| DRIL-QUIP INC uncertainties discussed under “Item 1A Risk Factors” in this report and the following: • the volatility of oil and natural gas prices; • the cyclical nature of the oil and gas industry; • uncertainties associated with the United States and worldwide economies, including those due to political tensions in the Middle East and elsewhere; • current and potential governmental regulatory actions in the United States and regulatory actions and political unrest in other countries; • operating interruptions (including explosions, fires, weather-related incidents, mechanical failure, unscheduled downtime, labor difficulties, transportation interruptions, spills and releases and other environmental risks); • the Company’s reliance on product development; • technological developments; • the Company’s dependence on key employees and skilled machinists, fabricators and technical personnel; 2 ______________________________________________________________________ [30]Table of Contents • the Company’s reliance on sources of raw materials; • control by certain stockholders; • impact of environmental matters; • competitive products and pricing pressures; • the Company’s reliance on significant customers; • creditworthiness of the Company’s customers; • access to capital markets; and • war and terrorist acts |
| Many of such factors are beyond the Company’s ability to control or predict |
| Any of the factors, or a combination of these factors, could materially affect the Company’s future results of operations and the ultimate accuracy of the forward-looking statements |
| These forward-looking statements are not guarantees of future performance, and the Company’s actual results and future developments may differ materially from those projected in the forward-looking statements |
| Management cautions against putting undue reliance on forward-looking statements or projecting any future results based on such statements or present or prior earnings levels |
| Every forward-looking statement speaks only as of the date of the particular statement, and the Company undertakes no obligation to publicly update or revise any forward-looking statement |
| Business General Dril-Quip, Inc, a Delaware corporation (the “Company” or “Dril-Quip”) designs, manufactures, sells and services highly engineered offshore drilling and production equipment that is well suited 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, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, wellhead connectors and diverters |
| Dril-Quip also provides installation and reconditioning services and rents running tools for use in connection with the installation and retrieval of its products |
| Dril-Quip has developed its broad line of subsea equipment, surface equipment and offshore rig equipment primarily through its internal product development efforts |
| The Company believes that it has achieved significant market share and brand name recognition with respect to its established products due to the technological capabilities, reliability, cost effectiveness and operational timesaving features of these products |
| In 2005, Dril-Quip introduced three new products, liner hangers, subsea control systems and subsea manifolds, which are expected to substantially broaden the market served by the Company |
| With the introduction of subsea control systems and subsea manifolds, the Company expects to be able to offer customers a fully integrated subsea production package, which will allow it to compete for the larger field development projects |
| 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) |
| The Company manufactures its products at its facilities located in Houston, Texas; Aberdeen, Scotland; Singapore and Macae, Brazil |
| The Company maintains additional facilities for fabrication and/or reconditioning in Norway, Denmark, and Australia |
| The Company’s manufacturing operations are vertically integrated, allowing it to perform substantially all of its forging, heat treating, machining, fabrication, inspection, assembly and testing at its own facilities |
| See note 11 to the consolidated financial statements |
| The Company’s major subsidiaries are Dril-Quip 3 ______________________________________________________________________ [31]Table of Contents (Europe) Limited (DQE), located in Aberdeen with branches in Denmark, Norway and Holland; Dril-Quip Asia Pacific PTE Ltd |
| (DQAP), located in Singapore; and Dril-Quip do Brasil LTDA, located in Macae, Brazil |
| is located in Port Harcourt, Nigeria and is a wholly-owned subsidiary of DQE Dril-Quip’s principal customers are major integrated oil and gas companies, large independent oil and gas companies and foreign national oil and gas companies that focus on offshore exploration and production |
| Dril-Quip markets its products through its offices and sales representatives located in the major international energy markets throughout the world |
| In 2005, the Company generated approximately 66prca of its revenues from foreign sales |
| The Company was co-founded in 1981 by Larry E Reimert, Gary D Smith, J Mike Walker and an investor who is no longer affiliated with the Company |
| Together, Messrs |
| Reimert, Smith and Walker have over 100 years of combined experience in the oilfield equipment industry, essentially all of which has been with the Company and its major competitors |
| In addition, most of the Company’s key department managers have been with the Company over 10 years, on average |
| The Company makes available free of charge on its internet website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such reports with, or furnishes them to, the SEC Our website address is http://www |
| Except to the extent explicitly stated herein, documents and information on the Company’s website are not incorporated by reference herein |
| Additionally, the Company makes available free of charge on its internet website: • its Code of Business Conduct and Ethical Practices, • its Corporate Governance Guidelines and • the charter of its Nominating, Governance and Compensation Committee, and • the charter of its Audit Committee |
| Any stockholder who so requests may obtain a printed copy of any of these documents from the Company |
| Changes in or waivers to our Code of Business Conduct and Ethical Practices involving directors and executive officers of the Company will be posted on its internet website within five business days and maintained for at least twelve months |
| Industry Overview Both the market for offshore drilling and production equipment and services and the Company’s business are substantially dependent on the financial 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 offshore |
| The level of capital expenditures has generally been dependent upon the prevailing view of future oil and gas prices, which are influenced by numerous factors affecting the supply and demand for oil and gas, including worldwide economic activity, interest rates and the cost of capital, environmental regulation, tax policies, and the ability of OPEC and other producing nations to set and maintain production levels and prices |
| Capital expenditures are also dependent on the cost of exploring for and producing oil and gas, the sale and expiration dates of offshore leases, the discovery rate of new oil and gas reserves in offshore areas and technological advances |
