UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q 

 

Commission file number: 1-8038

KEY ENERGY SERVICES, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

1301 McKinney Street, Suite 1800, Houston, Texas  77010

(Address of Principal Executive Offices) (Zip Code)

713/651-4300

(Registrant’s Telephone Number, Including Area Code)

None

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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   o       No   x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): 

Large Accelerated Filer x	Accelerated Filer o	Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o       No x

As of June 30, 2007, the number of outstanding shares of common stock of the Registrant was 131,593,695.

KEY ENERGY SERVICES, INC.

INDEX TO FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005

Part I — Financial Information
Note Regarding Our Financial Reporting Process
Item 1.				Unaudited Consolidated Financial Statements
				Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004
				Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2005 and 2004
				Condensed Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2005 and 2004
				Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004
				Notes to Condensed Consolidated Unaudited Financial Statements
Item 2.				Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.				Quantitative and Qualitative Disclosures About Market Risks
Item 4.				Controls and Procedures
Part II — Other Information
Item 1.			Legal Proceedings
Item 1A.			Risk Factors
Item 2.			Unregistered Sales Of Equity Securities And Use Of Proceeds
Item 3.			Defaults Upon Senior Securities
Item 4.			Submission Of Matters To A Vote Of Security Holders
Item 5.			Other Information
Item 6.			Exhibits

 

FORWARD-LOOKING STATEMENTS

In addition to statements of historical fact, this report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Statements that are not historical in nature or that relate to future events and conditions are, or may be deemed to be, forward-looking statements.  These “forward-looking statements” are based on our current expectations, estimates and projections about current expectations, estimates and projections about the Company, our industry and management’s beliefs and assumptions concerning future events and financial trends affecting our financial condition and results of operations.  In some cases, you can identify these statements by terminology such as “may,” “will,” “predicts,” “projects,” “potential” or “continue” or the negative of such terms and other comparable terminology.  These statements are only predictions and are subject to substantial risks and uncertainties.  Actual performance or results may differ materially and adversely.

We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of this report except as required by law.  All of our written and oral forward-looking statements are expressly qualified by these cautionary statements and any other cautionary statements that may accompany such forward-looking statements.  The reasons for these differences include changes that occur in our business environment as well as differences stemming from the delay in our financial reports, such as the following factors:

·                  Possible adverse consequences of failure to file past SEC reports;

·                  Limitations on access to public capital markets;

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·                  Inability of common stock to trade on a recognized exchange and potential inability to re-list on a recognized exchange;

·                  Impact of material weaknesses in internal control over financial reporting;

·                  Potential changes in tax liabilities; and

·                  Civil litigation.

PART I — FINANCIAL INFORMATION

NOTE REGARDING OUR FINANCIAL REPORTING PROCESS

This report has been delayed due to our restatement and financial reporting process for periods ending December 31, 2003, which began in March 2004.  That process was completed on October 19, 2006.  Our 2003 Financial and Informational Report on Form 8-K/A, filed with the Securities and Exchange Commission (“SEC”) on October 26, 2006, included an audited 2003 consolidated balance sheet which presented our financial condition as of December 31, 2003 in accordance with Generally Accepted Accounting Principles (“GAAP”).  We did not present other consolidated financial statements in accordance with GAAP as we were unable to determine with sufficient certainty the appropriate period(s) in 2003 or before in which to record certain write-offs and write-downs that were identified in our restatement process.  Our former registered public accounting firm expressed an unqualified opinion that the 2003 balance sheet fairly presented our financial condition on December 31, 2003.  The firm also audited the other financial statements presented in the 2003 Financial and Informational Report.  It opined that the financial statements other than the 2003 balance sheet did not fairly present our financial condition or results of operations or cash flows for the periods covered in accordance with GAAP.  Investors should refer to the 2003 Financial and Informational Report for a full description of the restatement and financial reporting process for periods prior to 2004.  Investors are strongly cautioned not to rely on any of the financial statements contained in the 2003 Financial and Informational Report, other than the 2003 balance sheet, as fairly presenting, for the periods covered, our financial condition or our results of operations or cash flows, in accordance with GAAP.  Any information set forth in the 2003 Financial and Informational Report that incorporates or discusses information contained in the financial statements is subject to the same caution.  You also should not rely on any of our previously-filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods that ended prior to and including September 30, 2003.

We have completed our financial statements for the years ended December 31, 2004, 2005 and 2006, and on August 13, 2007, we filed our Annual Report on Form 10-K for the year ended December 31, 2006.  Concurrently with the filing of this report, we are filing our Quarterly Reports on Form 10-Q for the first three quarters of 2006 and the remaining two quarters of 2005.  The 2005 Quarterly Reports on Form 10-Q also include 2004 quarterly information.  In light of our inability to provide financial statements in accordance with GAAP for periods prior to 2004, we will not be filing any other earlier reports, including annual reports for 2004 and 2005, or quarterly reports for the first three quarters of 2004.  Due to the delay in the filing of this Quarterly Report, certain information presented in this report relates to significant events that have occurred subsequent to June 30, 2005.

Item 1.                       CONSOLIDATED FINANCIAL STATEMENTS

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Key Energy Services, Inc.

Condensed Consolidated Balance Sheets

(In thousands)

(Unaudited)

		June 30,			December 31,
		2005			2004
ASSETS
Current assets:
Cash and cash equivalents		$	91,390		$	20,425
Accounts receivable, net of allowance for doubtful accounts of $10,970 and $8,990 at June 30, 2005 and December 31, 2004, respectively		200,805			190,518
Inventories		18,832			19,069
Prepaid expenses		7,879			7,472
Deferred tax asset		35,953			48,823
Other current assets		7,076			5,758
Current assets of discontinued operations		1,193			18,958
Total current assets		363,128			311,023
Property and equipment:
Well servicing equipment		796,164			770,001
Contract drilling equipment		26,424			21,916
Motor vehicles		85,604			87,189
Furniture and equipment		67,637			72,040
Buildings and land		44,280			48,268
Total property and equipment		1,020,109			999,414
Accumulated depreciation		(431,807		)	(401,636		)
Net property and equipment		588,302			597,778
Goodwill		320,971			320,942
Deferred costs, net		2,174			9,068
Notes and accounts receivable - related parties		59			101
Equity investment in IROC Systems Corp		9,412			3,786
Other assets		13,186			13,344
Non-current assets of discontinued operations		—			60,580
TOTAL ASSETS		$	1,297,232		$	1,316,622
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	15,064		$	14,465
Accrued payroll, taxes and employee benefits		43,027			36,218
Accrued operating expenditures		21,864			24,385
Income, sales, use and other taxes		20,855			21,881
Workers’ compensation claims accrual		16,762			14,684
Accrued rent		2,032			88
Vehicular Insurance		1,832			3,732
Accrued severance		703			326
Other accrued liabilities		16,779			8,052
Accrued interest		10,524			9,980
Current portion of capital lease obligations		5,779			6,354
Current liabilities of discontinued operations		239			4,938
Total current liabilities		155,460			145,103
Capital lease obligations, less current portion		8,512			7,177
Long-term debt		425,744			473,870
Workers’ compensation, vehicular, health and other insurance claims		37,397			35,829
Deferred tax liability		108,551			107,760
Other non-current accrued expenses		40,419			41,217
Commitments and contingencies		—			—
Stockholders’ equity:
Common stock, $0.10 par value; 200,000,000 shares authorized, 131,334,196 and 130,791,338 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively		13,175			13,121
Additional paid-in capital		714,485			713,563
Treasury stock, at cost; 416,666 and 416,666 shares at June 30, 2005 and December 31, 2004, respectively		(9,682		)	(9,682		)
Accumulated other comprehensive loss		(36,292		)	(36,421		)
Retained deficit		(160,537		)	(174,915		)
Total stockholders’ equity		521,149			505,666
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	1,297,232		$	1,316,622

 

See the accompanying notes which are an integral part of these condensed consolidated unaudited financial statements

