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EX-32.2 - EXHIBIT 32.2 - DRIL-QUIP INCexhibit3222018q3.htm
EX-32.1 - EXHIBIT 32.1 - DRIL-QUIP INCexhibit3212018q3.htm
EX-31.2 - EXHIBIT 31.2 - DRIL-QUIP INCexhibit3122018q3.htm
EX-31.1 - EXHIBIT 31.1 - DRIL-QUIP INCexhibit3112018q3.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________________________________________
FORM 10-Q
_______________________________________________________
(MARK ONE)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2018
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-13439
_______________________________________________________
DRIL-QUIP, INC.
(Exact name of registrant as specified in its charter)
_______________________________________________________
DELAWARE
 
74-2162088
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
6401 N. ELDRIDGE PARKWAY
HOUSTON, TEXAS
77041
(Address of principal executive offices) (Zip Code)
(713) 939-7711
(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  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
Accelerated filer
¨
Non-accelerated filer
¨
Smaller reporting company
¨
 
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  ý
As of October 24, 2018, the number of shares outstanding of the registrant’s common stock, par value $0.01 per share, was 35,777,241.



TABLE OF CONTENTS




PART I—FINANCIAL INFORMATION
Item 1.        Financial Statements
DRIL-QUIP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
 
September 30, 2018
 
December 31, 2017
 
(In thousands, except for par value and shares)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
424,053

 
$
493,180

Trade receivables, net
190,437

 
191,629

Inventories, net
242,123

 
291,087

Prepaids and other current assets
40,837

 
32,653

Total current assets
897,450

 
1,008,549

Property, plant and equipment, net
292,667

 
284,247

Deferred income taxes
5,512

 
5,364

Goodwill
47,120

 
47,624

Intangible assets
35,535

 
38,408

Other assets
14,475

 
15,613

                Total assets
$
1,292,759

 
$
1,399,805

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
21,155

 
$
33,480

Accrued income taxes
4,583

 
24,714

Customer prepayments
7,489

 
4,767

Accrued compensation
11,478

 
11,412

Other accrued liabilities
23,557

 
25,538

Total current liabilities
68,262

 
99,911

Deferred income taxes
3,211

 
3,432

Income tax payable
28,029

 

Other long-term liabilities
2,001

 
2,001

                 Total liabilities
101,503

 
105,344

Commitments and contingencies (Note 14)

 

Stockholders' equity:
 
 
 
Preferred stock: 10,000,000 shares authorized at $0.01 par value (none issued)

 

Common stock:
 
 
 
100,000,000 shares authorized at $0.01 par value, 36,152,694 and 38,132,693 shares issued and outstanding at September 30, 2018 and December 31, 2017
394

 
372

Additional paid-in capital
31,002

 
20,083

Treasury shares (at cost)
(71,107
)
 

Retained earnings
1,371,368

 
1,400,296

Accumulated other comprehensive losses
(140,401
)
 
(126,290
)
Total stockholders' equity
1,191,256

 
1,294,461

Total liabilities and stockholders' equity
$
1,292,759

 
$
1,399,805

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

3


DRIL-QUIP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(UNAUDITED)
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands, except per share data)
Revenues:
 
 
 
 
 
 
 
       Products
$
63,246

 
$
75,885

 
$
199,010

 
$
269,570

       Services
30,011

 
24,461

 
88,281

 
77,928

            Total revenues
93,257

 
100,346

 
287,291

 
347,498

Cost and expenses:
 
 
 
 
 
 
 
Cost of sales:
 
 
 
 
 
 
 
       Products
47,859

 
48,761

 
151,290

 
190,214

       Services
17,771

 
14,289

 
51,534

 
42,825

            Total cost of sales
65,630

 
63,050

 
202,824

 
233,039

Selling, general and administrative
31,566

 
27,985

 
83,359

 
85,060

Engineering and product development
10,159

 
10,379

 
30,133

 
32,537

Impairment and other charges

 
60,968

 

 
60,968

Gain on sale of assets
(14
)
 
9

 
(5,113
)
 
(79
)
Total costs and expenses
107,341

 
162,391

 
311,203

 
411,525

Operating loss
(14,084
)
 
(62,045
)
 
(23,912
)
 
(64,027
)
Interest income
1,893

 
957

 
5,965

 
2,963

Interest expense
(195
)
 
(12
)
 
(545
)
 
(44
)
Loss before income taxes
(12,386
)
 
(61,100
)
 
(18,492
)
 
(61,108
)
Income tax provision (benefit)
(2,028
)
 
(31,840
)
 
2,291

 
(31,959
)
Net loss
$
(10,358
)
 
$
(29,260
)
 
$
(20,783
)
 
$
(29,149
)
 
 
 
 
 
 
 
 
Loss per common share:
 
 
 
 
 
 
 
Basic
$
(0.28
)
 
$
(0.78
)
 
$
(0.56
)
 
$
(0.78
)
Diluted
$
(0.28
)
 
$
(0.78
)
 
$
(0.56
)
 
$
(0.78
)
Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
37,119

 
37,528

 
37,349

 
37,527

Diluted
37,119

 
37,528

 
37,349

 
37,527

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

4


DRIL-QUIP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
 
Three months ended
September 30,
 
Nine months ended
September 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Net loss
$
(10,358
)
 
$
(29,260
)
 
$
(20,783
)
 
$
(29,149
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
       Foreign currency translation adjustments
(5,566
)
 
13,187

 
(14,111
)
 
27,786

Total comprehensive loss
$
(15,924
)
 
$
(16,073
)
 
$
(34,894
)
 
$
(1,363
)
The accompanying notes are an integral part of these condensed consolidated financial statements.

5


DRIL-QUIP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
Nine months ended September 30,
 
2018
 
2017
 
(In thousands)
Operating activities
 
 
 
Net loss
$
(20,783
)
 
$
(29,149
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
25,966

 
32,231

Stock-based compensation expense
9,950

 
10,477

Impairment and other charges

 
60,968

Gain on sale of assets
(5,113
)
 
(79
)
Deferred income taxes
(914
)
 
(31,529
)
Changes in operating assets and liabilities:
 
 
 
Trade receivables, net
298

 
21,271

Inventories, net
32,610

 
32,596

Prepaids and other assets
(9,675
)
 
17,308

Accounts payable and accrued expenses
(41
)
 
(39,359
)
Other, net
309

 

Net cash provided by operating activities
32,607

 
74,735

Investing activities
 
 
 
Purchase of property, plant and equipment
(26,683
)
 
(19,563
)
Proceeds from sale of equipment
11,244

 
1,160

Acquisition of business, net of cash acquired

 
(21,289
)
Net cash used in investing activities
(15,439
)
 
(39,692
)
Financing activities
 
 
 
Repurchase of common shares
(80,937
)
 

ABL Credit Facility issuance costs
(815
)
 

Proceeds from exercise of stock options
1,106

 
455

Net cash provided by (used in) financing activities
(80,646
)
 
455

Effect of exchange rate changes on cash activities
(5,649
)
 
14,050

Increase (decrease) in cash and cash equivalents
(69,127
)
 
49,548

Cash and cash equivalents at beginning of period
493,180

 
423,497

Cash and cash equivalents at end of period
$
424,053

 
$
473,045

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

6


DRIL-QUIP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Organization and Principles of Consolidation
Dril-Quip, Inc., a Delaware corporation (the “Company” or “Dril-Quip”), designs, manufactures, sells and services highly engineered drilling and production equipment that is well suited primarily for use in deepwater, harsh environment and severe service applications. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, subsea control systems and manifolds, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, liner hangers, wellhead connectors, diverters and safety valves. Dril-Quip’s products are used by major integrated, large independent and foreign national oil and gas companies and drilling contractors throughout the world. Dril-Quip also provides technical advisory assistance on an as-requested basis during installation of its products, as well as rework and reconditioning services for customer-owned Dril-Quip products. In addition, Dril-Quip’s customers may rent or purchase running tools from the Company for use in the installation and retrieval of the Company’s products.
The Company’s operations are organized into three geographic segments— Western Hemisphere (including North and South America; headquartered in Houston, Texas), Eastern Hemisphere (including Europe and Africa; headquartered in Aberdeen, Scotland) and Asia-Pacific (including the Pacific Rim, Southeast Asia, Australia, India and the Middle East; headquartered in Singapore). Each of these segments sells similar products and services, and the Company has major manufacturing facilities in all three of its regional headquarter locations as well as in Macae, Brazil. The Company’s major subsidiaries are Dril-Quip (Europe) Limited, located in Aberdeen with branches in Denmark, Norway and Holland; Dril-Quip Asia-Pacific PTE Ltd., located in Singapore; and Dril-Quip do Brazil LTDA, located in Macae, Brazil. Other operating subsidiaries include TIW Corporation (TIW), located in Houston, Texas; DQ Holdings Pty. Ltd., located in Perth, Australia; Dril-Quip (Ghana) Ltd., located in Takoradi, Ghana; PT DQ Oilfield Services Indonesia, located in Jakarta, Indonesia; Dril-Quip (Nigeria) Ltd., located in Port Harcourt, Nigeria; Dril-Quip Egypt for Petroleum Services S.A.E., located in Alexandria, Egypt; Dril-Quip Oilfield Services (Tianjin) Co. Ltd., located in Tianjin, China, with branches in Shezhen and Beijing, China; and Dril-Quip Qatar LLC, located in Doha, Qatar; TIW de Mexico S.A. de C.V., located in Villahermosa, Mexico; TIW de Venezuela S.A., located in Anaco, Venezuela and with a registered branch located in Shushufindi, Ecuador; TIW (UK) Limited, located in Aberdeen, Scotland; TIW Hungary LLC, located in Szolnok, Hungary; and TIW International, LLC., with a registered branch located in Singapore.
On January 6, 2017, the Company acquired The Technologies Alliance Inc. d/b/a OilPatch Technologies (OPT) for approximately $20.0 million, which was integrated into the Company’s existing Western Hemisphere operations.
The condensed consolidated financial statements included herein are unaudited. The balance sheet at December 31, 2017 has been derived from the audited consolidated financial statements at that date. In the opinion of management, the unaudited condensed consolidated interim financial statements include all normal recurring adjustments necessary for a fair statement of the financial position as of September 30, 2018 and the results of operations and comprehensive income for the three and nine months ended September 30, 2018 and 2017 and cash flows for the nine-month periods ended September 30, 2018 and 2017. Certain information and footnote disclosures normally included in annual audited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Management believes the unaudited interim related disclosures in these condensed consolidated financial statements are adequate. The results of operations, comprehensive income and cash flows for the nine-month period ended September 30, 2018 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
2. Significant Accounting Policies
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany accounts and transactions have been eliminated.

