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FLOTEK INDUSTRIES INC/CN/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q (the "Quarterly Report"), and in particular, Part I, Item 2 - "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains "forward-looking statements" within the meaning of the safe harbor provisions, 15 U.S.C. § 78u-5, of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Forward-looking statements are not historical facts, but instead represent the Company's current assumptions and beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside the Company's control. Such statements include estimates, projections, and statements related to Flotek Industries, Inc.'s ("Flotek" or the "Company") business plan, objectives, expected operating results and assumptions upon which those statements are based. The forward-looking statements contained in this Quarterly Report are based on information available as of the date of this Quarterly Report. The forward-looking statements relate to future industry trends and economic conditions, forecast performance or results of current and future initiatives and the outcome of contingencies and other uncertainties that may have a significant impact on the Company's business, future operating results and liquidity. These forward-looking statements generally are identified by words including, but not limited to, "anticipate," "believe," "estimate," "continue," "intend," "expect," "plan," "forecast," "project" and similar expressions, or future-tense or conditional constructions such as "will," "may," "should," "could," etc. The Company cautions that these statements are merely predictions, and are not to be considered guarantees of future performance. Forward-looking statements are based upon current expectations and assumptions that are subject to risks and uncertainties that can cause actual results to differ materially from those projected, anticipated or implied. A detailed discussion of potential risks and uncertainties that could cause actual results and events to differ materially from forward-looking statements is included in Part I, Item 1A - "Risk Factors" of the Annual Report on Form 10-K for the year ended December 31, 2013 (the "Annual Report") and periodically in subsequent reports filed with the Securities and Exchange Commission (the "SEC"). The Company has no obligation to publicly update or revise any forward-looking statements, whether as a result of new information or future events, except as required by law. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the unaudited consolidated financial statements and the related notes thereto, as well as the Annual Report. Phrases such as "Company," "we," "our" and "us" refer to Flotek Industries, Inc. and its subsidiaries. Executive Summary Flotek is a global diversified, technology-driven company that develops and supplies oilfield products, services and equipment to the oil, gas and mining industries, and high value compounds to companies that make cleaning products, cosmetics, food and beverages, and other products that are sold in the consumer and industrial markets. The Company's oilfield businesses include specialty chemicals and logistics, down-hole drilling tools and production-related tools. Flotek's technologies enable customers to drill wells more efficiently, increase well production and decrease well operating costs. The Company also provides automated bulk material handling, loading facilities and blending capabilities. The Company sources citrus oil domestically and internationally and is one of the largest processors of citrus oil in the world. Products produced from processed citrus oil include (1) high value compounds used as additives by companies in the flavors and fragrances markets and (2) environmentally friendly chemicals for use in numerous industries around the world, specifically the oil and gas ("O&G") industry. Flotek operates in over 20 domestic and international markets, including the Gulf Coast, Southwest, West Coast, Rocky Mountains, Northeastern and Mid-Continental regions of the United States (the "U.S."), Canada, Mexico, Central America, South America, Europe, Africa, Middle East, Australia and Asia-Pacific. Customers include major integrated O&G companies, oilfield services companies, independent O&G companies, pressure-pumping service companies, national and state-owned oil companies, and international supply chain management companies. The Company's Consumer and Industrial Chemical Technologies ("CICT") segment also serves customers who purchase non-energy-related citrus oil and related products, including household and commercial cleaning product companies, fragrance and cosmetic companies, and food manufacturing companies. 20-------------------------------------------------------------------------------- Table of contents The operations of the Company are categorized into four reportable segments: Energy Chemical Technologies, Consumer and Industrial Chemical Technologies, Drilling Technologies and Production Technologies (previously referred to as Artificial Lift Technologies). • Energy Chemical Technologies designs, develops, manufactures, packages and markets specialty chemicals used in O&G well drilling, cementing, completion, stimulation and production. In addition, the Company's chemistries are used in specialized enhanced and improved oil recovery markets ("EOR" or "IOR"). Activities in this segment also include construction and management of automated material handling facilities and management of loading facilities and blending operations for oilfield services companies. • Consumer and Industrial Chemical Technologies designs, develops and manufactures products that are sold to companies in the flavor and fragrance industries and the specialty chemical industry. These technologies are used by beverage and food companies, fragrance companies, and companies providing household and industrial cleaning products. • Drilling Technologies rents, sells, inspects, manufactures and markets down-hole drilling equipment used in energy, mining, water well and industrial drilling activities. • Production Technologies assembles and markets production-related equipment, including the Petrovalve product line of rod pump components, electric submersible pumps, gas