| Oil and gas prices and the level of offshore drilling and production activity have historically been characterized by significant volatility |
| See “Item 1A Risk Factors—A material or extended decline in expenditures by the oil and gas industry could significantly reduce our revenue and income |
| High oil and gas prices in 2004 and 2005 have resulted in oil operators increasing capital spending for both exploration and development programs |
| As various geopolitical issues have limited the ability of oil and gas companies 4 ______________________________________________________________________ [32]Table of Contents to invest in areas such as Russia and the Middle East, an increasing amount of this capital spending has been in the deepwater areas in which the Company operates |
| However, any future decline in oil and gas prices significantly below current levels would likely have a material adverse effect on the Company’s results of operations |
| There can be no assurance that the current oil price levels will lead to increases in exploration and development activity or that demand for the Company’s products and services will reflect such improvement, if any |
| Products and Services Products Dril-Quip designs, manufactures, fabricates, inspects, assembles, tests and markets subsea equipment, surface equipment and offshore rig equipment |
| In 2005, the Company derived approximately 85prca of its revenues from the sale of its products |
| The Company’s products are used to explore for oil and gas on offshore drilling rigs, such as floating rigs and jack-ups, and for drilling and production of oil and gas wells on offshore platforms, TLPs, Spars and moored vessels such as FPSOs |
| TLPs are floating production platforms that are connected to the ocean floor via vertical mooring tethers (called tension legs) |
| A Spar is a floating cylindrical structure approximately six or seven times longer than its diameter that is anchored in place (like a Spar buoy) |
| FPSOs are floating production, storage and offloading monohull moored vessels |
| Subsea Equipment |
| Subsea equipment is used in the drilling and production of offshore oil and gas wells around the world |
| Included in the subsea equipment product line are subsea wellheads, mudline hanger systems, specialty connectors and associated pipe, subsea production trees, valves and TLP and Spar well systems |
| In 2005, the Company introduced three new products: liner hangers, multiplex subsea control systems and multiwell subsea manifolds |
| Subsea wellheads are pressure-containing forged and machined metal housings in which casing hangers are landed and sealed subsea to suspend casing (downhole pipe) |
| As drilling depth increases, successively smaller diameter casing strings are installed, each suspended by an independent casing hanger |
| Subsea wellheads are utilized when drilling from floating drilling rigs, either semi-submersible or drillship types, and TLPs and Spars |
| The Company’s SS-15 Big Bore Subsea Wellhead System is designed to accommodate additional casing strings installed through a conventional marine riser and a subsea blowout preventer |
| Mudline hanger systems are used in jack-up drilling operations to support the weight of the various casing strings at the ocean floor while drilling a well |
| They also provide a method to disconnect the casing strings in an orderly manner at the ocean floor after the well has been drilled, and subsequently reconnect to enable production of the well by either tying it back vertically to a subsequently installed platform or by installing a subsea tree |
| Large diameter weld-on specialty connectors (threaded or stab type) are used in offshore wells drilled from floating drilling rigs, jack-ups, fixed platforms, TLPs and Spars |
| Specialty connectors join lengths of conductor or large diameter (16-inch or greater) casing |
| Specialty connectors provide a more rapid connection than other methods of connecting lengths of pipe |
| Connectors may be sold individually or as an assembly after being welded to sections of Company or customer supplied pipe |
| Dril-Quip’s weld-on specialty connectors are designed to prevent cross threading and provide a quick, convenient method of joining casing joints with structural integrity compatible with casing strength |
| A subsea production tree is an assembly composed of valves, a wellhead connector, control equipment and various other components installed on a subsea wellhead or a mudline hanger system and used to control the flow of oil and gas from a producing well |
| Subsea trees may be either stand alone satellite type or template mounted cluster arrangements |
| Both types typically produce via flowlines to a central control point located on a platform, TLP, Spar or FPSO The use of subsea production trees has become an increasingly important method for producing wells located in hard-to-reach deepwater areas or economically marginal fields located in shallower waters |
| The Company is an established manufacturer of more complicated dual-bore production trees, which are used in severe service 5 ______________________________________________________________________ [33]Table of Contents applications |
| In addition, Dril-Quip manufactures a patented single bore (SingleBore^TM) subsea completion system which features a hydraulic mechanism instead of a wireline-installed mechanism that allows the operator to plug the tubing hanger annulus remotely from the surface via a hydraulic control line and subsequently unplug it when the well is put on production |
| This mechanism eliminates the need for an expensive multibore installation and workover riser, thereby saving both cost and installation time |
| Dril-Quip’s guidelineless subsea production tree is used in ultra-deepwater applications |
| This tree features remote multiple flowline and control connections, utilizing remotely operated intervention tools |
| The Company’s subsea production trees are generally custom designed and manufactured to customer specifications |
| A liner hanger is used to hang-off and seal casing into a previously installed casing string in the well bore, and can provide a means of tying back the liner for production to surface |
| Dril-Quip has developed a state-of-the-art liner hanger system and is in the final phase of field-performance testing |
| This product represents Dril-Quip’s entry into the market for downhole tools and is expected to provide new market opportunities for the Company |
| A subsea control system is used to remotely control the operations of subsea production equipment such as subsea trees and/or manifolds |
| In December 2005, Dril-Quip successfully installed in the North Sea a multiplex subsea control system used to control both a subsea manifold and subsea trees |
| The addition of this product expands Dril-Quip’s opportunities in subsea development projects |
| A subsea manifold is a structure located on the ocean floor consisting of valves, chokes, flowline connections and a control module used to collect and control the flow of oil and gas from subsea wells for delivery to a terminal |
| Dril-Quip successfully installed its first subsea manifold system in December 2005 |
