Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended September 30, 2009

or

 

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

For the transition period from              to             

Commission File Number: 1-13270

 

 

FLOTEK INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   90-0023731

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

2930 W. Sam Houston Pkwy N., Houston, Texas   77043
(Address of principal executive offices)   (Zip Code)

(713) 849-9911

(Registrant’s telephone number, including area code)

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ¨     No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.:

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x

There were 23,437,714 shares of the issuer’s common stock, $.0001 par value, outstanding as of October 30, 2009.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

   1

Item 1. Financial Statements

   1

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   19

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   28

Item 4. Controls and Procedures

   28

PART II – OTHER INFORMATION

   30

Item 1. Legal Proceedings

   30

Item 1A. Risk Factors

   30

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

   31

Item 3. Default Upon Senior Securities

   31

Item 4. Submission of Matters to Vote of Security Holders

   31

Item 5. Other Information

   32

Item 6. Exhibits

   32

SIGNATURES

   33

 

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PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements.

FLOTEK INDUSTRIES, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(in millions, except share data)

 

     September 30,
2009
    December 31,
2008
 
     (Unaudited)        
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 0.6      $ 0.2   

Accounts receivable, net of allowance for doubtful accounts of $0.7 million and $1.5 million, respectively

     15.9        37.2   

Inventories, net

     29.2        38.0   

Deferred tax asset, current

     —          0.9   

Income tax receivable

     4.4        —     

Other current assets

     1.4        1.3   
                

Total current assets

     51.5        77.6   

Property, plant and equipment, net

     62.4        66.8   

Goodwill

     27.0        45.5   

Intangible assets, net

     35.8        38.0   

Deferred tax assets, less current portion

     —          6.6   
                

TOTAL ASSETS

   $ 176.7      $ 234.5   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 7.9      $ 22.7   

Accrued liabilities

     6.1        13.5   

Accrued interest payable

     1.2        2.4   

Income taxes payable

     —          0.9   

Current portion of long-term debt

     26.0        9.0   
                

Total current liabilities

     41.2        48.5   

Long-term debt, less current portion

     0.3        29.5   

Convertible senior notes, net of discount of $20.6 million and $24.2 million at September 30, 2009 and December 31, 2008, respectively

     94.4        90.8   

Deferred tax liability, less current portion

     2.7        —     
                

Total liabilities

     138.6        168.8   
                

Commitments and contingencies

    

Stockholders’ equity:

    

Cumulative convertible preferred stock, $0.0001 par value, 100,000 shares authorized, 16,000 issued and outstanding at September 30, 2009, net of discount

     6.1        —     

Common stock, $0.0001 par value; 40,000,000 shares authorized; September 30, 2009 shares issued: 23,697,430; outstanding: 22,914,532; December 31, 2008 shares issued: 23,174,286; outstanding: 22,782,091

     —          —     

Additional paid-in capital

     88.0        76.8   

Accumulated other comprehensive income

     0.1        0.1   

Accumulated deficit

     (55.6     (10.7

Treasury stock: 259,716 shares and 158,697 shares at September 30, 2009 and December 31,2008, respectively

     (0.5     (0.5
                

Total stockholders’ equity

     38.1        65.7   
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 176.7      $ 234.5   
                

See notes to consolidated condensed financial statements.

 

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FLOTEK INDUSTRIES, INC.

CONSOLIDATED CONDENSED STATEMENTS OF INCOME (LOSS)

(UNAUDITED)

(in millions, except share and per share data)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Revenue

   $ 23.8      $ 62.8      $ 88.0      $ 166.1   

Cost of revenue

     17.5        36.2        65.5        95.9   

Expenses:

        

Impairment of goodwill

     —          —          18.5        —     

Selling, general and administrative

     7.2        12.4        26.6        34.3   

Depreciation and amortization

     1.2        1.6        3.7        4.2   

Research and development

     0.4        0.4        1.2        1.3   
                                

Total expenses

     8.8        14.4        50.0        39.8   
                                

Income (loss) from operations

     (2.5     12.2        (27.5     30.4   

Other expense:

        

Interest expense

     (4.1     (3.9     (11.6     (9.7

Investment income and other, net

     0.1        —          (0.1     —     
                                

Total other expense

     (4.0     (3.9     (11.7     (9.7

Income (loss) before income taxes

     (6.5     8.3        (39.2     20.7   

Provision for income taxes

     (15.8     (3.2     (4.9     (7.9
                                

Net income (loss)

     (22.3     5.1        (44.1     12.8   

Accrued dividends and accretion of discount on preferred stock

     (0.8     —          (0.8     —     
                                

Net income (loss) allocable to common stockholders

   $ (23.1   $ 5.1      $ (44.9   $ 12.8   
                                

Earnings (loss) per share allocable to common stockholders:

        

Basic

   $ (1.18   $ 0.27      $ (2.29   $ 0.68   

Diluted

   $ (1.18   $ 0.27      $ (2.29   $ 0.66   

Weighted average common shares used in computing basic earnings per common share (in thousands)

     19,645        18,972        19,578        18,832   

Incremental common shares from stock options, warrants and restricted stock (in thousands)

     —          429        —          514   
                                

Weighted average common shares used in computing diluted earnings per common share (in thousands)

     19,645        19,401        19,578        19,346   
                                

See notes to consolidated condensed financial statements.

 

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FLOTEK INDUSTRIES, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(in millions)

 

     Nine Months Ended
September 30,
 
     2009     2008  

Cash flows from operating activities:

    

Net income (loss) allocable to common stockholders

   $ (44.9   $ 12.8   

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

    

Depreciation and amortization

     10.5        9.4   

Amortization of deferred financing costs

     1.1        0.7   

Accretion of debt discount

     3.6        2.5   

Accretion of discount on preferred stock

     0.5        —     

Impairment of goodwill

     18.5        —     

Stock compensation expense

     1.3        2.1   

Deferred tax expense

     11.0        —     

Changes in working capital and other

     0.5        (4.1
                

Net cash provided by operating activities

     2.1        23.4   
                

Cash flows from investing activities:

    

Acquisitions, net of cash acquired

     —          (98.0

Proceeds from sale of assets

     2.1        1.1   

Capital expenditures

     (5.6     (16.6
                

Net cash used in investing activities

     (3.5     (113.5
                

Cash flows from financing activities:

    

Proceeds from exercise of stock options

     —          0.9   

Purchase of treasury stock

     —          (0.3

Proceeds from borrowings

     12.6        46.7   

Proceeds from convertible debt offering

     —          115.0   

Debt issuance cost

     (0.8     (5.5

Repayments of indebtedness

     (24.8     (66.2

Proceeds from preferred stock offering

     16.0        —     

Excess tax benefit of share based awards

     —          1.5   

Preferred stock issuance cost

     (1.2     —     
                

Net cash provided by financing activities

     1.8        92.1   
                

Net increase in cash and cash equivalents

     0.4        2.0   

Cash and cash equivalents at beginning of period

     0.2        1.3   
                

Cash and cash equivalents at end of period

   $ 0.6      $ 3.3   
                

Supplemental disclosure of cash flow information:

    

Interest paid

   $ 5.2      $ 5.6   

Income taxes paid

   $ 3.4      $ 7.8   

See notes to consolidated condensed financial statements.

 

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FLOTEK INDUSTRIES, INC.

CONSOLIDATED CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

(Amounts subsequent to December 31, 2008 are Unaudited)

(in millions)

 

     Common Stock    Preferred Stock     Treasury Stock     Additional
Paid-in
Capital
    Accumulated
Other
Comprehensive
Income
   Accumulated
Deficit
    Total  
     Shares
Issued
   Par
Value
   Shares
Issued
   Value     Shares     Cost           

Balance December 31, 2008

   23.2    $ —      —      $ —        (0.2   $ (0.5   $ 76.8      $ 0.1    $ (10.7   $ 65.7   

Common stock issued

   0.5      —      —        —        —          —          —          —        —          —     

Issuance of preferred stock and detachable warrants

   —        —      —        10.8      —          —          5.2        —        —          16.0   

Issuance cost related to preferred stock

   —        —      —        —        —          —          (1.2     —        —          (1.2

Accretion of discount on preferred stock

   —        —      —        0.5      —          —          —          —        (0.5     —     

Preferred stock dividends

   —        —      —        —        —          —          —          —        (0.3     (0.3

Beneficial conversion discount on preferred stock

   —        —      —        (5.2   —          —          5.2        —        —          —     

Treasury stock purchased

   —        —      —        —        —          —          —          —        —          —     

Restricted stock forfeited

   —        —      —        —        —          —          —          —        —          —     

Tax benefit related to ASC 470

   —        —      —        —        —          —          0.7        —          0.7   

Stock compensation expense

   —        —      —        —        —          —          1.3        —          1.3   

Net loss

   —        —      —        —        —          —          —          —        (44.1     (44.1
                                                                      

Balance September 30, 2009

   23.7    $ —      —      $ 6.1      (0.2   $ (0.5   $ 88.0      $ 0.1    $ (55.6   $ 38.1   
                                                                      

See notes to consolidated condensed financial statements.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

Note 1 – Our Business, Recent Events and Basis of Presentation

Our Business

Flotek Industries, Inc. (“Flotek,” “Company,” “us” or “we”) is engaged in the manufacturing and marketing of innovative specialty chemicals and downhole drilling and production equipment, and in the management of automated bulk material handling, loading and blending facilities. Flotek serves major and independent companies in the domestic and international oilfield service and mining industries.

Recent Events

The challenging economic conditions facing the oil and gas industry have adversely affected our financial performance and liquidity in 2009. Revenue has declined significantly across all of our segments due to decreased demand for our products and services as natural gas prices and the number of well completions and rig count continues to be depressed. At September 30, 2009, we were not in compliance with certain financial covenants contained in the New Credit Agreement. We requested and obtained a waiver of these financial covenant violations from our lenders. However, we expect that we will not be able to meet certain of the financial covenants under the New Credit Agreement as of December 31, 2009, and possibly throughout 2010. As a result, we have reclassified amounts owing under the New Credit Agreement as current.

We believe that, assuming current revenue levels and cost structure, our current cash balance and estimated cash flows will be sufficient to satisfy our anticipated cash requirements at least through September 30, 2010. However, if we are not in compliance with the financial covenants in our New Credit Facility as of December 31, 2009, or subsequent periods, and we are unable to obtain waivers of those covenant violations, our lenders would be entitled to exercise their remedies under the New Credit Facility, which could include accelerating all amounts due under the New Credit Facility. We would not have sufficient funds to repay all such amounts, and would be required to seek additional financing, which we might not be able to obtain on terms favorable to us or at all. Acceleration of amounts under our New Credit Facility could also constitute a default under our Convertible Notes. The Company expects that it will need to renegotiate the New Credit Facility or refinance all or a portion of its indebtedness on or before maturity. While the Company believes that it can be successful in renegotiating or refinancing its indebtedness, there can be no assurance that it will be able to on attractive terms or at all. We are working to lower our working capital needs and have focused on cash collections of our accounts receivable balances and reduction of inventory. In the event capital required is greater than the amount we have available at the time, we would reduce the expected level of capital expenditures, sell assets and/or seek additional capital. Cash generated by future asset sales may depend on the overall economic conditions of the industries served by these assets, the condition and location of the assets, and the number of interested buyers. We cannot assure you that needed capital will be available on acceptable terms or at all. Our ability to raise funds in the capital markets through the issuance of additional indebtedness may be limited by covenants in our credit facilities, our credit rating and the willingness of banks and other financial services companies to lend. At September 30, 2009, our net worth was less than the $50 million required by the continued listing standard of the NYSE. We intend to submit a plan to the NYSE that will provide for us to come back into compliance with the NYSE’s continued listing standards, although the NYSE may not accept our plan or we may be unable to accomplish the actions set forth in that plan to come back into compliance with the NYSE’s continued listing standards over the time period allowed by the NYSE. If we are not able to generate positive cash flows and profits or obtain adequate additional financing or refinancing, we may be required to curtail operations or be unable to continue as a going concern. A number of factors could influence our liquidity sources, as well as the timing and ultimate outcome of our on-going efforts.

As a result, management determined the realization of deferred tax assets is uncertain as the Company is unable to consider tax planning strategies or projections of future taxable income in its evaluation of the realizability of its deferred tax assets as of September 30, 2009. Under these circumstances, deferred tax assets may only be realized through future reversals of taxable temporary differences and carryback of net operating losses to available carryback periods. We have performed such an analysis and a valuation allowance of approximately $16.8 million has been provided against deferred tax assets as of September 30, 2009.

Basis of Presentation

These consolidated condensed financial statements are unaudited but, in the opinion of management, reflect all adjustments necessary for a fair presentation of the results for the periods reported. All such adjustments are of a normal recurring nature unless disclosed otherwise. These Consolidated Condensed Financial Statements, including selected notes, have been prepared in accordance with the applicable rules of the Securities and Exchange Commission (“SEC”) and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. These interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our 2008 Annual Report on Form 10-K.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated condensed financial statements and accompanying notes. Actual results could differ from those estimates.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Certain amounts for the three and nine months ended September 30, 2008 have been reclassified in the accompanying consolidated condensed financial statements to conform to the current quarter presentation. In prior periods, we presented depreciation that related directly to the production of revenue as a component of depreciation and amortization within our Consolidated Condensed Statements of Income (Loss) rather than including the portion as a component of cost of revenue. During the three and nine months ended September 30, 2008 the amount of depreciation related to the production of revenue which we have reclassified to cost of revenue was $1.9 million and $5.2 million, respectively. Additionally, see Note 9 – Long-Term Debt for discussion on the retrospective adjustments to the December 31, 2008 Consolidated Condensed Balance Sheet and the Consolidated Condensed Statement of Income (Loss) for the three and nine months ended September 30, 2008 related to the accounting for certain debt instruments that may be settled into cash upon conversion, primarily codified in Accounting Standards Codification (“ASC”) Topic 470, “Debt.”

Note 2 – New Accounting Requirements and Disclosures

In June 2009, the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (“ASU”) 2009-01, Topic No. 105 (ASU Topic 105), “ Generally Accepted Accounting Principles ” which replaced FASB Statement No. 168, “ The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles ” (“Codification”) and identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with US GAAP in the United States. Authoritative standards included in the Codification are designated by their ASC topical reference, with new standards designated as ASUs, with a year and assigned sequence number. The guidance is effective for financial statement issued for interim and annual periods ending after September 15, 2009. The Company adopted this standard for its September 30, 2009 interim report with no financial impact on its consolidated condensed financial statements.

In June 2009, the FASB issued accounting guidance related to accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing found primarily within ASC Topic 470, “Debt.” In October 2009, the FASB released ASU No. 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” which amends or added certain paragraphs to the related ASC Topic of “Debt.” These standards address the accounting for an entity’s own-share lending arrangement initiated in conjunction with convertible debt or other financing offering and the effect a share-lending arrangement has on earnings per share. Additionally, the guidance addresses the accounting and earnings per share implications for defaults by the share borrower, both when a default becomes probable of occurring and when a default actually occurs. This guidance released in June 2009 is effective for interim or annual periods beginning on or after June 15, 2009 for share-lending arrangements entered into in those periods. For all other arrangements within the scope, the guidance is applied retrospectively to share-lending arrangements that are outstanding as of the beginning of the fiscal year beginning on or after December 15, 2009. Early adoption is prohibited. Update guidance released in October 2009 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The update guidance is effective for all arrangements entered into on or before the beginning of the first reporting period that begins on or is after June 15, 2009. Update content shall be applied retrospectively for all arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company is currently evaluating the effect this will have on our consolidated condensed financial statements.

In May 2009, the FASB issued accounting guidance related to subsequent events found within ASC Topic 855, “Subsequent Events.” This guidance sets standards for the disclosure of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued. Additionally, the guidance sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. This guidance is effective for interim and annual periods ending after June 15, 2009. The Company adopted this guidance effective June 30, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In April 2009, the FASB issued accounting guidance related to interim disclosures about fair value of financial instruments found within ASC Topic 825, “Financial Instruments.” This guidance requires fair value disclosures in both interim as well as annual financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. This guidance is effective for interim and annual periods ending after June 15, 2009. The Company adopted this guidance effective June 30, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In June 2008, the FASB issued accounting guidance related to determining whether instruments granted in share-based payment transactions are participating securities found within ASC Topic 260, “Earnings Per Share (EPS).” This guidance states that unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. The Company adopted the guidance effective January 1, 2009. All prior period earnings per share (“EPS”) data presented has been adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this accounting guidance. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In May 2008, the FASB issued accounting guidance related to debt with conversion and other options found primarily within ASC Topic 470, “Debt,” ASC Topic 815, “Derivatives and Hedging” and ASC Topic 825, “Financial Instruments.” This guidance clarifies that convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate. The resulting debt discount would be amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. The guidance requires retrospective application to all periods presented in the financial statements with cumulative effect of the change reported in retained earnings as of the beginning of the first period presented. Our 5.25% Convertible Senior Notes due February 2028 (“Convertible Senior Notes”) are affected by this new standard. Upon adopting the provisions of this guidance, we retroactively applied its provisions and restated our Consolidated Condensed Financial Statements for prior periods. In applying this debt guidance, $27.8 million of the carrying value of our Convertible Senior Notes was reclassified to equity as of the February 2008 issuance date and offset by a related deferred tax liability of $10.6 million. This discount represents the equity component of the proceeds from the Convertible Senior Notes, calculated assuming an 11.5% non-convertible borrowing rate. The discount will be accreted to interest expense over the expected term of five years, which is based on the call/put option on the debt at February 2013. Accordingly, $1.2 million and $1.1 million of additional non-cash interest expense was recorded in the Consolidated Condensed Statement of Income (Loss) for the three months ended September 30, 2009 and 2008, respectively, and $3.5 million and $2.4 million of additional non-cash interest expense was recorded in the Consolidated Condensed Statement of Income (Loss) for the nine months ended September 30, 2009 and 2008, respectively.

In March 2008, the FASB issued accounting guidance related to derivative and hedging activities found within the ASC Topic 815, “Derivatives and Hedging.” This guidance requires enhanced disclosures about our derivative and hedging activities. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company adopted the guidance effective January 1, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

Note 3 – Acquisitions

In December 2007, the FASB issued accounting standards related to business combinations found within the ASC Topic 805, “Business Combinations.” This guidance requires use of the acquisition method of accounting, defines the acquirer, establishes the acquisition date and broadens the scope to all transactions and other events in which one entity obtains control over one or more other businesses. This guidance is effective for financial statements issued for fiscal years beginning on or after December 15, 2008 with earlier adoption prohibited. The Company has not acquired any companies since adopting this guidance or which would be applicable under this guidance. Additionally, the Company had no deferred acquisition costs capitalized on its balance sheet as of December 31, 2008 related to unconsummated acquisitions.

Acquisitions have been accounted for using the purchase method of accounting under grandfathered guidance as noted in ASU Topic 105, “Generally Accepted Accounting Principles,” related to accounting for business combinations. The acquired companies’ results have been included in the accompanying financial statements from their respective dates of acquisition. Allocation of the purchase price for acquisitions was based on estimates of fair value of the net assets acquired and is subject to adjustment upon finalization of the purchase price allocation within the one year anniversary of the acquisition.

On February 14, 2008, Teledrift Acquisition, Inc., a wholly-owned subsidiary of the Company, acquired substantially all of the assets of Teledrift, Inc. (“Teledrift”) for the aggregate cash purchase price of approximately $98.0 million, which includes a purchase price adjustment of $1.8 million recorded in the third quarter of 2008. Teledrift designs and manufactures wireless survey and measurement while drilling, or MWD, tools. The Company used the majority of the proceeds from issuance of the Convertible Senior Notes to fund this acquisition.

The following unaudited pro forma consolidated table presents information related to the Teledrift acquisition for the nine month period ended September 30, 2008 and assumes the acquisitions had been completed as of January 1, 2008 (in millions, except per share data):

 

     Nine Months
Ended
September 30,
2008

Revenue

   $ 168.0

Income before income taxes

     24.0

Net income

     14.9

Basic earnings per common share

   $ 0.78

Diluted earnings per common share

     0.76

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Note 4 – Revenue

The Company generates revenue through three main sales channels: Products, Rentals and Services. In most instances, we generate revenue through these channels on an integrated basis. Sales channel information is set out in the table below:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     (Unaudited)
     (in millions)

Revenue

           

Product

   $ 15.1    $ 42.0    $ 56.6    $ 109.5

Rental

     6.3      14.9      22.3      41.3

Service

     2.4      5.9      9.1      15.3
                           
   $ 23.8    $ 62.8    $ 88.0    $ 166.1
                           

Cost of revenue

           

Product

   $ 9.8    $ 23.6    $ 39.5    $ 64.2

Rental

     3.8      7.3      13.4      18.0

Service

     1.6      3.4      5.8      8.5

Depreciation

     2.3      1.9      6.8      5.2
                           
   $ 17.5    $ 36.2    $ 65.5    $ 95.9
                           

Within the Drilling Products segment amounts billed to customers for the cost of oilfield rental equipment that is damaged or lost-in-hole are reflected as rental revenue with the carrying value of the related equipment charged to cost of revenue. The revenue for lost-in-hole totaled $0.8 million and $0.9 million for the three months ended September 30, 2009 and 2008, respectively, and $2.4 million and $1.9 million for the nine months ended September 30, 2009 and 2008, respectively.

Note 5 – Inventories

The components of inventories as of September 30, 2009 and December 31, 2008 were as follows:

 

     September 30,
2009
    December 31,
2008
 
     (unaudited)        
     (in millions)  

Raw materials

   $ 9.3      $ 16.2   

Work-in-process

     1.2        1.9   

Finished goods (includes in-transit)

     23.0        22.3   
                

Gross inventories

     33.5        40.4   

Less: slow-moving and obsolescence reserve

     (4.3     (2.4
                

Inventories, net

   $ 29.2      $ 38.0   
                

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Note 6 – Property, Plant and Equipment

As of September 30, 2009 and December 31, 2008, property, plant and equipment comprised the following:

 

     September 30,
2009
    December 31,
2008
 
     (unaudited)        
     (in millions)  

Land

   $ 1.3      $ 1.3   

Buildings and leasehold improvements

     19.5        16.3   

Machinery and equipment

     10.8        8.8   

Rental tools

     50.9        47.1   

Equipment in progress

     0.1        5.5   

Furniture and fixtures

     1.3        1.2   

Transportation equipment

     4.3        4.9   

Computer equipment

     1.7        1.3   
                

Total property, plant and equipment

     89.9        86.4   

Less: accumulated depreciation

     (27.5     (19.6
                

Property, plant and equipment, net

   $ 62.4      $ 66.8   
                

Depreciation expense for the three months ended September 30, 2009 and 2008 was $2.9 million and $3.0 million, respectively, and for nine months ended September 30, 2009 and 2008 was $8.6 million and $7.0 million, respectively. Depreciation expense that directly relates to activities that generate revenue amounted to $2.3 million and $1.9 million for the three months ended September 30, 2009 and 2008, respectively, and $6.8 million and $5.2 million for the nine months ended September 30, 2009 and 2008, respectively. These amounts are recorded within cost of revenue in our Consolidated Condensed Statements of Income (Loss).

Note 7 – Goodwill

We evaluate the carrying value of goodwill during the fourth quarter of each year and on an interim basis if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Such circumstances could include, but are not limited to: (i) a significant adverse change in legal factors or in business climate, (ii) unanticipated competition, or (iii) an adverse action or assessment by a regulator. When evaluating whether goodwill is impaired, the Company compares the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying amount, including goodwill. The fair value of the reporting unit is estimated using a combination of the income, or discounted cash flows approach and the market approach, which utilizes comparable companies’ data. If the carrying amount of a reporting unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss is calculated by comparing the implied fair value of reporting unit goodwill to its carrying amount. In calculating the implied fair value of reporting unit’s goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. An impairment loss would be recognized when the carrying amount of goodwill exceeds its implied fair value.

The analysis conducted on the intangible assets of both the Teledrift and Chemical and Logistics reporting units did not result in any impairment as the calculated fair value of these assets exceeded their book value. Our recoverability assessment of these intangible assets considered company-specific projections, assumptions about market participant views and the Company’s overall market capitalization as of the testing date. Although certain factors surrounding market and industry risk rates utilized in the Company’s assessment decreased during the third quarter, the Company’s third quarter results of its Teledrift business continued to fluctuate, which negatively impacted the Company’s discounted cash flow forecast utilized in its impairment assessment compared to amounts used for the 2008 evaluations.

Due to the continued macro-economic conditions affecting the oil and gas industry and the financial performance of all of our reporting units, management tested for evidence of impairment in the second and again in the third quarter of 2009. The assessment for impairment focused mainly on the Teledrift and Chemical and Logistics reporting units as these are the only reporting units with material amounts of goodwill and other intangible assets. Based upon these evaluations, we recorded an impairment charge of approximately $18.5 million primarily related the Teledrift reporting unit in the second quarter of 2009. No additional impairment charge was required in the third quarter of 2009. The impairment analysis for the Chemical and Logistics reporting unit did not result in any impairment.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes the changes in our recorded goodwill by reporting units from December 31, 2007 through September 30, 2009:

 

     Reporting Units     Total  
     Chemical
and
Logistics
   Artificial
Lift
    Teledrift     Remaining
Drilling
Products
segment
   
     (in millions)        

Goodwill

    

December 31, 2007

   $ 11.6    $ 5.9      $ —        $ 43.0      $ 60.5   

Acquisition

     —        —          46.5        —          46.5   

Impairment

     —        (5.9     (12.6     (43.0     (61.5
                                       

December 31, 2008

   $ 11.6    $ —        $ 33.9      $ —        $ 45.5   

Impairment

     —        —          (18.5     —          (18.5
                                       

September 30, 2009

   $ 11.6    $ —        $ 15.4      $ —        $ 27.0   
                                       

Note 8 – Intangible Assets

The components of intangible assets at September 30, 2009 and December 31, 2008 are as follows:

 

     September 30,
2009
    December 31,
2008
 
     (unaudited)        
     (in millions)  

Patents

   $ 6.4      $ 6.3   

Customer lists

     28.6        28.6   

Non-compete

     1.7        1.7   

Brand name

     6.2        6.2   

Supply contract

     1.7        1.7   

Other

     0.4        0.5   

Accumulated amortization

     (13.4     (11.5
                

Total

     31.6        33.5   

Deferred financing costs

     6.4        5.6   

Accumulated amortization

     (2.2     (1.1
                

Net deferred financing costs

     4.2        4.5   
                

Intangible assets, net

   $ 35.8      $ 38.0   
                

Intangible and other assets are being amortized on a straight-line basis ranging from two to 20 years. The Company recorded amortization expense related to our intangible assets in depreciation and amortization in our Consolidated Condensed Statement of Income (Loss) of $0.6 million and $0.5 million for the three months ended September 30, 2009 and 2008, respectively, and $1.9 million and $2.4 million for the nine months ended September 30, 2009 and 2008, respectively.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Note 9 – Long-Term Debt

Long-term debt at September 30, 2009 and December 31, 2008 consisted of the following:

 

     September 30,
2009
    December 31,
2008
 
     (unaudited)        
     (in millions)  

Convertible Senior Notes

   $ 115.0      $ 115.0   

Discount on Convertible Senior Notes

     (20.6     (24.2
                

Convertible Senior Notes, net of discount

   $ 94.4      $ 90.8   
                

Long-term debt:

    

Senior credit facility

    

Equipment term loans

   $ 23.2      $ 34.0   

Real estate term loans

     0.7        0.8   

Revolving line of credit

     1.7        2.3   

Promissory note to stockholders of acquired business, maturing December 2009

     0.2        0.5   

Other

     0.5        0.9   
                

Total

     26.3        38.5   

Less: current portion

     (26.0     (9.0
                

Long-term debt, less current portion

   $ 0.3      $ 29.5   
                

Convertible Senior Notes

On February 11, 2008, the Company entered into an underwriting agreement (“Convertible Notes Underwriting Agreement”) with the subsidiary guarantors named therein (“Guarantors”) and Bear, Stearns & Co. Inc. (“Underwriter”). The Convertible Senior Notes Underwriting Agreement related to the issuance and sale (“Convertible Notes Offering”) of $100.0 million aggregate principal amount of the Company’s Convertible Senior Notes. The Convertible Senior Notes are guaranteed on a senior, unsecured basis by the Guarantors. Pursuant to the Convertible Notes Underwriting Agreement, the Company granted the Underwriter a 13-day over-allotment option to purchase up to an additional $15.0 million aggregate principal amount of the Convertible Senior Notes, which was exercised in full on February 12, 2008. The net proceeds received from the issuance of the Convertible Senior Notes were $111.8 million.

The Convertible Notes Underwriting Agreement contained customary representations, warranties and agreements by the Company and the Guarantors, and customary conditions to closing, indemnification obligations of both the Company and the Guarantors, on the one hand, and the Underwriter, on the other hand, including liabilities under the Securities Act of 1933, obligations of the parties and termination provisions. Because the Company is a holding company with no independent assets or operations, the Convertible Senior Notes are guaranteed by each of our 100% owned subsidiaries. The guarantees are full and unconditional, and joint and several.

The Company used the net proceeds from the Convertible Notes Offering to finance the acquisition of Teledrift and for general corporate purposes.

