UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

Commission file number 001-15423

Grant Prideco, Inc.

(281) 878-8000
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes [X]     No [  ]

     Indicate by check mark whether the issuer is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes [X]      No [  ]

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

GRANT PRIDECO, INC.

The accompanying notes are an integral part of these consolidated financial statements.

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GRANT PRIDECO, INC.

The accompanying notes are an integral part of these consolidated financial statements.

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GRANT PRIDECO, INC.

The accompanying notes are an integral part of these consolidated financial statements.

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GRANT PRIDECO, INC.

1. General

Basis of Presentation

     The accompanying consolidated financial statements of Grant Prideco, Inc. (the “Company” or “Grant Prideco”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all disclosures required by generally accepted accounting principles for complete financial statements. All significant transactions between Grant Prideco and its consolidated subsidiaries have been eliminated. The interim financial statements have not been audited. However, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial statements have been included. Results of operations for interim periods are not necessarily indicative of the results of operations that may be expected for the entire year. The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

     The Annual Report on Form 10-K for the year ended December 31, 2003 includes disclosures related to significant accounting policies including revenue recognition, inventory valuation, business combinations, impairment of long-lived assets, goodwill and intangible assets, deferred tax asset valuation, estimates related to contingent liabilities and future claims, and pension liabilities.

     Certain reclassifications of prior year balances have been made to conform such amounts to corresponding 2004 classifications. These reclassifications have no impact on net income. As explained in Note 14, during the second quarter of 2004, the Company completed the sale of its Texas Arai division. Prior year results of operations of Texas Arai have been reclassified as discontinued operations.

Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements, and the related 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, restructuring, self-insurance, valuation of goodwill and long-lived assets, allowance for doubtful accounts, determination of income taxes, contingent liabilities, and purchase accounting allocations. Actual results could differ from those estimates. Based on the Company’s review of accounts receivable at September 30, 2004, an increase to the allowance for doubtful accounts of $1.9 million was recorded, of which $1.6 million related to the Drill Bits segment, and was included in the Consolidated Statements of Operations in “Sales and marketing” for the three-month period ended September 30, 2004.

2. Stock-Based Compensation

     Pro Forma Stock Option Compensation Expense

     The Company has elected to account for its stock–based compensation using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees”, as allowed under Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock–Based Compensation”. Under this method, no compensation expense is recognized when the number of shares granted is known and the exercise price of the stock option at the time of grant is equal to or greater than the market price of the Company’s common stock. Reported net income does include compensation expense associated with restricted stock awards and accelerated vesting of certain stock awards related to severance.

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     Had compensation expense for stock options been determined based on the fair value at the grant dates for awards under the Company’s incentive compensation plans, the Company’s net income and net income per share would have been reduced to the pro forma amounts indicated as follows:

     The weighted average fair value of each stock option included in the preceding pro forma amounts was estimated using the Black-Scholes option pricing model and are amortized over the vesting period of the underlying options.

     Restricted Stock

     In February 2004, the Company awarded 341,950 shares of restricted stock to officers and other key employees under the Company’s 2000 Employee Stock Option and Restricted Stock Plan (2000 Plan). The restricted shares vest on the ninth anniversary of the date of grant (February 2013), however there is an accelerated vesting schedule based on the achievement of certain predetermined performance metrics. Beginning with the third anniversary date of the grant through the eighth anniversary date, the performance metrics are evaluated annually and early vesting will occur for meeting the performance goals. Restricted shares are subject to certain restrictions on ownership and transferability when granted. Unearned compensation of $4.7 million was recorded based on the market value of the shares on the date of grant and is being recognized ratably over the expected vesting period. For the nine-month period ended September 30, 2004, the Company recorded compensation expense of $0.5 million related to these shares.

