Consulting Agreement discussed above, we believe that the prices we charged Turnkey and Turnkey charged us were on terms similar to those that would have been available from other third parties.
In 2005, we sold four drilling rigs to Turnkey for proceeds of $35.0 million plus warrants exercisable over a course of two years to purchase one million shares of Turnkey stock at a price of C$6.00. We received a fairness opinion related to the sale of the rigs to Turnkey and as such believe that the terms of the rig sale were comparable to those that would have been available from other third parties. We did not exercise the warrants prior to their expiration in December 2007 and therefore we recognized a $1.2 million loss related to the fair value of the warrants when they were received.
St. Mary Land & Exploration Company
Our President and Chief Executive Officer is a member of the Board of Directors of St. Mary Land & Exploration Company (“St. Mary”). St. Mary is engaged in the exploration, development, acquisition and production of natural gas and oil in the U.S. During 2008 St. Mary did not purchase any services from us. During 2007 and 2006, St. Mary purchased $0.1 million and $0.6 million, respectively, in top drive rental and Tubular Services from us. We believe that the prices we charged St. Mary were on terms similar to those provided to other third parties.
Helix Energy Solutions Group, Inc.
Our former Chief Financial Officer was a member of the Board of Directors of Helix Energy Solutions Group, Inc. (“Helix”). Helix is an international offshore contract services provider and oil and gas exploration, development and production company. During 2008 Helix did not purchase any services from us. During 2007, Helix purchased and $0.1 million in Tubular Services from us. We believe that the prices we charged Helix were on terms similar to those provided to other third parties.
Bennett Jones LLP
Additionally, our primary outside counsel in Canada is Bennett Jones LLP. One of our directors is counsel at Bennett Jones LLP. During each of the years 2008, 2007 and 2006, we paid approximately $0.4 million for services from Bennett Jones LLP, excluding reimbursement by us of patent filing fees and other expenses. We believe that the rates we paid Bennett Jones LLP for services are on terms similar to those that would have been available from other third parties.
SIGNIFICANT ACCOUNTING POLICIES
The preparation and presentation of our financial statements requires management to make estimates that significantly affect the results of operations and financial position reflected in the financial statements. In making these estimates, management applies accounting policies and principles that it believes will provide the most meaningful and reliable financial reporting. Management considers the most significant of these estimates and their impact to be:
Foreign Currency Translation-The U.S. dollar is the functional currency for most of our worldwide operations. For foreign operations where the local currency is the functional currency, specifically our Canadian
Index to Financial Statements
operations, assets and liabilities denominated in foreign currencies are translated into U.S. dollars at end-of-period exchange rates, and the resultant translation adjustments are reported, net of their related tax effects, as a component of accumulated other comprehensive income in shareholders’ equity. Monetary assets and liabilities denominated in currencies other than the functional currency are remeasured into the functional currency prior to translation into U.S. dollars, and the resultant exchange gains and losses are included in income in the period in which they occur. Income and expenses are translated into U.S. dollars at the average exchange rates in effect during the period.
Revenue Recognition-We recognize revenues when the earnings process is complete and collectability is reasonably assured when title and risk of loss of the equipment is transferred to the customer, with no right of return. Revenue in the Top Drive segment may be generated from contractual arrangements that include multiple deliverables. Revenue from these arrangements is recognized as each item or service is delivered based on their relative fair value and when the delivered items or services have stand-alone value to the customer. For services and rental activities, we recognize revenues as the services are rendered based upon agreed daily, hourly or job rates.
We provide product warranties on equipment sold pursuant to manufacturing contracts and provide for the anticipated cost of such warranties in cost of sales when sales revenue is recognized. The accrual of warranty costs is an estimate based upon historical experience and upon specific warranty issues as they arise. We periodically review our warranty provision to assess its adequacy in the light of actual warranty costs incurred. Because the warranty accrual is an estimate, it is reasonably possible that future warranty issues could arise that could have a significant impact on our financial statements.
Deferred Revenues-We generally require customers to pay a non-refundable deposit for a portion of the sales price for Top Drive units with their order. These customer deposits are deferred until the customer takes title and risk of loss of the product.
Accounting for Stock-Based Compensation-We recognize compensation expense on stock-based awards to employees, directors and others. For those awards that we intend to settle in stock, compensation expense is based on the calculated fair value of each stock-based award at its grant date, the estimation of which may require us to make assumptions about the future volatility of our stock price, rates of forfeiture, future interest rates and the timing of grantees’ decisions to exercise their options.
Allowance for Doubtful Accounts Receivable-We perform ongoing credit evaluations of customers and grant credit based upon past payment history, financial condition and anticipated industry conditions. Customer payments are regularly monitored and a provision for doubtful accounts is established based upon specific situations and overall industry conditions. Many of our customers are located in international areas that are inherently subject to risks of economic, political and civil instabilities, which may impact management’s ability to collect those accounts receivable. The main factors in determining the allowance needed for accounts receivable are customer bankruptcies, delinquency, and management’s estimate of ability to collect outstanding receivables based on the number of days outstanding.
Excess and Obsolete Inventory Provisions-Quantities of inventory on hand are reviewed periodically to ensure they remain active part numbers and the quantities on hand are not excessive based on usage patterns and known changes to equipment or processes. Significant or unanticipated changes in business conditions could impact the amount and timing of any additional provision for excess or obsolete inventory that may be required.
Impairment of Long-Lived Assets, Goodwill and Intangibles-Long-lived assets, which include property, plant and equipment, goodwill and intangible and other assets, comprise a substantial portion of our assets. The carrying value of these assets is reviewed for impairment on an annual basis or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. This requires us to forecast future cash flows to be derived from the utilization of these assets based upon assumptions about future business
Index to Financial Statements
conditions or technological developments. Significant, unanticipated changes in circumstances could make these assumptions invalid and require changes to the carrying value of our long-lived assets.
Income Taxes-We use the liability method which takes into account the differences between financial statement treatment and tax treatment of certain transactions, assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Valuation allowances are established to reduce deferred tax assets when it is more likely than not that some portion or all of the tax asset will not be realized. Estimates of future taxable income and ongoing tax planning have been considered in assessing the utilization of available tax losses and credits. Changes in circumstances, assumptions and clarification of uncertain tax regimes may require changes to any valuation allowances associated with our deferred tax assets.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination of the Useful Life of Intangible Assets.” FSP No. SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The intent of FSP No. SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) (revised 2007), “Business Combinations” and other applicable accounting literature. FSP No. SFAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. We do not expect the adoption of this statement to have a material impact on our consolidated financial statements.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” This statement identifies the source of accounting principles and the framework for selecting the principles to be used in preparing financial statements presented in conformity with U.S. GAAP. Furthermore, it arranges these sources of U.S. GAAP in a hierarchy for users to apply accordingly. This statement was effective November 15, 2008 and the adoption did not have a material impact on our consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an Amendment of FASB Statement 133.” This statement enhances required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b) derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”; and (c) derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. We will adopt the provisions of SFAS No. 161 on January 1, 2009 and are currently reviewing the impact of the adoption of this statement. It is not expected to have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No.51.” This Statement amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. Additionally, this Statement requires that consolidated net income include the amounts attributable to both the parent and the noncontrolling interest. This Statement is effective for interim periods beginning on or after December 15, 2008. We will adopt the provisions SFAS No. 160 on January 1, 2009 and do not expect the adoption of this statement to have a material impact on our consolidated financial statements.
Index to Financial Statements In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 141 R, “Business Combinations (a revision of Statement No. 141,” which significantly changes the principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement is effective on a prospective basis to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, and early adoption is prohibited. SFAS 141R is effective for business combinations for which the acquisition date is on or after January 1, 2009. In addition, SFAS No. 141(R) is effective January 1, 2009 for certain income tax effects of prior acquisitions. In February 2009, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 141(R)-a, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies (“FSP 141(R)-a”), which will amend the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination under SFAS No. 141(R). The recently issued FSP 141(R)-a is also effective January 1, 2009. We are currently evaluating the potential impact of this statement. It is not expected to have a material impact on our consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2, “Effective Date of FASB Statement No. 157,” which delays the effective date for non-financial assets and non-financial liabilities to fiscal years beginning after November 15, 2008, except for items that are measured at fair value in the financial statements on a recurring basis (at least annually). We adopted the provisions of SFAS No. 157 for our financial assets and liabilities and those items for which we have measured on a recurring basis effective January 1, 2008, and the adoption did not have a material impact on our financial position and results of operations. For additional information see “Fair Value Reporting,” below. As provided by FSP No. 157-2, we have elected to defer the adoption of SFAS No. 157 for certain of our non-financial assets and liabilities, primarily its goodwill and intangible assets, and is currently evaluating the impact, if any, that this statement will have on our financial statements as it relates to non-financial assets and non-financial liabilities that are recognized or disclosed on a non-recurring basis. In October 2008 the FASB issued FSP SFAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, to clarify the application of the provisions of SFAS 157 in an inactive market and how an entity would determine fair value in an inactive market. FSP 157-3 became effective immediately and did not materially affect our results of operations or financial condition as of and for the periods ended December 31, 2008.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115.” This statement permits entities to choose to measure financial assets and liabilities, except those that are specifically scoped out of the Statement, at fair value. The election to measure a financial asset or liability at fair value can be made on an instrument-by-instrument basis and is irrevocable. The difference between carrying value and fair value at the election date is recorded as a transition adjustment to opening retained earnings. Subsequent changes in fair value are recognized in earnings. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. We did not elect to adopt the fair value provisions of SFAS No. 159 on January 1, 2008. Therefore, the adoption did not have a material impact on our financial position and results of operations.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. FIN No. 48
Index to Financial Statements
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. We adopted the provisions of FIN No. 48 on January 1, 2007. As a result of the implementation of FIN No. 48, we recognized no material adjustment in our accrual for uncertain tax positions. At the date of adoption, we had an accrual for uncertain tax positions of $1.4 million which was $0.6 million as of December 31, 2007 and $1.2 million as of December 31, 2008. Please see Item 8, Footnote 8 for further discussion of these accruals. We recognize interest related to uncertain tax positions in Interest Expense and penalties related to uncertain tax positions are recognized in Other Expense. At December 31, 2007, we had accrued $0.1 million, and at December 31, 2008, we had accrued $0.3 million for the potential payment of interest and penalties on uncertain tax positions.