| This new product further complements the Company’s product offerings for integrated system developments |
| Surface Equipment |
| Surface equipment is principally used for flow control on offshore production platforms, TLPs and Spars |
| Included in the Company’s surface equipment product line are platform wellheads and platform production trees |
| Dril-Quip’s development of platform wellheads and platform production trees was facilitated by adaptation of its existing subsea wellhead and tree technology to surface wellheads and trees |
| Platform wellheads are pressure-containing forged and machined metal housings in which casing hangers are landed and sealed at the platform deck to suspend casings |
| The Company emphasizes the use of metal-to-metal sealing wellhead systems with operational time-saving features which can be used in high pressure, high temperature and corrosive drilling and production applications |
| After installation of a wellhead, a platform production tree, consisting of gate valves, a wellhead connector, controls, tree cap and associated equipment, is installed on the wellhead to control and regulate oil or gas production |
| Platform production trees are similar to subsea production trees but utilize less complex equipment and more manual, rather than hydraulically activated, valves and connectors |
| Platform wellheads and platform production trees and associated equipment are designed and manufactured in accordance with customer specifications |
| Offshore Rig Equipment |
| Offshore rig equipment includes drilling and production riser systems, wellhead connectors and diverters |
| The drilling riser system consists of (i) lengths of riser pipe and associated riser connectors that secure one to another; (ii) the telescopic joint, which connects the entire drilling riser system to the diverter at the rig and provides a means to compensate for vertical motion of the rig relative to the ocean floor; and (iii) the wellhead connector, which provides a means for remote connection and disconnection of the drilling riser system to and from the blowout preventer stack |
| Production risers provide a vertical conduit from the subsea wellhead to a TLP, Spar or FPSO The wellhead connector also provides remote connection/disconnection of the blowout preventer stack, production tree or production riser to/from the wellhead |
| Diverters are used to provide protection from shallow gas blowouts and to divert gases off of the rig during the drilling operation |
| Wellhead connectors and drilling and production riser systems are also used on both TLPs and Spars, which are being installed more frequently in deepwater applications |
| The principal markets for offshore rig equipment are new 6 ______________________________________________________________________ [34]Table of Contents rigs, rig upgrades, TLPs and Spars |
| Diverters, drilling and production risers and wellhead connectors are generally designed and manufactured to customer specifications |
| Certain products of the Company are used in potentially hazardous drilling, completion and production applications that can cause personal injury, product liability and environmental claims |
| See “Item 1A Risk Factors—Our business involves numerous operating hazards that may not be covered by insurance |
| ” The occurrence of an event not fully covered by insurance could have a material adverse effect on the financial condition and results of operations of the Company |
| Services Services provided by Dril-Quip include field installation services, reconditioning of its products which are customer-owned, and rental running tools for installation and retrieval of its products |
| These services are provided from the Company’s worldwide locations and represented approximately 15prca of revenues in 2005 |
| Dril-Quip provides field installation services through the use of its technicians |
| These technicians assist in the onsite installation of Company products and are available on a 24-hour call out from the Company’s facilities located in Houston, Texas; Aberdeen, Scotland; Stavanger, Norway; Esbjerg, Denmark; Singapore; Perth, Australia; and Macae, Brazil |
| Reconditioning |
| The Company provides reconditioning of its products at its facilities in Houston, Texas; Aberdeen, Scotland; Stavanger, Norway; Singapore; and Macae, Brazil |
| The Company rents running and installation tools for use in installing its products |
| These tools are used to install and retrieve Company products which are purchased by customers |
| Running tools are available from Dril-Quip’s locations in Houston, Texas; Aberdeen, Scotland; Stavanger, Norway; Esbjerg, Denmark; Beverwijk, Holland; Singapore; Perth, Australia; and Macae, Brazil |
| Manufacturing Dril-Quip has major manufacturing facilities in Houston, Texas; Aberdeen, Scotland; and Singapore |
| Each location conducts a broad variety of processes, including machining, fabrication, inspection, assembly and testing |
| The Houston facility provides forged and heat treated products to all the major manufacturing facilities |
| The Company’s Houston and Aberdeen manufacturing plants are ISO 9001 and American Petroleum Institute certified |
| In addition, the Company’s manufacturing facility in Singapore is ISO 9001 certified |
| ” Dril-Quip maintains its high standards of product quality through the use of quality assurance specialists who work with product manufacturing personnel throughout the manufacturing process by inspecting and documenting equipment as it is processed through the Company’s manufacturing facilities |
| The Company has the capability to manufacture various products from each of its product lines at its major manufacturing facilities and believes that this localized manufacturing capability is essential in order to compete with the Company’s major competitors |
| The Company’s manufacturing process is vertically integrated, producing, in house, a majority of its forging requirements and essentially all of its heat treatment, machining, fabrication, inspection, assembly and testing |
| The Company’s primary raw material is cast steel ingots, from which it produces steel shaped forgings at its forging and heat treatment facility |
| The Company routinely purchases steel ingots from approximately four suppliers on a purchase order basis and does not have any long-term supply contracts |
| The Company’s Houston facility provides forgings and heat treatment for its Aberdeen and Singapore facilities |
| The Company’s major competitors depend on outside sources for all or a substantial portion of their forging and heat treatment requirements |
| The Company has made significant capital investments in developing its vertically integrated manufacturing capability |
| Prolonged periods of low demand in the market for offshore drilling and production equipment could have a greater effect on the Company than on certain of its competitors that have not made large capital investments in facilities |
| 7 ______________________________________________________________________ [35]Table of Contents Dril-Quip’s manufacturing facilities utilize state-of-the-art computer numerically controlled (“CNC”) machine tools and equipment, which contribute to the Company’s product quality and timely delivery |