Accounting standards guidance, primarily within ASC Topic 470, “Debt,” clarifies that convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate. The resulting debt discount would be accreted over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. Our Convertible Senior Notes are affected by this guidance. The Company assumed an 11.5% non-convertible rate and an expected term of the debt of five years to determine the debt discount. The expected term of five years is based upon the time until a call/put option on the Convertible Senior Notes at February 2013 can be exercised and the effective tax rate assumed at the inception of the Convertible Senior Notes was 38.0%. The guidance requires retrospective application to all periods presented. The effect of the application on stockholders’ equity as of December 31, 2008 was $15.0 million, which consisted of the discount on the debt of $27.8 million and the related deferred tax liability of $10.6 million at inception net of the accretion of the discount of $ 3.6 million and related tax effect of $1.4 million through December 31, 2008. For the three months ended September 30, 2009 and 2008 the accretion of the discount was $1.2 million and $1.1 million, respectively. For the nine months ended September 30, 2009 and 2008 the accretion of the discount was $3.6 million and $2.5 million, respectively.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

As of September 30, 2009 and December 31, 2008, unamortized debt discount was $20.6 million and $24.2 million, respectively. The following tables reflect the previously described retrospective adjustments related to the impact of the debt guidance on amounts previously reported as of December 31, 2008 and for the three and nine months ended September 30, 2008:

 

     December 31, 2008  
     As reported     As adjusted  
     (in millions)  

Deferred tax assets, less current portion

   $ 15.8      $ 6.6   

Total assets

     243.7        234.5   

Convertible Senior Notes, net of discount

     115.0        90.8   

Additional paid-in capital

     59.6        76.8   

Accumulated deficit

     (8.5     (10.7

Total stockholders’ equity

     50.7        65.7   

Total liabilities and stockholders’ equity

     243.7        234.5   

 

     Three Months Ended
September 30, 2008
    Nine Months Ended
September 30, 2008
 
     As
reported
    As
adjusted
    As
reported
    As
adjusted
 
     (in millions, except
per share data)
   

(in millions, except

per share data)

 

Interest expense

   $ (2.7   $ (3.9   $ (7.2   $ (9.7

Total other expense

     (2.7     (3.9     (7.2     (9.7

Income before taxes

     9.4        8.3        23.1        20.7   

Provision for income taxes

     (3.6     (3.2     (8.8     (7.9

Net income

     5.9        5.1        14.4        12.8   

Basic earnings per common share

     0.31        0.27        0.76        0.68   

Diluted earnings per common share

     0.30        0.27        0.74        0.66   

Senior Credit Facility

On February 4, 2008, the Company entered into a Second Amendment (“Amendment”) to the Amended and Restated Credit Agreement (as amended, modified or supplemented prior to the date thereof, the “Senior Credit Facility”), dated as of August 31, 2007, between the Company and Wells Fargo Bank, National Association. The Senior Credit Facility consisted of a revolving line of credit, an equipment term loan and two real estate term loans. The Amendment permitted the Company to consummate the acquisition of Teledrift, to issue up to $150 million of our Convertible Senior Notes to fund the purchase price of Teledrift, and to incur additional capital expenditures, and includes new financial covenants and other amendments.

The Amendment increased the principal payment required to be made by the Company from $0.5 million monthly to $2.0 million quarterly effective June 30, 2008.

On March 31, 2008, the Company entered into a new credit agreement with Wells Fargo Bank, National Association (“New Credit Agreement”). The New Credit Agreement provides for a revolving credit facility of a maximum of $25 million (“New Revolving Credit Facility”) and a term loan facility of $40 million (“New Term Loan Facility”) (collectively, the “New Senior Credit Facility”). The Company refinanced all but approximately $0.8 million of the outstanding indebtedness under its Senior Credit Facility with borrowings under the New Credit Facility. The amount under the Senior Credit Facility that was not refinanced relates to certain existing real estate loans.

The New Revolving Credit Facility will mature and be payable in full on March 31, 2011. The Company must make mandatory prepayments under the New Term Loan Facility annually beginning April 15, 2009, equal to 50% of the Company’s excess cash flow for the previous calendar year and accordingly paid $4.8 million on that date. The Company is required to repay the aggregate outstanding principal amount of the New Term Loan Facility in quarterly installments of $2.0 million, commencing with the quarter ending June 30, 2008 and accordingly the Company has made $2.0 million quarterly payments in 2008 and 2009, including the payment on September 30, 2009. All remaining amounts owed pursuant to the New Term Loan Facility mature and will be payable in full on March 31, 2011.

Interest accrues on amounts under the New Senior Credit Facility at variable rates based on, at the Company’s election, the prime rate or LIBOR, plus an applicable margin specified in the New Credit Agreement as amended by the Second Amendment to Credit Agreement dated as of March 13, 2009 (“Second Amendment”). A minimum of 50% of Advances as defined in the New Credit Agreement must be swapped from a floating to a fixed interest rate. At September 30, 2009, the interest rate swap had a notional amount of $21.0 million, swap rate of 2.785% and a fair value of ($0.4) million. The Company records the fair value of the swap in Accrued liabilities and the unrealized loss in other expense. The Company has no other derivative instruments.

 

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Table of Contents

FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

The rate of interest related to borrowings outstanding under the New Credit Agreement was approximately 8.2% at September 30, 2009.

The maximum amount of credit available under the New Revolving Credit Facility is based on a percentage of the Company’s eligible inventory and accounts receivable. The obligations of the Company under the New Credit Agreement are guaranteed by the Company’s domestic subsidiaries and are secured by substantially all present and future assets of the Company and its subsidiaries.

The New Credit Agreement contains certain financial and other covenants, including a minimum net worth covenant, a maximum leverage ratio covenant, a minimum fixed charge coverage ratio covenant, a maximum senior leverage ratio covenant, a covenant restricting capital expenditures, a covenant limiting the incurrence of additional indebtedness, and a covenant restricting acquisitions. Certain of these covenants were amended in February and March 2009 when the Company entered into the First Amendment and Temporary Waiver Agreement and the Second Amendment to our New Credit Agreement with our lenders (collectively the “Amendments”).

In August 2009, in connection with the private placement, we also entered into a Third Amendment to our New Senior Credit Facility (“Third Amendment”). The Third Amendment (i) waives certain potential defaults would have occurred pursuant to the Credit Agreement as of June 30, 2009 without such a waiver, (ii) modifies certain of the financial and other covenants contained in the Credit Agreement, (iii) provides that we are permitted to retain all of the net proceeds of the private placement, and also under most circumstances any proceeds derived by the Company from the exercise of any of the warrants issued in the private placement, and (iv) permits us to pay dividends in cash on the preferred stock in certain circumstances.

The Company determined during the second quarter of 2009 that it would breach the leverage ratio, the fixed charge coverage ratio, and the net worth covenants of the New Credit Agreement as of the quarter end of June 30, 2009 and during subsequent quarters unless the bank waived the possible June 30, 2009 breaches and these covenants were amended prospectively. The Third Amendment modified these covenants in the manner requested by the Company as described below.

The Third Amendment amended the Leverage Ratio covenant. “Leverage Ratio” is defined as the ratio that the debt of the Company bears to its trailing EBITDA (net income plus interest, tax, depreciation and amortization expense and other non-cash charges). The Third Amendment amended this covenant as follows: (i) there would be no Leverage Ratio covenant applicable to the periods beginning with the second quarter of 2009 through and including the first quarter of 2010, and (ii) thereafter, the Leverage Ratio could not exceed (a) 4.75 to 1.00 for the quarter ending on June 30, 2010, (b) 4.00 to 1.00 for the quarter ending on September 30, 2010, and (c) 3.75 to 1.00 for each quarter ending on or after December 31, 2010.

The Third Amendment also amended the Fixed Charge Coverage Ratio covenant of the New Credit Agreement. The New Credit Agreement defines “Fixed Charge Coverage Ratio” as the ratio of (a) the Company’s EBITDA for the trailing four quarters to (b) Fixed Charges for those four quarters. “Fixed Charges” is defined as the sum of (i) interest expense, (ii) scheduled debt payments, including capital leases payments, (iii) taxes payments, and (iv) actual maintenance capital expenditures. The Third Amendment modified this covenant by: (a) waiving the Fixed Charge Coverage Ratio for the second quarter of 2009, and (b) amending the Fixed Charge Coverage Ratio covenant for subsequent periods to provide that this ratio may not be less than: (i) 0.75 to 1.00 for the quarter ending September 30, 2009, (ii) 1.10 to 1.00 for the quarters ending December 31, 2009, March 31, 2010, and June 30, 2010, and (iii) 1.25 to 1.00 for each quarter ending on or after June 30, 2010. EBITDA and Fixed Charges will be determined for this purpose based on annualized results beginning with the results of the quarter ending September 30, 2009.

In addition, the Third Amendment amended the minimum Net Worth requirement set forth in the New Credit Agreement. “Net Worth” is defined as the shareholder’s equity of the Company and its subsidiaries, subject to certain adjustments. The Third Amendment modifies this covenant to now require that Net Worth at least equal (i) 90% of the Company’s Net Worth as of the end of the fiscal quarter ended June 30, 2009, plus (ii) 75% of the Company’s net income for each fiscal quarter ending after June 30, 2009 in which such net income is greater than $0, plus (iii) an amount equal to 100% of any proceeds of equity issuances by the Company after June 30, 2009.

Pursuant to the Third Amendment, the Company is required to maintain through June 30, 2010 at least $5.0 million of cash and availability under its revolving line of credit pursuant to the New Credit Agreement, and agreed to increase the amount of the annual principal payment it is required to make pursuant to the New Credit Agreement with respect to its term facility from 50% of Excess Cash Flow to 75% of Excess Cash Flow. “Excess Cash Flow” is the Company’s EBITDA, subject to certain adjustments, minus the sum of the following during such period: (i) taxes, (ii) permitted capital expenditures, (iii) cash interest expense, and (iv) principal installment payments and optional prepayments of the term facility.

In addition, the Third Amendment made certain other changes to the New Credit Agreement, including making changes relating to permitted debt, operating leases, acquisitions, and asset sales.

 

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Table of Contents

FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

At September 30, 2009, we were not in compliance with the Net Worth and the Fixed Charge Coverage covenants under our New Credit Agreement, as amended.

On November 16, 2009, we entered into a Waiver and Fourth Amendment with respect to our New Senior Credit Facility (“Fourth Amendment”). The Fourth Amendment (i) waives certain potential defaults that would have occurred pursuant to the New Credit Agreement as of September 30, 2009 as described above, (ii) provides that we may not make any draws with respect to the New Revolving Credit Facility until February 10, 2010, (iii) requires that we make on November 16, 2009 the $2,000,000 principal payment with respect to the New Term Loan Facility which otherwise would have been due on December 31, 2009, (iv) requires that we maintain availability under the New Revolving Credit Facility of at least $4,000,000, and (v) otherwise modifies certain of the reporting requirements and other covenants contained in the Credit Agreement. We do not expect to be able to meet certain of the financial covenants under the New Senior Credit Facility as of December 31, 2009 and possibly throughout 2010. As a result, we have reclassified amounts owed under the New Senior Credit Facility as short term debt in the Consolidated Balance Sheet at September 30, 2009. While we have been successful in obtaining waivers from our bank lenders in recent periods, however, there can be no assurance we will be successful obtaining such waivers for these events in the future.

Our availability under the revolving line of credit of the New Senior Credit Facility is defined by a borrowing base comprised of eligible accounts receivable and inventory. As of September 30, 2009, we had $1.7 million outstanding under the revolving line of credit of the New Senior Credit Facility. Total availability under our credit facility amounted to $13.2 million at September 30, 2009. During the period subsequent to this date through November 16, 2009, we borrowed an additional $9 million under this revolving line of credit. We paid the $2 million quarterly principal payment installment on November 16, 2009, which otherwise would have been due on December 31, 2009, according to the terms of the Fourth Amendment.

As of September 30, 2009, the Company had approximately $0.2 million outstanding in vehicle loans and capitalized vehicle leases.

Note 10 – Fair Value Disclosure

The following table presents information about the Company’s liability measured at fair value on a recurring basis as of September 30, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (in millions):

 

     Level 1    Level 2    Level 3    Total

Convertible Senior Notes

   —      $ 63.3    —      $ 63.3

The Company determined the estimated fair value amount of the Convertible Senior Notes by using available market information and commonly accepted valuation methodologies. However, considerable judgment is required in interpreting market data to develop estimates of fair value. Accordingly, the fair value estimate presented herein is not necessarily indicative of the amount that the Company or the debt-holder could realize in a current market exchange. The use of different assumptions and/or estimation methodologies may have a material effect on the estimated fair value.

Note 11 – Convertible Preferred Stock and Stock Warrants

On August 12, 2009, we closed a private placement transaction with certain accredited investors, pursuant to which such investors purchased an aggregate of 16,000 units (“Units”) at a purchase price of $1,000 per Unit. Each Unit was comprised of (i) one share of cumulative convertible preferred stock (“Convertible Preferred Stock”), (ii) warrants to purchase up to 155 shares of our common stock at an exercise price of $2.31 per share (“Exercisable Warrants”) and (iii) contingent warrants to purchase up to 500 shares of our Common Stock at an exercise price of $2.45 per share (“Contingent Warrants”). Each share of Convertible Preferred Stock is convertible at the holder’s option, at any time, into 434.782 shares of our common stock under certain conditions. This conversion ratio represents an equivalent conversion price of $2.31 per share. The closing of this private placement resulted in the receipt of proceeds of $14.8 million, net of transaction costs of $1.2 million. We used the net proceeds to reduce borrowings under our bank credit facility, thereby providing additional availability of credit, and for general corporate purposes.

Each share of Convertible Preferred Stock has a liquidation preference of $1,000. Dividends will accrue at the rate of 15% of the liquidation preference per year and will accumulate if not paid quarterly. As of September 30, 2009, the Company had accrued dividends of $0.3 million.

The Convertible Preferred Stock will, at the Company’s option (but not earlier than February 12, 2010), be automatically converted into shares of our common stock if the closing price of the common stock is equal to or greater than 150% of the then current conversion price for any 15 trading days during any 30 consecutive trading day period. If the Convertible Preferred Stock

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

automatically converts and the Company has not previously paid holders amounts equal to at least eight quarterly dividends on the Convertible Preferred Stock, the Company will also pay to the holders, in connection with any automatic conversion, and amount, in cash or shares of our common stock (based on the market value of the common stock), equal to eight quarterly dividends less any dividends previously paid to holders of the Convertible Preferred Stock.

The Company may redeem any of the Convertible Preferred Stock beginning on August 12, 2012. The initial redemption price will be 105% of the liquidation preference, declining to 102.5% on August 12, 2013, and to 100% on or after August 12, 2014, in each case plus accrued and unpaid dividends to the redemption date.

The Exercisable Warrants are immediately exercisable and will expire if not exercised by August 12, 2014. The Contingent warrants became exercisable after we obtained shareholder approval on November 9, 2009 and will expire if not exercised by November 9, 2014. Both the Exercisable Warrants and Contingent Warrants contain anti-dilution price protection in the event the Company issues shares of Common Stock or securities exercisable for or convertible into Common Stock at a price per share less than their exercise price, subject to certain exceptions.

The gross proceeds from the issuance of the Units were accounted for in accordance with ASC 470-20, “Debt – Debt with Conversion and Other Options” and were allocated at the date of the transaction based on the relative fair values of the preferred stock and the warrants. At the date of the transaction, the Company recorded approximately 68% of the proceeds or $10.8 million (net of the discount resulting from the allocation of the proceeds to the warrants) as preferred stock in stockholders’ equity and the detached warrants were recorded in additional paid-in capital at $5.2 million.

The Company evaluated whether the embedded conversion option within the preferred stock was beneficial (had intrinsic value) to the holders of the preferred stock. The intrinsic value of the conversion option was determined to be $5.2 million and was recognized as a beneficial conversion discount with offset to additional paid-in capital at the date of the transaction.

The conversion period for the preferred stock was estimated to be 36 months based on an evaluation of the conversion options. The accretion of the discount on the preferred stock recorded for the three and nine months ended September 30, 2009 was $0.5 million.

Note 12 – Treasury Stock

For the three and nine month periods ended September 30, 2009, 11,975 and 88,619 shares, respectively, previously issued as Restricted Stock Awards (“RSAs”) to employees, were forfeited or cancelled during 2009 and accounted for as treasury stock.

The Company accounts for treasury stock using the cost method and includes treasury stock as a component of stockholders’ equity. The Company currently neither has nor intends to initiate a share repurchase program.

Note 13 – Earnings Per Share

Basic earnings per share excludes dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the period including “contingent shares” if any. Contingent shares include common shares that would be issued from the conversion of preferred stock and exercisable stock warrants. For the three and nine months ended September 30, 2009, weighted average common shares related to convertible preferred stock of 3,705,099 and 1,248,605, respectively, were excluded from dilutive earnings per share because they were anti-dilutive. Additionally, warrants to purchase 10,480,000 shares of common stock were excluded from dilutive earnings per share, as the inclusion of such shares would have been antidilutive.

Diluted earnings per share is based on the weighted average number of shares outstanding during each period and the assumed exercise of dilutive instruments (stock options) less the number of common shares assumed to be purchased with the exercise proceeds using the average market price of the Common Stock for each of the periods presented. Due to the net loss for the three and nine month periods ended September 30, 2009, approximately 91,000 and 96,000 shares, respectively, of dilutive shares relating to stock options have been excluded from the calculation of diluted earnings per share due to their anti-dilutive effect.

In connection with the Convertible Notes Offering, the Company entered into a Share Lending Agreement with Bear Stearns International Ltd. (“BSIL”). In view of the contractual undertakings of BSIL in the Share Lending Agreement, which have the effect of substantially eliminating the economic dilution that otherwise would result from the issuance of the borrowed shares, the Company believes that under accounting principles generally accepted in the United States of America, the borrowed shares should not be considered outstanding for the purpose of computing and reporting the Company’s earnings per share.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Note 14 – Share-Based Compensation

The Company follows accounting guidance found in ASC Topic 715, “Compensation – Stock Compensation” and ASC Topic 505, “Equity.” This guidance requires all share-based payments, including grants of stock options, to be recognized in the income statement as an operating expense over the vesting period, based on their fair values.

In 2009, the Company awarded approximately 690,000 stock options to certain employees under the 2007 Long-Term Incentive Plan (“2007 Plan”). The fair value of these stock options, based on the Black-Scholes calculation, range from $0.80 to $1.66 per share. As of September 30, 2009, the Company has approximately 1,223,000 stock options outstanding of which approximately 511,000 are vested.

In 2009, the Company awarded approximately 423,000 RSAs to certain employees and non-employee directors under the 2007 Plan, all of which vest over a 4 year period. A summary of RSA activity for the nine months ended September 30, 2009 follows:

 

     2009  

Unvested as of January 1,

   233,498   

Granted

   423,144   

Vested

   (44,841

Forfeited

   (88,619
      

Unvested as of September 30,

   523,182   
      

Approximately $0.7 million and $0.6 million of share-based compensation expense was recognized during the three-month periods ended September 30, 2009 and 2008, respectively, related to stock option grants and RSAs. Approximately $1.3 million and $2.1 million of share-based compensation expense was recognized during the nine month periods ended September 30, 2009 and 2008, respectively, related to stock option grants and RSAs. As of September, 30, 2009 total share-based compensation related to unvested awards (stock options and RSAs) was approximately $5.7 million, and the weighted-average period over which this cost will be recognized is approximately 3.0 years.

Note 15 – Income Taxes

The effective income tax rate for the three months ended September 30, 2009 and 2008 was 243.1% and 38.1%, respectively. The effective income tax rate for the nine months ended September 30, 2009 and 2008 was 12.5% and 38.0%, respectively. Our effective income tax rate in 2009 differs from the federal statutory rate primarily due to state income taxes, and the valuation allowance recorded against certain deferred tax assets. Our effective income tax rate in 2008 differs from the federal statutory rate primarily due to state income taxes and the domestic production activities deduction.

Our current corporate organization structure requires us to file two separate consolidated U.S. federal income tax returns. As a result, taxable income of one group cannot be offset by tax attributes, including net operating losses, of the other group. As of September 30, 2009, one of the group has net operating loss (“NOL”) carryforwards and other net deferred tax assets of approximately $16.8 million. Our ability to utilize our net operating losses and other tax attributes could be subject to a significant limitation if we were to undergo an “ownership change” for purpose of Section 382.

ASC Topic 825, “Income Taxes” requires all available evidence, both positive and negative, to be considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. As discussed in “Note 1 – Our Business, Recent Events and Basis of Presentation,” we may need to generate additional financial resources in order to meet our business objectives and make scheduled payments or mandatory prepayments on our current debt obligations. If we are not able to generate positive cash flows and profits or obtain adequate additional financing or refinancing, we may be required to curtail operations or be unable to continue as a going concern. As a result, management determined the realization of deferred tax assets is uncertain as the Company is unable to consider tax planning strategies or projections of future taxable income in its evaluation of the realizability of it is deferred tax assets as of September 30, 2009. Under these circumstances, deferred tax assets may only be realized through future reversals of taxable temporary differences and carryback of net operating losses to available carryback periods. We have performed such an analysis and a valuation allowance of approximately $16.8 million has been provided against deferred tax assets as of September 30, 2009.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Note 16 – Commitments and Contingencies

The Company is involved, on occasion, in routine litigation incidental to its business. The Company believes that the ultimate resolution of the routine litigation that may develop will not have a material adverse impact on the Company’s financial position, results of operations or cash flows.

Note 17 – Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance.

The Company has determined that there are three reportable segments:

 

   

The Chemicals and Logistics segment is comprised of two business units. The specialty chemical business unit designs, develops, manufactures, packages and sells chemicals used by oilfield service companies in oil and gas well drilling, cementing, stimulation and production. The logistics business unit manages automated bulk material handling, loading facilities and blending capabilities for oilfield service companies.

 

   

The Drilling Products segment rents, inspects, manufactures and markets downhole drilling equipment for the energy, mining, water well and industrial drilling sectors.

 

   

The Artificial Lift segment manufactures and markets artificial lift equipment which includes the Petrovalve line of beam pump components, electric submersible pumps, gas separators, valves and services to support coal bed methane production.

The Company evaluates performance based on several factors, of which the primary financial measure is business segment income before taxes. The accounting policies of the business segments are the same as those described in “Note 2 – Summary of Significant Accounting Policies” in our December 31, 2008 Form 10-K. Inter-segment sales are accounted for at fair value as if sales were to third parties and are eliminated in the consolidated financial statements.

Summarized unaudited financial information concerning the segments for the three and nine months ending September 30, 2009 and 2008 is shown in the following tables (in millions):

 

Three months ended September 30, 2009

   Chemicals
and
Logistics
   Drilling
Products
    Artificial
Lift
   Corporate
and
Other
    Total  

Revenue

   $ 11.0    $ 10.2      $ 2.6    $ —        $ 23.8   

Income (loss) from operations

   $ 3.5    $ (3.2   $ 0.1    $ (2.9   $ (2.5

Capital expenditures

   $ 0.3    $ 0.4      $ —      $ —        $ 0.7   

Three months ended September 30, 2008

                            

Revenue

   $ 30.4    $ 26.6      $ 5.8    $ —        $ 62.8   

Income (loss) from operations

   $ 10.5    $ 5.4      $ 0.9    $ (4.6   $ 12.2   

Capital expenditures

   $ 0.8    $ 6.4      $ 0.1    $ 0.1      $ 7.4   

Nine months ended September 30, 2009

   Chemicals
and
Logistics
   Drilling
Products
    Artificial
Lift
   Corporate
and
Other
    Total  

Revenue

   $ 37.7    $ 40.1      $ 10.2    $ —        $ 88.0   

Income (loss) from operations (1)

   $ 9.5    $ (27.3   $ 0.9    $ (10.6   $ (27.5

Capital expenditures

   $ 0.4    $ 5.2      $ —      $ —        $ 5.6   

Nine months ended September 30, 2008

                            

Revenue

   $ 82.4    $ 70.3      $ 13.4    $ —        $ 166.1   

Income (loss) from operations

   $ 29.5    $ 12.9      $ 1.5    $ (13.5   $ 30.4   

Capital expenditures

   $ 1.9    $ 13.9      $ 0.2    $ 0.6      $ 16.6   

 

(1) Drilling Products segment includes a goodwill impairment charge of $18.5 million recorded during the second quarter of 2009.

 

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FLOTEK INDUSTRIES, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

 

Revenue generated from international sales for the three months ended September 30, 2009 and 2008 was $3.5 million and $3.9 million, respectively. Revenue generated from international sales for the nine months ended September 30, 2009 and 2008 was $11.8 million and $13.4 million, respectively.

Identifiable assets by reportable segment were as follows (in millions):

 

     September 30,
2009
   December 31,
2008
 
     (unaudited)       

Chemicals and Logistics

   $ 34.7    $ 44.1   

Drilling Products

     124.2      176.3   

Artificial Lift

     7.3      16.1   

Corporate and Other

     10.5      (2.0
               

Total assets

   $ 176.7    $ 234.5   
               

Goodwill by reportable segment was as follows (in millions):

 

     September 30,
2009
   December 31,
2008
     (unaudited)     

Chemicals and Logistics

   $ 11.6    $ 11.6

Drilling Products

     15.4      33.9

Artificial Lift

     —        —  
             

Total goodwill

   $ 27.0    $ 45.5
             

Note 18 – Subsequent Events

Through November 16, 2009, management has evaluated the events or transactions that have occurred for potential recognition or disclosure in the financial statements, the circumstances under which the Company should recognize events or transactions occurring after the September 30, 2009 balance sheet date in its financial statements and the disclosures that the Company should make about events or transactions that occurred after the balance sheet date.

On November 9, 2009, the Company held a special meeting of stockholders of record as of September 14, 2009. At the meeting, our stockholders voted on and approved (i) the amendment of the Company’s Amended and Restated Certificate of Incorporation to increase the number of authorized shares of common stock from 40,000,000 to 80,000,000 shares; (ii) the ability of the Company to pay dividends in the future in respect of its shares of preferred stock by issuing shares of the Company’s common stock; (iii) the anti-dilution price protection provision contained in certain warrants issued by the Company in a private placement in August 2009 and (iv) the contingent warrants issued by the Company in a private placement in August 2009.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Special Note About Forward-Looking Statements

Certain statements in Management’s Discussion and Analysis (“MD&A”), other than purely historical information, including estimates, projections and statements relating to the Company’s business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008, in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009 and in this Quarterly Report on Form 10-Q. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.

Overview

The following MD&A is intended to help the reader understand the results of operations, financial condition, and cash flows of Flotek. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated condensed financial statements and the accompanying notes to the consolidated condensed financial statements (“Notes”).

We are a technology-driven growth company serving the oil, gas, and mining industries. We operate in select domestic and international markets including the Gulf Coast, the Southwest and the Rocky Mountains, Canada, Mexico, Central America, South America, Europe and Asia. We provide products and services to address the drilling and production-related needs of oil and gas companies through our three business segments: Chemicals and Logistics, Drilling Products and Artificial Lift. The Chemicals and Logistics segments provides a full spectrum of oilfield specialty chemicals used for drilling, cementing, stimulation, and production designed to maximize recovery from both new and mature fields. The Drilling Products segment provides down-hole drilling tools used in the oilfield, mining, water-well and industrial drilling sectors. We manufacture, sell, rent and inspect specialized equipment for use in drilling, completion, production and work-over activities. The Artificial Lift segment provides pumping system components, including electric submersible pumps, or ESPs, gas separators, production valves and services. Our products address the needs of coal bed methane and traditional oil and gas production to efficiently move gas, oil and other fluids from the producing horizon to the surface. The customers for our products and services include the major integrated oil and natural gas companies, independent oil and natural gas companies, pressure pumping service companies and state-owned national oil companies. Our ability to compete in the oilfield services market is dependent on our ability to differentiate our products and services, provide superior quality products and services, and maintain a competitive cost structure. Activity levels are driven primarily by current and expected commodity prices, drilling rig count, oil and gas production levels, and customer capital spending allocated for drilling and production. See “Business” included in our Annual Report on Form 10-K for the year ended December 31, 2008 for more information on these operations.

The challenging economic conditions facing the oil and gas industry have adversely affected our financial performance and liquidity in 2009. Revenue has declined significantly across all of our segments due to decreased demand for our products and services as natural gas prices and the number of well completions and rig count continues to be depressed. At September 30, 2009, we were not in compliance with certain financial covenants contained in the New Credit Agreement. We requested and obtained a waiver of these financial covenant violations from our lenders. However, we expect that we will not be able to meet certain of the financial covenants under the New Credit Agreement as of December 31, 2009, and possibly throughout 2010. As a result, we have reclassified amounts owing under the New Credit Agreement as current.

We believe that, assuming current revenue levels and cost structure, our current cash balance and estimated cash flows will be sufficient to satisfy our anticipated cash requirements at least through September 30, 2010. However, if we are not in compliance with the financial covenants in our New Credit Facility as of December 31, 2009, or subsequent periods, and we are unable to obtain waivers of those covenant violations, our lenders would be entitled to exercise their remedies under the New Credit Facility, which could include accelerating all amounts due under the New Credit Facility. We would not have sufficient funds to repay all such amounts, and would be required to seek additional financing, which we might not be able to obtain on terms favorable to us or at all. Acceleration of amounts under our New Credit Facility could also constitute a default under our Convertible Notes. The Company expects that it will need to renegotiate the New Credit Facility or refinance all or a portion of its indebtedness on or before maturity. While the Company believes that it can be successful in renegotiating or refinancing its indebtedness, there can be no assurance that it will be able to on attractive terms or at all. We are working to lower our working capital needs and have focused on cash collections of our accounts receivable balances and reduction of inventory. In the event capital required is greater than the amount we have available at the time, we would reduce the expected level of capital expenditures, sell assets and/or seek additional capital. Cash generated by future asset sales may depend on the overall economic conditions of the industries served by these assets, the condition and location of the assets, and the number of interested buyers. We cannot assure you that needed capital will be available on acceptable terms or at all. Our ability to raise funds in the capital markets through the issuance of additional indebtedness may be limited by covenants in our credit facilities, our credit rating and the willingness of banks and other financial services companies to lend. At September 30, 2009, our net worth was less than the $50 million required by the continued listing standard of the NYSE. We intend to submit a plan to the NYSE that will provide for us to come back into compliance with the NYSE’s continued listing standards, although the NYSE may not accept our plan or we may be unable to accomplish the actions set forth in that plan to come back into compliance with the NYSE’s continued listing standards over the time period allowed by the NYSE. If we are not able to generate positive cash flows and profits or obtain adequate additional financing or refinancing, we may be required to curtail operations or be unable to continue as a going concern. A number of factors could influence our liquidity sources, as well as the timing and ultimate outcome of our on-going efforts.