SHARE CAPITAL
We have an unlimited number of Common Shares authorized for issuance. At February 23, 2009, there were 37,520,308 Common Shares issued and outstanding. At December 31, 2008, there were 1,479,054 outstanding options and 744,607 restricted stock awards exercisable into Common Shares.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
From time to time, we use derivative financial instruments in the management of our foreign currency and interest rate exposures. We do not use derivative financial instruments for trading or speculative purposes and account for all such instruments using the fair value method. Currency exchange exposures on foreign currency denominated balances and anticipated cash flows may be managed by foreign exchange forward contracts when it is deemed appropriate. Exposures arising from changes in prevailing levels of interest rates relative to the contractual rates on our debt may be managed by entering into interest rate swap agreements when it is deemed appropriate.
At December 31, 2007, we had entered into a series of 25 bi-weekly foreign currency forward contracts with notional amounts aggregating C$43.8 million at a weighted average exchange rate of 1.00 to hedge approximately 50% of the Canadian dollar requirements of our Canadian manufacturing operations. Although the forward currency contracts were entered into as an economic hedge of our currency exchange risk, they are not designated as a hedge for accounting purposes. Instead, they are accounted for using a fair value model with changes in each period being recorded in Foreign Exchange Losses in our Consolidated Statements of Income. Based on quoted market prices as of December 31, 2007 for contracts with similar terms and maturity dates, we recorded an asset of $0.1 million to record these foreign currency forward contracts at fair value at December 31, 2007, and to recognize the unrealized gain. During the year ended December 31, 2008, we terminated these bi-weekly foreign currency forward contracts and recognized a loss of $0.6 million. We replaced them with 14 monthly foreign currency forward contracts with notional amounts aggregating C$50.8 million. We subsequently settled two of these contracts and terminated the remaining 12 contracts, and recognized a loss of $0.2 million.
We were not party to any derivative financial instruments at December 31, 2008.
The carrying value of cash, investments in short-term commercial paper and other money market instruments, accounts receivable, accounts payable and accrued liabilities approximate their fair value due to the relatively short-term period to maturity of the instruments.
The fair value of our long term debt depends primarily on current market interest rates for debt issued with similar maturities by companies with risk profiles similar to us. The fair value of our debt related to our credit facility at December 31, 2008 was approximately $37.5 million. We also have long term debt in the form of a term loan. The fair value of our term loan debt at December 31, 2008 was approximately $9.6 million. A one percent change in interest rates would increase or decrease interest expense $0.5 million annually based on amounts outstanding at December 31, 2008.
Index to Financial Statements Our accounts receivable are principally with oil and gas service and exploration and production companies and are subject to normal industry credit risks. The recent volatility in the capital and credit markets could have a significant impact on our industry and us directly. Please see Part I, Item 1A. of this Form 10-K (“Risk Factors”) for further discussion of these recent risks.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Form 10-K and are presented beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in the SEC reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time period specified by the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. As of December 31, 2008, our Chief Executive Officer and Chief Financial Officer participated with our management in evaluating the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Our Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2008, our disclosure controls and procedures were effective.
Management’s Report on Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed by, or under the supervision of, a public company’s Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, and effected by the board of directors, management and other personnel, 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 (“GAAP”). A company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that receipts and expenditures are being made only in accordance with authorizations of management and directors of the company, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment or breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override.
Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Index to Financial Statements Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has assessed the effectiveness of our internal control over financial reporting as of December 31, 2008. In making this assessment, our management used the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
Based on management’s assessment using the COSO criteria we have concluded that, as of December 31, 2008, our internal control over financial reporting was effective.
The effectiveness of our internal control over financial reporting as of December 31, 2008 has been audited by PricewaterhouseCoopers LLP, our independent registered public accounting firm, as stated in their report which is included herein.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter and year ended December 31, 2008 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
Index to Financial Statements PART III
Items 10 through 14 will be included in TESCO’s Proxy Statement for our 2009 Annual Meeting of the Shareholders, and are incorporated herein by reference.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information required by this Item will be included under the section captioned “Election of Directors (Proposal 2)” in our Proxy Statement for the 2009 Annual Meeting of Shareholders, which information is incorporated into this Annual Report by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item will be included under the sections captioned “Compensation Discussion and Analysis” and “Certain Relationships and Related Transactions” in our Proxy Statement for the 2009 Annual Meeting of Shareholders, which information is incorporated into this Annual Report by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this Item will be included under the section captioned “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement for the 2009 Annual Meeting of Shareholders, which information is incorporated into this Annual Report by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
The information required by this Item will be included under the section captioned “Certain Relationships and Related Transactions” in our Proxy Statement for the 2009 Annual Meeting of Shareholders, which information is incorporated into this Annual Report by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Information required by this Item will be included under the section captioned “Ratification of the Appointment of the Independent Auditors (Proposal [3])” in our Proxy Statement for the 2009 Annual Meeting of Shareholders, which information is incorporated into this Annual Report by reference.
Index to Financial Statements PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
(1) Financial Statements
(b) Exhibits
Index to Financial Statements
Index to Financial Statements
* Incorporated by reference
+ Management contract or compensatory plan or arrangement
Index to Financial Statements 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.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Julio M. Quintana and James A. Lank, and each of them, acting individually, as his attorney-in-fact, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this annual report on Form 10-K and other documents in connection herewith and therewith, and to file the same, with all exhibits thereto, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection herewith and therewith and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
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 and on the dates indicated.
Index to Financial Statements INDEX TO FINANCIAL STATEMENTS OF TESCO CORPORATION
AND CONSOLIDATED SUBSIDIARIES
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets-December 31, 2008 and 2007
Consolidated Statements of Income for each of the three years in the period ended December 31,
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2008
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31,
Notes to the Consolidated Financial Statements
Schedule II-Valuation and Qualifying Accounts
Index to Financial Statements REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Tesco Corporation:
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Tesco Corporation and its subsidiaries at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in Management’s Report on Internal Control Over Financial Reporting, appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 8 to the consolidated financial statements, the Company changed the manner in which it accounts for income taxes uncertainties in 2007. As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based payments in 2006.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP
Houston, Texas
February 27, 2009
Index to Financial Statements TESCO CORPORATION
CONSOLIDATED BALANCE SHEETS
(In Thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
Index to Financial Statements TESCO CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, except per share and share information)
The accompanying notes are an integral part of these consolidated financial statements.
Index to Financial Statements TESCO CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
(In Thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
Index to Financial Statements TESCO CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Note 1-Organization and Basis of Presentation
Nature of Operations
Tesco Corporation (“TESCO” or the “Company”) is a global leader in the design, manufacture and service delivery of technology based solutions for the upstream energy industry. We seek to change the way people drill wells by delivering safer and more efficient solutions that add real value by reducing the costs of drilling for and producing oil and gas. Our product and service offerings include proprietary technology, including TESCO CASING DRILLING® (“CASING DRILLING”), TESCO’s Casing Drive System (“CDS™” or “CDS”) and TESCO’s Multiple Control Line Running System (“MCLRS™” or “MCLRS”). TESCO® is a registered trademark in Canada and the United States. TESCO CASING DRILLING® is a registered trademark in the United States. CASING DRILLING® is a registered trademark in Canada and CASING DRILLING™ is a trademark in the United States. Casing Drive System™, CDS™, Multiple Control Line Running System™ and MCLRS™ are trademarks in Canada and the United States.
Basis of Presentation
These Consolidated Financial Statements have been prepared by management in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).
Effective January 1, 2006, TESCO adopted the United States dollar (“U.S. dollar”) as its reporting currency since a majority of its revenue is closely tied to the U.S. dollar and to facilitate comparability to other oil and gas service companies. Unless indicated otherwise, all amounts in these Consolidated Financial Statements are denominated in U.S. dollars. All references to US$ or $ are to U.S. dollars and references to C$ are to Canadian dollars. All comparative figures for prior periods have been restated into U.S. dollars by applying the current rate method.
The consolidated financial statements include the accounts of the Company and its domestic and foreign subsidiaries, all of which are wholly owned. All significant intercompany transactions and balances have been eliminated in consolidation.
The Company incurs costs directly and indirectly associated with its revenues at a business unit level. Direct costs include expenditures specifically incurred for the generation of revenue, such as personnel costs on location or transportation, maintenance and repair, and depreciation of its revenue-generating equipment. Overhead costs, such as field administration and field operations support, are not directly associated with the generation of revenue within a particular business segment. In years prior to 2008, the Company allocated total overhead costs at a consolidated level based on a percentage of global revenues. During 2008, the Company identified and captured, where appropriate, the specific operating segments in which the Company incurred overhead costs at the business unit level. Using this information, the Company has reclassified prior year segment operating results to conform to the current year presentation.
The Company is organized under the laws of Alberta and is therefore subject to the Business Corporation Act (Alberta). The Company is also a reporting issuer (or the equivalent) in each of the provinces of Canada. Effective December 31, 2006, the Company became a U.S. registrant and a domestic filer with the SEC. Through December 31, 2007, the Company filed its financial statements with a reconciliation of its financial statements under U.S. GAAP to Canadian generally accepted accounting principles. This reconciliation is no longer included, as it is no longer required by Canada’s National Instrument 52-102, “Continuous Disclosure Obligations.”
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. The significant estimates made by management in the accompanying consolidated financial statements include reserves for inventory obsolescence, valuation of goodwill, valuation and useful lives of intangible assets and long-lived assets, allowance for doubtful accounts, determination of income taxes, contingent liabilities, stock based compensation, purchase price allocations, warranty provisions and investment valuations. These items are covered in more detail in Notes 2, 4, 5, 6, 7, 8, 9 and 10. Management makes these estimates based on its judgment of the likely outcome of future events and there is a risk that the actual outcome will be different than expected and that such differences will have a material financial effect on future reported results.
Note 2-Summary of Significant Accounting Policies
Revenue Recognition
The Company recognizes revenues when the earnings process is complete and collectability is reasonably assured. TESCO recognizes revenues when title and risk of loss of the equipment are transferred to the customer, with no right of return. Revenue in the Top Drive segment may be generated from contractual arrangements that include multiple deliverables. Revenue from these arrangements is recognized as each item or service is delivered based on their relative fair value and when the delivered items or services have stand-alone value to the customer. For project management services, service and repairs and rental activities, TESCO recognizes revenues as the services are rendered based upon agreed daily, hourly or job rates.