7


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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Some of the Company’s more significant estimates are those affected by critical accounting policies for revenue recognition, inventories and contingent liabilities.
Revenue Recognition
The Company generates revenues through the sale of products, the sale of services and the leasing of installation tools. The Company normally negotiates contracts for products, including those accounted for under the over time method, rental tools and services separately. Modifications to the scope and price of sales contracts may occur in the form of variations and change orders. For all product sales, it is the customer’s decision as to the timing of the product installation as well as whether Dril-Quip running tools will be purchased or rented. Furthermore, the customer is under no obligation to utilize the Company’s technical advisory assistance services. The customer may instead choose to use a third party or its own personnel.
Product and Service Revenues
Product and service revenues are recognized as the Company satisfies the performance obligation by transferring control of the promised good or service to the customer. Revenues are measured based on consideration specified in a contract with a customer and exclude sales incentives and amounts collected on behalf of third parties. In addition, some customers may impose contractually negotiated penalties for late delivery that are excluded from the transaction price.
Management has elected to utilize certain practical expedients allowed under Accounting Standards Codification 606, Revenue from Contracts with Customers (ASC 606). Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customer are excluded from the measurement of the transaction price. Shipping and handling activities that are performed after a customer obtains control of the good are accounted for as activities to fulfill the promise to transfer the good and thus are excluded from the transaction price.
Product revenues
The Company recognizes product revenues from two methods:
product revenues are recognized over time as control is transferred to the customer; and
product revenues from the sale of products that do not qualify for the over time method are recognized as point in time.
Revenues recognized under the over time method
The Company uses the over time method on long-term project contracts that have the following characteristics:
the contracts call for products which are designed to customer specifications;
the structural designs are unique and require significant engineering and manufacturing efforts generally requiring more than one year in duration;
the contracts contain specific terms as to milestones, progress billings and delivery dates;
product requirements cannot be filled directly from the Company’s standard inventory; and
The Company has an enforceable right to payment for any work completed to date and the enforceable payment includes a reasonable profit margin.
For each project, the Company prepares a detailed analysis of estimated costs, profit margin, completion date and risk factors which include availability of material, production efficiencies and other factors that may impact the project. On a quarterly basis, management reviews the progress of each project, which may result in revisions of previous estimates, including revenue recognition. The Company calculates the percentage complete and applies the percentage to determine the revenues earned and the appropriate portion of total estimated costs to be recognized. Losses, if any, are recorded in full in the period they become known. Historically, the Company’s estimates of total costs and costs to complete have approximated actual costs incurred to complete the project.
Under the over time method, billings may not correlate directly to the revenue recognized. Based upon the terms of the specific contract, billings may be in excess of the revenue recognized, in which case the amounts are included in customer prepayments as a liability on the Condensed Consolidated Balance Sheets. Likewise, revenue recognized may exceed customer billings in which case the amounts are reported in trade receivables. Unbilled revenues are expected to be billed and collected

8


within one year. At September 30, 2018 and December 31, 2017, receivables included $47.3 million and $41.0 million of unbilled receivables, respectively. For the three months ended September 30, 2018, there were eight projects representing approximately 15.7% of the Company's total revenues and approximately 23.1% of its product revenues that were accounted for using the over time method, compared to seven projects for the three months ended September 30, 2017, which represented approximately 15.0% of the Company's total revenues and approximately 20.0% of its product revenues. For the nine months ended September 30, 2018, there were 14 projects representing approximately 14.0% of the Company’s total revenues and approximately 20.3% of its product revenues that were accounted for using over time accounting, compared to eight projects for the nine months ended September 30, 2017, which represented approximately 15.0% of the Company’s total revenues and approximately 19.0% of its product revenues.
Revenues recognized under the point in time method
Revenues from the sale of standard inventory products, not accounted for under the over time method, are recorded at the point in time that the customer obtains control of the promised asset and the Company satisfies its performance obligation. This point in time recognition aligns with the time of shipment, which is when the Company typically has a present right to payment, title transfers to the customer, the customer or its carrier has physical possession and the customer has significant risks and rewards of ownership. The Company may provide product storage to some customers. Revenues for these products are recognized at the point in time that control of the product transfers to the customer, the reason for storage is requested by the customer, the product is separately identified, the product is ready for physical transfer to the customer and the Company does not have the ability to use or direct the use of the product. This point in time typically occurs when the products are moved to storage. We receive payment after control of the products has transferred to the customer.
Service revenues
The Company recognizes service revenues from two sources:
technical advisory assistance; and
rework and reconditioning of customer-owned Dril-Quip products.
The Company generally does not install products for its customers, but it does provide technical advisory assistance.
The Company normally negotiates contracts for products, including those accounted for under the over time method, and services separately. For all product sales, it is the customer’s decision as to the timing of the product installation as well as whether Dril-Quip running tools will be purchased or rented. Furthermore, the customer is under no obligation to utilize the Company’s technical advisory assistance services. The customer may use a third party or their own personnel. The contracts for these services are typically considered day-to-day.
Rework and reconditioning service revenues are recorded using the over time method based on the remaining steps that need to be completed as the refurbishment process is performed. The measurement of progress considers, among other things, the time necessary for completion of each step in the reconditioning plan, the materials to be purchased, labor and ordering procedures. We receive payment after the services have been performed by billing customers periodically (typically monthly).
Lease revenues
The Company earns lease revenues from the rental of running tools. Rental revenues are recognized within service revenues on a dayrate basis over the lease term.
Practical Expedients
We do not disclose the value of unsatisfied performance obligations for contracts with an original expected length of one year or less.
Fair Value of Financial Instruments
The Company’s financial instruments consist primarily of cash and cash equivalents, receivables and payables. The carrying values of these financial instruments approximate their respective fair values as they are short-term in nature.
Restructuring and Other Charges
In the third quarter of 2018, we initiated a global strategic analysis to better align our operations with current market conditions. As a result of this plan, during the three and nine months ended September 30, 2018, we incurred restructuring and other charges of approximately $3.7 million primarily related to employee termination benefits and consulting fees, which are included in "Selling, general and administrative" in our accompanying condensed consolidated statement of income (loss).

9


 Treasury Shares
On July 26, 2016, the Board of Directors authorized a share repurchase plan under which the Company can repurchase up to $100 million of its common stock. The repurchase plan has no set expiration date and any repurchased shares are expected to be cancelled. For the three-month period ended September 30, 2018, the Company purchased 1,395,521 shares under the share repurchase plan at an average price of approximately $50.95 per share totaling approximately $71.1 million, which is reflected in "Treasury shares (at cost)", in our accompanying condensed consolidated balance sheet. In May 2018, the Company purchased 219,102 shares under the share repurchase plan at an average price of approximately $44.87 per share totaling approximately $9.8 million and retired such shares, which is reflected within our retained earnings for the period ended September 30, 2018.
Earnings Per Share
Basic earnings per common share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed considering the dilutive effect of stock options and awards using the treasury stock method.
In each relevant period, the net income used in the basic and dilutive earnings per share calculations is the same. The following table reconciles the weighted average basic number of common shares outstanding and the weighted average diluted number of common shares outstanding for the purpose of calculating basic and diluted earnings per share:

 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Weighted average common shares outstanding - basic
37,119

 
37,528

 
37,349

 
37,527

Dilutive effect of common stock options and awards

 

 

 

Weighted average common shares outstanding - diluted
37,119

 
37,528

 
37,349

 
37,527

For the three and nine months ended September 30, 2018, the Company has excluded the following common stock options and awards because their impact on the loss per share is anti-dilutive (in thousands on a weighted average basis):
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Director stock awards
11

 
15

 
9

 
13

Stock options
181

 
328

 
196

 
333

Performance share units
126

 
212

 
90

 
207

Restricted stock awards
172

 
315

 
125

 
293

3. New Accounting Standards
In January 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-04, “Intangibles - Goodwill and Other (Topic 350).”  The standard simplifies the subsequent measurement of goodwill by removing the second step of the two-step impairment test.  The amendment requires an entity to perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount.  An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.  An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary.  The amendment should be applied on a prospective basis.  The standard is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.  The Company has adopted this standard as of October 1, 2017.


10



In January 2017, the FASB issued ASU 2017-01, “Business Combinations: Clarifying the Definition of a Business (Topic 805).” This update clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company has adopted this standard as of December 31, 2017.
In February 2016, the FASB issued ASU 2016-02 “Leases (Topic 842).” The new standard requires lessees to recognize lease assets (right of use) and lease obligations (lease liability) for leases previously classified as operating leases under generally accepted accounting principles on the balance sheet for leases with terms in excess of 12 months. The standard is effective for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. The Company has engaged a third-party expert to assist in the analysis of its lease arrangements to ensure the appropriate steps are taken in its assessment of the standard. The ultimate effect on our condensed consolidated financial statements will be based on an evaluation of the contract-specific facts and circumstances. With respect to leases in which we are the lessee, we expect to recognize a lease liability and a corresponding right of use asset. We plan to utilize the FASB package of three practical expedients under ASC 842-10-65-1(f). We are currently evaluating what other effect, if any, ASC 842 will have on our condensed consolidated financial statements and related disclosures.
Adoption of ASC Topic 606, “Revenue from Contracts with Customers”
In May 2014, the FASB issued ASU 2014-09 “Revenue from Contracts with Customers (Topic 606).” On January 1, 2018, we adopted the new accounting standard ASC 606, Revenue from Contracts with Customers and all the related amendments (the "new revenue standard”) for contracts that are not completed at the date of initial application using the modified retrospective method.
We recognized the cumulative effect of the initial application of the new revenue standard as an increase to the opening balance of retained earnings at January 1, 2018 for $1.8 million. Therefore, the comparative information for prior periods has not been restated and continues to be reported under the accounting standards in effect for those periods.
A majority of the Company's revenues are not subject to the new revenue standard. The adoption of ASC 606 resulted in an increase of approximately $0.1 million and $2.4 million in our results from operations for the three and nine months ended September 30, 2018, respectively, and did not have a material impact on the Company's consolidated financial position, results of operations, equity or cash flows. A majority of our product revenues continues to be recognized when products are shipped from our facilities.
4. Revenue Recognition (Adoption of ASC 606)
Revenues from contracts with customers consisted of the following:
 
Three months ended
 
September 30, 2018
 
Western Hemisphere
 
Eastern Hemisphere
 
Asia-Pacific
 
Intercompany
 
Total
 
(In thousands)
Product Revenues
$
43,825

 
$
17,834

 
$
1,587

 
$

 
$
63,246

Service Revenues
10,169

 
4,364

 
3,008

 