On November 16, 2009, we entered into a Waiver and Fourth Amendment with respect to our New Senior Credit Facility (“Fourth Amendment”). The Fourth Amendment (i) waives certain potential defaults that would have occurred pursuant to the New Credit Agreement as of September 30, 2009 as described above, (ii) provides that we may not make any draws with respect to the New Revolving Credit Facility until February 10, 2010, (iii) requires that we make on November 16, 2009 the $2,000,000 principal payment with respect to the New Term Loan Facility which otherwise would have been due on December 31, 2009, (iv) requires that we maintain availability under the New Revolving Credit Facility of at least $4,000,000, and (v) otherwise modifies certain of the reporting requirements and other covenants contained in the Credit Agreement. We do not expect to be able to meet certain of the financial covenants under the New Senior Credit Facility as of December 31, 2009 and possibly throughout 2010. As a result, we have reclassified amounts owed under the New Senior Credit Facility as short term debt in the Consolidated Balance Sheet at September 30, 2009. While we have been successful in obtaining waivers from our bank lenders in recent periods, however, there can be no assurance we will be successful obtaining such waivers for these events in the future.

 

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Market Conditions

Our operations are driven primarily by the number of oil and natural gas wells being drilled, the depth and drilling conditions of such wells, the number of well completions and the level of work-over activity in North America. Drilling activity, in turn, is largely dependent on the price of crude oil and natural gas and the volatility and expectations of future oil and natural gas prices. Our results of operations also depend heavily on the pricing we receive from our customers, which depends on activity levels, availability of equipment and other resources, and competitive pressures. These market factors often lead to volatility in our revenue and profitability. Historical market conditions are reflected in the table below:

 

     As of September 30,
     2009    % Change     2008

Rig Count: (1)

       

U.S.

     1,017    (49.0 )%      1,995

Canada

     228    (51.0 )%      465

Commodity Prices :

       

Crude Oil (West Texas Intermediate)

   $ 70.46    (30.0 )%    $ 100.70

Natural Gas (Henry Hub)

   $ 3.24    (60.2 )%    $ 8.15

 

(1) Estimate of drilling activity as measured by active drilling rigs based on Baker Hughes Inc. rig count information.

U.S. Rig Count

Demand for our services in the United States is driven primarily by oil and natural gas drilling activity, which tends to be extremely volatile, depending on the current and anticipated prices of crude oil and natural gas. During the last 10 years, the lowest average annual U.S. rig count was 601 in fiscal 1999 and the highest average annual U.S. rig count was 1,851 in fiscal 2008.

With the decline and volatility of oil and natural gas prices over the past nine months, tightening and uncertainty in the credit markets and the global economic slowdown, drilling rig activity in North America has declined significantly from October, 2008 through October, 2009. We have begun to see an abatement of the decline in drilling rig activity in recent weekly rig count reports; however, while we expect to see eventual increases in U.S. drilling activity in 2010, the timing and magnitude of the increase remains uncertain. The acceleration of drilling activity is influenced by a number of factors including commodity prices, global demand for oil and natural gas, supply and depletion rates of oil and natural gas reserves as well as broader variables such as government monetary and fiscal policy.

Canadian Rig Count

The demand for our services in Canada is driven primarily by oil and natural gas drilling activity, and similar to the United States, tends to be extremely volatile. During the last 10 years, the lowest average annual rig count was 212 in fiscal 1999 and the highest average annual rig count was 502 in fiscal 2006. Similar to activity in the United States, drilling rig activity in Canada has trended lower over the past twelve months.

Outlook

As described under “Market Conditions” above, our operations are driven primarily by the number of oil and natural gas wells being drilled, the depth and drilling conditions of such wells, the number of well completions and the level of work-over activity in North America. The global economic slowdown has led to a steep decline in oil and natural gas prices in the first quarter of this year. Since that time the price of oil has increased while natural gas prices have remained relatively stagnant, with current prices significantly below their historic highs in July 2008. The result of this price volatility is a reduction in cash flows of oil and gas producers that has led to significant reductions in drilling activity, particularly in the U.S. market.

The average U.S. drilling rig activity was 970 during the third quarter, slightly greater than the average rig count of 934 rigs working in the second quarter. We expect continued stabilization of the rig count in the fourth quarter and, while the timing and magnitude of the improvement remains uncertain, further improvement into 2010. Fourth quarter activity is traditionally influenced by periods of moderating activity resulting from seasonal holidays. While we have experienced a modest increase in overall business activity, pricing power and future pricing direction remains uncertain, a tenet which is consistent with historical pricing behavior as oilfield activity accelerates from the bottom of the business cycle. We continue to monitor customer activities and continue to take measures we consider appropriate within our organization to balance costs with our abilities to meet current and anticipated customer demand.

Third quarter drilling activity in Canada increased from second quarter as summer seasonal drilling programs reached peak activity levels. However, on a year-over-year basis, third quarter 2009 drilling activity was approximately 51% below levels a year ago.

 

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Results of Operations

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (in millions, except per share data)  

Revenue

   $ 23.8      $ 62.8      $ 88.0      $ 166.1   

Cost of revenue (1)

     17.5        36.2        65.5        95.9   

Expenses:

        

Impairment of Goodwill

     —          —          18.5        —     

Selling, general and administrative

     7.2        12.4        26.6        34.3   

Depreciation and amortization

     1.2        1.6        3.7        4.2   

Research and development

     0.4        0.4        1.2        1.3   
                                

Total expenses

     8.8        14.4        50.0        39.8   
                                

Income (loss) from operations

     (2.5     12.2        (27.5     30.4   

Income (loss) from operations %

     (10.5 )%      19.3     (31.3 )%      18.3

Other expense:

        

Interest expense (2)

     (4.1     (3.9     (11.6     (9.7

Investment income and other

     0.1        —          (0.1 )     —     
                                

Total other expense

     (4.0     (3.9     (11.7     (9.7

Income (loss) before income taxes

     (6.5     8.3        (39.2     20.7   

Provision for income taxes (3)

     (15.8     (3.2     (4.9     (7.9
                                

Net income (loss)

   $ (22.3   $ 5.1      $ (44.1   $ 12.8   

Accrued dividends and accretion of discount on cumulative convertible preferred stock

     (0.8     —          (0.8 )     —     
                                

Net income (loss) allocable to common stockholders

   $ (23.1   $ 5.1      $ (44.9   $ 12.8   
                                

Basic Earnings Per Share

   $ (1.18   $ 0.27      $ (2.29   $ 0.68   
                                

Diluted Earnings Per Share

   $ (1.18   $ 0.27      $ (2.29   $ 0.66   
                                

 

(1) Includes Depreciation directly related to production of Revenue of $2.3 million and $1.9 million for the three months ended September 30, 2009 and 2008, respectively, and $6.8 million and $5.2 million for the nine months ended September 30, 2009 and 2008, respectively.
(2) Includes Interest expense related to the application of Accounting Standards Codification (“ASC”) Topic 470, “Debt” of $1.2 million and $1.1 million for the three months ended September 30, 2009 and 2008, respectively, and $3.6 million and $2.5 million for the nine months ended September 30, 2009 and 2008, respectively.
(3) Includes Income tax expense of $18.6 million primarily related to the deferred tax valuation allowance recorded for the three and nine months ended September 30, 2009.

Consolidated – Comparison of Three and Nine Months Ended September 30, 2009 and 2008

Revenue declined in all periods across all of our segments due to a decrease in demand for our products and services as natural gas prices, well completions and rig count fell approximately 40%. We also experienced pricing pressure due to increased competition and decreased demand.

Gross profit decreased in all periods due to continued pricing pressures and lower demand for our services.

Selling, general and administrative costs are not directly attributable to products sold or services rendered. We implemented a program to reduce fixed costs during the first half of this year designed to more closely align these costs with our current level of operations. We accomplished these reductions through strategic in-sourcing of certain professional fees, personnel reductions and elimination of certain initiatives not aligned with our current operations.

Depreciation and amortization was flat year over year due to higher depreciation associated with acquired assets and increased capital expenditures during 2008 offset by a reduction of amortization costs associated with the impairment charge taken in the fourth quarter of 2008. Amortization charges were lower than the previous year due to the impairment charge recorded in 2008.

Research and development (“R&D”) costs as a percentage of revenue increased approximately 100 basis points and 50 basis points for the quarter and year-to-date compared to 2008. Due to the dramatic reduction in revenue, we have reduced spending in this area but maintain a minimum level of spending as an investment in our future growth.

 

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Interest expense increased as a result of higher debt levels incurred to finance the Teledrift acquisition, the accretion of the debt discount associated with our Convertible Senior Notes and increased working capital needs. To finance the Teledrift acquisition, we issued $115.0 million of our Convertible Senior Notes bearing an interest rate of 5.25% that are due in 2028.

The effective income tax rate for the three months ended September 30, 2009 and 2008 was 243.1% and 38.1%, respectively. The effective income tax rate for the nine months ended September 30, 2009 and 2008 was 38.1% and 38.0%, respectively. Our effective income tax rate in 2009 differs from the federal statutory rate primarily due to state income taxes, and the valuation allowance recorded against certain of our deferred tax assets. Our effective income tax rate in 2008 differs from the federal statutory rate primarily due to state income taxes and the domestic production activities deduction.

Our current corporate organization structure requires us to file two separate consolidated U.S. federal income tax returns. As a result, taxable income of one group cannot be offset by tax attributes, including net operating losses, of the other group. As of September 30, 2009 one of the groups has net operating loss (“NOL”) carryforwards and other net deferred tax assets of approximately $16.8 million. Primarily due to our inability under generally accepted accounting principles to assume future profits and due to our reduced ability to implement tax planning strategies to utilize our NOLs if we are unable to continue as a going concern, we concluded that valuation allowances on these deferred tax assets were required.

Results by Segment

Revenue and operating income amounts in this section are presented on a basis consistent with U.S. GAAP and include certain reconciling items attributable to each of the segments. Segment information appearing in “Note 17 – Segment Information” of the Notes is presented on a basis consistent with the Company’s current internal management reporting, in accordance with accounting guidance found in the “Classification” and “Financial Statements” topics of the Accounting Standards Codification. Certain corporate-level activity has been excluded from segment operating results and is presented separately.

Chemicals and Logistics

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (in millions)  

Revenue

   $ 11.0      $ 30.4      $ 37.7      $ 82.4   

Income from operations

     3.5        10.5        9.5        29.5   

Income from operations (% of revenue)

     31.8     34.6     25.2     35.8

Chemicals and Logistics – Comparison of Three and Nine Months Ended September 30, 2009 and 2008

Chemicals and Logistics revenue decreased as a result of decreased sales volume related to decreased well fracturing activities and increased pricing pressures due to the recent decline in oil and gas exploration activities. Sales of our proprietary, biodegradable, ‘green’ chemicals declined as the number of well completions declined throughout the year.

Income from operations decreased due to lower revenues. We have partially mitigated the effect of our lower demand and pricing pressure through indirect cost containment efforts related to professional fees and employee costs.

With product pricing pressures leveling off in North America and anticipated improvement in international sales, we anticipate modest improvement in revenue growth and margins for the segment in the fourth quarter of 2009.

Drilling Products

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (in millions)  

Revenue

   $ 10.2      $ 26.6      $ 40.1      $ 70.3   

Income (loss) from operations

     (3.2     5.4        (27.3     12.9   

Income (loss) from operations (% of revenue)

     (31.4 )%      20.6     (68.1 )%      18.4

Drilling Products – Comparison of Three and Nine Months Ended September 30, 2009 and 2008

In February 2008 we acquired substantially all the assets of Teledrift, which specializes in designing and manufacturing wireless survey and measurement while drilling (“MWD”) tools.

Drilling Products revenue decreased as a result of lower drilling activities in North America related to both oil and gas and competitive pricing pressures.

 

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Income (loss) from operations decreased and can also be attributed to a declining sales base and increased pricing pressure as well as the goodwill impairment for the nine months ended September 30, 2009. We have partially mitigated the effect of our lower demand and pricing pressure through staff reduction.

In Drilling Products, we expect international sales to gradually improve our Teledrift product line in the fourth quarter through year end. Copper prices, which have rebounded from second quarter lows, will drive more revenue in our mining business in 2010. We believe that as horizontal drilling increases, Drilling Products is well positioned to capitalize on this market as we have equipment well suited for these applications.

Artificial Lift

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (in millions)  

Revenue

   $ 2.6      $ 5.8      $ 10.2      $ 13.4   

Income from operations

     0.1        0.9        0.9        1.5   

Income from operations (% of revenue)

     3.8     15.8     8.8     10.8

Artificial Lift – Comparison of Three and Nine Months Ended September 30, 2009 and 2008

Artificial Lift revenue declined on a year-to-date basis and quarterly basis. The revenue decreased due to lower rig count and lower gas prices.

Income from operations decreased in the quarterly period mainly due to the revenue decrease and pricing pressure from our customer base. In all periods, we reduced indirect costs related to professional fees and employee related costs.

Liquidity and Capital Resources

The challenging economic conditions facing the oil and gas industry have adversely affected our financial performance and liquidity in 2009. Revenue has declined significantly across all of our segments due to decreased demand for our products and services as natural gas prices and the number of well completions and rig count continues to be depressed. At September 30, 2009, we were not in compliance with certain financial covenants contained in the New Credit Agreement. We requested and obtained a waiver of these financial covenant violations from our lenders. However, we expect that we will not be able to meet certain of the financial covenants under the New Credit Agreement as of December 31, 2009, and possibly throughout 2010. As a result, we have reclassified amounts owing under the New Credit Agreement as current.

We believe that, assuming current revenue levels and cost structure, our current cash balance and estimated cash flows will be sufficient to satisfy our anticipated cash requirements at least through September 30, 2010. However, if we are not in compliance with the financial covenants in our New Credit Facility as of December 31, 2009, or subsequent periods, and we are unable to obtain waivers of those covenant violations, our lenders would be entitled to exercise their remedies under the New Credit Facility, which could include accelerating all amounts due under the New Credit Facility. We would not have sufficient funds to repay all such amounts, and would be required to seek additional financing, which we might not be able to obtain on terms favorable to us or at all. Acceleration of amounts under our New Credit Facility could also constitute a default under our Convertible Senior Notes. The Company expects that it will need to renegotiate the New Credit Facility or refinance all or a portion of its indebtedness on or before maturity. While the Company believes that it can be successful in renegotiating or refinancing its indebtedness, there can be no assurance that it will be able to on attractive terms or at all. We are working to lower our working capital needs and have focused on cash collections of our accounts receivable balances and reduction of inventory. In the event capital required is greater than the amount we have available at the time, we would reduce the expected level of capital expenditures, sell assets and/or seek additional capital. Cash generated by future asset sales may depend on the overall economic conditions of the industries served by these assets, the condition and location of the assets, and the number of interested buyers. We cannot assure you that needed capital will be available on acceptable terms or at all. Our ability to raise funds in the capital markets through the issuance of additional indebtedness may be limited by covenants in our credit facilities, our credit rating and the willingness of banks and other financial services companies to lend. At September 30, 2009, our net worth was less than the $50 million required by the continued listing standard of the NYSE. We intend to submit a plan to the NYSE that will provide for us to come back into compliance with the NYSE’s continued listing standards, although the NYSE may not accept our plan or we may be unable to accomplish the actions set forth in that plan to come back into compliance with the NYSE’s continued listing standards over the time period allowed by the NYSE. If we are not able to generate positive cash flows and profits or obtain adequate additional financing or refinancing, we may be required to curtail operations or be unable to continue as a going concern. A number of factors could influence our liquidity sources, as well as the timing and ultimate outcome of our on-going efforts.

On August 12, 2009, we closed on the issuance of convertible preferred stock and received net cash proceeds of $14.8 million. We had cash and cash equivalents of $0.6 million at September 30, 2009 compared to $0.2 million at December 31, 2008.

 

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On November 16, 2009, we entered into a Waiver and Fourth Amendment with respect to our New Senior Credit Facility (“Fourth Amendment”). The Fourth Amendment (i) waives certain potential defaults would have occurred pursuant to the Credit Agreement as of September 30, 2009 without such a waiver, (ii) provides that we may not make any draws with respect to the New Revolving Credit Facility until February 10, 2010, (iii) requires that we make on November 16, 2009 the $2,000,000 principal payment with respect to the New Term Loan Facility which otherwise would have been due on December 31, 2009, (iv) requires that we maintain availability under the New Revolving Credit Facility of at least $4,000,000, and (v) otherwise modifies certain of the reporting requirements and other covenants contained in the Credit Agreement.

Our availability under the revolving line of credit of the New Senior Credit Facility is defined by a borrowing base comprised of eligible accounts receivable and inventory. As of September 30, 2009, we had $1.7 million outstanding under the revolving line of credit of the New Senior Credit Facility. Total availability under our credit facility amounted to $13.2 million at September 30, 2009. During the period subsequent to this date through November 16, 2009, we borrowed an additional $9 million under this revolving line of credit. We paid the $2 million quarterly principal payment installment on November 16, 2009, which otherwise would have been due on December 31, 2009, according to the terms of the Fourth Amendment. We do not expect to be able to meet certain of the financial covenants under the New Senior Credit Facility as of December 31, 2009 and possibly throughout 2010. As a result, we have reclassified amounts owed under the New Senior Credit Facility as short term debt in the Consolidated Balance Sheet at September 30, 2009. While we have been successful in obtaining waivers from our bank lenders in recent periods, however, there can be no assurance we will be successful obtaining such waivers for these events in the future.

Operating Activities

In the nine months ended September 30, 2009, we generated $2.1 million in cash from operating activities. Net loss allocable to common stockholders for the nine months ended September 30, 2009 was $44.9 million. Non-cash additions to net loss during the nine months ended September 30, 2009 consisted primarily of $10.5 million of depreciation and amortization, $11.0 million of deferred tax expense, $1.3 million of compensation expense related to options and restricted stock awards, $3.6 million related to the accretion of the debt discount related to our Convertible Senior Notes, $0.5 million related to accretion of discount on cumulative convertible preferred stock and $18.5 million related to the impairment of goodwill.

During the nine months ended September 30, 2009, working capital increased operating cash flow by $0.8 million due mainly to collection of accounts receivable and inventory reductions partially offset by payments of accounts payable and accrued liabilities.

Investing Activities

During the nine months ended September 30, 2009, we used $3.5 million in investing activities primarily due to capital expenditures. Capital expenditures for the nine months ended September 30, 2009 totaled approximately $5.6 million. Capital expenditures for the remainder of 2009 are expected to be approximately $1.0 million. Management has not established the capital expenditure budget for 2010; however, the capital expenditure budget for 2010 must be less than $11.0 million according to the Fourth Amendment. The most significant expenditures were related to our Drilling Products segment and the expansion of our Teledrift MWD tools, CAVO mud motor fleet and the addition of rental tools to expand our rental tool base. We also recognized approximately $2.1 million of proceeds related to the sale of assets that were mainly lost-in-hole by our rental customers during normal drilling activities.

Financing Activities

As of September 30, 2009, we had $1.7 million outstanding under the revolving line of credit of the New Senior Credit Facility and $0.6 million of cash. Total availability under the revolving line of credit as of September 30, 2009 was approximately $13.2 million. Bank borrowings are subject to certain covenants and a material adverse change subjective acceleration clause. As of September 30, 2009 we were not in compliance with certain of the financial covenants under our New Senior Credit Facility. We requested and obtained a waiver of these financial covenant violations from our bank lenders on November 16, 2009.

The following is a listing of our contractually required and actual covenant ratios as of September 30, 2009:

 

Covenant

 

Required $/Ratio

 

Actual $/Ratio

Minimum Net Worth

  Minimum $42.8 million   $24.7 million

Leverage Ratio (1)

  Waived   10.41 to 1.00

Fixed Charge Coverage

  Minimum 0.75 to 1.00   0.29 to 1.00

Senior Leverage

  Maximum 2.00 to 1.00   1.93 to 1.00

 

(1) Maximum leverage ratio was waived until June 30, 2010 in the August 6, 2009 amendment to our New Senior Credit Facility.

On August 6, 2009, we entered into an amendment (“Third Amendment”) to our New Senior Credit Facility. The Third Amendment changed the calculation of availability under our revolving line of credit, set a minimum liquidity maintenance amount, amended the annual Excess Cash Flow Recapture, waived the Mandatory Prepayment Requirement related to certain equity transactions, reduced the aggregate minimum threshold to trigger prepayment on an asset sale, increased interest charges related to margin rates and commitment fees, amended financial covenants related to Maximum Total Funded Debt to EBITDA, Minimum Fixed Charge Coverage Ratio and Minimum Net Worth, increased allowable capital expenditures for 2009, reduced additional indebtedness, changed certain reporting requirements and limited or restricted the company’s ability to acquire new business, sell assets, enter into operating leases, accelerate payments of subordinated debt or pay cash dividends.

 

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On August 12, 2009, we closed a private placement transaction with certain accredited investors, pursuant to which such investors purchased an aggregate of 16,000 units (“Units”) at a purchase price of $1,000 per Unit. Each Unit was comprised of (i) one share of cumulative redeemable convertible preferred stock (“Convertible Preferred Stock”), (ii) warrants to purchase up to 155 shares of our common stock at an exercise price of $2.31 per share (“Exercisable Warrants”) and (iii) contingent warrants to purchase up to 500 shares of our Common Stock at an exercise price of $2.45 per share (“Contingent Warrants”). Each share of Convertible Preferred Stock is convertible at the holder’s option, at any time, into 434.782 shares of our common stock under certain conditions. This conversion ratio represents an equivalent conversion price of $2.31 per share. The closing of this private placement resulted in the receipt of proceeds of $14.8 million, net of transaction costs of $1.2 million. We used the net proceeds to reduce borrowings under our bank credit facility, thereby providing additional availability of credit, and for general corporate purposes.

Each share of Convertible Preferred Stock has a liquidation preference of $1,000. Dividends will accrue at the rate of 15% of the liquidation preference per year and will accumulate if not paid quarterly. As of September 30, 2009, the Company had accrued and unpaid dividends of $0.3 million.

The Convertible Preferred Stock will, at our option (but not earlier than February 12, 2010), be automatically converted into shares of our common stock if the closing price of the common stock is equal to or greater than 150% of the then current conversion price for any 15 trading days during any 30 consecutive trading day period. If the Convertible Preferred Stock automatically converts and the Company has not previously paid holders amounts equal to at least eight quarterly dividends on the Convertible Preferred Stock, the Company will also pay to the holders, in connection with any automatic conversion, and amount, in cash or shares of our common stock (based on the market value of the common stock), equal to eight quarterly dividends less any dividends previously paid to holders of the Convertible Preferred Stock.

The Company may redeem any of the Convertible Preferred Stock beginning on August 12, 2012. The initial redemption price will be 105% of the liquidation preference, declining to 102.5% on August 12, 2013, and to 100% on or after August 12, 2014, in each case plus accrued and unpaid dividends to the redemption date.

The Exercisable Warrants are immediately exercisable and will expire if not exercised by August 12, 2014. The Contingent warrants became exercisable after we obtained shareholder approval on November 9, 2009 and will expire if not exercised by November 9, 2014. Both the Exercisable Warrants and Contingent Warrants contain anti-dilution price protection in the event we issues shares of Common Stock or securities exercisable for or convertible into Common Stock at a price per share less than their exercise price, subject to certain exceptions.

The Company used a portion of the proceeds from the private placement to repay amounts outstanding under its revolving line of credit, and will use the balance of the proceeds for general working capital needs and to satisfy future scheduled debt payments.

Contractual Obligations

As of September 30, 2009 the Company had approximately $0.2 million in vehicle loans and capitalized vehicle leases. Other than those discussed above related to our preferred stock offering, commitments under contractual obligations have not materially changed since our prior year end on December 31, 2008.

Impact of Recently Issued Accounting Standards

In June 2009, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (“ASU”) 2009-01, Topic No. 105 (ASU Topic 105), “ Generally Accepted Accounting Principles, ” which replaced FASB Statement No. 168, “ The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles ” and identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with US GAAP. Authoritative standards included in the Codification are designated by their ASC topical reference, with new standards designated as ASUs, with a year and assigned sequence number. The guidance is effective for financial statement issued for interim and annual periods ending after September 15, 2009. The Company adopted this standard for its September 30, 2009 interim report with no financial impact on its consolidated condensed financial statements.

In June 2009, the FASB issued accounting guidance related to accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing found primarily within ASC Topic 470, “Debt.” In October 2009, the FASB released ASU No. 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” which amends or added certain paragraphs to the related ASC Topic 470, “Debt .” These standards address the accounting for an entity’s own-share lending arrangement initiated in conjunction with convertible debt or other financing offering and the effect a share-lending arrangement has on earnings per share. Additionally, the guidance addresses the accounting and earnings per share

 

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implications for defaults by the share borrower, both when a default becomes probable of occurring and when a default actually occurs. This guidance released in June 2009 is effective for interim or annual periods beginning on or after June 15, 2009 for share-lending arrangements entered into in those periods. For all other arrangements within the scope, the guidance is applied retrospectively to share-lending arrangements that are outstanding as of the beginning of the fiscal year beginning on or after December 15, 2009. Early adoption is prohibited. Update guidance released in October 2009 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The update guidance is effective for all arrangements entered into on or before the beginning of the first reporting period that begins on or is after June 15, 2009. Update content shall be applied retrospectively for all arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company is currently evaluating the effect this will have on our consolidated condensed financial statements.

In May 2009, the FASB issued accounting guidance related to subsequent events found within ASC Topic 855, “Subsequent Events.” This guidance sets standards for the disclosure of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued. Additionally, the guidance sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. This guidance is effective for interim and annual periods ending after June 15, 2009. The Company adopted this guidance effective June 30, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In April 2009, the FASB issued accounting guidance related to interim disclosures about fair value of financial instruments found within ASC Topic 825, “Financial Instruments.” This guidance requires fair value disclosures in both interim as well as annual financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. This guidance is effective for interim and annual periods ending after June 15, 2009. The Company adopted this guidance effective June 30, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In June 2008, the FASB issued accounting guidance related to determining whether instruments granted in share-based payment transactions are participating securities found within the ASC Topic 260, “Earnings Per Share (EPS).” This guidance states that unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. The Company adopted the guidance effective January 1, 2009. All prior-period earnings per share (“EPS”) data presented have been adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of this Staff Position. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

In May 2008, the FASB issued accounting guidance related to debt with conversion and other options found primarily within ASC Topic 470, “Debt,” ASC Topic 815, “Derivatives and Hedging” and ASC Topic 825, “Financial Instruments.” This guidance clarifies that convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate. The resulting debt discount would be amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. The guidance requires retrospective application to all periods presented in the financial statements with cumulative effect of the change reported in retained earnings as of the beginning of the first period presented. Our 5.25% Convertible Senior Notes due February 2028 are affected by this new standard. Upon adopting the provisions of this guidance, we retroactively applied its provisions and restated our consolidated condensed financial statements for prior periods.

In applying this debt guidance, $27.8 million of the carrying value of our Convertible Senior Notes was reclassified to equity as of the February 2008 issuance date and offset by a related deferred tax liability of $10.6 million. This discount represents the equity component of the proceeds from the Convertible Senior Notes, calculated assuming an 11.5% non-convertible borrowing rate. The discount will be accreted to interest expense over the expected term of five years, which is based on the call/put option on the debt at February 2013. Accordingly, $1.2 million and $1.1 million of additional non-cash interest expense was recorded in the Consolidated Condensed Statement of Income (Loss) for the three months ended September 30, 2009 and 2008, respectively, and $3.5 million and $2.5 million of additional non-cash interest expense was recorded in the Consolidated Condensed Statement of Income (Loss) for the nine months ended September 30, 2009 and 2008, respectively. See Note 9 – Long-Term Debt for more details on the retrospective application of this debt guidance.

 

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In March 2008, the FASB issued accounting guidance related to derivative and hedging activities found within the ASC Topic 815, “Derivatives and Hedging.” This guidance requires enhanced disclosures about our derivative and hedging activities. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company adopted the guidance effective January 1, 2009. The implementation of this standard did not have a material impact on our consolidated condensed financial position and results of operations.

Off-Balance Sheet Arrangements

At September 30, 2009, we did not have any relationships which would have been established for the purpose of facilitating off-balance sheet arrangements.

Critical Accounting Policies

Our consolidated condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our 2008 Form 10-K, filed on March 16, 2009 as amended in the Form 8-K filed on August 26, 2009, in the Notes to the Consolidated Financial Statements found in our Form 8-K filed on August 26, 2009, Note 2, and the Critical Accounting Policies section.

Impairment Charge

Flotek records goodwill related to business acquisitions when the purchase price exceeds the fair value of identified assets and liabilities acquired. Under accounting guidance found in ASC Topic 350, “Intangibles – Goodwill and Other,” goodwill is subject to an annual impairment test. Flotek normally performs its annual goodwill impairment testing in the fourth quarter. If an event occurs, or circumstances change, that would more likely than not reduce the fair value of a reporting unit below its carrying value, an interim impairment test would be performed between annual tests. In the second quarter of 2009, the continued global financial and credit crisis and economic slowdown impacted our businesses and resulted in management reassessing the operating plans for its reporting units. As a result, we performed an interim impairment test at June 30, 2009. During the third quarter as a result of the continued slow-down in our businesses and liquidity concerns, we also performed an interim impairment test as of September 30, 2009. These impairment tests incorporated the revised plans included in our initial long range financial forecast and updated market and industry rates for each reporting unit to reflect our most current assessment of estimated fair value used for purposes of the goodwill impairment tests performed as of June 30 and September 30, 2009.