| The Company has also developed a cost effective, in-house machine tool rebuild capability which produces “like new” machine upgrades with customized features to enhance the economic manufacture of its specialized products |
| The Company purchases quality used machine tools as they become available and stores them at its facilities to be rebuilt and upgraded as the need arises |
| Rebuilding used machine tools allows for greater customization suitable for manufacturing Dril-Quip proprietary product lines |
| This provides the added advantage of requiring only in-house expertise for repairs and maintenance of these machines |
| A significant portion of the Company’s manufacturing capacity growth has been through the rebuild/upgrade of quality used machine tools, including the replacement of outdated control systems with state-of-the-art CNC controls |
| The Company has increased its facilities at its Eldridge site in Houston, Texas from approximately 280cmam000 square feet at the end of 1997 to approximately 886cmam000 square feet at the end of 2005 |
| Dril-Quip has consolidated its finish machining, assembly and warehouse functions in Houston from its Hempstead Highway location to its larger, state-of-the-art Eldridge Parkway facility |
| Customers The Company’s principal customers are major integrated oil and gas companies, large independent oil and gas companies and foreign national oil and gas companies |
| Offshore drilling contractors and engineering and construction companies also represent a minor customer base |
| The Company’s customers are generally oil and gas companies that are well-known participants in offshore exploration and production |
| The Company is not dependent on any one customer or group of customers |
| In 2004, the Company’s top 15 customers represented approximately 61prca of total revenues, with ConocoPhillips accounting for 15prca of the Company’s total revenues |
| In 2005, the Company’s top 15 customers represented approximately 62prca of total revenues, with no customer accounting for more than 10prca of the Company’s total revenues |
| The number and variety of the Company’s products required in a given year by any one customer depends upon the amount of that customer’s capital expenditure budget devoted to offshore exploration and production and on the results of competitive bids for major projects |
| Consequently, a customer that accounts for a significant portion of revenues in one fiscal year may represent an immaterial portion of revenues in subsequent years |
| While the Company is not dependent on any one customer or group of customers, the loss of one or more of its significant customers could, at least on a short-term basis, have an adverse effect on the Company’s results of operations |
| Marketing and Sales Dril-Quip markets its products and services throughout the world directly through its sales personnel in two domestic and eleven international locations |
| In addition, in certain foreign markets where the Company does not maintain offices, it utilizes independent sales representatives to enhance its marketing and sales efforts |
| Some of the locations in which Dril-Quip has sales representatives are India, Canada, Mexico, the Philippines, Brazil, Indonesia, Malaysia, China, Japan, and the Middle East |
| Although they do not have authority to contractually bind the Company, these representatives market the Company’s products in their respective territories in return for sales commissions |
| The Company also advertises its products and services in trade and technical publications targeted to its customer base |
| It also participates in industry conferences and trade shows to enhance industry awareness of its products |
| The Company’s customers generally order products on a purchase order basis |
| Orders are typically filled within three to six months after receipt of a purchase order, depending on the type of product and whether it is sold out of inventory or requires some customization |
| Contracts for certain of the Company’s larger, more complex products, such as subsea production trees, drilling risers and equipment for TLPs and Spars can take a year or more to complete |
| 8 ______________________________________________________________________ [36]Table of Contents The primary factors influencing a customer’s decision to purchase the Company’s products are the quality, reliability and reputation of the product, price and technologically superior features |
| Timely delivery of equipment is also very important to customer operations and the Company maintains an experienced sales coordination staff to help assure such delivery |
| For large drilling and production system orders, project management teams coordinate customer needs with engineering, manufacturing and service organizations, as well as with subcontractors and vendors |
| A portion of the Company’s business consists of designing, manufacturing, selling and installing equipment for major projects pursuant to competitive bids, and the number of such projects in any year fluctuates |
| The Company’s profitability on such projects is critically dependent on making accurate and cost effective bids and performing efficiently in accordance with bid specifications |
| Various factors can adversely affect the Company’s performance on individual projects, with potential adverse effects on project profitability |
| Product Development and Engineering The technological demands of the oil and gas industry continue to increase as offshore exploration and drilling expand into more hostile environments |
| Conditions encountered in these environments include well pressures of up to 15cmam000 psi (pounds per square inch), mixed flows of oil and gas under high pressure that may also be highly corrosive and water depths in excess of 8cmam000 feet |
| Since its founding, Dril-Quip has actively engaged in continuing product development to generate new products and improve existing products |
| When developing new products, the Company typically seeks to design the most technologically advanced version for a particular application to establish its reputation and qualification in that product |
| Thereafter, the Company leverages its expertise in the more technologically advanced product to produce less costly and complex versions of the product for less demanding applications |
| The Company also focuses its activities on reducing the overall cost to the customer, which includes not only the initial capital cost but also operating and installation costs associated with its products |
| The Company has continually introduced new products and product enhancements since its founding in 1981 |
| In the 1990s, the Company introduced a series of new products, including diverters, wellhead connectors, SingleBore^TM subsea trees, improved severe service dual bore subsea trees, subsea and platform valves, platform wellheads, platform trees, subsea tree workover riser systems, drilling risers and TLP and Spar production riser systems |
| In 2005, Dril-Quip introduced three new products: liner hangers, subsea control systems and subsea manifolds |
| Dril-Quip’s product development work is conducted at its facilities in Houston, Texas and Aberdeen, Scotland |