 
17,541

Total
$
53,994

 
$
22,198

 
$
4,595

 
$

 
$
80,787

 
Nine months ended
 
September 30, 2018
 
Western Hemisphere
 
Eastern Hemisphere
 
Asia-Pacific
 
Intercompany
 
Total
 
(In thousands)
Product Revenues
$
130,259

 
$
52,238

 
$
16,513

 
$

 
$
199,010

Service Revenues
29,173

 
15,485

 
8,345

 

 
53,003

Total
$
159,432

 
$
67,723

 
$
24,858

 
$

 
$
252,013



11


Contract Balances
Balances related to contracts with customers consisted of the following:
Contract Assets (amounts shown in thousands)
Contract Assets at December 31, 2017
$
41,825

Additions
44,110

Transfers to Accounts Receivable
10,180

Contract Assets at September 30, 2018
$
75,755

Contract Liabilities (amounts shown in thousands)
Contract Liabilities at December 31, 2017
$
4,767

Additions
25,039

Revenue Recognized
23,018

Contract Liabilities at September 30, 2018
$
6,788

Receivables, which are included in trade receivables, net, were $98.3 million and $136.5 million for the nine months ended September 30, 2018 and December 31, 2017, respectively. The amount of revenues from performance obligations satisfied (or partially satisfied) in previous periods was $3.9 million and $15.7 million for the three and nine months ended September 30, 2018, respectively. The contract liabilities primarily relate to advance payments from customers and are included in "Customer prepayments" in our accompanying condensed consolidated balance sheets. The contract assets primarily relate to unbilled amounts typically resulting from sales under contracts when the over time method of revenue recognition is utilized and revenue recognized exceeds the amount billed to the customer and is included in "Trade receivables, net" in our accompanying condensed consolidated balance sheets. Contract assets are transferred to the receivables when the rights become unconditional.
Obligations for returns and refunds were considered immaterial as of September 30, 2018.
Remaining Performance Obligations
The aggregate amount of the transaction price allocated to remaining performance obligations from our reconditioning services and over time product lines was $33.8 million as of September 30, 2018. The Company expects to recognize revenue on approximately 85% and 15% of the remaining performance obligations over the next 12 and 24 months, respectively, with the remainder recognized thereafter.
The Company applies the practical expedient available under the new revenue standard and does not disclose information about remaining performance obligations that have original expected durations of one year or less.
5. Stock-Based Compensation and Stock Awards
During the three and nine months ended September 30, 2018, the Company recognized approximately $2.4 million and $10.0 million, respectively, of stock-based compensation expense, which is included in "Selling, general and administrative" in our accompanying condensed consolidated statements of income (loss) and "Additional paid-in capital" in our accompanying condensed consolidated balance sheets, compared to $3.7 million and $10.5 million recognized for the three and nine months ended September 30, 2017, respectively. No stock-based compensation expense was capitalized during the three and nine months ended September 30, 2018 or 2017.

12


6. Inventories, net
Inventories consist of the following:
 
September 30,
 
December 31,
 
2018
2017
 
(In thousands)
Raw materials and supplies
$
59,505

 
$
70,188

Work in progress
53,546

 
65,382

Finished goods
206,543

 
239,083

 
319,594

 
374,653

Less: allowance for obsolete and excess inventory
(77,471
)
 
(83,566
)
Total inventory
$
242,123

 
$
291,087

7. Goodwill
The changes in the carrying amount of goodwill by reporting unit during the nine months ended September 30, 2018 were as follows:
 
Carrying Value
 
 
 
Carrying Value
 
December 31, 2017
 
Foreign Currency Translation
 
September 30, 2018
 
(In thousands)
Western Hemisphere
$
39,158

 
$
(93
)
 
$
39,065

Eastern Hemisphere
8,466

 
(411
)
 
8,055

Asia-Pacific

 

 

Total
$
47,624

 
$
(504
)
 
$
47,120

The Company performs its annual impairment tests of goodwill as of October 1 or when there is an indication an impairment may have occurred. As of September 30, 2018, there were no indications an impairment may have occurred.
The fair values used in the goodwill impairment assessment were determined using the net present value of the expected future cash flows for the reporting unit. During the Company’s goodwill impairment analysis, the Company determines the fair value of the reporting unit, as a whole, using a discounted cash flow analysis, which requires significant assumptions and estimates about future operations. The assumptions about future cash flows and growth rates are based on our current budget for the remainder of the current year, 2019 and for future periods, as well as our strategic plans and management’s beliefs about future exploration and development in the industry. Changes in management's forecast commodity price assumptions may cause us to reassess our goodwill for impairment and could result in non-cash impairment charges in the future.


13


8. Intangible Assets
Intangible assets, substantially all of which were acquired in the acquisition of TIW and OPT, consist of the following:
 
Estimated Useful Lives
September 30, 2018
 
Gross Book Value
Accumulated Amortization
Foreign Currency Translation
Net Book Value
 
 
(In thousands)
Trademarks
indefinite
$
8,275

$

$
(73
)
$
8,202

Patents
15 - 30 years
5,950

(1,309
)
(32
)
4,609

Customer relationships
5 - 15 years
25,889

(3,101
)
(136
)
22,652

Non-compete agreements
3 years
171

(99
)

72

 
$
40,285

$
(4,509
)
$
(241
)
$
35,535

 
Estimated Useful Lives
December 31, 2017
 
Gross Book Value
Accumulated Amortization
Foreign Currency Translation
Net Book Value
 
 
(In thousands)
Trademarks
indefinite
$
8,416

$

$
56

$
8,472

Patents
15 - 30 years
5,946

(968
)
80

5,058

Customer relationships
5 - 15 years
26,503

(1,675
)
(64
)
24,764

Non-compete agreements
3 years
171

(57
)

114

 
$
41,036

$
(2,700
)
$
72

$
38,408

Amortization expense for each of the three and nine months ended September 30, 2018 was $0.6 million and $1.7 million, respectively, compared to the three and nine months ended September 30, 2017 of $0.6 million and $1.8 million, respectively.
9. Gain on Sale of Assets
During the second quarter of 2018, we sold certain property, plant and equipment for a net gain of approximately $5.1 million as part of our reorganization and consolidation of operations at our headquarters location in Houston, Texas. A gain on property, plant and equipment or intangible assets is calculated as the difference between the cost of the asset disposed of, net of depreciation, and the sales proceeds received. The net gain is reflected in "Gain on sale of assets" in our accompanying condensed consolidated statements of income (loss). There were no significant sales of assets during the three months ended September 30, 2018.
10. Impairments and Other Charges
We carry a variety of long-lived assets on our balance sheet, including property, plant and equipment, goodwill and other intangibles. We conduct impairment tests on long-lived assets if events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We review the recoverability of the carrying value of our assets based upon estimated future cash flows while taking into consideration assumptions and estimates, including the future use of the asset, remaining useful life of the asset and service potential of the asset. Additionally, inventories are valued at the lower of cost or market.
In connection with our preparation and review of financial statements for the quarter ended September 30, 2017, after considering current Brent Crude consensus forecasts and expected rig counts for the foreseeable future, we determined that the carrying amount of certain of our long-lived assets in the Western Hemisphere exceeded their respective fair values due to projected declines in asset utilization and that the cost of some of our worldwide inventory exceeded its market value. As a result, we recorded corresponding impairments and other charges.

14


Primarily as a result of the factors described above, we recorded charges of approximately $33.6 million related to inventory and $27.4 million related to fixed assets during the three and nine months ended September 30, 2017. There were no impairments during the three and nine months ended September 30, 2018.
11. Asset Backed Loan (ABL) Credit Facility
On February 23, 2018, the Company, as borrower, and the Company’s subsidiaries TIW and Honing, Inc., as guarantors, entered into a five-year senior secured revolving credit facility (the “ABL Credit Facility”) with JPMorgan Chase Bank, N.A., as administrative agent, and other financial institutions as lenders with total commitments of $100.0 million, including up to $10.0 million available for letters of credit. The maximum amount that the Company may borrow under the ABL Credit Facility is subject to the borrowing base, which is based on a percentage of eligible accounts receivable and eligible inventory, subject to reserves and other adjustments.
All obligations under the ABL Credit Facility are fully and unconditionally guaranteed jointly and severally by the Company, TIW, Honing, Inc., and future significant domestic subsidiaries, subject to customary exceptions. Borrowings under the ABL Credit Facility are secured by liens on substantially all of the Company’s personal property, and bear interest at the Company’s option at either (i) the CB Floating Rate (as defined therein), calculated as the rate of interest publicly announced by JPMorgan Chase Bank, N.A., as its “prime rate,” subject to each increase or decrease in such prime rate effective as of the date such change occurs, with such CB Floating Rate not being less than Adjusted One Month LIBOR (as defined therein) or (ii) the Adjusted LIBOR (as defined therein), plus, in each case, an applicable margin. The applicable margin ranges from 1.00% to 1.50% per annum for CBFR loans and 2.00% to 2.50% per annum for Eurodollar loans and, in each case, is based on the Company’s leverage ratio. The unused portion of the ABL Credit Facility is subject to a commitment fee that varies from 0.250% to 0.375% per annum, according to average unused commitments under the ABL Credit Facility. Interest on Eurodollar loans is payable at the end of the selected interest period, but no less frequently than quarterly. Interest on CB Floating Rate loans is payable monthly in arrears.
The ABL Credit Facility contains various covenants and restrictive provisions that limit the Company’s ability to, among other things, (1) enter into asset sales; (2) incur additional indebtedness; (3) make investments or loans and create liens; (4) pay certain dividends or make other distributions and (5) engage in transactions with affiliates. The ABL Credit Facility also requires the Company to maintain a fixed charge coverage ratio of 1.0 to 1.0, based on the ratio of EBITDA (as defined therein) to Fixed Charges (as defined therein) during certain periods, including when availability under the ABL Credit Facility is under certain levels. If the Company fails to perform its obligations under the agreement that results in an event of default, the commitments under the ABL Credit Facility could be terminated and any outstanding borrowings under the ABL Credit Facility may be declared immediately due and payable. The ABL Credit Facility also contains cross default provisions that apply to the Company’s other indebtedness. The Company is in compliance with the related covenants as of September 30, 2018.
As of September 30, 2018, the availability under the ABL Credit Facility was $56.0 million, after taking into account the outstanding letters of credit of approximately $0.3 million issued under the facility.