The Company provides product warranties on equipment sold pursuant to manufacturing contracts and provides for the anticipated cost of its warranties in cost of sales when sales revenue is recognized. The accrual of warranty costs is an estimate based upon historical experience and upon specific warranty issues as they arise. The Company periodically reviews its warranty provision to assess its adequacy in light of actual warranty costs incurred. Because the warranty accrual is an estimate, it is reasonably possible that future warranty issues could arise that could have a significant impact on the Company’s financial statements.
Market for Common Stock
TESCO’s common stock is traded on The Nasdaq Global Market (“NASDAQ”) under the symbol “TESO.” Until June 30, 2008, TESCO’s common stock was also traded on the Toronto Stock Exchange (“TSX”) under the symbol “TEO.” Effective June 30, 2008, the Company voluntarily delisted its shares from the TSX.
Foreign Currency Translation
The U.S. dollar is the functional currency for all of the Company’s worldwide operations except for its Canadian operations. For foreign operations where the local currency is the functional currency, specifically the Company’s Canadian operations, assets and liabilities denominated in foreign currencies are translated into U.S. dollars at end-of-period exchange rates, and the resulting translation adjustments are reported, net of their related tax effects, as a component of Accumulated Other Comprehensive Income in Stockholders’ Equity. Assets and liabilities denominated in currencies other than the functional currency are remeasured into the functional currency prior to translation into U.S. dollars, and the resulting exchange gains and losses are included in income in the period in which they occur. Income and expenses are translated into U.S. dollars at the average exchange rates in effect during the period. The effects of foreign currency transactions were (gains) losses of ($0.4) million, $2.9 million and $1.1 million in the years 2008, 2007 and 2006, respectively.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Deferred Revenues
The Company generally requires customers to pay a non-refundable deposit for a portion of sales price for top drive units with their order. These customer deposits are deferred until the customer takes title and risk of loss of the product.
Cash and Cash Equivalents
Cash and Cash Equivalents include investments in highly liquid instruments with original maturities of less than three months, which are readily convertible to known amounts of cash, subject to insignificant risk of changes in value and held to meet operating requirements. At both December 31, 2008 and 2007, Cash and Cash Equivalents consisted entirely of bank balances.
Allowance for Doubtful Accounts
The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of the Company’s customers to make required payments. The primary factors used in determining the allowance needed for accounts receivable are customer bankruptcies, delinquency and management’s estimate of ability to collect outstanding receivables based on the number of days outstanding. At December 31, 2008 and 2007, the allowance for doubtful accounts on Trade Accounts Receivable was $3.2 million and $1.9 million, respectively.
Inventories
Inventories primarily consist of manufactured equipment and spare parts for after-market sales and services for TESCO manufactured equipment. During the manufacturing process, the Company values its inventories (work in progress and finished goods) primarily using standard costs, which approximate actual costs, and such costs include raw materials, direct labor and manufacturing overhead allocations.
Inventory costs for manufactured equipment are stated at the lower of cost or market using specific identification. Inventory costs for spare parts are stated at the lower of cost or market using the average cost method. The Company performs obsolescence reviews on its slow-moving and excess inventories and establishes reserves based on such factors as usage of inventory on-hand, technical obsolescence and market conditions, as well as future expectations related to its manufacturing sales backlog, its installed base and the development of new products.
At December 31, 2008 and 2007, inventories, net of reserves for excess and obsolete inventories, by major classification were as follows (in thousands):
Reserves for excess and obsolete inventory included in the Consolidated Balance Sheets at December 31, 2008 and 2007 were $3.0 million and $1.6 million, respectively. During 2007 and 2008, the Company applied $2.7 million and $0.6 million, respectively, of its reserve for excess and obsolete inventory for inventory write downs.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Property, Plant and Equipment
Property, plant and equipment is carried at cost. Maintenance and repairs are expensed as incurred. The costs of replacements, betterments and renewals are capitalized. When properties and equipment, other than top drive units in the Company’s rental fleet, are sold, retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the books and the resulting gain or loss is recognized in the accompanying Consolidated Statements of Income. When top drive units in the Company’s rental fleet are sold, the sales proceeds are included in revenues and the net book value of the equipment sold is included in Cost of Sales and Services in the accompanying Consolidated Statements of Income.
Drilling equipment includes related manufacturing costs and overhead. The net book value of used top drive rental equipment sold included in Cost of Sales and Services in the accompanying Consolidated Statements of Income was $2.3 million, $5.1 million and $2.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
At December 31, 2008 and 2007, property, plant and equipment, at cost, by major category were as follows (in thousands):
Property, plant and equipment are assessed for impairment whenever changes in facts and circumstances indicate a possible significant deterioration in the future cash flows expected to be generated by an asset group. If, upon review, the sum of the undiscounted pretax cash flows is less than the carrying value of the asset group, the carrying value is written down to estimated fair value. Individual assets are grouped for impairment purposes at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. The fair value of impaired assets is determined based on quoted market prices in active markets, if available, or upon the present values of expected future cash flows using discount rates commensurate with the risks involved in the asset group. Long-lived assets committed by management for disposal within one year are accounted for at the lower of amortized cost or fair value, less expected costs to sell.
Depreciation and amortization expense is included in the Consolidated Statements of Income as follows (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Depreciation and amortization of property, plant and equipment, including capital leases and intangible assets, is computed on the following basis:
Asset Category
Description
Method
Rate
Land, buildings and leaseholds
Buildings
Leasehold improvements
Straight line
Straight line
20 years
Lease term
Drilling equipment
Top Drive rental units Tubular Services equipment
CASING DRILLING equipment
Support equipment
Usage
Straight line
Straight line
Straight line
2,600 days
5 - 10 years
5 - 10 years
5 - 10 years
Manufacturing equipment
Straight line
5 - 10 years
Office equipment and other
Computer hardware and software
Furniture and equipment
Vehicles
Straight line
Straight line
Straight line
2 - 5 years
3 - 5 years
3 - 5 years
Assets Held for Sale
During the year ended December 31, 2008, the Company listed for sale a building and land located in Canada. The Company incurred approximately $0.9 million in soil remediation costs to prepare the property for sale that have been capitalized and are reported as an increase in the property’s net book value as of December 31, 2008. The property has a carrying value of $2.0 million and $1.7 million, net of accumulated depreciation as of December 31, 2008 and December 31, 2007, respectively, and is included in Property, Plant and Equipment in the accompanying Consolidated Balance Sheets.
Investments
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115.” This statement permits entities to choose to measure financial assets and liabilities, except those that are specifically scoped out of the Statement, at fair value. The election to measure a financial asset or liability at fair value can be made on an instrument-by-instrument basis and is irrevocable. The Company elected not to adopt the fair value option provisions of SFAS No. 159 for its financial assets and liabilities. The Company held no investments in equity securities as of December 31, 2008 or December 31, 2007.
The Company accounts for its investment in securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These securities are considered available-for-sale and are reported at fair value based upon quoted market prices in the accompanying Consolidated Balance Sheets. Unrealized gains and losses arising from the revaluation of available-for-sale securities are included, net of applicable deferred income taxes, in Accumulated Other Comprehensive Income within Shareholders’ Equity. Realized gains and losses on sales of investments based on specific identification of securities sold are included in Other (Income) Expense in the Consolidated Statements of Income.
As discussed in Note 11, in 2005 the Company received warrants to purchase one million shares of Turnkey E&P Inc. common stock at C$6.00 which expired on December 13, 2007 without being exercised. As a result,
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
the Company recognized a $1.2 million realized loss in 2007, which is included in Other Expense in the accompanying Consolidated Statements of Income. Unrealized loss, net of tax, related to the warrants for the year ended December 31, 2006 was $0.9 million.
Goodwill and Other Intangible Assets
Goodwill, which represents the value of businesses acquired by the Company in excess of the fair market value of all of the identifiable tangible and intangible net assets of the acquired businesses at the time of their acquisition, is carried at the lower of cost or fair value. The Company’s goodwill has an indefinite useful life and is subject to an annual impairment test in the fourth quarter of each year or the occurrence of a triggering event. In connection with its annual goodwill impairment assessment performed in the fourth quarter of 2008, the Company performed a step one impairment analysis under the provisions of SFAS No. 142. Management utilized a discounted cash flow methodology to estimate the fair value of the Company’s Tubular Services segment. In completing its step one analysis, management used a five-year projection of discounted cash flows, plus a terminal value determined using the constant growth method to estimate the fair value of the Tubular Services segment. In developing the fair value estimate, certain key assumptions included an assumed discount rate of 15% and an assumed long-term growth rate of 3%. Based on the results of the step one impairment test, management concluded that no impairment was indicated during the years ended December 31, 2008, 2007 or 2006. If a future impairment loss is recognized, it will be charged to income and disclosed separately in the Consolidated Statements of Income.
The Company has capitalized certain identified intangible assets, primarily customer relationships, patents and non-compete agreements, based on their estimated fair value at the date acquired. The customer relationship intangible assets are amortized on a straight-line basis over their weighted average estimated useful life of four years, the patents are amortized on a straight-line basis over an estimated useful life of 10 to 14 years, and the non-compete agreements are amortized on a straight-line basis over the weighted average term of the agreements of five years. These amortizable intangible assets are reviewed at least annually for impairment or when circumstances indicate their carrying value may not be recoverable based on a comparison of fair value to carrying value. No impairment losses were incurred during the years ended December 31, 2008, 2007 or 2006. If a future impairment loss is recognized, it will be charged to income and disclosed separately in the Consolidated Statements of Income.
For a description of the change in Goodwill and Other Intangible Assets during 2008 and 2007, see Note 4 below.
Derivative Financial Instruments
As a result of its worldwide operations, the Company is exposed to market risks from changes in interest and foreign currency exchange rates, which may affect its operating results and financial position. The Company manages its risks from fluctuations in interest and foreign currency exchange rates through its normal operating and financing activities. However, from time to time, the Company may manage its interest and foreign exchange rate risks through the use of derivative financial instruments. The Company does not use derivative financial instruments for trading or speculative purposes.
During the year ended December 31, 2007, the Company entered into a series of 25 bi-weekly foreign currency forward contracts with notional amounts aggregating C$43.8 million. Based on quoted market prices as of December 31, 2007 for contracts with similar terms and maturity dates, we recorded an asset of $0.1 million to record these foreign currency forward contracts at fair value at December 31, 2007, and to recognize the unrealized gain. During 2008, the Company terminated these bi-weekly foreign currency forward contracts and
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
recognized a loss of $0.6 million, which is included in Foreign exchange losses in the accompanying Consolidated Statements of Income. The Company replaced these by entering into a series of 14 monthly foreign currency forward contracts with notional amounts aggregating C$50.8 million. The Company subsequently settled two of these contracts and terminated the remaining 12 contracts, and recognized a loss of $0.2 million, which is included in Foreign exchange (gains) losses in the accompanying Consolidated Statements of Income. In the Consolidated Statement of Cash Flows, cash receipts or payments related to these exchange contracts are classified consistent with the cash flows from the transaction being hedged. The Company was not party to any derivative financial instruments as of December 31, 2008.