| In addition to the work of its product development staff, the Company’s application engineering staff provides engineering services to customers in connection with the design and sales of its products |
| The Company’s ability to develop new products and maintain technological advantages is important to its future success |
| There can be no assurance that the Company will be able to develop new products, successfully differentiate itself from its competitors or adapt to evolving markets and technologies |
| The Company believes that the success of its business depends more on the technical competence, creativity and marketing abilities of its employees than on any individual patent, trademark or copyright |
| Nevertheless, as part of its ongoing product development and manufacturing activities, Dril-Quip’s policy has been to seek patents when appropriate on inventions concerning new products and product improvements |
| All patent rights for products developed by employees are assigned to the Company and almost all of the Company’s products have components that are covered by patents |
| Dril-Quip has numerous US registered trademarks, including Dril-Quip^®, Quik-Thread^®, Quick-Stab^®, Multi-Thread^®, MS-15^®, SS-15^®, SS-10^®, SU-90^®, LS-15^® and DX^® |
| The Company has registered its trademarks in the countries where such registration is deemed material |
| Although in the aggregate the Company’s patents and trademarks are of considerable importance to the manufacturing and marketing of many of its products, the Company does not consider any single patent or trademark 9 ______________________________________________________________________ [37]Table of Contents or group of patents or trademarks to be material to its business as a whole, except the Dril-Quip^® trademark |
| At December 31, 2005, the Company held 75 US patents and 133 foreign patents |
| The Company also relies on trade secret protection for its confidential and proprietary information |
| There can be no assurance, however, that others will not independently obtain similar information or otherwise gain access to the Company’s trade secrets |
| Competition Dril-Quip faces significant competition from other manufacturers and suppliers of exploration and production equipment |
| Several of its primary competitors are diversified multinational companies with substantially larger operating staffs and greater capital resources than those of the Company and which, in many instances, have been engaged in the manufacturing business for a much longer period of time than the Company |
| The Company competes principally with Vetco International and the petroleum production equipment segments of Cooper Cameron Corporation, FMC Technologies, Inc |
| and Aker Kvaerner |
| Because of their relative size and diversity of products, several of these companies have the ability to provide “turnkey” services for offshore drilling and production applications, which enables them to use their own products to the exclusion of Dril-Quip’s products |
| See “Item 1A Risk Factors—We may be unable to successfully compete with other manufacturers of drilling and production equipment |
| ” The Company also competes to a lesser extent with a number of other companies in various products |
| The principal competitive factors in the petroleum drilling and production equipment markets are quality, reliability and reputation of the product, price, technology, service and timely delivery |
| Employees The total number of the Company’s employees as of December 31, 2005 was 1cmam514 |
| Of these, 948 were located in the United States |
| Substantially all of the Company’s employees are not covered by collective bargaining agreements, and the Company considers its employee relations to be good |
| The Company’s operations depend in part on its ability to attract quality employees |
| While the Company believes that its wage and salary rates are competitive and that its relationship with its labor force is good, a significant increase in the wages and salaries paid by competing employers could result in a reduction of the Company’s labor force, increases in the wage and salary rates paid by the Company or both |
| If either of these events were to occur, in the near-term, the profits realized by the Company from work in progress would be reduced and, in the long-term, the production capacity and profitability of the Company could be diminished and the growth potential of the Company could be impaired |
| See “Item 1A Risk Factors—Loss of our key management or other personnel could adversely impact our business |
| ” Governmental Regulations Many aspects of the Company’s operations are affected by political developments and are subject to both domestic and foreign governmental regulations, including those relating to oilfield operations, worker safety and the protection of the environment |
| In addition, the Company depends on the demand for its services from the oil and gas industry and, therefore, is affected by changing taxes, price controls and other laws and regulations relating to the oil and gas industry generally, including those specifically directed to offshore operations |
| The adoption of laws and regulations curtailing 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 the Company’s products |
| See “Item 1A Risk Factors—Our operations and our customers’ operations are subject to a variety of governmental laws and regulations that may increase our costs, limit the demand for our products and services or restrict our operations |
| ” In recent years, increased concern has been raised over the protection of the environment |
| Offshore drilling in certain areas has been opposed by environmental groups and, in certain areas, has been restricted |
| To the extent that 10 ______________________________________________________________________ [38]Table of Contents new laws or other governmental actions prohibit or restrict offshore drilling or impose additional environmental protection requirements that result in increased costs to the oil and gas industry in general and the offshore drilling industry in particular, the business of the Company could be adversely affected |
| The Company cannot determine to what extent its future operations and earnings may be affected by new legislation, new regulations or changes in existing regulations |
| See “Item 1A Risk Factors—Our business and our customers’ businesses are subject to environmental laws and regulations that may increase our costs, limit the demand for our products and services or restrict our operations |
| ” Based on the Company’s experience to date, the Company does not currently anticipate any material adverse effect on its business or consolidated financial position as a result of future compliance with existing environmental laws and regulations controlling the discharge of materials into the environment |
| However, future events, such as changes in existing laws and regulations or their interpretation, more vigorous enforcement policies of regulatory agencies, or stricter or different interpretations of existing laws and regulations, may require additional expenditures by the Company, which may be material |
| Item 1A Risk Factors In this Item 1A, the terms “we,” “our,” “us,” and “Dril-Quip” used herein refer to Dril-Quip, Inc |
| and its subsidiaries unless otherwise indicated or as the context so requires |