15



12. Geographic Areas
 
Three months ended September 30,
 
Western Hemisphere
 
Eastern Hemisphere
 
Asia-Pacific
 
DQ Corporate
 
Total
 
2018
2017
 
2018
2017
 
2018
2017
 
2018
2017
 
2018
2017
 
(In thousands)
Revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Products
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Standard Products
$
34,101

$
43,344

 
$
12,918

$
9,246

 
$
1,587

$
7,940

 
$

$

 
$
48,606

$
60,530

Percentage of Completion
9,724


 
4,916

7,954

 

7,401

 


 
14,640

15,355

Total Products
43,825

43,344

 
17,834

17,200

 
1,587

15,341

 


 
63,246

75,885

Services
 

 
 

 
 

 
 
 
 
 

Technical Advisory
7,305

6,732

 
3,612

3,931

 
2,889

1,701

 


 
13,806

12,364

Reconditioning
2,864

2,008

 
752

844

 
119

19

 


 
3,735

2,871

Total Services (excluding rental tools)
10,169

8,740

 
4,364

4,775

 
3,008

1,720

 


 
17,541

15,235

Leasing
5,899

5,666

 
3,115

2,782

 
3,456

778

 


 
12,470

9,226

Total Services (including rental tools)
16,068

14,406

 
7,479

7,557

 
6,464

2,498

 


 
30,011

24,461

Intercompany
2,564

12,569

 
1,302

267

 
573

416

 


 
4,439

13,252

Eliminations


 


 


 
(4,439
)
(13,252
)
 
(4,439
)
(13,252
)
Total Revenues
$
62,457

$
70,319

 
$
26,615

$
25,024

 
$
8,624

$
18,255

 
$
(4,439
)
$
(13,252
)
 
$
93,257

$
100,346

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
$
5,607

$
6,827

 
$
1,057

$
1,073

 
$
1,390

$
1,015

 
$
670

$
603

 
$
8,724

$
9,518

Income (loss) before income taxes
$
13,902

$
(40,472
)
 
$
8,133

$
(2,882
)
 
$
(301
)
$
(4,525
)
 
$
(34,120
)
$
(13,221
)
 
$
(12,386
)
$
(61,100
)

16


 
Nine months ended September 30,
 
Western Hemisphere
 
Eastern Hemisphere
 
Asia-Pacific
 
DQ Corporate
 
Total
 
2018
2017
 
2018
2017
 
2018
2017
 
2018
2017
 
2018
2017
 
(In thousands)
Revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Products
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Standard Products
$
110,074

$
162,656

 
$
35,556

$
29,919

 
$
13,031

$
26,298

 
$

$

 
$
158,661

$
218,873

Percentage of Completion
20,185

275

 
16,682

23,648

 
3,482

26,774

 


 
40,349

50,697

Total Products
130,259

162,931

 
52,238

53,567

 
16,513

53,072

 


 
199,010

269,570

Services
 

 
 

 
 

 
 
 
 
 

Technical Advisory
20,835

21,709

 
12,785

11,135

 
7,021

5,340

 


 
40,641

38,184

Reconditioning
8,338

5,985

 
2,700

1,392

 
1,324

204

 


 
12,362

7,581

Total Services (excluding rental tools)
29,173

27,694

 
15,485

12,527

 
8,345

5,544

 


 
53,003

45,765

Leasing
18,162

21,604

 
10,837

8,158

 
6,279

2,401

 


 
35,278

32,163

Total Services (including rental tools)
47,335

49,298

 
26,322

20,685

 
14,624

7,945

 


 
88,281

77,928

Intercompany
9,685

22,700

 
1,835

554

 
1,300

533

 


 
12,820

23,787

Eliminations


 


 


 
(12,820
)
(23,787
)
 
(12,820
)
(23,787
)
Total
$
187,279

$
234,929

 
$
80,395

$
74,806

 
$
32,437

$
61,550

 
$
(12,820
)
$
(23,787
)
 
$
287,291

$
347,498

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
$
17,091

$
24,153

 
$
3,402

$
3,228

 
$
3,521

$
3,046

 
$
1,952

$
1,804

 
$
25,966

$
32,231

Income (loss) before income taxes
$
12,999

$
(28,558
)
 
$
13,792

$
3,401

 
$
(45
)
$
3,115

 
$
(45,238
)
$
(39,066
)
 
$
(18,492
)
$
(61,108
)
 
Western Hemisphere
 
Eastern Hemisphere
 
Asia-Pacific
 
DQ Corporate
 
Total
 
September 30, 2018
December 31, 2017
 
September 30, 2018
December 31, 2017
 
September 30, 2018
December 31, 2017
 
September 30, 2018
December 31, 2017
 
September 30, 2018
December 31, 2017
 
(In thousands)
Long-Lived Assets
$
466,703

$
482,636

 
$
256,779

$
264,828

 
$
66,466

$
58,606

 
$
(394,640
)
$
(414,814
)
 
$
395,309

$
391,256

Total Assets
$
800,936

$
877,779

 
$
777,868

$
752,967

 
$
161,662

$
185,229

 
$
(447,707
)
$
(416,170
)
 
$
1,292,759

$
1,399,805

The Company’s operations are organized into three geographic segments - Western Hemisphere (including North and South America; headquartered in Houston, Texas), Eastern Hemisphere (including Europe and Africa; headquartered in Aberdeen, Scotland) and Asia-Pacific (including the Pacific Rim, Southeast Asia, Australia, India and the Middle East; headquartered in Singapore). Each of these segments sells similar products and services and the Company has major manufacturing facilities in all three of its regional headquarter locations as well as in Macae, Brazil.
Eliminations of operating profits are related to intercompany inventory transfers that are deferred until shipment is made to third party customers.


17


13. Income Tax
The effective tax rates for the three and nine months ended September 30, 2018 were 16.4% and (12.4)%, respectively, compared to 52.0% and 52.2% for the same periods in 2017. The Company established valuation allowances on deferred tax assets for losses and tax credits generated in each period, which, when applied to losses for the three and  nine months ended September 30, 2018, resulted in lower effective tax rates than the U.S. statutory rate. The negative tax rate for the nine months ended September 30, 2018 is the result of net tax expense recorded against a pre-tax loss for the period.  The change in effective tax rate from 2017 to 2018 was also impacted by the decrease in the U.S. federal corporate tax rate from 35% in 2017 to 21% in 2018.
On December 22, 2017, the President of the United States signed into law P.L. 115-97, informally known as the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). Tax Reform amends the Internal Revenue Code to reduce tax rates and modify policies, credits and deductions for individuals and businesses. For businesses, Tax Reform reduced the corporate federal tax rate from a maximum of 35% to 21% and transitions from a worldwide tax system to a modified territorial tax system. Tax Reform also adds many new provisions including changes to bonus depreciation, the deduction for executive compensation and interest expense, a tax on global intangible low-taxed income, the base erosion anti-abusive tax and a deduction for foreign-derived intangible income.  Given the amount and complexity of the changes to tax law, we continue to finalize our accounting for the income tax effects stemming from Tax Reform. At December 31, 2017, certain provisional amounts were taken as estimates to account for the impact of Tax Reform. The actual impact of Tax Reform may differ from the estimates used due to, among other things, further refinement of our calculations, changes in interpretations and assumptions we have made, guidance that may be issued and actions we may take as a result of the tax legislation. Any adjustments to these provisional estimates will be reported as a component of income tax expense in the reporting period in which any such adjustments are identified, which will be no later than the fourth quarter of 2018. For the three and nine months ended September 30, 2018, the Company reclassified $28.0 million from current income taxes payable to non-current income taxes payable due to tax return elections, recent guidance and regulations occurring in the quarter.

14. Commitments and Contingencies
Brazilian Tax Issue
From 2002 to 2007, the Company’s Brazilian subsidiary imported goods through the State of Espirito Santo in Brazil and subsequently transferred them to its facility in the State of Rio de Janeiro. During that period, the Company’s Brazilian subsidiary paid taxes to the State of Espirito Santo on its imports. Upon the final sale of these goods, the Company’s Brazilian subsidiary collected taxes from customers and remitted them to the State of Rio de Janeiro net of the taxes paid on importation of those goods to the State of Espirito Santo in accordance with the Company’s understanding of Brazilian tax laws.
In December 2010 and January 2011, the Company’s Brazilian subsidiary was served with two assessments totaling approximately $13.0 million from the State of Rio de Janeiro to cancel the credits associated with the tax payments to the State of Espirito Santo (Santo Credits) on the importation of goods from July 2005 to October 2007. The Company has objected to these assessments on the grounds that they would represent double taxation on the importation of the same goods and that the Company is entitled to the credits under applicable Brazilian law. The Company’s Brazilian subsidiary filed appeals with a State of Rio de Janeiro judicial court to annul both of these tax assessments following rulings against the Company by the tax administration’s highest council. In connection with those appeals, the Company deposited with the court a total amount of approximately $8.8 million in December 2014 and December 2016 as the full amount of the assessments with penalties and interest. The Company believes that these credits are valid and that success in the judicial court process is probable. Based upon this analysis, the Company has not accrued any liability in conjunction with this matter.
Since 2007, the Company’s Brazilian subsidiary has paid taxes on the importation of goods directly to the State of Rio de Janeiro and the Company does not expect any similar issues to exist for periods subsequent to 2007.

18


General
The Company operates its business and markets its products and services in most of the significant oil and gas producing areas in the world and is, therefore, subject to the risks customarily attendant to international operations and dependency on the condition of the oil and gas industry. Additionally, products of the Company are used in potentially hazardous drilling, completion, and production applications that can cause personal injury, property damage and environmental claims. Although exposure to such risk has not resulted in any significant problems in the past, there can be no assurance that ongoing and future developments will not adversely impact the Company.
The Company is also involved in a number of legal actions arising in the ordinary course of business. Although no assurance can be given with respect to the ultimate outcome of such legal action, in the opinion of management, the ultimate liability with respect thereto will not have a material adverse effect on the Company’s results of operations, financial position or cash flows.

15. Subsequent Events
On October 18, 2018, we announced that Dril-Quip (Europe) Limited, our wholly owned subsidiary, has entered into a Front End Engineering and Design (FEED) Contract and Frame Agreement with Premier Oil Exploration and Production Limited (Premier) to provide the subsea production systems for the Sea Lion Phase 1 Development located offshore the Falkland Islands.  The Frame Agreement replaces the previously announced letter of intent. The current estimated value of the equipment portion of the scope of work is $207 million, which includes plans for up to 30 subsea production systems, including wellheads, horizontal trees, tubing hangers, control systems, associated production and injection manifolds and subsea umbilicals.  Under the Frame Agreement, it is envisaged that Dril-Quip will provide vendor financing for up to 30% of the equipment portion of the contract.  Formal contract award will be subject to agreement of a definitive contract and Premier taking a final investment decision.