Goodwill impairment is evaluated using a two-step process. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying value. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed. The second step compares the implied fair value of the reporting unit’s goodwill to the carrying amount of its goodwill to measure the amount of impairment loss. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination (e.g., the fair value of the reporting unit is allocated to all of the assets and liabilities, including any unrecognized intangible assets, as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit).

The primary technique we utilize in estimating the fair value of our reporting units is discounted cash flow analysis. Discounted cash flow analysis requires us to examine market risk and equity rates and also to make various judgments, estimates and assumptions about future sales, operating margins, growth rates, capital expenditures, working capital and discount rates.

The long-range financial forecast is normally completed in the fourth quarter of each year, and it serves as the primary basis for our estimate of reporting unit fair values, absent significant changes in our outlook on future results. In addition, we compared the sum of the fair values that resulted from our discounted cash flow analysis of our reporting units to our current market capitalization to determine that our estimates of fair value were reasonable.

For purposes of the impairment testing, we determined that our Chemical and Logistics operating segment and our Artificial Lift operating segment to be reporting units. Additionally, we determined that a component of our Drilling Products operating segment, Teledrift, to be a reporting unit due to the availability of discrete financial information and that operating segment management regularly reviews its results. The remaining components of the Drilling Products operating segment were considered to be a reportable unit due to their similar economic characteristics.

 

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In the first step of the impairment tests performed as of June 30 and September 30, 2009, we determined that the carrying value of our Teledrift reporting unit exceed its estimated fair value; therefore, step two of the goodwill impairment test was required for that reporting unit. Additionally, in our impairment test of the Chemical and Logistics reporting unit, we determined an estimated fair value that exceed the carrying value of this reporting unit by more than as of June 30 and September 30, 2009 by more than 50%.

The second step of the goodwill impairment test determines the amount of impairment loss by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied goodwill is determined in a manner similar to determining the amount of goodwill recognized in a business combination. Accordingly, we assigned the fair value of the reporting unit to all the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The excess of fair value of the reporting unit over the amounts assigned to the reporting units is the implied goodwill. We performed this assignment process only for purposes of testing goodwill and did not write-up or write-down a recognized asset or liability, nor did we recognize a previously unrecognized intangible asset as a result of this allocation process. We determined that the carrying amount exceeded the implied goodwill for the Teledrift reporting unit and recognized an impairment loss of $18.5 million equal to that excess at June 30, 2009. At September 30, 2009 the implied fair value of goodwill of the Teledrift reporting unit exceeded the carrying amount by approximately 20% and therefore we did not record an impairment charge.

There are significant inherent uncertainties and judgment involved in estimating the fair value of our reporting units. While we believe we have used reasonable estimates and assumptions to estimate the fair value of our reporting units, it is possible that material changes could occur due to factors impacting the global financial markets and our industry in particular.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We are exposed to financial instrument market risk from changes in interest rates, and, to a limited extent, commodity prices and foreign currency exchange rates. Market risk is measured as the potential negative impact on earnings, cash flows or fair values resulting from a hypothetical change in interest rates or foreign currency exchange rates over the next year. We manage the exposure to market risks at the corporate level. The portfolio of interest-sensitive assets and liabilities is monitored and adjusted to provide liquidity necessary to satisfy anticipated short-term needs. Our risk management policies allow the use of specified financial instruments for hedging purposes only; speculation on interest rates or foreign currency rates is not permitted. We do not consider any of these risk management activities to be material. Our New Senior Credit Facility has variable-rates. As required by the New Senior Credit Facility, the Company has entered into an interest rate swap agreement on 50% of the New Term Loan Facility to partially reduce our exposure to interest rate risk.

Financial instruments that potentially subject us to credit risk consist of cash and cash equivalents and accounts receivable. Certain of our cash and cash equivalents balances exceed FDIC insured limits or are invested in money market accounts with investment banks that are not FDIC insured. We place our cash and cash equivalents in what we believe to be credit-worthy financial institutions. Additionally, we actively monitor the credit risk of our receivable and derivative counterparties.

Furthermore, we are exposed to the impact of interest rate changes on our variable rate indebtedness within our New Senior Credit Facility. The impact on the average outstanding balance of our variable rate indebtedness as of September 30, 2009 from a hypothetical 10% increase in interest rates would be an increase in interest expense of approximately $2.6 million .

 

Item 4. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934, as amended (“Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosures.

Our management, with the participation of our principal executive and principal financial officers, or persons performing similar functions, evaluated the effectiveness of the design and operation of our disclosure controls and procedures in connection with the preparation of our financial statements for the period ended September 30, 2009. As a result of that evaluation, our principal executive and principal financial officers, or persons performing similar functions, identified the following control deficiencies that constituted a material weakness in connection with the preparation of our financial statements for the period ended September 30, 2009:

 

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Control environment  – We did not maintain an effective control environment. The control environment, which is the responsibility of senior management, sets the tone of the organization, influences the control consciousness of its people, and is the foundation for all other components of internal control over financial reporting. We did not maintain an effective control environment because of the following:

(a) As a result of numerous resignations, we did not maintain an appropriate level of senior management and Board level oversight related to financial reporting and internal controls.

(b) We did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience, and training in the application of GAAP commensurate with our financial reporting requirements.

Based on management’s evaluation, because of the material weakness described above, management has concluded that our internal control over financial reporting was not effective in connection with the preparation of our financial statements for the period ended September 30, 2009.

Remediation Plan

Our management, under new leadership as described below, has been actively engaged in the planning for, and the implementation of, remediation efforts to address the material weakness, as well as other identified areas of risk. These remediation efforts, outlined below, are intended to address the identified material weakness and to enhance our overall financial control environment.

In October, 2009, the Board of Directors restructured the Company’s executive management team to more effectively manage the Company’s day-to-day operations. Mr. Jesse “Jempy” Neyman, Executive Vice President, Finance and Strategic Planning, was designated by the Board to act as the Company’s principal financial officer and principal accounting officer and Mr. Steve Reeves was appointed to serve as Executive Vice President, Business Development and Special Projects, of the Company.

In November 2009, the Board elected Mr. Kenneth T. Hern and Mr. John Reiland as directors. Mr. Hern was also elected to serve as a member of the Compensation and Audit Committees and as the Chairman of the Governance and Nominating Committee. Mr. Reiland was elected to serve as a member of the Compensation and Governance and Nominating Committees and as the Chairman of the Audit Committee. Mr. Richard Wilson, who has been a director of the Company since 2003, was also elected to serve as a member of the Governance and Nominating Committee and the Audit Committee and as the Chairman of the Compensation Committee.

Our new executive management team, together with our Board of Directors, is committed to achieving and maintaining a strong control environment, high ethical standards, and financial reporting integrity. In addition, we are in the process of evaluating our personnel and plan to make the necessary changes to strengthen the level of competency in key accounting and financial reporting functions.

(b) Changes in Internal Control over Financial Reporting

During the fourth quarter, we have begun the implementation of some of the remedial measures described above, including the appointment of our new executive management team and members of the Board of Directors. We also expect to commence an assessment of our financial business processes and our accounting and finance department shortly. We plan to implement the recommendations derived from this assessment.

 

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PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings.

On August 7, 2009, a class action suit was commenced in the United States District Court for the Southern District of Texas on behalf of purchasers of the common stock of the Company between May 8, 2007 and January 23, 2008, inclusive, seeking to pursue remedies under the Securities Exchange Act of 1934. There have been no material changes in the class action suit disclosed in the “Legal Proceedings” section of our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2009. See “Legal Proceedings” in our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2009.

We are subject to claims and legal actions in the ordinary course of our business. We believe that all such claims and actions currently pending against us are either adequately covered by insurance or would not have a material adverse effect on us.

 

Item 1A. Risk Factors.

We may not be able to continue as a going concern.

Our consolidated financial statements have been prepared on the basis that we will continue as a going concern. At September 30, 2009, we were not in compliance with certain financial covenants contained in the New Credit Agreement. We requested and obtained a waiver of these financial covenant violations from our bank lenders. We do not expect to be able to meet certain of the financial covenants under the New Credit Facility as of December 31, 2009 and possibly throughout 2010. As a result, we have reclassified amounts owing under the New Senior Credit Facility as short term debt in the Consolidated Balance Sheet at September 30, 2009. Management recognizes that we will need to generate additional financial resources in order to meet our objectives and make scheduled payments or mandatory prepayments on our current debt obligations. If we are not able to generate positive cash flows and profits or obtain adequate additional financing or refinancing, we will be required to curtail operations. Furthermore, our inability to continue as a going concern would require us to restate our assets and liabilities on a liquidation basis, which could differ significantly from the going concern basis.

We may not be able to generate sufficient cash flows, to meet our debt service obligations or other liquidity needs, and we may not be able to successfully negotiate waivers, a forbearance or a new credit agreement to cure any covenant violations under our current credit agreements.

On several occasions we have failed to meet, or have projected that we would in the future fail to meet, the financial covenant requirements in our bank credit facilities. We have been required on these occasions to seek waivers of such covenant violations and amendments to our bank credit facility to modify these covenants. Most recently, we were not in compliance with certain of the financial covenants in our bank credit facility as of September 30, 2009, and we sought and obtained a waiver of these financial covenant violations from our bank lenders.

Our ability to generate sufficient cash flows from operations to make scheduled payments or mandatory prepayments on our current debt obligations and other future debt obligations we may incur will depend on our future financial performance, which may be affected by a range of economic, competitive, regulatory and industry factors, many of which are beyond our control. In addition, we may be required under generally accepted accounting principles to record further impairment charges in the future relating to the carrying value of our goodwill and intangible assets. If as a result of our financial performance, future impairment charges or other events we violate the financial covenants in our debt agreements or are unable to generate sufficient cash flows or otherwise obtain the funds required to make principal and interest payments on our indebtedness, we may have to seek waivers or a forbearance of these covenants from our lenders or undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital expenditures or seeking to raise additional capital through the issuance of debt securities or other securities. We cannot assure you that we will be able to obtain any required waivers or a forbearance from our lenders or that we will be able to accomplish any necessary refinancing, sale of assets or issuance of securities on terms that are acceptable. Our inability to obtain any required waivers or a forbearance, to generate sufficient cash flows to satisfy such obligations, or to refinance our obligations on commercially reasonable terms, would have an adverse effect on our business, financial condition and results of operations.

The tightening of the credit markets or a downgrade in our credit ratings could increase our borrowing costs and make it more difficult for us to access funds, to refinance our existing indebtedness, to enter into agreements for new indebtedness or to obtain funding through the issuance of securities. If such conditions were to persist, we would seek alternative sources of liquidity but may not be able to meet our obligations as they become due.

Our principal source of liquidity, other than cash flows from operations, is the revolving line of credit under our amended senior credit facility. The borrowing base under our revolving line of credit is based on our eligible accounts receivable and inventory. If our revenues and inventory decrease as a result of the current economic environment or otherwise, our borrowing capacity under our

 

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revolving line of credit could decrease, and such decreases could require us to repay excess borrowings under the revolving line. Any such decreases could also outpace any offsetting reductions in our working capital requirements, which could lead to reduced liquidity. While we believe that the proceeds of our equity private placement in August 2009, our cash flows from operations and amounts available under our new revolving line of credit are sufficient to meet our obligations in the near term, our needs for cash may exceed the levels generated from operations and available to us under our revolving line of credit due to factors which are beyond our control.

Our debt agreements also contain representations, warranties, fees, affirmative and negative covenants, and default provisions. A breach of any of these covenants could result in a default under these agreements. Upon the occurrence of an event of default under our debt agreements, the lenders could elect to declare all amounts outstanding to be immediately due and payable and terminate all commitments to extend further credit. If the lenders accelerate the repayment of borrowings, we may not have sufficient assets to repay our indebtedness. Also, should there be an event of default, or need to obtain waivers or a forbearance following an event of default, we may be subject to higher borrowing costs and/or more restrictive covenants in future periods. Acceleration of any obligation under any of our material debt instruments will permit the holders of our other material debt to accelerate their obligations.

If we do not meet the New York Stock Exchange continued listing requirements, our common stock may be delisted, which could have an adverse impact on the liquidity and market price of our common stock.

Our common stock is currently listed on the New York Stock Exchange (“NYSE”). Under the NYSE’s continued listing standards, a company will be considered to be below compliance standards if, among other things, (i) both its average market capitalization is less than $50 million over a 30 trading-day period and its stockholders’ equity is less than $50 million; (ii) its average market capitalization is less than $15 million over a 30 trading-day period, which will result in immediate initiation of suspension procedures; or (iii) the average closing price of a listed security is less than $1.00 over a consecutive 30 trading-day period. As of September 30, 2009, our stockholders’ equity was less than $50 million. When a listed company’s stock falls below the market capitalization and stockholders’ equity standard, a company is considered “below criteria,” and the company is permitted to submit a business plan demonstrating its ability to return to compliance with these continued listing standards within 18 months of receipt of receipt from the NYSE of notification that it is below criteria. We intend to submit a business plan that will advise the NYSE of definitive action we intend to take that will bring us into conformity with the NYSE continued listing standards within the required period. However, if our plan is not approved or if we are unable to regain compliance with the NYSE listing requirements, our stock could be delisted from trading on the NYSE. A delisting of our common stock could negatively impact us by: (i) reducing the liquidity and market price of our common stock; (ii) reducing the number of investors willing to hold or acquire our common stock, which could negatively impact our ability to raise equity financing; and (iii) decreasing the amount of news and analyst coverage for us. In addition, we may experience other adverse effects, including, without limitation, the loss of confidence in us by current and prospective suppliers, customers, employees and others with whom we have or may seek to initiate business relationships, and our ability to attract and retain personnel by means of equity compensation could be impaired. If our common stock is delisted from the NYSE and we are unable within 30 days to obtain a listing of our common stock on another national securities exchange, we are required to make an offer to repurchase our Convertible Senior Notes, and we could be unable to raise the required funds to make any such repurchases.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Not Applicable.

 

Item 3. Defaults Upon Senior Securities.

Not Applicable.

 

Item 4. Submission of Matters to a Vote of Security Holders.

On November 9, 2009, we held a special meeting of our stockholders of record as of September 14, 2009. At the meeting, our stockholders voted on and approved (i) the amendment of the Company’s Amended and Restated Certificate of Incorporation to increase the number of authorized shares of common stock from 40,000,000 to 80,000,000 shares (“Charter Amendment”); (ii) the ability of the Company to pay dividends in the future in respect of its shares of preferred stock by issuing shares of the Company’s common stock (“Preferred Stock PIK Dividend Provision”); (iii) the anti-dilution price protection provision contained in certain warrants issued by the Company in a private placement in August 2009 (“Exercisable Warrant Anti-dilution Provision”) and (iv) the contingent warrants issued by the Company in a private placement in August 2009 (“Contingent Warrants”).

 

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The holders of a total of 13,966,964 shares of common stock, representing 59.6% of the total shares of common stock outstanding and entitled to vote, were present in person or by proxy at the special meeting, constituting a quorum. At the meeting, the votes cast for and against, and those abstaining from voting with respect to each of the proposals described above, were as follows:

 

     Charter
Amendment (1)
   Preferred Stock PIK
Dividend Provision
   Exercisable Warrant
Anti-dilution Provision
   Contingent
Warrants

For

   12,320,492    12,427,677    12,666,434    12,420,149

Against

   1,422,139    1,281,885    1,012,029    1,201,156

Abstain

   224,333    257,402    288,501    345,659

Broker and Other Non-Votes

   —      —      —      —  

 

(1) The proposal of the Charter Amendment required a majority vote “for” of all common shares outstanding to be approved. All other proposals required a majority vote “for” of all shares voted.

 

Item 5. Other Information.

In the Current Report on Form 8-K filed on November 10, 2009, the Company reported the resignation of Mr. Scott Stanton, Mr. Barry Stewart and Mr. Kevin McMahon as occurring on November 5, 2005. This was a typographical error. Messrs. Stanton, Steward and McMahon resigned on November 5, 2009.

 

Item 6. Exhibits.

 

Exhibit

No.

  

Description of Exhibit

  3.1    Certificate of Amendment to the Amended and Restated Certificate of Incorporation, filed on November 9, 2009.
10.1    Amended and Restated Credit Agreement between the Company and Wells Fargo Bank, N.A. dated August 31, 2007.
10.2    Credit Agreement, dated as of March 31, 2008, among Flotek Industries, Inc., Wells Fargo Bank, National Association and the Lenders named therein.
10.3    Second Amendment to Credit Agreement, dated as of March 13, 2009, among Flotek Industries, Inc., Wells Fargo Bank, N.A. and the Lenders named therein.
10.4    Waiver Agreement and Fourth Amendment to Credit Agreement, dated as of November 16, 2009, among Flotek Industries, Inc., Wells Fargo Bank, N.A. and the Lenders named therein.
31.1    Certification (pursuant to Rule 13a-14(a) and 15d-14(a) of the Exchange Act) by Principal Executive Officer.
31.2    Certification (pursuant to Rule 13a-14(a) and 15d-14(a) of the Exchange Act) by Principal Financial Officer.
32.1    Section 1350 Certification of Periodic Report by Principal Executive Officer and Principal Financial Officer.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

FLOTEK INDUSTRIES, INC.
(Registrant)
FLOTEK INDUSTRIES, INC.
By:  

/s/    J OHN W. C HISHOLM        

  John W. Chisholm
  Interim President
By:  

/s/    J ESSE E. N EYMAN        

  Jesse E. Neyman
 

Executive Vice President,

Finance and Strategic Planning,

Principal Financial Officer and

Principal Accounting Officer

November 16, 2009

 

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EXHIBITS

 

Exhibit

No.

  

Description of Exhibit

  3.1    Certificate of Amendment to the Amended and Restated Certificate of Incorporation, filed on November 9, 2009.
10.1    Amended and Restated Credit Agreement between the Company and Wells Fargo Bank, N.A. dated August 31, 2007.
10.2    Credit Agreement, dated as of March 31, 2008, among Flotek Industries, Inc., Wells Fargo Bank, National Association and the Lenders named therein.
10.3    Second Amendment to Credit Agreement, dated as of March 13, 2009, among Flotek Industries, Inc., Wells Fargo Bank, N.A. and the Lenders named therein.
10.4    Waiver Agreement and Fourth Amendment to Credit Agreement, dated as of November 16, 2009, among Flotek Industries, Inc., Wells Fargo Bank, N.A. and the Lenders named therein.
31.1    Certification (pursuant to Rule 13a-14(a) and 15d-14(a) of the Exchange Act) by Principal Executive Officer.
31.2    Certification (pursuant to Rule 13a-14(a) and 15d-14(a) of the Exchange Act) by Principal Financial Officer.
32.1    Section 1350 Certification of Periodic Report by Principal Executive Officer and Principal Financial Officer.

 

34

Exhibit 3.1

CERTIFICATE OF AMENDMENT

TO THE

AMENDED AND RESTATED

CERTIFICATE OF INCORPORATION

OF

FLOTEK INDUSTRIES, INC.

Flotek Industries, Inc. (the “ Corporation ”), a corporation duly organized and validly existing under the General Corporation Law of the State of Delaware (the “ DGCL ”), hereby files this Certificate of Amendment (this “ Amendment ”) to the Amended and Restated Certificate of Incorporation of the Corporation, as amended, and hereby certifies as follows:

 

1. The name of the Corporation is Flotek Industries, Inc. The original Certificate of Incorporation of the Corporation was filed with the Secretary of State of the State of Delaware on October 30, 2001, and an Amended and Restated Certificate of Incorporation of the Corporation was filed with the Secretary of State of the State of Delaware on October 2, 2007.

 

2. The first paragraph of Article Fourth of the Corporation’s Amended and Restated Certificate of Incorporation, as amended, is hereby amended and restated in its entirety to read as follows:

“The aggregate number of shares which the corporation shall have the authority to issue is 80,100,000, consisting of 80,000,000 shares of Common Stock, par value of $.0001 per share, and 100,000 shares of Preferred Stock, par value of $.0001 per share.”

 

3. This Amendment was duly adopted in accordance with the provisions of Section 242 of the DGCL.

 

4. This Amendment shall become effective upon its filing in accordance with the provisions of Section 103(d) of the DGCL.

[ Remainder of page intentionally left blank ]


IN WITNESS WHEREOF, the Corporation has caused this Amendment to be executed by its duly authorized officer on November 9, 2009.

 

FLOTEK INDUSTRIES, INC.
By:   /s/ John Chisholm
Name:   John Chisholm
Title:   President

Exhibit 10.1

 

 

 

AMENDED AND RESTATED CREDIT AGREEMENT

BETWEEN

FLOTEK INDUSTRIES, INC.

AND

WELLS FARGO BANK, NATIONAL ASSOCIATION

Dated as of August 31, 2007

 

 

 


TABLE OF CONTENTS

 

ARTICLE I DEFINITIONS AND ACCOUNTING TERMS

   1

SECTION 1.01

   Certain Defined Terms    1

SECTION 1.02

   Accounting Terms    13

SECTION 1.03

   Interpretation    13

ARTICLE II AMOUNTS AND TERMS OF THE ADVANCES

   14

SECTION 2.01

   The Advances    14

SECTION 2.02

   Making the Advances    15

SECTION 2.03

   Reduction and Changes in the Commitment    16

ARTICLE III NOTES, INTEREST AND PAYMENT

   16

SECTION 3.01

   The Notes    16

SECTION 3.02

   Interest Elections    17

SECTION 3.03

   Interest    18

SECTION 3.04

   Principal Payments    19

SECTION 3.05

   Voluntary Prepayments    19

SECTION 3.06

   Mandatory Prepayments    19

SECTION 3.07

   Fees    20

SECTION 3.08

   Payments and Computations    20

SECTION 3.09

   The Borrower Unconditionally Liable    21

SECTION 3.10

   Reserve Requirements; Change in Circumstances    21

SECTION 3.11

   Indemnity    22

ARTICLE IV LETTERS OF CREDIT

   23

SECTION 4.01

   General    23

SECTION 4.02

   Notice of Issuance, Amendment, Renewal, Extension; Certain Conditions    23

SECTION 4.03

   Expiration Date    23

SECTION 4.04

   Reimbursement    24

SECTION 4.05

   Obligations Absolute    24

SECTION 4.06

   Disbursement Procedures    25

SECTION 4.07

   Interim Interest    25

SECTION 4.08

   Cash Collateralization    25

ARTICLE V CONDITIONS OF LENDING

   26

SECTION 5.01

   Condition Precedent to Initial Credit Extension    26

SECTION 5.02

   Conditions Precedent to All Advances    27

ARTICLE VI REPRESENTATIONS AND WARRANTIES

   28

SECTION 6.01

   Organization, Standing and Qualification    28

SECTION 6.02

   Authority    28

SECTION 6.03

   Financial Condition    28

SECTION 6.04

   Litigation    28

 

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SECTION 6.05

   Regulation U    29

SECTION 6.06

   Compliance with Law    29

SECTION 6.07

   Other Instruments    29

SECTION 6.08

   Title to Properties    29

SECTION 6.09

   Taxes    29

SECTION 6.10

   Environmental Compliance    29

SECTION 6.11

   No Default    30

SECTION 6.12

   Subsidiaries    30

SECTION 6.13

   ERISA    30

SECTION 6.14

   Acceptable Security Interest    31

ARTICLE VII AFFIRMATIVE COVENANTS

   31

SECTION 7.01

   Compliance with Laws, Etc.    31

SECTION 7.02

   Reporting Requirements    32

SECTION 7.03

   Visitation Rights    33

SECTION 7.04

   Maintenance of Insurance    33

SECTION 7.05

   Maintenance of Properties, Etc.    33

SECTION 7.06

   Keeping of Records and Books of Account    33

SECTION 7.07

   Preservation of Existence, Etc.    33

SECTION 7.08

   Notification of Adverse Events    34

SECTION 7.09

   ERISA Compliance    34

SECTION 7.10

   Additional Security    34

SECTION 7.11

   Borrowing Base Audits    35

SECTION 7.12

   Treasury Management Services    35

SECTION 7.13

   Use of Proceeds    35

ARTICLE VIII NEGATIVE COVENANTS

   35

SECTION 8.01

   Liens    35

SECTION 8.02

   Indebtedness    35

SECTION 8.03

   Change in Nature of Business    36

SECTION 8.04

   Transactions with Affiliates    36

SECTION 8.05

   Investments    36

SECTION 8.06

   Distributions    36

SECTION 8.07

   Subordinated Debt    36

SECTION 8.08

   Leverage Ratio    37

SECTION 8.09

   Fixed Charge Coverage Ratio    37

SECTION 8.10

   Consolidated Net Income    37

SECTION 8.11

   Prohibition of Fundamental Changes    37

SECTION 8.12

   Asset Sales    37

SECTION 8.13

   Capital Expenditures    37

SECTION 8.14

   Restrictions on CAVO    37

ARTICLE IX EVENTS OF DEFAULT AND REMEDIES

   38

SECTION 9.01

   Events of Default    38

ARTICLE X MISCELLANEOUS

   40

SECTION 10.01

   Amendments, Etc.    40

 

-ii-


SECTION 10.02

   Notices, Etc.    40

SECTION 10.03

   No Waiver; Remedies    40

SECTION 10.04

   Costs, Expenses and Taxes    40

SECTION 10.05

   Right of Set-off    41

SECTION 10.06

   Interest    41

SECTION 10.07

   Indemnification    42

SECTION 10.08

   Binding Effect    42

SECTION 10.09

   Governing Law    42

SECTION 10.10

   Execution in Counterparts    42

SECTION 10.11

   Assignment    42

SECTION 10.12

   Separability    42

SECTION 10.13

   Limitation by Law    42

SECTION 10.14

   Waiver of DTPA Actions    43

SECTION 10.15

   Agreement for Binding Arbitration    43

SECTION 10.16

   Final Agreement of the Parties    44

Exhibits

 

Exhibit A

   Compliance Certificate

Exhibit B

   Working Capital Loan Borrowing Base Certificate

Exhibit C

   Form of Request for Advance

Exhibit D

   Form of Joinder Agreement

Schedules

 

Schedule 1.01

   Real Property

Schedule 6.12

   Subsidiaries

Schedule 8.02

   Existing Indebtedness

Schedule 8.08

   Existing Investments

 

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AMENDED AND RESTATED CREDIT AGREEMENT

This Amended and Restated Credit Agreement dated as of August 31, 2007, is between FLOTEK INDUSTRIES, INC. , a Delaware corporation (the “ Borrower ”), and WELLS FARGO BANK, NATIONAL ASSOCIATION , a national banking association (the “ Bank ”).

A. The Borrower and the Bank are parties to the Amended and Restated Credit Agreement (as the same has been amended, supplemented and modified, the “ Existing Credit Agreement ”) dated as of January 4, 2007 (the “ Original Effective Date ”).

B. The Borrower has requested that the Existing Credit Agreement be amended and restated in its entirety as more fully set forth herein.

C. The Bank is willing to so amend and restate the Existing Credit Agreement on the terms and subject to the conditions set forth in this Agreement.

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged by the parties hereto, the parties hereby agree as follows:

ARTICLE I

DEFINITIONS AND ACCOUNTING TERMS

SECTION 1.01 Certain Defined Terms . As used in this Agreement, the following terms have the following meanings:

Acceptable Security Interest ” means with respect to any Property, a Lien that (i) exists in favor of the Bank, (ii) is superior to all other Liens (except Permitted Liens), (iii) secures the Obligations, and (iv) is perfected and enforceable against all Persons.

Accounts Receivable ” has the same meaning as the term “ Accounts ” as defined in the Security Agreement to the extent there exists an Acceptable Security Interest on same.

Acquisition ” means the purchase by the Borrower or a Subsidiary of Borrower of 100% of the Equity Interests in SES from the Sellers pursuant to the terms and conditions of the Acquisition Documents.

Acquisition Documents ” means (i) the Stock Purchase Agreement dated as of August 31, 2007, between the Sellers and Flotek Industries, Inc. and (ii) all assignments, agreements and other documents executed and delivered in connection therewith.

Adjusted LIBO Rate ” means, with respect to any Eurodollar Advance for any Interest Period, an interest rate per annum (rounded upwards, if necessary, to the next 1/16 of 1%) equal to (a) the LIBO Rate for such Interest Period multiplied by (b) the Statutory Reserve Rate.

Advance ” means an advance by the Bank to the Borrower pursuant to Article II .


Advance Date ” means, with respect to each Advance, the Business Day upon which the proceeds of such Advance are to be made available to the Borrower.

Advance Request ” means a request by the Borrower for an Advance in accordance with Section 2.02 .

Affiliate ” of any Person means any other Person directly or indirectly controlled by, controlling or under common control with such Person, and also includes all general partners in such Person. A Person shall be deemed to control an entity if such Person (i) possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of such entity, whether through the ownership of voting securities, by contract or otherwise or (ii) owns directly or indirectly 10% or more of the outstanding Equity Interests of such Person.

Agreement ” means this Credit Agreement, as the same may be amended, supplemented, restated or modified from time to time.

Alternate Base Rate ” means, for any day, a rate per annum equal to the greater of (a) the Prime Rate in effect on such day and (b) the Federal Funds Effective Rate in effect on such day plus  1 / 2 of 1%. Any change in the Alternate Base Rate due to a change in the Prime Rate or the Federal Funds Effective Rate shall be effective from and including the effective date of such change in the Prime Rate or the Federal Funds Effective Rate, respectively.