Fair Value Reporting
The Company adopted the provisions of SFAS No. 157, “Fair Value Measurement,” for its financial assets and liabilities for which it has recognized or disclosed at fair value on a recurring basis effective January 1, 2008. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2, “Effective Date of FASB Statement No. 157,” which delays the effective date for non-financial assets and non-financial liabilities to fiscal years beginning after November 15, 2008, except for items that are measured at fair value in the financial statements on a recurring basis (at least annually). As provided by FSP No. 157-2, the Company has elected to defer the adoption of SFAS No. 157 for certain of its non-financial assets and liabilities, primarily its goodwill and intangible assets, until January 1, 2009. In October 2008 the FASB issued FSP SFAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, to clarify the application of the provisions of SFAS 157 in an inactive market and how an entity would determine fair value in an inactive market. FSP 157-3 was effective immediately and did not affect the Company’s results of operations or financial condition as of the date of adoption or the period from the date of adoption through December 31, 2008 as the Company held no investments in equity securities during the period.
To obtain fair values, observable market prices are used if available. In some instances, observable market prices are not readily available for certain financial instruments and fair value is determined using present value or other techniques appropriate for a particular financial instrument. These techniques involve some degree of judgment and as a result are not necessarily indicative of the amounts the Company would realize in a current market exchange. The use of different assumptions or estimation techniques may have a material effect on the estimated fair value amounts. SFAS No. 157’s valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. SFAS No. 157 classifies these inputs into the following hierarchy:
Level 1 Inputs-Quoted prices for identical instruments in active markets.
Level 2 Inputs-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3 Inputs-Instruments with primarily unobservable value drivers.
The Company held no assets or liabilities carried at fair value as of December 31, 2008. The following table provides a summary of the changes in Level 3 assets and liabilities measured at fair value on a recurring basis during the year ended December 31, 2008 (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Pursuant to the provisions of SFAS No. 157, the Company uses a market approach to value the assets and liabilities for outstanding derivative contracts which consists solely of foreign currency forward contracts as discussed in Note 1 above. These contracts are valued using current market information in the form of foreign currency spot rates as of the reporting date. The Company recognizes the unrealized net gains or losses on these contracts on the accrual basis in Foreign exchange losses in the Consolidated Statements of Income. The Company was not a party to any derivative financial instruments as of December 31, 2008.
Debt Issue Costs
The Company has incurred debt issue costs which are amortized over the life of the debt term. At December 31, 2008 and 2007, net capitalized debt issue costs were $0.9 million and $1.5 million, respectively, and are included in Intangible and Other Assets in the accompanying Consolidated Balance Sheets.
Accounting for Operating Leases
The Company has entered into non-cancelable operating lease agreements primarily involving office space. Certain of these leases contain escalating lease payments and the Company recognizes expense on a straight line basis which is more representative of the time pattern in which the leased property is physically employed. In certain instances the Company is also entitled to reimbursements for part or all of leasehold improvements made and records a deferred credit for such reimbursements which is amortized over the remaining life of the lease term as a reduction in lease expense.
Research and Engineering Expenses
The Company expenses research and engineering costs when incurred. Payments received from third parties, including payments for the use of equipment prototypes, during the research or development process are recognized as a reduction in research and engineering expense when the payments are received.
Severance Costs
During 2008, the Company eliminated approximately 100 employee positions due to a review of its personnel structure and recorded termination benefits of $1.1 million associated with the reduction. These severance costs are recorded in Cost of Sales and Services ($0.9 million), Selling, General and Administrative expense ($0.1) and Research and Engineering expense ($0.1 million) in the accompanying Consolidated Statements of Income based on the respective functions performed by those employees who were terminated during the period.
Environmental Costs
The cost of preventative environmental programs is expensed when incurred. When a clean-up program becomes likely, and it is probable the Company will incur clean-up costs and those costs can be reasonably estimated, the Company accrues remediation costs for known environmental liabilities. During 2008, the Company listed for sale a building and land located in Canada. The Company incurred approximately $0.9 million in soil remediation costs to prepare the property for sale that have been capitalized and are reported as an increase in the property’s net book value as of December 31, 2008.
Income Taxes
The liability method is used to account for income taxes. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The effect of a change in tax rates on deferred income tax assets or liabilities is recognized in the period that the change occurs. A valuation allowance for deferred tax assets is recorded when it is more likely than not that some or all of the benefit from the deferred tax asset will not be realized. Estimates of future taxable income and ongoing tax planning have been considered in assessing the utilization of available tax losses and credits. Changes in circumstances, assumptions and clarification of uncertain tax regimes may require changes to any valuation allowances associated with the Company’s deferred tax assets.
Stock-Based Compensation
On May 18, 2007, the Company’s shareholders approved amendments to its 2005 Incentive Plan to, among other things, provide for a variety of forms of equity compensation awards to be granted to employees, directors and other persons. As a result, the Company changed the method by which it provides stock-based compensation to its employees by reducing the number of stock options granted and instead issuing restricted stock awards as a form of compensation. The Company has granted two different types of restricted stock awards: restricted stock units (“RSUs”) which are subject to time based vesting criteria and performance share units (“PSUs”) which contain both time and performance based criteria. Both RSUs and PSUs may be settled by delivery of shares or the payment of cash equal to the market value of TESCO shares that would otherwise be deliverable at the time of settlement at the discretion of the Company. For further description of the Company’s stock-based compensation plan, see Note 7 below.
The Company adopted SFAS No. 123 effective January 1, 2003 for options granted to employees after January 1, 2003. In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”), which supersedes SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) requires the same fair value methodology pursuant to SFAS No. 123 but the Company is required to estimate the pre-vesting forfeiture rate beginning on the date of grant. Effective January 1, 2006, the Company adopted SFAS No. 123(R) to account for its stock-based compensation programs. The Company elected to adopt the modified prospective application method provided by SFAS 123(R). Under SFAS No. 123(R), the Company uses the same fair value methodology pursuant to SFAS 123 but the Company is required to estimate the pre-vesting forfeiture rate beginning on the date of grant. On January 1, 2006, the date the Company adopted SFAS No. 123(R), the Company recorded a one-time cumulative adjustment of $0.2 million, after-tax, to record an estimate of future forfeitures on outstanding unvested awards at the date of adoption. With respect to the determination of the pool of windfall tax benefits, the Company elected to use the transition election of SFAS No. 123(R)-3 (the “short-cut method”) as of the adoption of SFAS No. 123(R). Under the “short-cut method” the windfall tax benefits recognized for fully vested awards, as defined in SFAS No. 123(R)-3, are recognized as an addition to Paid-in Capital and are required to be reported as a financing cash inflow and an operating cash outflow within the Consolidated Statement of Cash Flows. Windfall tax benefits for partially vested awards should be recognized as if the Company had always followed the fair-value method of recognizing compensation cost in its consolidated financial statements and would be included as a financing cash inflow and an operating cash outflow within the Consolidated Statement of Cash Flows.
The Company measures stock-based compensation cost as of grant date or the employee start date for pre-employment grants, based on the estimated fair value of the award less an estimated rate for pre-vesting forfeitures, and recognizes compensation expense on a straight-line basis over the vesting period. Compensation expense is recognized with an offsetting credit to Contributed Surplus, which is then transferred to Common Shares when the award is distributed or the option is exercised. Consideration received on the exercise of stock options is also credited to Common Shares. For stock option grants, the Company uses a Black-Scholes valuation model to determine the estimated fair value.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Stock compensation expense is recorded in Cost of Sales and Services, Research and Engineering expense and Selling, General & Administrative expense in the accompanying Consolidated Statements of Income based on the respective functions for those employees receiving stock option grants. Stock compensation expense is included in the Consolidated Statements of Income as follows (in thousands):
Per share information
Per share information is computed using the weighted average number of common shares outstanding during the year. Diluted per share information is calculated, including the dilutive effect of stock options which are determined using the treasury stock method. The treasury stock method assumes that the proceeds that would be obtained upon exercise of “in the money” options would be used to purchase common shares at the average market price during the period. No adjustment to diluted earnings per share is made if the result of this calculation is anti-dilutive.
The following table reconciles basic and diluted weighted average shares (in thousands):
Recent Accounting Pronouncements
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” This statement identifies the source of accounting principles and the framework for selecting the principles to be used in preparing financial statements presented in conformity with U.S. GAAP. Furthermore, it arranges these sources of U.S. GAAP in a hierarchy for users to apply accordingly. This statement became effective November 15, 2008 and it did not have a material impact on the Company’s consolidated financial statements.