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Key Energy Services, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
REVENUES:
Well servicing		$	238,696		$	201,988		$	459,029		$	397,217
Pressure pumping		36,246			22,680			66,750			40,739
Fishing and rental		19,959			18,863			40,326			37,557
Total revenues		294,901			243,531			566,105			475,513
COSTS AND EXPENSES:
Well servicing		161,653			143,342			311,275			277,463
Pressure pumping		25,367			15,144			42,597			29,677
Fishing and rental		13,775			12,379			27,380			25,377
Depreciation and amortization		28,212			23,076			55,986			45,283
General and administrative		34,137			61,795			69,076			87,887
Interest expense		16,326			9,837			29,678			19,561
(Gain) loss on early extinguishment of debt		5,481			—			5,881			12,025
(Gain) loss on sale of assets		(755		)	(401		)	(30		)	4,928
Interest income		(736		)	(209		)	(1,160		)	(254		)
Other, net		(5,018		)	116			(4,970		)	(46		)
Total costs and expenses, net		278,442			265,079			535,713			501,901
Income (loss) from continuing operations before income taxes		16,459			(21,548		)	30,392			(26,388		)
Income tax benefit (expense)		(7,086		)	4,126			(12,654		)	3,587
INCOME (LOSS) FROM CONTINUING OPERATIONS		9,373			(17,422		)	17,738			(22,801		)
Discontinued operations, net of tax expense of $(486), $(4,590), and $(403) for the three months ended June 30, 2004 and six months ended June 30, 2005 and 2004, respectively		—			815			(3,361		)	629
NET INCOME (LOSS)		$	9,373		$	(16,607	)	$	14,377		$	(22,172	)
EARNINGS (LOSS) PER SHARE:
Net income (loss) from Continuing Operations
Basic		$	0.07		$	(0.13	)	$	0.14		$	(0.17	)
Diluted		$	0.07		$	(0.13	)	$	0.13		$	(0.17	)
Discontinued Operations
Basic		$	—		$	0.01		$	(0.03	)	$	—
Diluted		$	—		$	0.01		$	(0.03	)	$	—
Net Income (loss)
Basic		$	0.07		$	(0.12	)	$	0.11		$	(0.17	)
Diluted		$	0.07		$	(0.12	)	$	0.10		$	(0.17	)
WEIGHED AVERAGE SHARES OUTSTANDING:
Basic		130,828			130,791			130,810			130,722
Diluted		132,879			130,791			133,085			130,722

 

See the accompanying notes which are an integral part of these condensed consolidated unaudited financial statements

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Key Energy Services, Inc.

Condensed Consolidated Statement of Comprehensive Income

(In thousands)

(Unaudited)

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
NET INCOME (LOSS)		$	9,373		$	(16,607	)	$	14,377		$	(22,172	)
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Foreign currency translation gain (loss)		53			(9		)	129			122
COMPREHENSIVE INCOME (LOSS), NET OF TAX		$	9,426		$	(16,616	)	$	14,506		$	(22,050	)

 

See the accompanying notes which are an integral part of these condensed consolidated unaudited financial statements

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Key Energy Services, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

		Six Months Ended June 30,
		2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	14,377		$	(22,172	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		55,986			45,283
Accretion expense		264			260
Income from equity investment		(27		)	—
Amortization of deferred debt issuance costs, discount and premium		888			1,069
Deferred income tax expense (benefit)		13,661			(16,840		)
Capitalized interest		(324		)	(1,239		)
(Gain) loss on sale of assets		(30		)	4,928
Loss on early extinguishment of debt		5,881			12,025
Stock-based compensation		976			536
Accrual for former officer’s severance		—			30,232
Changes in working capital:
Accounts receivable, net		(9,943		)	(27,938		)
Other current assets		(1,273		)	(54		)
Accounts payable, accrued interest and accrued expenses		15,256			(6,393		)
Other assets and liabilities		(5,392		)	24,399
Operating cash flows provided by (used by) discontinued operations		13,169			(1,952		)
Net cash provided by operating activities		103,469			42,144
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures - Well Servicing		(36,450		)	(22,468		)
Capital expenditures - Pressure Pumping		(6,216		)	(1,636		)
Capital expenditures - Fishing and Rental		(1,338		)	(428		)
Capital expenditures - Other		(4,227		)	(1,795		)
Proceeds from sale of fixed assets		8,138			439
Acquisitions, net of cash acquired		—			(22,154		)
Investing cash flows provided by discontinued operations		60,477			—
Net cash provided by (used in) investing activities		20,384			(48,042		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of long-term debt		—			(104,357		)
Proceeds from long-term debt		—			52,000
Repayments under revolving credit facility		(48,000		)	(22,000		)
Repayment of capital lease obligations		(5,557		)	(7,876		)
Proceeds from exercise of stock options and warrants		—			1,586
Net cash used in financing activities		(53,557		)	(80,647		)
Effect of exchange rates on cash		669			(163		)
Net increase (decrease) in cash and cash equivalents		70,965			(86,708		)
Cash and cash equivalents, beginning of period		20,425			103,215
Cash and cash equivalents, end of period		$	91,390		$	16,507

 

See the accompanying notes which are an integral part of these condensed consolidated unaudited financial statements

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Key Energy Services, Inc.

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

1.                                      ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The Company

Key Energy Services, Inc. is a Maryland corporation that was organized in April 1977 and commenced operations in July 1978 under the name National Environmental Group, Inc. We emerged from a prepackaged bankruptcy plan in December 1992 as Key Energy Group, Inc. On December 9, 1998, we changed our name to Key Energy Services, Inc. (“Key” or the “Company”). We believe that we are now the leading onshore, rig-based well servicing contractor in the United States. From 1994 through 2002, we grew rapidly through a series of over 100 acquisitions, and today we provide a complete range of well services to major oil companies and independent oil and natural gas production companies, including rig-based well maintenance, workover, well completion and recompletion services, oilfield transportation services, cased-hole electric wireline services and ancillary oilfield services, fishing and rental services and pressure pumping services. During 2005, Key conducted well servicing operations onshore in the continental United States in the following regions: Gulf Coast (including South Texas, Central Gulf Coast of Texas and South Louisiana), Permian Basin of West Texas and Eastern New Mexico, Mid-Continent (including the Anadarko, Hugoton and Arkoma Basins and the ArkLaTex and North Texas regions), Four Corners (including the San Juan, Piceance, Uinta, and Paradox Basins), the Appalachian Basin, Rocky Mountains (including the Denver-Julesberg, Powder River, Wind River, Green River and Williston Basins), and California (the San Joaquin Basin), and internationally in Argentina. During 2005, we conducted pressure pumping and cementing operations in a number of major domestic producing basins including California, the Permian Basin, the San Juan Basin, the Mid-Continent region, and in the Barnett Shale of North Texas. Our fishing and rental services are located primarily in the Gulf Coast and Permian Basin regions of Texas, as well as in California and the Mid-Continent region.  During 2004, we also conducted land drilling operations in a number of major domestic producing basins including the Permian Basin, the San Juan Basin, the Powder River Basin, and the Appalachian Basin, as well as internationally in Argentina; however, we sold all of our Permian Basin and San Juan Basin contract drilling assets as well as certain drilling assets located in the Rocky Mountain and Four Corners regions to Patterson-UTI Energy, Inc. on January 15, 2005. As of June 30, 2005, we continue to conduct limited land drilling operations domestically in the Appalachian Basin of West Virginia and the Powder River Basin of Wyoming, as well as internationally in Argentina.

Basis of Presentation

The filing of this Quarterly Report on Form 10-Q was delayed due to our restatement and financial reporting process for periods ending December 31, 2003, which began in March 2004. That process was completed on October 19, 2006. Our 2003 Financial and Informational Report on Form 8-K/A, filed with the Securities and Exchange Commission (“SEC”) on October 26, 2006, included an audited 2003 consolidated balance sheet which presented our financial condition as of December 31, 2003 in accordance with Generally Accepted Accounting Principles (“GAAP”). We did not present our other consolidated financial statements in accordance with GAAP as we were unable to determine with sufficient certainty the appropriate period(s) in 2003 or before in which to record certain write-offs and write-downs that were identified in our restatement process. Our former registered public accounting firm expressed an unqualified opinion that the 2003 balance sheet fairly presented our financial condition on December 31, 2003 in accordance with GAAP. The firm also audited the other financial statements presented in the 2003 Financial and Informational Report. It opined that the financial statements other than the 2003 balance sheet did not fairly present our financial condition or results of operations or cash flows for the periods covered in accordance with GAAP. Investors should refer to the 2003 Financial and Informational Report for a full description of the restatement and financial reporting process for periods prior to 2004.