Bank ” has the meaning specified in the introduction to this Agreement.

Base Rate ”, when used in reference to any Advance, refers to whether such Advance bears interest at a rate determined by reference to the Alternate Base Rate.

Borrower ” has the meaning specified in the introduction to this Agreement.

Business Day ” means any day that is not a Saturday, Sunday or other day on which commercial banks in New York City and Houston, Texas are authorized or required by Law to remain closed; provided that, when used in connection with a Eurodollar Loan, the term “ Business Day ” shall also exclude any day on which banks are not open for dealings in dollar deposits in the London interbank eurodollar market.

Capital Expenditures ” means expenditures for plant, property and equipment less the sum of (i) any such expenditures incurred with the proceeds of Indebtedness plus (ii) any reimbursement from customers of “lost in-hole” rental tools.

CAVO ” means Cavo Drilling Motors, Ltd. Co., a Texas limited liability company.

CAVO Regulations ” means the letter agreement between B.L. Perez and Turbeco, Inc. setting forth certain matters relating to the operations of CAVO.

Change of Control ” means (i) any Person or “group” of Persons (within the meaning of Rules 13d-3 and 13d-5 under the Exchange Act) shall have (A) acquired, directly or indirectly, beneficial ownership (within the meaning of Rule 13d-3 under the Exchange Act) of securities representing 50% or more of the combined voting power of all outstanding voting securities of

 

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the Borrower or (B) obtained the power (whether or not exercised) to elect a majority of the Borrower’s directors or (ii) a majority of the members of the Board of Directors of the Borrower shall not be Continuing Directors.

Code ” means the Internal Revenue Code of 1986, as amended from time to time.

Collateral ” has the meaning set forth in the Security Agreement.

Commitments ” means the obligations of the Bank under the terms and conditions set forth in the Loan Documents to make Advances under the Equipment Loan Commitment and the Working Capital Commitment.

Compliance Certificate ” means, as of any date, a certification of the chief financial officer of the Borrower demonstrating compliance by the Borrower and its Subsidiaries with the provisions of Section 8.01 through Section 8.12 and substantially in the form of Exhibit A .

Consolidated Net Income ” means, for any period, the consolidated net income (or loss) of the Borrower and its Subsidiaries for such period determined in accordance with GAAP; provided , however , that there shall be excluded:

(i) the income (or loss) of any Person (other than a Subsidiary) in which any Credit Party has an ownership interest, except to the extent that any such income has been actually received by such Credit Party in the form of cash dividends or similar cash distributions,

(ii) any restoration to income of any contingency reserve, except to the extent that provision for such reserve was made out of income accrued during such period,

(iii) any aggregate net gain (but not any aggregate net loss) during such period arising from the sale, conversion, exchange or other disposition of capital assets,

(iv) any gains resulting from the write-up of assets (but not any loss resulting from any write-down of assets), and

(v) any net income or gain (but not any loss) during such period from (A) any change in accounting principles in accordance with GAAP, (B) any prior period adjustments resulting from any change in accounting principles in accordance with GAAP, (C) any extraordinary items or (D) any discontinued operations or the disposition thereof.

Continuing Directors ” means the directors of the Borrower on the date hereof and each other director if such director’s nomination for election to the Board of Directors of the Borrower is recommended by a majority of the then Continuing Directors.

Credit Extension ” means, at the date of such determination, the aggregate amount of all outstanding Advances.

Credit Parties ” means the Borrower and the Guarantors.

 

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Current Maturities ” as of any date means the Indebtedness scheduled to be paid during the twelve month period beginning on such date.

Deed of Trust ” means each mortgage, deed of trust, security agreement, fixture financing statement and assignment of rent executed by the applicable Credit Party to the Bank or the trustee named therein granting Liens on the tracts of real property owned or leased by such Credit Party located in the counties and states shown on Schedule 1.1 or as otherwise required by Section 7.10(b).

Default ” means an Event of Default or any event or condition that, with notice or lapse of time or both would, unless cured or waived, become an Event of Default.

Dollars ” and the sign “ $ ” mean lawful money of the United States of America.

Domestic Subsidiary ” means any Subsidiary of the Borrower organized under the laws of the United States, any state thereof, the District of Columbia or Puerto Rico.

EBITDA ” means, with respect to any period, the sum of (i) the Borrower’s Consolidated Net Income for such period plus (ii) to the extent deducted in determining the Borrower’s Consolidated Net Income, interest expense, taxes, depreciation, amortization and other non-cash charges for such period; provided , however , that EBITDA shall be subject to pro forma adjustments approved by the Bank for acquisitions and dispositions of lines of businesses.

Effective Date ” means the date on which the conditions set forth in Section 5.01 are satisfied.

Eligible Accounts Receivable ” means, as to the Borrower and its Subsidiaries on a consolidated basis at any time of determination, all Accounts Receivable of such Persons, each of which meets all of the following criteria on the date of any determination:

(a) the payment of such Account Receivable is not more than 90 days past the invoice date;

(b) such Account Receivable was created in the ordinary course of business of the Borrower or any Subsidiary;

(c) such Account Receivable represents a legal, valid and binding payment obligation of the account debtor enforceable in accordance with its terms and arises from an enforceable contract, the performance of which, insofar as it relates to such Account Receivable, has been completed by the Borrower or such Subsidiary;

(d) the Borrower or such Subsidiary has good and indefeasible title to such Account Receivable, and the Bank holds an Acceptable Security Interest in such Account Receivable;

(e) such Account Receivable is not evidenced by a promissory note, chattel paper or other instrument that is not in the actual possession of the Borrower;

 

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(f) such Account Receivable is not subject to any set-off, counterclaim, defense, allowance or adjustment and there has been no dispute, objection or complaint by the account debtor concerning its liability for such Account Receivable, and the Inventory, the sale of which gave rise to such Account Receivable, has not been returned, rejected, lost or damaged;

(g) the account debtor with respect to such Account Receivable is domiciled in and organized under the laws of the United States and such Account Receivable is denominated in dollars;

(h) such Account Receivable, together with all other Accounts Receivable due from the same account debtor, does not comprise more than 25% of the aggregate Eligible Accounts Receivable;

(i) such Account Receivable is not due from the United States government, any state or municipal government or any agency of any of same;

(j) unless otherwise approved by the Bank, such Account Receivable is not due from an account debtor that (i) has at any time more than 20% of its aggregate Accounts Receivable owed to the Borrower more than 90 days past due, (ii) is the subject of a proceeding under the United States Bankruptcy Code or any similar proceeding or (iii) the Bank has notified the Borrower does not have a satisfactory credit standing (as determined in the sole discretion of the Bank);

(k) such Account Receivable is not due from any Affiliate of a Credit Party;

(l) such Account Receivable is not the result of a credit balance relating to an Account Receivable more than 90 days past the invoice date; and

(m) such Account Receivable does not relate to work-in-progress or finance or service charges.

Eligible Inventory ” means inventories of products located in the United States that are not in transit, work in progress, damaged, defective, obsolete, unmerchantable and/or aged more than one year. In addition to the above, Inventory will be deemed Eligible by the Bank subject to inventory test counts conducted during initial and subsequent working capital collateral audits.

Environmental Laws ” means any laws, statutes, regulations, rules, orders or determinations of any governmental authority pertaining to health or the environment in effect in any and all jurisdictions in which the Borrower and its Subsidiaries are or at any time have done business or where the Property of the Borrower or any Subsidiary of the Borrower is located, including the Clean Air Act; the Comprehensive Environmental Response, Compensation and Liability Act; the Federal Water Pollution Control Act; the Resource Conservation and Recovery Act; the Safe Drinking Water Act; the Superfund Amendments and Reauthorization Act of 1986; the Toxic Substances Control Act; the Occupational Safety and Health Act; the Federal Insecticide, Fungicide and Rodenticide Act and other environmental conservation and environmental protection laws.

 

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Equipment ” means equipment that is the subject of the appraisal described in Section 5.01(h) and similar equipment acquired by the Borrower or any Subsidiary after the date hereof.

Equipment Loan ” has the meaning specified in Section 2.01(b) .

Equipment Loan Commitment ” means the Bank’s Commitment to make Advances in the aggregate amount of $36,000,000.

Equipment Note ” means a promissory note payable to the order of the Bank evidencing the Equipment Loan, together with all modifications, extensions, renewals and rearrangements thereof.

Equity Interests ” means (i) any capital stock, partnership, joint venture, member or limited liability or unlimited liability interest, beneficial interest in a trust or similar entity, or other equity interest in another Person of whatever nature, and (ii) any warrants, options or other rights to acquire such stock or interests.

ERISA ” means the Employee Retirement Income Security Act of 1974 and the regulations promulgated and rulings issued thereunder.

ERISA Affiliate ” means any trade or business (whether or not incorporated) that, together with the Borrower, is treated as a single employer under Section 414(b) or (c) of the Code or, solely for purposes of Section 302 of ERISA and Section 412 of the Code, is treated as a single employer under Section 414 of the Code.

ERISA Event ” means (a) any “reportable event”, as defined in Section 4043 of ERISA or the regulations issued thereunder with respect to a Plan (other than an event for which the 30-day notice period is waived); (b) the existence with respect to any Plan of an “accumulated funding deficiency” (as defined in Section 412 of the Code or Section 302 of ERISA), whether or not waived; (c) the filing pursuant to Section 412(d) of the Code or Section 303(d) of ERISA of an application for a waiver of the minimum funding standard with respect to any Plan; (d) the incurrence by the Borrower or any of its ERISA Affiliates of any liability under Title IV of ERISA with respect to the termination of any Plan; (e) the receipt by the Borrower or any ERISA Affiliate from the PBGC or a plan administrator of any notice relating to an intention to terminate any Plan or to appoint a trustee to administer any Plan; (f) the incurrence by the Borrower or any of its ERISA Affiliates of any liability with respect to the withdrawal or partial withdrawal from any Plan or Multiemployer Plan; or (g) the receipt by the Borrower or any ERISA Affiliate of any notice, or the receipt by any Multiemployer Plan from the Borrower or any ERISA Affiliate of any notice, concerning the imposition of withdrawal liability or a determination that a Multiemployer Plan is, or is expected to be, insolvent or in reorganization, within the meaning of Title IV of ERISA.

Eurodollar ”, when used in reference to any Advance, refers to whether such Advance bears interest at a rate determined by reference to the Adjusted LIBO Rate.

Event of Default ” means the occurrence of any one or more of the events referred to in Section 9.1 hereof.

 

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Excess Cash Flow ” means, with respect to any fiscal year of the Borrower, an amount equal to (a) the Borrower’s EBITDA for such fiscal year minus (b) without duplication, the sum of (i) taxes actually paid by the Borrower and its Subsidiaries during such fiscal year, (ii) Capital Expenditures of the Borrower and its Subsidiaries actually paid during such fiscal year, (iii) the consolidated interest expense of the Borrower and its Subsidiaries actually paid during such fiscal year, and (iv) scheduled principal payments of Indebtedness of the Borrower and its Subsidiaries during such fiscal year.

Existing Letters of Credit ” means the Letters of Credit (as such term is defined under the Existing Credit Agreement) outstanding as of the Effective Date under the Existing Credit Agreement.

Final Payment Date ” means the date on which all Advances, interest, fees and other amounts payable under any Loan Document (other than obligations for taxes, costs, indemnifications, reimbursements and similar amounts for which no claim or demand for payment has been made) have been paid, the Commitments have terminated and all outstanding Letters of Credit have expired or been terminated.

Fixed Charge Coverage Ratio ” means, at any date of determination, the ratio of (i) EBITDA for the 12 month period ending on such date to (ii) Fixed Charges for such period.

Fixed Charges ” means, with respect to any period, the sum of (i) interest expense, (ii) Current Maturities of Indebtedness, (iii) taxes paid in cash and (iv) Maintenance Capital Expenditures, in each case for such period.

GAAP ” means generally accepted accounting principles as in effect from time to time as set forth in the opinions, statements and pronouncements of the Accounting Principles Board of American Institute of Certified Public Accounting, the Financial Accounting Standards Board and such other Persons who shall be approved by a significant segment of the accounting profession.

Guarantor ” means (i) subject to the release of any of the following as a Guarantor in accordance with the terms of this Agreement, each Subsidiary of the Company listed on Schedule 6.12 that it is a Domestic Subsidiary and (ii) each other Subsidiary of the Borrower that executes a Joinder Agreement in accordance with Section 7.10.

Guaranty ” means the Guaranty dated as of February 11, 2005, executed and delivered by the Subsidiaries of the Borrower party thereto in favor of the Bank.

Hazardous Substances ” means any pollutants, contaminants, toxic or hazardous materials, substances, or wastes, or flammable, explosive or radioactive materials, or material otherwise regulated under any Environmental Law.

Hedging Arrangement ” means a hedge, call, swap, collar, floor, cap, option, forward sale or purchase or other contract or similar arrangement (including any obligations to purchase or sell any security at a future date for a specific price) that is entered into to reduce or eliminate or otherwise protect against the risk of fluctuations in interest rates, foreign exchange rates or commodity prices.

 

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Highest Lawful Rate ” means at any date the maximum nonusurious interest rate that may under applicable law then be contracted for, charged, received, taken, collected or reserved by the Bank on the Notes or the Obligations.

Indebtedness ” means, for any Person, (i) indebtedness for borrowed money of such Person, (ii) obligations of such Person evidenced by bonds, debentures, notes or other similar instruments, (iii) obligations of such Person to pay the deferred purchase price of property or services, other than trade payables incurred in the ordinary course of business and not more than 120 days past due, (iv) obligations of such Person as lessee under leases that are or should be, in accordance with GAAP, recorded as capital leases, (v) obligations of such Person under direct or indirect guaranties in respect of, and obligations (contingent or otherwise) to purchase or otherwise acquire, or otherwise to assure a creditor against loss in respect of, Indebtedness or obligations of others, (vi) all Indebtedness (as defined in the other clauses of this definition) of others secured by (or for which the holder of such Indebtedness has an existing right, contingent or otherwise, to be secured by) a Lien on any Property of such Person, whether or not such Indebtedness is assumed by such Person, and (vii) any Debt of a partnership for which such Person is liable either by agreement or by operation of law but only to the extent of such liability.

Interest Election Request ” means a request by the Borrower to convert or continue a Borrowing in accordance with Section 3.02 .

Interest Payment Date ” means (a) with respect to any Base Rate Advance, the last day of each calendar month, and (b) with respect to any Eurodollar Advance, the last day of the Interest Period applicable to such Advance and, in the case of a Eurodollar Advance with an Interest Period of more than three months’ duration, each day prior to the last day of such Interest Period that occurs at intervals of three months’ duration after the first day of such Interest Period.

Interest Period ” means with respect to any Eurodollar Advance, the period commencing on the date of such Advance and ending on the numerically corresponding day in the calendar month that is one, two, three or six months thereafter, as the Borrower may elect; provided , that (i) if any Interest Period would end on a day other than a Business Day, such Interest Period shall be extended to the next succeeding Business Day unless such next succeeding Business Day would fall in the next calendar month, in which case such Interest Period shall end on the next preceding Business Day, and (ii) any Interest Period pertaining to a Eurodollar Advance that commences on the last Business Day of a calendar month (or on a day for which there is no numerically corresponding day in the last calendar month of such Interest Period) shall end on the last Business Day of the last calendar month of such Interest Period. For purposes hereof, the date of a Borrowing initially shall be the date on which such Borrowing is made and thereafter shall be the effective date of the most recent conversion or continuation of such Borrowing.

Inventory ” has the meaning of such term as defined in the Security Agreement to the extent that there exists an Acceptable Security Interest on same.

Investment ” means any investment so classified under GAAP made by stock purchase, capital contribution, loan or advance or by purchase of property or otherwise, but in any event shall include as an investment in any Person that amount of all Indebtedness owed by such Person and all accounts receivable from such Person that are not current assets and did not arise from services rendered or sales to such Person in the ordinary course of business.

 

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Joinder Agreement ” means a Joinder Agreement in the form of Exhibit D or such other form as the Bank shall approve executed by any new Domestic Subsidiary making such Subsidiary a Guarantor and a party to the Security Agreement.

LC Disbursement ” means a payment made by the Bank pursuant to a Letter of Credit.

LC Exposure ” means, at any time, the sum of (a) the aggregate undrawn amount of all outstanding Letters of Credit at such time plus (b) the aggregate amount of all LC Disbursements that have not yet been reimbursed by or on behalf of the Borrower or converted into an Advance pursuant to Section 4.04 at such time.

Letter of Credit ” means any letter of credit issued pursuant to this Agreement.

Leverage Ratio ” means, as of any date of determination, the ratio of (a) Indebtedness of the Borrower at such date [less any Indebtedness of CAVO guaranteed by the Borrower] to (b) EBITDA for the 12 month period ending on such date.

LIBO Rate ” means, with respect to any Eurodollar Advance for any Interest Period, the rate appearing at Reuters Reference Screen LIBOR01 (or on any successor or substitute page of such service, or any successor to or substitute for such service, providing rate quotations comparable to those currently provided on such page of such service, as determined by the Bank from time to time for purposes of providing quotations of interest rates applicable to dollar deposits in the London interbank market) at approximately 11:00 a.m., London time, two Business Days prior to the commencement of such Interest Period, as the rate for dollar deposits with a maturity comparable to such Interest Period. In the event that such rate is not available at such time for any reason, then the “ LIBO Rate ” with respect to such Eurodollar Advance for such Interest Period shall be the rate at which dollar deposits of $1,000,000 and for a maturity comparable to such Interest Period are offered by the principal London office of the Bank in immediately available funds in the London interbank market at approximately 11:00 a.m., London time, two Business Days prior to the commencement of such Interest Period.

Lien ” means with respect to any asset (i) any mortgage, lien, pledge, charge, security interest or encumbrance or any other type of preferential arrangement of any kind in respect of such asset, whether arising by contract, operation of law or otherwise, or (ii) the interest of a vendor or lessor under any conditional sale agreement, capital lease or other title retention agreement relating to such asset.

Loan Documents ” means this Agreement, the Notes, the Guaranty, the Security Agreement, the Deeds of Trust and any other documents executed by any Person in connection with, as evidence of or as security for, the obligations of any Person hereunder.

Maintenance Capital Expenditures ” means an amount equal to $2,000,000 for each 12 month period.

 

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Material Adverse Effect ” means a material adverse effect (a) on the business, condition (financial or otherwise), results of operations or prospects of the Borrower and its Subsidiaries, taken as a whole; (b) on the legality, validity or enforceability of any Loan Document; (c) on any Credit Party’s ability to perform its obligations under any Loan Document; or (d) the rights and remedies of or benefits available to the Bank under any Loan Document.

Multiemployer Plan ” means a multiemployer plan as defined in Section 4001(a)(3) of ERISA.

Net Proceeds ” means with respect to any disposition of assets by the Borrower or any Subsidiary, an amount equal to the gross proceeds in cash (including cash equivalents and any cash payments received by way of deferred payment of principal pursuant to a note or installment receivable or purchase price adjustment receivable or otherwise, but only as and when received) of such disposition, net of attorneys’ fees, accountants’ fees, brokerage, consultant fees, underwriting commissions and other fees and expenses actually incurred in connection with such disposition and reserves for taxes and other liabilities established in connection with such disposition.

Notes ” means the Working Capital Note, the Equipment Note and the Real Estate Note.

Obligations ” means (a) all principal, interest (including post-petition interest), fees, reimbursements, indemnifications, and other amounts now or hereafter owed by any of the Credit Parties to the Bank under the Loan Documents and any increases, extensions, and rearrangements of those obligations under any amendments, supplements, and other modifications of the documents and agreements creating those obligations and (b) all obligations of any Credit Party owing to the Bank or an Affiliate of the Bank under any Hedging Arrangements that are permitted by the terms hereof.

Other Instruments ” means as to any Person the certificate or articles of incorporation, bylaws, or partnership agreement of such Person and all agreements, loan or credit agreements (other than the Loan Documents), instruments, documents, judgments, orders, writs, injunctions, decrees, determinations, awards, ordinances, laws, rules, statutes, regulations, rulings, franchises, permits or the like to which such Person is a party or by which such Person or any assets of such person may be bound or affected.

PBGC ” means the Pension Benefit Guaranty Corporation and any successor to all or any of its functions under ERISA.

Permits ” means any and all registrations, notifications, licenses, authorizations, permits, certificates, approvals and consents required by any governmental agency or authority.

Permitted Investments ” means (a) readily marketable direct obligations of the United States of America, (b) certificates of time deposit with the Bank, (c) demand deposits with the Bank, (d) securities issued or guaranteed by an agency of the government of the United States of America or repurchase agreements collateralized by such securities, (e) prime commercial paper with a credit rating of A-1 or better as published by Standard & Poor’s Ratings Group in its most recent applicable rating publication or a rating of P-1 or better as published by Moody’s Investors Service, Inc. in its most recent applicable rating publication and (f) commercial paper of the Bank.

 

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Permitted Liens ” means (i) Liens granted to the Bank to secure the Obligations, (ii) Liens for taxes, assessments or other governmental charges which are not yet due or which are being actively contested in good faith by appropriate proceedings diligently conducted, (iii) Liens securing Indebtedness permitted pursuant to Section 8.02(c) but only on the Property acquired and improvements and accessions thereto and (iv) landlord’s, materialmen’s, mechanics’, carriers’, workmen’s, warehouseman’s and repairmen’s liens, and other similar liens imposed by Law arising in the ordinary course of business securing obligations that are not overdue for a period of more than 30 days or are being contested in good faith by appropriate procedures or proceedings and for which adequate reserves have been established.

Person ” (whether or not capitalized) means an individual, corporation, limited liability company, partnership, joint venture, trust, association, unincorporated organization, receiver, custodian or similar official or any other juridical entity, or a government or any agency or political subdivision thereof.

Plan ” has the meaning set forth in Section 6.13 .

Prime Rate ” means a fluctuating interest rate per annum (computed on the basis of a year of 365 (or 366) days for the actual number of days elapsed, including the first day but excluding the last day) as shall be in effect from time to time, which rate per annum shall at all times be equal to the rate of interest announced publicly by the Bank from time to time as the Bank’s prime commercial rate, each change in such fluctuating interest rate to take effect simultaneously with the corresponding change in the Bank’s prime commercial rate. The Prime Rate may not represent the lowest or best rate actually charged to customers of the Bank.

Pro Forma Fixed Charge Coverage Ratio ” means, at any time, the ratio of (i) EBITDA for the 12 month period most recently ended prior to such time for which financial statements are available to (ii) the sum of Fixed Charges for such period plus the payments of principal of the Subordinated Debt from the last day of such 12 month period through such time.

Property ” of any Person means any and all property or assets (real, personal or mixed, tangible or intangible) of such Person.

Real Estate Loan ” has the meaning specified in Section 2.01(c) .

Real Estate Note ” means the promissory note payable to the order of the Bank evidencing the Real Estate Loan, together with all modifications, extensions, renewals and rearrangements thereof, delivered to the Bank prior to the Effective Date.

Real Property ” means the real property described on Schedule 1.01 and any additional real property that is subject to the Lien of any Deed of Trust delivered after the date hereof pursuant to Section 7.10(b).

Request for Advance ” has the meaning specified in Section 2.02 .

 

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Restricted Payment ” means (a) any payment, dividend or other distribution, direct or indirect, in respect of any Equity Interest in the Borrower or any Subsidiary, except a distribution payable solely in additional Equity Interests in the Borrower, and (b) any payment, direct or indirect, on account of the redemption, retirement, purchase or other acquisition of any Equity Interest in the Borrower or any Subsidiary.

Security Agreement ” means the Security Agreement dated as of February 11, 2005, granting to the Bank a Lien on certain of the assets of the Credit Parties.

SES ” means SES Holdings, Inc., an Oklahoma corporation.

Sellers ” means Owen Richman, Antony Dyakowski and Gwen Bristow.

Statutory Reserve Rate ” means a fraction (expressed as a decimal), the numerator of which is the number one and the denominator of which is the number one minus the aggregate of the maximum reserve percentages (including any marginal, special, emergency or supplemental reserves) expressed as a decimal established by the Federal Reserve Board to which the Bank is subject with respect to the Adjusted LIBO Rate, for Eurocurrency funding (currently referred to as “Eurocurrency Liabilities” in Regulation D of the Federal Reserve Board). Such reserve percentages shall include those imposed pursuant to such Regulation D. Eurodollar Advances shall be deemed to constitute Eurocurrency funding and to be subject to such reserve requirements without benefit of or credit for proration, exemptions or offsets that may be available from time to time to the Bank under such Regulation D or any comparable regulation. The Statutory Reserve Rate shall be adjusted automatically on and as of the effective date of any change in any reserve percentage.

Subordinated Debt ” means the Indebtedness of the Borrower and its Subsidiaries, calculated in accordance with GAAP, heretofore or hereafter incurred, that is subordinate and subject in right to payment on terms satisfactory to the Bank in its sole discretion and, with respect to the Borrower and its Subsidiaries, includes as of the Effective Date the subordinated indebtedness described on Schedule 8.02 hereto.

Subsidiary ” means, as to any Person (the “parent”), any corporation, partnership or other entity, a majority of the outstanding Equity Interests having by the terms thereof ordinary voting power to elect a majority of the board of directors or similar body of such entity (irrespective of whether or not at the time Equity Interests of any other class or classes of such entity have or might have voting power by reason of the happening of any contingency) is at the time directly or indirectly owned or controlled by the parent or one or more of the Subsidiaries of the parent.

Termination Date ” means January 31, 2010.

Type ”, when used in reference to any Advance, refers to whether the rate of interest on such Advance is determined by reference to the Adjusted LIBO Rate or the Alternate Base Rate.

Wells Fargo ” means Wells Fargo Bank, National Association.

 

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Working Capital Commitment ” means the Bank’s Commitment to make Advances in the aggregate amount of $25,000,000 pursuant to Section 2.01(a) as reduced from time to time pursuant to Section 2.03 .

Working Capital Exposure ” means, with respect to the Bank at any time, the sum of the outstanding principal amount of the Working Capital Loan and the LC Exposure at such time.

Working Capital Loan ” has the meaning specified in Section 2.01(a) .

Working Capital Loan Borrowing Base ” means, at any time such determination is made, an amount calculated in accordance with the Working Capital Loan Borrowing Base Certificate equal to the sum of (i) 85% of Eligible Accounts Receivables and (ii) the least of (A) 50% of the Eligible Inventory, (B) $10,000,000 and (C) the amount in clause (i).

Working Capital Loan Borrowing Base Certificate ” means as of any date, a certification to the Working Capital Loan Borrowing Base as of such date substantially in the form of Exhibit B .

Working Capital Loan Maturity Date ” means August 8, 2009.

Working Capital Note ” means a promissory note payable to the order of the Bank evidencing the Working Capital Loan, together with all modifications, extensions, renewals and rearrangements thereof.

SECTION 1.02 Accounting Terms . All accounting terms not otherwise defined herein have the meanings assigned to them in accordance with GAAP in the preparation of the financial statements referred to in Section 7.02 .

SECTION 1.03 Interpretation .

(a) In this Agreement, unless a clear contrary intention appears:

(i) the singular number includes the plural number and vice versa;

(ii) reference to any gender includes each other gender;

(iii) the words “herein,” “hereof” and “hereunder” and other words of similar import refer to this Agreement as a whole and not to any particular Article, Section or other subdivision;

(iv) reference to any Person includes such Person’s successors and assigns but, if applicable, only if such successors and assigns are permitted by this Agreement, and reference to a Person in a particular capacity excludes such Person in any other capacity or individually, provided that nothing in this clause (iv) is intended to authorize any assignment not otherwise permitted by this Agreement;

 

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(v) reference to any agreement, document or instrument means such agreement, document or instrument as amended, supplemented or modified and in effect from time to time in accordance with the terms thereof and, if applicable, the terms hereof, and reference to any Note includes any note issued pursuant hereto in extension or renewal thereof and in substitution or replacement therefor;

(vi) unless the context indicates otherwise, reference to any Article, Section, Schedule or Exhibit means such Article or Section hereof or such Schedule or Exhibit hereto;

(vii) the word “including” (and with correlative meaning “include”) means including, without limiting the generality of any description preceding such term;

(viii) with respect to the determination of any period of time, the word “from” means “from and including” and the word “to” means “to but excluding”;

(ix) reference to any law means such as amended, modified, codified or reenacted, in whole or in part, and in effect from time to time; and

(x) whenever the character or amount of any asset or liability or item of income or expense is required to be determined, such determination shall be made in accordance with GAAP.

(b) The Article and Section headings herein and the Table of Contents are for convenience only and shall not affect the construction hereof.

(c) No provision of this Agreement shall be interpreted or construed against any Person solely because that Person or its legal representative drafted such provision.

ARTICLE II

AMOUNTS AND TERMS OF THE ADVANCES

SECTION 2.01 The Advances .

(a) Subject to the terms and conditions of this Agreement, including those in Article V , the Bank shall make Advances (the “ Working Capital Loan ”) to the Borrower from time to time on any Business Day during the period from the date hereof until the Working Capital Loan Maturity Date in an aggregate amount not to exceed at any time outstanding the Working Capital Commitment; provided , however , that the Working Capital Exposure shall at no time exceed the lesser of (y) the Working Capital Commitment or (z) the Working Capital Loan Borrowing Base. Within the foregoing limits, the Borrower may borrow, prepay and reborrow pursuant to the terms hereof.

(b) Subject to the terms and conditions of this Agreement, including those in Article V , the Bank shall make an Advance (the “ Equipment Loan ”) to the Borrower on the date hereof in an aggregate amount not to exceed the Equipment Loan Commitment.

