Edgar Filing: DRIL-QUIP INC

Form 10-Q for Period Ended March 31, 2006

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006

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

Commission file number 001-13439

DRIL-QUIP, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		74-2162088
(State or other jurisdiction		(I.R.S. Employer Identification No.)
of incorporation or organization)

13550 HEMPSTEAD HIGHWAY

HOUSTON, TEXAS

77040

(Address of principal executive offices)

(Zip Code)

(713) 939-7711

(Registrant’s telephone number, including area code)

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

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

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

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

As of May 5, 2006, the number of shares outstanding of the registrant’s common stock, par value $.01 per share, was 19,520,700.

PART I—FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

DRIL-QUIP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)


	December 31, 2005			March 31, 2006
ASSETS	(In thousands)

Current assets:
Cash and cash equivalents	$	32,762		$	34,379
Trade receivables, net		108,330			118,456
Inventories, net		155,157			153,287
Deferred income taxes		9,333			9,519
Prepaids and other current assets		5,634			6,254

Total current assets		311,216			321,895
Property, plant and equipment, net		116,583			118,216
Other assets		463			398

Total assets	$	428,262		$	440,509


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	48,111		$	28,190
Current maturities of long-term debt		734			737
Accrued income taxes		6,401			3,812
Customer prepayments		11,634			20,515
Accrued compensation		8,782			7,521
Other accrued liabilities		14,662			14,212

Total current liabilities		90,324			74,987
Long-term debt		3,113			2,996
Deferred income taxes		5,363			5,336

Total liabilities		98,800			83,319

Commitments and contingencies

Stockholders’ equity:
Preferred stock, 10,000,000 shares authorized at $0.01 par value (none issued)		—			—
Common stock:
50,000,000 shares authorized at $0.01 par value, 19,271,973 and 19,513,700 shares issued and outstanding at December 31, 2005 and March 31, 2006, respectively		193			195
Additional paid-in capital		152,571			162,050
Retained earnings		177,729			195,048
Foreign currency translation adjustment		(1,031	)		(103	)

Total stockholders’ equity		329,462			357,190

Total liabilities and stockholders’ equity	$	428,262		$	440,509

The accompanying notes are an integral part of these statements.

DRIL-QUIP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)


	Three months ended March 31,
	2005		2006
	(In thousands, except share data)
Revenues	$	70,004	$	98,198

Cost and expenses:
Cost of sales		48,944		57,163
Selling, general and administrative		9,493		11,177
Engineering and product development		5,009		4,895

		63,446		73,235

Operating income		6,558		24,963
Interest expense (income)		364		(109	)

Income before income taxes		6,194		25,072
Income tax provision		1,845		7,753

Net income	$	4,349	$	17,319


Earnings per share:
Basic	$	0.25	$	0.89

Diluted	$	0.24	$	0.87


Weighted average shares:
Basic		17,449,989		19,373,555

Diluted		17,810,308		19,904,700

The accompanying notes are an integral part of these statements.

DRIL-QUIP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Three months ended March 31,
	2005			2006
	(In thousands)
Operating activities
Net income	$	4,349		$	17,319
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		3,307			3,585
Stock-based compensation expense		—			424
Gain on sale of equipment		(26	)		(57	)
Deferred income taxes		(275	)		(168	)
Changes in operating assets and liabilities:
Trade receivables, net		(3,528	)		(8,842	)
Inventories, net		(6,435	)		2,734
Prepaids and other assets		(470	)		(404	)
Trade accounts payable and accrued expenses		5,234			(16,055	)

Net cash provided by (used in) operating activities		2,156			(1,464	)

Investing activities
Purchase of property, plant and equipment		(4,697	)		(4,743	)
Proceeds from sale of equipment		374			112

Net cash used in investing activities		(4,323	)		(4,631	)

Financing activities
Proceeds from revolving line of credit and long-term borrowing		1,600			35
Principal payments on revolving line of credit and long-term debt		(244	)		(194	)
Proceeds from exercise of stock options		3,748			5,571
Excess tax benefit-stock options		—			3,486

Net cash provided by financing activities		5,104			8,898
Effect of exchange rate changes on cash activities		194			(1,187	)

Increase in cash and cash equivalents		3,131			1,616
Cash and cash equivalents at beginning of period		5,159			32,763

Cash and cash equivalents at end of period	$	8,290		$	34,379

The accompanying notes are an integral part of these statements.