separators, valves and services that support natural gas and oil production activities. Market Conditions The Company's success is sensitive to a number of factors, which include, but are not limited to, drilling activity, customer demand for its advanced technology products, market prices for raw materials and governmental actions. Drilling activity levels are influenced by a number of factors, including the number of rigs in operation, the geographical areas of rig activity, and drill rig efficiency (rig days required per well). Additional factors that influence the level of drilling activity include: • Historical, current, and anticipated future O&G prices, • Federal, State and local governmental actions that may encourage or discourage drilling activity, • Customers' strategies relative to capital funds allocations, • Weather conditions, and • Technological changes to drilling methods and economics. Historical North American drilling activity is reflected in "TABLE A" on the following page. Customers' demand for advanced technology products and services provided by the Company are dependent on their recognition of the value of: • Chemistries that improve the economics of their O&G operations, • Drilling products that improve drilling operations and efficiencies, and • Chemistries that are economically viable, socially responsible and ecologically sound. Market prices for citrus oils can be influenced by: • Historical, current, and anticipated future production levels of the global citrus (primarily orange) crop, • Weather related risks, and • Health and condition of citrus trees (e.g., disease and pests). Governmental actions may restrict the future use of hazardous chemicals, including but not limited to, the following industrial applications: • O&G drilling and completion operations, • O&G production operations, and • Non-O&G industrial solvents. 21-------------------------------------------------------------------------------- Table of contents TABLE A Three months ended September 30, Nine months ended September 30, 2014 2013 % Change 2014 2013 % Change North American Average Active Drilling Rigs U.S. 1,903 1,770 7.5 % 1,845 1,763 4.7 % Canada 386 350 10.3 % 370 349 6.0 % Total Average North American Drilling Rigs 2,289 2,120 8.0 % 2,215 2,112 4.9 % U.S. Average Active Drilling Rigs by Type Vertical 372 436 (14.7 )% 385 443 (13.1 )% Horizontal 1,314 1,073 22.5 % 1,246 1,096 13.7 % Directional 217 261 (16.9 )% 214 224 (4.5 )% Total Average U.S. Drilling Rigs by Type 1,903 1,770 7.5 % 1,845 1,763 4.7 % Oil vs. Natural Gas Average North American Drilling Rigs Oil 1,797 1,609 11.7 % 1,731 1,610 7.5 % Natural Gas 492 511 (3.7 )% 484 502 (3.6 )% Total North America 2,289 2,120 8.0 % 2,215 2,112 4.9 % U.S. Average Wells Drilled per Quarter per Rig 5.19 5.31 (2.3 )% 5.22 5.20 0.4 % Source: Rig and well counts are per Baker Hughes, Inc. (www.bakerhughes.com). Rig counts are the averages of the weekly rig count activity. Average wells drilled per quarter per rig is the number of wells drilled in the reporting period divided by the average weekly rig count. Current quarter well count data from Baker Hughes, Inc. is preliminary and is subject to revision. During the three and nine months ended September 30, 2014, total North American active drilling rig count saw an increase when compared to the comparable periods of 2013, primarily in oil drilling rigs. Average North American oil drilling rig activity increased by 11.7% and 7.5% for the three and nine months ended September 30, 2014, respectively, when compared to the same periods of 2013. North American natural gas drilling rig count decreased by 3.7% and 3.6% for the three and nine months ended September 30, 2014, respectively, compared to the same periods of 2013. Overall U.S. rig activity increased 7.5% and 4.7% for the three and nine months ended September 30, 2014 compared to the same periods in 2013, and the number of wells drilled per rig per quarter held relatively constant for the nine months ended September 30, 2014 at 5.22 compared to 5.20 for the same period in 2013. For the three and nine months ended September 30, 2014, U.S. drilling rigs by type continued to show a shift toward horizontal wells and away from vertical and directional wells. Company Outlook Future economic conditions are expected to remain consistent with recent market conditions. Increases in drilling rig operating efficiencies noted above are resulting in pricing pressure on rig-based operations. To some extent, those pressures impact drilling suppliers such as Flotek, especially in our Drilling Technologies segment. Our tools are being leased for a smaller amount of time per well drilled, which is partially offset by the expansion in the number of wells being drilled per quarter per rig. The Company is expanding its Energy Chemical Technologies and Drilling Technologies businesses by expanding its production capacity, developing innovative new products and pursuing and developing new market opportunities. The Company continues to reposition the Production Technologies segment to focus on niche technologies in the oil and natural gas markets. As a result of this repositioning, the Company plans to increase capital allocated to this segment. Capital expenditures, exclusive of acquisitions, totaled $13.5 million and $10.0 million for the nine months ended September 30, 2014 and 2013, respectively. The Company continues to pursue selected strategic acquisitions and relationships, both domestically and internationally, when opportunities arise. • In November 2013, the Company signed a shareholder agreement with Tasneea Oil and Gas Technologies, LLC ("Tasneea") an Omani Limited Liability Company, to form Omani based Flotek Gulf, LLC ("Flotek Gulf") and Flotek Gulf Research, LLC ("Flotek Gulf Research"). During the three months ended September 30, 2014, Flotek and Tasneea transferred initial capital into Flotek Gulf and Flotek Gulf Research. Flotek Gulf and Flotek Gulf Research will develop and market specialty chemistries for the oil and gas industry throughout the Middle East and North Africa. In the coming year, Flotek Gulf expects to construct a manufacturing facility designed to produce Flotek's patented and proprietary products for distribution throughout the region. 