19


Item 2.        Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is management’s discussion and analysis of certain significant factors that have affected aspects of the Company’s financial position, results of operations, comprehensive income and cash flows during the periods included in the accompanying unaudited condensed consolidated financial statements. This discussion should be read in conjunction with the Company's unaudited condensed consolidated financial statements and notes thereto presented elsewhere herein as well as the discussion under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
Overview
Dril-Quip, Inc., a Delaware corporation (the “Company” or “Dril-Quip”), designs, manufactures, sells and services highly engineered drilling and production equipment that is well suited primarily for use in deepwater, harsh environment and severe service applications. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, subsea control systems and manifolds, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, liner hangers, wellhead connectors, diverters and safety valves. Dril-Quip’s products are used by major integrated, large independent and foreign national oil and gas companies and drilling contractors throughout the world. Dril-Quip also provides technical advisory assistance on an as-requested basis during installation of its products, as well as rework and reconditioning services for customer-owned Dril-Quip products. In addition, Dril-Quip’s customers may rent or purchase running tools from the Company for use in the installation and retrieval of the Company’s products.
Oil and Gas Prices
The market for drilling and production equipment and services and the Company’s business are substantially dependent on the condition of the oil and gas industry and, in particular, the willingness of oil and gas companies to make capital expenditures on exploration, drilling and production operations. Oil and gas prices and the level of drilling and production activity have historically been characterized by significant volatility.
According to the Energy Information Administration (EIA) of the U.S. Department of Energy, Brent Crude oil prices per barrel are listed below for the periods covered by this report:
 
Three months ended
September 30,
 
Nine months ended
September 30,
Brent Crude Oil Price per Barrel
2018

2017

 
2018

2017

Low
$
68.38

$
46.47

 
$
61.94

$
43.98

High
82.72

59.77

 
82.72

59.77

Average
75.07

52.10

 
72.17

51.75

Closing
$
82.72

$
57.02

 
$
82.72

$
57.02

According to the October 2018 release of the Short-Term Energy Outlook published by the EIA, Brent Crude oil prices are projected to average approximately $74.0 per barrel in 2018 and $75.0 per barrel in 2019. In its October 2018 Oil Market Report, the International Energy Agency projected the 2018 global oil demand will grow to 79.0 million barrels per day, a 1.3 million barrels per day increase over 2017.

20


Offshore Rig Count
Detailed below is the average contracted offshore rig count (rigs currently drilling as well as rigs committed, but not yet drilling) for the Company’s geographic regions for the nine months ended September 30, 2018 and 2017. The rig count data includes floating rigs (semi-submersibles and drillships) and jack-up rigs. The Company has included only these types of rigs as they are the primary assets used to deploy the Company’s products.
 
Nine months ended September 30,
 
2018
 
2017
 
Floating Rigs
 
Jack-up Rigs
 
Floating Rigs
 
Jack-up Rigs
Western Hemisphere
58

 
38

 
63

 
42

Eastern Hemisphere
58

 
63

 
56

 
58

Asia-Pacific
33

 
226

 
31

 
217

Total
149

 
327

 
150

 
317

Source: IHS—Petrodata RigBase – September 30, 2018 and 2017
According to IHS-Petrodata RigBase, as of September 30, 2018, there were 466 contracted rigs for the Company’s geographic regions (145 floating rigs and 321 jack-up rigs), which represents a marginal increase from the rig count of 464 rigs (148 floating rigs and 316 jack-up rigs) as of September 30, 2017.
The Company believes that the number of rigs (semi-submersibles, drillships and jack-up rigs) under construction impacts its backlog and resulting revenues because in certain cases, its customers order some of the Company’s products during the construction of such rigs. As a result, an increase in rig construction activity tends to favorably impact the Company’s backlog while a decrease in rig construction activity tends to negatively impact the Company’s backlog. According to IHS-Petrodata RigBase, as of September 30, 2018 and 2017, there were 126 and 143 rigs, respectively, under construction, which represents an approximate 12% decrease in rigs under construction. The expected delivery dates for the rigs under construction at September 30, 2018 are as follows:
 
Floating
 
Jack-Up
 
 
 
Rigs
 
Rigs
 
Total
2018
7

 
16

 
23

2019
16

 
42

 
58

2020
12

 
22

 
34

2021
7

 
4

 
11

After 2021 or unspecified delivery date

 

 

Total
42

 
84

 
126

However, given the slow recovery of oil and gas prices and oversupply of offshore drilling rigs, the Company believes it is possible that delivery of some rigs under construction could be postponed or cancelled, limiting the opportunity for supply of the Company’s products.
Regulation
The demand for the Company’s products and services is also affected by laws and regulations relating to the oil and gas industry in general, including those specifically directed to offshore operations. The adoption of new laws and regulations, or changes to existing laws or regulations that curtail exploration and development drilling for oil and gas for economic or other policy reasons, could adversely affect the Company’s operations by limiting demand for its products.

21


In March 2018, the President of the United States issued a proclamation imposing a 25 percent global tariff on imports of certain steel products, effective March 23, 2018. The President subsequently proposed an additional 25 percent tariff on approximately $50 billion worth of imports from China, and the government of China responded with a proposal of an additional 25 percent tariff on U.S. goods with a value of $50 billion.  The initial U.S. tariffs were implemented on July 6, 2018 covering $34 billion worth of Chinese goods, with another $16 billion of goods facing tariffs beginning on August 23, 2018. In September 2018, the President directed the U.S. Trade Representative to place additional tariffs on approximately $200 billion worth of additional imports from China. These tariffs, which took effect on September 24, 2018, initially have been set at a level of 10 percent until the end of the year, at which point the tariffs will rise to 25 percent. These tariffs, or any additional tariffs or trade restrictions initiated by or against the United States, could cause our cost of raw materials to increase or affect the markets for our products.  However, given the uncertainty regarding the scope and duration of these trade actions by the United States and other countries, their ultimate impact on our business and operations remains uncertain.
Business Environment
Oil and gas prices and the level of drilling and production activity have been characterized by significant volatility in recent years. Worldwide military, political, economic and other events have contributed to oil and natural gas price volatility and are likely to continue to do so in the future. Sustained low crude oil and natural gas prices have resulted in a trend of customers seeking to renegotiate contract terms with the Company, including reductions in the prices of its products and services, extensions of delivery terms and, in some instances, contract cancellations or revisions. In some cases, a customer may already hold an inventory of the Company's equipment, which may delay the placement of new orders. In addition, some of the Company’s customers could experience liquidity or solvency issues or could otherwise be unable or unwilling to perform under a contract, which could ultimately lead a customer to enter bankruptcy or otherwise encourage a customer to seek to repudiate, cancel or renegotiate a contract. An extended period of reduced crude oil and natural gas prices may accelerate these trends. If the Company experiences significant contract terminations, suspensions or scope adjustments to its contracts, then its financial condition, results of operations and cash flows may be adversely impacted.
The Company expects continued pressure in both crude oil and natural gas prices, as well as in the level of drilling and production related activities. Even during periods of increasing prices for oil and natural gas, companies exploring for oil and gas may cancel or curtail programs, seek to renegotiate contract terms, including the price of products and services, or reduce their levels of capital expenditures for exploration and production for a variety of reasons. Continued low hydrocarbon prices have had and are expected to continue to have a material adverse effect on the Company’s results of operations.
The Company believes that its backlog should help mitigate the impact of negative market conditions; however, slow recovery in the commodity prices or an extended downturn in the global economy or future restrictions on, or declines in, oil and gas exploration and production could have a negative impact on the Company and its backlog. The Company’s product backlog at September 30, 2018 was approximately $249.0 million, compared to approximately $260.9 million at June 30, 2018, $266.7 million at March 31, 2018 and $207.3 million at December 31, 2017.

22


The following table represents the change in backlog for the three months ended September 30, 2018, June 30, 2018, March 31, 2018 and December 31, 2017:
 
Three months ended
 
September 30, 2018
 
June 30, 2018
 
March 31, 2018
 
December 31, 2017
 
(In thousands)
Beginning Backlog
$
260,894

 
$
266,675

 
$
207,305

 
$
216,495

Bookings:
 
 
 
 
 
 
 
Product (1)
56,117

 
64,818

 
130,283

 
74,513

Service
30,012

 
30,142

 
28,128

 
26,409

Cancellation/Revision adjustments
(3,374
)
 
(3,920
)
 
(253
)
 
(1,260
)
Translation adjustments
(1,416
)
 
(1,960
)
 
385

 
(879
)
Total Bookings
81,339

 
89,080

 
158,543

 
98,783

Revenues:
 
 
 
 
 
 
 
Product
63,246

 
64,719

 
71,045

 
81,564

Service
30,011

 
30,142

 
28,128

 
26,409

Total Revenue
93,257

 
94,861

 
99,173

 
107,973

Ending Backlog (1)
$
248,976

 
$
260,894

 
$
266,675

 
$
207,305

(1) The backlog data shown above includes all bookings as of September 30, 2018, including contract awards and signed purchase orders for which the contracts would not be considered enforceable or qualify for the practical expedient under ASC 606. As of September 30, 2018, approximately $84 million related to contract awards is included in our backlog. As a result, this table above will not agree to the disclosed performance obligations of $33.8 million within "Revenue Recognition (Adoption of ASC 606)", Note 4 to the Notes to Condensed Consolidated Financial Statements. 
During the first quarter of 2018, Dril-Quip Asia-Pacific Pte Ltd. was awarded a contract to supply top-tensioned riser (TTR) systems and related services for the development of the Ca Rong Do Project (CRD Project) located offshore Vietnam operated by Repsol with the participation of Mubadala, PVEP and PetroVietnam.  The CRD Project is included within the backlog balance presented in the table above; however, due to ongoing territorial discussions between China and Vietnam, the CRD Project may experience continued delays or cancellation. 
In August 2012, the Company’s Brazilian subsidiary, Dril-Quip do Brasil LTDA, was awarded a four-year contract by Petroleo Brasileiro S.A. (Petrobras), Brazil’s national oil company, which was amended in 2016 to extend the term of the contract through July 2020.  As of September 30, 2018, the Company’s backlog included $5.6 million of purchase orders under this Petrobras contract. The Company has not yet recognized revenue of approximately $1.5 million as of September 30, 2018 for certain items of equipment that were completed but not yet accepted for delivery by Petrobras. If Petrobras does not ultimately accept these items for delivery or if they refuse to accept these or similar items completed in the future, the Company’s results of operations may be adversely affected. As part of the amendment to extend the term of the contract, Petrobras agreed to issue purchase orders totaling a minimum of approximately $24.5 million (based on current exchange rates) before 2019. As of September 30, 2018, approximately $5.6 million of the purchase orders have been issued (based on current exchange rates). The Company cannot provide assurance that Petrobras will order all of the equipment under the contract.
As of September 30, 2017, the total number of the Company's employees was 2,067, of which 1,099 were located in the United States. The total number of the Company’s employees as of December 31, 2017 was 2,019, of which 1,095 were located in the United States. As a result of natural attrition and reductions in workforce, the total number of employees as of September 30, 2018 was 1,849, of which 820 were located in the United States.
The Company operates its business and markets its products and services in most of the significant oil and gas producing areas in the world and is, therefore, subject to the risks customarily attendant to international operations and investments in foreign countries. These risks include nationalization, expropriation, war, acts of terrorism and civil disturbance, restrictive action by local governments, limitation on repatriation of earnings, change in foreign tax laws and change in currency exchange rates, any of which could have an adverse effect on either the Company’s ability to manufacture its products in its facilities abroad or the demand in certain regions for the Company’s products or both. To date, the Company has not experienced any significant problems in foreign countries arising from local government actions or political instability, but there is no assurance that such problems will not arise in the future. Interruption of the Company’s international operations could have a material adverse effect on its overall operations.