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Organization and Principles of Consolidation

Dril-Quip, Inc., a Delaware corporation (the “Company” or “Dril-Quip”) designs, manufactures, sells and services highly engineered offshore drilling and production equipment that is well suited for use in deepwater, harsh environment and severe service applications. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, wellhead connectors and diverters. Dril-Quip’s products are used by major integrated, large independent and foreign national oil and gas companies in offshore areas throughout the world. Dril-Quip also provides installation and reconditioning services and rents running tools for use in the installation and retrieval of its products.

The Company’s operations are organized into three geographic segments—Western Hemisphere (including North and South America; headquartered in Houston, Texas), Eastern Hemisphere (including Europe and Africa; headquartered in Aberdeen, Scotland) and Asia-Pacific (including the Pacific Rim, Southeast Asia, Australia, India and the Middle East; headquartered in Singapore). Each of these segments sells similar products and services and the Company has major manufacturing facilities in all three of its headquarter locations.

The condensed consolidated financial statements included herein have been prepared by Dril-Quip and are unaudited, except for the balance sheet at December 31, 2005, which has been derived from the audited financial statements at that date. In the opinion of management, the unaudited condensed consolidated interim financial statements include all normal recurring adjustments necessary for a fair presentation of the financial position as of March 31, 2006 and the results of operations and the cash flows for each of the three-month periods ended March 31, 2006 and 2005. Although management believes the unaudited interim related disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in annual audited financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The results of operations and the cash flows for the three-month period ended March 31, 2006 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated financial statements included herein should be read in conjunction with the consolidated audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

2. Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany accounts and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Some of the Company’s more significant estimates are those affected by critical accounting policies for revenue recognition, inventories and contingent liabilities as discussed more fully in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Cash and cash equivalents

Investments that have a maturity of three months or less from the date of purchase are classified as cash equivalents.

Inventories

Inventory costs are determined principally by the use of the first-in, first-out (FIFO) method, and are stated at the lower of cost or market. Inventory is valued principally using standard costs that are calculated based upon direct costs incurred and overhead allocations. Periodically, obsolescence reviews are performed on slow-moving inventories and reserves are established based on current assessments about future demands and market conditions. The inventory values have been reduced by a reserve for excess and obsolete inventories. Inventory reserves of $16.2 million and $9.8 million were recorded as of March 31, 2006 and 2005, respectively. If market conditions are less favorable than those projected by management, additional inventory reserves may be required.

Property, Plant and Equipment

Property, plant, and equipment are carried at cost, with depreciation provided on a straight-line basis over their estimated useful lives.

Income Taxes

The Company accounts for income taxes using the liability method. Deferred income taxes are provided on income and expenses which are reported in different periods for income tax and financial reporting purposes.

Revenue Recognition

The Company delivers most of its products and services to its customers on an as-needed basis and records revenues as the products are shipped and as services are rendered. Allowances for doubtful accounts are determined generally on a case by case basis. Certain revenues are derived from long-term product contracts which generally require more than one year to fulfill. Revenues and profits on long-term product contracts are recognized under the percentage-of-completion method based on the rates of costs incurred to total estimated costs. Losses, if any, on contracts are fully recognized when they become known. Contracts for long-term projects contain provisions for customer progress payments. Payments in excess of revenues recognized are included as a customer prepayment liability.

Foreign Currency

The financial statements of foreign subsidiaries are translated into U.S. dollars at current exchange rates except for revenues and expenses, which are translated at average rates during each reporting period. Translation adjustments are reflected as a separate component of stockholders’ equity and have no current effect on earnings or cash flows.

Foreign currency exchange transactions are recorded using the exchange rate at the date of the settlement. These amounts are included in selling, general and administrative costs in the consolidated statements of income.