22-------------------------------------------------------------------------------- Table of contents • Effective January 1, 2014, the Company acquired Eclipse IOR Services, LLC ("EOGA"), a leading enhanced oil recovery (EOR) design and injection firm. EOGA's expertise in enhanced oil recovery processes and the use of polymers to improve the performance of EOR projects has been combined with the Company's existing EOR products and services. The combined product and service offerings are well positioned to serve the growing market for EOR products and services. • On April 1, 2014, the Company acquired 100% of the membership interests in SiteLark, LLC ("SiteLark") for $0.4 million and 5,327 shares of the Company's common stock. SiteLark provides reservoir engineering and modeling services for a variety of hydrocarbon applications. Its services include proprietary software which assists engineers with reservoir simulation, reservoir engineering and waterflood optimization. • In May 2014, the Company launched its patent pending FracMax™ software technology. The FracMax™ application is an innovative software technology that allows the Company to quantitatively demonstrate the benefits associated with the use of the Company's patented and proprietary Complex nano-Fluid® chemistries. The FracMax™ application has been integrated into the Company's sales and marketing process leading to new sales opportunities. In October 2014, the Company announced the formation of FracMax Analytics, LLC, a wholly owned subsidiary that will use the FracMax™ software platform to provide customized data analysis to oil and gas operators, investors and other companies. The Company believes governmental reaction to constituents' environmental concerns regarding the hydraulic fracturing process and the use of hazardous chemicals in O&G operations could work to its advantage. These environmental concerns favor the Company's chemistries as economical replacements for more hazardous chemicals currently in use in many drilling and producing operations. Several states and countries have grass-roots, citizen movements that are aimed specifically at "greening" the hydraulic fracturing process, and management believes it is likely these environmental concerns/reactions will broaden to other states in the quarters to come. The outlook for the Company's consumer and industrial chemistries will be driven by availability and demand for citrus oils and other bio-based raw materials. Current inventory and crop expectations for 2014 and into 2015 are sufficient to meet the Company's needs to supply its flavor and fragrance business as well as the industrial markets. However, market price volatility will likely result in revenue and margin fluctuations from quarter to quarter. The Company works to maintain a portfolio of products which are adaptable to meet our customers' demands for customized products for the various drilling and producing environments in which they operate. The Company's commitment to research and innovation permits the Company to remain responsive to increased demand and continued growth. The Company remains committed to continued development of its product technologies to better serve its customers' needs. The Company believes that it is well-positioned to respond to increased demand for the Company's suite of hydrocarbon stimulation and completion products, particularly the Company's patented Complex nano-Fluid™ chemistries. In addition, the Company anticipates continued strong demand for its Teledrift® Pro-series tool product lines and its recently introduced Stemulator® tool. Changes to global geo-political and economic events could have an impact, either positive or negative, on the Company's business. In the event of significant adverse changes to the demand for O&G production, the market conditions affecting the Company could change quickly and materially. Should such adverse changes to market conditions occur, management believes the Company has adequate liquidity to withstand the impact of such changes. In addition, management believes the Company is well-positioned to take advantage of significant increases in demand for its products should market conditions improve in the near term. The Company expects that competition for contracts and margins will remain intense in the future but believes that product innovation, service improvements and quantitative data from its FracMax™ technology will enable the Company to realize market share gains during the remainder of 2014 and into 2015. 23-------------------------------------------------------------------------------- Table of contents Consolidated Results of Operations (in thousands): Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue $ 116,761 $ 98,388 $ 324,653 $ 270,217 Cost of revenue 70,683 60,886 192,585 162,491 Gross margin 46,078 37,502 132,068 107,726 Gross margin % 39.5 % 38.1 % 40.7 % 39.9 % Selling, general and administrative costs 21,499 19,542 63,924 58,640 Selling, general and administrative costs % 18.4 % 19.9 % 19.7 % 21.7 % Depreciation and amortization 2,439 2,038 7,225 5,231 Research and development 1,293 835 3,599 2,689 Income from operations 20,847 15,087 57,320 41,166 Income from operations % 17.9 % 15.3 % 17.7 % 15.2 % Interest and other expense, net (511 ) (471 ) (1,565 ) (1,378 ) Income before income taxes 20,336 14,616 55,755 39,788 Income tax expense (6,064 ) (5,648 ) (18,425 ) (14,615 ) Net income $ 14,272 $ 8,968 $ 37,330 $ 25,173 Net income % 12.2 % 9.1 % 11.5 % 9.3 % Consolidated Results of Operations: Three and Nine Months Ended September 30, 2014 Compared to the Three and Nine Months Ended September 30, 2013 Consolidated revenue for the three and nine months ended September 30, 2014 increased $18.4 million, or 18.7%, and $54.4 million, or 20.1%, respectively, relative to the comparable periods of 2013. The increase in revenue for the three months ended September 30, 2014 compared to the same period of 2013 was primarily due to increased sales of stimulation chemical additives in our Energy Chemical Technologies segment, increased actuated tool and Teledrift® tool rentals in our Drilling Technologies segment, and increased international valve and valve equipment sales in our Production Technologies segment. The increase in revenue for the nine months ended September 