23


The June 23, 2016 referendum by British voters to exit the European Union (Brexit) adversely impacted global markets, including currencies, and resulted in a decline in the value of the British pound sterling, as compared to the U.S. dollar and other currencies. Volatility in exchange rates could be expected to continue in the short term as the United Kingdom (U.K.) negotiates its exit from the European Union. A weaker British pound sterling compared to the U.S. dollar during a reporting period would cause local currency results of the Company's U.K. operations to be translated into fewer U.S. dollars. Continued adverse consequences such as deterioration in economic conditions and volatility in currency exchange rates could have a negative impact on the Company's financial position and results of operations. See “Our international operations expose us to instability and changes in economic and political conditions and other risks inherent to international business, which could have a material adverse effect on our results of operations, financial position or cash flows" under "Item 1A. Risk Factors" in Part I of the Company's Annual Report on Form 10-K for the year ended December 31, 2017.
In the third quarter of 2018, we initiated a global strategic analysis to better align our operations with current market conditions. As a result of our ongoing analysis, we expect related cost savings to begin in early 2019.
Revenues. Dril-Quip’s revenues are generated from two sources: products and services. Product revenues are derived from the sale of drilling and production equipment. Service revenues are earned when the Company provides technical advisory assistance and rental tools during installation and retrieval of the Company’s products. Additionally, the Company earns service revenues when rework and reconditioning services are provided. For the three months ended September 30, 2018 and 2017, the Company derived 67.8% and 75.6%, respectively, of its revenues from the sale of its products and 32.2% and 24.4%, respectively, of its revenues from services. For the nine months ended September 30, 2018 and 2017, the Company derived 69.3% and 77.6%, respectively, of its revenues from the sales of its products and 30.7% and 22.4%, respectively, of its revenues from services. Service revenues generally correlate to revenues from product sales because increased product sales typically generate increased demand for technical advisory assistance services and rental of running tools during installation. The Company has substantial international operations, with approximately 57.0% and 56.0% of its revenues derived from foreign sales for the nine months ended September 30, 2018 and 2017, respectively. The majority of the Company’s domestic revenue relates to operations in the U.S. Gulf of Mexico. Domestic revenue approximated 43.0% and 44.0% of the Company’s total revenues for the nine months ended September 30, 2018 and 2017, respectively.
Product contracts are negotiated and sold separately from service contracts. In addition, service contracts are not typically included in the product contracts or related sales orders and are not offered to the customer as a condition of the sale of the Company’s products. The demand for products and services is generally based on worldwide economic conditions in the oil and gas industry and is not based on a specific relationship between the two types of contracts. Substantially all of the Company’s sales are made on a purchase order basis. Purchase orders are subject to change and/or termination at the option of the customer. In case of a change or termination, the customer is required to pay the Company for work performed and other costs necessarily incurred as a result of the change or termination.
Generally, the Company attempts to raise its prices as its costs increase. However, the actual pricing of the Company’s products and services is impacted by a number of factors, including global oil prices, competitive pricing pressure, the level of utilized capacity in the oil service sector, maintenance of market share, the introduction of new products and general market conditions.
The Company accounts for larger and more complex projects that have relatively longer manufacturing time frames on an over time basis. For the three months ended September 30, 2018, there were eight projects representing approximately 15.7% of the Company’s total revenues and approximately 23.1% of its product revenues that were accounted for using over time accounting, compared to seven projects for the three months ended September 30, 2017, which represented approximately 15.0% of the Company’s total revenues and approximately 20.0% of its product revenues. For the nine months ended September 30, 2018, there were 14 projects representing approximately 14.0% of the Company’s total revenues and approximately 20.3% of its product revenues that were accounted for using over time accounting, compared to eight projects for the nine months ended September 30, 2017, which represented approximately 15.0% of the Company’s total revenues and approximately 19.0% of its product revenues. These percentages may fluctuate in the future. Revenues accounted for in this manner are generally recognized based upon a calculation of the percentage complete, which is used to determine the revenue earned and the appropriate portion of total estimated cost of sales to be recognized. Accordingly, price and cost estimates are reviewed periodically as the work progresses, and adjustments proportionate to the percentage complete are reflected in the period when such estimates are revised. Losses, if any, are recorded in full in the period they become known. Amounts received from customers in excess of revenues recognized are classified as a current liability.
Cost of Sales. The principal elements of cost of sales are labor, raw materials and manufacturing overhead. Cost of sales as a percentage of revenues is influenced by the product mix sold in any particular period, costs from projects accounted for under the over time method, over/under manufacturing overhead absorption, pricing and market conditions. The Company’s costs related to its foreign operations do not significantly differ from its domestic costs.

24


Selling, General and Administrative Expenses. Selling, general and administrative expenses include the costs associated with sales and marketing, general corporate overhead, business development expenses, compensation expense, stock-based compensation expense, legal expenses, foreign currency transaction gains and losses and other related administrative functions.
Engineering and Product Development Expenses. Engineering and product development expenses consist of new product development and testing, as well as application engineering related to customized products.
Gain on sale of assets. Gain on sale of assets consists of sales of certain property, plant and equipment of $5.1 million, which occurred during the three months ended June 30, 2018. See "Gain on Sale of Assets," Note 9 to the Notes to Condensed Consolidated Financial Statements for more detail.
Impairment and Other Charges. Impairment and other charges consist of certain fixed asset and inventory write-downs of $27.4 million and $33.6 million, respectively, which occurred in connection with our preparation and review of financial statements for the quarter ended September 30, 2017. See "Impairments and Other Charges," Note 10 to the Notes to Condensed Consolidated Financial Statements for more detail.
Income Tax Provision. The Company’s effective income tax rate has historically been lower than the statutory rate primarily due to foreign income tax rate differentials and research and development credits; however, the 2018 income tax expense has been negatively impacted by the valuation allowances in the North America and Asia-Pacific regions.

25


Results of Operations
The following table sets forth, for the periods indicated, certain consolidated statement of income data expressed as a percentage of revenues:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues:
 
 
 
 
 
 
 
Products
67.8
 %
 
75.6
 %
 
69.3
 %
 
77.6
 %
Services
32.2

 
24.4

 
30.7

 
22.4

Total revenues
100.0

 
100.0

 
100.0

 
100.0

Cost of sales:
 
 
 
 
 
 
 
Products
51.3

 
48.6

 
52.7

 
54.7

Services
19.1

 
14.2

 
17.9

 
12.3

Total cost of sales
70.4

 
62.8

 
70.6

 
67.0

Selling, general and administrative
33.8

 
27.9

 
29.0

 
24.5

Engineering and product development
10.9

 
10.3

 
10.5

 
9.4

Impairment and other charges

 
60.8

 

 
17.5

Gain on sale of assets

 

 
(1.8
)
 

Operating loss
(15.1
)
 
(61.8
)
 
(8.3
)
 
(18.4
)
Interest income
2.0

 
1.0

 
2.1

 
0.9

Interest expense
(0.2
)
 

 
(0.2
)
 

Income (loss) before income taxes
(13.3
)
 
(60.8
)
 
(6.4
)
 
(17.5
)
Income tax provision (benefit)
(2.2
)
 
(31.7
)
 
0.8

 
(9.2
)
Net loss
(11.1
)%
 
(29.1
)%
 
(7.2
)%
 
(8.3
)%

26


The following table sets forth, for the periods indicated, a breakdown of our products and service revenues:
 
Three months ended
September 30,
 
Nine months ended
September 30,
 
2018
 
2017
 
2018
 
2017
 
(In millions)
Revenues:
 
 
 
 
 
 
 
Products:
 
 
 
 
 
 
 
         Subsea
$
49.8

 
$
64.8

 
$
155.8

 
$
224.9

         Surface
4.5

 
3.0

 
14.6

 
11.4

         Downhole
8.3

 
5.6

 
25.7

 
23.1

         Offshore Rig
0.6

 
2.4

 
2.9

 
10.1

              Total products
63.2

 
75.8

 
199.0

 
269.5

   Services
30.0

 
24.5

 
88.3

 
77.9

              Total revenues
$
93.2

 
$
100.3

 
$
287.3

 
$
347.4


Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017
Revenues. Revenues decreased by $7.1 million, or approximately 7.1%, to $93.2 million for the three months ended September 30, 2018 from $100.3 million in the three months ended September 30, 2017, primarily due to a decrease in demand for exploration and production equipment. Product revenues decreased by approximately $12.6 million for the three months ended September 30, 2018 compared to the same period in 2017 as a result of decreased revenues of $15.0 million in subsea equipment and $1.8 million in offshore rig equipment, partially offset by increased revenues of $2.7 million in downhole tools and $1.5 million in surface equipment. Product revenues decreased in the Asia-Pacific by $13.8 million, offset by an increase in the Western and Eastern Hemispheres of $0.5 million and $0.6 million, respectively. While the rise in oil and gas prices has resulted in slightly increased demand for exploration and production equipment in the Western and Eastern Hemispheres during the quarter, the increase has not resulted in increased demand in the Asia-Pacific. In any given time period, the revenues recognized between the various product lines and geographic areas will vary depending upon the timing of shipments to customers, completion status of the projects accounted for under the over time accounting method, market conditions and customer demand. Service revenues increased by approximately $5.5 million resulting from increased service revenues in the Asia-Pacific and Western Hemisphere of $4.0 million,and $1.7 million, respectively. The majority of the increases in service revenues related to increased technical advisory assistance and reconditioning of customer-owned property.
Cost of Sales. Cost of sales increased by $2.5 million, or approximately 4%, to $65.6 million for the three months ended September 30, 2018 from $63.1 million for the same period in 2017. As a percentage of revenues, cost of sales increased to 70.4% from 62.8% for the three months ended September 30, 2018, as compared to the same period in 2017, primarily as a result of product mix, pricing concessions and unabsorbed manufacturing costs.
Selling, General and Administrative Expenses. For the three months ended September 30, 2018, selling, general and administrative expenses increased by approximately $3.6 million, or 13%, to $31.6 million from $28.0 million for the same period in 2017, primarily due to the restructuring charges of approximately $3.7 million and an increase in our bad debt expense of approximately $1.8 million related to the settlement of our accounts receivable from two customers, partially offset by decreased professional fees of $2.9 million. Selling, general and administrative expenses as a percentage of revenues, excluding the restructuring charge and bad debt expense, was approximately 27.9% for both the three months ended September 30, 2018 and for the same period in 2017.
Restructuring and Other Charges. In the third quarter of 2018, we initiated a global strategic analysis to better align our operations with current market conditions. As a result of this plan, during the three months ended September 30, 2018, we incurred restructuring and other charges of approximately $3.7 million primarily related to employee termination benefits and consulting fees, which are included in "Selling, general and administrative" in our Condensed Consolidated Statement of Income (Loss). We believe that our plan will be finalized by mid-2019 and that we will incur additional charges with respect to this plan.
Engineering and Product Development Expenses. For the three months ended September 30, 2018, engineering and product development expenses decreased by approximately $0.2 million, or 1.9%, to $10.2 million from $10.4 million for the same period in 2017.