The accompanying unaudited condensed consolidated financial statements in this report have been prepared in accordance with the instructions for interim financial reporting prescribed by the SEC.  The December 31, 2004 year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all the disclosures required by GAAP.  These interim financial statements should be read together with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2006.

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The unaudited condensed consolidated financial statements contained in this report include all material adjustments that, in the opinion of management, are necessary for a fair statement of the results of operations for the interim periods presented herein.  The results of operations for the interim periods presented in this report are not necessarily indicative of the results to be expected for the full year or any other interim period due to fluctuations in demand for our services, timing of maintenance and other expenditures, and other factors.

The preparation of these consolidated financial statements requires us to develop estimates and to make assumptions that affect our financial position, results of operations and cash flows. These estimates also impact the nature and extent of our disclosure, if any, of our contingent liabilities. Among other things, we use estimates to (1) analyze assets for possible impairment, (2) determine depreciable lives for our assets, (3) assess future tax exposure and realization of deferred tax assets, (4) determine amounts to accrue for contingencies, (5) value tangible and intangible assets, and (6) assess workers’ compensation, vehicular liability, self-insured risk accruals and other insurance reserves. Our actual results may differ materially from these estimates. We believe that our estimates are reasonable.

Due to the delay in the filing of this report as discussed above, additional information regarding certain liabilities and uncertainties that existed as of the date of this report has become available, either through additional facts about, or the ultimate settlement or resolution of, the liability or uncertainty.  We have taken any additional information that has come to light into account in our estimates and disclosure of any potential liabilities or other contingencies as of the date of this report, in accordance with FASB Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”).  The discussion of our commitments and contingencies (see Note 6) should be read in conjunction with the corresponding disclosures made in our Annual Report on Form 10-K for the year ended December 31, 2006.

Certain reclassifications have been made to prior period amounts to conform to current period financial statement classifications. These reclassifications primarily relate to the change in our reportable segments. Prior to 2004, our Pressure Pumping and Fishing and Rental segments were reported as part of our Well Servicing segment; Pressure Pumping and Fishing and Rental are now presented as independent reportable segments. Additionally, as further discussed in Note 2—“Discontinued Operations,” we sold the majority of our contract drilling assets to Patterson-UTI Energy on January 15, 2005. These assets had previously been reported as part of our Contract Drilling reportable segment. The assets, cash flows, and results of operations of these activities are presented as discontinued operations in our condensed consolidated unaudited financial statements for all periods presented in this Report.

Our remaining contract drilling operations are now reported as part of our Well Servicing segment. We apply the provisions of EITF Issue 04-10, “Determining Whether to Aggregate Operating Segments That Do Not Meet Quantitative Thresholds” (“EITF 04-10”) in our segment reporting in Note 8—“Segment Information.” Our remaining contract drilling operations do not meet the quantitative thresholds as described in Statement of Financial Accounting Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information” (“SFAS 131”), and, under the provisions of EITF 4-10, since the operating segments meet the aggregation criteria we are permitted to combine information about this segment with other similar segments that individually do not meet the quantitative thresholds to produce a reportable segment.

Restatement for Error

In connection with the preparation of these financial statements, we identified an error in our balance sheet as of December 31, 2003.  This error affected both our retained earnings and deferred tax liabilities accounts, and arose as a result of our lack of roll-forwards and other appropriate reconciliations of the differences between the book and tax bases of our fixed assets.  The error had been carried forward into our consolidated balance sheets as of December 31, 2003 from differences that initially arose in our 1999 fiscal year, and resulted in an overstatement of our retained deficit as of December 31, 2003 by approximately $10 million and an overstatement of our deferred tax liability as of the same date by the same amount.  Our retained earnings and deferred tax liabilities were adjusted as of December 31, 2003 to correct this error and the adjustment is reflected in these consolidated financial statements.  Total liabilities and stockholders’ equity at December 31, 2003 was not impacted by this error.

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Principles of Consolidation

Within our consolidated financial statements, we include our accounts and the accounts of our majority-owned or controlled subsidiaries. We eliminate intercompany accounts and transactions. We account for our interest in entities for which we do not have significant control or influence under the cost method. When we have an interest in an entity and can exert significant influence but not control, we account for that interest using the equity method. See Note 4—“Investment in IROC Systems Corp.”

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51” (“FIN 46”). In December 2003, the FASB issued the updated and final interpretation of ARB No. 51 (“FIN 46R”). FIN 46R requires that an equity investor in a variable interest entity have significant equity at risk (generally a minimum of 10%, which is an increase from the 3% required under previous guidance) and hold a controlling interest, evidenced by voting rights, and either absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected returns, or both. If the equity investor is unable to evidence these characteristics, the entity that retains these ownership characteristics will be required to consolidate the variable interest entities created or obtained after March 15, 2004. The adoption of FIN 46R did not materially impact our consolidated financial statements.

Revenue Recognition

                                                Well Servicing.  Well servicing revenue consists primarily of maintenance services, workover services, completion services and plugging and abandonment services. We recognize revenue when services are performed, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the price is fixed or determinable. These criteria are typically met at the time we complete a job for a customer. Primarily, we price well servicing rig services by the hour of service performed. Depending on the type of job, we may charge by the project or by the day.

                                                Oilfield Transportation.  Oilfield transportation revenue consists primarily of fluid and equipment transportation services and frac tanks which are used in conjunction with fluid hauling services. We recognize revenue when services are performed, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the price is fixed or determinable. These criteria are typically met at the time we complete a job for a customer. Primarily, we price oilfield transportation services by the hour or by the quantities hauled.

                                                Pressure Pumping and Fishing and Rental Services.  Pressure pumping and fishing rental services include well stimulation and cementing services, and recovering lost or stuck equipment in the wellbore.  We recognize revenue when services are performed, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the price is fixed or determinable. These criteria are typically met at the time we complete a job for a customer. Generally, we price fishing and rental tool services by the day and the pressure pumping services by the job.

                                                Ancillary Oilfield Services.  Ancillary oilfield services include services such as wireline operations, wellsite construction, roustabout services, foam units and air drilling services. We recognize revenue when services are performed, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the price is fixed or determinable. These criteria are typically met at the time we complete a job for a customer. These criteria are typically met at the time we complete a job for a customer. We price ancillary oilfield services by the hour, day or project depending on the type of services performed.

Cash and Cash Equivalents

We consider short-term investments with an original maturity of less than three months to be cash equivalents. None of our cash is restricted and we have not entered into any compensating balance arrangements. However, at June 30, 2005, all of our obligations under the Senior Credit Facility (hereinafter defined) were secured by most of our assets, including assets held by our subsidiaries, which includes cash, among other assets. We restrict investment of cash to financial institutions with high credit standing and limit the amount of credit exposure to any one financial institution.

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Property and Equipment

Asset Retirement Obligations.  In connection with our well servicing activities, we operate a number of Salt Water Disposal (“SWD”) facilities. Our operations involve the transportation, handling and disposal of fluids in our SWD facilities that have been determined to be harmful to the environment. SWD facilities used in connection with our fluid hauling operations are subject to future costs associated with the abandonment of these properties. As a result, we have incurred costs associated with the proper storage and disposal of these materials. In accordance with Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”), we recognize a liability for the fair value of all legal obligations associated with the retirement of tangible long-lived assets and capitalize and equal amount as a cost of the asset. We depreciate the additional cost over the estimated useful life of the assets. Significant judgment is involved in estimating future cash flows associated with such obligations, as well as the ultimate timing of those cash flows. If our estimates of the amount or timing of the cash flows change, such changes may have a material impact on our results of operations.

Adoption of SFAS 143 was required for all companies with fiscal years beginning after June 15, 2002. Amortization of the assets associated with the asset retirement obligations was $0.1 million and $0.1 million for the quarters ended June 30, 2005 and 2004, respectively.  Amortization of the assets associated with the asset retirement obligations was $0.2 million and $0.2 million for the six months ended June 30, 2005 and 2004, respectively.