Stock-Based Compensation

As described more fully in Note 12 of the Company’s Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2005, the Company has stock option grants outstanding

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

under the Dril-Quip, Inc. 1997 Incentive Plan (as amended, the “1997 Plan”). In addition, on May 13, 2004 the Company’s stockholders approved the 2004 Incentive Plan of Dril-Quip, Inc. (the “2004 Plan”), which reserved up to 1,378,147 shares of Common Stock to be issued in connection with the 2004 Plan. No options have been granted under the 2004 Plan and no additional options will be awarded under the 1997 Plan.

Prior to January 1, 2006, the Company accounted for these plans under the disclosure-only provisions of Statements of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”). Accordingly, no compensation cost was recognized for the options granted under the Company’s incentive plans prior to January 1, 2006. Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R, “Share-Based Payments.” This statement is a revision of SFAS No. 123 and supersedes Accounting Principals Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” Using the fair value method and a Black-Scholes option pricing model, compensation cost recognized in the three months ended March 31, 2006 included compensation costs for all share-based payments granted prior to, but not yet vested, as of January 1, 2006. Results for prior periods have not been restated.

Fair Value of Financial Instruments

The Company’s financial instruments consist primarily of cash and cash equivalents, receivables, payables, and debt instruments. The carrying values of these financial instruments approximate their respective fair values as they are either short-term in nature or carry interest rates which approximate market rates.

Concentration of Credit Risk

Financial instruments which subject the Company to concentrations of credit risk consist principally of trade receivables. The Company grants credit to its customers, which operate primarily in the oil and gas industry. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company maintains reserves for potential losses and such losses have historically been within management’s expectations.

Comprehensive Income

SFAS No. 130, “reporting comprehensive income,” establishes the rules for the reporting and display of comprehensive income and its components. SFAS No. 130 requires the Company to include unrealized gains or losses on foreign currency translation adjustments in other comprehensive income. Generally, gains are attributed to a weakening U.S. dollar and losses are the result of a strengthening U.S. dollar.

The following table provides comprehensive income for the periods indicated:


	Three months ended March 31,
	2005			2006
	(In thousands)
Net income	$	4,349		$	17,319
Foreign currency translation adjustment		(1,084	)		928

Comprehensive income	$	3,265		$	18,247

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed considering the dilutive effect of stock options.

The net income used in the basic and dilutive earnings per share calculations is the same. The following table reconciles the number of common shares outstanding at March 31 of each year to the weighted average of common shares outstanding and the weighted average number of common and dilutive potential common shares outstanding for the purpose of calculating basic and diluted earnings per common share:


	Three months ended March 31,
	2005	2006
	(In thousands)
Number of common shares outstanding at end of period	17,450	19,514
Effect of using weighted average common shares outstanding	—	(140	)

Weighted average basic common shares outstanding	17,450	19,374
Dilutive effect of common stock options	360	531

Weighted average diluted common shares outstanding	17,810	19,905

3. Stock-Based Compensation and Stock Option Awards.

As a result of adopting SFAS No. 123R, stock-based compensation expense recognized during the three months ended March 31, 2006 totaled $424,000 related to unvested outstanding stock option grants. Accordingly, the Company's income before income taxes and net income for the three months ended March 31, 2006 was $424,000 and $282,000 lower, respectively, than if the Company had continued to account for share-based compensation under APB Opinion No. 25.

Had stock-based compensation expense for the Company's plans been determined based on the fair value at the grant dates for awards consistent with the method available under SFAS No. 123, the Company's net income and earnings per share for the three months ended March 31, 2005 would have been reduced to the pro forma amounts listed below.