 

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The Borrower may not reborrow amounts repaid with respect to the Equipment Loan. The Equipment Loan Commitment shall terminate at the close of business on the Effective Date.

(c) Prior to the date hereof, the Bank has made Advances to the Borrower having an aggregate principal amount currently outstanding of $932,731 that have been designated as Real Estate Loans under the Existing Credit Agreement. Such Advances shall remain outstanding following the effectiveness of this Agreement and are hereinafter referred to collectively as the “ Real Estate Loan ”. The Borrower may not reborrow amounts repaid with respect to the Real Estate Loan.

(d) Each Advance shall be either a Base Rate Advance or a Eurodollar Advance as the Borrower may request in accordance herewith. The Bank at its option may make any Eurodollar Advance by causing any domestic or foreign branch or Affiliate of the Bank to make such Advance; provided that any exercise of such option shall not affect the obligation of the Borrower to repay such Advance in accordance with the terms of this Agreement.

(e) At the commencement of each Interest Period for any Eurodollar Advance, such Advance shall be in an aggregate amount that is an integral multiple of $500,000 and not less than $1,000,000. At the time that each Base Rate Advance is made, such Base Rate Advance shall be in an aggregate amount that is an integral multiple of $500,000 and not less than $1,000,000; provided that a Base Rate Advance may be in an aggregate amount that is equal to the entire unused balance of the total Working Capital Commitment or that is required to finance the reimbursement of an LC Disbursement as contemplated by Section 4.04. Advances of more than one Type may be outstanding at the same time, provided that there shall not at any time be more than a total of four Eurodollar Advances outstanding. Notwithstanding any other provision of this Agreement, the Borrower shall not be entitled to request, or to elect to convert or continue, any Advance if the Interest Period requested with respect thereto would end after the maturity date for such Advance.

SECTION 2.02 Making the Advances .

(a) To request an Advance, the Borrower shall notify the Bank of such request (i) in the case of a Eurodollar Advance, not later than 11:00 a.m., New York City time, three Business Days before the date of the proposed Advance or (ii) in the case of a Base Rate Advance, not later than 11:00 a.m., New York City time, on the date of the proposed Advance. The Borrower shall make each such request by delivery to the Bank of a written Request for Advance in substantially the form of Exhibit C and signed by the Borrower (a “ Request for Advance ”), and each Request for Advance shall be irrevocable. Each Request for Advance shall specify the following information in compliance with Section 2.01:

(i) the aggregate amount of the requested Advance;

(ii) the date of such Advance, which shall be a Business Day;

 

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(iii) whether such Advance is to be a Base Rate Advance or a Eurodollar Advance;

(iv) in the case of a Eurodollar Advance, the initial Interest Period to be applicable thereto, which shall be a period contemplated by the definition of the term “ Interest Period ”;

(v) the amount of the then effective Working Capital Loan Borrowing Base, the current total Working Capital Exposure (without regard to the requested Advance) and the pro form a total Working Capital Exposure (giving effect to the requested Advance); and

(vi) the location and number of the Borrower’s account to which funds are to be disbursed.

If no election as to the Type of Advance is specified, then the requested Advance shall be a Base Rate Advance. If no Interest Period is specified with respect to any requested Eurodollar Advance, then the Borrower shall be deemed to have selected an Interest Period of one month’s duration. Each Request for Advance shall constitute a representation that the amount of the requested Borrowing shall not cause the Working Capital Exposure to exceed the Working Capital Commitment.

SECTION 2.03 Reduction and Changes in the Commitment .

(a) The Borrower shall have the right, upon at least three Business Days’ prior written notice to the Bank, to terminate in whole or reduce in part, the unused portion of the Working Capital Commitment; provided, however , that the Borrower may not terminate or partially reduce such Commitment at any time to an amount less than the sum of all Credit Extensions then outstanding under such Commitment; and provided further , that any such partial reduction shall be in amounts of not less than $500,000 and shall be an integral multiple of $25,000. Such notice shall specify the date and the amount of the termination or reduction of the Commitment.

(b) On the Working Capital Loan Maturity Date the Working Capital Commitment shall terminate.

ARTICLE III

NOTES, INTEREST AND PAYMENT

SECTION 3.01 The Notes .

(a) The aggregate amount of all Advances made by the Bank under the Working Capital Loan shall be evidenced by the Working Capital Note. The aggregate amount of all Advances made by the Bank under the Equipment Loan shall be evidenced by the Equipment Note. The aggregate amount of all Advances made by the Bank under the Real Estate Loan shall be evidenced by the Real Estate Notes.

 

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(b) The Borrower shall pay interest and shall pay principal on the Advances as provided herein. The Bank shall use its best efforts to keep a record of the Advances made by it and the payments received by it with respect to each Note, and the aggregate unpaid principal amount so recorded shall be rebuttable presumptive evidence of the principal amount owing and unpaid on each Note. The failure so to record any such amount or any error in so recording any such amount shall not, however, limit or otherwise affect the obligations of the Borrower hereunder or under each Note to repay the outstanding principal amount of the Advances together with all interest accruing thereon.

SECTION 3.02 Interest Elections .

(a) Each Advance initially shall be of the Type specified in the applicable Advance Request and, in the case of a Eurodollar Advance, shall have an initial Interest Period as specified in such Advance Request. Thereafter, the Borrower may elect to convert such Advance to a different Type or to continue such Advance and, in the case of a Eurodollar Advance, may elect Interest Periods therefor, all as provided in this Section. The Borrower may elect different options with respect to different portions of the affected Advance, in which event each such portion shall be treated as a separate Advance.

(b) To make an election pursuant to this Section, the Borrower shall notify the Bank of such election by the time that a Request for Advance would be required under Section 2.02 if the Borrower were requesting an Advance of the Type resulting from such election to be made on the effective date of such election. Each such Interest Election Request shall be irrevocable and shall be made by delivery to the Bank of a written Interest Election Request in a form approved by the Bank and signed by the Borrower.

(c) Each Interest Election Request shall specify the following information in compliance with Section 2.01:

(i) the Advance to which such Interest Election Request applies and, if different options are being elected with respect to different portions thereof, the portions thereof to be allocated to each resulting Advance (in which case the information to be specified pursuant to clauses (iii) and (iv) below shall be specified for each resulting Advance);

(ii) the effective date of the election made pursuant to such Interest Election Request, which shall be a Business Day;

(iii) whether the resulting Advance is to be a Base Rate Advance or a Eurodollar Advance; and

(iv) if the resulting Advance is a Eurodollar Advance, the Interest Period to be applicable thereto after giving effect to such election, which shall be a period contemplated by the definition of the term “Interest Period”.

 

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If any such Interest Election Request requests a Eurodollar Advance but does not specify an Interest Period, then the Borrower shall be deemed to have selected an Interest Period of one month’s duration.

(d) If the Borrower fails to deliver a timely Interest Election Request with respect to a Eurodollar Advance prior to the end of the Interest Period applicable thereto, then, unless such Advance is repaid as provided herein, at the end of such Interest Period such Advance shall be converted to a Base Rate Advance. Notwithstanding any contrary provision hereof, if an Event of Default has occurred and is continuing and the Bank so notifies the Borrower, then, so long as an Event of Default is continuing (i) no outstanding Advance may be converted to or continued as a Eurodollar Advance and (ii) unless repaid, each Eurodollar Advance shall be converted to a Base Rate Advance at the end of the Interest Period applicable thereto.

SECTION 3.03 Interest .

(a) Each Base Rate Advance shall bear interest on the unpaid principal amount thereof at a rate per annum equal to the lesser of (i) the Alternate Base Rate minus 0.25% and (ii) the Highest Lawful Rate.

(b) Each Eurodollar Advance shall bear interest on the unpaid principal amount thereof at a rate per annum equal to the lesser of (i) the Adjusted LIBO Rate for the Interest Period in effect for such Advance plus 1.75% and (ii) the Highest Lawful Rate.

(c) Notwithstanding the foregoing, if any principal of or interest on any Advance or any fee or other amount payable by the Borrower hereunder is not paid when due, whether at stated maturity, upon acceleration or otherwise, or any other Event of Default shall occur and be continuing, the Advance shall bear interest on the unpaid principal amount thereof, after, as well as before judgment, at a rate per annum equal to the lesser of (i) 4% plus the rate applicable to Base Rate Advances as provided in paragraph (a) of this Section and (ii) the Highest Lawful Rate.

(d) Accrued interest on each Loan shall be payable in arrears on each Interest Payment Date for such Loan and, in the case of Working Capital Loans, upon termination of the Working Capital Loan Commitment; provided that (i) interest accrued pursuant to paragraph (c) of this Section shall be payable on demand, (ii) in the event of any repayment or prepayment of any Advance, accrued interest on the principal amount repaid or prepaid shall be payable on the date of such repayment or prepayment and (iii) in the event of any conversion of any Eurodollar Loan prior to the end of the current Interest Period therefor, accrued interest on such Loan shall be payable on the effective date of such conversion.

(e) All interest hereunder shall be computed on the basis of a year of 360 days, except that interest computed by reference to the Alternate Base Rate at times when the Alternate Base Rate is based on the Prime Rate shall be computed on the basis of a year of 365 days (or 366 days in a leap year), and in each case shall be payable for the

 

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actual number of days elapsed (including the first day but excluding the last day). The applicable Alternate Base Rate, Adjusted LIBO Rate or LIBO Rate shall be determined by the Bank, and such determination shall be conclusive absent manifest error.

SECTION 3.04 Principal Payments .

(a) Subject to the mandatory prepayment and acceleration provisions of this Agreement, the Borrower hereby promises to pay the unpaid principal balance of the Working Capital Note on the Working Capital Loan Maturity Date.

(b) The Borrower hereby promises to pay the Equipment Loan in 52 installments of $428,571.43 payable on the last day of each month and a final installment of $ 14,142,857.14 payable on December 31, 2011.

(c) The Borrower hereby promises to pay the Real Estate Loan in 52 installments of $6,002.43 payable on the last day of each calendar month and a final installment of $733,793.63 payable on December 31, 2011.

SECTION 3.05 Voluntary Prepayments .

(a) The Borrower may prepay the outstanding principal amount of any Advance in whole or in part, together with accrued unpaid interest to the date of such prepayment on the principal amount prepaid. All such prepayments shall be applied first to accrued, but unpaid, interest on such Advance, then to the principal amount of such Advance. Payments of principal on the Equipment Loan and the Real Estate Loan shall be applied to the remaining installments thereof in inverse order of maturity. If the Borrower prepays all or part of the Equipment Loan or the Real Estate Loan prior to February 11, 2008, the Borrower shall pay the Bank a prepayment fee equal to 1% of the then outstanding balance of the Equipment Loan and the Real Estate Loan.

(b) The Borrower shall provide to the Bank written notice of any prepayment hereunder (i) in the case of prepayment of a Eurodollar Advance, not later than 11:00 a.m., Houston time, three Business Days before the date of prepayment, or (ii) in the case of prepayment of a Base Rate Advance, not later than 11:00 a.m., Houston time, one Business Day before the date of prepayment. Each such notice shall be irrevocable and shall specify the prepayment date and the principal amount of each Advance or portion thereof to be prepaid. Each partial prepayment of any Advance shall be in an amount that would be permitted in the case of an Advance of the same Type as provided in Section 2.02.

SECTION 3.06 Mandatory Prepayments .

(a) In the event any Working Capital Loan Borrowing Base Certificate submitted pursuant to Section 7.02 reflects that the Working Capital Exposure exceeds the Working Capital Loan Borrowing Base, the Borrower shall promptly make a prepayment in an aggregate principal amount equal to such excess.

 

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(b) Within 15 days after the delivery of annual financial statements of the Borrower and its Subsidiaries for the fiscal year ending December 31, 2007, and each fiscal year thereafter, as contemplated by Section 7.02(a) , the Borrower shall repay the Equipment Loan, without premium or penalty, in an amount equal to 50% of Excess Cash Flow for such fiscal year.

(c) Within 90 days after the last day of each fiscal quarter, the Borrower shall prepay the Equipment Loan from the Net Proceeds of any Equipment sold during such quarter that have not been reinvested in similar equipment prior to such 90 th day.

(d) Any prepayment of the Equipment Loan shall be applied to the remaining installments of the Equipment Loan in inverse order of maturity.

SECTION 3.07 Fees .

(a) The Borrower shall pay to the Bank a commitment fee equal to 0.25% per annum on the average daily amount by which the Working Capital Loan Commitment exceeds the outstanding Working Capital Exposure. Such fee is due quarterly in arrears on each March 31, June 30, September 30 and December 31 and on the Working Capital Loan Maturity Date.

(b) The Borrower shall pay to the Bank the following fees with respect to Letters of Credit:

(i) a letter of credit fee for each Letter of Credit issued hereunder in an amount equal to the 1.75% per annum (calculated on the basis of a 360 day year) on the face amount of such Letter of Credit for the period such Letter of Credit is outstanding. Such fee shall be due and payable quarterly in arrears on March 31, June 30, September 30, and December 31 of each year, and on the Working Capital Loan Maturity Date; and

(ii) Such other usual and customary fees associated with any transfers, amendments, drawings, negotiations or reissuances of any Letters of Credit. Such fees shall be due and payable as requested by the Bank in accordance with the Bank’s then current fee policy.

SECTION 3.08 Payments and Computations .

(a) The Borrower shall make each payment or prepayment hereunder and under the Notes not later than 12:00 Noon (Houston, Texas time) on the day when due in Dollars to the Bank at its address referred to in Section 10.02 in same day funds.

(b) Each determination by the Bank of an interest rate hereunder shall be conclusive and binding for all purposes, absent manifest error.

(c) Whenever any payment hereunder or under the Notes shall be stated to be due on a day other than a Business Day, such payment shall be made on the next succeeding Business Day, and such extension of time shall in such case be included in the computation of payment of interest.

 

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SECTION 3.09 The Borrower Unconditionally Liable . The Borrower shall be unconditionally liable to the Bank for the principal amount of all Credit Extensions, interest due thereon, and all other amounts due to the Bank hereunder or under any other agreement or security document executed in connection herewith, and shall make prompt and punctual payment when due of such amounts.

SECTION 3.10 Reserve Requirements; Change in Circumstances .

(a) It is understood that the cost to the Bank of making or maintaining any of the Advances may fluctuate as a result of the applicability of, or changes in, reserve requirements imposed by the Board of Governors of the Federal Reserve System. The Borrower agrees to pay to the Bank from time to time, as provided in paragraph (d) below, such amounts as shall be necessary to compensate the Bank for the portion of the cost of making or maintaining Advances resulting from any such reserve requirements to the extent set forth in this Section.

(b) Notwithstanding any other provision herein, if after the date of this Agreement the introduction of any applicable law or regulation or any change in applicable law or regulation or in the interpretation or administration thereof by any governmental authority charged with the interpretation or administration thereof, or compliance by the Bank with any applicable guideline or request from any central bank or governmental authority (whether or not having the force of law) (i) shall change the basis of taxation of payments to the Bank of the principal of or interest on any Advance made by the Bank or any other fees or amounts payable hereunder, other than (x) taxes imposed on the overall net income or franchise taxes with respect to the Bank or its lending office by the jurisdiction in which the Bank or its lending office has its principal office or by any political subdivision or taxing authority therein (or any tax which is enacted or adopted by such jurisdiction, political subdivision or taxing authority as a direct substitute for any such taxes) or (y) any tax, assessment or other governmental charge that would not have been imposed but for the failure of the Bank to comply with any certification, information, documentation or other reporting requirement, or (ii) shall impose, modify or deem applicable any reserve, special deposit or similar requirement against assets of, deposits with or for the account of, or credit extended by the Bank, and the result of any of the foregoing shall be to increase the cost to the Bank of maintaining its Commitment or to reduce the amount of any sum received or receivable by the Bank hereunder (whether of principal, interest or otherwise) in respect thereof by an amount deemed in good faith by the Bank to be material, then the Borrower shall pay to the Bank such additional amount as will compensate the Bank for such increase or reduction upon demand by the Bank. Notwithstanding the foregoing, in no event shall the Bank be permitted to receive any compensation hereunder constituting interest in excess of the Highest Lawful Rate.

 

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(c) If the Bank shall have determined in good faith that the adoption of any applicable law, rule, regulation or guideline regarding capital adequacy, or any change therein, or any change in the interpretation or administration thereof by any governmental authority, central bank or comparable agency charged with the interpretation or administration thereof, or compliance by the Bank (or any lending office of the Bank) with any request or directive regarding capital adequacy (whether or not having the force of law) of any such authority, central bank or comparable agency (including any capital adequacy guidelines under consideration as of the date of this Agreement by the Board of Governors of the Federal Reserve System and the Comptroller of the Currency) (except any such adoption or change reflected in the Adjusted LIBO Rate), has or would have the effect of reducing the rate of return on the Bank’s capital or any corporation controlling the Bank’s capital as a consequence of its obligations hereunder to a level below that which the Bank could have achieved but for such adoption, change or compliance (taking into consideration the Bank’s policies with respect to capital adequacy) by an amount deemed by the Bank to be material, then from time to time the Borrower shall pay to the Bank such additional amount or amounts as will compensate the Bank for such reduction upon demand by the Bank. Notwithstanding the foregoing, in no event shall the Bank be permitted to receive any compensation hereunder constituting interest in excess of the Highest Lawful Rate.

(d) If the Bank seeks compensation under this Agreement it will notify the Borrower of any event occurring after the date of this Agreement which will entitle the Bank to compensation pursuant to this Section, as promptly as practicable, and in any event within 180 days after it becomes aware thereof and determines to request compensation. A certificate of the Bank setting forth in reasonable detail (i) such amount or amounts as shall be necessary to compensate the Bank as specified in paragraph (a) or (b) above, as the case may be, and (ii) the calculation of such amount or amounts shall be delivered to the Borrower and shall be prima facie evidence of such amount or amounts. The Borrower shall pay to the Bank the amount shown as due on any such certificate within ten days after its receipt of the same.

(e) Failure on the part of the Bank to demand compensation for any increased costs or reduction in amounts received or receivable or reduction in return on capital with respect to any Advance shall not constitute a waiver of the Bank’s rights to demand compensation for any increased costs or reduction in amounts received or receivable or reduction in return on capital with respect to such Advance, provided that Borrower’s obligation to pay the Bank shall be limited to the increased costs or reduced amount that is attributable to the period commencing 180 days prior to the date on which the Bank gives the Borrower notice under subsection (d) hereof. The protection of this Section shall be available to the Bank regardless of any possible contention of invalidity or inapplicability of law, regulation or condition that has been imposed.

SECTION 3.11 Indemnity . The Borrower shall indemnify the Bank against any loss or reasonable expense which the Bank may sustain or incur as a consequence of (a) any failure by the Borrower to fulfill on the date of any Advance hereunder the applicable conditions set forth in Article V , (b) any failure by the Borrower to borrow hereunder after a Request for Advance pursuant to Article II has been given, (c) any default in the payment or prepayment of the principal amount of any Advance or any part thereof or interest accrued thereon, as and when due and payable (at the due date thereof, by notice of prepayment or otherwise) or (d) the

 

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occurrence of any Event of Default. A certificate of the Bank setting forth any amount or amounts which the Bank is entitled to receive pursuant to this Section shall be delivered to the Borrower and shall be conclusive, if made in good faith, absent demonstrable error. The Borrower shall pay to the Bank the amount shown as due on any certificate within 30 days after its receipt of the same. Notwithstanding the foregoing, in no event shall the Bank be permitted to receive any compensation hereunder constituting interest in excess of the Highest Lawful Rate. Without prejudice to the survival of any other obligations of the Borrower hereunder, the obligations of the Borrower as to any claim under this Section shall survive the termination of this Agreement, the payment or assignment of any of the Notes or any combination of the foregoing provided notice of such claim shall have been given to the Borrower within 180 days after such termination or assignment.

ARTICLE IV

LETTERS OF CREDIT

SECTION 4.01 General . Subject to the terms and conditions set forth herein, the Borrower may request the issuance of Letters of Credit for its own account, in a form reasonably acceptable to the Bank, at any time and from time to time prior to the Working Capital Loan Maturity Date. In the event of any inconsistency between the terms and conditions of this Agreement and the terms and conditions of any form of letter of credit application or other agreement submitted by the Borrower to, or entered into by the Borrower with, the Bank relating to any Letter of Credit, the terms and conditions of this Agreement shall control. On and after the Effective Date, each Existing Letter of Credit shall be a Letter of Credit issued hereunder.

SECTION 4.02 Notice of Issuance, Amendment, Renewal, Extension; Certain Conditions . To request the issuance of a Letter of Credit (or the amendment, renewal or extension of an outstanding Letter of Credit), the Borrower shall hand deliver or telecopy (or transmit by electronic communication, if arrangements for doing so have been approved by the Bank) to the Bank (reasonably in advance of the requested date of issuance, amendment, renewal or extension) a notice requesting the issuance of a Letter of Credit, or identifying the Letter of Credit to be amended, renewed or extended, and specifying the date of issuance, amendment, renewal or extension (which shall be a Business Day), the date on which such Letter of Credit is to expire (which shall comply with Section 4.03), the amount (in Dollars) of such Letter of Credit, the name and address of the beneficiary thereof and such other information as shall be necessary to prepare, amend, renew or extend such Letter of Credit. If requested by the Bank, the Borrower also shall submit a letter of credit application on the Bank’s standard form in connection with any request for a Letter of Credit. A Letter of Credit shall be issued, amended, renewed or extended only if (and upon issuance, amendment, renewal or extension of each Letter of Credit, the Borrower shall be deemed to represent and warrant that) after giving effect to such issuance, amendment, renewal or extension (i) the LC Exposure shall not exceed $1,000,000 and (ii) the total Working Capital Exposure shall not exceed the total Working Capital Loan Commitment.

SECTION 4.03 Expiration Date . Each Letter of Credit shall expire at or prior to the close of business on the earlier of (i) the date one year after the date of the issuance of such Letter of Credit (or, in the case of any renewal or extension thereof, one year after such renewal

 

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or extension) and (ii) the date that is 30 Business Days prior to the Working Capital Loan Maturity Date; provided , however , that any Letter of Credit with a one-year tenor may provide for the renewal thereof for additional one-year periods (which shall in no event extend beyond the date referred to in clause (ii) above).

SECTION 4.04 Reimbursement . If the Bank makes any LC Disbursement in respect of a Letter of Credit, the Borrower shall reimburse such LC Disbursement by paying to the Bank an amount equal to such LC Disbursement not later than 12:00 noon, Houston, Texas time, on (i) the Business Day that the Borrower receives notice of such LC Disbursement, if such notice is received prior to 11:00 a.m., Houston, Texas time, on the day of receipt, or (ii) the Business Day immediately following the day that the Borrower receives such notice, if such notice is not received prior to such time on the day of receipt; provided , however , that, if no Default has occurred and is continuing, the Borrower may, subject to the conditions to borrowing set forth herein, request in accordance with Section 2.01(a) an Advance to finance such reimbursement and, to the extent so financed, the Borrower’s obligation to make such payment shall be discharged and replaced by the resulting Working Capital Advance.

SECTION 4.05 Obligations Absolute . The Borrower’s obligation to reimburse LC Disbursements as provided in Section 4.04 shall be absolute, unconditional and irrevocable, and shall be performed strictly in accordance with the terms of this Agreement under any and all circumstances whatsoever and irrespective of (i) any lack of validity or enforceability of any Letter of Credit or this Agreement, or any term or provision therein, (ii) any draft or other document presented under a Letter of Credit proving to be forged, fraudulent or invalid in any respect or any statement therein being untrue or inaccurate in any respect, (iii) payment by the Bank under a Letter of Credit against presentation of a draft or other document that does not comply with the terms of such Letter of Credit, or (iv) any other event or circumstance whatsoever, whether or not similar to any of the foregoing, that might, but for the provisions of this Section, constitute a legal or equitable discharge of, or provide a right of setoff against, the Borrower’s obligations hereunder. Neither the Bank nor any of its Affiliates shall have any liability or responsibility by reason of or in connection with the issuance or transfer of any Letter of Credit or any payment or failure to make any payment thereunder (irrespective of any of the circumstances referred to in the preceding sentence), or any error, omission, interruption, loss or delay in transmission or delivery of any draft, notice or other communication under or relating to any Letter of Credit (including any document required to make a drawing thereunder), any error in interpretation of technical terms or any consequence arising from causes beyond the control of the Bank; provided , however , that the foregoing shall not be construed to excuse the Bank from liability to the Borrower to the extent of any direct damages (as opposed to consequential damages, claims in respect of which are hereby waived by the Borrower to the extent permitted by applicable law) suffered by the Borrower that are caused by the Bank’s failure to exercise care when determining whether drafts and other documents presented under a Letter of Credit comply with the terms thereof. In the absence of gross negligence or willful misconduct on the part of the Bank (as finally determined by a court of competent jurisdiction), the Bank shall be deemed to have exercised care in each such determination. In furtherance of the foregoing and without limiting the generality thereof, with respect to documents presented that appear on their face to be in substantial compliance with the terms of a Letter of Credit, the Bank may, in its sole discretion, either accept and make payment upon such documents without responsibility for further investigation, regardless of any notice or information to the contrary, or refuse to accept and make payment upon such documents if such documents are not in strict compliance with the terms of such Letter of Credit.

 

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SECTION 4.06 Disbursement Procedures . The Bank shall, promptly following its receipt thereof, examine all documents purporting to represent a demand for payment under a Letter of Credit. The Bank shall promptly notify the Borrower by telephone (confirmed by telecopy) of such demand for payment and whether the Bank has made or will make an LC Disbursement thereunder; provided , however , that any failure to give or delay in giving such notice shall not relieve the Borrower of its obligation to reimburse the Bank with respect to any such LC Disbursement.

SECTION 4.07 Interim Interest . If the Bank shall make any LC Disbursement, then, unless the Borrower shall reimburse such LC Disbursement in full on the date such LC Disbursement is made, the unpaid amount thereof shall bear interest, for each day from and including the date such LC Disbursement is made to but excluding the date that the Borrower reimburses such LC Disbursement, at the rate per annum then applicable to the Working Capital Loan; provided , however , that, if the Borrower fails to reimburse such LC Disbursement when due pursuant to Section 4.04 , then Section 3.03(c) shall apply.

SECTION 4.08 Cash Collateralization . If any Event of Default shall occur and be continuing, on the Business Day that the Borrower receives notice from the Bank demanding the deposit of cash collateral pursuant to this paragraph, the Borrower shall deposit in an account with the Bank, in the name of the Bank, an amount in cash equal to 105% of the LC Exposure as of such date plus any accrued and unpaid interest thereon; provided , however , that the obligation to deposit such cash collateral shall become effective immediately, and such deposit shall become immediately due and payable, without demand or other notice of any kind, upon the occurrence of any Event of Default with respect to the Borrower described in clause (d) or (e) of Section 9.01 . Such deposit shall be held by the Bank as collateral for the payment and performance of the obligations of the Borrower under this Agreement. The Bank shall have exclusive dominion and control, including the exclusive right of withdrawal, over such account. Other than any interest earned on the investment of such deposits, which investments shall be made at the option and sole discretion of the Bank and at the Borrower’s risk and expense, such deposits shall not bear interest. Interest or profits, if any, on such investments shall accumulate in such account. The Bank shall apply moneys in such account to reimburse itself for LC Disbursements for which it has not been reimbursed and, to the extent not so applied, shall be held for the satisfaction of the reimbursement obligations of the Borrower for the LC Exposure at such time or, if the maturity of the Loans has been accelerated, be applied to satisfy other obligations of the Borrower under this Agreement. If the Borrower is required to provide an amount of cash collateral hereunder as a result of the occurrence of an Event of Default, such amount (to the extent not applied as aforesaid) shall be returned to the Borrower within three Business Days after all Events of Default have been cured or waived.

 

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ARTICLE V

CONDITIONS OF LENDING

SECTION 5.01 Condition Precedent to Initial Credit Extension . The obligations of the Bank under this Agreement shall not become effective until the date on which each of the following conditions is satisfied (or waived in accordance with Section 10.01 ):

(a) The Bank shall have received the Working Capital Note and the Equipment Note, each duly executed and delivered by the Borrower to the order of the Bank.

(b) The Bank shall have received certified copies of all documents evidencing necessary governmental approvals, if any, with respect to the Loan Documents.

(c) The Bank shall have received a certificate of the Secretary of each Credit Party certifying inter alia , (i) true and correct copies of the organizational documents of such Credit Party, (ii) true and correct copies of resolutions adopted by the Board of Directors (or comparable body) of each Credit Party (A) authorizing the execution, delivery and performance by each Credit Party of the Loan Documents to which it is a party and the incurrence of its obligations thereunder, (B) approving the forms of the Loan Documents that will be delivered at or prior to the Effective Date and (C) authorizing the officers of such Credit Party to execute and deliver the Loan Documents to which it is a party and any related documents, including any agreement or security document contemplated by this Agreement, and (iii) the incumbency and specimen signatures of the officers of such Credit Party executing any documents on behalf of such Credit Party.

(d) The Bank shall have received a certificate of the chief financial officer of the Borrower certifying inter alia , (i) the truth of the representations and warranties made by the Borrower in any Loan Document that will be delivered at or prior to the Effective Date, (ii) the absence of any proceedings for the dissolution or liquidation of the Borrower and (iii) the absence of the occurrence and continuance of any Default.

(e) The Bank shall have received certificates as to existence, qualification and good standing issued by the Secretary of State of each state wherein any Credit Party is or should be qualified to do business as a foreign entity.

(f) The Bank shall have received the written opinion of Doherty & Doherty LLP, counsel for the Borrower, dated the Effective Date, in form and substance satisfactory to the Bank.

(g) The Bank shall have received the payment of all fees required to be paid, and all expenses for which invoices have been presented.