In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets.” FSP No. SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The intent of FSP No. 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) (revised 2007), “Business Combinations” and other applicable accounting literature. FSP No. 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. The Company does not expect the adoption of this statement to have a material impact on the Company’s consolidated financial statements.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an Amendment of FASB Statement 133.” This statement enhances required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b) derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”; and (c) derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company will adopt the provisions of SFAS No. 161 on January 1, 2009 and is currently reviewing the impact of the adoption of this statement. It is not expected to have a material impact on the Company’s consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations (a revision of Statement No. 141),” which significantly changes the principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement is effective on a prospective basis to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, and early adoption is prohibited. SFAS 141R is effective for business combinations for which the acquisition date is on or after January 1, 2009. In addition, SFAS No. 141(R) is effective January 1, 2009 for certain income tax effects of prior acquisitions. In February 2009, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 141(R)-a, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies (“FSP 141(R)-a”), which will amend the provisions related to the initial recognition and measurement, subsequent measurement and disclosure of assets and liabilities arising from contingencies in a business combination under SFAS No. 141(R). The recently issued FSP 141(R)-a is also effective January 1, 2009. The Company is currently evaluating the potential impact of this statement. It is not expected to have a material impact on the Company’s consolidated financial statements.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No.51.” This Statement amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. Additionally, this Statement requires that consolidated net income include the amounts attributable to both the parent and the noncontrolling interest. This Statement is effective for interim periods beginning on or after December 15, 2008. The Company will adopt the provisions SFAS No. 160 on January 1, 2009 and does not expect the adoption will have a material impact on the Company’s financial position and results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115.” This statement permits entities to choose to measure financial assets and liabilities, except those that are specifically scoped out of the Statement, at fair value. The election to measure a financial asset or liability at fair value can be made on an instrument-by-instrument basis and is irrevocable. The difference between carrying value and fair value at the election date is recorded as a transition adjustment to opening retained earnings. Subsequent changes in fair value are recognized in earnings. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company did not elect to adopt the fair value provisions of SFAS No. 159 on January 1, 2008. Therefore, the adoption did not have a material impact on its financial position and results of operations.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement.” This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FSP No. 157-2, “Effective Date of FASB Statement No. 157,” which delays the effective date for non-financial assets and non-financial liabilities to fiscal years beginning after November 15, 2008, except for items that are measured at fair value in the financial statements on a recurring basis (at least annually). The Company adopted the provisions of SFAS No. 157 for its financial assets and liabilities and those items for which it has measured on a recurring basis effective January 1, 2008, and the adoption did not have a material impact on its financial position and results of operations. For additional information see “Fair Value Reporting,” above. As provided by FSP No. 157-2, the Company has elected to defer the adoption of SFAS No. 157 for certain of its non-financial assets and liabilities, primarily its goodwill and intangible assets, and is currently evaluating the impact, if any, that this statement will have on its financial statements as it relates to its non-financial assets and non-financial liabilities that are recognized or disclosed on a non-recurring basis. In October 2008, the FASB issued FSP No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, to clarify the application of the provisions of SFAS 157 in an inactive market and how an entity would determine fair value in an inactive market. FSP 157-3 was effective immediately and did not materially affect the Company’s results of operations or financial condition as of and for the period ended December 31, 2008.
Note 3-Accumulated Comprehensive Income
Accumulated Comprehensive Income is defined as a change in the equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, including foreign currency translation adjustments and unrealized gains (losses) on investments. The Company presents its comprehensive income in its consolidated statements of Shareholders’ Equity.
The following table summarizes the components of Accumulated Comprehensive Income (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Note 4-Acquisitions
During the second half of 2007, the Company acquired four businesses that provide conventional casing running and tubular services. One of these businesses is based in Colorado and services the Rockies region, including the Piceance Basin and the remaining three businesses are based in Alberta, Canada and service northwest Alberta and northeast British Columbia regions. The combined purchase price of these acquisitions was approximately $21.5 million. These acquisitions were funded by the Company’s Revolver (defined below). All of these assets and operating results are included in the Tubular Services business segment. These acquisitions expand and strengthen the Company’s position in these growing regions and provide expansion opportunities for the Company’s proprietary Casing Drive System for casing running as well as further opportunities to expand its CASING DRILLING offering.
The assets and liabilities acquired in these acquisitions are valued based upon appraisals of the tangible and intangible assets acquired. During 2008, the Company finalized its goodwill valuation related to one of these acquisitions and reduced the carrying amount of goodwill by $0.1 million. The remaining change in the carrying amount of goodwill of $1.0 million is due to the effect of foreign currency exchange rates.
The Company’s valuation of the assets acquired, liabilities assumed and total consideration paid for these acquisitions is as follows (in thousands):
Goodwill related to these acquisitions was assigned to the Tubular Services segment and approximately $11.2 million of the goodwill acquired as a result of these acquisitions is amortizable for income tax purposes. The $5.5 million of acquired intangible assets in these acquisitions relate to customer relationships which have a weighted average estimated useful life of seven years and non-compete agreements which have a weighted average term of five years.
Note 5-Fair Value of Financial Instruments
During the year ended December 31, 2007, the Company entered into a series of 25 bi-weekly foreign currency forward contracts with notional amounts aggregating C$43.8 million. Based on quoted market prices as of December 31, 2007 for contracts with similar terms and maturity dates, the Company recorded an asset of $0.1 million to record these foreign currency forward contracts at fair market value at December 31, 2007, and to recognize the related unrealized gain. During the year ended December 31, 2008, the Company terminated these bi-weekly foreign currency forward contracts and recognized a loss of $0.6 million, which is included in Foreign exchange (gains) losses in the Consolidated Statements of Income, and replaced them with a series of 14 monthly foreign currency forward contracts with notional amounts aggregating C$50.8 million. The Company subsequently settled two of these contracts and terminated the remaining 12 contracts, and recognized a loss of $0.2 million for the year ended December 31, 2008, which is included in Foreign exchange (gains) losses in the accompanying Consolidated Statements of Income. In the Consolidated Statement of Cash Flows, cash receipts
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
or payments related to these exchange contracts are classified consistent with the cash flows from the transaction being hedged. The Company was not party to any derivative financial instruments as of December 31, 2008. The Company did not enter into any derivative financial instruments during 2006.
The carrying value of cash, investments in short-term commercial paper and other money market instruments, accounts receivable, accounts payable, accrued liabilities and capital leases approximate their fair value due to the relatively short-term period to maturity of the instruments.
The fair value of the Company’s long term debt depends primarily on current market interest rates for debt issued with similar maturities by companies with risk profiles similar to TESCO. The fair value of its debt related to the Company’s credit facility at December 31, 2008 of $39.4 million is estimated to be $37.5 million. The Company also has long term debt in the form of a term loan. The fair value of the Company’s term loan of $10.0 million at December 31, 2008 is estimated to be $9.6 million.
Note 6-Long Term Debt
Long term debt consists of the following (in thousands):
On June 5, 2007, TESCO and Tesco US Holding LP, an indirect, wholly-owned subsidiary of TESCO, entered into a $125 million amended and restated credit agreement with Amegy Bank, N.A., The Bank of Nova Scotia, Natixis, Comerica Bank, Trustmark National Bank, Bank of Texas, N.A. and JPMorgan Chase Bank, N.A., as administrative agent for the lenders. The $125 million facility consisted of a $100 million revolver and a $25 million term loan. On December 21, 2007, TESCO and Tesco US Holding LP entered into an amendment to the $125 million amended and restated credit agreement (collectively, with the $125 million amended and restated credit agreement dated June 5, 2007, the “Amended Credit Agreement”) with the Company’s existing lenders and JPMorgan Chase Bank, N.A., as administrative agent to increase the Amended Credit Facility revolver from $100 million to $145 million. The Amended Credit Agreement provides for up to $145 million in revolving loans and swingline loans (collectively, the “Revolver”). Under the Revolver, Tesco US Holding LP may borrow up to $145 million in revolving loans, while either Tesco US Holding LP or TESCO may borrow up to $15 million in swingline loans, provided that the aggregate amount of revolving loans and swingline loans may not exceed $145 million in outstanding principal. The Secured Term Loan terms and maturity date remains unchanged. Amounts outstanding under the Secured Term Loan issued under the Prior Credit Agreement continue to be due in $2.5 million quarterly installments with the balance at December 31, 2008 of $10 million and the last installment payment is due October 31, 2009.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
The Amended Credit Agreement has a term of five years and all outstanding borrowings on the $145 million Revolver will be due and payable on June 5, 2012. Amounts available under the Revolver are reduced by letters of credit issued under the Amended Credit Agreement not to exceed $20 million in the aggregate of all undrawn amounts and amounts that have yet to be disbursed under all existing letters of credit. Amounts available under the swingline loans may also be reduced by letters of credit or by means of a credit to a general deposit account of the applicable borrower. At December 31, 2008, the Company had $5.5 million in letters of credit outstanding under the Revolver.
The Amended Credit Agreement had original covenants that the Company considers usual and customary for an agreement of this type, including a leverage ratio, a minimum net worth, and a fixed charge coverage ratio. Pursuant to the terms of the Amended Credit Agreement, the Company is prohibited from incurring other additional indebtedness over $15 million, paying cash dividends to shareholders and other restrictions which are standard to the industry. The Amended Credit Agreement is secured by substantially all of the Company’s assets and all of the Company’s direct and indirect material subsidiaries in the United States and Canada are guarantors of borrowings under the Amended Credit Agreement. Additionally, the Company’s capital expenditures are limited to 70% of consolidated EBITDA (as defined in the Amended Credit Agreement) plus net proceeds from asset sales. In March 2008, the Company entered into a second amendment to the Amended Credit Agreement in order to increase the limit on permitted capital expenditures during the quarters ending March 31, June 30 and September 30, 2008 from 70% to 85% of consolidated EBITDA plus proceeds from sales of assets. For the quarters ending December 31, 2008 through June 30, 2010 the capital expenditure limitation returns to 70% of EBITDA plus proceeds from the sale of assets. The capital expenditure limit decreases to 60% of consolidated EBITDA plus net proceeds from asset sales for fiscal quarters ending after June 30, 2010. As of December 31, 2008, the Company believes it was in compliance with the debt covenants in the Amended Credit Agreement.
In addition to regularly scheduled payment obligations, the occurrence of certain circumstances will trigger an obligation to prepay certain of the Company’s term loans owing under the Amended Credit Agreement by an amount equal to 50% of the net cash proceeds realized by the Company from any (i) asset sale or event of loss, upon the occurrence of certain conditions; (ii) issuance or other sale of any equity interest in the Company or any of its subsidiaries in excess of $10 million after the effective date of the Amended Credit Agreement; or (iii) subordinated indebtedness incurred by the Company or any of its affiliates. In addition, repayment of borrowings under the Amended Credit Agreement is subject to acceleration upon the occurrence of events of default that the Company considers usual and customary for an agreement of this type.
Rates for revolving and term loans under the Amended Credit Agreement are based, at Tesco US Holding LP’s election, on an interest rate tied to a Eurodollar rate or JPMorgan Chase Bank, N.A.’s prime rate. With respect to Eurodollar loans, the rate is determined as follows: the sum of (i) Adjusted LIBO Rate (as defined in the Amended Credit Agreement) plus (ii) the Applicable Rate (as defined in the Amended Credit Agreement), which is 1.00 percent based on the Company’s leverage ratio at December 31, 2008. With respect to non-Eurodollar loans, the rate is set by the alternate base rate, which is determined by taking the greater of (i) the prime rate for U.S. dollar loans announced by JPMorgan Chase Bank, N.A. in New York or (ii) the sum of the weighted average overnight federal funds rate published by the Federal Reserve Bank of New York plus 0.50 percent. Swingline loans will bear interest as determined by the alternate base rate described above.