Asset and Investment Impairments. We account for asset and investment impairments under Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). This statement requires that long-lived assets held and used by us, including certain identifiable intangibles, be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. For purposes of applying this statement, we group our long-lived assets on a division-by-division basis and compare the estimated future cash flows of each division to the division’s net carrying value. The division level represents the lowest level for which identifiable cash flows are available. We would record an impairment charge, reducing the division’s net carrying value to an estimated fair value, if its estimated future cash flows were less than the division’s net carrying value. “Trigger events,” as defined in SFAS 144, that cause us to evaluate our fixed assets for recoverability and possible impairment may include market conditions, such as adverse changes in the prices of oil and natural gas, which could reduce the fair value of certain of our property and equipment. The development of future cash flows and the determination of fair value for a division involves significant judgment and estimates.  As of June 30, 2005 and December 31, 2004, no trigger events had been identified by management.

Goodwill and Other Intangible Assets

Goodwill results from business acquisitions and represents the excess of acquisition costs over the fair value of the net assets acquired. We account for goodwill and other intangible assets under the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 142 eliminates amortization for goodwill and other intangible assets with indefinite lives. Intangible assets with lives restricted by contractual, legal, or other means will continue to be amortized over their expected useful lives. Goodwill and other intangible assets not subject to amortization are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. SFAS 142 requires a two-step process for testing impairment. First, the fair value of each reporting unit is compared to its carrying value to determine whether an indication of impairment exists. If impairment is indicated, then the fair value of the reporting unit’s goodwill is determined by allocating the unit’s fair value to its assets and liabilities (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The amount of impairment for goodwill is measured as the excess of its carrying value over its fair value. We conduct annual impairment assessments, the most recent affecting this report as of December 31, 2004. This assessment did not result in an indication of goodwill impairment.

Intangible assets subject to amortization under SFAS 142 consist of noncompete agreements and patents and trademarks. Amortization expense for noncompete agreements is calculated using the straight-line method over the period of the agreement, ranging from three to seven years. The cost and accumulated amortization are retired when the noncompete agreement is fully amortized and no longer enforceable. Amortization expense for patents and trademarks is calculated using the straight-line method over the useful life of the patent or trademark, ranging from five to seven years.  Amortization of noncompete agreements for the quarters ended June 30,

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2005 and 2004 was $0.7 million and $0.8 million, respectively.  Amortization of noncompete agreements for the six months ended June 30, 2005 and 2004 was $1.5 million and $1.8 million, respectively.  Amortization of patents and trademarks for the quarters ended June 30, 2005 and 2004 was $0.1 million.  Amortization of patents and trademarks for the six months ended June 30, 2005 and 2004 was $0.2 million.  During the six months ended June 30, 2005, the Company capitalized no costs associated with noncompete agreements and approximately $0.1 million of costs associated with patents and trademarks.

Earnings Per Share

We present earnings per share information in accordance with the provisions of Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”). Under SFAS 128, basic earnings per common share is determined by dividing net earnings applicable to common stock by the weighted average number of common shares actually outstanding during the year. Diluted earnings per common share is based on the increased number of shares that would be outstanding assuming conversion of dilutive outstanding convertible securities using the “as if converted” method.

		Three Months Ended June 30, 2005			Three Months Ended June 30, 2004			Six Months Ended June 30, 2005			Six Months Ended June 30, 2004
		(in thousands, except per share data)
Basic EPS Computation:
Numerator
Income (loss) from continuing operations		$	9,373		$	(17,422	)	17,738			$	(22,801	)
Discontinued operations, net of tax		—			815			(3,361		)	629
Net income (loss)		$	9,373		$	(16,607	)	$	14,377		$	(22,172	)
Denominator
Weighted average shares outstanding		130,828			130,791			130,810			130,722
Basic EPS:
Income (loss) from continuing operations		$	0.07		$	(0.13	)	$	0.14		$	(0.17	)
Discontinued operations, net of tax		—			0.01			(0.03		)	—
Net income (loss)		$	0.07		$	(0.12	)	$	0.11		$	(0.17	)
Diluted EPS Computation:
Numerator
Income (loss) from continuing operations		$	9,373		$	(17,422	)	$	17,738		$	(22,801	)
Discontinued operations, net of tax		—			815			(3,361		)	629
Net income (loss)		$	9,373		$	(16,607	)	$	14,377		$	(22,172	)
Denominator
Weighted average shares outstanding		130,828			130,791			130,810			130,722
Stock options		1,581			—			1,796			—
Warrants		470			—			479			—
		132,879			130,791			133,085			130,722
Diluted EPS:
Income (loss) from continuing operations		$	0.07		$	(0.13	)	$	0.13		$	(0.17	)
Discontinued operations, net of tax		—			0.01			(0.03		)	—
Net income (loss)		$	0.07		$	(0.12	)	$	0.10		$	(0.17	)

 

The diluted earnings per share calculation for the three months ended June 30, 2005 and 2004 excludes the potential exercise of 672,500 and zero stock options, respectively, because the effects of such exercises on earnings per share in those years would be anti-dilutive.  The diluted earnings per share calculation for the six months ended June 30, 2005 and 2004 excludes the potential exercise of 501,250 and zero stock options, respectively, because the

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effects of such exercises on earnings per share in those years would be anti-dilutive.  The diluted earnings per share calculation for the three and six months ended June 30, 2004 also excludes the potential conversion of our 5% Convertible Subordinated Notes (hereinafter defined), because the effects of this conversion on earnings per share would be anti-dilutive.

Stock-Based Compensation

We account for stock option grants to employees using the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).  Our stock incentive plan, which is described more fully in Note 7 – “Stockholders’ Equity,” provides that the amount an employee must pay to exercise an option to acquire a share of the Company’s stock should be at or above the closing market price on the trading day prior to the date of grant.  In that event, the options have no intrinsic value at grant date, and in accordance with the provisions of APB 25, no compensation cost is recorded.

Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), sets forth alternative accounting and disclosure requirements for stock-based compensation arrangements.  Under SFAS 123, companies are permitted to continue following the provisions of APB 25 to measure and recognize employee stock-based compensation, but are required to disclose pro forma net income and earnings per share that would have been reported under the fair value recognition provisions of SFAS 123.  The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition principles of SFAS 123 to stock-based employee compensation in 2004 and 2005.  As noted above, we followed APB 25 to account for stock-based compensation during those years; the stock-based compensation expense included in net income (loss) in the following table represents the compensation expense for the 996,352 options, net of forfeitures, that were granted at strike prices ranging from $0.10 to $2.53 below the market price of our common stock on the date of grant.

		Three Months  Ended June 30, 2005			Three Months  Ended June 30, 2004			Six Months Ended  June 30, 2005			Six Months Ended  June 30, 2004
		(in thousands, except per share amounts)
Net income (loss):
As reported		$	9,373		$	(16,607	)	$	14,377		$	(22,172	)
Add: stock-based employee compensation expense included in reported net income (loss), net of related tax effects		434			94			411			497
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(677		)	(716		)	(896		)	(3,019		)
Pro forma		$	9,130		$	(17,229	)	$	13,892		$	(24,694	)
Basic earnings per share:
As reported		$	0.07		$	(0.12	)	$	0.11		$	(0.17	)
Pro forma		$	0.07		$	(0.13	)	$	0.11		$	(0.19	)
Diluted earnings per share:
As reported		$	0.07		$	(0.12	)	$	0.10		$	(0.17	)
Pro forma		$	0.07		$	(0.13	)	$	0.10		$	(0.19	)

 

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For additional information regarding the computations presented above, see Note 7—”Stockholders’ Equity.”

In addition to the stock option grants discussed above, in June 2005 we began making grants of restricted shares of common stock to certain of our employees and non-employee directors.  These shares have vesting periods ranging from zero to three years. In 2005, for shares with immediate vesting, the Company recognized expense equal to the intrinsic value of the shares on the date of grant immediately in earnings.  For restricted shares that did not immediately vest, compensation cost equal to the intrinsic value of the grant, net of actual and estimated forfeitures, was recognized in earnings ratably over the vesting period of the grant.

Foreign Currency Gains and Losses

The local currency is the functional currency for our foreign operations in Argentina and our former Canadian operations. The U.S. dollar is the functional currency for our former operations in Egypt. The cumulative translation gains and losses, resulting from translating each foreign subsidiary’s financial statements from the functional currency to U.S. dollars, are included as a separate component of stockholders’ equity in other comprehensive income until a partial or complete sale or liquidation of our net investment in the foreign entity.

Accounting Principles Not Yet Adopted in This Report

SFAS 123(R).  In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” which revises SFAS 123, (“SFAS 123(R)”). SFAS 123(R) is effective July 1, 2005 for all calendar year-end companies and requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. This expense will be recognized over the period during which an employee is required to provide services in exchange for the award.  Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 will be recognized ratably over the remaining vesting period. The compensation cost for the unvested portion of awards will be based on the fair value at date of grant as calculated for our pro forma disclosure under SFAS 123. However, we will continue to account for any portion of awards outstanding on January 1, 2006 that were initially measured using intrinsic value method in accordance with APB 25.  We will recognize compensation expense under SFAS 123(R) for new awards granted after January 1, 2006.  We will use the Black-Scholes option pricing model to calculate fair value of awards granted after January 1, 2006, and we will estimate forfeitures and volatility for the calculation of compensation expense and grant date fair value.  The adoption of this standard will not materially impact our financial statements.

SFAS 148.  In December 2002, the FASB issued SFAS 148, which was an amendment to SFAS 123 and provided transitional guidance for a voluntary change to the fair value based method of accounting for employee stock-based compensation expense. As noted above, we continue to follow APB 25 to account for stock-based compensation and will adopt SFAS 123(R) on January 1, 2006.

FIN 47.  In March 2005 the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”), which becomes effective for all for fiscal years ending after December 15, 2005, with early adoption  encouraged.  This interpretation clarifies the term of conditional asset retirement obligation used in SFAS 143 and refers to a legal obligation to perform an asset retirement obligation to perform an asset retirement activity in which the timing and method of settlement are conditional on a future event that may or may not be within our control.  However, our obligation to perform the asset retirement activity is unconditional, despite the uncertainties that exist. Accordingly, we are required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. The adoption of this standard will not materially impact our consolidated financial statements.

SFAS 154.  In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and SFAS No. 3,” (“SFAS 154”). SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the

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change. The provisions of SFAS 154 are effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005.  The adoption of this standard will not have a material impact on our consolidated financial statements.

FSP FIN No. 45-3.                                         In November 2005, the FASB issued FASB Staff Position No. 45-3, “Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners” (“FSP FIN 45-3”). FSP Fin 45-3 served as an amendment to FIN 45 by adding minimum revenue guarantees to the list of examples of contracts to which FIN 45 applies. Under FSP FIN 45-3, a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FSP FIN 45-3 is effective for new minimum revenue guarantees issued or modified on or after January 1, 2006. The adoption of this interpretation will not materially impact our financial statements.

EITF 04-10.                           In June 2005, the FASB issued EITF Issue 04-10, “Determining Whether to Aggregate Operating Segments That Do Not Meet the Quantitative Thresholds.” This standard considers how a company should evaluate the aggregation criteria in FAS 131 to operating segments that do not meet the quantitative thresholds. Several of our operating segments do not meet the quantitative thresholds as described in SFAS 131. Under this standard, we are permitted to combine information about certain operating segments with other similar segments that individually do not meet the quantitative thresholds to produce a reportable segment since the operating segments meet the aggregation criteria. It is effective for fiscal years ending after September 15, 2005.

2.                                      DISCONTINUED OPERATIONS

On January 15, 2005, we sold the majority of our contract drilling operations to Patterson-UTI Energy for $62.0 million in cash. We received net cash proceeds of $60.5 million, net of liabilities assumed by the buyer and after paying all costs related to closing the sale. As a result of the sale, the results for these operations, which was previously reported as part of our contract drilling segment, have been presented as discontinued operations for all periods, and we recorded after-tax income to discontinued operations of $0.8 million, or $0.01 per diluted share, during the three months ended June 30, 2004; an after-tax charge to discontinued operations of $3.4 million, or $0.03 per diluted share, during the six months ended June 30, 2005; and after-tax income to discontinued operations of $0.7 million, or $0.01 per diluted share, for the six months ended June 30, 2004.

Results for activities reported as discontinued operations were as follows:

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
		(in thousands)						(in thousands)
Revenues		$	—		$	18,046		$	3,361		$	33,818
Costs and expenses		—			16,745			2,132			32,786
Income before income taxes		—			1,301			1,229			1,032
Income tax expense		—			(486		)	(4,590		)	(403		)
Income (loss) from discontinued operations		$	—		$	815		$	(3,361	)	$	629

 

Balance sheet data attributable to discontinued operations were as follows:

 

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3.             INCOME TAXES

Income tax expense differs from amounts computed by applying the statutory federal rate as follows:

 

4.             INVESTMENT IN IROC SYSTEMS CORP.

On July 22, 2004, we entered into an agreement with IROC Systems Corp. (“IROC”), an Alberta-based oilfield services company, to sell IROC ten remanufactured Skytop well service rigs, along with supporting equipment and inventory.  We began delivering these rigs in the fall of 2004, and completed delivery in the second quarter of 2005.  The purchase price for the rigs was US $7.0 million, which was paid by way of the issuance of approximately 8.2 million shares of IROC’s common stock.  During 2004, we recognized a loss of $0.1 million, which represents the difference between the fair market value of the IROC shares we received on the delivery dates and the carrying values of the rigs that were delivered.  In 2005, we delivered four additional rigs, and we recognized a gain of $1.6 million and $0.3 million in the first and second quarter of 2005, respectively, which represents the difference between the value of the IROC shares we received on the delivery dates of the rigs and the carrying value of the rigs that we delivered.

As of June 30, 2005, we own 8,187,058 shares of IROC common stock, which represents approximately 26.5% of IROC’s outstanding common stock on that date.  IROC shares trade on the Toronto Venture Stock Exchange and had a closing price of $2.15 CDN per share on June 30, 2005.  Pursuant to the terms of the agreement with IROC, Mr. William Austin, our Chief Financial Officer, and Mr. Newton W. Wilson III, our General Counsel, were appointed to the board of directors of IROC.

We have significant influence over the operations of IROC, but do not control it.  We account for our investment in IROC using the equity method.  The value of our investment is recorded in our Consolidated Balance Sheets as a component of other non-current assets.  The pro-rata share of IROC’s earnings and losses to which we are entitled are recorded in our Consolidated Statements of Operations as a component of other income and expense, with an offsetting increase or decrease to the value of our investment, as appropriate.  Any earnings distributed back to us from IROC in the form of dividends would result in a decrease in the value of our equity investment.

We recorded a $0.1 million loss of equity income related to our investment in IROC for the quarter ended June 30, 2005.  We recorded an immaterial of equity income related to our investment in IROC for the six months ended June 30, 2005.  During those time periods, no earnings were distributed back to us by IROC in the form of dividends.  The value of our investment in IROC totaled $9.4 million as of June 30, 2005.

5.             LONG-TERM DEBT

The components of our long-term debt are as follows:

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Senior Credit Facility

On November 10, 2003, we entered into a Fourth Amended and Restated Credit Agreement (the “Senior Credit Facility”). The Senior Credit Facility consists of a $175.0 million revolving loan facility with the entire revolving credit facility available for letters of credit. We have the right, subject to certain conditions, to increase the total commitment under the Senior Credit Facility from $175.0 million to up to $225.0 million if we are able to obtain additional lending commitments. The revolving loan commitments are scheduled to terminate on November 10, 2007, and all revolving loans are required to be paid on or before that date. The revolving loans bear interest based upon, at our option, the agent’s base rate for loans or the agent’s reserve-adjusted LIBOR rate for loans, plus, in either case, a margin which would fluctuate based upon our consolidated total leverage ratio and, in either case, according to the pricing grid set forth in the Senior Credit Facility.

The Senior Credit Facility contains various financial covenants applicable to specific periods, including: (i) a maximum consolidated total leverage ratio, (ii) a minimum consolidated interest coverage ratio, and (iii) a minimum net worth. The Senior Credit Facility subjects us to other restrictions, including restrictions upon our ability to incur additional debt, liens and guarantee obligations, to merge or consolidate with other persons, to make acquisitions, to sell assets, to pay dividends, to repurchase our stock or subordinated debt, to make investments, loans and advances or to make changes to debt instruments and organizational documents. All obligations under the Senior Credit Facility are guaranteed by most of our subsidiaries and are secured by most of our assets, including our accounts receivable, inventory and most equipment.