30, 2014 compared to the same period of 2013 was primarily due to increased sales of stimulation chemical additives in our Energy Chemical Technologies segment, the acquisition of Florida Chemical in the second quarter of 2013, and incremental revenue from the 2014 acquisitions of EOGA and SiteLark. These increases were partially offset by revenue declines in the Drilling Technologies and Production Technologies segments. Consolidated gross margin for the three and nine months ended September 30, 2014 increased $8.6 million, or 22.9%, and $24.3 million, or 22.6%, respectively, relative to the comparable periods of 2013. The increase in gross margin was primarily due to the increase in revenue. Gross margin as a percentage of revenue increased to 39.5% for the three months ended September 30, 2014 from 38.1% in the same period of 2013, primarily due to increased international sales in our Production Technologies segment. Gross margin as a percentage of revenue increased to 40.7% for the nine months ended September 30, 2014 from 39.9% in the same period of 2013, primarily attributable to supply chain benefits from the Florida Chemical acquisition, partially offset by the change in portfolio mix resulting from the inclusion of Florida Chemical in the consolidated results for the nine months ended September 30, 2014. Selling, general and administrative ("SG&A") expenses are not directly attributable to products sold or services provided. SG&A costs as a percentage of revenue declined from 19.9% to 18.4% for the three months ended September 30, 2014 and from 21.7% to 19.7% for the nine months ended September 30, 2014 as compared to the same periods of 2013, as revenues grew faster than SG&A costs. SG&A costs increased $2.0 million, or 10.0%, for the three months ended September 30, 2014 as compared to the same period of 2013, primarily due to costs for additional headcount to support the Company's growth and costs attributable to the companies we acquired. SG&A costs increased $5.3 million, or 9.0%, for the nine months ended September 30, 2014, compared to the same period of 2013 primarily due to SG&A costs for the acquired companies discussed above. Depreciation and amortization expense for the three and nine months ended September 30, 2014 increased by $0.4 million, or 19.7%, and $2.0 million, or 38.1%, respectively, relative to the comparable periods of 2013. The increase for the nine months 24-------------------------------------------------------------------------------- Table of contents ended September 30, 2014 was primarily attributable to the depreciation and amortization of assets recognized as part of the acquisition of Florida Chemical in the second quarter of 2013 and the acquisition of EOGA in the first quarter of 2014. Research and Development ("R&D") expense increased $0.5 million, or 54.9%, and $0.9 million, or 33.8%, for the three and nine months ended September 30, 2014, respectively, as compared to the same periods in 2013. The increase in R&D is primarily attributable to new product development and Flotek's commitment to remaining responsive to customer needs, increased demand and continued growth of our existing product lines. Interest and other expense remained relatively flat for the three and nine months ended September 30, 2014 as compared to the same periods of 2013. The Company recorded income tax provisions of $6.1 million and $18.4 million, yielding effective tax rates of 29.8% and 33.0% for the three and nine months ended September 30, 2014, respectively, compared to income tax provisions of $5.6 million and $14.6 million reflecting effective tax rates of 38.6% and 36.7% for the comparable periods in 2013. Results by Segment Energy Chemical Technologies (dollars in thousands) Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue $ 68,181 $ 51,670 $ 193,148 $ 144,029 Gross margin 28,424 21,849 85,074 61,548 Gross margin % 41.7 % 42.3 % 44.0 % 42.7 % Income from operations 19,903 16,247 60,690 45,300 Income from operations % 29.2 % 31.4 % 31.4 % 31.5 % Energy Chemical Technologies Results of Operations: Three and Nine Months Ended September 30, 2014 Compared to the Three and Nine Months Ended September 30, 2013 Energy Chemical Technologies revenue for the three months ended September 30, 2014 increased $16.5 million, or 32.0%, relative to the comparable period of 2013. Excluding the incremental revenue impact of the EOGA and SiteLark acquisitions of $1.5 million, revenue increased $15.0 million, or 29.1%, for the three months ended September 30, 2014 compared to the same period of 2013. Increased sales of stimulation chemical additives accounted for the majority of the revenue increase. Revenue for the nine months ended September 30, 2014 increased $49.1 million, or 34.1%, relative to the comparable period of 2013. Excluding the incremental revenue impact of the Florida Chemical, EOGA and SiteLark acquisitions of $9.4 million, revenue increased $39.7 million, or 28.6%, compared to the same period of 2013, primarily due to the increased sales of stimulation chemical additives mentioned above. Energy Chemical Technologies gross margin increased $6.6 million, or 30.1%, and $23.5 million, or 38.2%, for the three and nine months ended September 30, 2014, respectively, compared to the same periods of 2013 primarily due to the increase in product sales revenue. Gross margin as a percentage of revenue decreased to 41.7% for the three months ended September 30, 2014 from 42.3% in the same period of 2013, primarily due to a new incentive pricing structure, increased logistics costs and inventory adjustments during 2014, partially offset by improved margins for xylene replacement products, expanded markets for CnF® and productivity improvements in the manufacturing process. Gross margin as a percentage of revenue increased to 44.0% for the nine months ended September 30, 2014 from 42.7% in the same period of 2013, primarily due to the supply chain benefits of the Florida Chemical acquisition. Income from operations for the Energy Chemical Technologies segment increased $3.7 million, or 22.5%, for the three months ended September 30, 2014, and increased $15.4 million, or 34.0%, for the nine months ended September 30, 2014 relative to the comparable periods of 2013. The increase in income from operations for both periods is primarily attributable to an increase in gross margin, partially offset by increased headcount, travel and associated costs related to the pursuit of growth opportunities. 