Based on the Company’s leverage ratio at December 31, 2008, the Company is required to pay a facility fee of 0.20 percent per annum of the aggregate unused commitments under the Amended Credit Agreement. A letter of credit fee equal to the Applicable Rate (as defined in the Amended Credit Agreement) multiplied by the outstanding face amount of any letter of credit issued under the Amended Credit Agreement is also required to be paid by the Company.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
The scheduled repayments of the Company’s debt for the next five years and thereafter are as follows (in thousands):
Note 7-Shareholders’ Equity and Stock-Based Compensation
The Company has authorized an unlimited number of first preferred and second preferred shares, none of which are issued or outstanding.
The Company has authorized an unlimited number of common shares without par value.
Stock-Based Compensation
In May 2007, the Company amended and restated its incentive plan, now called the Amended and Restated Tesco Corporation 2005 Incentive Plan (the “Restated Plan”). The maximum number of shares of common stock that may be issued in connection with awards under the Restated Plan may not exceed 10% of the issued and outstanding shares of the Company’s common stock. The plan authorizes the grant of awards to eligible directors, officers, employees and other persons. Under the terms of the Company’s Restated Plan, 3,751,386 shares of common stock were authorized as of December 31, 2008 for the grant of stock-based compensation to eligible directors, officers, employees and other persons. As of December 31, 2008, the Company had approximately 1,158,275 shares available for future grants.
The Company measures stock-based compensation cost as of the grant date based on the estimated fair value of the award less an estimated rate for pre-vesting forfeitures, and recognizes compensation expense on a straight-line basis over the vesting period. Compensation expense is recognized with an offsetting credit to Contributed Surplus, which is then transferred to Common Shares when the award is distributed or the option is exercised. For stock option grants, the Company uses a Black-Scholes valuation model to determine the estimated fair value.
Stock Options
Prior to May 2007, the Company granted stock options denominated only in Canadian dollars. Under the Restated Plan, stock options and other stock based awards may be denominated in Canadian dollars or U.S. dollars, at the Company’s discretion. On June 30, 2008, the Company voluntarily delisted from the Toronto Stock Exchange. With all shares of common stock being traded on the NASDAQ, the Company plans to denominate all future grants of equity-based awards in U.S. dollars. Options granted by the Company have historically vested equally over a three year period and expired no later than seven years from the date of grant, although the Board of Directors may choose different parameters in the future. The exercise price of stock options under the plan may not be less than the fair value on the date of the grant, as defined in the Restated Plan.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
The following summarizes option activity for the options issued in Canadian dollars during the years ended December 31, 2008, 2007 and 2006:
The intrinsic value of options exercisable at December 31, 2008, 2007 and 2006 was (C$5.1) million, C$11.1 million and C$7.3 million, respectively. The intrinsic value of options exercised during 2008, 2007 and 2006 was C$9.9 million, C$11.7 million and C$3.9 million, respectively. The weighted average grant-date fair value of options granted during 2008 was C$11.21 per share, during 2007 was C$9.68 per share and during 2006 was C$10.70 per share.
Details of the exercise prices and expiry dates of Canadian dollar options outstanding at December 31, 2008 are as follows:
No options were issued in U.S. dollars during the years ended December 31, 2007 and 2006. The following summarizes option activity for the options issued in U.S. dollars during the year ended December 31, 2008:
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
No options granted in U.S. dollars were exercisable during 2008, and accordingly, the intrinsic value of options exercisable at December 31, 2008 and the intrinsic value of options exercised during 2008 were zero. The weighted average grant-date fair value of options granted during 2008 was $6.30 per share.
Details of the exercise prices and expiry dates of U.S. dollar options outstanding at December 31, 2008 are as follows:
The assumptions used in the Black-Scholes option pricing model were:
For options granted in 2008 and 2007, the Company decreased the expected option life to 4.5 years from 6 years to reflect recent option exercise experience.
Restricted Stock
Beginning in 2007, the Company began granting two different types of stock-based awards: RSU awards which vest equally in three annual installments from date of grant and entitle the grantee to receive the value of one share of TESCO common stock upon vesting, and PSU awards which vest in full after three years and include a performance measure. PSU awards entitle the grantee to receive the value of one share of TESCO common stock for each PSU, subject to adjustment based on the performance measure. The PSU performance objective multiplier can range from zero when threshold performance is not met to a maximum of 2.5 times the initial award. Both RSU awards and PSU awards may be settled by delivery of shares or the payment of cash based on the market value of a TESCO share at the time of settlement at the discretion of the Company.
The following summarizes restricted stock activity during the years ended December 31, 2008 and 2007:
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
The weighted average grant-date fair value of restricted stock granted during 2008 in U.S. dollars and Canadian dollars was $12.60 per share and C$24.67 per share, respectively, and the weighted average grant-date fair value of restricted stock granted during 2007 was C$36.19 per share. The weighted average expected forfeiture rate for RSU awards is 15% and for PSU awards is 5%.
Note 8-Income Taxes
Tesco Corporation is an Alberta (Canada) corporation. The Company and its subsidiaries conduct business and are taxed on profits earned in a number of jurisdictions around the world. Income taxes have been provided based on the laws and rates in effect in the countries in which operations are conducted or in which TESCO or its subsidiaries are considered resident for income tax purposes.
Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the tax basis of an asset or liability and its basis as reported in the consolidated financial statements. The measurement of deferred tax assets and liabilities is based on enacted tax laws and rates currently in effect in the jurisdictions in which the Company has operations.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Deferred tax assets and liabilities are classified as current or non-current according to the classification of the related asset or liability for financial reporting. The components of the net deferred tax asset (liability) were as follows (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Since the Company and its subsidiaries are taxable in a number of jurisdictions around the world, income tax expense as a percentage of pre-tax earnings fluctuates from year to year based on the level of profits earned in these jurisdictions and the tax rates applicable to such profits.
The combined Canadian federal and Alberta provincial income tax rate for 2008 was 29.5%. The combined rates in 2007 and 2006 were 32.1% and 32.5% respectively.
The Company’s income before income taxes consisted of the following (in thousands):
The Company’s income tax provision (benefit) consisted of the following (in thousands):
A reconciliation of the statutory rate and the effective income tax rate is as follows:
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
The Company’s effective tax rate for 2008 was 27% compared to 24% in 2007. The 2008 effective tax rate reflects a $0.8 million benefit from the generation of Canadian research and development credits offset by a $1.2 million charge related to a reduction in deferred tax assets attributable to decreasing Canadian federal statutory tax rates. The effective tax rate for the year ended December 31, 2008 is lower than the Canadian statutory tax rate due to earnings generated in jurisdictions with statutory tax rates that are lower than the Canadian statutory tax rate and the effects of certain legal entity restructurings.
The 2007 effective tax rate reflects a $3.4 million benefit related to 2006 return to accrual adjustments as a result of the Company’s Canadian, U.S. and other foreign tax returns and a $0.8 million benefit primarily related to the favorable resolution of a Mexico tax claim offset by a $1.7 million charge related to a reduction in deferred tax assets attributable to reduced statutory tax rates for Canadian federal taxes. The 2007 effective tax rate also includes a $1.5 million benefit related to the release of the valuation allowance established against the foreign tax credits generated in 2006, which was offset by a $1.1 million valuation allowance established against the foreign tax credits generated in 2007 and a $0.3 million valuation allowance established against 2007 losses of certain foreign subsidiaries.
During 2008, the Company utilized $5.5 million of its non-capital loss carryforwards in Canada. At December 31, 2008, the Company had $33.8 million of loss carryforwards remaining. These losses can be carried forward seven to ten years, depending on the date generated, and applied to reduce future taxable income. The loss carryforwards at December 31, 2008 expire as follows (in thousands):
Based on current market conditions, the Company’s recent history of generating taxable income to utilize its loss carryforwards, expected future income and potential tax planning strategies, the Company expects to fully utilize these loss carryforwards. Therefore, there is no valuation allowance offsetting the deferred tax asset for these losses.
Certain of the Company’s foreign subsidiaries file separate tax returns and have incurred losses in foreign jurisdictions. At December 31, 2008, the Company has $4.8 million of such loss carryforwards. Due to insufficient earnings history in the jurisdictions where such losses were generated, the Company does not expect to fully utilize these losses. Therefore, a partial valuation allowance has been established against the deferred tax asset for these losses. The valuation allowance at December 31, 2008 was $1.2 million.
During 2008, the Company generated $6.0 million of foreign tax credits for taxes paid on foreign branch operations that are creditable against the Company’s Canadian taxes. The Company estimates that it will be able to utilize 100% of these foreign tax credits in either 2008 or future tax years to offset its tax liability. Therefore, the valuation allowance at December 31, 2007 was not adjusted during 2008, and the valuation allowance that exists against the foreign tax credit carryforward balance at December 31, 2008 is $1.1 million.
No provision is made for taxes that may be payable on the repatriation of accumulated earnings in foreign subsidiaries on the basis that these earnings will continue to be used to finance the activities of these subsidiaries. It is not practicable to determine the amount of unrecognized deferred income taxes associated with these unremitted earnings.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. TESCO adopted the provisions of FIN No. 48 on January 1, 2007. At December 31, 2007, the Company had an accrual for uncertain tax positions of $0.5 million, which was increased to $1.2 million at December 31, 2008. This liability is offset by the Company’s net income tax receivables and, as of December 31, 2007 and 2008, was included in Prepaid and Other Assets and Income Taxes Payable, respectively, in the accompanying Consolidated Balance Sheets as the Company anticipates that these uncertainties will be resolved in the next 12 months. The resolution of these uncertainties should not have a material impact on the Company’s effective tax rate.
A reconciliation of the beginning and ending accrual for uncertain tax positions is as follows (in thousands):
The Company recognizes interest related to uncertain tax positions in interest expense and penalties related to uncertain tax positions are recognized in Other Expense. At December 31, 2008 and 2007, the Company had accrued $0.3 million and $0.1 million, respectively, for the potential payment of interest and penalties on uncertain tax positions. As a result of the implementation of FIN No. 48, the Company recognized no material adjustment in the accrual for uncertain tax positions.
TESCO and its subsidiaries are subject to Canada federal and provincial income tax and have concluded substantially all Canada federal and provincial tax matters for tax years through 2001. TESCO and its subsidiaries are also subject to U.S. federal and state income tax and have concluded substantially all U.S. federal income tax matters for tax years through 2003. One of the Company’s U.S. subsidiaries has been audited through tax year 2004 and one U.S. subsidiary has been audited through tax year ended October 31, 2005. At December 31, 2008, the Company’s consolidated tax return for the year 2006 was under audit. The Company anticipates that the results of this audit will have no material impact to the Company’s financial positions, results of operations or cash flows.