Our failure to file our 2003 Annual Report on Form 10-K on a timely basis violated covenants under the Senior Credit Facility.  Between March 31, 2004 and June 30, 2005, we amended the terms of the Senior Credit Facility six times to waive the covenant for non-compliance and extend the due date for this and other filings.  We paid a total of $0.5 million, $0.6 million, $1.1 million and $0.6 million in fees during the three and six months ended June 30, 2005 and 2004, respectively, related to the various amendments to the Senior Credit Facility.

6.375% Senior Notes

On May 14, 2003, we completed a public offering of $150.0 million of 6.375% Senior Notes due May 1, 2013 (the “6.375% Senior Notes”). The proceeds from the public offering, net of fees and expenses, were used to repay the balance of the revolving loan facility then outstanding under our then-existing credit facility, with the remainder being used for general corporate purposes. The 6.375% Senior Notes are senior unsecured obligations and are fully and unconditionally guaranteed by substantially all of our subsidiaries. The 6.375% Senior Notes are effectively subordinated to Key’s secured indebtedness, which includes borrowings under our Senior Credit Facility.  The 6.375% Senior Notes require semi-annual interest payments on May 1 and November 1 of each year.

8.375% Senior Notes

On March 6, 2001, we completed a private placement of $175.0 million of 8.375% Senior Notes due March 1, 2008 (the “8.375% Senior Notes,” together with the 6.375% Senior Notes, the “Senior Notes”). The net cash proceeds from the private placement were used to repay the remaining balance of the original term loans and a portion of the revolving loans outstanding under our then-existing credit facility. On March 1, 2002, we completed a public offering of an additional $100.0 million of 8.375% Senior Notes. The net cash proceeds from the public offering were used to repay the outstanding balance of the revolving loan facility under our credit facility. The 8.375% Senior Notes are senior unsecured obligations. The 8.375% Senior Notes are effectively subordinated to Key’s secured indebtedness

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which includes borrowings under our Senior Credit Facility.  The 8.375% Senior Notes require semi-annual interest payments on March 1 and September 1 of each year.

Consents to Amend to Extend the Reporting Requirements Under the Senior Note Indentures

Our failure to file our 2003 Annual Report on Form 10-K with the SEC and deliver it to the trustee under the Senior Note indentures on or before March 30, 2004 was a default under each of the indentures for the Senior Notes.  During 2004 and for the six months ended June 30, 2005, we amended the terms of each of the Senior Note indentures three times to waive the covenant non-compliance and extend the due date for our 2003 Annual Report on Form 10-K and other filings.  In order to obtain these amendments and consents, we incurred $9.0 and $5.1 million of expenses in 2005 and for the six months ended June 30, 2004, respectively.  We were required under the last consent by the holders of each series of Senior Notes to file our 2003 Annual Report on form 10-K on or before May 31, 2005 and our 2004 quarterly reports on Form 10-Q and our Annual Report on Form 10-K for 2004 on or before July 31, 2005. The consent also provided that the Quarterly Reports on Form 10-Q for the first quarter and second quarter of 2005 had to be filed no later than October 31, 2005. We failed to meet those deadlines, and as a result, on June 6, 2005, the trustee for the Senior Notes sent us notice of the financial reporting violation, which then triggered a 60-day cure period.

14% Senior Subordinated Notes

On January 22, 1999, we completed the private placement of 150,000 units (the “Units”) consisting of $150.0 million of 14% Senior Subordinated Notes due January 15, 2009 (the “14% Senior Subordinated Notes”) and 150,000 warrants to purchase 2,173,433 shares of the Company’s Common Stock at an exercise price of $4.88125 per share (the “Warrants”). The 14% Senior Subordinated Notes were issued at a discount, which was amortized to interest expense over the term of the 14% Senior Subordinated Notes.

The 14% Senior Subordinated Notes required semi-annual interest payments on January 15 and July 15 of each year. The 14% Senior Subordinated Notes were subordinated to our other senior indebtedness, which included borrowings under the Prior Senior Credit Facility, the 8.375% Senior Notes and the 6.375% Senior Notes.  Before January 15, 2002, we were allowed to redeem up to 35% of the aggregate principal amount of the 14% Senior Subordinated Notes at 114% of par, plus accrued interest with the proceeds of certain sales of equity. During the years prior to 2004, we redeemed approximately $52.5 million of principal amount of our 14% Senior Subordinated Notes at varying times and redemption prices, plus accrued interest.

We repaid all the $97.5 million outstanding principal amount of the 14% Senior Subordinated Notes on January 15, 2004.  The notes were redeemed at a redemption price of 107% of the principal amount outstanding plus accrued and unpaid interest to the redemption date, for a total cash outlay of $111.2 million.  This transaction resulted in a gain of $6.8 million.

As of June 30, 2005, 63,500 Warrants had been exercised, providing $4.2 million of proceeds to us and leaving 86,500 Warrants outstanding. On the date of issuance, the value of the Warrants was estimated at $7.4 million and was classified as equity.  Under the terms of the Warrants, we are required to maintain an effective registration statement covering the shares of common stock issuable upon exercise. If we are unable to maintain an effective registration statement, we are required to pay liquidated damages for periods in which an effective registration statement is not maintained. We have been unable to maintain our effective registration statement due to our failure to timely file our SEC reports. As a result, we paid liquidated damages starting at $0.05 per Warrant per week and escalating to $0.20 per Warrant per week. The total amount paid to the holders of the Warrants was $0.1 million during the six months ended June 30, 2005.

5% Convertible Subordinated Notes

In 1997, we completed a private placement of $216.0 million of 5% Convertible Subordinated Notes due September 15, 2004 (the “5% Convertible Notes”). The 5% Convertible Notes were subordinated to our senior indebtedness. The 5% Convertible Notes were convertible, at the holder’s option, into shares of Key’s common stock at a conversion price of $38.50 per share, subject to certain adjustments. The 5% Convertible Notes were redeemable, at our option, on and after September 15, 2000, in whole or part, together with accrued and unpaid interest. The initial

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redemption price was 102.86% for the year beginning September 15, 2000 and declined ratably thereafter on an annual basis.  During the years prior to 2004, we repurchased and canceled through open market transactions approximately $187.2 million principal amount of the 5% Convertible Notes at various times and prices.  The remaining $18.7 million outstanding principal amount of the 5% Convertible Notes matured and were repaid on September 15, 2004, plus accrued interest and fees, for a total cash outlay of $19.2 million.

Interest on the 5% Convertible Notes was payable on March 15 and September 15 of each year. Interest of $0.5 million was paid on March 15, 2004.

Interest Expense

Interest expense for the three and six months ended June 30, 2005 and 2004 consisted of the following:

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
		(in thousands)
Cash payments		$	5,362		$	5,177		$	17,731		$	24,301
Commitment and agency fees paid		7,021			1,108			10,840			1,605
Amortization of discount and premium on notes		(63		)	(58		)	(125		)	(116		)
Amortization of debt issuance costs		438			578			1,013			1,184
Net change in accrued interest		3,777			3,667			544			(6,174		)
Capitalized interest		(209		)	(635		)	(325		)	(1,239		)
Total interest expense		$	16,326		$	9,837		$	29,678		$	19,561

 

6.             COMMITMENTS AND CONTINGENCIES

As discussed in Note 1–”Organization and Summary of Significant Accounting Policies—Basis of Presentation,” due to the delay in the filing of this report, this note includes information regarding certain liabilities and uncertainties that became available after the end of the period covered by this report, but has been taken into consideration in the preparation of this report.

Litigation.  Various suits and claims arising in the ordinary course of business are pending against us. Due to locations where we conduct business in the continental United States, we are often subject to jury verdicts and arbitration hearings that result in favor of the plaintiffs. We do not believe that the disposition of any of these items will result in a material adverse impact on our consolidated financial position, results of operations or cash flows.

Government Investigations.  On March 29, 2004, we were notified by the Fort Worth office of the SEC that it had commenced an inquiry regarding the Company.  The SEC issued a formal order of investigation on July 15, 2004.  On May 30, 2007, we were informed by the staff of the Enforcement Division of the SEC that it had completed its investigation as to Key and it did not intend to recommend enforcement action.  In addition, on January 5, 2005, we were served with a subpoena issued by a grand jury in Midland, Texas, that asked for the production of documents in connection with an investigation being conducted by the U.S. Attorney’s Office for the Western District of Texas.  In October 2006, we were notified by the U.S. Attorney’s Office that it would not pursue any criminal charges against the Company.