	Three months ended March 31, 2005
	(In thousands, except share data)
Net income, as reported	$	4,349
Less: Compensation expense per SFAS No. 123, net of tax		(424	)

Pro forma net income	$	3,925

Earnings per share
As reported
Basic	$	0.25

Diluted	$	0.24

Pro forma
Basic	$	0.22

Diluted	$	0.22

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

A summary of option activity under the Company’s stock compensation plans as of March 31, 2006 and changes during the three months ended March 31, 2006 is as follows:


	Number of Shares
	1997 Plan	2004 Plan	Total
Stock options outstanding at December 31, 2005	1,493,443	—	1,493,443
Options granted	—	—	—
Options forfeited	—	—	—
Options exercised	241,727	—	241,727

Stock options outstanding at March 31, 2006	1,251,716	—	1,251,716

Options exercisable at March 31, 2006	977,872	—	977,872

The following summary provides additional information about stock options that are outstanding and exercisable at March 31, 2006:


	Stock Options Outstanding
Range of Exercise Prices	Number Outstanding	Weighted Average Exercise Price		Weighted Average Contractual Life
$14.95 to $24.00	1,156,390	$	18.87	5.53 years
$32.13	95,326	$	32.13	4.58 years

	1,251,716	$	19.88	5.46 years


	Stock Options Exercisable
Range of Exercise Prices	Number Exercisable	Weighted Average Exercise Price		Weighted Average Contractual Life
$14.95 to $24.00	882,546	$	20.82	4.99 years
$32.13	95,326	$	32.13	4.58 years

	977,872	$	19.60	4.95 years

4. Inventories

Inventories consist of the following:


	December 31,		March 31,
	2005		2006
	(In thousands)
Raw materials and supplies	$	36,697	$	36,218
Work in progress		30,844		29,168
Finished goods		87,616		87,901

	$	155,157	$	153,287

DRIL-QUIP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

5. Geographic Areas


	Three months ended March 31,
	2005			2006
	(In thousands)
Revenues:
Western Hemisphere:
Products	$	28,993		$	38,885
Services		6,791			6,878
Intercompany		6,586			17,166

Total	$	42,370		$	62,929

Eastern Hemisphere
Products	$	21,248		$	30,516
Services		3,419			6,741
Intercompany		474			43

Total	$	25,141		$	37,300

Asia – Pacific
Products	$	8,840		$	13,891
Services		713			1,287
Intercompany		809			441

Total	$	10,362		$	15,619

Summary
Products	$	59,081		$	83,292
Services		10,923			14,906
Intercompany		7,869			17,650
Eliminations		(7,869	)		(17,650	)

Total	$	70,004		$	98,198

Income (loss) before taxes:
Western Hemisphere	$	4,485		$	11,383
Eastern Hemisphere		(723	)		6,176
Asia – Pacific		2,418			6,228
Eliminations		14			1,285

Total	$	6,194		$	25,072

	As of March 31,
	2005			2006
	(In thousands)
Total Long-Lived Assets:
Western Hemisphere	$	102,823		$	103,756
Eastern Hemisphere		25,525			28,428
Asia – Pacific		7,154			8,110
Eliminations		(21,260	)		(21,680	)

	$	114,242		$	118,614

Total Assets:
Western Hemisphere	$	185,189		$	271,741
Eastern Hemisphere		101,686			134,578
Asia – Pacific		33,944			39,711
Eliminations		(4,057	)		(5,521	)

	$	316,762		$	440,509

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

The following is management’s discussion and analysis of certain significant factors that have affected certain aspects of the Company’s financial position and results of operations during the periods included in the accompanying unaudited condensed consolidated financial statements. This discussion should be read in conjunction with the unaudited condensed consolidated financial statements included elsewhere herein, and with the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the annual consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Overview

Dril-Quip designs, manufactures, sells and services highly engineered offshore drilling and production equipment that is well suited for use in deepwater, harsh environment and severe service applications. The Company designs and manufactures subsea equipment, surface equipment and offshore rig equipment for use by major integrated, large independent and foreign national oil and gas companies in offshore areas throughout the world. The Company’s principal products consist of subsea and surface wellheads, subsea and surface production trees, mudline hanger systems, specialty connectors and associated pipe, drilling and production riser systems, wellhead connectors and diverters. Dril-Quip also provides installation and reconditioning services and rents running tools for use in connection with the installation and retrieval of its products.