     Also included in the February 2004 restricted stock award was a tax gross up bonus component based on the incremental tax rate needed to reimburse the employees for the federal income taxes resulting from the vesting of the restricted shares. As the tax gross-up bonus component will change based on the share price at the vesting date, the estimated cash liability to the employees is considered to be a variable award under APB No. 25 and therefore the liability is required to be adjusted as the stock price changes. The estimated tax liability at September 30, 2004 was $4.7 million based on the stock price at that date, and is being recognized ratably over the expected vesting period. For the nine-month period ended September 30, 2004, the Company recorded compensation expense of $0.6 million associated with this liability.

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3. Comprehensive Income

     Comprehensive income includes changes in stockholders’ equity during the periods that do not result from transactions with stockholders. The Company’s total comprehensive income was as follows:

4. Inventories

     Inventories by category are as follows:

     5. Property, Plant and Equipment

     Net property, plant and equipment consisted of the following:

6. Other Charges

     Results for the three- and nine-month periods ended September 30, 2004 include other charges of $3.8 million ($2.7 million net of tax) and $9.0 million ($6.1 million net of tax), respectively. The three months ended September 30, 2004 include charges of $3.8 million related to the relocation of the Company’s Corporate offices in September. The year to date charges also include $2.1 million due to lease termination, severance and other exit costs related to the Drilling Products rationalization program and $3.2 million of severance costs related to the Tubular Technology and Services organizational restructuring.

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     These charges are summarized in the following chart (in thousands):

(a)		The lease termination costs of $1.4 million, primarily recorded in the first quarter of 2004, are for a long-term lease which is expected to be repaid over the next year for equipment located at the Company’s Canadian facility. Due to the downsizing of the Company’s Canadian operations, this equipment will no longer be utilized. This amount was included in “Other Current Liabilities” in the Consolidated Balance Sheets.
(b)		Severance costs of $0.3 million, primarily recorded in the first quarter of 2004, relate to employees that were terminated in connection with the downsizing of the Company’s Canadian operations. These costs related to 79 employees and were paid in July 2004.
(c)		Other exit costs of $0.3 million, primarily recorded in the first quarter of 2004, are associated with the downsizing of the Canadian operations and the closing of the Company’s manufacturing facility.
(d)		Severance costs of $3.2 million, of which $0.9 million was recorded in the first quarter of 2004 and $2.3 million was recorded in the second quarter of 2004, relate to the organizational restructuring of the Company’s Tubular Technology and Services segment. These costs relate to 4 employees and of the $3.2 million, $2.5 million related to accelerated vesting of stock options with the remaining $0.7 million paid by June 2004.
(e)		Corporate relocation charge of $3.8 million, recorded in the third quarter of 2004, primarily relates to the write-off of leasehold improvements and furniture and fixtures resulting from the relocation of the Company’s Corporate offices in September 2004.

7. Net Income Per Share

     Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution from the exercise or conversion of securities into common stock. Common stock equivalent shares are excluded from the computation if their effect was antidilutive. The computation of diluted earnings per share for the three- and nine-month periods ended September 30, 2004 did not include options to purchase 2.4 million and 3.9 million shares, respectively, of common stock because their exercise prices were greater than the average market price of the common stock for the applicable period. The computation of diluted earnings per share for the three- and nine-month periods ended September 30, 2003 did not include options to purchase 5.4 million and 5.2 million shares, respectively, of common stock because their exercise prices were greater than the average market price of the common stock for the applicable period.

8. Senior Credit Facility

     As of September 30, 2004, the Company had outstanding borrowings of $20.5 million under its $240 million Senior Credit Facility (Senior Credit Facility), which related to the term loan portion of the Senior Credit Facility. Additionally, the Company had $6.4 million of revolver availability reserved to support outstanding letters of credit. At September 30, 2004, the Company had no outstanding balances under the revolver portion of its Senior Credit Facility. Net borrowing availability was $153.0 million.

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9. Goodwill and Other Intangible Assets

     The carrying amount of goodwill by reporting unit is as follows: