UNITED STATE SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-K/A AMENDMENT NO. 3 (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 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 1-2199 ALLIS-CHALMERS ENERGY INC. -------------------------- (Exact name of registrant as specified in its charter) DELAWARE 39-0126090 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 5075 WESTHEIMER, SUITE 890, HOUSTON, TEXAS 77056 ------------------------------------------------- (Address of principal executive offices) (Zip code) (713) 369-0550 -------------- Registrant's telephone number, including area code SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, PAR VALUE $0.15 PER SHARE 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 if the disclosure of delinquent filers pursuant to ITEM 405 of Regulation S-K (ss.220.405 of this Chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] The aggregate market value of the common equity held by non-affiliates of the registrant, computed using the average of the bid and ask price of the common stock of $1.52 per share on April 2, 2004, as reported on the OTC Bulletin Board, was approximately $3,009,298 (affiliates included for this computation only: directors, executive officers and holders of more than 5% of the registrant's common stock). At April 14, 2004, there were 31,393,789 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE: 2003 FORM 10-K/A CONTENTS ------------------------- PART II 6. Selected Financial Data................................................. 4 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................. 4 8. Financial Statements.................................................... 24 9A. Controls and Procedures................................................ 49 PART IV 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K........ 50 Signatures and Certifications.............................................. 50 2 INTRODUCTORY NOTE Allis-Chalmers Energy Inc. is filing this Amendment No. 3 to the Company's Quarterly report on Form 10-Q for the year ended December 31, 2003 to reflect the restatement of our financial results resulting from an error in the application of SFAS No. 128 Earnings Per Share. The restatement is discussed in more detail in Note 2 to the accompanying consolidated financial statements. PART II 6. Selected Financial Data................................................. 4 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................. 4 8. Financial Statements.................................................... 24 9A. Controls and Procedures................................................ 49 PART IV 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K........ 50 Signatures and Certifications.............................................. 50 Unaffected items have not been repeated in this Amendment No. 3. PLEASE NOTE THAT THE INFORMATION CONTAINED IN THIS AMENDMENT NO. 3, INCLUDING THE FINANCIAL STATEMENTS AND THE NOTES THERETO, DOES NOT REFLECT EVENTS OCCURRING AFTER THE ORIGINAL FILING DATE. SUCH EVENTS INCLUDE, AMONG OTHERS, THE EVENTS DESCRIBED IN OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2004, OUR QUARTERLY REPORTS ON FORM 10-Q FOR THE PERIODS ENDED MARCH 31, 2005 AND JUNE 30, 2005 AND THE EVENTS DESCRIBED IN OUR CURRENT REPORTS ON FORM 8-K FILED SUBSEQUENT TO THE ORIGINAL FILING DATE. FOR A DESCRIPTION OF THESE EVENTS, PLEASE READ OUR EXCHANGE ACT REPORTS FILED SINCE THE ORIGINAL FILING DATE INCLUDING ALL AMENDMENTS THERETO. 3 PART II ITEM 6. SELECTED FINANCIAL DATA. As discussed in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation", in May 2001, for financial reporting purposes, we were deemed to be acquired by OilQuip Rentals, Inc. Accordingly, the following data for periods prior to May 2001 reflect only the operations of OilQuip Rentals, Inc., which was incorporated in February 2000, and, from February 2001, its subsidiary, Mountain Air. Our historical consolidated financial statements have been restated for the period from July 1, 2003 through March 31, 2005, as described in the notes to our consolidated financial statements included elsewhere herein. CONSOLIDATED STATEMENTS OF OPERATIONS DATA Year Ended December 31, (in thousands, except per share data) STATEMENT OF OPERATIONS DATA: 2003 2002 2001 ------------ ------------ ------------ (Restated) Sales $ 32,724 $ 17,990 $ 4,796 Income (loss) from operations $ 2,526 $ (1,170) $ (1,433) Net income (loss) $ 2,927 $ (3,969) $ (4,577) Net income (loss) attributed to common shareholders $ 2,271 $ (4,290) $ (4,577) Per Share Data: Net (loss) income per common share: Basic $ 0.12 $ (0.23) $ (1.15) Diluted $ 0.10 $ (0.23) $ (1.15) Weighted average number of common shares outstanding: Basic 19,633 18,831 3,952 Diluted 29,248 18,831 3,952 CONSOLIDATED BALANCE SHEET DATA YEAR ENDED DECEMBER 31, 2003 2002 2001 ------------ ------------ ------------ (Restated) Total Assets $ 53,662 $ 34,778 $ 12,465 Long-term debt classified as: Current $ 3,992 $ 13,890 $ 1,023 Long Term $ 28,241 $ 7,731 $ 6,833 Stockholders' Equity $ 4,541 $ 1,009 $ 1,250 Book value per share $ 0.23 $ 0.05 $ 0.32 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information in this Item 7 contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of risks and uncertainties, including, but not limited to, those discussed below under "Risk Factors", and those discussed in other reports filed with the Securities and Exchange Commission. You should not rely on these forward-looking statements, which reflect our position as of the date of this report. We are under no obligation to revise or update any forward-looking statements. OVERVIEW OF OUR BUSINESS We provide services and equipment to the oil and gas drilling industry. Our customers are principally small independent and major oil and gas producers engaged in the exploration and development of oil and gas wells. Our operations are conducted principally in the Texas Gulf Coast, offshore in the United States Gulf of Mexico, West Texas, and the Rocky Mountain regions of New Mexico and Colorado. We also operate in Mexico through a Mexican partner. 4 We provide casing and tubing handling services and drilling services, which includes our directional drilling services segment and compressed air drilling services segment. Our casing and tubing services segment supplies specialized equipment and trained operators to install casing and tubing, change out drill pipe and retrieve production tubing for both onshore and offshore drilling and workover operations. Our directional drilling operations provide directional, horizontal and "measure while drilling" services to oil and gas companies operating both onshore and offshore in Texas and Louisiana. Our compressed air drilling segment provides compressed air and related products and services for the air drilling, workover, completion, and transmission segments of the oil, gas and geothermal industries. We plan to broaden the geographic regions in which we operate and to expand the types of services and equipment we provide to the oil and gas drilling industry. We derive operating revenues from rates per day and rates per job that we charge for the labor and equipment required to provide a service. The rates vary widely from project to project depending upon the scope of services we are asked to provide. The price we charge for our services depends upon several factors, including the level of oil and gas drilling activity in the particular geographic regions in which we operate and the competitive environment. Contracts are awarded based on price, quality of service and equipment, and general reputation and depth of operations and management personnel. The demand for drilling services has historically been volatile and is affected by the capital expenditures of oil and gas exploration and development companies, which in turn are impacted by the prices of oil and natural gas, or the expectation for the prices of oil and natural gas. The number of working drilling rigs is an important indicator of activity levels in the oil and gas industry, typically referred to as the "rig count." The rig count in the U.S. increased from 862 as of December 31, 2002 to 1,126 on December 31, 2003, according to the Baker Hughes rig count. According to the Baker Hughes rig count, the directional and horizontal rig counts increased from 283 as of December 31, 2002 to 381 on December 31, 2003, which accounted for 32.8% and 33.8% of the total U.S. rig count, respectively. Our operating expenses represent all direct and indirect costs associated with the operation and maintenance of our equipment. The principal elements of these costs are direct and indirect labor and benefits, repairs and maintenance of our equipment, insurance, equipment rentals and fuel. Operating expenses do not necessarily fluctuate in proportion to changes in revenues because we have a fixed base of inventory of equipment and facilities to support our operations, and we may also seek to preserve labor continuity to market our services and maintain our equipment. Prior to May 2001, we operated primarily through Houston Dynamic Services, Inc., which conducted a machine repair business. In May 2001, as part of a strategy to acquire and develop businesses in the natural gas and oil services industry, we consummated a merger in which we acquired 100% of the capital stock of OilQuip Rentals, Inc., which owned Mountain Compressed Air, Inc., which provided compressed air drilling services. In December 2001, we disposed of Houston Dynamic Service, Inc., and in February 2002, we acquired substantially all of the capital stock of Strata Directional Technology, Inc. and approximately 81% of the capital stock of Jens' Oilfield Service, Inc. In July 2003, through Mountain Compressed Air, we entered into a limited liability company operating agreement with M-I L.L.C., a joint venture between Smith International and Schlumberger N.V. to form a Texas limited liability company named AirComp LLC. We own 55% and M-I owns 45% of AirComp. We have consolidated AirComp into our financial statements beginning with the quarter ending September 30, 2003. For accounting purposes, the OilQuip Rentals merger was treated as a reverse acquisition by OilQuip Rentals of Allis-Chalmers and financial statements presented herein for periods prior to May 2001 present the results of operations and financial condition of OilQuip Rentals. As a result of the OilQuip Rentals merger, the fixed assets and other intangibles of Allis-Chalmers in existence immediately prior to the merger were increased by $2.7 million. 5 RESTATEMENT The Company understated diluted earnings per share due to an incorrect calculation of its weighted shares outstanding for the third and fourth quarters of 2003, for each of the first three quarters of 2004, for the year ended December 31, 2004 and the for the quarter ended March 31, 2005. In addition, the Company understated basic earnings per share due to an incorrect calculation of its weighted average basic shares outstanding for the quarter ended September 30, 2004. Consequently, the Company has restated its financial statements for each of those periods. The incorrect calculation resulted from a mathematical error and an improper application of SFAS 128, Earnings Per Share. The effect of the restatement is to reduce weighted average diluted shares outstanding for each period and to reduce weighted average basic shares outstanding for the quarter ended September 30, 2004. Consequently, weighted average diluted earnings per share were increased for each period and weighted average basic earnings per share was increased for the quarter ended September 30, 2004. As a result, earnings per share were increased in each period in inverse Proportion to the decrease in shares outstanding. See Note 2 to our consolidated Financial statements included in Part II, Item 8. In connection with the formation of AirComp in 2003, the Company and M-I contributed assets to AirComp in exchange for a 55% interest and 45% interest, respectively, in AirComp. We originally accounted for the formation of AirComp as a joint venture, but in February 2005 determined that the transaction should have been accounted for using purchase accounting pursuant to Statement of Financial Accounting Standard ("SFAS") No. 141, "Business Combinations" and SEC Staff Accounting Bulletin ("SAB") No. 51 "Accounting for Sales of Stock by a Subsidiary". Consequently, we have restated our financial statements for the year ended December 31, 2003 and for the three quarters ended September 30, 2004. RESULTS OF OPERATIONS Results of operations for 2001 reflect the business operations of OilQuip Rentals. From its inception on February 4, 2000 to February 6, 2001, OilQuip Rentals was in the developmental stage. OilQuip Rentals' activities for the period prior to February 6, 2001 consisted of developing its business plan, raising capital and negotiating with potential acquisition targets. Therefore, the results for operations for the period prior to February 6, 2001 reflect no sales, cost of sales, or marketing and administrative expenses that would be reflective of an operating company. On February 6, 2001, OilQuip Rentals acquired the assets of Mountain Air, which provides compressed air drilling services to natural gas exploration operations. On May 9, 2001, OilQuip Rentals merged with a subsidiary of Allis-Chalmers, and was deemed to acquire the assets of Allis-Chalmers, including the operations of Houston Dynamic Services. The results of operation of Houston Dynamic Services, which was sold in December 2001, are included in discontinued operations from May 9, 2001. On February 6, 2002, Allis-Chalmers acquired 81% of the outstanding stock for Jens' Oilfield Service, Inc., which supplies specialized equipment and operations to install casing and production tubing required to drill and complete oil and gas wells. On February 6, 2002, we also purchased substantially all the outstanding common stock and preferred stock of Strata Directional Technology, Inc., which provides directional and horizontal drilling services for specific targeted reservoirs that cannot be reached vertically. The results from our casing and tubing services and directional drilling services are included in our operating results from February 1, 2002. In July 2003, through our subsidiary Mountain Air, we entered into a limited liability company operating agreement with a division of M-I L.L.C., a joint venture between Smith International and Schlumberger N.V. to form AirComp. We own 55% and M-I owns 45% of AirComp. We have consolidated AirComp into our financial statements beginning with the quarter ending September 30, 2003. Comparison of Years Ended December 31, 2003 and 2002 ---------------------------------------------------- Revenues for the year ended December 31, 2003 totaled $32.7 million, an increase of 81.7% from the $18.0 million in revenues for the year ended December 31, 2002. The increase in revenues is due to the general increase in oil and gas drilling activity and the inclusion of AirComp, our compressed air drilling venture, beginning in July 2003. The increase in revenues is also due to 2003 being the first full year of revenue contribution from the casing and tubing services segment and the directional drilling segment, both of which were acquired in February 2002. Our gross profit for the year ended December 31, 2003 was $8.7 million, or 26.5% of revenues, compared to $3.4 million, or 18.9 % of revenues for the year ended December 31, 2002, due to increased utilization of our equipment and personnel and increased pricing in each of our business segments due to the increase in industry activity. Our cost of revenues consist principally of our labor costs and benefits, equipment rentals, maintenance and repairs of our equipment, insurance and fuel. Because many of our costs are fixed, our gross profit as a percentage of revenues is generally affected by our level of revenues. Gross profit as a percentage of revenues increased as a result of higher revenues and better pricing for our services. 6 General and administrative expenses were $6.2 million, or 19.0% of revenues, in 2003 compared to $3.8 million, or 21.1% of revenues, in 2002. The increase in general and administrative expenses in absolute terms was due to the inclusion of general and administrative expenses for AirComp, which created a larger operation compared to our previous Mountain Air subsidiary, the hiring of additional sales force and operations personnel due to the improvement in the oil and gas drilling market, and the inclusion of the operations of our casing and tubing services and directional drilling services segments for a full year in 2003. Depreciation and amortization expenses increased to $2.9 million in 2003 compared to $2.6 million in 2002, due to the formation of AirComp in July 2003, and the acquisition of our casing and tubing services and directional drilling services segments in February 2002. Income from operations for the year 2003 totaled $2.5 million reflecting the general increase in oil and gas drilling activity and the inclusion of revenues and operating income contributed by M-I through the formation of AirComp in July 2003. In the comparable period of 2002, we incurred an operating loss of $1.2 million. During the third quarter of 2002, we reorganized in order to contain costs and recorded charges related to the reorganization in the amount of $495,000. These charges consisted of related payroll costs for terminated employees of $307,000, consulting fees of $113,000, and costs associated with a terminated rent obligation of $75,000. We also recorded one-time charges for costs related to abandoned acquisitions and an abandoned private placement in the amount of $233,000. Interest expense increased to $2.5 million in 2003, compared to $2.3 million in the prior year due to increased debt associated with acquisitions completed in 2002, and debt associated with the formation of AirComp in July 2003. Minority interest in income of subsidiaries for 2003 was $343,000 compared to $189,000 in 2003 due to the increase in the net income of our casing and tubing services subsidiary, which until September 30, 2004, was owned 19% by Jens Mortensen; and the formation, in July 2003, of AirComp, which is owned 45% by M-I. In the year ended December 31, 2003 we recorded a one-time gain on the reduction of a note payable of $1.0 million in the third quarter as a result of settling a lawsuit against the former owners of Mountain Air Drilling Service Co. Inc. The gain was calculated in part by discounting the note payable to $1.5 million using a present value calculation and accreting the note payable to $1.9 million, the amount due in September 2007. We will record interest expense totaling $394,043 over the life of the note payable beginning July 2003. In addition, we also recorded a one-time non-operating gain on the sale of an interest in a subsidiary of $2.4 million in connection with the formation of AirComp. The Company has adopted a policy that any gain or loss in the future incurred on the sale in the stock of a subsidiary would be recognized as such in the income statement. The net loss for 2002 included a discount given to the holder of the Houston Dynamic Services note in the amount of $191,000 as an incentive to pay-off the note in September 2002. We had a net income attributed to common stockholders of $2.3 millionfor the year ended December 31, 2003 compared with a net loss of ($4.3 million) for the year ended December 31, 2002. 7 The following table compares revenues and income from operations for each of our business segments for the years ended December 31, 2003, 2002 and 2001. Income from operations consists of our revenues less cost of revenues, general and administrative expenses, and depreciation and amortization: Revenues 2003 2002 Change 2001 Change -------------- -------------- ------------- ------------ ------------- Casing services $ 10,037 $ 7,796 $ 2,241 $ -- $ 7,796 Directional drilling services 16,008 6,529 9,479 -- $ 6,529 Compressed air drilling services 6,679 3,665 3,014 4,796 (1,131) General corporate -- -- -- -- -- -------------- -------------- ------------- ------------ ------------- Total $ 32,724 $ 17,990 $ 14,734 $ 4,796 $ 13,194 ============== ============== ============= ============ ============= Income (Loss) from Operations 2003 2002 Change 2001 Change -------------- -------------- ------------- ------------ ------------- (Restated) (Restated) Casing services $ 3,628 $ 2,495 $ 1,133 $ -- $ 2,495 Directional drilling services 1,103 (576) 1,679 -- $ (576) Compressed air drilling services 17 (945) 962 434 (1,379) General corporate (2,222) (2,144) (78) (1,867) (277) --------------- -------------- ------------- ------------- ------------- Total $ 2,526 $ (1,170) $ 3,696 $ (1,433) $ 263 ============== ============== ============= ============= ============= CASING AND TUBING SERVICES SEGMENT Revenues for the year ended December 31, 2003 for the casing and tubing services segment were $10.0 million, an increase of 28.2% from the $7.8 million in revenues for the year ended December 31, 2002. Revenues from domestic operations increased to $6.3 million in 2003 from $5.1 million in 2002 as a result of a general improvement in oil and gas drilling activity in South Texas and the inclusion of this segment, which was acquired in February 2002, for a full year in 2003. Revenues from Mexican operations increased to $3.7 million in 2003 from $2.7 million in 2002 as a result of increased drilling activity in Mexico. Income from operations increased 45.4% to $3.6 million in 2003 from $2.5 million in 2002 due to the increase in revenues. DIRECTIONAL DRILLING SERVICES SEGMENT Revenues for 2003 for directional drilling services were $16.0 million, an increase of 146.2% from $6.5 million in revenues for 2002 due to increased drilling activity in the Texas and Gulf Coast areas in 2003. Operating income increased to $1.1 million for 2003 compared to a loss from operations of ($576,000) for the same period in 2002 due to the increase in revenues, which more than offset an increase in operating expenses due to the addition of operations and sales personnel. 8 COMPRESSED AIR DRILLING SERVICES SEGMENT Our compressed air drilling revenues were $6.7 million in 2003, an increase of 81.1% compared to $3.7 million in revenues in 2002. Revenues increased in 2003 due to the inclusion of revenues contributed by M-I through the formation of AirComp in July 2003. Operating income increased to $17,000 in 2003 from a ($945,000) loss from operations in 2002 due to the inclusion, for six months in the 2003 period, of the business contributed by M-I in connection with the formation of AirComp in July 2003. Through this venture, we have been able to expand the geographical areas in which we operate to include gas drilling in West Texas along with the drilling and workover operations of Mountain Air in the San Juan basin in New Mexico. PRO FORMA RESULTS The unaudited pro forma consolidated summary financial information illustrates the effects of the formation of AirComp on the Company's results of operations, based on the historical statements of operations, as if the transaction had occurred as of the beginning of the periods presented. Pro forma results of operations set forth below includes results of operations for all of 2003 and 2002. These financial statements should be read in conjunction with the pro forma financial statements included herein. Pro forma sales for the year 2003 totaled $33,605,000, reflecting the revenue of AirComp. In the comparable period of 2002, pro forma sales were $21,595,000. The increase in 2003 compared to 2002 was primarily due to higher revenues resulting from the overall upturn in the petroleum industry. Pro forma gross margin, as a percentage of sales, was 26.3% for the year ended December 31, 2003 compared with a pro forma gross margin of 17.5 % for the year ended December 31, 2002. The gross margin ratio increased as a result of increased market share and increased pricing in the Casing Services, Directional Drilling Services and Compressed Air Drilling Services segments. Because we have made significant investments in equipment and have a constant number of personnel, many of our costs are fixed, and as a result, our gross profit margins are impacted by either increases or decreases in revenues. Pro forma general and administrative expense was $5,958,000 in 2003 compared with $4,841,000 in 2002. The pro forma general and administrative expense increased in 2003 due to the costs associated with the formation of AirComp and the hiring of additional sales force and operations personnel due to the upturn in the market. The Company had pro forma operating income for the year 2003 of $2,902,000 as compared to pro forma operating (loss) of ($24,000) in 2002. The increase in pro forma operating income for 2003 was primarily due to higher revenues resulting from the overall upturn in the petroleum industry. The Company incurred a pro forma net income of $2,882,000 or $0.15 per common share, for the year ended December 31, 2003 compared with a pro forma net loss of ($4,070,000), or ($0.22) per common share, for the year ended December 31 2002. The pro forma net income for 2003 included a one-time gain on the reduction of the note payable $1,034,000 in the third quarter as a result of settling a lawsuit against the former owners of Mountain Air Drilling Service Company. The gain was calculated by discounting the note payable to $1,469,152 using a present value calculation and accreting the note payable to $1,863,195, the amount due in September 2007. In addition, we also recorded a one-time non-operating gain on the sale of an interest in a subsidiary of $2.4 million in connection with the formation of AirComp. The pro forma net loss for 2002 included a factoring discount given to the holder of the HDS note in the amount of $191,000 as an incentive to pay-off the note by September 30, 2002. During the third quarter of 2002, the Company reorganized itself in order to contain costs and recorded charges related to the reorganization in the amount of $495,000. These charges consisted of related payroll costs for terminated employees of $307,000, consulting fees of $113,000, and costs associated with a terminated rent obligation of $75,000. The Company also recorded one-time charges for costs related to an abandoned acquisitions and an abandoned private placement in the amount of $233,000. 9 Comparison of Years Ended December 31, 2002 and 2001 ---------------------------------------------------- Revenues for the year 2002 totaled $18.0 million compared to $4.8 million in 2001. The 275.0% increase in revenues reflects the revenues of our casing and tubing services and directional drilling services segments, which were acquired in February 2002. Revenues for the year ended December 31, 2002 for the casing and tubing services, directional drilling services, and compressed air drilling services segments were $7.8 million, $6.5 million and $3.7 million, respectively. We had no revenues from casing and tubing services and directional drilling services in 2001 as those operations were acquired in February 2002. Revenues for the compressed air drilling services segment decreased to $3.7 million in 2002 from $4.8 million for the year ended December 31, 2001, primarily due to lower revenues from Burlington Resources, which decreased from $3.3 million in 2001 to $1.8 million in 2002. Burlington Resources represented 49.9% and 62.6% of the compressed air drilling services revenues in 2002 and 2001, respectively. Revenues also declined as a result of an overall decline in drilling activity. The rig count in the United States decreased from an average of 1,156 in 2001 to an average of 830 in 2002, according to the Baker Hughes rig count. Our gross profit for the year ended December 31, 2002 was $3.3 million, or 18.9% of revenues, compared to $1.5 million, or 31.2% of revenues for the year ended December 31, 2001, due to the acquisition of the casing and tubing services and directional drilling services segments in 2002 and a decreased gross margin in our compressed air drilling operation due to reduced revenues at Mountain Air. Our cost of revenues consists principally of our labor costs and benefits, equipment rentals, maintenance and repairs of our equipment, insurance and fuel. General and administrative expense was $3.8 million, or 21.1% of revenues in 2002, compared with $2.9 million, or 60.4% of revenues in 2001. The general and administrative expenses increased in absolute terms in 2002 compared to 2001 due to the acquisition of our casing and tubing services and directional drilling services segments in February 2002. In 2002 we reported a ($1.2) million loss from operations compared to a loss from operations of ($1.4) million in 2001. The loss from operations in 2002 includes the restructuring and other one-time charges totaling $728,000. Interest expense in 2002 was $2.3 million, compared to $869,000 in 2001, due to the increase in debt associated with the acquisitions of our casing and tubing services and directional drilling services operations. We incurred a net loss attributed to common stockholders of ($4.3 million), or ($0.23) per common share, for the year ended December 31, 2002 compared with a loss of ($4.6 million), or ($1.15) per common share, for the year ended December 31, 2001. The net loss for 2002 included a discount given to the holder of the Houston Dynamic Services note in the amount of $191,000 as an incentive to pay-off the note in September 2002. The net loss in 2001 included a ($2.0 million) loss from the sale of discontinued operations. PRO FORMA RESULTS The following unaudited pro forma consolidated summary financial information illustrates the effects of the acquisitions of Jens', Strata and Mountain Air and the merger with OilQuip on the Company's results of operations, based on the historical statements of operations, as if the transactions had occurred as of the beginning of the periods presented. The discontinued HDS operations are not included in the pro forma information. Pro forma results of operations set forth below includes results of operations for all of 2002 and 2001. These financial statements should be read in conjunction with the pro forma financial statements included herein. Pro forma sales for the year 2002 totaled $19,142,000, reflecting the revenue of Mountain Air, Jens' and Strata. In the comparable period of 2001, pro forma sales were $28,244,000. Pro forma revenues for the year ended December 31, 2002 for the Casing Services, Directional Drilling Services, and Compressed Air Drilling Services segments were $8,500,000, $6,977,000 and $3,665,000, respectively. Pro forma revenues for the year ended December 31, 2001 for the Casing Services, Directional Drilling Services and Compressed Air Drilling Services segments were $9,949,000, $12,986,000 and $5,289,000, respectively. The decrease in 2002 compared to 2001 was primarily due to lower revenues resulting from the overall downturn in the petroleum industry. Revenues for Casing Services, Directional Drilling Services and Compressed Air Drilling Services declined 15%, 47% and 31% in 2002 compared to 2001. 10 Pro forma gross margin, as a percentage of sales, was 18.4% for the year ended December 31, 2002 compared with a pro forma gross margin of 33.8 % for the year ended December 31, 2001. The gross margin ratio declined as a result of the Jens' and Strata acquisitions in 2002 and lower gross margin ratios at Mountain Air resulting from lower revenues. Pro forma general and administrative expense was $3,040,000 in 2002 compared with $4,719,000 in 2001. The pro forma general and administrative expense decreased in 2002 due to cost reductions at Strata and Corporate. The Company had pro forma operating (loss) for the year 2002 of ($401,000) as compared to pro forma operating income of $4,089,000 in 2001. Pro forma operating income (loss) for the year ended December 31, 2002 for the Casing Services, Directional Drilling Services, Compressed Air Drilling Services and General Corporate segments were $2,756,000, ($584,000), ($795,000) and ($1,778,000), respectively. The pro forma operating income for the year ended December 31, 2001 for the Casing Services, Directional Drilling Services, Compressed Air Drilling Services and General Corporate segments were $3,954,000, $1,420,000, $581,000 and ($1,866,000), respectively. The decrease in pro forma operating income for 2002 was primarily due to lower revenues resulting from the overall downturn in the petroleum industry. The Company incurred a pro forma net loss of ($4,431,000), or ($0.24) per common share, for the year ended December 31, 2002 compared with a pro forma net loss of ($71,000), or ($0.02) per common share, for the year ended December 31 2001. The pro forma net loss for 2002 included a factoring discount given to the holder of the HDS note in the amount of $191,000 as an incentive to pay-off the note by September 30, 2002. During the third quarter of 2002, the Company reorganized itself in order to contain costs and recorded charges related to the reorganization in the amount of $495,000. These charges consisted of related payroll costs for terminated employees of $307,000, consulting fees of $113,000, and costs associated with a terminated rent obligation of $75,000. The Company also recorded one-time charges for costs related to an abandoned acquisitions and an abandoned private placement in the amount of $233,000. LIQUIDITY AND CAPITAL RESOURCES Our on-going capital requirements arise primarily from our need to service our debt and retire redeemable securities, to acquire and maintain equipment, for working capital and for acquisitions. Our primary sources of liquidity are borrowings under our revolving lines of credit, proceeds from the issuance of equity securities and cash flows from operations. We had cash and cash equivalents of $1.3 million at December 31, 2003 and compared to $146,000 at December 31, 2002. OPERATING ACTIVITIES For the 12 months ended December 31, 2003, we generated $1.9 million in cash from operating activities compared to $2.2 million in cash from operating activities for the same period in 2002. Net income for the 2003 period improved to $2.9 million, compared to a net loss of ($4.0 million) in the comparable 2002 period, due to the increase in revenues and gross profit in 2003 due to the general increase in oil and gas drilling activity and the inclusion of AirComp, our compressed air drilling subsidiary in July 2003. Net income for 2003 also includes a $1.0 million gain from the settlement of a lawsuit and a $2.4 million gain on sale of interest in AirComp. Non-cash adjustments to net income totaled $305,000 in 2003 net of $3.4 million of non-cash gains, including the $1.0 million non-cash gain from the settlement of a lawsuit, compared to $3.4 million of non-cash gains in 2002, consisting principally of depreciation and amortization expense, including amortization of discount on debt, and minority interest in the income of a subsidiary. 11 During the 12 months ended December 31, 2003, changes in working capital used $1.3 million in cash compared to changes in working capital, which provided $2.8 million in cash in the 2002 period, principally due, in 2003, to an increase in accrued expenses of $1.7 million, an increase in accounts receivable and other current assets of $5.6 million, and an increase in accounts payable of $2.2 million. The increase in accrued expenses is due to a decrease in accrued interest of $126,000 due to the retirement of the subordinated debt carrying an interest rate of 12% and lower interest rates on other debt with variable interest rates, an increase in accrued expenses of $397,000 due to accrued motor costs and related expenses, and an increase in accrued employee benefits and payroll taxes of $1.3 million due to the payroll cycle ending at December 31, 2003. Accounts receivable increased $4.4 million due to increased revenues in our directional drilling services segment, compressed air drilling services segment from the inclusion of the business contributed by M-I to AirComp in July 2003, and our casing and tubing services segment. Other current assets decreased primarily because of the recovery of a lease deposit related to an equipment lease, which was paid off in June 2003. Accounts payable increased by $2.3 million in the 2003 period due to increased costs related to increased revenues, and the inclusion of the accounts payable of AirComp in July 2003. INVESTING ACTIVITIES During the 12 month period ended December 31, 2003, we used $4.5 million in investing activities, consisting of the purchases of equipment of $5.4 million, which was partially offset by the proceeds from the sales of equipment of $843,000. This compares to net cash used in investing activities in the comparable 2002 period of $8.5 million, due to the acquisitions of our Jens' and Strata subsidiaries for a total of $8.3 million, purchases of other equipment of $518,000, and proceeds from the sales of equipment of $367,000. FINANCING ACTIVITIES During the year ended December 31, 2003 financing activities provided a net of $3.8 million in cash compared to a net of $6.3 million in cash from financing activities in the prior year. In 2003, we received $14.1 million from the issuance of long-term debt and $30.5 million from borrowings under our lines of credit. These proceeds were used to pay long-term debt in the amount of $10.8 million and make principal payments on outstanding borrowings under our lines of credit in the amount of $29.4 million. We also used $408,000 in cash for debt issuance costs in 2003. In 2002, we received $9.7 million from the issuance of long-term debt and $7.1 million from borrowings under our lines of credit. These proceeds were used to pay long-term debt in the amount of $4.1 million and make principal payments on outstanding borrowings under our lines of credit in the amount of $5.8 million. We also used $588,000 in cash for debt issuance costs in 2002. We have several bank credit facilities and other debt instruments at Allis-Chalmers and at our three operating subsidiaries. Allis-Chalmers guarantees the loans owed by Jens' and Strata, and Mountain Compressed Air, a wholly-owned subsidiary, guarantees AirComp's bank debt. All three of our subsidiaries are consolidated on our financial statements. At December 31, 2003, we had $32.2 million in outstanding indebtedness, of which $28.2 million was long-term debt and $4.0 million was the current portion of long-term debt. Through Jens', our casing and tubing services subsidiary, at December 31, 2003, we had two principal bank facilities. We had a term loan in the original amount of $4.0 million that was increased, in October 2003, to $5.1 million. We were required to make monthly principal payments of $85,000 plus 25% of our collections from our operations in Mexico. Interest accrued at a floating rate plus a margin. The interest rate on the term loan was 6.00% at December 31, 2003 and the outstanding amount was $3.0 million. We also had a $1.0 million bank line of credit of which $26,000 was outstanding at December 31, 2003. Interest accrued at a floating rate plus a margin. The interest rate on the line of credit was 7.00% at December 31, 2003. We paid a 0.5% per annum fee on the undrawn portion of the line of credit. Our Jens' subsidiary also has a note payable to Jens Mortensen, who sold Jens' to us and is a director and the President of Jens'. The note is in the original amount of $4.0 million at 7.5% simple interest with quarterly interest payments. At December 31, 2003, $533,000 of interest was accrued and was included in accounts payable to related parties. The principal and interest are due on January 31, 2006. In connection with the purchase of Jens', we also agreed to pay a total of $1.2 million to Mr. Mortensen in exchange for a non-compete agreement. We are required to make monthly payments of $20,576 through January 31, 2007. As of December 31, 2003, the balance due is approximately $761,000, including $247,000 classified as short-term. 12 Jens' also had outstanding two term loans at December 31, 2003. One was a real estate bank loan in the amount of $532,000 at a floating interest rate with monthly principal payments of $14,778 plus interest. The interest rate was 6.00% at December 31, 2003 and the outstanding amount due was $207,000. The second loan is a bank loan in the original amount of $397,080 at a floating interest rate with monthly principal payments of $11,000 plus interest. At December 31, 2003 the interest rate was 6.00% and the balance due was $354,000. The final maturity date of the loan is September 17, 2006. Through Strata, our directional drilling services operating subsidiary, we had a $2.5 million bank line of credit of which $2.4 million was outstanding at December 31, 2003. The interest rate was 7.00% at December 31, 2003 and we paid a 0.5% per annum fee on the undrawn portion of the line of credit. In December 2003, Strata entered into a short-term vendor financing agreement in the original amount of $1.7 million with a major supplier for drilling motor rentals, motor lease costs and motor repair costs. The agreement provides for repayment of all amounts not later than December 31, 2005. Payment of interest is due monthly and principal payments of $582,000 are due in each of October 2004, April 2005, and December 2005. The interest rate is fixed at 8.0%. As of December 31, 2003 the outstanding balance was $1.7 million. AirComp had the following facilities at December 31, 2003: * A $1.0 million bank line of credit of which $369,000 was outstanding at December 31, 2003. Interest accrues at a floating rate plus a margin and was 6.25% at December 31, 2003. We paid a 0.5% per annum fee on the undrawn portion. Borrowings under the line of credit were subject to a borrowing base consisting of eligible accounts receivable. * A term loan in the original amount of $8.0 million with a floating interest rate based on either prime or the London interbank offered rate ("LIBOR") plus a margin. The interest rate averaged 4.09% at December 31, 2003. Principal payments of $286,000 were due quarterly, plus interest, with a final maturity date of June 27, 2007. The remaining balance at December 31, 2003. was $7.4 million. * A "delayed draw" term loan facility in the amount of $1.0 million to be used for capital expenditures. Interest accrues at a rate equal to LIBOR plus a margin. Quarterly principal payments commence on March 31, 2005 in an amount equal to 5.0% of the outstanding balance as of December 31, 2004. AirComp had not yet drawn on this facility as of December 31, 2003. The AirComp credit facilities are secured by liens on substantially all of AirComp's assets. The agreement governing these credit facilities contains customary events of default and requires that AirComp satisfy various financial covenants. It also limits AirComp's ability to incur additional indebtedness, make capital expenditures, pay dividends or make other distributions, create liens, and sell assets. Mountain Compressed Air guaranteed the obligations of AirComp under these facilities. AirComp also has a subordinated note payable to M-I in the amount of $4.8 million bearing interest at an annual rate of 5.0%. In 2007 each party has the right to cause AirComp to sell its assets (or the other party may buy out such party's interest), and in such event this note (including accrued interest) is due and payable. The note is also due and payable if M-I sells its interest in AirComp or upon a termination of AirComp. At December 31, 2003, $120,000 of interest was included in accrued interest. Neither the Company nor Mountain Compressed Air is liable for the obligations of AirComp under this note. The Company has a subordinated note in the original amount of $3.0 million with a fixed interest rate of 12.0%. The outstanding balance was $2.7 million at December 31, 2003. In connection with this note, we issued redeemable warrants, which were recorded as a liability of $900,000 and as a discount to the face amount of the debt. This amount is amortized as additional interest expense over the term of the note. The debt was recorded at $2.7 million net of unamortized portion of the put obligation. 13 In connection with the issuance of the $3.0 million subordinated note, we issued redeemable warrants that are exercisable for up to 233,000 shares of our common stock at an exercise price of $0.75 per share and non-redeemable warrants that are exercisable for a maximum of 67,000 shares of our common stock at $5.00 per share. The warrants were exercisable for $0.75 per share are subject to cash redemption provisions in the amount of $900,000 at the discretion of the warrant holders at any time after January 31, 2005. We recorded a liability of $900,000 in respect of the warrant redemption rights, and amortize the effects of the puts to interest expense over the life of the $3.0 million subordinated debt. In 1999 we compensated directors who served on the board of directors from 1989 to March 31, 1999 without compensation by issuing promissory notes totaling $325,000. The notes bear interest at the rate of 5.0% and are due on March 28, 2005. At December 31, 2003, the principal and accrued interest on these notes totaled approximately $386,000. As part of the acquisition of Mountain Air in 2001, we issued a note to the sellers of Mountain Air in the original amount of $2.2 million at 5.75% simple interest which was reduced to $1.5 million as a result of the settlement of a legal action against the sellers. At December 31, 2003 the outstanding amount due, including accrued interest, was $1.5 million. Mountain Air has a term loan in the original amount of $267,000 at an interest rate of 5.0%, with principal and interest payments of $5,039 due on the last day of each month. At December 31, 2003, the outstanding amount due was $247,000 and the final maturity date is June 30, 2008. In connection with incurring subordinated debt that was subsequently extinguished in connection with the formation of AirComp, Mountain Air issued redeemable warrants, which have been recorded as a liability of $600,000. The following table summarizes the Company's obligations and commitments to make future payments under its notes payable, operating leases, employment contracts and consulting agreements for the periods specified as of December 31, 2003. PAYMENTS BY PERIOD (IN THOUSANDS) AFTER TOTAL 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS -------------- -------------- ------------- ------------ ------------- CONTRACTUAL OBLIGATIONS Notes Payable $ 32,233 $ 3,992 $ 14,998 $ 10,434 $ -- Interest Payments on notes payable 2,088 431 973 684 -- Operating Lease 814 318 323 173 -- Employment Contracts 760 750 -- -- -- -------------- -------------- ------------- ------------ ------------- Total Contractual Cash Obligations $ 35,885 $ 8,299 $ 16,249 $ 11,291 $ -- ============== ============== ============= ============ ============= We have no off balance sheet arrangements that have or are likely to have a current or future effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. We do not guarantee obligations of any unconsolidated entities. 