TESCO has been advised by the Mexican tax authorities that they believe significant expenses incurred by the Company’s Mexican operations from 1996 through 2002 are not deductible for Mexican tax purposes. Between 2002 and 2008, formal reassessments disallowing these deductions were issued for each of these years, all of which the Company appealed to the Mexican court system. TESCO has obtained final court rulings deciding all years in dispute in the Company’s favor, except for 1996 (discussed below), and 2001 and 2002, both of which are currently before the Mexican Tax Court. The outcome of such appeals is uncertain. However, TESCO recorded an accrual of $0.3 million during 2008 for the Company’s anticipated exposure on these issues ($0.2 million related to interest and penalties was included in Other Income and $0.1 million was included in Income Tax Expense). TESCO continues to believe that the basis for these reassessments was incorrect, and that
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
the ultimate resolution of those outstanding matters that remain will likely not have a material adverse effect on the Company’s financial position, results of operations or cash flows.
In May 2002, TESCO paid a deposit of $3.3 million with the Mexican tax authorities in order to appeal the reassessment for 1996. In 2007 the Company requested and received a refund of approximately $3.7 million (the original deposit amount of $3.3 million plus $0.4 million in interest). Therefore, in the third quarter of 2007 the Company reversed an accrual for taxes, interest and penalties ($1.4 million related to interest and penalties was included in Other Income and $0.7 million benefit in Income Tax Expense). With the return of the $3.3 million deposit, the Mexican tax authorities issued a resolution indicating that TESCO was owed an additional $3.4 million in interest but this amount had been retained by the tax authorities to satisfy a second reassessment for 1996. The Company believes the second reassessment is invalid, and has appealed it to the Mexican Tax Court. In January 2009, the Tax Court issued a decision accepting the Company’s arguments in part, which is subject to further appeal. Due to uncertainty regarding the ultimate outcome, TESCO has not recognized the additional interest in dispute as an asset.
Note 9-Goodwill and Other Intangible Assets
The Company accounts for its goodwill and intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The Company’s goodwill has an indefinite useful life and is subject to at least an annual impairment test in the fourth quarter of each year or the occurrence of a triggering event. For 2008 and 2007, the Company completed its annual assessment, which indicated no impairment.
All of the Company’s goodwill has been assigned to the Tubular Services segment, and approximately $28.5 million is amortizable for income tax purposes. During 2008, the Company finalized its goodwill valuation related to one of its 2007 acquisitions and reduced the carrying amount of goodwill by $0.1 million. The remaining change in the carrying amount of goodwill of $1.0 million is due to the effect of foreign currency exchange rates.
The Company’s intangible assets are recorded at their estimated fair value at the date acquired and are amortized on a straight line basis over their estimated useful lives. The Company’s intangible assets primarily consist of customer relationships, patents and non-compete agreements related to acquisitions in 2007 (see Note 4 above) and acquisitions in 2005. Intangible assets related to customer relationships have a weighted average estimated useful life of four years, patents have a weighted average estimated useful life of 13 years and non-compete agreements have a weighted average term of five years. The carrying amount and accumulated amortization of intangible assets at December 31, 2008 and 2007 were as follows (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Amortization of intangibles was $1.9 million in 2008, $1.3 million in 2007 and $0.8 million in 2006, and is included in Cost of Sales and Services in the accompanying Consolidated Statements of Income. Estimated amortization expense for each of the next five years through December 31, 2013 is $1.9 million, $1.3 million, $1.2 million, $0.9 million and $0.6 million, respectively.
Note 10-Commitments and Contingencies
Legal Contingencies
The Company, in the normal course of its business, is subject to legal proceedings brought against it and its subsidiaries. The estimates below represent management’s best estimates based on consultation with internal and external legal counsel. There can be no assurance as to the eventual outcome or the amount of loss the Company may suffer as a result of these proceedings.
The amount of loss the Company may suffer as a result of these proceedings is not generally reasonably estimable until settlement is reached or judgment obtained. Management does not believe that any such proceedings currently underway against the Company, either individually or in the aggregate, will have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
Varco I/P, Inc. (“Varco”) filed suit against TESCO in April 2005 in the U.S. District Court for the Western District of Louisiana, alleging that our Casing Drive System (“CDS”) infringes certain of Varco’s U.S. patents. Varco seeks past damages and an injunction against further infringement. The Company filed a countersuit against Varco in June 2005 in the U.S. District Court for the Southern District of Texas, Houston Division seeking invalidation of the Varco patents in question. In July 2006, the Louisiana case was transferred to the federal district court in Houston, and as a result, the issues raised by Varco have been consolidated into a single proceeding in which we are the plaintiff. The Company also filed a request with the U.S. Patent and Trademark Office (“USPTO”) for reexamination of the patents on which Varco’s claim of infringement is based. The USPTO accepted the Varco patents for reexamination, and the district court stayed the patent litigation pending the outcome of the USPTO reexamination. In May 2008, the USPTO issued an Action Closing Prosecution, agreeing with TESCO and rejecting all of the Varco patent claims that it had contested. Varco may appeal this decision or seek other administrative remedies within the USPTO. The outcome and amount of any future financial impacts from this litigation are not determinable at this time.
Franks International, Inc. (“Franks”) filed suit against TESCO in the United States District Court for the Eastern District of Texas, Marshall Division, on January 10, 2007, alleging that its CDS infringes two patents held by Franks. Franks seeks past damages and an injunction against further infringement. TESCO filed a response denying the Franks allegation and asserting the invalidity of its patents. In May 2008, Franks withdrew its claims with respect to one of the patents and in July 2008, TESCO filed a request with the USPTO for reexamination of the other patent. In September 2008, the USPTO ordered a reexamination of that patent. That reexamination will proceed in parallel with the civil lawsuit, unless the lawsuit is stayed to await the result of the reexamination. In January 2009, the USPTO issued its initial office action, finding that all of the claims in the Franks patent at issue are invalid. Franks has until March 2009 to respond to this patent office action. The lawsuit is set for trial in May 2009. TESCO believes it has meritorious defenses to the allegations of infringement. However, in the event of an adverse ruling at trial that is not overturned on appeal, and assuming the USPTO does not ultimately invalidate or substantially modify the Franks patent at issue in the course of its pending reexamination, TESCO could be liable for past damages. The expert retained by Franks in this litigation has opined that reasonable past damages would be approximately $5.4 million. If the court finds any infringement was willful, any award for past damages could be trebled. The court would also have the discretion to award prejudgment interest from 2002 in the event of an adverse ruling. The Company does not believe that an adverse result in this suit, including any appeals, is probable.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Weatherford International, Inc. and Weatherford/Lamb Inc. (“Weatherford”) filed suit against TESCO in the United States District Court for the Eastern District of Texas, Marshall Division, on December 5, 2007, alleging that various TESCO technologies infringe ten different patents held by Weatherford. Weatherford seeks past damages and an injunction against further infringement. The TESCO technologies referred to in the claim include the CDS, the CASING DRILLING system and method, a float valve, and the locking mechanism for the controls of the tubular handling system. The Company has filed a general denial seeking a judicial determination that it does not infringe the patents in question and/or that the patents are invalid. In November 2008, the Company filed requests with the USPTO, seeking invalidation of substantially all of the Weatherford patent claims in the suit. The trial is set for May 2011. The outcome and amount of any future financial impacts from this litigation are not determinable at this time.
In July 2006, the Company received a claim for withholding tax, penalties and interest related to payments over the periods from 2000 to 2004 in a foreign jurisdiction. The Company disagrees with this claim and is currently litigating this matter. However, at June 30, 2006 the Company accrued its estimated pre-tax exposure on this matter at $3.8 million, with $2.6 million included in other expense and $1.2 million included in interest expense. During 2007 and 2008, the Company accrued an additional $0.2 million and $0.2 million, respectively, of interest expense related to this claim.
In August 2008, the Company received a claim in Mexico for $1.1 million in fines and penalties related to the exportation of certain temporarily imported equipment that remained in Mexico beyond the authorized time limit for its return. The Company disagrees with this claim and is currently litigating the matter. Due to considerable uncertainty regarding the ultimate outcome of this matter, the Company has not provided an accrual for this contingency.
In February 2009, the Company received notification of a regulatory review of its payroll practices in one of its North American business districts. The outcome of this review and any potential financial impact is uncertain at this time. However, the Company does not believe the ultimate outcome would have a material impact on the financial position, cash flows or results of operations.
Other Contingencies
The Company is contingently liable under letters of credit and similar instruments that it is required to provide from time to time in connection with the importation of equipment to foreign countries and to secure its performance on certain contracts. At December 31, 2008 the total exposure to the Company under outstanding letters of credit was $6.4 million.
Product Warranties
In late 2006, the Company identified technical problems associated with the Company’s new EMI 400 top drives. In addition to its standard accrual for warranty work associated with top drive sales, the Company accrued an additional $0.8 million to correct the identified technical problem with the EMI 400 units and such cost was included in Cost of Sales and Services in the accompanying Consolidated Statements of Income. As a result of substantially correcting the technical problems associated with its EMI 400 top drives, during 2007 the Company reversed $1.3 million of its warranty accrual related to this issue. In 2005, the Company provided an additional warranty reserve of $6.6 million, net of amounts which are contractually recoverable from the manufacturer of the steel forgings, related to the replacement of load path parts of certain equipment sold to customers and in TESCO’s top drive rental fleet. In 2007, the Company, as a result of substantially completing the replacement of load path parts in customers and TESCO’s rental fleet, reversed $0.9 million of its remaining warranty accrual for this issue. These warranty accrual reversals were included in Cost of Sales and Services in the accompanying Consolidated Statements of Income. The Company continues to monitor its activities for warranty work to ensure accrued amounts are reasonable.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Commitments
The Company has future minimum lease commitments under non-cancelable operating leases with initial or remaining terms of one year or more as of December 31, 2008 as follows (in thousands):
Rent expense during 2008, 2007 and 2006 was $7.3 million, $4.7 million and $2.3 million, respectively.
Note 11-Transactions with Related Parties
Turnkey E & P Inc.