(h) The Bank shall have received an executed payoff letter from the Sellers and BancFirst with accompanying releases in regard to the Indebtedness owing to said parties by SES or the Sellers;

 

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(i) The Bank shall have received a Working Capital Loan Borrowing Base Certificate certified by the chief financial officer of the Borrower.

(j) The Bank shall have received certificates of insurance covering the properties of the Borrower and its Subsidiaries with such insurance carriers, for such amounts and covering such risks as are acceptable to the Bank;

(k) The Equipment Loan and the Working Capital Loan outstanding under the Existing Credit Agreement shall have been prepaid (or prepaid simultaneously with the closing hereunder) together with accrued interest and fees and all other amounts thereunder.

(l) The Bank shall be satisfied with the form and substance of the Acquisition Documents, the total financing requirements for the Acquisition of SES shall not exceed $8,200,000, the Acquisition shall have been consummated or shall be consummated simultaneously on the Effective Date in accordance with the terms of the Acquisition Documents (without any waiver or amendment of any such terms not approved by the Bank), and the Bank shall have received a certificate to such effect;

(m) Each Guarantor shall have executed and delivered to the Bank an agreement confirming the continued effectiveness of the Guaranty, the Security Agreement and the Deeds of Trust in a form satisfactory to the Bank; and

(n) The Bank shall have received all other documents that it may reasonably request relating to any other matters relevant hereto.

SECTION 5.02 Conditions Precedent to All Advances . The obligation of the Bank to make an Advance or issue, amend, renew or extend a Letter of Credit shall be subject to the satisfaction or waiver of the following conditions precedent on the date of such Advance or issuance:

(a) The Bank shall have received the Request for Advance required by Section 2.02 or a request for the issuance, amendment, renewal or extension of a Letter of Credit pursuant to Section 4.02 .

(b) No Default has occurred and is continuing or will result from the making of such Advance.

(c) The representations and warranties of the Credit Parties contained in the Loan Documents shall be true and correct as of the date of such Advance, with the same effect as though made on such date.

(d) With respect to Advances under the Working Capital Loan, immediately after giving effect to such Advance, the Working Capital Exposure shall not exceed the lesser of (i) the Working Capital Loan Commitment or (ii) the Working Capital Loan Borrowing Base as set forth in the most current certificate required to be delivered pursuant to Section 7.02 .

 

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(e) No Material Adverse Effect shall have occurred since the Effective Date.

Each Advance hereunder shall be deemed to be a representation and warranty by the Borrower on the date of such Advance as to the facts specified in clauses (a) through (e) of this Section 5.02 .

ARTICLE VI

REPRESENTATIONS AND WARRANTIES

The Borrower as to itself and its Subsidiaries represents and warrants to the Bank as follows:

SECTION 6.01 Organization, Standing and Qualification . Each Credit Party is a corporation duly organized, validly existing and in good standing under the laws of the state of its organization and is duly qualified and licensed to do business and in good standing in each jurisdiction where the failure to be so qualified, licensed and in good standing would reasonably be likely to result in a Material Adverse Effect.

SECTION 6.02 Authority . The execution, delivery and performance by each Credit Party of the Loan Documents to which it is a party are within such Credit Party’s corporate powers, have been duly authorized by all necessary corporate action, and do not contravene (i) its Other Instruments, or (ii) any applicable law, regulation, ruling or order of any government or governmental entity or any contract to which any Credit Party is a party or by which the property of any Credit Party is bound. This Agreement, the other Loan Documents and the Acquisition Documents constitute the legal, valid and binding obligations of the Credit Parties party thereto enforceable in accordance with their respective terms, except as limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws at the time in effect affecting the rights of creditors generally and subject to general principles of equity, regardless of whether considered in a proceeding in equity or at law.

SECTION 6.03 Financial Condition . The consolidated balance sheets of the Borrower and its Subsidiaries at December 31, 2006 and June 30, 2007, and the related consolidated statements of income, retained earnings and cash flows of the Borrower and its Subsidiaries for the fiscal year and six month periods then ended, copies of which have been furnished to the Bank and certified by the chief financial officer of the Borrower, fairly present the consolidated financial condition of the Borrower and its Subsidiaries as at such dates and the results of the operations of the Borrower and its Subsidiaries for the periods ended on such dates, all in accordance with GAAP. Since December 31, 2006, there has been no Material Adverse Effect.

SECTION 6.04 Litigation . There is no pending or, to the best knowledge of the Borrower, threatened action or proceeding against or affecting the Borrower or any Subsidiary of the Borrower before any court, governmental agency or arbitrator (i) in which an adverse decision may have a Material Adverse Effect, (ii) that involve any Loan Document, Acquisition Document or the Acquisition, or (iii) that could impair the consummation of the Acquisition within the time and in the manner contemplated by the Acquisition Documents.

 

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SECTION 6.05 Regulation U . The proceeds of the Credit Extensions will be used by the Borrower only for general corporate purposes and without limiting the foregoing, in no event will any proceeds of the Credit Extensions be used to acquire any security in any transaction that is subject to Sections 13 and 14 of the Securities Exchange Act of 1934 or to purchase or carry any margin stock (within the meaning of Regulation U issued by the Board of Governors of the Federal Reserve System) or to extend credit to others for the purpose of purchasing or carrying any such margin stock. The Borrower is not engaged in the business of extending credit for the purpose of purchasing or carrying such margin stock.

SECTION 6.06 Compliance with Law . Each of the Borrower and its Subsidiaries is, and at all times since January 1, 2007, has been, in compliance with each law that is or was applicable to it or to the conduct or operation of its business or the ownership or use of any of its assets where the failure to be in compliance could reasonably be expected to result in a Material Adverse Effect; and neither the Borrower nor any of its Subsidiaries has received any notice of, nor does any of them have knowledge of, the assertion by any governmental authority of any such violation or of any obligation of the Borrower or any Subsidiary to undertake any remedial action under any law.

SECTION 6.07 Other Instruments . No Credit Party is a party to any indenture, loan or credit agreement or any lease or other agreement or instrument or subject to any restriction which would have a Material Adverse Effect.

SECTION 6.08 Title to Properties . Borrower and each of its Subsidiaries has good, indefeasible and insurable title to all its material properties, including all property reflected in the consolidated balance sheet of the Borrower (except for such property as has been sold or otherwise disposed of in the ordinary course of business since the date thereof), free from any Liens except Permitted Liens.

SECTION 6.09 Taxes . Except as disclosed in writing by the Borrower to the Bank prior to the Effective Date, the federal tax returns of each Credit Party and such other tax returns and reports required to be filed with the appropriate governmental agencies in all jurisdictions in which such returns or reports are required to be filed have been filed and all of the foregoing are in all material respects, true and correct and complete. Each Credit Party has filed all federal, state and local tax returns and other reports required by law to be filed and have paid all taxes and other similar charges that are due and payable by it.

SECTION 6.10 Environmental Compliance .

(a) The Borrower and each of its Subsidiaries has been and is currently in compliance in all respects with all applicable Environmental Laws, except where such noncompliance is unlikely to have a Material Adverse Effect;

(b) Neither the Borrower nor any of its Subsidiaries has received notice that it is or may be a potentially responsible party for removal or remediation of any Hazardous Substance or petroleum product, or that any Person has or may exert a claim for contribution or reimbursement for such removal or remediation;

 

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(c) To the best of the Borrower’s knowledge, there has been no release of any Hazardous Substance or petroleum product from, onto or under the Property of Borrower or any Subsidiary of the Borrower which release would have a Material Adverse Effect; and

(d) without limiting the foregoing:

(i) There is no existing or, to the best of the Borrower’s knowledge, anticipated order requiring the Borrower or any Subsidiary of the Borrower to clean up or remediate any Hazardous Substance or petroleum product on any property presently or formerly owned, leased or used by the Borrower or any Subsidiary of the Borrower;

(ii) All underground and above ground storage tanks located on the Property of the Borrower or any Subsidiary of the Borrower (“ Tanks ”) have been registered and all fees required by any Environmental Law have been paid;

(iii) The Borrower and Borrower’s Subsidiaries and all Tanks are in compliance with Chapter 26 of the Texas Water Code, Chapter 334 of the Texas Administrative Code, the Resource Conservation and Recovery Act and 40 C.F.R. Part 280, as supplemented and amended, including without limitation, requirements for financial assurance, tank replacement, and monitoring.

SECTION 6.11 No Default . Neither the Borrower nor any Subsidiary of the Borrower is in default under any instrument evidencing Indebtedness, and the execution, delivery and performance of this Agreement and the Loan Documents by the Credit Parties will not result in a default in the payment or performance of any obligations or in the performance of any mortgage, lease, contract or other agreement to which the Borrower or such Subsidiary is a party or by which the Borrower or such Subsidiary is or any of the Borrower’s or such Subsidiary’s properties or assets may be bound and no default thereunder has occurred and is continuing.

SECTION 6.12 Subsidiaries . Except as listed on Schedule 6.12, the Borrower has no Subsidiaries.

SECTION 6.13 ERISA . The Borrower and its Subsidiaries and each member of such parties’ “ Controlled Group ”, within the meaning of Section 414 of the Code or Section 4001(a) of ERISA, have timely fulfilled all their obligations under the minimum funding standards of ERISA and the Code with respect to each “ Employee Benefit Plan ” (within the meaning of Section 3(3) of ERISA), whether or not terminated, to or with respect to which either the Borrower, any Subsidiary of the Borrower and/or a member of its Controlled Group is making or accruing an obligation to make contributions or within the preceding six years has made or had an obligation to make contributions (a “ Plan ”) and are (and have been) in compliance in all material respects with the applicable provisions of ERISA, the Code and other law with respect to each Plan. Each Plan is (and/or has been) maintained and operated in compliance in all material respects with the applicable provisions of ERISA, the Code and other law. Neither the Borrower, any of its Subsidiaries nor any member of their Controlled Group:

 

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(a) has sought (or is seeking) a waiver of the minimum funding standard under Section 412 of the Code in respect of any Plan;

(b) has failed to timely make any contribution or payment to or in respect of any Plan, or made any amendment to any Plan that has resulted or could result in the imposition of a Lien or the posting of a bond or other security under ERISA or the Code; or

(c) has incurred (and no event exists which could result in) any liability under Title IV of ERISA (other than a liability to the PBGC for premiums under Section 4007 of ERISA). No litigation, investigation or claim (other than a routine claim for benefits) is pending or, to the knowledge of the Borrower, threatened or anticipated concerning any Plan and no unfunded liability (whether or not current or contingent) exists under or with respect to any Plan.

SECTION 6.14 Acceptable Security Interest . The Security Agreement is effective to create in favor of the Bank a valid Lien on all right, title and interest of each Credit Party, as applicable, in the Collateral, as security for the Obligations, prior and superior in right to any other Lien (except for Liens permitted by Section 8.01 ). All financing statements have been filed that are necessary to perfect any security interest created pursuant to the Security Agreement that can be perfected by the filing of such financing statements and all actions necessary to provide control to the Bank, with respect to any Collateral for which control can be established in favor of the Bank, have been taken, including delivery of such Collateral to the Bank to the extent such Collateral is certificated or for which possession can provide perfection with respect thereto.

ARTICLE VII

AFFIRMATIVE COVENANTS

Until the Final Payment Date the Borrower as to itself and its Subsidiaries covenants as follows:

SECTION 7.01 Compliance with Laws, Etc .

(a) The Borrower shall, and shall cause each of its Subsidiaries to, comply in all material respects with all applicable laws, rules, regulations and orders, such compliance to include, without limitation, paying before the same become delinquent all taxes, assessments and governmental charges imposed upon it or upon its property except to the extent contested in good faith by appropriate proceedings diligently conducted and shall comply with and perform and observe all material covenants, provisions and conditions to be performed and observed on the part of the Borrower or such Subsidiary in connection with all of its Other Instruments.

(b) Notwithstanding the foregoing, each of the Borrower and its Subsidiaries shall (i) comply in a timely fashion with, or operate pursuant to valid waivers of, the provisions of all Environmental Laws unless the failure to do so will not have a Material Adverse Effect, (ii) notify each Bank promptly in the event of any actual or alleged

 

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material noncompliance with any Environmental Laws or any notice of any actual or alleged obligation to take corrective action with respect to any Hazardous Substance or petroleum product and (iii) promptly forward to the Bank a copy of any claim, judgment, order, notice, civil or criminal complaint, actual or threatened Lien, request for injunction, threatened or actual withdrawal of any Permit or other communication or report in connection with any material matter relating to Environmental Laws, Hazardous Substances or petroleum products as it may adversely affect the Borrower or such Subsidiary or any Property of the Borrower or such Subsidiary.

SECTION 7.02 Reporting Requirements . The Borrower will furnish or will cause to be furnished at its expense to the Bank:

(a) as soon as available and in any event within 120 days after the end of each fiscal year of the Borrower, a copy of the consolidated and consolidating balance sheets of the Borrower and its Subsidiaries as of the end of such year and the related consolidated and consolidating statements of income and cash flows for such year, audited and bearing an unqualified opinion by independent certified public accountants acceptable to the Bank and certified by the chief financial officer of the Borrower as fairly presenting the financial position of the Borrower and its Subsidiaries as at the dates indicated and in accordance with GAAP together with a statement of such accountants stating that, in making the examination necessary for their report, they obtained no knowledge of any Default, or, if such accountants shall have obtained knowledge of any such Default, specifying the details and the nature and status thereof;

(b) as soon as available and in any event within 25 days after the end of each calendar month of the Borrower, the consolidated and consolidating balance sheets of the Borrower as of the end of such month and the related consolidated and consolidating statements of income and cash flows of the Borrower for such month all in reasonable detail, certified by the chief financial officer of the Borrower as fairly presenting the financial position of the Borrower as at the dates indicated and in accordance with GAAP;

(c) as soon as available and in any event within 25 days after the end of each calendar month, a completed Working Capital Loan Borrowing Base Certificate as of the end of such month;

(d) as soon as available and in any event within 25 days after the end of the first three fiscal quarters of each fiscal year of the Borrower and within 120 days after the end of each fiscal year of the Borrower, a Compliance Certificate from the Borrower as of the end of such period;

(e) as soon as available and in any event within 25 days after the end of each calendar month of the Borrower, a monthly Accounts Receivable aging, accounts payables aging and inventory listing and aging report of Borrower, in form satisfactory to the Bank;

 

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(f) as soon as available and in any event within ten days after the end of each fiscal year of the Borrower, a listing of all Accounts Receivable debtors including physical addresses, contact names and phone numbers;

(g) Within 30 days after the end of each fiscal year of the Borrower, annual operating and capital budgets for the current fiscal year;

(h) Promptly after the commencement thereof, notice of all actions, suits, investigations and proceedings before any court , tribunal, agency or other governmental authority, affecting the Borrower or any of its Subsidiaries;

(i) As soon as available and in any event within 25 days after the end of each fiscal quarter of the Borrower, an Equipment sales report from the Borrower as of the end of such period; and

(j) such other information as the Bank may from time to time reasonably request.

SECTION 7.03 Visitation Rights . At any reasonable time and from time to time upon prior notice to the Borrower, the Borrower shall permit the Bank or any agents or representatives thereof to examine and make copies of and abstracts from the records and books of account of, and visit and inspect the Properties, Inventory and chattel paper of, the Borrower or any Subsidiary of the Borrower and to discuss the affairs, finances and accounts of the Borrower or such Subsidiary with any officer of the Borrower or such Subsidiary and their independent public accountants.

SECTION 7.04 Maintenance of Insurance . The Borrower shall, and shall cause each Subsidiary of the Borrower to, maintain insurance with responsible and reputable insurance companies in such amounts and covering such risks as are usually carried by companies engaged in similar businesses and owning similar properties in the same trade and general areas in which the Borrower or such Subsidiaries operate. Each liability insurance policy shall name the Bank as an additional insured and each property insurance policy shall name the Bank as loss payee. The Borrower will, and will cause each Subsidiary of the Borrower to, furnish evidence of any such insurance referred to in this Section upon request by the Bank.

SECTION 7.05 Maintenance of Properties, Etc . The Borrower shall, and shall cause each Subsidiary of the Borrower to, maintain and preserve all of its Properties, necessary or useful in the proper conduct of its business in good working order and condition, ordinary wear and tear excepted.

SECTION 7.06 Keeping of Records and Books of Account . The Borrower shall, and shall cause each Subsidiary of the Borrower to, keep adequate records and books of account in accordance with GAAP.

SECTION 7.07 Preservation of Existence, Etc . The Borrower shall, and shall cause each Subsidiary of the Borrower to, preserve and maintain its existence, rights, franchises and privileges in the state of its formation and qualify and remain qualified in each jurisdiction in which such qualification is necessary or desirable in view of its business and operations and the ownership of its Properties.

 

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SECTION 7.08 Notification of Adverse Events . The Borrower shall notify the Bank of all Events of Default within five days of the occurrence thereof.

SECTION 7.09 ERISA Compliance . The Borrower shall, and shall cause each ERISA Affiliate to, comply in all material respects with the provisions of ERISA, the Internal Revenue Code of 1986, as amended, and all other applicable laws and the regulations and interpretations thereunder.

SECTION 7.10 Additional Security .

(a) No later than ten days after any Person becomes a Subsidiary, the Borrower shall, and shall cause such Subsidiary (unless it is not a Domestic Subsidiary) and its parent to, execute and deliver a Joinder Agreement under which (i) such Domestic Subsidiary shall grant a security interest in its assets described in the Security Agreement as security for the Obligations and become a Guarantor, and (ii) such parent pledges to the Bank 100% of the common stock or other ownership interests of such Domestic Subsidiary (or 65% of the common stock or other ownership interests of such Subsidiary if it is not a Domestic Subsidiary) and to deliver to the Bank such other documents relating to such Subsidiary as the Bank may reasonably request.

(b) From and after the Closing Date, if (i) the Borrower or any Guarantor acquires any fee interest in real property having a book value in excess of $100,000 or (ii) at the time any Person becomes a Guarantor, such Person owns or holds any such fee interest in real property of such value, such Credit Party shall deliver to the Bank, at its request after such acquisition of such property or such Person becomes a Guarantor, as the case may be, the following:

(i) A fully executed and notarized mortgage or deed of trust (an “ Additional Mortgage ”), duly recorded in all appropriate places in all applicable jurisdictions, encumbering the interest of such Credit Party in such property;

(ii) If requested by the Bank, a title report issued by a title company acceptable to the Bank with respect thereto, dated not more than 30 days prior to the date such Additional Mortgage is to be recorded and satisfactory in form and substance to the Administrative Agent, together with copies of any documents listed as exceptions to such title and, to the extent the Borrower or any Subsidiary obtains an owner’s title policy on said property, a mortgagee’s policy in an equal amount insuring the Lien in subsection (i) above; and

(iii) If requested by the Bank, evidence that said property is not in an area designated as prone to flooding or, if so, evidence of flood insurance reasonably satisfactory to the Bank.

 

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SECTION 7.11 Borrowing Base Audits . The Borrower shall, and shall cause each of its Subsidiaries to, permit the Bank, at any reasonable time, and upon reasonable notice, to perform one collateral audit of the assets of the Borrower and its Subsidiaries that comprise the Borrowing Base during each fiscal year; provided , however , that, if an Event of Default has occurred and is continuing, the Bank shall be permitted to conduct additional audits as it determines. Regardless of whether an Event of Default has occurred and is continuing, all such audits shall be performed at the Borrower’s sole cost and expense.

SECTION 7.12 Treasury Management Services . The Borrower shall maintain in effect the existing depositing services provided by the Bank on an exclusive basis from the Effective Date through the Final Payment Date.

SECTION 7.13 Use of Proceeds . The Borrower shall use the proceeds of the Advances (i) to finance the working capital requirements of the Borrower and its Subsidiaries and for general corporate purposes, (ii) to finance the Acquisition and (iii) to refinance the Working Capital Loan and the Equipment Loan outstanding under the Existing Credit Agreement.

ARTICLE VIII

NEGATIVE COVENANTS

Until the Final Payment Date, the Borrower shall not and shall not permit any Subsidiary of the Borrower to:

SECTION 8.01 Liens . Create, incur, assume or suffer to exist any Lien upon or with respect to any of its Properties, now owned or hereafter acquired, or assign or otherwise convey any right to receive income or sell any accounts or notes receivable except Permitted Liens. Notwithstanding the foregoing, the parties acknowledge that they do not intend to subordinate the Lien granted to the Bank to any Permitted Lien that may arise in the future.

SECTION 8.02 Indebtedness . Create, incur, assume or suffer to exist any Indebtedness without the written consent of the Bank except for:

(a) Indebtedness of the Borrower under the Loan Documents;

(b) Indebtedness shown on Schedule 8.02 ;

(c) Indebtedness in the amount of $1,000,000 or less incurred to finance the purchase price for assets necessary in Borrower’s ordinary course of business;

(d) A guarantee of Indebtedness of CAVO owed to the Bank and outstanding on the date hereof not to exceed $2,200,000 and any extensions, renewals, refinancings and replacements thereof; and

(e) Subordinated Indebtedness owing or to be owing by Turbeco, Inc. to Preston Phenes, in the approximate original principal amount of One Million Five Hundred Forty-Five Thousand Three Hundred Ninety-One and No/100 Dollars ($1,545,391.00), with a maturity date of September 1, 2009.

 

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SECTION 8.03 Change in Nature of Business . Make any material change in the nature of the business of the Borrower or any Subsidiary of the Borrower as carried on at the date hereof.

SECTION 8.04 Transactions with Affiliates . Make any sale to, make any purchase from, extend credit to, make payment for services rendered by, or enter into any other transaction with any Affiliate unless, in each case, such sale, purchase or extension of credit is made or such services are rendered or such other transaction is entered into in the ordinary course of business and on terms and conditions at least as favorable to the Borrower or any Subsidiary of the Borrower as the terms and conditions that would apply in a similar transaction on an arms-length basis with a Person other than such Affiliate.

SECTION 8.05 Investments . Make any Investments in any Person except:

(a) Investments made to officers, employees or shareholders of the Borrower not in excess of $250,000 at any time outstanding;

(b) Investments by the Borrower in its Subsidiaries existing on the date hereof and as set forth in Schedule 6.12 ;

(c) Permitted Investments; and

(d) the Acquisition.

SECTION 8.06 Distributions . Directly or indirectly declare, order, pay, make or set apart any sum for any Restricted Payment except for dividends by a Subsidiary to the Borrower or another Subsidiary.

SECTION 8.07 Subordinated Debt . Prepay any Subordinated Debt without the written consent of the Bank, or amend, modify, or change in any way any of the Subordinated Debt so as to change the stated maturity date of the principal of such debt, or any installment of interest thereon, to an earlier date, increase the rate of interest thereon or any premium payable on the redemption thereof, change any of the redemption or subordination provisions thereof (or the definitions of any defined terms contained therein) or otherwise change in any respect materially adverse to the interests of the Bank any of the terms thereof, in each case, without the written consent of the Bank; provided , however , the Borrower may make scheduled principal payments of the Subordinated Debt as they become due if (A) on the due date no Default exists, (B) the Bank has not notified either the Borrower or any holder of Subordinated Debt that a Default then exists or would be created by such payment, (C) the Pro Forma Fixed Charge Coverage Ratio at the time of such scheduled principal payment shall not be less than 1.5 to 1.0 and (D) immediately following such payment the lesser of the Working Capital Loan Borrowing Base and the Working Capital Commitment shall exceed the Working Capital Exposure by at least $500,000.

 

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SECTION 8.08 Leverage Ratio . Permit the Leverage Ratio on the last day of any month to be more than (i) 3.0 to 1.0 for any month ending prior to January 1, 2008, and (ii) 2.5 to 1.0 thereafter.

SECTION 8.09 Fixed Charge Coverage Ratio . Permit the Fixed Charge Coverage Ratio on the last day of any month to be less than 1.3 to 1.0.

SECTION 8.10 Consolidated Net Income . Permit its Consolidated Net Income to be less than zero (i) for any fiscal quarter or (ii) for any Fiscal Year.

SECTION 8.11 Prohibition of Fundamental Changes . The Borrower shall not, nor shall it permit any of its Subsidiaries to, merge or consolidate with, or acquire all or any substantial part of the assets or class of stock or other ownership interests of, any other Person without the prior written consent of the Bank, except as follows:

(i) any wholly-owned Subsidiary may merge with any other wholly-owned Subsidiary; and

(ii) the Borrower may merge with any wholly-owned Subsidiary so long as the Borrower is the surviving entity.

SECTION 8.12 Asset Sales . The Borrower shall not, nor shall it permit any of its Subsidiaries to, sell, convey, lease, transfer or otherwise dispose of, in one transaction or a series of transactions, any assets except for:

(a) Sales of inventory in the ordinary course of business;

(b) Sales of Equipment provided that the proceeds of such sales are either reinvested in similar equipment and value or used to prepay the Equipment Loan within 90 days after the end of the fiscal quarter in which such sales were made; and

(c) Sales of assets other than Equipment that do not exceed $250,000 since the Effective Date.

SECTION 8.13 Capital Expenditures . The Borrower shall not permit the aggregate Capital Expenditures by the Borrower and its Subsidiaries in any fiscal year to exceed $15,000,000.

SECTION 8.14 Restrictions on CAVO . The Borrower will not, and will not permit any of its Subsidiaries to, vote for any amendment or termination of the CAVO Regulations, or any other agreement material to CAVO’s operations, except, in each case, for amendments that would not reduce CAVO’s cash flow and with respect to which the Borrower has provided to the Bank a copy of the proposed amendment at least five days prior to the effective date of such amendment.

 

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ARTICLE IX

EVENTS OF DEFAULT AND REMEDIES

SECTION 9.01 Events of Default . The occurrence of any one or more of the following events shall constitute an Event of Default hereunder:

(a) Any opinion, certification, representation or warranty to the Bank set forth in this Agreement or any other Loan Document or in any certificate required to be delivered herewith or therewith (including any Request for Advance) at any time (whether made or delivered on the date of this Agreement or prior to or after such date) shall be false when made or delivered in any material respect;

(b) Any Credit Party shall fail to comply with any of the provisions of any Loan Document other than those obligations referenced in Section 9.01(c) and such event continues for a period of 30 days after the Bank has sent the Borrower notice thereof or the Borrower has actual notice thereof;

(c) The Borrower shall fail to pay any principal or interest of any Note when due, whether by acceleration or otherwise, or any Credit Party shall fail to pay any Obligations owed under any Loan Document when due, in each case within three Business Days from the date when due;

(d) The Borrower or any Subsidiary of the Borrower (i) admits in writing its inability to pay its debts generally as they become due; (ii) is generally not paying its debts as they become due, except if contested in good faith by appropriate proceedings; (iii) files a petition under any bankruptcy law or any insolvency law or similar laws (including, without limitation, the Federal Bankruptcy Code of 1978 or any amendment thereto); (iv) makes a general assignment for the benefit of its creditors; or (v) files a petition or answer seeking for itself, or consenting to or acquiescing in any reorganization, arrangement, composition, readjustment, liquidation, dissolution or similar relief under any law referred to in clause (iii) of this paragraph (d) or fails to deny the material allegations of or to contest any such petition filed against it within 60 days;

(e) There is appointed a receiver, custodian, liquidator, fiscal agent or trustee of the Borrower or any Subsidiary of the Borrower or of the whole or any substantial part of the properties or assets of the Borrower or any Subsidiary of the Borrower or any court enters an order, judgment or decree approving a petition filed against the Borrower or any Subsidiary of the Borrower seeking reorganization, arrangement, composition, readjustment, liquidation, dissolution or similar relief under any law referred to in clause (iii) of paragraph (d) of this Section or an order of relief is entered pursuant to any such law with respect to the Borrower or any Subsidiary of the Borrower and such order, judgment, decree or appointment shall not be dismissed within a period of 60 days;

(f) The Borrower or any Subsidiary of the Borrower fails to pay at maturity or renew any Indebtedness of the Borrower or Subsidiary of the Borrower or the default by the Borrower or any Subsidiary of the Borrower under any note, indenture, mortgage or

 

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obligation incurred pursuant thereto, the effect of which default (assuming the giving of notice or the passage of time or both) accelerates, or entitles any Person to accelerate, any maturity thereof or results in the forfeiture by Borrower or such Subsidiary of any of its rights under any such note, indenture or mortgage and the amount of any such Indebtedness (other than Subordinated Debt) individually or in the aggregate exceeds $100,000;

(g) The Borrower or any Subsidiary of the Borrower suffers a final judgment against it which, within 60 days from the date such judgment is entered, shall not have been discharged or execution thereof stayed pending appeal unless (i) such judgment is adequately covered by insurance; or (ii) adequate accruals with respect to such judgment have been established in accordance with GAAP and the aggregate amount of all such judgments not adequately covered by insurance is not at any time in excess of $200,000;

(h) The Borrower or any Subsidiary of the Borrower suffers to exist any order, judgment, claim, notice, injunction or decree of any governmental agency in connection with any Environmental Law requiring Borrower to (1) pay any penalty, (2) take corrective action or reimburse any Person for corrective action or (3) correct any violation, if the potential cost to the Borrower and its Subsidiaries of any of same exceeds individually or in the aggregate $200,000 and such order, judgment, claim or notice is not dismissed or continuously stayed or enjoined within a period of five days from the date the Borrower’s payment or corrective action is required;

(i) A Change of Control shall have occurred;

(j) Any material adverse change shall have occurred to the business, condition (financial or otherwise), results of operation or prospects of the Borrower and its Subsidiaries, taken as a whole, since the Effective Date;

(k) Any Loan Document shall at any time and for any reason cease to be in full force and effect and binding on the Credit Party party thereto or shall be contested by any party thereto or any Credit Party shall deny it has any liability under any Loan Document to which it is a party, or any Loan Document shall at any time and for any reason cease to create an Acceptable Security Interest in the Property purported to be subject to such agreement in accordance with the terms of such agreement; or

(l) An ERISA Event shall have occurred.