| Our principal stockholders have the ability to significantly influence our management and affairs and matters on which shareholders may vote |
| Our principal stockholders, Larry E Reimert, Gary D Smith and J Mike Walker and certain entities they control, beneficially own approximately 43prca of our common stock and are able to exert significant control over us |
| Reimert, Smith and Walker and certain entities they control are parties to a stockholders agreement pursuant to which each party has agreed to vote the shares of our common stock held by such party to elect to our board of directors one designee of Mr |
| Reimert, Smith and Walker are able to significantly influence all matters affecting us |
| In addition, such ownership may have the effect of delaying or preventing a change of control |
| Our principal stockholders are generally not prohibited from selling their interest in us to a third party |
| The rights and obligations of each of Messrs |
| Reimert, Smith and Walker and their related parties under the stockholders agreement terminate if they or their permitted transferees cease to own more than 10prca of the total number of issued and outstanding shares of our common stock |
| A material or extended decline in expenditures by the oil and gas industry could significantly reduce our revenue and income |
| Our business depends upon 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 offshore |
| The level of capital expenditures is generally dependent on the prevailing view of future oil and gas prices, which are influenced by numerous factors affecting the supply and demand for oil and gas, including: • worldwide economic activity; • the level of exploration and production activity; • interest rates and the cost of capital; • environmental regulation; • federal, state and foreign policies regarding exploration and development of oil and gas; • the ability of the Organization of Petroleum Exporting Countries to set and maintain production levels and pricing; 11 ______________________________________________________________________ [39]Table of Contents • the cost of exploring for and producing oil and gas; • the cost of developing alternative energy sources; • the sale and expiration dates of offshore leases in the United States and overseas; • the discovery rate of new oil and gas reserves in offshore areas; • technological advances; and • weather conditions |
| Oil and gas prices and the level of offshore drilling and production activity have been characterized by significant volatility in recent years |
| Worldwide military, political and economic events have contributed to oil and natural gas price volatility and are likely to continue to do so in the future |
| Although hydrocarbon prices have improved in recent years and the level of offshore exploration, drilling and production activity has increased, we cannot assure you that such price and activity levels will be sustained and that there will not be continued volatility in the level of drilling and production related activities |
| Even during periods of high prices for oil and natural gas, companies exploring for oil and gas may cancel or curtail programs, or reduce their levels of capital expenditures for exploration and production for a variety of reasons |
| In addition, a significant and prolonged decline in hydrocarbon prices would likely have a material adverse effect on our results of operations |
| 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 operations or financial condition |
| We have substantial international operations, with approximately 62prca, 64prca and 66prca, respectively, of our revenues derived from foreign sales in each of 2003, 2004 and 2005 |
| We operate our business and market our products and services in all of the significant oil and gas producing areas in the world and are, therefore, subject to the risks customarily attendant to international operations and investments in foreign countries |
| Risks associated with our international operations include: • volatility in general economic, social and political conditions; • terrorist acts, war and civil disturbances; • expropriation or nationalization of assets; • renegotiation or nullification of existing contracts; • foreign taxation, including changes in law or interpretation of existing law; • assaults on property or personnel; • restrictive action by local governments; • foreign and domestic monetary policies; • limitations on repatriation of earnings; • travel limitations or operational problems caused by public health threats; and • changes in currency exchange rates |
| Any of these risks could have an adverse effect on our ability to manufacture products abroad or the demand for our products and services in some locations |
| To date, we have 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 our international operations could have a material adverse effect on our overall operations |
| 12 ______________________________________________________________________ [40]Table of Contents We are subject to taxation in many jurisdictions and there are inherent uncertainties in the final determination of our tax liabilities |
| As a result of our international operations, we are subject to taxation in many jurisdictions |
| Therefore, the final determination of our tax liabilities involves the interpretation of the statutes and requirements of taxing authorities worldwide |
| Foreign income tax returns of foreign subsidiaries, unconsolidated affiliates and related entities are routinely examined by foreign tax authorities |
| These tax examinations may result in assessments of additional taxes or penalties or both |
| We may suffer losses as a result of foreign currency fluctuations and limitations on the ability to repatriate income or capital to the US We conduct a portion of our business in currencies other than the United States dollar, and our operations are subject to fluctuations in foreign currency exchange rates |
| We cannot assure you that we will be able to protect the company against such fluctuations in the future |
| Historically, we have not conducted business in countries that limit repatriation of earnings |
| However, as we expand our international operations, we may begin operating in countries that have such limitations |
| Further, we cannot assure you that the countries in which we currently operate will not adopt policies limiting repatriation of earnings in the future |
| Our business involves numerous operating hazards that may not be covered by insurance |
| The occurrence of an event not fully covered by insurance could have a material adverse effect on our financial conditions and results of operations |
| Our products are used in potentially hazardous drilling, completion and production applications that can cause personal injury, product liability and environmental claims |
| A catastrophic occurrence at a location where our equipment and/or services are used may expose us to substantial liability for personal injury, wrongful death, product liability or commercial claims |
| Such insurance does not, however, provide coverage for all liabilities, and we cannot assure you that our insurance coverage will be adequate to cover claims that may arise or that we will be able to maintain adequate insurance at rates we consider reasonable |