27


Impairment and Other Charges. In connection with our preparation and review of financial statements for the quarter ended September 30, 2017, after considering current Brent Crude consensus forecasts and expected rig counts for the foreseeable future, we determined that the carrying amount of certain of our long-lived assets in the Western Hemisphere exceeded their respective fair values due to projected declines in asset utilization and that the cost of some of our worldwide inventory exceeded its market value. As a result, we recorded corresponding impairments and other charges. Primarily as a result of the factors described above, we recorded charges of approximately $33.6 million related to inventory and $27.4 million related to fixed assets during the three months ended September 30, 2017. There were no impairments during the three months ended September 30, 2018. See "Impairments and Other Charges," Note 10 to the Notes to Condensed Consolidated Financial Statements for further discussion.
Gain on Sale of Assets. There were no significant sales of assets during the three months ended September 30, 2018. See "Gain on Sale of Assets," Note 9 to the Notes to Condensed Consolidated Financial Statements for further discussion.
Income Tax Provision. Income tax benefit for the three months ended September 30, 2018 was $2.0 million on a loss before taxes of $12.4 million, resulting in an effective tax rate of 16.1%. Income tax benefit for the three months ended September 30, 2017 was $31.8 million on a loss before taxes of $61.1 million, resulting in an effective income tax rate of approximately 52.0%. Historically, the change in the effective income tax rate percentage primarily reflects the changes in taxable income among the Company’s three geographic areas, which have different income tax rates.
On December 22, 2017, the President of the United States signed into law P.L. 115-97, informally known as the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). Tax Reform amends the Internal Revenue Code to reduce tax rates and modify policies, credits and deductions for individuals and businesses. For businesses, Tax Reform reduced the corporate federal tax rate from a maximum of 35% to 21% and transitions from a worldwide tax system to a modified territorial tax system. Tax Reform also adds many new provisions including changes to bonus depreciation, the deduction for executive compensation and interest expense, a tax on global intangible low-taxed income (GILTI), the base erosion anti-abuse tax (BEAT) and a deduction for foreign-derived intangible income (FDII).  Given the amount and complexity of the changes to tax law, we continue to finalize our accounting for the income tax effects stemming from Tax Reform. At December 31, 2017, certain provisional amounts were taken as estimates to account for the impact of Tax Reform. The actual impact of Tax Reform may differ from the estimates used due to, among other things, further refinement of our calculations, changes in interpretations and assumptions we have made, guidance that may be issued and actions we may take as a result of the tax legislation. Any adjustments to these provisional estimates will be reported as a component of income tax expense in the reporting period in which any such adjustments are identified, which will be no later than the fourth quarter of 2018.
Net Loss. Net loss was approximately $10.4 million for the three months ended September 30, 2018, compared to net loss of $29.3 million for the same period in 2017 for the reasons set forth above.
Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017
Revenues. Revenues decreased by $60.2 million, or approximately 17.3%, to $287.3 million for the nine months ended September 30, 2018 from $347.5 million for the same period in 2017, primarily due to a decrease in demand for exploration and production equipment.
Product revenues decreased by approximately $70.6 million for the nine months ended September 30, 2018 compared to the same period in 2017 as a result of decreased revenues of $69.2 million in subsea equipment and $7.2 million in offshore rig equipment, partially offset by increased revenues of $2.6 million in downhole tools and $3.2 million in surface equipment. Product revenues decreased in the Western, Eastern and Asia-Pacific Hemispheres by $32.7 million, $1.3 million and $36.6 million, respectively. While oil and gas prices have increased, such increase has not been large enough to result in increased demand for exploration and production equipment, especially subsea equipment. In any given time period, the revenues recognized between the various product lines and geographic areas will vary depending upon the timing of shipments to customers, completion status of the projects accounted for under the over time accounting method, market conditions and customer demand. Service revenues increased by approximately $10.3 million resulting from decreased service revenues in the Western Hemisphere of $2.0 million, offset by increased service revenues in the Eastern and Asia-Pacific Hemispheres of $5.6 million and $6.7 million, respectively. The majority of the increase in service revenues related to increased demand for reconditioning of customer-owned property and technical advisory assistance, largely due to higher oil and gas prices leading to increased exploration and production activities.
Cost of Sales. Cost of sales decreased by $30.2 million, or approximately 13.0%, to $202.8 million for the nine months ended September 30, 2018 from $233.0 million for the same period in 2017. The cost of sales as a percentage of revenues increased to 70.6% from 67.0% in the first nine months of 2018 as compared to the same period in 2017, primarily as a result of unabsorbed manufacturing costs, product mix and pricing concessions.

28


Selling, General and Administrative Expenses. For the nine months ended September 30, 2018, selling, general and administrative expenses decreased by approximately $1.7 million, or 2.0%, to $83.4 million from $85.1 million for the same period in 2017. The Company experienced a non-cash pre-tax foreign currency transaction gain of $0.8 million for the nine months ended September 30, 2018, compared to a loss of $4.0 million for the same period in 2017, an increase in our bad debt expense of approximately $1.8 million related to the settlement of our accounts receivable from two customers and a decrease in other selling costs of approximately $0.5 million. Selling, general and administrative expenses as a percentage of revenues, excluding the restructuring charge and bad debt expense, was approximately 26.9% for the first nine months of 2018 as compared to 24.5% for the same period in 2017.
Restructuring and Other Charges. In the third quarter of 2018, we initiated a global strategic analysis to better align our operations with current market conditions. As a result of this plan, during the nine months ended September 30, 2018, we incurred restructuring and other charges of approximately $3.7 million primarily related to employee termination benefits and consulting fees, which are included in "Selling, general and administrative" in the Condensed Consolidated Statement of Income (Loss). We believe that our plan will be finalized by mid-2019 and that we will incur additional charges with respect to this plan.
Engineering and Product Development Expenses. For the nine months ended September 30, 2018, engineering and product development expenses decreased by approximately $2.4 million, or 7.4%, to $30.1 million from $32.5 million for the same period in 2017. The majority of the decrease was due to lower revenues related to projects during 2018. Engineering and product development expenses as a percentage of revenues increased to 10.5% in the first nine months of 2018 from 9.4% for the same period in 2017.
Impairment and Other Charges. In connection with our preparation and review of financial statements for the quarter ended September 30, 2017, after considering current Brent Crude consensus forecasts and expected rig counts for the foreseeable future, we determined that the carrying amount of certain of our long-lived assets in the Western Hemisphere exceeded their respective fair values due to projected declines in asset utilization and that the cost of some of our worldwide inventory exceeded its market value. As a result, we recorded corresponding impairments and other charges. Primarily as a result of the factors described above, we recorded charges of approximately $33.6 million related to inventory and $27.4 million related to fixed assets during the nine months ended September 30, 2017. There were no impairments during the nine months ended September 30, 2018. See "Impairments and Other Charges," Note 10 to the Notes to Condensed Consolidated Financial Statements for further discussion.
Gain on Sale of Assets. During the second quarter of 2018, we sold certain property, plant and equipment for a net gain of approximately $5.1 million as part of our reorganization and consolidation of operations at our headquarters location in Houston, Texas. See "Gain on Sale of Assets," Note 9 to the Notes to Condensed Consolidated Financial Statements for further discussion.
Income Tax Provision. Income tax expense for the nine months ended September 30, 2018 was $2.3 million on a loss before taxes of $18.5 million, resulting in an effective tax rate of (12.4)%. Income tax benefit for the nine months ended September 30, 2017 was $32.0 million on a loss before taxes of $61.1 million, resulting in an effective income tax rate of approximately 52.2%. Historically, the change in the effective income tax rate percentage primarily reflects the changes in taxable income among the Company’s three geographic areas, which have different income tax rates. The 2018 income tax expense has also been negatively impacted by the valuation allowances in the North America and Asia-Pacific regions.
On December 22, 2017, the President of the United States signed into law the Tax Reform. Tax Reform amends the Internal Revenue Code to reduce tax rates and modify policies, credits and deductions for individuals and businesses. For businesses, Tax Reform reduced the corporate federal tax rate from a maximum of 35% to 21% and transitions from a worldwide tax system to a modified territorial tax system. Tax Reform also adds many new provisions including changes to bonus depreciation, the deduction for executive compensation and interest expense, a tax on GILTI, BEAT and a deduction for FDII.  Given the amount and complexity of the changes to tax law, we continue to finalize our accounting for the income tax effects stemming from Tax Reform. At December 31, 2017, certain provisional amounts were taken as estimates to account for the impact of Tax Reform. The actual impact of Tax Reform may differ from the estimates used due to, among other things, further refinement of our calculations, changes in interpretations and assumptions we have made, guidance that may be issued and actions we may take as a result of the tax legislation. Any adjustments to these provisional estimates will be reported as a component of income tax expense in the reporting period in which any such adjustments are identified, which will be no later than the fourth quarter of 2018.
Net Loss. Net loss was approximately $20.8 million for the nine months ended September 30, 2018, compared to net loss of $29.1 million for the same period in 2017 for the reasons set forth above.