25-------------------------------------------------------------------------------- Table of contents Consumer and Industrial Chemical Technologies (dollars in thousands) Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue $ 13,713 $ 15,292 $ 39,351 $ 27,967 Gross margin 3,310 3,588 10,237 7,281 Gross margin % 24.1 % 23.5 % 26.0 % 26.0 % Income from operations 1,758 2,301 5,064 4,648 Income from operations % 12.8 % 15.0 % 12.9 % 16.6 % CICT Results of Operations: Three and Nine Months Ended September 30, 2014 Compared to the Three and Nine Months Ended September 30, 2013 CICT revenue for the three months ended September 30, 2014 decreased $1.6 million, or 10.3%, compared to the same period in 2013, primarily due to decreased terpene sales between the two periods. Revenue for the nine months ended September 30, 2014 increased $11.4 million, or 40.7%, from the comparable period of 2013, as the segment was created in the second quarter of 2013 upon the acquisition of Florida Chemical. CICT gross margin for the three months ended September 30, 2014 decreased $0.3 million, or 7.7%, from the comparable period of 2013, primarily due to the lower terpene sales mentioned above. Gross margin for the nine months ended September 30, 2014 increased $3.0 million, or 40.6%, from the comparable period of 2013, primarily due to the segment being created in the second quarter of 2013 upon the acquisition of Florida Chemical. Gross margin as a percentage of revenue increased to 24.1% for the three months ended September 30, 2014 from 23.5% in the same period of 2013, primarily due to increased sales of higher margin flavor and fragrance products. Gross margin as a percentage of revenue remained flat at 26.0% for the nine months ended September 30, 2014 as compared to the same period of 2013. Income from operations for the CICT segment decreased $0.5 million, or 23.6%, for the three months ended September 30, 2014 compared to the same period of 2013, primarily due to the revenue and gross margin factors described above. Income from operations increased $0.4 million, or 9.0%, for the nine months ended September 30, 2014 compared to the same period of 2013, primarily due to the increased revenue between the two periods. Drilling Technologies (dollars in thousands) Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue $ 29,920 $ 27,569 $ 82,061 $ 86,268 Gross margin 11,928 10,821 32,477 34,622 Gross margin % 39.9 % 39.3 % 39.6 % 40.1 % Income from operations 5,557 4,309 13,073 15,510 Income from operations % 18.6 % 15.6 % 15.9 % 18.0 % Drilling Technologies Results of Operations: Three and Nine Months Ended September 30, 2014 Compared to the Three and Nine Months Ended September 30, 2013 Drilling Technologies revenue for the three months ended September 30, 2014 increased $2.4 million, or 8.5%, relative to the same period in 2013, primarily due to an increase in actuated tool rentals, Teledrift® tool rentals, and increases in float equipment product sales. Revenue for the nine months ended September 30, 2014 decreased $4.2 million, or 4.9%, relative to the same period in 2013, primarily due to a decrease in Teledrift® domestic rental revenue, decreased international drill pipe sales, and decreased non-actuated tool rentals. • Rental revenue for the three months ended September 30, 2014 increased $1.7 million, or 10.9%, compared to the same period of 2013. This increase can be attributed to an 45.2% increase in actuated tool rental revenue in the Bakken and a 22.9% increase in international Teledrift® tool rentals. Rental revenue for the nine months ended September 30, 2014 decreased by $0.9 million, or 1.9%, compared to the same period of 2013. This decline is due to a 5.1% decrease in Teledrift® domestic tool rental revenue attributed to competitive pricing pressure and decreasing vertical rig counts, 26-------------------------------------------------------------------------------- Table of contents partially offset by an increase of 11.8% in actuated tool and Stemulator® tool rentals for the nine months ended September 30, 2014 as compared to the same period of 2013. • Product sales revenue for the three months ended September 30, 2014 compared to the same period of 2013 increased by $0.9 million, or 9.9%, due to increased float and centralizer equipment sales. Product revenue for the nine months ended September 30, 2014 decreased by $2.8 million, or 9.8%, relative to the same period in 2013, primarily due to decreased international drill pipe sales for the mining industry and decreased domestic motor sales. • Service revenue for the three and nine months ended September 30, 2014 decreased $0.2 million, or 4.7%, and $0.5 million, or 4.6%, respectively, relative to comparable periods of 2013. The decrease in service revenue was primarily related to decreased rig service jobs and inspections. Drilling Technologies gross margin for the three months ended September 30, 2014 increased $1.1 million, or 10.2%, from the comparable period of 2013, primarily due to the revenue factors mentioned above and a 5.4% decrease in direct costs, due to lower employee-related compensation costs. Drilling Technologies gross margin for the nine months ended September 30, 2014 decreased $2.1 million, or 6.2%, due to the reduction in revenue and increased Teledrift® repair expenses. Gross margin as a percentage of revenue remained relatively flat for the three and nine months ended September 30, 2014. Drilling Technologies income from operations for the three months ended September 30, 2014 increased by $1.2 million, or 29.0%, as compared to the same period of 2013. Income from operations as a percentage of revenue increased to 18.6% for the three months ended September 30, 2014, up from 15.6% for the same period of 2013. These increases are primarily due to reductions in direct costs, increased rental activity, and increased product sales. Drilling Technologies income from operations for the nine months ended September 30, 2014 decreased by $2.4 million, or 15.7%, over the same period of 2013. Income from operations as a percentage of revenue decreased to 15.9% for