| The occurrence of an event not fully covered by insurance could have a material adverse effect on our financial condition and results of operations |
| A portion of our business consists of designing, manufacturing, selling and installing equipment for major projects pursuant to competitive bids, and is performed on a fixed-price basis |
| Under these contracts, we are typically responsible for all cost overruns, other than the amount of any cost overruns resulting from requested changes in order specifications |
| Our actual costs and any gross profit realized on these fixed-price contracts will often vary from the estimated amounts on which these contracts were originally based |
| This may occur for various reasons, including: • errors in estimates or bidding; • changes in availability and cost of labor and materials; and • variations in productivity from our original estimates |
| These variations and the risks inherent in our projects may result in reduced profitability or losses on projects |
| Depending on the size of a project, variations from estimated contract performance could have a significant impact on our operating results |
| 13 ______________________________________________________________________ [41]Table of Contents Our business could be adversely affected if we do not develop new products and secure and retain patents related to our products |
| Technology is an important component of our business and growth strategy, and our success as a company depends to a significant extent on the development and implementation of new product designs and improvements |
| Whether we can continue to develop systems and services and related technologies to meet evolving industry requirements and, if so, at prices acceptable to our customers will be significant factors in determining our ability to compete in the industry in which we operate |
| Many of our competitors are large multinational companies that may have significantly greater financial resources than we have, and they may be able to devote greater resources to research and development of new systems, services and technologies than we are able to do |
| Our ability to compete effectively will also depend on our ability to continue to obtain patents on our proprietary technology and products |
| As of December 31, 2005 we held 75 US patents and 133 foreign patents |
| Although we do not consider any single patent to be material to our business as a whole, the inability to protect our future innovations through patents could have a material adverse effect |
| We may be required to recognize a charge against current earnings because of percentage-of-completion accounting |
| Some of our revenues are earned on a percentage-of-completion basis generally based on the ratio of costs incurred to the total estimated costs |
| Accordingly, purchase order price and cost estimates are reviewed periodically as the work progresses, and adjustments proportionate to the percentage of completion are reflected in the period when such estimates are revised |
| To the extent that these adjustments result in a reduction or elimination of previously reported profits, we would have to recognize a charge against current earnings, which could be significant depending on the size of the project or the adjustment |
| Loss of our key management or other personnel could adversely impact our business |
| We depend on the services of our executive management team, Larry E Reimert, Gary D Smith and J Mike Walker |
| The loss of any of these officers could have a material adverse effect on our operations and financial condition |
| In addition, competition for skilled machinists, fabricators and technical personnel among companies that rely heavily on engineering and technology is intense, and the loss of qualified employees or an inability to attract, retain and motivate additional highly skilled employees required for the operation and expansion of our business could hinder our ability to conduct research activities successfully and develop and produce marketable products and services |
| While we believe that our wage rates are competitive and that our relationship with our skilled labor force is good, a significant increase in the wages paid by competing employers could result in a reduction of our skilled labor force, increases in the wage rates paid by us or both |
| If either of these events were to occur, in the near-term, the profits realized by us from work in progress would be reduced and, in the long-term, our production capacity and profitability could be diminished and our growth potential could be impaired |
| Our operations and our customers’ operations are subject to a variety of governmental laws and regulations that may increase our costs, limit the demand for our products and services or restrict our operations |
| Our business and our customers’ businesses may be significantly affected by: • federal, state and local and foreign laws and other regulations relating to the oilfield operations, worker safety and the protection of the environment; • changes in these laws and regulations; and • the level of enforcement of these laws and regulations |
| In addition, we depend on the demand for our products and services from the oil and gas industry |
| This demand is affected by changing taxes, price controls and other laws and regulations relating to the oil and gas industry 14 ______________________________________________________________________ [42]Table of Contents generally, including those specifically directed to offshore operations |
| For example, the adoption of laws and regulations curtailing exploration and development drilling for oil and gas for economic or other policy reasons could adversely affect our operations by limiting demand for our products |
| We cannot determine the extent to which our future operations and earnings may be affected by new legislation, new regulations or changes in existing regulations |
| Because of our foreign operations and sales, we are also subject to changes in foreign laws and regulations that may encourage or require hiring of local contractors or require foreign contractors to employ citizens of, or purchase supplies from, a particular jurisdiction |
| If we fail to comply with any applicable law or regulation, our business, results of operations or financial condition may be adversely affected |
| Our businesses and our customers’ businesses are subject to environmental laws and regulations that may increase our costs, limit the demand for our products and services or restrict our operations |
| Our operations and the operations of our customers are also subject to federal, state and local and foreign laws and regulations relating to the protection of the environment |
| These environmental laws and regulations affect the products and services we design, market and sell, as well as the facilities where we manufacture our products |
| In addition, environmental laws and regulations could limit our customers’ exploration and production activities |
| We are required to invest financial and managerial resources to comply with environmental laws and regulations and anticipate that we will continue to be required to do so in the future |