Upon the occurrence and during the continuance of an Event of Default, the Bank may (i) declare the Bank’s obligation to make Advances to be terminated, whereupon the same shall forthwith terminate, and (ii) may take any and all actions, including to declare the Notes or any one of them, all interest thereon and all other amounts payable under this Agreement to be forthwith due and payable, whereupon said Note, all such interest and all such amounts shall become and be forthwith due and payable, without grace, demand, presentment for payment, notice of dishonor, default, acceleration of the maturity thereof and of the intent to accelerate the maturity thereof, protest and notice of protest and notice of any kind, filing of suit, diligence in collecting the Note and bringing suit and enforcing of the security rights of the Bank, all of

 

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which, except for the notices referred to in Sections 9.01(b) , are hereby expressly waived by the Borrower, and thereafter the Bank may pursue any remedy or take any action that it may have hereunder, at law, in equity, or otherwise (including, but not limited to, reducing any claim to judgment) if the Note is not paid at maturity (on demand, by acceleration or otherwise); provided , however , that in the event of an Event of Default described in either clause (d) or (e) above, (A) the obligation of the Bank to make Advances shall automatically be terminated and (B) the Notes, all such interest and all such amounts shall automatically become and be due and payable, without presentment, demand, protest or any notice of any kind, all of which are hereby expressly waived by the Borrower.

ARTICLE X

MISCELLANEOUS

SECTION 10.01 Amendments, Etc . No amendment or waiver of any provision of this Agreement or the Notes, nor consent to any departure by the Borrower therefrom, shall in any event be effective unless the same shall be in writing and signed by the Bank and then such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given.

SECTION 10.02 Notices, Etc . All notices and other communications provided for hereunder shall be in writing (including telecopy or electronic communication) and mailed, telecopied or delivered as follows:

(a) if to the Borrower, at its address at 7030 Empire Central Drive, Houston, Texas 77040, Attention: Chief Financial Officer;

(b) if to the Bank, at its address at 1000 Louisiana, 3 rd Floor, T5001-031, Houston, Texas 77002, Attention: Chad Johnson.

All such notices and communications shall when be effective when received.

SECTION 10.03 No Waiver; Remedies . No failure on the part of the Bank to exercise, and no delay in exercising, any right hereunder or under the Notes shall operate as a waiver thereof; nor shall any single or partial exercise of any such right preclude any other or further exercise thereof or the exercise of any other right. The remedies herein provided are cumulative and not exclusive of any remedies provided by law.

SECTION 10.04 Costs, Expenses and Taxes . The Borrower shall pay on demand all reasonable out-of-pocket costs and expenses of the Bank in connection with the preparation, execution, delivery, administration, modification, and amendment of this Agreement, the Notes, and the other Loan Documents, including costs associated with field examinations, appraisals and collateral reviews, the reasonable fees and out-of-pocket expenses of counsel for the Bank with respect to advising the Bank as to its rights and responsibilities under this Agreement, and all out-of-pocket costs and expenses, if any, of the Bank in connection with the enforcement (whether through negotiations, legal proceedings, or otherwise) of this Agreement, the Notes, and the other Loan Documents. If the Borrower fails to perform any agreement contained herein, the Bank may itself perform, or cause performance of, such agreement, and the costs and expenses of the Bank incurred in connection therewith shall be payable and the Borrower hereby promises to pay same, on demand.

 

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SECTION 10.05 Right of Set-off . Upon the occurrence and during the continuance of any Event of Default the Bank is hereby authorized at any time and from time to time, to the fullest extent permitted by law, to set off and apply any and all deposits (general or special, time or demand, provisional or final) at any time held and other Indebtedness at any time owing by the Bank to or for the credit or the account of the Borrower against any and all of the obligations of the Borrower now or hereafter existing under this Agreement, the Note and the other Loan Documents, whether or not the Bank shall have made any demand under this Agreement or any such Note and although such obligations may be unmatured. The Bank shall apply any amounts set off as herein described first to the Indebtedness of the Borrower owing under the Notes and the Loan Documents. The Bank shall promptly notify the Borrower after any such set-off and application made by the Bank, provided that the failure to give such notice shall not affect the validity of such set-off and application. The rights of the Bank under this Section are in addition to other rights and remedies (including other rights of set-off) that the Bank may have.

SECTION 10.06 Interest . Anything in this agreement or the other Loan Documents to the contrary notwithstanding, the Borrower shall never be required to pay unearned interest on any Note and shall never be required to pay interest on such Note at a rate in excess of the Highest Lawful Rate, and if the effective rate of interest that would otherwise be payable under this Agreement, the other Loan Documents and such Note would exceed the Highest Lawful Rate, or if the holder of such Note shall receive any unearned interest or shall receive monies that are deemed to constitute interest that would increase the effective rate of interest payable by the Borrower under this Agreement and the other Loan Documents to a rate in excess of the Highest Lawful Rate, then (a) the amount of interest that would otherwise be payable by the Borrower under this Agreement, such Note and the other Loan Documents shall be reduced to the highest nonusurious amount allowed under applicable law; and (b) any unearned interest paid by the Borrower or any interest paid by the Borrower in excess of the Highest Lawful Rate shall be credited on the principal of such Note and, to the extent any funds remain, refunded to the Borrower. Without limitation of the foregoing, all calculations of the rate of interest contracted for, charged or received by the Bank under the Note, or under this Agreement, are made for the purpose of determining whether such rate exceeds the Highest Lawful Rate applicable to the Bank (such Highest Lawful Rate being the Bank’s “ Maximum Permissible Rate ”) and shall be made, to the extent permitted by usury laws applicable to the Bank (now or hereafter enacted), by amortizing, prorating and spreading in equal parts during the period of the full stated term of the Advances evidenced by said Note all interest at any time contracted for, charged or received by the Bank in connection therewith. If at any time and from time to time (i) the amount of interest payable to the Bank on any date shall be computed at the Bank’s Maximum Permissible Rate pursuant to this Section and (ii) in respect of any subsequent interest computation period the amount of interest otherwise payable to the Bank would be less than the amount of interest payable to the Bank computed at the Bank’s Maximum Permissible Rate, then the amount of interest payable to the Bank in respect of such subsequent interest computation period shall continue to be computed at the Bank’s Maximum Permissible Rate until the total amount of interest payable to the Bank shall equal the total amount of interest that would have been payable to the Bank if the total amount of interest had been computed without giving effect to this Section.

 

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SECTION 10.07 Indemnification . The Borrower shall indemnify the Bank, the Affiliates of the Bank, and their respective directors, officers, employees, agents, representatives and attorneys of each of them (the “ Indemnified Parties ”) from, and hold each of them harmless against, any and all liabilities, obligations, losses, penalties, actions, judgments, suits, costs, expenses or disbursements of any kind or nature whatsoever to which any of them may become subject arising out of or based on the Loan Documents but excluding any such liabilities, obligations, losses, penalties, actions, judgments, suits, costs, expenses or disbursements of any kind or nature whatsoever incurred by reason of the gross negligence or willful misconduct of the Indemnified Party. The obligations of the Borrower under this Section shall survive the termination of this Agreement and/or the payment or assignment of the Notes. IT IS THE EXPRESS INTENTION OF THE BORROWER THAT THE INDEMNIFIED PARTIES SHALL BE INDEMNIFIED AND HELD HARMLESS AGAINST ANY AND ALL LIABILITIES, OBLIGATIONS, LOSSES, PENALTIES, ACTIONS, JUDGMENTS, SUITS, COSTS, EXPENSES OR DISBURSEMENTS OF ANY KIND OR NATURE WHATSOEVER ARISING OUT OF THE SOLE OR CONTRIBUTORY NEGLIGENCE OR STRICT LIABILITY OF THE INDEMNIFIED PARTY OR EACH OF THEM .

SECTION 10.08 Binding Effect . This Agreement shall become effective when it shall have been executed by the Borrower and the Bank and thereafter shall be binding upon and inure to the benefit of the Borrower, the Bank and their respective successors and assigns, except that the Borrower shall not have the right to assign its rights hereunder or any interest herein without the prior written consent of the Bank.

SECTION 10.09 Governing Law . This Agreement and the Notes shall be governed by, and construed in accordance with, the laws of the State of Texas without regard to its choice of law principles.

SECTION 10.10 Execution in Counterparts . This Agreement may be executed in any number of counterparts, each of which when so executed shall be deemed to be an original.

SECTION 10.11 Assignment . The Bank may assign, transfer, convey or sell a participation or otherwise share its respective obligations and benefits hereunder; provided , however , that without the express written consent of the Borrower (which consent shall not be unreasonably withheld) no such assignment, transfer, conveyance or sale shall affect the rights and obligations of the Bank vis-a-vis the Borrower.

SECTION 10.12 Separability . Should any clause, sentence, paragraph or Section of this Agreement be judicially declared to be invalid, unenforceable or void, such decision shall not have the effect of invalidating or voiding the remainder of this Agreement, and the parties hereto agree that the part or parts of this Agreement so held to be invalid, unenforceable or void shall be deemed to have been stricken herefrom and the remainder shall have the same force and effectiveness as if such part or parts had never been included herein.

SECTION 10.13 Limitation by Law . All rights, remedies and powers provided in this Agreement and the other Loan Documents may be exercised only to the extent that the exercise thereof does not violate any applicable provision of law, and all the provisions of this Agreement and the other Loan Documents are intended to be subject to all applicable mandatory

 

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provisions of law that may be controlling and to be limited to the extent necessary so that they will not render this Agreement or any other Loan Document invalid, unenforceable, in whole or in part, or not entitled to be recorded, registered or filed under the provisions of any applicable law.

SECTION 10.14 Waiver of DTPA Actions . THE BORROWER HEREBY WAIVES ALL PROVISIONS OF THE TEXAS DECEPTIVE TRADE PRACTICES-CONSUMER PROTECTION ACT (AS AMENDED FROM TIME TO TIME, THE “ DTPA ”) AND EXPRESSLY RECOGNIZES THAT IT (i) HAS ASSETS OF $5 MILLION OR MORE, (ii) HAS KNOWLEDGE AND EXPERIENCE IN FINANCIAL AND BUSINESS MATTERS THAT ENABLES IT TO EVALUATE THE MERITS AND RISKS OF THIS TRANSACTION AND (iii) IS NOT IN A SIGNIFICANTLY DISPARATE BARGAINING POSITION RELATIVE TO THE PARTIES TO THIS CREDIT AGREEMENT.

SECTION 10.15 Agreement for Binding Arbitration .

(a) Any controversy or claim between or among the parties hereto, including but not limited to those arising out of or relating to this Agreement or the Loan Documents, including any claim based on or arising from an alleged tort, shall be determined by binding arbitration in accordance with the Federal Arbitration Act (or if not applicable, the applicable state law), the rules of practice and procedure for the arbitration of commercial disputes of the American Arbitration Association (“ AAA ”), and the “special rules” set forth in paragraph (b) below. In the event of any inconsistency, the special rules shall control. Judgment upon any arbitration award may be entered in any court having jurisdiction. Any party to this Agreement may bring an action, including a summary or expedited proceeding, to compel arbitration of any controversy or claim to which this Agreement or any of the Loan Documents applies in any court having jurisdiction over such action.

(b) The arbitration shall be conducted in Houston, Texas and administered by AAA, who shall appoint an arbitrator; if AAA is unable or legally precluded from administering the arbitration, then the Judicial Arbitration and Mediation Services, Inc. shall serve. All arbitration hearings shall be commenced within 90 days of the demand for arbitration; further, the arbitrator shall only, upon a showing of cause, be permitted to extend the commencement of such hearing for up to an additional 60 days.

(c) Nothing in this Agreement shall be deemed to (i) limit the applicability of any otherwise applicable statutes of limitation or repose and any waivers contained in this Agreement or the Loan Documents; or (ii) be a waiver by the Bank of the protection afforded to it by 12 U.S.C. §91 or any substantially equivalent state law; or (iii) limit the rights of the Bank hereto (A) to exercise self help remedies such as (but not limited to) set-off, or (B) to foreclose against any real or personal property collateral, or (C) to obtain from a court provisional or ancillary remedies such as (but not limited to) injunctive relief, writ of possession or the appointment of a receiver. The Bank may exercise such self help rights, foreclose upon such Property, or obtain such provisional or ancillary remedies before, during, or after the pendency of any arbitration proceeding brought pursuant to this Agreement. Neither this exercise of self help remedies nor the

 

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institution or maintenance of an action for foreclosure or provisional or ancillary remedies shall constitute a waiver of the right of any party, including the claimant in any such action, to arbitrate the merits of the controversy or claim occasioning resort to such remedies.

SECTION 10.16 Final Agreement of the Parties . THIS AGREEMENT, THE NOTES, THE SECURITY AGREEMENT AND THE OTHER LOAN DOCUMENTS CONSTITUTE A “LOAN AGREEMENT” AS DEFINED IN SECTION 26.02(A) OF THE TEXAS BUSINESS AND COMMERCE CODE, AND REPRESENTS THE FINAL AGREEMENT AMONG THE PARTIES AND MAY NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS OR SUBSEQUENT ORAL AGREEMENTS OF THE PARTIES. THERE ARE NO ORAL AGREEMENTS BETWEEN THE PARTIES .

[Signatures on following page]

 

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IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their respective officers thereunto duly authorized, effective as of the Effective Date.

 

FLOTEK INDUSTRIES, INC.
By:   /s/ Lisa Bromiley Meier
  Lisa Bromiley Meier
  Chief Financial Officer

 

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WELLS FARGO BANK, NATIONAL ASSOCIATION
By:   /s/ Chad Johnson
  Chad Johnson
  Vice President

 

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Exhibit A

FLOTEK INDUSTRIES, INC.

COMPLIANCE CERTIFICATE

AS OF [                              ]

The undersigned Lisa B. Meier, Chief Financial Officer of Flotek Industries, Inc. (the “ Borrower ”) hereby certifies that the following, in accordance with the current information on the books and records of the Borrower and its Subsidiaries, sets forth the results of the calculations necessary to establish compliance with the provisions of Section 8.01 through Section 8.13 of the Amended and Restated Credit Agreement (the “ Credit Agreement ”) dated as of August      , 2007 between the Borrower and Wells Fargo Bank, National Association, and accurately reflects (i) the amounts required or permitted, as applicable under each of referenced provisions of the Credit Agreement and (ii) the actual amounts as they exist with respect to each of such provisions, as of the date of this certificate. All capitalized terms used herein without definition have the respective meaning specified therefore in the Credit Agreement. The details of such calculations are attached.

 

1. Section 8.02 - Indebtedness

The Borrower shall not, and shall not permit any subsidiary to, create, incur, assume or suffer to exist any Indebtedness without the written consent of the Bank except for (a) Indebtedness of the Borrower under the Loan Documents, (b) Indebtedness shown on Schedule 8.02, (c) Indebtedness in the amount of $1,000,000 or less incurred to finance the purchase price for assets necessary in Borrower’s ordinary course of business, (d) a guarantee of Indebtedness of CAVO owed to the Bank not to exceed $2,200,000 and any extensions, renewals, refinancings and replacements thereof, and (e) Subordinated Indebtedness owing by Turbeco, Inc. to Preston Phenes, evidenced by that one certain promissory note dated                                  , 200      in the original principal amount of One Million Five Hundred Forty-Five Thousand Three Hundred Ninety-One and No/100 Dollars ($1,545,391), bearing interest and due and payable as therein provided.

 

Trade payables more than 120 days past due

   $                 

Purchase money Indebtedness

   $                 

 

2. Section 8.05 - Investments

Borrower shall not make any Investments except (a) Investments made to officers, employees, shareholders of the Borrower not in excess of $250,000, (b) Investments in Subsidiaries listed on Schedule 6.12 and (c) Permitted Investments.

 

Investments made during the quarter ended [                  ]

   $                 

Investments made to officers, employees, and shareholders of the Borrower during the quarter ended [                  ]

   $                 

Investments in Subsidiaries

   $                 

Investments in Permitted Investments

   $                 

 

A-1


3. Section 8.06 - Distributions

Borrower shall not directly or indirectly declare, order, pay, make or set apart any sum for any Restricted Payment except for dividends by a Subsidiary to the Borrower or another Subsidiary.

 

  Restricted Payments made during the quarter ended [                  ]    $ ________________

 

4. Section 8.07 - Subordinated Debt

Borrower may not prepay any Subordinated Debt, provided however, that the Borrower may make scheduled principal payments as they come due if (A) on the due date no Default exists, (B) the Bank has not notified either the Borrower or any holder of Subordinated Debt that a Default then exists or would be created by such payment, (C) the Pro Forma Fixed Charge Coverage Ratio at the time of such scheduled principal payment shall not be less than 1.5 to 1.0 and (D) immediately following such payment the lesser of the working Capital Loan Borrowing Base and the Working Capital Commitment shall exceed the Working Capital Exposure by at least $500,000.

 

  (1)   

Prepayment made during the quarter ended [                  ]

As of the date of such prepayments:

   $                         
           
  (2)    Working Capital Loan Borrowing Base    $  
           
  (3)    Working Capital Commitment    $  
           
  (4)    Lesser of (2) and (3)    $  
           
  (5)    Working Capital Exposure    $  
           
  (6)    Working Capital Exposure plus $500,000    $  
           

 

5. Section 8.08 - Leverage Ratio

Borrower shall not permit the Leverage Ratio on the last day of any month to be more than (a) 3.0 to 1.0 for any month ending prior to January 1, 2008, and (ii) 2.5 to 1.0 for periods ending thereafter.

 

   (1   Indebtedness outstanding as of [                  ]    $                         
           
   (2   Less: CAVO Debt guaranteed as of [                  ]    $  
           
   (3   Net Indebtedness as of [                  ] [(1)-(2)]    $  
           
   (4   EBITDA for the 12 month period ended [                  ]    $  
           
   (5   Leverage Ratio [(3) ÷ (4)]      [          ] to 1.0

 

6. Section 8.09 - Fixed Charge Coverage Ratio

Borrower shall not permit the Fixed Charge Coverage Ratio to be less than 1.3 to 1.0.

 

  (1   EBITDA for the 12 month period ended [                  ]    $                         
          
  (2   Fixed Charges for the 12 month period ended [                  ]    $  
          
  (3   Fixed Charge Coverage Ratio [(1) ÷ (2)]      [          ] to 1.0

 

A-2


7. Section 8.10 - Consolidated Net Income

Borrower shall not permit its Consolidated Net Income to be less than zero (i) for any fiscal quarter or (ii) for any Fiscal Year.

 

Consolidated Net Income for the quarter ended [                  ]

   $             

Consolidated Net Income for the Fiscal Year ended [                  ]

   $             

 

8. Section 8.12 - Asset Sales

The Borrower shall not, nor shall it permit any of its Subsidiaries to, sell, convey, lease, transfer or otherwise dispose of, in one transaction or a series of transactions, any assets except for (a) sales of Inventory in the ordinary course of business; (b) sales of Equipment provided that the proceeds of such sales are either reinvested in similar equipment and value or used to prepay the Equipment Loan within 90 days after the end of the fiscal quarter in which such sales were made; and (c) sales of assets other than Equipment that do not exceed $250,000 since the Effective Date.

 

(1)

   Net Proceeds from sales of Equipment during the quarter ended [                        ]    $             

(2)

   Net Proceeds reinvested in similar Equipment    $             

(3)

   Net Proceeds used to prepay the Equipment Loan    $             

(4)

   Total reinvested in similar Equipment and used for prepayments [(2) + (3)]    $             

 

9. Section 8.13 - Capital Expenditures

The Borrower shall not permit the aggregate Capital Expenditures by the Borrower and its Subsidiaries to exceed $10,000,000 in any Fiscal Year.

 

Capital Expenditures from January 1, [              ], through [                              ]

   $             

 

10. The undersigned further certifies that:

(a) She is familiar with and knowledgeable of all other terms, agreements, and provisions, warranties, representations and covenants contained in the Credit Agreement and the other Loan Documents;

(b) Her name appears on the specimen of signatures and incumbency certificate delivered to the Bank by the Borrower and now in effect, and she is authorized to execute this Compliance Certificate on behalf of the Borrower;

(c) No Default or Event of Default has occurred and is continuing except as follows:

[Describe any Default or Event of Default]

 

A-3


(d) The representations and warranties of the Borrower made or referred to in the Credit Agreement and the other Loan Documents (other than those representations and warranties that are by their express terms limited to the date of the instrument in which they are initially made or in respect to which each such change shall be and has been communicated, in writing, to the Bank and approved, in writing by the Bank) are true and correct in all material respects as of and on the date of this Compliance Certificate, except as follows:

[Describe any exceptions]

(e) There has been no material adverse change in the condition, financial or otherwise, of the Borrower since the date of the financial statements (audited or unaudited, as the case may be) of the Borrower most recently prepared and delivered to the Bank, except as follows:

[Describe any material adverse change]

Dated the              day of                          .

 

FLOTEK INDUSTRIES, INC.
By:    
Name:   Lisa Meier
Title:  

Chief Financial Officer

Flotek Industries, Inc.

 

A-4


Exhibit B

FLOTEK INDUSTRIES, INC.

WORKING CAPITAL LOAN

BORROWING BASE CERTIFICATE

FOR THE MONTH OF                         

The capitalized terms used herein have the meanings and are used as set forth in that certain Consolidated Financial Statement of Borrower dated as of                          .

 

I.

   Eligible Accounts Receivables      Amount
   -    Accounts Receivable generated in ordinary course of business under a completed contract (gross)    $                 
   -    Less those more than 90 days past due    $                 
   -    Less those evidenced by note, etc.    $                 
   -    Less those subject to set-off    $                 
   -    Less foreign Accounts Receivable    $                 
   -    Less those due from debtor having concentration of greater than 25% of the Accounts Receivable    $                 
   -    Less those due from debtor having more than 20% of its total Accounts Receivable more than 90 days past due    $                 
   -    Less those due from debtor in bankruptcy or uncreditworthy debtor    $                 
   -    Less those due from an Affiliate    $                 
   -    Less those subject to credit balances relating to Account Receivable more than 90 days past due    $ $                 
   -    Less those relating to work-in-progress, finance charges or service charge   
     

TOTAL LINE 1

   $                 

II.

   Eligible Inventory    $                 
     

TOTAL LINE 2 (Eligible Inventory)

   $                 

III.

   Working Capital Loan Borrowing Base   
      Line 1 x 80%    $                 
      Line 2 x 50% may not exceed $10,000,000    $                 
     

TOTAL LINE 3

   $                 

Availability

   $                 
     

-      Total available under Borrowing Base

   $                 
     

-      Available under line (Not to exceed $25,000,000.00 total borrowings)

   $                 
     

-      Less Advances outstanding

   $                 
     

-      Excess available under Line (Not to exceed $25,000,000.00 total borrowings)

   $                 
     

       TOTAL

   $                 

 

B-1


The undersigned certifies that (i) the above calculations are true and correct as of the date of this Borrowing Base Certificate and (ii) there are no assets represented in this Borrowing Base which serve as security for any lender other than the Bank.

 

FLOTEK INDUSTRIES, INC.,

a Delaware corporation

By:  
Name:  
Title:  

 

B-2


Exhibit C

FORM OF REQUEST FOR ADVANCE

Wells Fargo Bank, National Association

1000 Louisiana, 3rd Floor

Houston, Texas 77002

Attention: Chad Johnson

Gentlemen:

Reference is made to the Amended and Restated Credit Agreement dated as of August      , 2007 (the “ Credit Agreement ”), between Flotek Industries, Inc. (the “ Borrower ”), and Wells Fargo Bank, National Association. Capitalized terms used herein and not otherwise defined herein have the meanings assigned to such terms in the Credit Agreement. The Borrower hereby gives you notice pursuant to Section 2.02 of the Credit Agreement that it requests an Advance under the Credit Agreement, and in that connection sets forth below the terms on which such Advance is requested to be made:

 

(A)

  

Proposed Date of

Advance (which is a

Business Day)

    

(B)

   Working Capital Loan Advance    $

(C)

   Requested Advance is to be a [Base Rate Advance] [Eurodollar Advance];

(D)

   In the case of a Eurodollar Advance, the initial Interest Period applicable thereto is [                ];

(E)

   Amount of Borrowing Base in effect on the date hereof is $[                ];

(F)

   Working Capital Exposure on the date hereof (i.e., outstanding principal amount of Working Capital Loan and the LC Exposure) is $[                ];

(G)

   Pro forma total Working Capital Exposure (giving effect to the requested Advance) is $[                ]; and

(H)

   Location and number of the Borrower’s account to which funds are to be disbursed is as follows:
   [                                           ]   
   [                                           ]   
   [                                           ]   
   [                                           ]   
   [                                           ]   

 

C-1


By the delivery of this Request for Advance and the acceptance of the Advance made by the Bank in response to this Request for Advance, the Borrower is deemed to have represented and warranted that the conditions to lending specified in Section 5.02 of the Credit Agreement have been satisfied with respect to the Advance requested hereby.

 

Very truly yours,

 

FLOTEK INDUSTRIES, INC.,

 

a Delaware corporation

By:    

 

C-2


Exhibit D

FORM OF JOINDER AGREEMENT

This JOINDER AGREEMENT (this “ Agreement ”) dated as of [              ], is among Flotek Industries, Inc. (the “ Borrower ”), [[              ] (“ Parent ”)], and [              ] (“ New Subsidiary ”), for the benefit of Wells Fargo Bank, National Association (the “ Bank ”), as the lender under the Credit Agreement (as defined below). All capitalized terms used herein without definition have the meanings assigned to such terms in the Credit Agreement.

PRELIMINARY STATEMENT

A. The Borrower and the Bank are parties to that certain Amended and Restated Credit Agreement dated as of August __, 2007 (the “ Credit Agreement ”), relating to the extension of credit by the Bank to the Borrower and, in exchange, imposing obligations on the Borrower and its Subsidiaries in accordance with the terms and conditions thereof. Pursuant to a Guaranty dated as of February 11, 2005 (the “ Guaranty ”), Subsidiaries of the Borrower guaranteed the Obligations (as defined in the Credit Agreement).

B. In connection with the Credit Agreement, the Borrower and the Guarantors executed a Security Agreement dated as of February 11, 2005 (the “ Security Agreement ”), in favor of the Bank. Under the terms of the Security Agreement, the Borrower and the Guarantors, as debtors, granted to the Bank, as secured party, Liens on substantially all of their respective personal property, as more fully described therein as security for the payment and performance of the Obligations.

C. The Security Agreement provides that the Liens granted therein are given as security for the obligations described in the Credit Agreement as the same may be amended and in effect from time to time.

D. Pursuant to Section 7.10 of the Credit Agreement, the Bank (as defined in the Security Agreement) is requiring New Subsidiary to execute this Agreement in order to become a party to the Guaranty and the Security Agreement and agree to perform the obligations of a Guarantor and Debtor thereunder and to grant and confirm the Liens of the Security Agreement, acknowledging that the Liens granted under the terms thereof serve as security for the Obligations.

E. The Borrower, Parent, and New Subsidiary have agreed to this and execute this Agreement for the purpose of evidencing such agreement.

NOW THEREFORE, in consideration of the premises and the mutual covenants herein contained, the Borrower, Parent and New Subsidiary hereby agree for the benefit of the Bank as follows:

Section 1. Joinder to and Ratification of Guaranty and Security Agreement . New Subsidiary hereby approves and adopts the Guaranty and the Security Agreement, assumes the obligations of a Guarantor under the Guaranty and the Obligations of a Debtor under the Security

 

D-1


Agreement and agrees to be bound thereby. The Borrower [and Parent] hereby agree[s] that all of the Obligations of the Credit Parties contained in the Guaranty and the Security Agreement and all of the rights, privileges and interests of the Bank arising therefrom (except to the extent any of same may have been previously released by the Bank) are hereby adopted, agreed to, ratified, renewed, confirmed and brought forward in all respects and the Security Agreement shall continue to serve as security for the Obligations, as same may be amended, renewed or restated from time to time, as well as any renewals or extensions thereof or any substitutions or replacements therefor.

Section 2. Grant of Security Interest . To induce the Bank to continue to extend credit to the Borrower pursuant to the Credit Agreement, and as security for the Obligations, New Subsidiary hereby grants to the Bank, to the maximum extent allowed by applicable law, a Lien on all of the assets of New Subsidiary of the kind described in the Security Agreement, whether now held or hereafter acquired, pursuant to and in accordance with the terms of the Security Agreement. Notwithstanding anything to the contrary contained in the Security Agreement or this Agreement, all references to “first priority liens” intended to be created hereby shall be deemed to mean “first priority liens, subject to the Permitted Liens”.

Section 3. Pledge of Equity Interests . In accordance with Section 7.10 of the Credit Agreement, [Borrower] [Parent] hereby confirms its grant to the Bank, pursuant to the Security Agreement, of a Lien on all of its right, title and interest in the ownership interests of New Subsidiary and, if such ownership interests are certificated securities, as defined in the Uniform Commercial Code, shall forthwith deliver to the Bank certificates evidencing such ownership interests.

Section 4. Representations . New Subsidiary represents and warrants to the Bank that this Joinder Agreement has been duly authorized, executed and delivered by it by all requisite corporate, limited liability company or partnership action and constitutes its legal, valid and binding obligation, enforceable against it in accordance with its terms (subject to applicable bankruptcy, reorganization, insolvency, moratorium or similar laws affecting creditors’ rights generally and subject, as to enforceability, to equitable principles of general application (regardless of whether enforcement is sought in a proceeding in equity or at law)).

Section 5. Authorization to Take Further Action . The Borrower, New Subsidiary and Parent hereby authorize the Bank to file