29


Non-GAAP Financial Measures
We have performed a detailed analysis of the non-GAAP measures that are relevant to our business and its operations and determined that the appropriate unit of measure to analyze our performance is Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization, as well as other significant non-cash items and other adjustments for certain charges and credits). The Company believes that the exclusion of these charges and credits from these financial measures enables it to evaluate more effectively the Company's operations period over period and to identify operating trends that could otherwise be masked by excluded items. It is our determination that Adjusted EBITDA is a more relevant measure of how the Company reviews its ability to meet commitments and pursue capital projects.
Adjusted EBITDA
We calculate Adjusted EBITDA as one of the indicators to evaluate and compare the results of our operations from period to period by removing the effect of our capital structure from our operating structure. This measurement is used in concert with net income and cash flows from operations, which measures actual cash generated in the period.  In addition, we believe that Adjusted  EBITDA is a supplemental measurement tool used by analysts and investors to help evaluate overall operating performance, ability to pursue and service possible debt opportunities and analyze possible future capital expenditures.  Adjusted EBITDA does not represent funds available for our discretionary use and is not intended to represent or to be used as a substitute for net income, as measured under U.S. generally accepted accounting principles.  The items excluded from Adjusted EBITDA, but included in the calculation of reported net income, are significant components of the consolidated statements of income and must be considered in performing a comprehensive assessment of overall financial performance.  Our calculation of Adjusted EBITDA may not be consistent with calculations of Adjusted EBITDA used by other companies. 
The following table reconciles our reported net income to Adjusted EBITDA for each of the respective periods:


Three months ended September 30,

Nine months ended September 30,


2018
2017

2018
2017


(In thousands)
Net loss
$
(10,358
)
$
(29,260
)
 
$
(20,783
)
$
(29,149
)
Add:
 
 
 
 
 
 
 
Interest (income) expense
(1,698
)
(945
)
 
(5,420
)
(2,919
)
 
Income tax expense (benefit)
(2,028
)
(31,840
)
 
2,291

(31,959
)
 
Depreciation and amortization expense
8,724

9,518

 
25,966

32,231

 
Restructuring costs
3,745


 
4,345


 
Impairment and other charges

60,968

 

60,968

 
Gain on sale of assets
(14
)

 
(5,113
)

 
Foreign currency loss (gain)
41

380

 
(810
)
3,965

 
Severance costs

1,163

 

3,040

 
Stock compensation expense
2,366

3,694

 
9,950

10,477

Adjusted EBITDA
$
778

$
13,678

 
$
10,426

$
46,654

Adjusted EBITDA does not measure financial performance under GAAP and, accordingly, should not be considered as an alternative to net income as an indicator of operating performance.

30


Liquidity and Capital Resources
Cash Flows
Cash flows provided by (used in) type of activity were as follows:

Nine months ended September 30,

2018
 
2017

(In thousands)
Operating activities
$
32,607

 
$
74,735

Investing activities
(15,439
)
 
(39,692
)
Financing activities
(80,646
)
 
455


(63,478
)
 
35,498

Effect of exchange rate changes on cash activities
(5,649
)
 
14,050

Increase (decrease) in cash and cash equivalents
$
(69,127
)
 
$
49,548

Statements of cash flows for entities with international operations that are local currency functional exclude the effects of the changes in foreign currency exchange rates that occur during any given period, as these are non-cash changes. As a result, changes reflected in certain accounts on the Condensed Consolidated Statements of Cash Flows may not reflect the changes in corresponding accounts on the Condensed Consolidated Balance Sheets.
The primary liquidity needs of the Company are (i) to fund capital expenditures to improve and expand facilities and manufacture additional running tools and (ii) to fund working capital. The Company’s principal source of funds is cash flows from operations. As of September 30, 2018, the Company had availability of $56.0 million under the ABL Credit Facility.
Net cash provided by operating activities for the nine months ended September 30, 2018 was $32.6 million as compared to $74.7 million for the nine months ended September 30, 2017. The net change is primarily due to the change to a net loss for the third quarter of 2018 totaling $8.4 million, a gain on sale of fixed assets of $5.0 million, decreased depreciation and amortization of $6.3 million, partially offset by increased changes in operating activities of $8.6 million, increases in deferred income taxes of $30.6 million, increases in stock-based compensation of $0.5 million and other decreases in cash flow of $0.3 million.
The change in operating assets and liabilities for the nine months ended September 30, 2018 resulted in a $23.2 million increase in cash. The decrease in trade receivables resulted in increased cash flow of $0.3 million, resulting from increased collections and settlements during the nine months ended September 30, 2018. The decrease in inventory resulted in increased cash flow of $32.6 million. The increase in prepaids and other assets decreased operating cash flow by $9.7 million.
The change in operating assets and liabilities for the nine months ended September 30, 2017 resulted in a $31.8 million increase in cash. Trade receivables decreased $21.3 million primarily due to lower revenues during the period. Inventory decreased by $32.6 million from reductions in customer orders and efforts to utilize existing inventory. Prepaids and other assets decreased by $17.3 million due to decreases in vendor prepayments. Accounts payable and accrued expenses decreased by approximately $39.4 million primarily due to a reduction in income tax payable of $20.7 million, which is comprised of the $8.2 million impact from the patent box benefit and lower income before taxes, decreases in accounts payable of $11.7 million and customer prepayments of $6.7 million.
The change in investing cash flows for the nine months ended September 30, 2018 resulted in a $24.3 million decrease to cash. Capital expenditures by the Company were $26.7 million and $19.6 million for the nine months ended September 30, 2018 and 2017, respectively. The capital expenditures for the nine months ended September 30, 2018 were $12.9 million for buildings, $9.2 million for rental tools, $2.3 million for machinery and equipment and $2.3 million for other expenditures. The capital expenditures for the nine months ended September 30, 2017 were $3.9 million for machinery and equipment, $10.9 million for facilities, $4.4 million for rental tools and $0.4 million for other capital expenditures.
The exercise of stock options generated cash to the Company of $1,106,000 for the nine months ended September 30, 2018 as compared to $455,000 for the same period of 2017.

31


Repurchase of Equity Securities
On July 26, 2016, the Board of Directors authorized a share repurchase plan under which the Company can repurchase up to $100 million of its common stock. The repurchase plan has no set expiration date and any repurchased shares are expected to be cancelled. For the three-month period ended September 30, 2018, the Company purchased 1,395,521 shares under the share repurchase plan at an average price of approximately $50.95 per share totaling approximately $71.1 million, which is reflected in "Treasury shares (at cost)" in the Condensed Consolidated Balance Sheet. In May 2018, the Company purchased 219,102 shares under the share repurchase plan at an average price of approximately $44.87 per share totaling approximately $9.8 million and retired such shares, which is reflected within our retained earnings for the period ended September 30, 2018. As of September 30, 2018, the maximum dollar value in shares remaining that may yet be repurchased was $19.1 million. We completed our repurchase plan in October 2018 by repurchasing the remaining $19.1 million value in shares, pursuant to a 10b5-1 plan. We retired all of the shares repurchased on October 16, 2018. For additional information on the share repurchase, see "Item 2. Unregistered Sales of Equity Securities and Use of Proceeds" in Part II of this report.
Asset Backed Loan (ABL) Credit Facility
On February 23, 2018, the Company, as borrower, and the Company’s subsidiaries TIW Corporation and Honing, Inc., as guarantors, entered into a five-year senior secured revolving credit facility (the “ABL Credit Facility”) with JPMorgan Chase Bank, N.A., as administrative agent, and other financial institutions as lenders with total commitments of $100.0 million, including up to $10.0 million available for letters of credit. The maximum amount that the Company may borrow under the ABL Credit Facility is subject to the borrowing base, which is based on a percentage of eligible accounts receivable and eligible inventory, subject to reserves and other adjustments.
As of September 30, 2018, the availability under the ABL Credit Facility was $56.0 million, after taking into account the outstanding letters of credit of approximately $0.3 million issued under the facility. For additional information on the ABL Credit Facility, see "Asset Backed Loan (ABL) Credit Facility," Note 11 to the Notes to Condensed Consolidated Financial Statements.
Off-Balance Sheet Arrangements
The Company currently has no derivative instruments and no off-balance sheet hedging or financing arrangements, contracts or operations.
Other Matters
From time to time, the Company enters into discussions or negotiations to acquire other businesses or enter into joint ventures. The timing, size or success of any such efforts and the associated potential capital commitments are unpredictable and dependent on market conditions and opportunities existing at the time. The Company may seek to fund all or part of any such efforts with proceeds from debt or equity issuances. Debt or equity financing may not, however, be available at that time due to a variety of events, including, among others, the Company’s credit ratings, industry conditions, general economic conditions and market conditions.
Critical Accounting Policies
Refer to our Annual Report on Form 10-K for the year ended December 31, 2017 for a discussion of our critical accounting policies. During the nine months ended September 30, 2018, there were no material changes in our judgments and assumptions associated with the development of our critical accounting policies.

32



Item 3.    Quantitative and Qualitative Disclosures About Market Risk
The Company is currently exposed to certain market risks related to interest rate changes on its short-term investments and fluctuations in foreign exchange rates. The Company does not engage in any material hedging transactions, forward contracts or currency trading which could mitigate the market risks inherent in such transactions. There have been no material changes in market risks for the Company since December 31, 2017.
Foreign Exchange Rate Risk
The Company has operations in various countries around the world and conducts business in a number of different currencies. Our significant foreign subsidiaries may also have monetary assets and liabilities not denominated in their functional currency. These monetary assets and liabilities are exposed to changes in currency exchange rates which may result in non-cash gains and losses primarily due to fluctuations between the U.S. dollar and each subsidiary's functional currency.
The Company experienced a foreign currency pre-tax gain of a minimal amount and approximately $0.8 million, respectively, during the three and nine-month periods ended September 30, 2018 and a pre-tax loss of $0.4 million and $4.0 million, respectively, in the same periods of 2017. These losses and gains were primarily due to the exchange rate fluctuations between the U.S. dollar and various currencies within the foreign regions where we do business.
The Company does not engage in any material hedging transactions, forward contracts or currency trading which could mitigate the effects and risks inherent in such transactions. Additionally, there is no assurance that the Company will be able to protect itself against currency fluctuations in the future.

Item 4.        Controls and Procedures
In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2018 to provide reasonable assurance that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and such information is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
There has been no change in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

33



PART II—OTHER INFORMATION
Item 1.        Legal Proceedings
For a description of the Company’s legal proceedings, see “Commitments and Contingencies,” Note 14 to the Notes to Condensed Consolidated Financial Statements.

Item 1A.    Risk Factors
There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

Item 2.        Unregistered Sales of Equity Securities and Use of Proceeds
The following table summarizes the repurchase and cancellation of our common stock during the three and nine months ended September 30, 2018:
 
Three months ended September 30, 2018
 
Total Number of Shares Purchased
 
Average Price paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)
 
Maximum Dollar Value (in millions) of Shares that May Yet be Purchased Under the Plans or Programs
July 1-30, 2018

 
$

 

 
$
90.2

August 1-30, 2018
639,584

 
51.49

 
639,584

 
57.2

September 1-30, 2018
755,937

 
50.46

 
755,937

 
19.1

 
1,395,521

 
$
50.95

 
1,395,521

 
$
19.1