14 We intend to implement a growth strategy of increasing the scope of services through both internal growth and acquisitions. We are regularly involved in discussions with a number of potential acquisition candidates. We expect to make capital expenditures to acquire and to maintain our existing equipment. Our performance and cash flow from operations will be determined by the demand for our services, which, in turn, are affected by our customers' expenditures for oil and gas exploration and development and industry perceptions and expectations of future oil and gas prices in the areas where we operate. We will need to refinance our existing debt facilities as they become due and provide funds for capital expenditures and acquisitions. To effect our expansion plans, we will require additional equity or debt financing in excess of our current working capital and amounts available under credit facilities. There can be no assurance that we will be successful in raising the additional debt or equity capital or that we can do so on terms that will be acceptable to us. CRITICAL ACCOUNTING POLICIES ---------------------------- We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 in the Notes to the Consolidated Financial Statements included elsewhere in this Report. Our preparation of this report requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS. The determination of the collectibility of amounts due from our customers requires us to use estimates and make judgments regarding future events and trends, including monitoring our customer payment history and current credit worthiness to determine that collectibility is reasonably assured, as well as consideration of the overall business climate in which our customers operate. Those uncertainties require us to make frequent judgments and estimates regarding our customers' ability to pay amounts due us in order to determine the appropriate amount of valuation allowances required for doubtful accounts. Provisions for doubtful accounts are recorded when it becomes evident that the customers will not be able to make the required payments at either contractual due dates or in the future. Over the past two years, reserves for doubtful accounts, as a percentage of total accounts receivable before reserves, have ranged from 1% to 2%. At December 31, 2003 and 2002, reserves for doubtful accounts totaled $168,000, or 2%, and $32,000, or 1%, of total accounts receivable before reserves, respectively. We believe that our reserve for doubtful accounts is adequate to cover anticipated losses under current conditions; however, changes in the financial condition of our customers could impact the amount of provisions for doubtful accounts. REVENUE RECOGNITION. Our revenue recognition policy is significant because revenue is a key component of the results of operations. In addition, revenue recognition determines the timing of certain expenses, such as commissions and royalties. We provide rental equipment and drilling services to our customers at per day and per job contractual rates and recognize the drilling related revenue as the work progresses and when collectibility is reasonably assured. The Securities and Exchange Commission's (SEC) Staff Accounting Bulletin (SAB) No. 104, REVENUE RECOGNITION IN FINANCIAL STATEMENTS ("SAB No. 104"), provides guidance on the SEC staff's views on application of generally accepted accounting principles to selected revenue recognition issues. Our revenue recognition policy is in accordance with generally accepted accounting principles and SAB No. 104. IMPAIRMENT OF LONG-LIVED ASSETS. Long-lived assets, which include property, plant and equipment, goodwill and other intangibles, comprise a significant amount of the Company's total assets. The Company makes judgments and estimates in conjunction with the carrying value of these assets, including amounts to be capitalized, depreciation and amortization methods and useful lives. Additionally, the carrying values of these assets are reviewed for impairment or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. An impairment loss is recorded in the period in which it is determined that the carrying amount is not recoverable. This requires the Company to make long-term forecasts of its future revenues and costs related to the assets subject to review. These forecasts require assumptions about demand for the Company's products and services, future market conditions and technological developments. Significant and unanticipated changes to these assumptions could require a provision for impairment in a future period. 15 GOODWILL AND OTHER INTANGIBLES. The Company has recorded approximately $7,661000 of goodwill and $2,290000 of other identifiable intangible assets. The Company performs purchase price allocations to intangible assets when it makes a business combination. Business combinations and purchase price allocations have been consummated for purchase of the Mountain Air, Strata and Jens' operating segments. The excess of the purchase price after allocation of fair values to tangible assets is allocated to identifiable intangibles and thereafter to goodwill. Subsequently, the Company has performed its initial impairment tests and annual impairment tests in accordance with Financial Accounting Standards Board No. 141, BUSINESS COMBINATIONS, and Financial Accounting Standards Board No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. These initial valuations used two approaches to determine the carrying amount of the individual reporting units. The first approach is the Discounted Cash Flow Method, which focuses on the expected cash flow of the Company. In applying this approach, the cash flow available for distribution is projected for a finite period of years. Cash flow available for distribution is defined as the amount of cash that could be distributed as a dividend without impairing the future profitability or operation of the Company. The cash flow available for distribution and the terminal value (the value of the Company at the end of the estimation period) are then discounted to present value to derive an indication of value of the business enterprise. This valuation method is dependent upon the assumptions made regarding future cash flow and cash requirements. The second approach is the Guideline Company Method, which focuses on comparing the Company to selected reasonably similar publicly traded companies. Under this method, valuation multiples are: (i) derived from operating data of selected similar companies; (ii) evaluated and adjusted based on the strengths and weaknesses of the Company relative to the selected guideline companies; and (iii) applied to the operating data of the Company to arrive at an indication of value. This valuation method is dependent upon the assumption that the value of the Company can be evaluated by analysis of its earnings and its strengths and weaknesses relative to the selected similar companies. Significant and unanticipated changes to these assumptions could require a provision for impairment in a future period. AIRCOMP AND SALE OF INTEREST IN VENTURE. The Company has adopted SEC Staff Accounting Bulletin (SAB) No. 51, Accounting for Sales of Stock by a Subsidiary, to account for its investment in AirComp. AirComp operates in a manner similar to a joint venture but has been accounted for and consolidated as a subsidiary under SFAS No. 141, BUSINESS COMBINATIONS. Pursuant to SAB No. 51, the Company has recorded its own contribution of assets and liabilities at its historical cost basis. Since liabilities exceeded assets, the Company's basis in AirComp was a negative amount. The Company has accounted for the assets contributed from M-I at a fair market value as determined by an outside appraiser. The Company gave M-I a 45% interest in AirComp in exchange for the assets contributed. As a result of the formation of the venture and its retention of 55% interest in the venture, the Company realized an immediate gain to the extent of its negative basis and its 55% interest in the combined assets and liabilities of the venture. In accordance with SAB No. 51, the Company has recorded its negative basis investment in AirComp as an addition to equity and its share of the combined assets and liabilities realized from M-I assets as non-operating income. STOCK BASED COMPENSATION. The Company accounts for its stock-based compensation using Accounting Principles Board's Opinion No. 25 ("APB No. 25"). Under APB No. 25, compensation expense is recognized for stock options with an exercise price that is less than the market price on the grant date of the option. For stock options with exercise prices at or above the market value of the stock on the grant date, the Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION ("SFAS 123"). The Company has adopted the disclosure-only provisions of SFAS 123 for the stock options granted to the employees and directors of the Company. Accordingly, no compensation cost has been recognized for these options. Many equity instrument transactions are valued based on pricing models such as Black-Scholes, which require judgments by management. Values for such transactions can vary widely and are often material to the financial statements. Quantitative and Qualitative Disclosure About Market Risk. ---------------------------------------------------------- We are exposed to market risk primarily from changes in interest rates and foreign currency exchange risks. 16 INTEREST RATE RISK. Fluctuations in the general level of interest rates on our current and future fixed and variable rate debt obligations expose us to market risk. We are vulnerable to significant fluctuations in interest rates on our variable rate debt and on any future repricing or refinancing of our fixed rate debt and on future debt. At December 31, 2003 we were exposed to interest rate fluctuations on approximately $32.2 million of notes payable and bank credit facility borrowings carrying variable interest rates. A hypothetical one hundred basis point increase in interest rates for these notes payable would increase our annual interest expense by approximately $332,000. Due to the uncertainty of fluctuations in interest rates and the specific actions that might be taken by us to mitigate the impact of such fluctuations and their possible effects, the foregoing sensitivity analysis assumes no changes in our financial structure. We have also been subject to interest rate market risk for short-term invested cash and cash equivalents. The principal of such invested funds would not be subject to fluctuating value because of their highly liquid short-term nature. FOREIGN CURRENCY EXCHANGE RATE RISK. We conduct business in Mexico through our Mexican partner, Matyep. This business exposes us to foreign exchange risk. To control this risk, we provide for payment in U.S. dollars. However, we have historically provided our partner a discount upon payment equal to 50% of any loss suffered by our partner as a result of devaluation of the Mexican peso between the date of invoicing and the date of payment. During 2003 and 2002 the discounts have not exceeded $10,000 per year. Failure to Maintain Effective Internal Controls Could Have a Material Adverse Effect on Our Operations. ----------------------------------------------------------------------------- We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Auditors addressing these assessments. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly. RECENT DEVELOPMENTS On April 2, 2004, the Company entered into the following transactions: o In exchange for an investment of $2 million, the Company issued 3,100,000 shares of common stock for a purchase price equal to $0.50 per share, and warrants to purchase 4,000,000 shares of common stock at an exercise price of $0.50 per share, expiring on April 1, 2006, to an investor group (the "Investor Group") consisting of entities affiliated with Donald and Christopher Engel and directors Robert Nederlander and Leonard Toboroff. The aggregate purchase price for the common stock was $1,550,000, and the aggregate purchase price for the warrants was $450,000. o Energy Spectrum converted its 3,500,000 shares of Series A 10% Cumulative Convertible Preferred Stock, including accrued dividend rights, into 8,590,449 shares of common stock. 17 o The Company, the Investor Group, Energy Spectrum, and director Saeed Sheikh, and officers and directors Munawar H. Hidayatallah and Jens H. Mortensen entered into a stockholders agreement pursuant to which the parties have agreed to vote for the election to the board of directors of the Company three persons nominated by Energy Spectrum, two persons nominated by the Investor Group and one person nominated by Messrs. Hidayatallah, Mortensen and Sheikh. In addition, the parties and the Company agreed that in the event the Company has not effected a public offering of its shares prior to September 30, 2005, then, at the request of Energy Spectrum, the Company will retain an investment banking firm to identify candidates for a transaction involving the sale of the Company or its assets. o Wells Fargo Credit, Inc. and Wells Fargo Energy Capital, Inc. extended the maturity dates for certain obligations (which at December 31, 2003, aggregated approximately $9,768,000) from January and February of 2005 to January and February 2006. As a condition of the extension, the Company will make a $400,000 initial payment and 24 monthly principal payments in the amount of $25,000 each to Wells Fargo Energy Capital, Inc. As part of the extension, the lenders waived certain defaults including defaults relating to the failure of Jens' and Strata to comply with certain covenants relating to the amount of their capital expenditures, and amended certain covenants set forth in the loan agreements on an on-going basis. In addition, Wells Fargo Credit, Inc. increased Strata's line of credit from $2.5 million to $4.0 million. As a result of the foregoing transactions, the parties to the stockholders agreement own 86.4% of the outstanding common stock of the Company, calculated in accordance with Rule 13d-3 of the Securities and Exchange Commission. The proceeds of the sale of the common stock and warrants will be used by the Company to reduce debt, to fund potential acquisitions and for general corporate purposes. RISK FACTORS This Annual Report on Form 10-K (including without limitation the following Risk Factors) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934) regarding our business, financial condition, results of operations and prospects. Words such as expects, anticipates, intends, plans, believes, seeks, estimates and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report on Form 10-K. Although forward-looking statements in this Annual Report on Form 10-K reflect the good faith judgment of our management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below and elsewhere in this Annual Report on Form 10-K and in our other SEC filings and publicly available documents. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Annual Report on Form 10-K. Low prices for oil and natural gas will adversely affect the demand for our --------------------------------------------------------------------------- services and products. ---------------------- The oil and natural gas exploration and drilling business is highly cyclical. As market prices decrease, exploration and drilling activity declines as marginally profitable projects become uneconomic and either are delayed or eliminated. A decline in the number of operating oil and natural gas rigs would adversely affect our business. Accordingly, when oil and natural gas prices are relatively low, our revenues and income will suffer. The oil and gas industry is extremely volatile and subject to change based on political and economic factors outside our control. 18 We are Highly Leveraged. ------------------------ As a result of acquisition financing, we are highly leveraged. At December 31, 2003, and April 1, 2004, we had approximately $32,233,000 and $30,903,000, respectively, of debt outstanding. Our high level of debt will impair our ability to obtain additional financing, makes us more vulnerable to economic downturns and declines in oil and natural gas prices, makes us more vulnerable to increases in interest rates. We may not maintain sufficient revenues to meet our debt obligations. Even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis in the future. To service our indebtedness, we will require a significant amount of cash. Our ------------------------------------------------------------------------------ ability to generate cash depends on many factors beyond our control. -------------------------------------------------------------------- Our ability to fund operations, to make payments on or refinance our indebtedness, and to fund planned acquisitions and capital expenditures will depend on our ability to generate cash in the future. This ability, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our failure to obtain additional financing may adversely affect us. ------------------------------------------------------------------- Expansion of our operations through the acquisition of additional companies will require substantial amounts of capital. In addition, we are required to refinance our existing debt upon its maturity. The availability of financing may affect our ability to refinance our debt or to expand. There can be no assurance that such funds, whether from equity or debt financings or other sources, will be available or, if available, will be on terms satisfactory to us. We may also enter into strategic partnerships for the purpose of developing new businesses. Our future growth may be limited if we are unable to complete acquisitions or strategic partnerships. We may have difficulties integrating acquired businesses. --------------------------------------------------------- We may not be able to successfully integrate the business of our operating subsidiaries or any business we acquire in the future. The integration of the businesses will be complex and time consuming and may disrupt our future business. We may encounter substantial difficulties, costs and delays involved in integrating common information and communication systems, operating procedures, financial controls and human resources practices, including incompatibility of business cultures and the loss of key employees and customers. The various risks associated with our acquisition of businesses and uncertainties regarding the profitability of such operations could have a material adverse effect on us. Our success is dependent upon our ability to acquire and integrate additional ----------------------------------------------------------------------------- businesses. ----------- Our business strategy is to acquire companies operating in the oil and natural gas equipment rental and services industry. However, there can be no assurance that we will be successful in acquiring any additional companies. Our successful acquisition of new companies will depend on various factors, including our ability to obtain financing, the competitive environment for acquisitions, as well as the integration issues described in the preceding paragraph. There can be no assurance that we will be able to acquire and successfully operate any particular business or that we will be able to expand into areas that we have targeted. We may not experience expected synergies. ----------------------------------------- We may not be able to achieve the synergies we expect from the combination of businesses, including our plans to reduce overhead through shared facilities and systems, to cross-market to the business' customers, and to access a larger pool of customers due to the combined businesses' ability to provide a larger range of services. 19 There is no trading market for our common stock. ------------------------------------------------ Our common stock is not registered on any exchange or NASDAQ and is traded only sporadically on the Over the Counter Bulletin Board. On March 15, 2004, we filed an application to list the common stock on the American Stock Exchange. However, approval of the listing of the common stock is subject to numerous conditions, including that we effect a reverse stock split resulting in an increase in our per share price to at least $3.00 per share, and meet certain other quantitative and qualitative standards. While the stockholders and board of directors have approved a future reverse stock split (see "Item 4 - Submission of Matters to a Vote of Security Holders"), there can be no assurance that we will meet the listing requirements of the American Stock Exchange or any other exchange. There can be no assurance that an active market for our common stock will develop in the future. We do not expect to pay dividends on our common stock. ------------------------------------------------------ We have not within the last ten years paid, and have no intentions in the foreseeable future to pay, any cash dividends on our common stock. Therefore an investor in our common stock, in all likelihood, will realize a profit on his investment only if the market price of our common stock increases in value. Existing stockholders may be diluted in connection with additional financings. ------------------------------------------------------------------------------ We expect to issue additional equity securities to repay debt, in connection with the acquisition of additional businesses, as well as in connection with employee benefit plans and other plans. Such issuances will dilute the holdings of existing stockholders. Such securities may have a dividend, liquidation, or other preferences or may be on parity with our common stock. Competition could cause our business to suffer. ----------------------------------------------- The natural gas equipment rental and services industry is highly competitive, and a number of individual and regional operators compete with us throughout our existing and targeted markets. Some of our competitors are significantly larger and have greater financial, technological and operating resources than we do. These competitors compete with us both for customers and for acquisitions of other businesses. This competition may cause our business to suffer. Our products and services may become obsolete. ---------------------------------------------- Our business success is dependent upon providing our customers efficient, cost-effective oil and gas drilling equipment and technology. It is possible that competing technologies may render our equipment and technologies obsolete, and have a material adverse effect on us. Our historical results are not an indicator of future operations. ----------------------------------------------------------------- Our business is conducted through three subsidiaries, one of which was acquired in February 2001 and two of which were acquired in February 2002. As a result, past performance is not indicative of future results and our likelihood of success must be considered in light of the volatility of our industry, our leveraged condition, competition, and other factors set forth herein. We are controlled by a few stockholders. ---------------------------------------- A small number of stockholders effectively control us. As discussed in "Management's Discussion and Analysis of Results of Operation and Financial Condition - Recent Developments," Energy Spectrum, the Investor Group, our Chief Executive Officer and Chairman Munawar H. Hidayatallah, our President and director Jens H. Mortensen, and director Saeed M. Sheikh are parties to a stockholders agreement which includes provision for the election of six directors to our board of directors. This group of stockholders beneficially owns approximately 86.4% of our common stock. This group thus has the power to elect a majority of the Board of Directors of the Company, and to control its affairs. 