the nine months ended September 30, 2014, down from 18.0% for the same period of 2013. These decreases are primarily due to the decreased revenue explained above and increased Teledrift® repair expenses. Production Technologies (dollars in thousands) Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue $ 4,947 $ 3,857 $ 10,093 $ 11,953 Gross margin 2,416 1,244 4,280 4,275 Gross margin % 48.8 % 32.3 % 42.4 % 35.8 % Income from operations 1,583 769 1,925 2,712 Income from operations % 32.0 % 19.9 % 19.1 % 22.7 % Production Technologies Results of Operations: Three and Nine Months Ended September 30, 2014 Compared to the Three and Nine Months Ended September 30, 2013 Revenue for the Production Technologies segment for the three months ended September 30, 2014 increased by $1.1 million, or 28.3%, from the same period in 2013 due to increased sales of international valves, valve equipment, and domestic hydraulic lifting units. For the nine months ended September 30, 2014, revenue decreased by $1.9 million, or 15.6%, relative to the same period in 2013 as sales of pumps and pump equipment declined. Production Technologies gross margin increased by $1.2 million, or 94.2%, for the three months ended September 30, 2014 as compared to the same period in 2013, and gross margin as a percentage of revenue increased to 48.8% for the three months ended September 30, 2014 from 32.3% for the same period in 2013. These increases are due to product mix from increased international Petrovalve sales and decreased domestic rod pump component sales. Gross margin was flat for the nine months ended September 30, 2014, but gross margin as a percentage of revenue increased to 42.4%, compared to 35.8% for the same period in 2013, primarily due to the higher margins associated with the international valve sales and improving margins on pump equipment. Income from operations increased by $0.8 million, or 105.9%, for the three months ended September 30, 2014 compared to the same period in 2013, due to product mix. Income from operations decreased by $0.8 million, or 29.0%, for the nine months ended September 30, 2014 compared to the same period in 2013, primarily due to decreases in sales and increases in SG&A costs attributable to employee-related expenses as the segment continues to refocus and reposition for growth in the market. 27-------------------------------------------------------------------------------- Table of contents Off-Balance Sheet Arrangements There have been no transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as "structured finance" or "special purpose entities" ("SPEs"), established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of September 30, 2014, the Company was not involved in any unconsolidated SPEs. The Company has not made any guarantees to customers or vendors nor does the Company have any off-balance sheet arrangements or commitments that have, or are reasonably likely to have, a current or future effect on the Company's financial condition, change in financial condition, revenue, expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors. Critical Accounting Policies and Estimates The Company's Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). Preparation of these statements requires management to make judgments, estimates and assumptions that affect the amounts reported in the financial statements and accompanying footnotes. Part II, Item 8, Financial Statements and Supplementary Data, Note 2 of "Notes to Unaudited Consolidated Financial Statements" and Part II, Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations, "Critical Accounting Policies and Estimates" of the Company's Annual Report, and the "Notes to Unaudited Consolidated Financial Statements" of this Quarterly Report describe the significant accounting policies and critical accounting estimates used to prepare the consolidated financial statements. Critical accounting policies and estimates are defined as those that are both most important to the portrayal of the Company's financial condition and results of operations and require management's most subjective judgments. The Company regularly reviews and challenges judgments, assumptions and estimates related to critical accounting policies. The Company's estimates and assumptions are based on historical experience and expected changes in the business environment; however, actual results may materially differ from the estimates. As part of the acquisition process the Company reaffirmed policies and estimates surrounding business combination in accordance with GAAP, specifically, utilizing the guidance of Accounting Standards Codification ("ASC") Topic 805, formerly Statement of Financial Accounting Standards ("SFAS") No. 141R, as amended by FSP SAFAS No. 141(R)-1 which became effective on January 1, 2009. ASC Topic 805 requires an acquiring entity in a transaction to recognize all of the identifiable assets acquired and liabilities assumed at fair value at the acquisition date at their estimated fair values on the acquisition date, to recognize and measure pre-acquisition contingencies, including contingent consideration, at fair value (if possible), to remeasure liabilities related to contingent consideration at fair value in each subsequent reporting period and to expense all acquisition relates costs. Though the Company has implemented business combination accounting guidance, there have been no significant changes in the Company's critical accounting estimates during the nine months ended September 30, 2014. Application of New Accounting Standards Effective January 1, 2014, the Company adopted the accounting guidance in Accounting Standards Update ("ASU") No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists," which provides guidance for reporting unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists at the reporting date. The guidance requires an unrecognized tax benefit to be presented as a decrease in a deferred tax asset where a net operating loss, a similar tax loss, or a tax credit carryforward exists and certain criteria are met. Implementation of this standard did not have a material effect on the consolidated financial statements. New Accounting Requirements and Disclosures In June 2014, the Financial Accounting Standards Board ("FASB") issued ASU No. 2014-12, "Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period." The ASU requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. The ASU is effective for annual reporting periods beginning after December 15, 2015, with early adoption permitted. The Company is evaluating the potential impacts of the new standard on its existing stock-based compensation plans. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers." The ASU will supersede most of the existing revenue recognition requirements in U.S. GAAP and will require entities to recognize revenue at an amount that reflects the consideration to which the Company expects to be entitled in exchange for transferring goods or services to a customer. The new standard also requires significantly expanded disclosures regarding the qualitative and quantitative information of an entity's nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The 28-------------------------------------------------------------------------------- Table of contents pronouncement is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period and is to be applied retrospectively, with early application not permitted. The Company is currently evaluating the impact the pronouncement will have on the consolidated financial statements and related disclosures. In April 2014, the FASB issued ASU No. 2014-08, "Presentation of Financial Statements and Property, Plant, and Equipment - Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity," which amends the definition of a discontinued operation by raising the threshold for a disposal to qualify as discontinued operations. The ASU will also require entities to provide additional disclosures about discontinued operations as well as disposal transactions that do not meet the discontinued operations criteria. The pronouncement is effective prospectively for all disposals (except disposals classified as held for sale before the adoption date) of components initially classified as held for sale in periods beginning on or after December 15, 2014. Early adoption is permitted. The Company is currently evaluating this guidance and does not expect that adoption will have a material effect on the consolidated financial statements. Capital Resources and Liquidity Overview Ongoing capital requirements arise from the Company's need to service debt, acquire and maintain equipment, and fund working capital requirements. During the first nine months of 2014, the Company funded capital requirements primarily with operating cash flows. The Company's primary source of debt financing is its Revolving Credit Facility with PNC Bank. This credit facility contains provisions for revolving debt of up to $75.0 million, based on a borrowing base supported by accounts receivable and inventory, and a term loan of $50.0 million. As of September 30, 2014, the Company had $4.2 million in outstanding borrowings under the revolving debt portion of the credit facility and $37.3 million outstanding under the term loan. At September 30, 2014, the Company was in compliance with all debt covenants. Significant terms of the Company's credit facility are discussed in Part I, Item 1 - "Financial Statements" in Note 9 of "Notes to Unaudited Consolidated Financial Statements" in this Quarterly Report. Cash and cash equivalents totaled $5.3 million at September 30, 2014. During the first nine months of 2014, the Company generated $39.9 million of cash inflows from operations, net of $12.7 million expended in working capital. The Company used $16.7 million of net cash in investing activities, including $13.5 million for capital expenditures and $5.7 million, net of cash acquired, for the purchase of EOGA and SiteLark, partially offset by proceeds of $3.3 million from the sale of assets. Net cash used in financing activities totaled $20.7 million. The Company repaid net draws and term loans on the amended Credit Facility of $12.0 million and $8.5 million, respectively. Additionally, the Company paid $6.1 million in purchases of treasury stock for tax withholding purposes related to vesting of restricted stock awards. Cash Flows Consolidated cash flows by type of activity are noted below (in thousands): Nine months ended September 30, 2014 2013 Net cash provided by operating activities $ 39,897 $ 21,360 Net cash used in investing activities (16,656 ) (58,786 ) Net cash provided by financing activities (20,676 ) 39,274 Effect of changes in exchange rates on cash and cash equivalents (38 ) (179 ) Net increase (decrease) in cash and cash equivalents $ 2,527 $ 1,669 Operating Activities Net cash provided by operating activities was $39.9 million and $21.4 million during the nine months ended September 30, 2014 and 2013, respectively. Consolidated net income for the nine months ended September 30, 2014 totaled $37.3 million, compared to consolidated net income of $25.2 million for the nine months ended September 30, 2013. During the nine months ended September 30, 2014, net non-cash contributions to net income totaled $15.2 million. Contributory non-cash items consisted of $13.5 million for depreciation and amortization, $7.4 million for stock-based compensation expense and $0.2 million for net decreases in deferred income taxes. Non-cash reductions to net income included $2.6 million for net gains on asset disposals, $3.4 million for recognized incremental tax benefits related to the Company's share based awards. 