Robert M. Tessari is Chairman of the Board and President of Turnkey E & P Inc. (“Turnkey”) and serves on the Company’s Board of Directors and was its founder and former Chief Executive Officer and Chief Technology Officer. On November 16, 2007, TESCO, Turnkey and Mr. Tessari entered into a Consulting Agreement and Intellectual Property Rights Assignment (the “Consulting Agreement”), effective as of July 16, 2007. The Agreement provides that Turnkey will make Mr. Tessari available to provide consulting services to TESCO from time to time and provide reasonable assistance in testing and developing our products and services. The term of the Consulting Agreement is for three years from its effective date and shall thereafter automatically renew for successive one year terms unless any party gives 180 days’ written notice of termination prior to the renewal date. As consideration, Turnkey will (i) be reimbursed for all reasonable, ordinary and necessary expenses incurred by Mr. Tessari and (ii) will receive preferred customer pricing on our products as follows:
•
For purchased products for Turnkey’s internal use, Turnkey shall receive preferred customer pricing equal to the lesser of (a) the Company’s direct cost plus ten percent (10%) or (b) eighty-five percent (85%) of the lowest price charged to another one of our customers that is not an affiliate. In the event Turnkey can demonstrate that it can build a consumable product of ours at a substantially lower cost than ours, Turnkey may offer to us the right to provide such product at such lower price. If the Company chooses not to provide such product at such price, Turnkey may manufacture such product and pay the Company a royalty of 10% of Turnkey’s manufacturing cost.
•
For rented products for Turnkey’s internal use, the preferred customer day rate pricing shall be calculated as the sum of (a) the Company’s direct manufacturing cost of the product divided by 730 plus (b) 10%. Turnkey guarantees a minimum of 200 rental days per year for each rented product.
In addition, in the event that Turnkey proposes development of a product or service (the “New Technology”) that the Company does not want to design, test and/or commercialize, Turnkey shall have a limited, nonexclusive, nontransferable license to develop, manufacture and use the New Technology for its own internal purposes. If TESCO subsequently decides to manufacture the New Technology, the Company shall give notice to Turnkey, and Turnkey shall thereafter be obliged to purchase any additional products containing the New Technology from the Company at the prices set forth above. In that event, TESCO shall repay Turnkey three times the documented development cost of the New Technology. All intellectual property rights in any way related to inventions made or conceived or reduced to practice within the oilfield services field pursuant to the Consulting Agreement will belong to the Company. During 2008 and 2007, Turnkey purchased $1.0 million and $0.7 million, respectively, of products and services from us pursuant to the Consulting Agreement. In November
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
2008, Turnkey filed for protection under Chapter 11 of the U.S. Bankruptcy Code. As a result, TESCO recognized bad debt expense of $0.4 million associated with a write-off of accounts receivable due to the Company from Turnkey.
During 2007 prior to the effective date of the Consulting Agreement discussed above and during 2006, Turnkey purchased other CASING DRILLING-related and other services and equipment from TESCO in the amount of $1.9 million and $2.2 million, respectively. The prices the Company charged Turnkey prior to July 16, 2007 were on terms similar to those that the Company charged other third parties. After that date, Turnkey was charged rates as specified in the Consulting Agreement. Also, during 2006, TESCO provided drilling rigs to our CASING DRILLING customers which the Company had leased from a third party. The crews for these drilling rigs were provided to the Company by Turnkey pursuant to a Rig Personnel Supply Agreement. Turnkey charged the Company $5.1 million to supply these drilling rig crews in 2006 which represents the actual cost incurred by Turnkey plus a 15% markup. The Rig Personnel Supply Agreement terminated in late 2006. However, pursuant to that agreement, TESCO has since indemnified Turnkey for $0.5 million in third party claims arising under that agreement. Prior to the effective date of the Consulting Agreement discussed above, the Company believes that the prices it charged Turnkey and Turnkey charged the Company were on terms similar to those that would have been available from other third parties.
In 2005, the Company sold four drilling rigs to Turnkey for proceeds of $35.0 million plus warrants exercisable over a course of two years to purchase one million shares of Turnkey stock at a price of C$6.00. TESCO received a fairness opinion related to the sale of the rigs to Turnkey and as such believes that the terms of the rig sale were comparable to those that would have been available from other third parties. The Company did not exercise the warrants prior to their expiration in December 2007 and therefore it recognized a $1.2 million loss related to the fair value of the warrants when they were received.
St. Mary Land & Exploration Company
TESCO’s President and Chief Executive Officer is a member of the Board of Directors of St. Mary Land & Exploration Company (“St. Mary”). St. Mary is engaged in the exploration, development, acquisition and production of natural gas and oil in the U.S. During 2008, St. Mary did not purchase any services from the Company. During 2007 and 2006, St. Mary purchased $0.1 million and $0.6 million, respectively, in top drive rental and Tubular Services from the Company. TESCO believes that the prices it charged St. Mary were on terms similar to those provided to other third parties.
Helix Energy Solutions Group, Inc.
TESCO’s former Chief Financial Officer was a member of the Board of Directors of Helix Energy Solutions Group, Inc. (“Helix”). Helix is an international offshore contract services provider and oil and gas exploration, development and production company. During 2008, Helix did not purchase any services from TESCO. During 2007, Helix purchased and $0.1 million in Tubular Services from the Company. TESCO believes that the prices we charged Helix were on terms similar to those provided to other third parties.
Bennett Jones LLP
Additionally, the Company’s primary outside counsel in Canada is Bennett Jones LLP. One of our directors is counsel at Bennett Jones LLP. During each of the years 2008, 2007 and 2006, the Company paid $0.4 million for services from Bennett Jones LLP, excluding reimbursement by the Company of patent filing fees and other expenses. TESCO believes that the rates it paid Bennett Jones LLP for services are on terms similar to those that would have been available from other third parties.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Note 12-Segment Information
Business Segments
Historically, the Company organized its activities into three business segments: Top Drives, Casing Services and Research and Engineering. Effective December 31, 2008, the Company determined that the CASING DRILLING segment no longer met the criteria which allowed it to be aggregated with the Tubular Services segment and therefore changed the presentation of its Tubular Services activities and CASING DRILLING activities into two separate segments and the financial and operating data for the years ended December 31, 2006 through 2008 have been recast to be presented consistently with this structure. The Company’s four business segments are: Top Drives, Tubular Services, CASING DRILLING and Research and Engineering. The Top Drive business is comprised of top drive sales, top drive rentals and after-market sales and service. The Tubular Services business includes both our proprietary and conventional Tubular Services. The CASING DRILLING segment consists of our proprietary CASING DRILLING technology, and the Research and Engineering segment is comprised of our research and development activities related to Tubular Services technology and Top Drive model development.
These segments report their results of operations to the level of operating income. Certain functions, including certain sales and marketing activities and corporate general and administrative expenses, are provided centrally from the corporate office. The costs of these functions, together with other (income) expense and income taxes, are not allocated to these segments. Assets are allocated to the Top Drive, Tubular Services, CASING DRILLING or Research and Engineering segments to which they specifically relate. All of the Company’s goodwill has been allocated to the Tubular Services segment. The Company’s chief operating decision maker is not provided a measure of assets by business segment and as such this information is not presented.
The Company incurs costs directly and indirectly associated with its revenues at a business unit level. Direct costs include expenditures specifically incurred for the generation of revenue, such as personnel costs on location or transportation, maintenance and repair, and depreciation of the Company’s revenue-generating equipment. Overhead costs, such as field administration and field operations support, are not directly associated with the generation of revenue within a particular business segment. In years prior to 2008, the Company allocated total overhead costs at a consolidated level based on a percentage of global revenues. Beginning in 2008, the Company was able to identify and capture, where appropriate, the specific operating segments in which it incurred its overhead costs at the business unit level. Using this information, the Company has reclassified 2007 and 2006 segment operating results to conform to the current year presentation. These reclassifications resulted in an increase of $12.3 million and $2.0 million, respectively, in operating income for the Top Drive segment, and a corresponding decrease of $12.3 million and $2.0 million, respectively, for the Tubular Services segment.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Significant financial information relating to these segments is as follows (in thousands):
Geographic Areas
The Company attributes revenues to geographic regions based on the location of the customer. Generally, for service activities, this will be the region in which the service activity occurs and, for equipment sales, this will be the region in which the customer’s purchasing office is located. The Company’s revenues occurred and property, plant, equipment were located in the following areas of the world (in thousands):
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Major Customers and Credit Risk
The Company’s accounts receivable are principally with major international and state oil and gas service and exploration and production companies and are subject to normal industry credit risks. The Company performs ongoing credit evaluations of customers and grants credit based upon past payment history, financial condition and anticipated industry conditions. Customer payments are regularly monitored and a provision for doubtful accounts is established based upon specific situations and overall industry conditions. Many of the Company’s customers are located in international areas that are inherently subject to risks of economic, political and civil instabilities, which may impact management’s ability to collect those accounts receivable. The main factors in determining the allowance needed for accounts receivable are customer bankruptcies, delinquency, and management’s estimate of ability to collect. Bad debt expense is included in Selling, General and Administrative Expense in the accompanying Consolidated Statements of Income.
For the years ended December 31, 2008, 2007 and 2006, no single customer represented more than 10% of total revenue.
Index to Financial Statements TESCO CORPORATION
Notes to the Consolidated Financial Statements
Note 13-Selected Quarterly Financial Data (Unaudited)
The following table presents unaudited quarterly financial data for 2008, 2007 and 2006 (in thousands, except for per share amounts).
For the three months ended September 30, 2007, income tax benefits totaling $2.1 million related to the filing of the Company’s Canadian income tax return in June 2007 were based on a change in strategy related to the treatment of foreign tax credits and research and development credits. Because these benefits relate to a change in Canadian tax strategy, such benefit should have been recorded in the three month period ended June 30, 2007 instead of the three month period ended September 30, 2007. The Company believes that the effect of recording these benefits during the three month period ended September 30, 2007 instead of the earlier period is immaterial to both quarterly financial statements taken as a whole.
Index to Financial Statements Schedule II
VALUATION AND QUALIFYING ACCOUNTS
For the Years Ended December 31, 2008, 2007 and 2006
(a) Represents currency translation adjustments and reclasses.
(b) Primarily represents the elimination of accounts receivable and inventory deemed uncollectible or worthless and providing warranty services to customers.
(c) Negative amounts represent net recoveries of previously written-off receivables or changes to inventory and warranty reserve estimates. In 2007, the Company reversed $2.2 million in warranty reserves as described in Note 10 of the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K (Financial Statements and Supplementary Data).
(d) Relates to interest earned but unpaid on deposits held by Mexican tax authorities for which the Company is uncertain of recovery.