20 Dependence upon key personnel. ------------------------------ We are dependent upon the efforts and skills of our executives, including our Chief Executive Officer and Chairman Munawar H. Hidayatallah, our President and Chief Operating Officer Jens H. Mortensen, and President and Chief Executive Officer of Strata, David Wilde, to manage our business as well as to identify and consummate additional acquisitions. In addition, our business strategy is to acquire businesses, which are dependent upon skilled management personnel, and to retain such personnel to operate the business. The loss of the services of Mr. Hidayatallah or one or more of our key personnel at our operating subsidiaries could have a material adverse effect on us. We do not maintain key man insurance on any of our personnel. In addition, our development and expansion will require additional experienced management and operations personnel. No assurance can be given that we will be able to identify and retain such employees. Our customers' credit risks could cause our business to suffer. --------------------------------------------------------------- Our customers are engaged in the oil and natural gas drilling business in the southwestern United States and Mexico. This concentration of customers may impact our overall exposure to credit risk, in that customers may be similarly affected by changes in economic and industry conditions. We are vulnerable to personal injury and property damage. --------------------------------------------------------- Our services are used for the exploration and production of oil and natural gas. These operations are subject to inherent hazards that can cause personal injury or loss of life, damage to or destruction of property, equipment, the environment and marine life, and suspension of operations. Litigation arising from an accident at a location where our products or services are used or provided may result in our being named as a defendant in lawsuits asserting potentially large claims. We maintain customary insurance to protect our business against these potential losses. However, we could become subject to material uninsured liabilities. Government regulations could cause our business to suffer. ---------------------------------------------------------- We are subject to various federal, state and local laws and regulations relating to the energy industry in general and the environment in particular. Environmental laws have in recent years become more stringent and have generally sought to impose greater liability on a larger number of potentially responsible parties. Although we are not aware of any proposed material changes in any such statutes, rules or regulations, any changes could cause our business to suffer. Labor costs or the unavailability of skilled workers could cause our business to -------------------------------------------------------------------------------- suffer. ------- We are dependent upon the available labor pool of skilled employees. We are also subject to the Fair Labor Standards Act, which governs such matters as a minimum wage, overtime and other working conditions. A shortage in the labor pool or other general inflationary pressures or changes in applicable laws and regulations could require us to enhance our wage and benefits packages. There can be no assurance that our labor costs will not increase. Any increase in our operating costs could cause our business to suffer. We may be subject to certain environmental liabilities relating to discontinued ------------------------------------------------------------------------------- operations. ----------- We were reorganized under the bankruptcy laws in 1988; since that time, a number of parties, including the Environmental Protection Agency (the "EPA"), have asserted that we are responsible for the cleanup of hazardous waste sites. These assertions have been made only with respect to our pre-bankruptcy activities. We believe such claims are barred by applicable bankruptcy law; however, if we do not prevail with respect to these claims, we could become subject to material environmental liabilities. 21 We may be subject to certain products liability claims. ------------------------------------------------------- We were reorganized under the bankruptcy laws in 1988; since that time we have been regularly named in products liability lawsuits primarily resulting from our manufacture of products containing asbestos. In connection with our bankruptcy, a special products liability trust was established to be responsible for such claims. We believe that claims against Allis-Chalmers Corporation are banned by applicable bankruptcy law, and that the Products Liability Trust will continue to be responsible for these claims, and since 1988 no court has ruled that we are responsible for such claims. However, if the products liability trust were terminated and its funds disbursed, or we were otherwise subject to product liability claims and did not prevail in our claim that our bankruptcy bars claims against us, we could become subject to material products liabilities related to our pre-bankruptcy activities. We have not manufactured products containing asbestos since our bankruptcy. 22 ITEM 8. FINANCIAL STATEMENTS. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ PAGE ---- INDEX TO FINANCIAL STATEMENTS Financial Statements: ALLIS CHALMERS CORPORATION Report of Independent Registered Public Accounting Firm F-3 Restated Consolidated Balance Sheets as of December 31, 2003 and 2002 F-4 Restated Consolidated Statements of Operations for the Years Ended December 31, 2003, December 31, 2002 and December 31, 2001 F-5 Restated Consolidated Statement of Stockholders' Equity for the Years Ended December 31, 2003, December 31, 2002 and December 31, 2001 F-6 Restated Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, December 31, 2002 and December 31, 2001 F-7 Notes to Restated Consolidated Financial Statements F-8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors Allis-Chalmers Corporation Houston, Texas We have audited the accompanying consolidated balance sheets of Allis-Chalmers Corporation. as of December 31, 2003 and 2002 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Allis-Chalmers Corporation. as of December 31, 2003 and 2002, and the results of consolidated operations and cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 2 to the consolidated financial statements, the Company restated the consolidated financial statements as of and for the year ended December 31, 2003. /S/ GORDON, HUGHES & BANKS, LLP ------------------------------- March 3, 2004, except as to Note 11 which date is June 10, 2004, Notes 17 and 19 which date is February 10, 2005 and Note 2 which date is August 5, 2005. Greenwood Village, Colorado F-3 ALLIS-CHALMERS CORPORATION. CONSOLIDATED BALANCE SHEETS (in thousands) SEE EXPLANATORY NOTE DECEMBER 31, 2003 2002 --------- --------- (Restated) ASSETS Cash and cash equivalents $ 1,299 $ 146 Trade receivables, net of allowance for doubtful accounts of $168 and $32 at December 31, 2003 and 2002, respectively 8,823 4,409 Lease Deposit -- 525 Lease receivable, current (Note 14) 180 180 Prepaid expenses and other 887 317 --------- --------- Total current assets 11,189 5,577 Property and equipment, net of accumulated depreciation of $2,586 and $2,340 at December 31, 2003 and 2002, respectively 31,128 17,124 Goodwill 7,661 7,661 Other intangible assets, net of accumulated amortization of $1,254, and $726 at December 31, 2003 and 2002, respectively 2,290 2,818 Debt issuance costs, net of accumulated amortization of $462, and $331 at December 31, 2003 and 2002, respectively 567 515 Lease receivable, less current portion (Note 14) 787 1,042 Other Assets 40 41 --------- --------- Total Assets $ 53,662 $ 34,778 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current maturities of long-term debt (Note 9) $ 3,992 $ 13,890 Trade accounts payable 3,133 2,106 Accrued salaries, benefits and payroll taxes 591 280 Accrued interest 152 811 Accrued expenses 1,761 1,506 Accounts payable, related parties (Note 15) 787 -- --------- --------- Total current liabilities 10,416 18,593 Accrued postretirement benefit obligations (Note 4) 545 670 Long-term debt, net of current maturities (Note 9) 28,241 7,331 Other long-term liabilities 270 270 Redeemable warrants (Notes 9 and 13) 1,500 1,500 Redeemable convertible preferred stock, $0.01 par value (4,200,000 shares authorized; 3,500,000 issued and outstanding at December 31, 2003) ($1 redemption value) including accrued dividends (Note 11) 4,171 3,821 --------- --------- Total liabilities 45,143 32,185 Commitments and Contingencies (Note 10 and Note 21) Minority interests 3,978 1,584 COMMON STOCKHOLDERS' EQUITY (NOTE 11) Common stock, $0.01 par value (10,000,000 shares authorized; 19,633,340 issue and outstanding) 2,945 2,945 Capital in excess of par value 7,842 7,237 Accumulated (deficit) (6,246) (9,173) --------- --------- Total stockholders' equity 4,541 1,009 --------- --------- Total liabilities and stockholders' equity $ 53,662 $ 34,778 ========= ========= The accompanying Notes are an integral part of the Financial Statements. F-4 ALLIS-CHALMERS CORPORATION. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31. (in thousands, except per share amounts) 2003 2002 2001 --------- --------- --------- (Restated) Revenues $ 32,724 $ 17,990 $ 4,796 Cost of revenues 24,029 14,640 3,331 --------- --------- --------- Gross margin 8,695 3,350 1,465 General and administrative expense 6,169 3,792 2,898 Personnel restructuring costs -- 495 -- Abandoned acquisition/private placement costs -- 233 -- --------- --------- --------- Total operating expenses 6,169 4,520 2,898 --------- --------- --------- Income/ (loss) from operations 2,526 (1,170) (1,433) Other income (expense): Interest income 3 49 41 Interest expense (2,467) (2,256) (869) Minority interests in income of subsidiaries (343) (189) -- Factoring costs on note receivable -- (191) -- Settlement on lawsuit 1,034 -- -- Gain on sale of interest in AirComp 2,433 -- -- Other 111 58 (12) --------- --------- --------- Total other income (expense) 771 (2,529) (840) --------- --------- --------- Net income/ (loss) before income taxes 3,297 (3,699) (2,273) Provision for foreign income tax (370) (270) -- --------- --------- --------- Net income/ (loss) from continuing operations 2,927 (3,969) (2,273) (Loss) from discontinued operations -- -- (291) (Loss) from sale of discontinued operations -- -- (2,013) --------- --------- --------- Net (loss) from discontinued operations -- -- (2,304) --------- --------- --------- Net income/ (loss) 2,927 (3,969) (4,577) Preferred stock dividend (656) (321) -- --------- --------- --------- Net income/ (loss) attributed to common stockholders $ 2,271 $ (4,290) $ (4,577) ========= ========= ========= Income/ (loss) per common share - basic Continued operations $ 0.12 $ (0.23) $ (0.57) Discontinued operations -- -- (0.58) --------- --------- --------- $ 0.12 $ (0.23) $ (1.15) ========= ========= ========= Income/ (loss) per common share - diluted Continued operations $ 0.10 $ (0.23) $ (0.57) Discontinued operations -- -- (0.58) --------- --------- --------- $ 0.10 $ (0.23) $ (1.15) ========= ========= ========= Weighted average number of common shares outstanding: Basic 19,633 18,831 3,952 ========= ========= ========= Diluted 29,248 18,831 3,952 ========= ========= ========= The accompanying Notes are an integral part of the Financial Statements. F-5 ALLIS-CHALMERS CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (In thousands, except number of shares) PREFERRED STOCK COMMON STOCK CAPITAL IN ------------------------ ------------------------ EXCESS OF ACCUMULATED SHARES AMOUNT SHARES AMOUNT PAR VALUE (DEFICIT) TOTAL ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balances, December 31, 2000 - - 400,000 60 2,915 (627) 2,348 Issuance of common stock in connection with Recapitalization - - 11,188,128 1,678 1,101 - 2,779 Issuance of stock options for services - - - - 500 - 500 Issuance of stock purchase warrants for services - - - - 200 - 200 Net (loss) - - - - - (4,577) (4,577) ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balances, December 31, 2001 - - 11,588,128 1,738 4,716 (5,204) 1,250 Issuance of common stock in connection with the purchase of Jens' - - 1,397,849 210 420 - 630 Issuance of stock purchase warrants in connection with the purchase of Jens' - - - - 47 - 47 Issuance of preferred and common stock in connection with the purchase of Strata 3,500,000 3,500 6,559,863 984 1,968 - 2,952 Issuance of stock purchase warrants in connection with the purchase of Strata - - - - 267 - 267 Issuance of common stock in connection with the purchase of Strata - - 87,500 13 140 - 153 Accrual of preferred dividends - 321 - - (321) - (321) Net (Loss) - - - - - (3,969) (3,969) ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balances, December 31, 2002 3,500,000 $ 3,821 19,633,340 $ 2,945 $ 7,237 $ (9,173) $ 1,009 Effect of Consolidation of AirComp 955 955 Accrual of preferred dividends - 350 - - (350) - (350) Net Income - - - - - 2,927 2,927 (Restated) ----------- ----------- ----------- ----------- ----------- ----------- ----------- Balances, December 31, 2003 3,500,000 $ 4,171 19,633,340 $ 2,945 $ 7,842 $ (6,246) $ 4,541 (Restated) =========== =========== =========== =========== =========== =========== =========== The accompanying Notes are an integral part of the Financial Statements. F-6 ALLIS-CHALMERS CORPORATION. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) YEARS ENDED DECEMBER 31, 2003 2002 2001 --------- --------- --------- (Restated) Cash flows from operating activities: Net income / (loss) $ 2,927 $ (3,969) $ (4,577) Adjustments to reconcile net income/(loss) to net cash provided by operating activities: Depreciation expense 2,052 1,837 621 Amortization expense 884 744 482 Issuance of stock options for services -- -- 500 Amortization of discount on debt 516 475 183 (Gain) on change in PBO liability (125) -- -- (Gain) on settlement of lawsuit (1,034) -- -- (Gain) on sale of interest in AirComp (2,433) -- -- Minority interest in income of subsidiaries 343 189 -- Loss on sale of property 82 119 -- Changes in working capital: Decrease (increase) in accounts receivable (4,414) (713) (511) Decrease (increase) in due from related party -- 61 43 Decrease (increase) in other current assets (1,260) 1,644 (139) Decrease (increase) in other assets 1 902 -- Decrease (increase) in lease deposit 525 176 -- (Decrease) increase in accounts payable 2,251 1,316 238 (Decrease) increase in accrued interest (126) 651 176 (Decrease) increase in accrued expenses 397 (339) 156 (Decrease) increase in other long-term liabilities -- (123) -- (Decrease) increase in accrued employee benefits and payroll taxes 1,293 (788) 463 Discontinued operations Loss on sale of HDS operations -- -- 2,013 Operating cash provided -- -- 381 Depreciation and amortization -- -- 124 --------- --------- --------- Net cash provided by operating activities 1,879 2,182 153 Cash flows from investing activities: Recapitalization, net of cash received -- -- (88) Business acquisition costs -- -- (141) Acquisition of MADSCO assets, net of cash acquired -- -- (9,534) Acquisition of Jens', net of cash acquired -- (8,120) -- Acquisition of Strata, net of cash acquired -- (179) -- Purchase of equipment (5,354) (518) (402) Proceeds from sale-leaseback of equipment, net of lease deposit -- -- 2,803 Proceeds from sale of equipment 843 367 45 --------- --------- --------- Net cash (used) by investing activities (4,511) (8,450) (7,317) Cash flows from financing activities: Proceeds from issuance of long-term debt 14,127 9,683 5,832 Payments on long-term debt (10,826) (4,079) (489) Payments on related party debt (246) -- -- Proceeds from issuance of common stock, net -- -- 1,838 Borrowings on lines of credit 30,537 7,050 375 Payments on lines of credit (29,399) (5,804) -- Debt issuance costs (408) (588) (244) --------- --------- --------- Net cash provided (used) by financing activities 3,785 6,262 7,312 --------- --------- --------- Net increase (decrease) in cash and cash equivalents 1,153 (6) 148 Cash and cash equivalents: Beginning of year 146 152 4 --------- --------- --------- End of year $ 1,299 $ 146 $ 152 ========= ========= ========= Supplemental information: Interest paid $ 2,341 $ 1,082 $ 802 ========= ========= ========= The accompanying Notes are an integral part of the Financial Statements. F-7 ALLIS-CHALMERS CORPORATION NOTES TO FINANCIAL STATEMENTS (RESTATED) FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 PLEASE NOTE THAT THESE FINANCIAL STATEMENTS AND THE NOTES THERETO DO NOT REFLECT EVENTS OCCURRING AFTER APRIL 14, 2004. FOR A DESCRIPTION OF THESE EVENTS, PLEASE READ OUR EXCHANGE ACT REPORTS FILED SINCE THE DATE OF THE ORIGINAL FILING. EXPLANATORY NOTE This Amendment No. 2 to the Company's Annual Report on Form 10-K for the year ended December 31, 2003 (the "Original Filing"), includes restatements related to our unaudited consolidated financial statements for the period ended December 31, 2003. The restatement is discussed in Note 2. NOTE 1 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION OF BUSINESS OilQuip Rentals, Inc., an oil and gas rental company ("OilQuip"), was incorporated on February 4, 2000 to find and acquire acquisition targets to operate as subsidiaries. On February 6, 2001, OilQuip, through its subsidiary, Mountain Compressed Air Inc. ("Mountain Air"), a Texas corporation, acquired certain assets of Mountain Air Drilling Service Co., Inc. ("MADSCO"), whose business consists of providing equipment and trained personnel in the four corner areas of the southwestern United States. Mountain Air primarily provides compressed air equipment and related products and services and trained operators to companies in the business of drilling for natural gas. On May 9, 2001, OilQuip merged into a subsidiary of Allis-Chalmers Corporation. ("Allis-Chalmers" or the "Company"). In the merger, all of OilQuip's outstanding common stock was converted into 10,000,000 shares of Allis-Chalmers' common stock. For legal purposes, Allis-Chalmers acquired OilQuip, the parent company of Mountain Air. However, for accounting purposes, OilQuip was treated as the acquiring company in a reverse acquisition of Allis-Chalmers. The financial statements prior to the merger are the financial statements of OilQuip. As a result of the merger, the fixed assets and other intangibles of Allis-Chalmers were increased by $2,691,000. On November 30, 2001, the Company entered into an agreement to sell its wholly-owned subsidiary, Houston Dynamic Service, Inc. ("HDS"), to the general manager of HDS in a management buy-out. The sale of HDS was finalized on December 12, 2001. In conjunction with the sale of HDS, the Company formally discontinued the operations segment related to precision machining of rotating equipment, which was the principal HDS business. On February 6, 2002, Allis-Chalmers acquired 81% of the outstanding stock of Jens' Oilfield Service, Inc. ("Jens'"), which supplies highly specialized equipment and operations to install casing and production tubing required to drill and complete oil and gas wells. The Company also purchased substantially all the outstanding common stock and preferred stock of Strata Directional Technology, Inc. ("Strata"), which provides high-end directional and horizontal drilling services for specific targeted reservoirs that cannot be reached vertically. In July 2003, through the subsidiary Mountain Air, the Company entered into a limited liability company operating agreement with a division of M-I L.L.C. ("M-I"), a joint venture between Smith International and Schlumberger N.V. (Schlumberger limited), to form a Texas limited liability company named AirComp LLC ("AirComp"). Both Companies contributed assets with a combined value of approximately $16.6 million to AirComp. The assets contributed by Mountain Air were recorded at Mountain Air's historical cost of $6.3 million, and the assets contributed by M-I was recorded at a fair market value of $10.3 million. The Company owns 55% and M-I owns 45% of AirComp. Because the Company controls AirComp, the Company has consolidated the joint venture's financial position and operations into those of the Company. VULNERABILITIES AND CONCENTRATIONS The Company provides oilfield services in several regions, including the states of California, Texas, Utah, Louisiana and New Mexico, the Gulf of Mexico and southern portions of Mexico. The nature of the Company's operations and the many regions in which it operates subject it to changing economic, regulatory and political conditions. The Company believes it is vulnerable to the risk of near-term and long-term severe changes in the demand for and prices of oil and natural gas. F-8 USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Future events and their effects cannot be perceived with certainty. Accordingly, the Company's accounting estimates require the exercise of judgment. While management believes that the estimates and assumptions used in the preparation of the consolidated financial statements are appropriate, actual results could differ from those estimates. Estimates are used for, but are not limited to, determining the following: allowance for doubtful accounts, recoverability of long-lived assets and intangibles, useful lives used in depreciation and amortization, income taxes and related valuation allowances. The accounting estimates used in the preparation of the consolidated financial statements may change as new events occur, as more experience is acquired, as additional information is obtained and as the Company's operating environment changes. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Allis-Chalmers and its subsidiaries and venture, AirComp. The Company's subsidiaries are Mountain Air, Jens', and Strata. All significant inter-company transactions have been eliminated. REVENUE RECOGNITION The Company's revenue recognition policy is significant because revenue is a key component of results of operations. In addition, revenue recognition determines the timing of certain expenses, such as commissions and royalties. The Company provides rental equipment and drilling services to its customers at per day and per job contractual rates and recognizes the drilling related revenue as the work progresses and when collectibility is reasonably assured. The Securities and Exchange Commission's (SEC) Staff Accounting Bulletin (SAB) No. 104, REVENUE RECOGNITION IN FINANCIAL STATEMENTS ("SAB No. 104"), provides guidance on the SEC staff's views on application of generally accepted accounting principles to selected revenue recognition issues. The Company's revenue recognition policy is in accordance with generally accepted accounting principles and SAB No. 104. ALLOWANCE FOR DOUBTFUL ACCOUNTS Accounts receivable are customer obligations due under normal trade terms. The Company sells its services to oil and natural gas drilling companies. The Company performs continuing credit evaluations of its customers' financial condition and although the Company generally does not require collateral, letters of credit may be required from customers in certain circumstances. The Company records an allowance for doubtful accounts based on specifically identified amounts that are uncollectible. The Company has a limited number of customers with individually large amounts due at any given balance sheet date. Any unanticipated change in any one of these customer's credit worthiness or other matters affecting the collectibility of amounts due from such customers could have a material effect on the results of operations in the period in which such changes or events occur. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. As of December 31, 2003 and 2002, the Company had recorded an allowance for doubtful accounts of $168,000 and $32,000, respectively. Bad debt expense was $136,000, $32,000 and $0 for the years ended December 31, 2003, 2002 and 2001, respectively. CASH EQUIVALENTS The Company considers all highly liquid investments with an original maturity of three months or less at the time of purchase to be cash equivalents. PROPERTY AND EQUIPMENT Property and equipment is recorded at cost less accumulated depreciation. Maintenance and repairs are charged to operations when incurred. Maintenance and repairs expense was $568,996, $631,939, and $126,436 for the years ended December 31, 2003, 2002 and 2001, respectively. Refurbishments and renewals are capitalized when the value of the equipment is enhanced for an extended period and the cost exceeds a minimum amount of $1,000. When property and equipment are sold or otherwise disposed of, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations. F-9 The cost of property and equipment currently in service is depreciated over the estimated useful lives of the related assets, which range from three to fifteen years. Depreciation is computed on the straight-line method for financial reporting purposes. Depreciation expense charged to operations was $2,052,000 for the year ended December 31, 2003, $1,837,000 for the year ended December 31, 2002, and $621,000 for the year ended December 31, 2001. GOODWILL, INTANGIBLE ASSETS AND AMORTIZATION On January 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS ("SFAS No. 142"). Goodwill, including goodwill associated with equity method investments, and intangible assets with infinite lives are not amortized, but tested for impairment annually or more frequently if circumstances indicate that impairment may exist. Intangible assets with finite useful lives are amortized either on a straight-line basis over the asset's estimated useful life or on a basis that reflects the pattern in which the economic benefits of the intangible assets are realized. The Company performs impairment tests on the carrying value of its goodwill of each reporting unit on an annual basis as of June 30th and December 31st for the Mountain Air and Strata operating subsidiaries, respectively. As of December 31, 2003 and 2002, no evidence of impairment exists. In 2001, goodwill associated with subsidiaries was amortized using the straight-line method over its expected useful life of 20 years. For the period ended December 31, 2001, the Company recorded $403,000 of amortization expense related to its goodwill. Amortization ceased after 2001 in accordance with SFAS No. 142. AIRCOMP AND SALE OF INTEREST IN VENTURE The Company has adopted SEC Staff Accounting Bulletin (SAB) No.51, Accounting for Sales of Stock by a Subsidiary, to account for its investment in AirComp. AirComp operates in a manner similar to a joint venture but has been accounted for and consolidated as a subsidiary under SFAS No. 141, BUSINESS COMBINATIONS. Pursuant to SAB No. 51, the Company has recorded its own contribution of assets and liabilities at its historical cost basis. Since liabilities exceeded assets, the Company's basis in AirComp was a negative amount. The Company has accounted for the assets contributed from M-I at a fair market value as determined by an outside appraiser. The Company gave M-I a 45% interest in AirComp in exchange for the assets contributed. As a result of the formation of the venture and its retention of 55% interest in the venture, the Company realized an immediate gain to the extent of its negative basis and its 55% interest in the combined assets and liabilities of the venture. In accordance with SAB No. 51, the Company has recorded its negative basis investment in AirComp as an addition to equity and its share of the combined assets and liabilities realized from M-I assets as non-operating income. IMPAIRMENT OF LONG-LIVED ASSETS Long-lived assets, which include property, plant and equipment and other intangible assets, and certain other assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recorded in the period in which it is determined that the carrying amount is not recoverable. The determination of recoverability is made based upon the estimated undiscounted future net cash flows, excluding interest expense. The impairment loss is determined by comparing the fair value, as determined by a discounted cash flow analysis, with the carrying value of the related assets. FINANCIAL INSTRUMENTS Financial instruments consist of cash and cash equivalents, accounts receivable and payable, and debt. The carrying values of cash and cash equivalents, accounts receivable and payable approximate fair value. The Company believes the fair values and the carrying value of the debt would not be materially different due to the instruments' interest rates approximating market rates for similar borrowings at December 31, 2003 and 2002. CONCENTRATION OF CREDIT AND CUSTOMER RISK SFAS No. 105, DISCLOSURE OF INFORMATION ABOUT FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND FINANCIAL INSTRUMENTS WITH CONCENTRATIONS OF CREDIT RISK, requires disclosure of significant concentration of credit risk regardless of the degree of such risk. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and trade accounts receivable. The Company transacts its business with several financial institutions. However, the amount on deposit in three financial institutions exceeded the $100,000 federally insured limit at December 31, 2003 by a total of $1,050,793. Management believes that the financial institutions are financially sound and the risk of loss is minimal. F-10 The Company sells its services to major and independent domestic and international oil and gas companies. See Note 18 for further information on major customers. The Company performs ongoing credit valuations of its customers and provides allowance for probable credit losses where necessary. Two customers comprised 25% of the Company's domestic revenues for the year ended December 31, 2003 as compared to approximately 21% of the Company's domestic revenues for the year ended December 31, 2002. Customer 2003 % of total 2002 % of total Revenue revenue Revenue revenue --------------------------------------- ------- ---------- ------- ---------- El Paso Production Oil and Gas $4,529 13.8 $1,831 10.2 --------------------------------------- ------- ---------- ------- ---------- Burlington Reserve Oil & Gas Co., L.P $3,646 11.1 $1,828 11.1 --------------------------------------- ------- ---------- ------- ---------- One customer comprised 100% of the Company's international revenues for the years ended December 31, 2003 and 2002, respectively. Customer 2003 % of total 2002 % of total Revenue revenue Revenue revenue --------------------------------------- ------- ---------- ------- ---------- Materiales Y Equipo Petroleos $3,329 10.1 $2,699 15.0 --------------------------------------- ------- ---------- ------- ---------- Two customers comprised 21% of the Company's domestic revenues for the year ended December 31, 2002 as compared to approximately 79% of the Company's domestic revenues for the year ended December 31, 2001. Customer 2002 % of total 2001 % of total Revenue revenue Revenue revenue --------------------------------------- ------- ---------- ------- ---------- El Paso Production Oil and Gas $1,831 10.2 $ - - --------------------------------------- ------- ---------- ------- ---------- Burlington Reserve Oil & Gas Co., L.P $1,828 11.1 $3,311 64.7% --------------------------------------- ------- ---------- ------- ---------- Devon Energy Production Company -- -- $ 730 14.2% --------------------------------------- ------- ---------- ------- ---------- One customer comprised 100% of the Company's international revenues for the year ended December 31, 2002 and we had no international sales year ended December 31, 2001. Customer 2002 % of total 2001 % of total Revenue revenue Revenue revenue --------------------------------------- ------- ---------- ------- ---------- Materiales Y Equipo Petroleos $2,699 15.0 $ - - --------------------------------------- ------- ---------- ------- ---------- DEBT ISSUANCE COSTS The costs related to the issuance of debt are capitalized and amortized to interest expense using the straight-line method over the maturity periods of the related debt. The maturity periods range from 2 to 5 years. ADVERTISING The Company expenses advertising costs as they are incurred. Advertising expenses for the years ended December 31, 2003, 2002, and 2001 totaled $41,000, $96,500 and $31,400, respectively. INCOME TAXES The Company has adopted the provisions of SFAS No. 109, ACCOUNTING FOR INCOME TAXES ("SFAS No. 109"). SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or income tax returns. Under this method, the deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. COMPREHENSIVE INCOME SFAS No. 130, REPORTING COMPREHENSIVE INCOME requires the presentation and disclosure of all changes in equity from non-owner sources as "Comprehensive Income". The Company had no items of comprehensive income in the reported periods. F-11 PERSONNEL RESTRUCTURING COSTS The Company has recorded and classified separately from recurring selling, general and administrative costs of approximately $495,000 incurred to terminate and relocate several members of management that occurred in September 2002. BUSINESS ACQUISITION COSTS The Company capitalizes direct costs associated with successful business acquisitions and expenses acquisition costs for unsuccessful acquisition efforts. STOCK-BASED COMPENSATION The Company accounts for its stock-based compensation using Accounting Principle Board Opinion No. 25 ("APB No. 25"). Under APB 25, compensation expense is recognized for stock options with an exercise price that is less than the market price on the grant date of the option. For stock options with exercise prices at or above the market value of the stock on the grant date, the Company adopted the disclosure-only provisions of SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION ("SFAS 123"). The Company also adopted the disclosure-only provisions of SFAS No. 123 for the stock options granted to the employees and directors of the Company. Accordingly, no compensation cost has been recognized under APB No. 25. Had compensation expense for the options granted been recorded based on the fair value at the grant date for the options, consistent with the provisions of SFAS 123, the Company's net income/(loss) and net income/(loss) per share for the years ended December 31, 2003, 2002, and 2001 would have been decreased to the pro forma amounts indicated below. FOR THE YEAR ENDED DECEMBER 31, ------------------------------- (in thousands, except per share 2003 2002 2001 -------- -------- -------- (Restated) Net income/ (loss): As reported $ 2,271 $(3,969) $(4,577) Pro forma (117) (3,969) (4,577) ======== ======== ======== Net (loss) per share: Basic As reported $ 0.12 $ (0.21) $ (1.16) Pro forma (0.01) (0.21) (1.16) ======== ======== ======== Diluted As reported $ 0.08 $ (0.21) $ (1.16) Pro forma (0.01) (0.21) (1.16) ======== ======== ======== There were options granted in 2003 and 2001. See Note 12 for further disclosures regarding stock options. FOR THE YEAR ENDED DECEMBER 31, 2003 2002 2001 ---- ---- ---- Expected dividend yield 0 -- -- Expected price volatility 265.08% -- 100% Risk-free interest rate 6.25% -- 5.0% Expected life of options 7 years -- 4 years SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION The Company discloses the results of its segments in accordance with SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION ("SFAS No. 131"). The Company designates the internal organization that is used by management for allocating resources and assessing performance as the source of the Company's reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas and major customers. At December 31, 2003 and 2002, the Company operates in three segments organized by service line: casing services, directional drilling services and compressed air drilling services. At December 31, 2001, the Company operated in only one segment. Please see Note 18 for further disclosure in accordance with SFAS No. 131. PENSION AND OTHER POST RETIREMENT BENEFITS SFAS No. 132, EMPLOYER'S DISCLOSURES ABOUT PENSION AND OTHER POST RETIREMENT BENEFITS ("SFAS No. 132"), requires certain disclosures about employers' pension and other post retirement benefit plans and specifies the accounting and measurement or recognition of those plans. SFAS No. 132 requires disclosure of information on changes in the benefit obligations and fair values of the plan assets that facilitates financial analysis. Please see Note 4 for further disclosure in accordance with SFAS No. 132. F-12 DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ("SFAS No. 133"), establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Currently, the Company has no derivative instruments. INCOME (LOSS) PER COMMON SHARE The Company computes income (loss) per common share in accordance with the provisions of SFAS No. 128, EARNINGS PER SHARE ("SFAS No. 128"). SFAS No. 128 requires companies with complex capital structures to present basic and diluted earnings per share. Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Preferred dividends are deducted from net income (loss) and have been considered in the calculation of income available to common stockholders in computing basic earnings per share. Diluted earnings per share is similar to basic earnings per share, but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible preferred stock, stock options, etc.) as if they had been converted. potential dilutive common shares that have an anti-dilutive effect (e.g., those that increase income per share or decrease loss per share) are excluded from diluted earnings per share. As a result of the Company's net loss for the years ended December 31, 2002 and 2001, common stock equivalents have been excluded because their effect would be anti-dilutive. The components of basic and diluted earnings per share are as follows: 2003 ------------- (RESTATED) (In thousands, except earnings per share) Numerator: Net income available for common stockholders $ 2,271 Plus income impact of assumed conversions: Preferred stock dividends/interest 656 ------------- Net income (loss) applicable to common stockholders Plus assumed conversions $ 2,927 Denominator: Denominator for basic earnings per share - weighted average shares outstanding 19,633 Effect of potentially dilutive common shares: Convertible preferred stock and employee and director stock options 9,616 ------------- Denominator for diluted earnings per share - weighted average shares outstanding and assumed conversions 29,248 Basic earnings (loss) per share $ 0.12 ============ Diluted earning (loss) per share $ 0.10 ============ NEW ACCOUNTING PRONOUNCEMENTS In September 2003, the FASB approved SFAS No. 150, ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY ("SFAS No. 150"). SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after September 15, 2003. The effect on the Company's financial position include the fact that beginning on July 1, 2003, redeemable warrants will be classified as liabilities and not shown in the mezzanine equity section of the balance sheet. The adoption of SFAS No. 150 could also affect the Company's debt covenant calculations for purposes of its bank loans. As of, December 31, 2003, the Company was in default of certain covenants at Jens' and Strata and has obtained waivers for these covenant defaults from its lender. NOTE 2 - RESTATEMENT Earnings per Share restatement The Company understated diluted earnings per share due to an incorrect calculation of its weighted shares outstanding for the third and fourth quarters of 2003, for each of the first three quarters of 2004, for the year ended December 31, 2004 and the for the quarter ended March 31, 2005. In addition, the Company understated basic earnings per share due to an incorrect calculation of its weighted average basic shares outstanding for the quarter ended September 30, 2004. Consequently, the Company has restated its financial statements for each of those periods. The incorrect calculation resulted from a mathematical error and an improper application of SFAS 128, Earnings Per Share. The effect of the restatement is to reduce weighted average diluted shares outstanding for each period and to reduce weighted average basic shares outstanding for the quarter ended September 30, 2004. Consequently, weighted average diluted earnings per share were increased for each period and weighted average basic earnings per share was increased for the quarter ended September 30, 2004. A restated earnings per share calculation for the year ended December 31, 2003 reflecting the above adjustments to our results as previously presented or restated (see below), is presented below. The amounts are in thousands, except for share amounts: YEAR ENDED DECEMBER 31, 2003 ------------------------------------------ AS AS REPORTED ADJUSTMENTS RESTATED ------------ ------------ ------------ Income/ (loss) per common share - diluted $ 0.08 $ 0.02 $ 0.10 ============ ============ ============ Weighted average number of common shares outstanding: Diluted 28,805 445 29,248 ============ ============ ============ AirComp restatement In connection with the formation of AirComp in 2003, the Company and M-I contributed assets in exchange for a 55% interest and 45% interest, respectively, in AirComp. We originally accounted for the formation of AirComp as a joint venture, but in February 2005, determined that the transaction should have been accounted for using purchase accounting pursuant to SFAS No. 141, BUSINESS COMBINATIONS and accounting for the sale of an interest in a subsidiary in accordance with SAB No. 51. Consequently, we have restated our financial statements for the year ended December 31, 2003 to reflect the following adjustments: F-13 INCREASE IN BOOK VALUE OF FIXED ASSETS. Under joint venture accounting, we originally recorded the value of the assets contributed by M-I to AirComp at M-I's historical cost of $6,932,000. Under purchase accounting, we increased the recorded value of the assets contributed by M-I by approximately $3,337,000 to $10,269,000 to reflect their fair market value as determined by a third party appraisal. In addition, under joint venture accounting, we established negative goodwill which reduced fixed assets in the amount of $1,550,000. Under purchase accounting, we increased fixed assets by $1,550,000 to reverse the negative goodwill previously recorded. Therefore, fixed assets have been increased by a total of $4,887,000. INCREASE IN MINORITY INTEREST AND PAID IN CAPITAL. Under purchase accounting, minority interest and paid in capital were increased by $1,499,000 and $955,000, respectively. RECOGNITION OF NON-OPERATING GAIN. Under joint venture accounting, no gain or loss was recognized in connection with the formation of AirComp. Under purchase accounting, we recorded a $2,433,000 non-operating gain in the third quarter of 2003. REDUCTION IN NET INCOME. As a result of the increase in fixed assets, during the year ended December 31, 2003 depreciation expense increased by $98,000 and minority interest expense decreased by $44,000, resulting in reduction in net income attributable to common stockholders of $54,000. As a result of recording the above non-operating gain and recording the reduction in income, net income attributed to common stockholders increased by $2,379,000. A restated consolidated balance sheet at December 31, 2003, a restated consolidated of operations and a restated consolidated statement of cash flows for the year ended December 31, 2003, reflecting the above adjustments, is presented below. The amounts are in thousands, except for share amounts: F-14 At December 31, 2003 -------------------- As Reported Adjustments As Restated -------- ----------- ----------- ASSETS Cash and cash equivalents $ 1,299 $ 1,299 Trade receivables, net of allowance for doubtful accounts 8,823 8,823 Lease Receivable, current 180 180 Prepaid expenses and other 887 887 --------- --------- Total current assets 11,189 11,189 Property and equipment, net of accumulated depreciation 26,339 4,789 31,128 Goodwill 7,661 7,661 Other intangible assets, net of accumulated amortization 2,290 2,290 Debt issuance costs, net of accumulated amortization 567 567 Lease receivable, less current portion 787 787 Other Assets 40 40 --------- -------- --------- Total Assets $ 48,873 $ 4,789 $ 53,662 ========= ======== ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current maturities of long-term debt $ 3,992 $ 3,992 Trade accounts payable 3,133 3,133 Accrued salaries, benefits and payroll taxes 591 591 Accrued interest 152 152 Accrued expenses 1,761 1,761 Accounts payable, related parties 787 787 --------- --------- Total current liabilities 10,416 10,416 Accrued postretirement benefit obligations 545 545 Long-term debt, net of current maturities 28,241 28,241 Other long-term liabilities 270 270 Redeemable warrants 1,500 1,500 Redeemable convertible preferred stock including accrued dividends 4,171 4,171 --------- --------- Total liabilities 45,143 45,143 Commitments and Contingencies Minority interests 2,523 1,455 3,978 COMMON STOCKHOLDERS' EQUITY Common stock 2,945 2,945 Capital in excess of par value 6,887 955 7,842 Accumulated (deficit) (8,625) 2,379 (6,246) --------- -------- --------- Total stockholders' equity 1,207 3,334 4,541 --------- -------- --------- Total liabilities and stockholders' equity $ 48,873 $ 4,789 $ 53,662 ========= ======== ========= F-15 Year Ended December 31, 2003 ---------------------------- As As Reported Adjustments Restated -------- ----------- -------- Revenues $ 32,724 $ 32,724 Cost of revenues 23,931 98 24,029 --------- --------- --------- Gross margin 8,793 (98) 8,695 General and administrative expense 6,169 -- 6,169 --------- --------- --------- Income/ (loss) from operations 2,624 (98) 2,526 Other income (expense): Interest income 3 -- 3 Interest expense (2,467) -- (2,467) Minority interests in income of subsidiaries (387) 44 (343) Settlement on lawsuit 1,034 -- 1,034 Gain on sale of stock in a subsidiary -- 2,433 2,433 Other 111 -- 111 --------- --------- --------- Total other income (expense) (1,706) 2,477 771 --------- --------- --------- Net income/ (loss) before income taxes 918 2,379 3,297 Provision for foreign income tax (370) -- (370) --------- --------- --------- Net income/ (loss) 548 2,379 2,927 Preferred stock dividend (656) -- (656) --------- --------- --------- Net income attributed to common stockholders $ (108) $ 2,379 $ 2,271 ========= ======== ========= Income/ (loss) per common share - basic $ (0.01) $ 0.12 ========= ========= Income/ (loss) per common share - diluted $ (0.01) $ 0.08 ========= ========= Weighted average number of common shares outstanding: Basic 19,633 19,633 ========= ========= Diluted 28,805 28,805 ========= ========= F-16 Year Ended December 31, 2003 ---------------------------- As Reported Adjustment As Restated -------- ---------- ----------- Cash flows from operating activities: Net income/ (loss) $ 548 $ 2,379 $ 2,927 Adjustments to reconcile net income/ (loss) to net cash provided by operating activities: Depreciation expense 1,954 98 2,052 Amortization expense 884 -- 884 Issuance of stock options for services -- -- -- Amortization of discount on debt 516 -- 516 (Gain) / loss on change PBO liability (125) -- (125) (Gain) / loss on settlement of lawsuit (1,034) -- (1,034) (Gain) / loss on sale of interest in AirComp -- (2,433) (2,433) Minority interest in income of subsidiaries 387 (44) 343 Loss on sale of property 82 -- 82 Changes in working capital: Decrease (increase) in accounts receivable (4,414) -- (4,414) Decrease (increase) in due from related party -- -- -- Decrease (increase) in other current assets (1,260) -- (1,260) Decrease (increase) in other assets 1 -- 1 Decrease (increase) in lease deposit 525 -- 525 Increase (decrease) in accounts payable 2,251 -- 2,251 Increase (decrease) in accrued interest (126) -- (126) Increase (decrease) in accrued expenses 397 -- 397 Increase (decrease) in other long-term liabilities -- -- -- Increase (decrease) in accrued employee benefits and payroll taxes 1,293 -- 1,293 --------- --------- --------- Net cash provided by operating activities 1,879 -- 1,879 --------- --------- --------- Cash flows from investing activities: Recapitalization, net of cash received -- -- Business acquisition costs -- -- Acquisition of MADSCO assets, net of cash acquired -- -- Acquisition of Jens', net of cash acquired -- -- Acquisition of Strata, net of cash acquired -- -- Purchase of equipment (5,354) (5,354) Proceeds from sale-leaseback of equipment, net of lease deposit -- -- Proceeds from sale of equipment 843 843 --------- --------- Net cash (used) by investing activities (4,511) -- (4,511) --------- --------- --------- Cash flows from financing activities: Proceeds from issuance of long-term debt 14,127 14,127 Payments on long-term debt (10,826) (10,826) Payments on related party debt (246) (246) Proceeds from issuance of common stock, net -- -- Borrowing on lines of credit 30,537 30,537 Pay,ents on lines of credit (29,399) (29,399) Debt issuance costs (408) (408) --------- --------- Net cash provided (used) by financing activities 3,785 3,785 --------- --------- Net increase (decrease) in cash and cash equivalents 1,153 1,153 Cash and cash equivalents: Beginning of the year 146 146 --------- --------- End of the year $ 1,299 $ 1,299 ========= ========= Supplemental information: Interest paid $ 2,341 -- $ 2,341 ========= ========== ========= F-17 In addition, the accompanying 2003 financial statements have been restated from the previously filed interim financial statements included in Form 10-Q for the first, second and third quarters of 2003. As discussed in Note 8 to the accompanying financial statements, an adjustment was recorded in the fourth quarter of 2003 to reflect a change in estimate of the recoverability of foreign taxes paid in 2002 and 2003. The effect of the significant fourth quarter adjustment on the individual quarterly financial statements is as follows: Three Months Three Months Three Months Ended Ended Ended March 31, 2003 June 30, 2003 September 30, 2003 -------------- ------------- ------------------ Net income (loss) attributed to common stockholders Previously reported $ (183) $ (330) $ 1,136 Adjustment - gain on sale of stock in a subsidiary -- -- 2,433 Adjustment - depreciation expense -- -- (49) Adjustment - minority interest expense -- -- 22 Adjustment - foreign tax expense (158) (92) (93) Restated (341) (422) 3,449 Net income (loss) per share, basic and diluted Previously reported $ (0.01) $ (0.02) $ 0.06 Total adjustments (0.01) (0.01) 0.13 Restated (0.02) (0.03) 0.18 Certain amounts in the accompanying statement of operations for the year ended December 31, 2002 have been reclassified to conform to the restatement including the reclassification of the foreign income taxes from cost of goods sold to foreign tax expense. NOTE 3 - EMERGENCE FROM CHAPTER 11 Allis-Chalmers Corporation. emerged from Chapter 11 proceedings on October 31, 1988 under a plan of reorganization, which was consummated on December 2, 1988. The Company was thereby discharged of all debts that arose before confirmation of its First Amended and Restated Joint Plan of Reorganization ("Plan of Reorganization"), and all of its capital stock was cancelled and made eligible for exchange for shares of common stock of the reorganized Company. On May 9, 2001, the reverse merger with OilQuip described in Note 1 constituted the event whereby the exchange of shares of common stock of the reorganized Company occurred. NOTE 4 - PENSION AND POST RETIREMENT BENEFIT OBLIGATIONS PENSION PLAN ------------ In 1994, the Company's independent pension actuaries changed the assumptions for mortality and administrative expenses used to determine the liabilities of the Allis-Chalmers Consolidated Pension Plan (the "Consolidated Plan"), and as a result the Consolidated Plan was under funded on a present value basis. The Company was unable to fund its obligations and in September 1997 obtained from the Pension Benefit Guaranty Corporation ("PBGC") a "distress" termination of the Consolidated Plan under section 4041(c) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). The PBGC agreed to a plan termination date of April 14, 1997. The PBGC became trustee of the terminated Consolidated Plan on September 30, 1997. Upon termination of the Consolidated Plan, the Company and its subsidiaries incurred a liability to the PBGC that the PBGC estimated to be approximately $67.9 million (the "PBGC Liability"). In September 1997, the Company and the PBGC entered into an agreement in principle for the settlement of the PBGC Liability, which required, among other things, satisfactory resolution of the Company's tax obligations with respect to the Consolidated Plan under Section 4971 of the Internal Revenue Code of 1986, as amended ("Code"). In August 1998, the Company and the Internal Revenue Service ("IRS") settled the Company's tax liability under Code Section 4971 for $75,000. F-18 In June 1999, the Company and the PBGC entered into an agreement for the settlement of the PBGC Liability (the "PBGC Agreement"). Pursuant to the terms of the PBGC Agreement, the Company issued 585,100 shares of its common stock to the PBGC, reducing the pension liability by the estimated fair market value of the shares to $66.9 million (the Company has a right of first refusal with respect to the sale of such shares). In connection with the PBGC Agreement, the Company and the PBGC entered into the following agreements: (i) a Registration Rights Agreement (the "Registration Rights Agreement"); and (ii) a Lock-Up Agreement by and among Allis-Chalmers, the PBGC, and others. In connection with the merger with OilQuip described below, the Lock-Up Agreement was terminated and the Registration Rights Agreement was amended to provide the PBGC the right to have its shares of common stock registered under the Securities Act of 1933 on Form S-3 during the 12 month period following the Merger (to the extent the Company is eligible to use Form S-3 which it currently is not) and thereafter to have its shares registered on Form S-1 or S-2. In order to satisfy and discharge the PBGC Liability, the PBGC Agreement provided that the Company had to either: (i) receive, in a single transaction or in a series of related transactions, debt financing which made available to the Company at least $10 million of borrowings or (ii) consummate an acquisition, in a single transaction or in a series of related transactions, of assets and/or a business where the purchase price (including funded debt assumed) is at least $10 million ("Release Event"). The merger with OilQuip (the "Merger") on May 9, 2001 (as described in Note 1) constituted a Release Event, which satisfied and discharged the PBGC Liability. In connection with the Merger, the Company and the PBGC agreed that the PBGC should have the right to appoint one member of the Board of Directors of the Company for so long as it holds at least 117,020 shares of the common stock. In connection with the Merger, the Lock-Up Agreement was terminated in its entirety. As of December 31, 2003 and 2002, the Company is no longer liable for any obligations of the Consolidated Plan. MEDICAL AND LIFE ---------------- Pursuant to the Plan of Reorganization, the Company assumed the contractual obligation to Simplicity Manufacturing, Inc. (SMI) to reimburse SMI for 50% of the actual cost of medical and life insurance claims for a select group of retirees (SMI Retirees) of the prior Simplicity Manufacturing Division of Allis-Chalmers. The actuarial present value of the expected retiree benefit obligation is determined by an actuary and is the amount that results from applying actuarial assumptions to (1) historical claims-cost data, (2) estimates for the time value of money (through discounts for interest) and (3) the probability of payment (including decrements for death, disability, withdrawal, or retirement) between today and expected date of benefit payments. As of December 31, 2003 and 2002, the Company has recorded post-retirement benefit obligations of $545,000 and $670,000, respectively, associated with this transaction. 401(k) SAVINGS PLAN On January 1, 2003 the Company adopted the 401(k) Profit Sharing Plan (the "Plan"). The Plan is a defined contribution savings plan designed to provide retirement income to eligible employees of the Company and its subsidiaries. The Plan is intended to be qualified under Section 401(k) of the Internal Revenue Code of 1986, as amended. It is funded by voluntary pre-tax contributions from eligible employees who may contribute a percentage of their eligible compensation, limited and subject to statutory limits. The Plan is also funded by discretionary matching employer contributions from the Company. Eligible employees cannot participate in the Plan until they have attained the age of 21 and completed six-months of service with the Company. Upon leaving the Company, each participant is 100% vested with respect to the participants' contributions while the Company's matching contributions are vested over a three-year period in accordance with the Plan document. Contributions are invested, as directed by the participant, in investment funds available under the Plan. Matching contributions of approximately $10,000 were paid in 2003. NOTE 5 - ACQUISITIONS On February 6, 2001, Mountain Air acquired the business and certain assets of MADSCO, a private company, for $10,000,000 (including a $200,000 deposit paid in 2000) in cash and a $2,200,000 promissory note to the sellers (with interest at 5 3/4 percent and principal and interest due February 6, 2006). The acquisition was accounted for as a business combination using the purchase method of accounting. Goodwill of $3,661,000 and other identifiable intangible assets of $800,000 were recorded on consolidation. F-19 On May 9, 2001, OilQuip merged into a subsidiary of Allis-Chalmers. In the Merger, all of OilQuip's outstanding common stock was converted initially into 400,000 shares of Allis-Chalmers' common stock plus 9,600,000 shares of Allis-Chalmers' common stock issued on October 15, 2001. The acquisition was accounted for using the purchase method of accounting as a reverse acquisition. Goodwill and other identifiable intangible assets of $1,009,000 were recorded on consolidation. Effective on the date of the merger, OilQuip retroactively became the reporting company. As a result, financial statements prior to the merger are those of OilQuip. The Company completed two acquisitions and related financing on February 6, 2002. The Company purchased 81% of the outstanding stock of Jens'. Jens' supplies highly specialized equipment and operations to install casing and production tubing required to drill and complete oil and gas wells. The Company also purchased substantially all the outstanding common stock and preferred stock of Strata. Strata provides high-end directional and horizontal drilling technology for specific targeted reservoirs that cannot be reached vertically. The aggregate purchase price for Jens' and Strata was (i) $10,250,000 in cash, (ii) a $4,000,000 note payable due in four years, (iii) $1,234,560 for a non-compete agreement payable over five years, (iv) 7,957,712 shares of common stock of the Company, (v) 3,500,000 shares of a newly created Series A 10% Cumulative Convertible Preferred Stock of the Company ("Preferred Stock") and (vi) an additional payment estimated to be from $1,000,000 to $1,250,000, based upon Jens' working capital on February 1, 2002. The actual working capital adjustment was approximately $983,000. In addition, in connection with the Strata acquisition, Energy Spectrum Partners LP was issued warrants to purchase 437,500 shares of Company common stock at an exercise price of $0.15 per share. The acquisitions were accounted for using the purchase method of accounting. Goodwill of $4,168,000 and other identifiable intangible assets of $2,035,000 were recorded with consolidation of the acquisitions. In July 2003, through the subsidiary Mountain Air, the Company entered into a limited liability company operating agreement with a division of M-I L.L.C. ("M-I"), a joint venture between Smith International and Schlumberger N.V. (Schlumberger limited), to form a Texas limited liability company named AirComp LLC ("AirComp"). Pursuant to the terms of the AirComp operating agreement, the Company contributed approximately $6.3 million in assets through its subsidiary Mountain Air in exchange for a 55% ownership in AirComp and M-I contributed assets which the Company recorded at fair market value of $10.3 million in exchange for a 45% ownership in AirComp. The assets contributed by Mountain Air were recorded at historical cost basis and the assets contributed by M-I were contributed at fair market value. As a result of the Company's controlling interest and operating control, the Company has consolidated AirComp in its financial statements. AirComp is in the compressed air drilling services industry The following unaudited pro forma consolidated summary financial information illustrates the effects of the formation of AirComp on the Company's results of operations as of December 31, 2003 and the acquisitions of Jens' and Strata on the Company's results of operations for December 31, 2002, based on the historical statements of operations, as if the transactions had occurred as of the beginning of the periods presented. Year Ended December 31, (UNAUDITED) (in thousands, except per share) 2003 2002 Revenues $ 34,446 $ 19,142 Operating income (loss) $ 3,008 $ (401) Net income ( loss) $ 411 $ (4,431) Net income (loss) per common share Basic $ 0.02 $ (0.23) Diluted $ 0.01 $ (0.23) F-20 NOTE 6 - DISCONTINUED OPERATIONS On December 12, 2001, the Company consummated the sale of its wholly-owned subsidiary, HDS, to the general manager of HDS (the "Buyer"), in a management buy-out with an effective date of November 30, 2001. Under the terms of the sale, the Company received a promissory note from the Buyer in the amount of $790,500 due on November 30, 2007, secured by certain HDS equipment. The note was to accrue interest at a rate of 7% through the payment date. On September 30, 2002, the Company received cash in the amount of $600,000 and recorded $191,000 in factoring costs related to the early termination of the promissory note from the buyer of HDS. A loss on the sale of approximately $2.0 million was recorded in the year ended December 31, 2001. In conjunction with the sale of HDS, the Company formally discontinued the operations segment related to precision machining of rotating equipment in 2001. All assets involved in the discontinued operation were disposed of prior to December 31, 2001. The operating results of the business sold have been reported separately as discontinued operations in the accompanying statement of operations and consists of the following: Period May 9, 2001 through November 30, 2001 (in thousands) Revenues $ 1,925 Cost of Sales 1,486 -------- Gross Profit 439 Operating expenses 594 Depreciation and amortization 124 -------- (Loss) from operations (279) Other (expense) income Interest expense (12) -------- (Loss) from discontinued operations $ (291) ======== Loss on sale of discontinued operations $(2,013) ======== F-21 NOTE 7 - PROPERTY AND OTHER INTANGIBLES ASSETS Property and equipment is comprised of the following at December 31: Depreciation Period 2003 2002 ---- ---- (Restated) Land $ 27 $ 25 Building and improvements 15 - 20 years 729 706 Machinery and equipment 3 -15 years 28,860 14,674 Tools, furniture, fixtures and leasehold improvements 3 - 7 years 4,098 4,059 ---------- ----------- Total $ 33,714 $ 19,464 Less: accumulated depreciation (2,586) (2,340) ---------- ----------- Property and equipment, net $ 31,128 $ 17,124 ========== =========== Intangible assets are as follows at December 31: Amortization Period 2003 2002 ---- ---- Intellectual Property 20 years $ 1,009 $ 1,009 Non-compete agreements 3 - 5 years 1,535 1,535 Other intangible assets 3 - 10 years 1,000 1,000 ---------- ----------- Total $ 3,544 $ 3,544 Less: accumulated amortization (1,254) (726) ---------- ----------- Intangibles assets, net $ 2,290 $ 2,818 ========== =========== 2003 2002 Gross Accumulated Current year Gross Accumulated Current year Value amortization amortization value amortization amortization ------ ------------ ------------ ------ ------------ ------------ Intellectual property $1,009 $ 183 $ 46 $1,009 $ 137 $ 46 Non-compete agreements 1,535 731 347 1,535 384 324 Other intangible assets 1,000 340 135 1,000 205 132 ------ ------------ ------------ ------ ------------ ------------- Total $3,544 $ 1,254 $ 528 $3,544 $ 726 $ 502 ====== ============ ============ ====== ============ ============= Amortization of intangible assets at December 31, is as follows: INTANGIBLE AMORTIZATION BY PERIOD --------------------------------- (in thousands) Year ended December 31, 2008 and 2004 2005 2006 2007 thereafter ---------- ---------- ---------- ---------- ---------- Intangible Assets Amortization Intellectual property $ 50 $ 50 $ 50 $ 50 $ 625 Non-compete agreements 286 250 247 21 -- Other intangible assets 135 135 99 65 226 ---------- ---------- ---------- ---------- ---------- Total Intangible Amortization $ 471 $ 435 $ 396 $ 136 $ 851 ========== ========== ========== ========== ========== F-22 NOTE 8 - INCOME TAXES Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. A valuation allowance is established for deferred tax assets when management, based upon available information, considers it more likely than not that a benefit from such assets will not be realized. The Company has recorded a valuation allowance equal to the excess of deferred tax assets over deferred tax liabilities as the Company was unable to determine that it is more likely than not that the deferred tax asset will be realized. The Tax Reform Act of 1986 contains provisions that limit the utilization of net operating loss and tax credit carry forwards if there has been a "change of ownership" as described in Section 382 of the Internal Revenue Code. Such a change of ownership may limit the Company's utilization of its net operating loss and tax credit carry forwards, and could be triggered by a public offering or by subsequent sales of securities by the Company or its stockholders. Deferred income tax assets and the related allowance as of December 31, 2003 and 2002 are as follows: 2003 2002 --------- --------- Deferred non-current income tax assets: Net future tax deductible items $ 500 $ 500 Net operating loss carry forwards 2,975 2,033 A-C Reorganization Trust claims 35,000 35,000 --------- --------- Total deferred non-current income tax assets 38,475 37,533 Valuation allowance (38,475) (37,533) --------- --------- Net deferred non-current income taxes $ -- $ -- ========= ========= Net operating loss carry forwards for tax purposes at December 31, 2003 and 2002 are estimated to be $8.5 million and $5.9 million, respectively, expiring through 2022. Net future tax-deductible items relate primarily to differences in book and tax depreciation and amortization and to compensation expense related to the issuance of stock options. Gross deferred tax liabilities at December 31, 2003 and 2002 are not material. The Company and its subsidiaries file a consolidated U.S. federal income tax return. The Company has no current tax expense for the years ended December 31, 2003, 2002 and 2001, respectively. The Company and specifically, its Jens' subsidiary, does pay foreign income taxes within the country of Mexico related to its earnings on Mexico revenues. The Company paid $370,000 and $270,000 in foreign income taxes to Mexico during the years ended December 31, 2003 and 2002, respectively. There is approximately $640,000 of U.S. foreign tax credits available to the Company and of that amount, the Company has determined that approximately $205,000 will be recoverable in a future period by applying the credits back to the taxable income of the Jens' subsidiary in 2001 and 2000. The $205,000 of recoverable foreign income taxes has been recorded as "other current assets" on the accompanying balance sheet of the Company as of December 31, 2003. The remaining $435,000 of available U.S. foreign tax credits may or may not be recoverable by the Company depending upon the availability of taxable income in future years and therefore, have not been recorded as an asset as of December 31, 2003. The foreign tax credits available to the Company begin to expire in the year 2007. F-23 The following table reconciles income taxes based on the U.S. statutory tax rate to the Company's income tax expense from continuing operations: 2003 2002 2001 --------- --------- ------- Income tax expense based on the U.S. statutory tax rate $ -- $ -- $ -- Foreign income subject to foreign taxes a rate different than the U.S. statutory rate 370,468 269,568 -- --------- --------- ------- Total $370,468 $269,568 $ -- ========= ========= ======= The Plan of Reorganization established the A-C Reorganization Trust to settle claims and to make distributions to creditors and certain stockholders. The Company transferred cash and certain other property to the A-C Reorganization Trust on December 2, 1988. Payments made by the Company to the A-C Reorganization Trust did not generate tax deductions for the Company upon the transfer but generate deductions for the Company as the A-C Reorganization Trust makes payments to holders of claims. The Plan of Reorganization also created a trust to process and liquidate product liability claims. Payments made by the A-C Reorganization Trust to the product liability trust did not generate current tax deductions for the Company. Deductions are available to the Company as the product liability trust makes payments to liquidate claims or incurs other expenses. The Company believes the above-named trusts are grantor trusts and therefore includes the income or loss of these trusts in the Company's income or loss for tax purposes, resulting in an adjustment of the tax basis of net operating and capital loss carry forwards. The income or loss of these trusts is not included in the Company's results of operations for financial reporting purposes. F-24 NOTE 9 - DEBT Debt is as follows at: Year Ended December 31, (in thousands) -------------- 2003 2002 -------- -------- Debt of Mountain Air Line of Credit with Wells Fargo $ -- $ 330 Note payable to Wells Fargo - Term Note -- 2,392 Note payable to Wells Fargo - Subordinated Debt, net -- 1,783 Note payable to Wells Fargo - Equipment Term Note -- 160 Note payable to Wells Fargo - Equipment leasing 247 -- Note payable to Seller of Mountain Air Drilling Service Company 1,511 2,200 Debt of Jens' Line of Credit with Wells Fargo 26 67 Note payable to Wells Fargo - Term Note 4,654 3,369 Note payable to Wells Fargo - Real Estate Note 207 384 Subordinated Note payable to Seller of Jens' 4,000 4,000 Note payable to Seller of Jens' for non-compete agreement 761 1,008 Note payable to Texas State Bank - Term Note 354 -- Debt of Strata Line of Credit with Wells Fargo 2,413 1,275 Note payable to Wells Fargo - Term Note -- 1,041 Vendor financing 2,383 455 Note payable to former stockholder -- 12 Debt of Allis-Chalmers Notes payable to certain former Directors 386 370 Note payable to Wells Fargo - Subordinated debt 2,675 2,375 Debt of AirComp Line of Credit with Wells Fargo 369 -- Note payable to Wells Fargo - Term Note 7,429 -- Subordinated Note Payable to M-I L L C 4,818 -- -------- -------- Total Debt $32,233 $21,221 Less: short-term debt and current maturities 3,992 13,890 ------- ------- Long-term debt obligations $28,241 $ 7,331 ======== ======== The debt above is stated as of December 31, 2003 and 2002, net of the remaining put obligations totaling approximately $325,000 and $842,000, respectively that are disclosed further in "REDEEMABLE WARRANTS" below. As of December 31, 2003 and 2002, the gross debt is equal to approximately $32,558,000 and $22,063,000, respectively. Substantially all of the Company's assets are pledged as collateral to the outstanding debt agreements. As of December 31, 2003, the Company's weighted average interest rate for all of its outstanding debt is approximately 6.34%. As of December 31, 2002, the Company's weighted average interest rate for all of its outstanding debt was approximately 8.5%. Maturities of debt obligations at December 31, 2003 are as follows: Maturities of Debt ------------------ (in thousands) Year Ended: December 31, 2004 $ 3,992 December 31, 2005 9,465 December 31, 2006 7,973 December 31, 2007 5,950 December 31, 2008 and thereafter 4,853 ------------- Total $ 32,233 ============= F-25 The debt agreements are as follows: MOUNTAIN AIR NOTES PAYABLE TO WELLS FARGO - EQUIPMENT LEASING - A term loan in the original amount of $267,000 at an interest rate of 5%, interest payable monthly, with monthly principal payments of $5,039 due on the last day of the month. The maturity date of the loan is June 30, 2008. The balance at December 31, 2003 was $247,000. NOTE PAYABLE TO SELLER OF MOUNTAIN AIR DRILLING SERVICE COMPANY ("MADSCO") - A note to the sellers of MADSCO assets in the original amount of $2,200,000 at 5.75% simple interest was reduced to $1,469,151 as a result of the settlement of a legal action against the sellers. The principal and accrued interest is due on September 30, 2007 in the amount of $1,863,195. See Note 16 for information regarding the modification to the terms of this agreement. The balance at December 31, 2003 was $1,511,000. JENS' NOTE PAYABLE TO WELLS FARGO CREDIT, INC. - TERM NOTE - A term loan in the original amount of $4,042,396 was amended in October 2003 to $5,100,000 at a floating interest rate (6.0% at December 31, 2003) with monthly principal payments of $85,000 plus 25% of Jens' receipt of any payment from Maytep. The maturity date of the loan was January 31, 2005 but in April 2004 was extended to January 31, 2006. The balance at December 31, 2003 was $4,654,000. NOTE PAYABLE TO WELLS FARGO CREDIT INC. - REAL ESTATE NOTE - A real estate loan in the amount of $532,000 at floating interest rate (6.0% at December 31, 2003) with monthly principal payments of $14,778 plus accrued interest. The principal will be due on January 31, 2005. The balance at December 31, 2003 was $207,000. LINE OF CREDIT WITH WELLS FARGO CREDIT, INC. - At December 31, 2003, Jens' had a $1,000,000 line of credit at Wells Fargo Credit, Inc., of which $26,000 was outstanding at December 31, 2003. The committed line of credit is due on January 31, 2005 but in April 2003 was extended to January 31, 2006. Interest accrues at a floating rate plus 3% (7.0% at December 31, 2003) for the committed portion. Additionally, Jens' pays a 0.5% fee for the uncommitted portion. SUBORDINATED NOTE PAYABLE TO SELLER OF JENS' - A subordinated seller's note in the original amount of $4,000,000 at 7.5% simple interest. At December 31, 2003, $533,000 of interest was accrued and was included in accounts payable, related parties. The principal and interest are due on January 31, 2006. The note is subordinated to the rights of the Company's bank lenders. NOTE PAYABLE TO SELLER OF JENS' FOR NON-COMPETE AGREEMENT - In conjunction with the purchase of Jens' (Note 5), the Company agreed to cause Jens' to pay a total of $1,234,560 to the Seller of Jens' in exchange for a non-compete agreement signed simultaneously. Jens' is to make monthly payments of $20,576 through the period ended January 31, 2007. As of December 31, 2003 the balance was approximately $761,000, including $247,000 classified as short-term. NOTE PAYABLE TO TEXAS STATE BANK - TERM NOTE - A term loan in the original amount of $397,080 at a floating interest rate (6.0% at December 31, 2003) with monthly principal payments of $11,000 plus interest. The maturity date of the loan is September 17, 2006. As of December 31, 2003, the outstanding balance was $354,000. STRATA VENDOR FINANCING - In December 2003, Strata entered into a short-term vendor financing agreement in the original amount of $1,746,000 with a major supplier of drilling motors for drilling motor rentals, motor lease costs and motor repair costs. The agreement provides for repayment of all amounts due no later than December 30, 2005. Payment of the interest on the note is due monthly and three principal payments are due in October 2004, April 2005 and December 2005. The vendor financing incurs interest at a rate of 8.0%. As of December 31, 2003, the outstanding balance was approximately $1,746,000. VENDOR FINANCING - In October 2003, Strata entered into a short-term vendor financing agreement in the original amount of $779,000 with a major supplier of drilling motors for the purchase of fifty (50) drilling motors. The agreement provides for repayment of all amounts due no later than October 31, 2004. Payment on the note is due monthly in the amount of $71,000 plus interest. The vendor financing incurs interest at a rate of 8.0%. As of December 31, 2003, the outstanding balance was approximately $637,000. F-26 LINE OF CREDIT WITH WELLS FARGO CREDIT, INC. - At December 31, 2003, Strata has a $2,500,000 line of credit at Wells Fargo Credit, Inc., of which $2,413,000 was outstanding at December 31, 2003. The committed line of credit was due on January 31, 2005 but in April 2004 was extended to January 31, 2006. Interest accrues at a floating interest rate plus 3% (7.0% at December 31, 2003) for the committed portion. Additionally, Strata pays a 0.5% annual fee for the uncommitted portion. ALLIS-CHALMERS NOTES PAYABLE TO WELLS FARGO ENERGY CAPITAL, INC. - Subordinated Debt And Amortization Of Redeemable Warrant - Secured subordinated debt issued to partially finance the acquisitions of Jens' and Strata in the original amount of $3,000,000 at 12% interest payable monthly. Of this amount, $2,675,000 was outstanding on December 31, 2003. The principal was due on January 31, 2005 but in April 2004 was extended to February 1, 2006. In connection with incurring the debt, the Company issued redeemable warrants valued at $900,000, which have been recorded as a discount to the subordinated debt and as a liability (see Redeemable Warrants below and Note 13). The discount is amortizable over three years beginning February 6, 2002 as additional interest expense of which $300,000 was recognized for the year ended December 31, 2003. The debt is recorded at $2,675,000 at December 31, 2003, net of the unamortized portion of the put obligation. NOTES PAYABLE TO CERTAIN FORMER DIRECTORS - The Allis-Chalmers Board established an arrangement by which to compensate former and continuing Board members who had served from 1989 to March 31, 1999. Pursuant to the arrangement in 1999, Allis-Chalmers issued promissory notes totaling $325,000 to current or former directors and officers. The notes bear interest at the rate of 5%, compounded quarterly, and are due March 28, 2005. At December 31, 2003, the notes were recorded at $386,000, including accrued interest. REDEEMABLE WARRANTS - The Company issued redeemable warrants that are exercisable for up to 1,165,000 shares of the Company's common stock at an exercise price of $0.15 per share ("Warrants A and B") and non-redeemable warrants that are exercisable for a maximum of 335,000 shares of the Company's common stock at $1.00 per share ("Warrant C"). The warrants were issued in connection with the issuance of a subordinated debt instrument for Mountain Air in 2001, subsequently repaid in connection with the formation of AirComp in July 2003 and the related issuance of the $3 million subordinated debt discussed above (collectively, the "Subordinated Debt"). Warrants A and B are subject to cash redemption provisions ("puts") in the amount of $600,000 and $900,000, respectively, at the discretion of the warrant holders beginning at the earlier of the final maturity date of the Subordinated Debt or three years from the closing of the Subordinated Debt (January 31, 2005). Warrant C does not contain any such puts or provisions. In April 2004 the maturity date of the debt was extended to February 1, 2006. The Company has recorded a liability of $600,000 at Mountain Air and $900,000 at Allis-Chalmers for a total of $1,500,000 and is amortizing the effects of the puts to interest expense over the life of the Subordinated Debt. GUARANTEE OF SUBSIDIARY OBLIGATIONS. The Company guarantees many of its subsidiaries' obligations. In addition, the Company's Chief Executive Officer and Chairman, Munawar H. Hidayatallah, and his wife, guarantee substantially all of the Company's obligations. AIRCOMP LLC LINE OF CREDIT WITH WELLS FARGO BANK - a $1,000,000 line of credit at Wells Fargo bank, of which $369,000 was outstanding at December 31, 2003. Interest accrues at a floating interest rate plus 2.25% (6.25% at December 31, 2003) for the committed portion and is payable quarterly starting in September 2003. Additionally, AirComp pays a 0.5% annual fee for the uncommitted portion. The line of credit must be repaid on June 27, 2007. NOTES PAYABLE TO WELLS FARGO - TERM NOTE - A term loan in the original amount of $8,000,000 at variable interest rates related to the Prime or LIBOR rates (4.09% at December 31, 2003), interest payable quarterly, with quarterly principal payments of $286,000 due on the last day of the quarter beginning in July 2003. The maturity date of the loan is June 27, 2007. The balance at December 31, 2003 was $7,429,000. F-27 NOTE PAYABLE TO WELLS FARGO - EQUIPMENT TERM LOAN - A delayed draw term loan in the amount of $1,000,000 with interest at a rate equal to the LIBOR rate plus 2.0% to 2.75%, with quarterly payments of interest and quarterly payments of principal equal to 5% of the outstanding balance commencing in the first quarter of 2005. The maturity date of the loan is June 27, 2007. AirComp has not yet drawn down on this note and there was no outstanding balance at December 31, 2003. NOTE PAYABLE TO M-I L.L.C. - SUBORDINATED DEBT - Subordinated debt in the amount of $4,818,000 bearing an annual interest rate of 5% in conjunction with the joint venture. The note is due and payable when M-I sells its interest or a termination of AirComp occurs. At December 31, 2003, $120,000 of interest was accrued and included in accrued interest. NOTE 10 - COMMITMENTS AND CONTINGENCIES The Company rents office space on a five-year lease, which expires February 5, 2006. The Company and its subsidiaries also rent certain other facilities and shop yards for equipment storage and maintenance. Facility rent expense for the years ended December 31, 2003, 2002 and 2001 was $370,000, $303,000 and $90,000, respectively. The Company has no further lease obligations. At December 31, 2003, future minimum rental commitments for all operating leases are as follows: Operating Leases ---------------- (in thousands) Year Ended: December 31, 2004 $ 318 December 31, 2005 207 December 31, 2006 116 December 31, 2007 115 December 31, 2008 and thereafter 58 ------------ Total $ 814 ============ NOTE 11 - STOCKHOLDERS' EQUITY The equity and per share data on the financial statements as of December 31, 2001 have been presented so as to give effect to the recapitalization of the Company, which occurred in the reverse acquisition of Allis-Chalmers on May 9, 2001. Under the recapitalization, the original number of shares outstanding of the formerly private OilQuip is considered to have been exchanged for the 10,000,000 shares of Allis-Chalmers that were issued on the date of the reverse acquisition to the owners of OilQuip. For legal purposes, Allis-Chalmers acquired OilQuip, the parent company of Mountain Air. However, for accounting purposes OilQuip was treated as the acquiring company in a reverse acquisition of Allis-Chalmers. The business combination was accounted for as a purchase. As a result, $2,779,000, the value of the Allis-Chalmers common stock outstanding at the date of acquisition, was added to stockholders' equity, which reflects the recapitalization of Allis-Chalmers and the reorganization of the combined company. On February 6, 2002, in connection with the acquisition of 81% of the outstanding stock of Jens' (Note 5), the Company issued 1,397,849 shares of common stock to the seller of Jens', an individual presently employed as the President of the Company. The business combination was accounted for as a purchase. As a result, $630,000, the fair value of the Company's common stock issued at the date of the acquisition, was added to stockholders' equity. On February 6, 2002, in connection with the acquisition of 95% of the outstanding stock of Strata (Note 5), the Company issued 6,559,863 shares of common stock to the seller of Strata, Energy Spectrum. The business combination was accounted for as a purchase. As a result, $2,952,000, the fair value of the Company's common stock issued at the date of the acquisition, was added to stockholders' equity. On May 31, 2002, the Company acquired the remaining 5% of the outstanding stock of Strata and issued 87,500 shares of common stock to the seller, Energy Spectrum. As a result, $153,000, the fair value of the Company's common stock issued at the date of the purchase, was added to stockholders' equity. F-28 In connection with the Strata purchase, the Company authorized the creation of Preferred Stock. The Preferred Stock has cumulative dividends at ten percent per annum payable in additional shares of Preferred Stock or if elected and declared by the Company, in cash. Additionally, the Preferred Stock was convertible into common stock of the Company. The Preferred Stock is also subject to mandatory redemption on or before February 4, 2004 or earlier from the net proceeds of new equity sales and optional redemption by the Company at any time. The redemption price of the Preferred Stock was $1.00 per share plus accrued but unpaid dividends. The Preferred Stock, including accrued dividends, was converted into 8,590,449 shares of common stock on April 2, 2004 (See, "Recent Developments"). For the year ended December 31, 2003, the Company has accrued $671,000 of dividends payable to the Preferred Stock holders. No dividends have been declared or paid to date. In connection with the Strata Acquisition, the Company issued to Energy Spectrum a warrant to purchase 437,500 shares of the Company's common stock at an exercise price of $0.15 per share, and on February 19, 2003, the Company issued an additional warrant to purchase 875,000 shares of the Company's common stock at an exercise price of $0.75 per share. The warrant issued on February 19, 2003 was valued in accordance with the Black-Scholes valuation model at approximately $306,000. The fair value of this warrant issuance was recorded similar to a preferred share dividend. In connection with the formation of AirComp in July 2003, the Company recorded $955,000, as the effect of the consolidation of the AirComp venture in which the Company realized a benefit by elimination of its negative investment in the cost basis of the venture. The business combination was accounted for as a purchase. As a result, the Company recognized the benefit of $955,000 as an increase in its stockholders equity rather than as period income. NOTE 12 - STOCK OPTIONS In 2000, in conjunction with the promissory notes issued to certain current and former Directors (Note 9), Allis-Chalmers' Board of Directors also granted stock options to these same individuals. Options to purchase 24,000 shares of common stock were granted with an exercise price of $2.75. These options vested immediately and may be exercised any time prior to March 28, 2010. As of December 31, 2003, none of the stock options were exercised. No compensation expense has been recorded for these options that were issued with an exercise price equal to the fair value of the common stock at the date of grant. On May 31, 2001, the Board granted to Leonard Toboroff, a director of Allis-Chalmers, an option to purchase 500,000 shares of common stock at $0.50 per share, exercisable for 10 years from October 15, 2001. The option was granted for services provided by Mr. Toboroff to OilQuip prior to the merger, including providing financial advisory services, assisting in OilQuip's capital structure and assisting OilQuip in finding strategic acquisition opportunities. The Company recorded compensation expense of $500,000 for the issuance of the option for the year ended December 31, 2001. On December 16, 2003, the Board granted to the employees of the Company options to purchase 4,272,500 shares of common stock, and issued options to purchase 70,000 shares of common stock to non-employee directors and to Energy Spectrum Partners LP as compensation for services rendered by directors in 2002 and 2003. As further disclosed in Note 1, the Company accounts for its stock-based compensation using APB No. 25. The Company has adopted the disclosure-only provisions of SFAS No. 123 for the stock options granted to the employees and directors of the Company. Accordingly, no compensation cost has been recognized for these options. These options are exercisable for 10 years from December 16, 2003 at $0.55 per share. As of December 31, 2003, none of the stock options were exercised. A summary of the Company's stock option activity and related information is as follows: December 31, 2003 December 31, 2002 December 31, 2001 Weighted Avg. Weighted Avg. Weighted Avg. Shares Under Exercise Shares Under Exercise Shares Under Exercise Option Price Option Price Option Price ---------------- -------------- --------------- ---------------- ----------------- -------------- Beginning balance 524,000 $ 0.60 524,000 $ 0.60 24,000 $ 2.75 Granted 4,342,500 0.55 - - 500,000 0.50 Canceled - - - - - - Exercised - - - - - - ---------------- -------------- --------------- ---------------- ----------------- -------------- Ending balance 4,866,500 $ 0.56 524,000 $ 0.60 524,000 $ 0.60 ================ ============== =============== ================ ================= ============== F-29 The following table summarizes additional information about the Company's stock options outstanding as of December 31, 2003: Fair Value Weighted Average Remaining Exercise Price Shares Under Option Contractual Life Weighted Average ---------------- -------------------- -------------------------- ------------------ $0.50 500,000 7.75 years $1.00 $2.75 24,000 6.25 years $1.97 $0.55 4,342,500 10.00 years $0.55 ------- --------- ------------ ------ $ 0.56 4,866,500 9.75 years $0.63 ======= ========= ============ ====== There were no stock options issued to employees or directors in the year ended December 31, 2002. NOTE 13 - STOCK PURCHASE WARRANTS In conjunction with the Mountain Air purchase by OilQuip in February of 2001, Mountain Air issued a common stock warrant for 620,000 shares to a third-party investment firm that assisted the Company in its initial identification and purchase of the Mountain Air assets. The warrant entitles the holder to acquire up to 620,000 shares of common stock of Mountain Air at an exercise price of $.01 per share over a nine-year period commencing on February 7, 2001. The stock purchase warrant has been recorded at a fair value of $200,000 for the year ended December 31, 2001. As more fully described in Note 9, Mountain Air and Allis-Chalmers issued two warrants ("Warrants A and B") for the purchase of 1,165,000 total shares of the Company's common stock at an exercise price of $0.15 per share and one warrant for the purchase of 335,000 shares of the Company's common stock at an exercise price of $1.00 per share ("Warrant C") in connection with their subordinated debt financing. The holders may redeem Warrants A and B for a total of $1,500,000 as of January 31, 2005. The fair value of Warrant C was established in accordance with the Black-Scholes valuation model and as a result, $47,000 was added to stockholders' equity. The following assumptions were utilized to determine fair value: no dividend yield; expected volatility of 67.24%; risk free interest rate of 5%; and expected lives of four years. On February 6, 2002, in