29-------------------------------------------------------------------------------- Table of contents During the nine months ended September 30, 2013, net non-cash contributions to net income totaled $15.2 million, primarily consisting of $8.7 million for stock compensation expense and $11.0 million for depreciation and amortization, partially offset by $3.5 million for net gain on sale of assets, $0.3 million for deferred income taxes, and $0.8 million recognized incremental tax benefits related to the Company's share based awards. During the nine months ended September 30, 2014, net working capital was reduced by $12.7 million. Working capital was used to increase inventory by $18.0 million, increase other current assets by $5.0 million, and increase accounts receivable by $3.9 million. The reductions to working capital were partially offset by increased accounts payable of $12.6 million, increased income taxes payable of $1.1 million, and increased accrued liabilities by $1.0 million. During the nine months ended September 30, 2013, net working capital was reduced by $19.0 million. Working capital was primarily used to decrease accounts payable by $17.3 million, increase inventories by $2.1 million, increase accounts receivable by $6.5 million, partially offset by a decrease in other current assets of $0.3 million, increase income taxes payable of $1.6 million, and an increase in accrued liabilities of $4.9 million. Investing Activities Net cash used in investing activities was $16.7 million for the nine months ended September 30, 2014. Cash used by investing activities in 2014 were for capital expenditures of $13.5 million and net cash payments for the acquisitions of EOGA, SiteLark, and various patents of $6.5 million, partially offset by $3.3 million for proceeds received from the sale of fixed assets. Net cash used in investing activities was $58.8 million for the nine months ended September 30, 2013. Cash used by investing activities in 2013 were for the acquisition of Florida Chemical in the second quarter of 2013 for $53.4 million and capital expenditures of $10.0 million, partially offset by $4.6 million for proceeds received from the sale of fixed assets. Financing Activities Net cash used by financing activities was $20.7 million for the nine months ended September 30, 2014. Cash used by financing activities was primarily due to $20.6 million for repayments of debt, net of borrowings, $6.1 million for purchases of treasury stock for tax withholding purposes related to vesting of restricted stock awards, and debt issuance costs of $0.3 million. Cash used by financing activities was partially offset by proceeds from the exercise of stock warrants of $1.5 million, proceeds from the excess tax benefit related to stock-based compensation of $3.4 million, proceeds from the sale of common stock of $0.8 million and proceeds from the exercise of stock options of $0.5 million. During the nine months ended September 30, 2013, financing activities provided net cash of $39.3 million. Financing activities included proceeds from borrowings, net of repayments of debt, of $43.8 million, proceeds from the excess tax benefit related to stock-based compensation of $0.8 million, proceeds from the sale of common stock of $0.6 million, and proceeds from the exercise of stock options of $0.5 million. Cash provided by financing activities was partially offset by purchases of treasury stock of $5.3 million and debt issuance costs of $1.2 million. Although the Company has no immediate intention to access the capital markets, the Company intends to file a "universal" shelf registration with the Securities and Exchange Commission in the future. This shelf registration statement will register the issuance and sale from time to time of various securities by the Company, including but not limited to senior notes, subordinated notes, preferred stock, common stock, and warrants. Once this shelf registration statement is filed with the Securities and Exchange Commission and becomes effective, the Company will have the financial flexibility to access the capital markets quickly and efficiently from time to time as the need may arise. Contractual Obligations Cash flows from operations are dependent on a variety of factors, including fluctuations in operating results, accounts receivable collections, inventory management, and the timing of payments for goods and services. Correspondingly, the impact of contractual obligations on the Company's liquidity and capital resources in future periods is analyzed in conjunction with such factors. 30-------------------------------------------------------------------------------- Table of contents Material contractual obligations consist of repayment of amounts borrowed on the Company's Credit Facility with PNC Bank and payment of operating lease obligations. Contractual obligations at September 30, 2014 are as follows (in thousands): Payments Due by Period Less than 1 More than 5 Total year 1 - 3 years 3 - 5 years years Term loan $ 37,327 $ 7,143 $ 14,286 $ 15,898 $ - Interest expense on term loan (1) 3,887 1,330 2,101 456 - Borrowings under revolving credit facility (2) 4,224 4,224 - - - Operating lease obligations 25,247 2,123 4,962 3,843 14,319 Total $ 70,685 $ 14,820 $ 21,349 $ 20,197 $ 14,319 (1) Interest expense amounts assume interest rates on this variable rate obligation remain unchanged from September 30, 2014 rates. The weighted-average interest rate is 2.43% at September 30, 2014. (2) The borrowing is classified as current debt. The weighted-average interest rate is 1.77% at September 30, 2014. Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company is exposed to market risk from changes in interest rates and, to a limited extent, commodity prices and foreign currency exchange rates. There have been no material changes to the quantitative or qualitative disclosures about market risk set forth in Part II, Item 7A of the Company's Annual Report. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company's disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. The Company's disclosure controls and procedures are also designed to ensure such information is accumulated and communicated to management, including the principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance that control objectives are attained. The Company's disclosure controls and procedures are designed to provide such reasonable assurance. The Company's management, with the participation of the principal executive and principal financial officers, evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures as of September 30, 2014, as required by Rule 13a-15(e) of the Exchange Act. Based upon that evaluation, the principal executive and principal financial officers have concluded that the Company's disclosure controls and procedures were effective as of September 30, 2014. Changes in Internal Control Over Financial Reporting There have been no changes in the Company's system of internal control over financial reporting during the three months ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 31-------------------------------------------------------------------------------- Table of Contents |