Shareholder Class Action Suits.  Since June 2004, we have been named as a defendant in six class action complaints for alleged violations of federal securities laws, which have been filed in federal district court in Texas. The complaints generally allege that we made false and misleading statements and omitted material information from our public statements and SEC reports during the class period in violation of the Securities Exchange Act of 1934, including alleged: (i) overstatement of revenues, net income, and earnings per share, (ii) failure to take write-downs of assets, consisting of primarily idle equipment,

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(iii) failure to amortize the Company’s goodwill, (iv) failure to disclose that the Company lacked adequate internal controls and therefore was unable to ascertain the true financial condition of the Company, (v) material inflation of the Company’s financial results at all relevant times, (vi) misrepresentation of the value of acquired businesses, and (vii) failure to disclose misappropriation of funds by employees.

Shareholder Derivative Actions.  Four shareholder derivative actions have been filed by certain of our shareholders. Those actions are filed by individual shareholders purporting to act on our behalf, asserting various claims against the named officer and director defendants. The derivative actions generally allege the same facts as those in the shareholder class action suits. Those suits also allege breach of fiduciary duty, abuse of control, waste of corporate assets, and unjust enrichment by these defendants.

In each of the shareholder class actions and derivative actions described above, plaintiffs are seeking an unspecified amount of monetary damages. At this time, we cannot ascertain the ultimate aggregate amount of monetary liability or financial impact of the class actions and derivative lawsuits. While we have directors and officers insurance in the aggregate amount of $50.0 million, we cannot determine whether these actions will, individually or collectively, have a material adverse effect on our business, results of operations, financial condition and cash flows. We and named directors and officers intend to vigorously defend these actions.

Tax Audits.  We are routinely the subject of audits by tax authorities and have received some material assessments from tax auditors.  As of June 30, 2005, we have recorded reserves for future potential liabilities as a result of these audits that management feels are appropriate. While we have fully reserved for these assessments, the ultimate amount of settlement can vary from this estimate. In connection with our Egyptian operations, we are undergoing income tax audits for all periods in which we had operations.  Based on information as of the period covered by this report, we have determined that additional income taxes will be owed and have recorded a liability of approximately $0.9 million.

Self-Insurance Reserves.  We maintain insurance policies for workers' compensation, vehicle liability and general liability claims. These insurance policies carry self-insured retention limits or deductibles on a per occurrence basis. The retention limits or deductibles are accounted for in our accrual process for all workers' compensation, vehicular liability and general liability claims. We maintain reserves on our balance sheet based on our judgment and estimates using an actuarial method based on claims incurred for workers' compensation and vehicle liability. We estimate general liability claims on a case-by-case basis.  As of June 30, 2005 and December 31, 2004, we have recorded $60.5 million and $55.3 million, respectively, of self-insurance reserves related to worker’s compensation, vehicular liabilities and general liability claims.

Environmental Remediation Liabilities.  For environmental reserve matters, including remediation efforts for current locations and those relating to previously-disposed properties, we record liabilities when our remediation efforts are probable and the costs to conduct such remediation efforts are reasonably estimated.  Environmental reserves do not reflect management’s assessment of the insurance coverage that may apply to these matters at issue, whereas our litigation reserves do reflect the application of our insurance coverage. At June 30, 2005 and December 31, 2004, respectively, we have recorded $5.5 million and $5.5 million for our environmental remediation liabilities.

Francis D. John Employment Agreement.  Effective as of July 1, 2001, we entered into an amended and restated employment agreement with Francis D. John (the “2001 Employment Agreement”) pursuant to which Mr. John served as the Chairman of the Board, President and Chief Executive Officer of Key. The 2001 Employment Agreement provided for the payment of a one-time retention incentive payment of $13.1 million. The purpose of this retention incentive payment was to retire all amounts owed by Mr. John under incentive-based loans previously made to him (which, because certain performance criteria had been previously met, we were scheduled to forgive ratably over a ten-year period as long as Mr. John continued to serve Key in his capacity as Chairman of the Board, President and Chief Executive Officer) and in the process provide Mr. John with an incentive to remain with Key for the next ten years. On December 1, 2001, the incentive retention payment was paid to Mr. John and was comprised of two components: (i) $7.5 million in loan principal and interest accrued through the date of the payment and (ii) $5.6 million in a tax “gross-up” payment. The entire payment was withheld by us and used to satisfy Mr. John’s tax obligations and his obligations under the loans. Pursuant to the 2001 Employment Agreement, Mr. John would earn the incentive retention payment over a ten-year period beginning July 1, 2001, with one-tenth of the total bonus being earned on September 30 of each year, beginning on September 30, 2002. The 2001 Employment Agreement was amended and restated effective December 31, 2003 (the “2003 Employment Agreement”). Under the 2003 Employment Agreement, if Mr. John voluntarily terminated his employment with Key or if Mr. John was terminated by Key for Cause (as defined in the 2003 Employment Agreement), Mr. John would be obligated to repay the entire remaining unearned balance of the retention incentive payment immediately upon such termination. However, if Mr. John’s employment with Key was terminated (i) by Key other than for Cause, (ii) by Mr. John for Good Reason, (iii) as a result of Mr. John’s death or Disability (as defined in the 2003 Employment Agreement), or (iv) as a result of a Change in Control (as defined in the 2003 Employment Agreement), the remaining unearned balance of the retention incentive payment would be treated as earned as of the date of such event.

Argentina Payroll Matters.  Our Argentinean subsidiary, Key Energy Services S.A., had previously underpaid our social security contributions to the Administración Federal de Ingressos Públicos (“AFIP”) as a result of applying an incorrect rate in the calculation of our obligation. Additionally, we also underpaid AFIP as a result of our incorrect use of food stamp equivalents provided to employees as compensation. The correct amounts have been reflected in these financial statements. On May 31, 2007 we paid AFIP $3.5 million, representing the cumulative amount of underpayment and interest. As a result of our underpayment, AFIP has imposed fines and penalties against us and has begun an audit of our filings made to them in prior years. We have recorded an appropriate liability for this matter, and do not expect the ultimate resolution of this matter to have a material impact to our results of operations, cash flows or financial position.

Guarantees.  We provide performance bonds to provide financial surety assurances for the remediation and maintenance of our SWD properties to comply with environmental protection standards. Costs for SWD properties may be mandatory (to comply with applicable laws and regulations), in the future (required to divest or cease operations), or for optimization (to improve operations, but not for safety or regulatory compliance).

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7.             STOCKHOLDERS’ EQUITY

Common Stock

On June 30, 2005, we had 200,000,000 shares of common stock authorized with a $0.10 par value of which 131,334,196 of these shares of common stock were issued and outstanding, net of 416,666 shares held in treasury, and no dividends were issued.  On December 31, 2004, we had 200,000,000 shares of common stock authorized with a $0.10 par value of which 130,791,338 of these shares were issued and outstanding, net of 416,666 shares held in treasury, and no dividends had been issued.

Stock Incentive Plans

On January 13, 1998, Key’s shareholders approved the Key Energy Group, Inc. 1997 Incentive Plan, as amended (the “1997 Incentive Plan”). The 1997 Incentive Plan is an amendment and restatement of the plans formerly known as the Key Energy Group, Inc. 1995 Stock Option Plan and the Key Energy Group, Inc. 1995 Outside Directors Stock Option Plan (collectively, the “Prior Plans”).

All options previously granted under the Prior Plans and outstanding as of November 17, 1997 (the date on which our board of directors adopted the 1997 Incentive Plan) were assumed and continued, without modification, under the 1997 Incentive Plan.

Under the 1997 Incentive Plan, Key may grant the following awards to certain key employees, directors who are not employees (“Outside Directors”) and consultants of Key, our controlled subsidiaries, and our parent corporation, if any: (i) incentive stock options (“ISOs”) as defined in Section 422 of the Internal Revenue Code of 1986, as amended (the “Code”), (ii) ”nonstatutory” stock options (“NSOs”), (iii) stock appreciation rights (“SARs”), (iv) shares of restricted stock, (v) performance shares and performance units, (vi) other stock-based awards and (vii) supplemental tax bonuses (collectively, “Incentive Awards”). ISOs and NSOs are sometimes referred to collectively herein as “Options.”