| These laws and regulations change frequently, which makes it impossible for us to predict their cost or impact on our future operations |
| The modification of existing laws or regulations or the adoption of new laws or regulations imposing more stringent environmental restrictions could adversely affect our operations |
| These laws may provide for “strict liability” for damages to natural resources or threats to public health and safety, rendering a party liable for environmental damage without regard to negligence or fault on the part of such party |
| Sanctions for noncompliance may include revocation of permits, corrective action orders, administrative or civil penalties, and criminal prosecution |
| Some environmental laws and regulations provide for joint and several strict liability for remediation of spills and releases of hazardous substances |
| In addition, we may be subject to claims alleging personal injury or property damage as a result of alleged exposure to hazardous substances, as well as damage to natural resources |
| These laws and regulations also may expose us to liability for the conduct of or conditions caused by others, or for our acts-that were in compliance with all applicable laws and regulations at the time such acts were performed |
| Any of these laws and regulations could result in claims, fines or expenditures that could be material to our earnings, financial condition or cash flow |
| We may be unable to successfully compete with other manufacturers of drilling and production equipment |
| Several of our primary competitors are diversified multinational companies with substantially larger operating staffs and greater capital resources than ours and which have been engaged in the manufacturing business for a much longer time than us |
| If these competitors substantially increase the resources they devote to developing and marketing competitive products and services, we may not be able to compete effectively |
| Similarly, consolidation among our competitors could enhance their product and service offerings and financial resources, further intensifying competition |
| The loss of a significant customer could have an adverse impact on our financial results |
| Our principal customers are major integrated oil and gas companies, large independent oil and gas companies and foreign national oil and gas companies |
| Offshore drilling contractors and engineering and construction companies also represent a portion of our customer base |
| In 2004, our top 15 customers represented approximately 61prca of total revenues, with ConocoPhillips accounting for approximately 15prca of our total revenues |
| In 2005, our top 15 customers represented approximately 62prca of total revenues, with no customers accounting for more than 10prca of our total revenues |
| While we are not dependent on any one customer or group of customers, the loss of one or more of our significant customers could, at least on a short-term basis, have an adverse effect on our results of operations |
| 15 ______________________________________________________________________ [43]Table of Contents Our customers’ industries are undergoing continuing consolidation that may impact our results of operations |
| The oil and gas industry is rapidly consolidating and, as a result, some of our largest customers have consolidated and are using their size and purchasing power to seek economies of scale and pricing concessions |
| This consolidation may result in reduced capital spending by some of our customers or the acquisition of one or more of our primary customers, which may lead to decreased demand for our products and services |
| We cannot assure you that we will be able to maintain our level of sales to a customer that has consolidated or replace that revenue with increased business activity with other customers |
| As a result, the acquisition of one or more of our primary customers may have a significant negative impact on our results of operations or our financial condition |
| We are unable to predict what effect consolidations in the industry may have on price, capital spending by our customers, our selling strategies, our competitive position, our ability to retain customers or our ability to negotiate favorable agreements with our customers |
| Increases in the cost of raw materials and energy used in our manufacturing processes could negatively impact our profitability |
| During 2004 and 2005, commodity prices for items such as nickel, molybdenum and heavy metal scrap that are used to make the steel alloys required for our products increased significantly, resulting in an increase in our raw material costs |
| Similarly, energy costs to produce our products have increased significantly |
| If we are not successful in raising our prices on products, our margins will be negatively impacted |
| We depend on third party suppliers for timely deliveries of raw materials, and our results of operations could be adversely affected if we are unable to obtain adequate supplies in a timely manner |
| Our manufacturing operations depend upon obtaining adequate supplies of raw materials from third parties |
| The ability of these third parties to deliver raw materials may be affected by events beyond our control |
| Any interruption in the supply of raw materials needed to manufacture our products could adversely affect our business, results of operations and reputation with our customers |
| Our shares that are eligible for future sale may have an adverse effect on the price of our common stock |
| Future sales of substantial amounts of our common stock, or a perception that such sales could occur, could adversely affect the market price of our common stock and could impair our ability to raise capital through the sale of our equity securities |
| This risk is compounded by the fact that a substantial portion of our common stock is owned by Messrs |
| Reimert, Smith and Walker and certain entities they control have piggyback and demand registration rights that provide for the registration of the resale of shares at our expense which will allow those shares to be sold in the public market generally without restriction |
| The market price of our common stock is volatile |
| The trading price of our common stock and the price at which we may sell common stock in the future are subject to large fluctuations in response to any of the following: • limited trading volume in our common stock; • quarterly variations in operating results; • general financial market conditions; • the prices of natural gas and oil; • announcements by us and our competitors; • our liquidity; 16 ______________________________________________________________________ [44]Table of Contents • changes in government regulations; • our ability to raise additional funds; • our involvement in litigation; and • other events |
| We do not anticipate paying dividends on our common stock in the near future |
| We have not paid any dividends in the past and do not intend to pay cash dividends on our common stock in the foreseeable future |
| Our board of directors reviews this policy on a regular basis in light of our earnings, financial condition and market opportunities |
| We currently intend to retain any earnings for the future operation and development of our business |