connection with the acquisition of substantially all of the outstanding stock of Strata (Note 5), the Company issued a warrant for the purchase of 437,500 shares of the Company's common stock at an exercise price of $0.15 per share over the term of four years. The fair value of the warrant was established in accordance with the Black-Scholes valuation model and as a result, $267,000 was added to stockholders' equity. The following assumptions were utilized to determine fair value: no dividend yield; expected volatility of 67.24%; risk free interest rate of 5%; and expected lives of four years. In connection with the Strata Acquisition, on February 19, 2003, the Company issued Energy Spectrum an additional warrant to purchase 875,000 shares of the Company's common stock at an exercise price of $0.15 per share. The Preferred Stock, including accrued dividends, was converted into 8,590,448 shares of common stock on April 2, 2004 (See, "Recent Developments")(unaudited). NOTE 14 - LEASE RECEIVABLE In June 2002, the Company's subsidiary, Strata, sold its measurement while drilling (MWD) assets to a third party. Under the terms of the sale, the Company will receive at least $15,000 per month for thirty-six months. After thirty-six months, the purchaser has the option to pay the remaining balance or continue paying a minimum of $15,000 per month for twenty-four additional months. After the expiration of the additional twenty-four months, the purchaser must repay any remaining balance. This transaction has been accounted for as a direct financing lease with the nominal residual gain from the asset sale deferred into income over the life of the lease. During the year ended December 31, 2003, the Company received a total of $251,000 in payments from the third party related to this lease. F-30 NOTE 15 - RELATED PARTY TRANSACTIONS At December 31, 2003 and 2002, the Company owed the Chief Executive Officer of the Company $193,000 related to deferred compensation, and for advances totaling $49,000, respectively. Also, the Company owed a former Executive Vice President and stockholder of the Company advances totaling $70,000, and deferred compensation of $42,000. During the years ended December 31, 2003 and 2002, the Company's Chief Executive Officer, Munawar H. Hidayatallah, and his wife guaranteed substantially all of the debt obligations of the Company and its subsidiaries. The Company agreed to pay the Chief Executive Officer an annual fee equal to 1/4 of 1% of the amount of debts of the Company and its subsidiaries guaranteed by Mr. Hidayatallah and his wife payable quarterly beginning on March 31, 2004. The President of the Company is the former owner of Jens' and currently holds a 19% minority interest in Jens'. This same individual is the holder of a $4,000,000 subordinated note payable issued by Jens' and is also owed $533,000 in accrued interest and $761,000 related to the obligation of a non-compete agreement (Note 9). The President of the Company and formerly the sole proprietor of Jens' owns a shop yard, which he leases to Jens' on a monthly basis. The annual lease payments to the President under the terms of the lease were $28,800 for each of the years ended December 31, 2003 and 2002. In addition, the President of the Company and members of his family own 100% of Tex-Mex Rental & Supply Co., a Texas corporation, that sold approximately $173,000 and $290,000 of equipment and other supplies to Jens' for the years ended December 31, 2003 and 2002, respectively. Management of the Company believes these transactions were on terms at least as favorable to Jens' as could have been obtained from unrelated third parties. As further explained in Note 9, former directors of the Company were provided with promissory notes in 2000 in lieu of compensation for past services provided. A total of $386,000 included in the long-term debt of the Company is due the former directors and current stockholders of the Company as of December 31, 2003. At December 31, 2003, Mountain Air owes its other joint venture partner in AirComp, LLC, M-I Fluids, LLC a total of $73,000. NOTE 16 - SETTLEMENT ON LAWSUIT In June 2003, Mountain Air filed a lawsuit against the former owners of Mountain Air Drilling Service Company (the "Sellers") for breaches in the asset purchase agreement. The Sellers stored hazardous materials on the property leased by Mountain Air without the consent of Mountain Air and violated the non-compete clause in the asset purchase agreement. On July 15, 2003, Mountain Air entered into a settlement agreement with the Sellers. As of the date of the agreement, Mountain Air owed the Sellers a total of $2,563,195 including $2.2 million in principal and $363,195 in accrued interest. As part of the settlement agreement, the note payable to the Sellers was reduced from $2.2 million to $1.5 million. The note payable no longer accrues interest and the due date of the note payable was extended from February 6, 2006 to September 30, 2007. The lump-sum payment due the Sellers at that date will be $1,863,195. Mountain Air recorded a one-time gain on the reduction of the note payable to the Sellers of $1,034,000 in the third quarter of 2003. The gain was calculated by discounting the note payable to $1,469,152 using a present value calculation and accreting the note payable to $1,863,195, the amount due in September 2007. The Company will record interest expense totaling $394,043 over the life of the note payable beginning July 2003. F-31 NOTE 17 - GAIN ON SALE OF INTEREST IN A SUBSIDIARY In July 2003, through the subsidiary Mountain Air, the Company entered into a limited liability company operating agreement with a division of M-I to form a Texas limited liability company named AirComp. AirComp is being operated in a manner similar to a joint-venture, however, the Company controls daily operating decisions and has a majority interest in the venture. Both companies contributed assets with a combined value of $16.6 million to AirComp. The contributed assets from Mountain Air were contributed at a historical book value of approximately $6,252,000 and the assets contributed by M-I were contributed at a fair market value of approximately $10,269,000. The value of $10,269,000 was arrived at by a third party evaluation of the business enterprise using the income approach based on the present value of the cash flows expected to be grated in the future by M-I assets being contributed immediately prior to the formation of AirComp. Prior to the formation of AirComp, the Company owned 100% of Mountain Air and after the formation of AirComp, the Company owns 55% and M-I owns 45% of the business combination. The business combination was accounted for as a purchase and recorded a one-time non-operating gain on the sale of the 45% interest in the subsidiary of approximately $2,433,000. The gain was calculated after recording the assets contributed by M-I of approximately $10,269,000 less the subordinated note issued to M-I in the amount of approximately 4,818,000, recording minority interest of approximately $2,049,000 and an increase in equity of $955,000 in accordance with Staff Accounting Bulletin No. 51 ("SAB 51"). The Company has not recorded any deferred income taxes because the increase in assets and gain is a permanent timing difference. The Company has adopted a policy that any gain or loss in the future incurred on the sale in the stock or an interest of a subsidiary would be recognized as such in the income statement. NOTE 18 - SEGMENT INFORMATION The Company has three operating segments including Casing Services (Jens'), Directional Drilling Services (Strata) and Compressed Air Drilling Services (AirComp). All of the segments provide services to the petroleum industry. The Company only operated in one reporting segment for the year ended December 31, 2001. The revenues, operating income (loss), depreciation and amortization, interest, capital expenditures and assets of each of the reporting segments plus the Corporate function are reported below for the years ended December 31, 2003 and 2002: Year Ended December 31, 2003 2002 --------- --------- (Restated) (in thousands) REVENUES: Casing services $ 10,037 $ 7,796 Directional drilling services 16,008 6,529 Compressed air drilling services 6,679 3,665 --------- --------- Total revenues $ 32,724 $ 17,990 ========= ========= OPERATING INCOME (LOSS): Casing services $ 3,628 $ 2,495 Directional drilling services 1,103 (576) Compressed air drilling services 17 (945) General corporate (2,222) (2,144) --------- --------- Total income/(loss) from operations $ 2,526 $ (1,170) ========= ========= DEPRECIATION AND AMORTIZATION EXPENSE: Casing services $ 1,413 $ 1,265 Directional drilling services 275 295 Compressed air drilling services 1,139 955 General corporate 109 65 --------- --------- Total depreciation and amortization expense $ 2,936 $ 2,580 ========= ========= INTEREST EXPENSE: Casing services $ 1,044 $ 643 Directional drilling services 268 215 Compressed air drilling services 839 761 General corporate 316 637 --------- --------- Total interest expense $ 2,467 $ 2,256 ========= ========= F-32 CAPITAL EXPENDITURES Casing services $ 2,176 $ 137 Directional drilling services 1,066 83 Compressed air drilling services 2,093 288 General corporate 19 10 --------- --------- Total capital expenditures $ 5,354 $ 518 ========= ========= ASSETS: Casing services $ 18,191 $ 15,681 Directional drilling services 11,529 8,888 Compressed air drilling services 22,735 9,138 General corporate 1,207 1,071 --------- --------- Total assets $ 53,662 $ 34,778 ========= ========= REVENUES United States $ 29,395 $ 15,291 Mexico 3,329 2,699 --------- --------- TOTAL $ 32,724 $ 17,990 ========= ========= F-33 NOTE 19 - SUPPLEMENTAL CASH FLOWS INFORMATION December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- (Restated) (in thousands) Non-cash investing and financing transactions in connection with the acquisition of Mountain Air assets and merger of Allis-Chalmers and OilQuip: Fair value of net assets acquired $ -- $ -- $ (7,183) Goodwill and other intangibles -- -- (2,732) Notes payable to Seller of Mountain Air -- -- 2,200 Fair value of common stock exchanged $ -- $ -- $ (2,799) Fair value of net assets, net of cash received -- -- 892 --------- --------- --------- Net cash paid to acquire subsidiary and consummate merger $ -- $ -- $ (9,622) ========= ========= ========= Non-cash investing and financing transactions in connection with the acquisitions of Jens' and Strata: Fair value of net assets acquired $ -- $(13,945) $ -- Goodwill and other intangibles -- (5,903) -- Note payable to Seller of Jens' Oilfield Service -- 4,000 -- Value of common stock issued -- 3,735 -- Issuance of preferred stock -- 3,500 -- Fair value of warrants issued -- 314 -- --------- --------- --------- Net cash paid to acquire subsidiary $ -- $ (8,299) $ -- ========= ========= ========= Other non-cash investing and financing transactions: Sale of property & equipment in connection with the direct financing lease (Note 14) $ -- $ 1,193 $ -- (Gain) on settlement of debt $ (1,034) $ -- $ -- Amortization of discount on debt $ 442 $ -- $ -- Purchase of equipment financed through assumption of debt or accounts payable $ 906 $ -- $ -- Non-cash investing and financing transactions in connection with the formation of AirComp: Other non-cash investing and financing transactions in connection with AirComp: Issuance of debt to joint venture by M-I $ (4,818) $ -- $ -- Contribution of property, plant and equipment by M-I to joint venture $ 10,268 $ -- $ -- Increase in minority interest $ (2,063) $ -- $ -- (Gain) on sale of stock in a subsidiary $ (2,433) $ -- $ -- Difference of Company's investment cost basis in AirComp and their share of underlying equity of net assets of AirComp $ (955) $ -- $ -- --------- --------- --------- Net cash paid in connection with the joint venture $ -- $ -- $ -- ========= ========= ========= F-34 NOTE 20 - QUARTERLY RESULTS (UNAUDITED) First Second Third Fourth Quarter Quarter Quarter Quarter --------- --------- --------- --------- (Restated) (Restated) (In thousands, except per share amounts) YEAR 2003 Revenues $ 6,999 $ 7,340 $ 8,089 $ 10,296 Operating income (loss) 1,023 910 678 (85) Net income (loss) 53 (335) 3,537 (328) --------- --------- --------- --------- Preferred stock dividend (394) (87) (88) (87) --------- --------- --------- --------- Net income (loss) attributed to common shares $ (341) $ (422) $ 3,449 $ (415) ========= ========= ========= ========= Income (loss) per common share Basic: $ (0.02) $ (0.02) $ 0.18 $ (0.02) ========= ========= ========= ========= Income (loss) per common share Diluted: $ (0.02) $ (0.02) $ 0.12 $ (0.02) ========= ========= ========= ========= YEAR 2002 Revenues $ 3,253 $ 4,238 $ 4,775 $ 5,724 Operating income (loss) (133) (729) (540) 232 Net income (loss) (640) (869) (1,505) (955) --------- --------- --------- --------- Preferred stock dividend (58) (87) (87) (89) --------- --------- --------- --------- Net income (loss) attributed to common shares $ (698) $ (956) $ (1,592) $ (1,044) ========= ========= ========= ========= Income (loss) per common share (Basic and diluted) $ (0.04) $ (0.05) $ (0.08) $ (0.06) ========= ========= ========= ========= NOTE 20 - LEGAL MATTERS The Company is named from time to time in legal proceedings related to the Company's activities prior to its bankruptcy in 1988; however, the Company believes that it was discharged from liability for all such claims in the bankruptcy and believes the likelihood of a material loss relating to any such legal proceeding is remote. The Company is involved in various other legal proceedings in the ordinary course of business. The legal proceedings are at different stages; however, the Company believes that the likelihood of material loss relating to any such legal proceeding is remote. F-35 NOTE 21 - SUBSEQUENT EVENTS On April 2, 2004, the Company entered into the following transactions: o In exchange for an investment of $2 million, the Company issued 3,100,000 shares of common stock for a purchase price equal to $0.50 per share, and warrants to purchase 4,000,000 shares of common stock at an exercise price of $0.50 per share, expiring on April 1, 2006, to an investor group (the "Investor Group") consisting of entities affiliated with Donald and Christopher Engel and directors Robert Nederlander and Leonard Toboroff. The aggregate purchase price for the common stock was $1,550,000, and the aggregate purchase price for the warrants was $450,000. o Energy Spectrum converted its 3,500,000 shares of Series A 10% Cumulative Convertible Preferred Stock, including accrued dividends, into 8,590,449 shares of common stock. o The Company, the Investor Group, Energy Spectrum, and director Saeed Sheikh, and officers and directors Munawar H. Hidayatallah and Jens H. Mortensen entered into a stockholders agreement pursuant to which the parties have agreed to vote for the election to the board of directors of the Company three persons nominated by Energy Spectrum, two persons nominated by the Investor Group and one person nominated by Messrs. Hidayatallah, Mortensen and Sheikh. In addition, the parties and the Company agreed that in the event the Company has not effected a public offering of its shares prior to September 30, 2005, then, at the request of Energy Spectrum, the Company will retain an investment banking firm to identify candidates for a transaction involving the sale of the Company or its assets. o Wells Fargo Credit, Inc. and Wells Fargo Energy Capital, Inc. extended the maturity dates for certain obligations (which at December 31, 2003, aggregated approximately $9,768,000) from January and February of 2005 to January and February 2006. As a condition of the extension, the Company will make a $400,000 initial payment and 24 monthly principal payments in the amount of $25,000 each to Wells Fargo Energy Capital, Inc. As part of the extension, the lenders waived certain defaults including defaults relating to the failure of Jens' and Strata to comply with certain covenants relating to the amount of their capital expenditures, and amended certain covenants set forth in the loan agreements on an on-going basis. In addition, Wells Fargo Credit, Inc. increased Strata's line of credit from $2.5 million to $4.0 million. F-36 ITEM 9A - CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended, are recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosures. Our internal control system is designed to provide reasonable assurance regarding the preparation and fair presentation of published financial statements. All internal control systems are designed based in part upon certain assumptions about the likelihood of future events, and, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation and may not prevent or detect all misstatements. Management, including our chief executive officer and our chief financial officer, has evaluated the effectiveness of our "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Report (the "Evaluation Date"). Management has concluded that, as of the Evaluation Date, due to the deficiencies described below, our controls and procedures over financial reporting were not effective to enable us to record, process, summarize, and report information required to be included in our SEC filings within the required time period, and to ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial accounting officer, to allow timely decisions regarding required disclosure. As described below, we are taking steps to remediate the deficiencies in our control over the financial reporting process. On August 4, 2005, our Board of Directors, upon the recommendation of the Audit Committee of our Board of Directors, concluded that our previously issued financial statements for the periods from July 1, 2003 through March 31, 2005, were required to be restated to correct the understatement of net income per share which resulted from a miscalculation of the number of basic and diluted shares outstanding on a weighted average basis in accordance with SFAS No. 128, Earnings Per Share. The deficiency resulted from errors discovered by our independent accountants on August 1, 2005, while reviewing our financial statements for the quarter ended June 30, 2005. The major components of the errors were as follows: o For all periods involved we had not applied the treasury stock method of accounting for options and warrants as prescribed in SFAS No. 128. Specifically, we overstated diluted shares outstanding because we failed to reduce diluted shares outstanding by the number of shares that could be purchased with the proceeds to us from the exercise of dilutive warrants and options. o In 2003 and 2004, we overstated diluted shares by not correctly calculating the number of common shares into which our preferred stock was convertible; by not applying the "if converted" method of calculating diluted net earnings which requires that dividends actually paid on preferred stock be added to net income attributed to common shares in calculating diluted earnings per common share; and by continuing to report the preferred shares as dilutive after the preferred shares were converted to common stock on April 2, 2004. o During the third quarter of 2004, we misstated the number of common shares outstanding on a weighted average basis due to a mathematical error in calculating the number of days certain shares issued during the quarter were outstanding. In addition, in March 2005, we restated our financial statements for the year ended December 31, 2003 and for the three quarters ended September 30, 2004, relating to our acquisition of a 55% interest in our AirComp, LLC subsidiary in 2003. We originally accounted for the formation of AirComp as a joint venture, but in February 2005, determined that the transaction should have been accounted for using purchase accounting pursuant to SFAS No. 141, BUSINESS COMBINATIONS and accounting for the sale of an interest in a subsidiary in accordance with SAB No. 51. 23 We have restated our financial statements as set forth in Note 2 to the Consolidated Financial Statements contained in Part II, Item 8. Public Company Accounting Oversight Board ("PCAOB") Auditing Standard No. 2 identifies a number of circumstances that, because of their likely significant negative effect on internal control over financial reporting, are to be regarded as at least significant deficiencies as well as strong indicators that a material weakness exists, including the restatement of previously-issued financial statements to reflect the correction of a misstatement. Management evaluated the impact of the restatement of our previously-issued financial statements on our assessment of our system of internal control and has concluded that the restatements resulted from the lack of sufficient experienced accounting personnel resulting in a lack of effective control over the financial reporting process. We have implemented a number of actions that we believe address the deficiencies in our financial reporting process, including the following: o The addition of experienced accounting personnel with appropriate experience and qualifications to perform quality review procedures and to satisfy our financial reporting obligation. During August 2004, we hired a new chief financial officer and in October of 2004 we hired a full-time general counsel. In March 2005, we hired a certified public accountant as our financial reporting manager and in July 2005 we hired as chief accounting officer a certified public accountant who has significant prior experience as a chief accounting officer of a publicly traded company. o In the fourth quarter of 2004, we engaged an independent internal controls consulting firm which is in the process of documenting, analyzing, identifying and correcting weaknesses and testing our internal controls and procedures, including our controls over internal financial reporting. o Our audit committee dismissed our prior independent auditors in October 2004 and engaged new independent auditors who we believe have greater experience with publicly traded companies. o We are in the process of implementing new accounting software to facilitate timely and accurate reporting. CHANGE IN INTERNAL CONTROL OVER FINANCIAL REPORTING. o There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 24 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) List of Documents Filed The Index to Financial Statements is included on page xv of this report. Financial statements Schedules not included in this report have been omitted because they are not applicable or the required information is included in the Financial Statements or Notes thereto. The exhibits listed on the Exhibit Index located at Page 26 of this Annual Report are filed as part of this Form 10K. (b) Reports on Form 8-K None. (c) Exhibits The exhibits listed on the Exhibit Index located at Page 51-- of this Annual Report are filed as part of this Form 10K. (d) Financial Statement Schedules None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 16, 2005. /S/ MUNAWAR H. HIDAYATALLAH ------------------------------------ MUNAWAR H. HIDAYATALLAH CHIEF EXECUTIVE OFFICER AND CHAIRMAN 25 EXHIBIT INDEX 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer, President and Chief Financial Officer pursuant to 18 U.S.C. (i) 26