The following table summarizes the stock option activity related to the plans (shares in thousands):

 

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The following table summarizes information about the stock options outstanding at June 30, 2005:

		Options Outstanding
		Weighted Average Remaining Contractual Life (Years)		Number of Options Outstanding June 30, 2005			Weighted Average Exercise Price			Weighted Average Fair Value
Range of Exercise Prices:
$3.00 - $7.34		3.32		1,407			$	5.14		$	3.08
$7.35 - $8.25		5.66		2,804			$	8.15		$	4.74
$8.26 - $8.50		4.88		1,813			$	8.46		$	5.22
$8.51 - $9.75		5.25		1,381			$	9.25		$	5.80
$9.76 - $14.51		7.43		2,091			$	11.00		$	4.58
				9,496			$	8.55		$	4.70
Aggregate intrinsic value (in thousands)				$	9,081

 

 

The total fair value of stock options granted during the six months ended June 30, 2005 was $1.9 million. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option-pricing model, based on the following weighted-average assumptions:

 

Common Stock Awards

Beginning in June 2005, we began granting shares of common stock to our outside directors and certain employees. These shares are restricted as to exercisability and transferability, and in certain cases, have required service periods before they are vested and are subject to forfeiture. The vesting periods on these grants range from zero (immediately vested) to three years. The total fair market value of all common stock awards granted during the six months ended June 30, 2005 was $6.5 million. No common stock awards were granted prior to June 2005.

We issued a total of 550,000 common shares to our outside directors and employees during the six months ended June 30, 2005 at a weighted-average issuance price of $11.90 per share. Of these, 50,000 were issued to our outside directors and vested immediately, while the remaining 500,000 vest ratably over a three year period.

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For common stock grants that vest immediately upon issuance, we record expense equal to the fair market value of the shares on the date of grant. For common stock grants that do not immediately vest, we recognize compensation cost ratably over the vesting period of the grant, net of actual and estimated forfeitures.  For the six months ended June 30, 2005, we recognized $0.6 million of expense related to common stock awards, net of estimated and actual forfeitures.

8.             SEGMENT INFORMATION

For 2005, our reportable business segments are well servicing, pressure pumping and fishing and rental.

Well Servicing.  These operations provide a full range of well services, including rig-based services, oilfield transportation services and other ancillary oilfield services necessary to complete, maintain and workover oil and natural gas producing wells. Our Argentina operations are included in our well servicing segment. We aggregate our operating divisions engaged in well servicing activities into our well servicing reportable segment.

Pressure Pumping. These operations provide well stimulation and cementing services.  Stimulation includes fracturing, nitrogen services and acidizing services and is used to enhance the production of oil and natural gas wells from formations which exhibit a restricted flow of oil and / or natural gas.  Cementing services include pumping cement into a well between the casing and the wellbore.

Fishing and Rental.  These operations provide services that include “fishing” to recover lost or stuck equipment in a wellbore through the use of “fishing tools.”  In addition, this segment offers a full line of services and rental equipment designed for use both on land an offshore for drilling and workover services and includes an inventory consisting of tubulars, handling tools, pressure-control equipment and power swivels.

We evaluate the performance of our operating segments based on revenue and EBITDA, which is a non-GAAP measure and not disclosed below. Corporate expenses include general corporate expenses associated with managing all reportable operating segments. Corporate assets consist principally of cash and cash equivalents, deferred debt financing costs and deferred income tax assets.

The following table sets forth our segment information as of and for the periods ended June 30, 2005 and June 30, 2004, respectively:

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		Well Servicing			Pressure Pumping			Fishing and Rental			Corporate / Other			Discontinued Operations			Eliminations			Total
		(in thousands)
As of and for the three months ended June 30, 2005:
Operating revenues		$	238,696		$	36,246		$	19,959		$	—		$	—		$	—		$	294,901
Gross margin		77,041			10,880			6,185			—			—			—			94,106
Depreciation and amortization		21,545			2,295			1,505			2,867			—			—			28,212
Interest expense		18			(71		)	6			16,373			—			—			16,326
Net income (loss) from continuing operations		42,738			11,367			3,293			(48,025		)	—			—			9,373
Propery, plant and equipment, net		471,679			53,948			26,565			36,110			—			—			588,302
Total assets		909,838			125,224			69,202			578,633			1,193			(386,858		)	1,297,232
Capital expenditures, excluding acquisitions		(24,092		)	(5,090		)	(869		)	(3,259		)	—			—			(33,310		)

 

		Well Servicing			Pressure Pumping			Fishing and Rental			Corporate / Other			Discontinued Operations			Eliminations			Total
		(in thousands)
As of and for the three months ended June 30, 2004:
Operating revenues		$	201,988		$	22,680		$	18,863		$	—		$	—		$	—		$	243,531
Gross margin		58,647			7,535			6,484			—			—			—			72,666
Depreciation and amortization		18,524			1,568			1,367			1,617			—			—			23,076
Interest expense		21			(15		)	3			9,828			—			—			9,837
Net income (loss) from continuing operations		25,978			5,215			4,275			(52,890		)	—			—			(17,422		)
Propery, plant and equipment, net		568,007			45,211			27,654			47,424			—			—			688,296
Total assets		922,646			108,610			65,677			759,650			88,054			(631,917		)	1,312,720
Capital expenditures, excluding acquisitions		(13,573		)	(723		)	(543		)	(2,286		)	—			—			(17,125		)

 

		Well Servicing			Pressure Pumping			Fishing and Rental			Corporate / Other			Discontinued Operations			Eliminations			Total
		(in thousands)
As of and for the six months ended June 30, 2005:
Operating revenues		$	459,029		$	66,750		$	40,326		$	—		$	—		$	—		$	566,105
Gross margin		147,754			24,153			12,946			—			—			—			184,853
Depreciation and amortization		42,838			4,459			2,955			5,734			—			—			55,986
Interest expense		22			(84		)	12			29,728			—			—			29,678
Net income (loss) from continuing operations		74,939			21,684			6,585			(85,470		)	—			—			17,738
Propery, plant and equipment, net		471,679			53,948			26,565			36,110			—			—			588,302
Total assets		909,838			125,224			69,202			578,633			1,193			(386,858		)	1,297,232
Capital expenditures, excluding acquisitions		(36,450		)	(6,216		)	(1,338		)	(4,227		)	—			—			(48,231		)

 

		Well Servicing			Pressure Pumping			Fishing and Rental			Corporate / Other			Discontinued Operations			Eliminations			Total
		(in thousands)
As of and for the six months ended June 30, 2004:
Operating revenues		$	397,217		$	40,739		$	37,557		$	—		$	—		$	—		$	475,513
Gross margin		119,754			11,062			12,180			—			—			—			142,996
Depreciation and amortization		37,056			2,856			2,720			2,651			—			—			45,283
Interest expense		72			(18		)	1			19,506			—			—			19,561
Net income (loss) from continuing operations		53,636			6,870			7,879			(91,186		)	—			—			(22,801		)
Propery, plant and equipment, net		568,007			45,211			27,654			47,424			—			—			688,296
Total assets		922,646			108,610			65,677			759,650			88,054			(631,917		)	1,312,720
Capital expenditures, excluding acquisitions		(22,468		)	(1,636		)	(428		)	(1,795		)	—			—			(26,327		)

 

Operating revenues for our foreign operations were $17.8 million and $14.3 million for the three months ended June 30, 2005 and 2004, respectively. Operating revenues for our foreign operations were $35.2 million and $27.5 million for the six months ended June 30, 2005 and 2004, respectively.  Gross margins for our foreign operations were $4.4 million and $4.8 million for the three months ended June 30, 2005 and 2004, respectively. Gross margins for our foreign operations were $9.8 million and $9.3 million for the six months ended June 30, 2005 and 2004, respectively.

We have $61.3 million and $54.4 million of identifiable assets related to our foreign operations as of June 30, 2005 and December 31, 2004, respectively.  Capital expenditures for our foreign operations were $4.1 million and $4.0 million for the six months ended June 30, 2005 and 2004, respectively.

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9.             CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

Our Senior Notes are guaranteed by substantially all of our domestic subsidiaries, all of which are wholly-owned.  The guarantees are joint and several, full, complete and unconditional.  There are no restrictions on the ability of subsidiary guarantors to transfer funds to the parent company.

The accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.”  The information is not intended to present the financial position, results of operations and cash  flows of the individual companies or groups of companies in accordance with accounting principles generally accepted in the United States of America.

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