Both the market for offshore drilling and production equipment and services and the Company’s business are substantially dependent on the condition of the oil and gas industry and, in particular, the willingness of oil and gas companies to make capital expenditures on exploration, drilling and production operations offshore. Oil and gas prices and the level of offshore drilling and production activity have historically been characterized by significant volatility.

Revenues. Dril-Quip’s revenues are generated from two sources: products and services. Product revenues are derived from the sale of offshore drilling and production equipment and service revenues are earned when the Company provides installation and reconditioning services as well as rental running tools for installation and retrieval of its products. For the three months ended March 31, 2006 the Company derived 85% of its revenues from the sale of its products and 15% of its revenues from services. Service revenues generally correlate to revenues from product sales because increased product sales generate increased revenues from installation services and rental running tools. Substantially all of Dril-Quip’s sales are made on a purchase order basis. Purchase orders are subject to change and/or termination at the option of the customer. In case of a change or termination, the customer is required to pay the Company for work performed and other costs necessarily incurred as a result of the change or termination.

The Company accounts for larger and more complex projects that have relatively longer manufacturing time frames on a percentage of completion basis. For the first three months of 2006, two projects representing approximately 8% of the Company’s revenues were accounted for using percentage of completion accounting. This percentage may fluctuate in the future. Revenues accounted for in this manner are generally recognized on the ratio of costs incurred to the total estimated costs. Accordingly, price and cost estimates are reviewed periodically as the work progresses and adjustments proportionate to the percentage of completion are reflected in the period when such estimates are revised. Losses, if any, are recognized when they become known. Amounts billed to or received from customers in excess of revenues recognized are classified as a current liability.

Foreign sales represent a significant portion of the Company’s business. In the three months ended March 31, 2006, the Company generated approximately 59% of its revenues from sales outside the United States. In this period, approximately 64% (on the basis of revenues generated) of all products sold were manufactured in the United States.

Cost of Sales. The principal elements of cost of sales are labor, raw materials and manufacturing overhead. Variable costs, such as labor, raw materials, supplies and energy, generally account for approximately two-thirds of the

Company’s cost of sales. Fixed costs, such as the fixed portion of manufacturing overhead, constitute the remainder of the Company’s cost of sales. Cost of sales as a percentage of revenues is also influenced by the product mix sold in any particular quarter and market conditions. The Company’s costs related to its foreign operations do not significantly differ from its domestic costs.

Selling, General and Administrative Expenses. Selling, general and administrative expenses include the costs associated with sales and marketing, general corporate overhead, compensation expense, legal expenses, foreign currency transaction gains and losses, and other related administrative functions.

Engineering and Product Development Expenses. Engineering and product development expenses consist of new product development and testing, as well as application engineering related to customized products.

Income Tax Provision. Dril-Quip’s effective tax rate has historically been lower than the statutory rate due to benefits from its foreign sales corporation or foreign income tax rate differentials.

Results of Operations

The following table sets forth, for the periods indicated, certain statement of operations data expressed as a percentage of revenues:


	Three months ended March 31,
	2005		2006
Revenues:
Products	84.4	%	84.8	%
Services	15.6		15.2

Total	100.0		100.0
Cost of sales	69.9		58.2
Selling, general and administrative expenses	13.6		11.4
Engineering and product development expenses	7.2		5.0

Operating income	9.3		25.4
Interest expense (income)	0.5		(0.1	)

Income before income taxes	8.8		25.5
Income tax provision	2.6		7.9

Net income	6.2	%	17.6	%

Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005.

Revenues. Revenues increased by $28.2 million, or approximately 40.3%, to $98.2 million in the three months ended March 31, 2006 from $70.0 million in the three months ended March 31, 2005. The net increase resulted primarily from increased product revenues in the Western Hemisphere, Eastern Hemisphere and Asia-Pacific of $9.9 million, $9.3 million and $5.0 million, respectively. Service revenues increased by approximately $4.0 million with increased service revenues in the Western Hemisphere, Eastern Hemisphere and Asia-Pacific of $100,000, $3.3 million and $600,000 respectively. In general, the increase in revenues resulted from increased demand for the Company’s products realized on a worldwide basis as oil and gas companies have increased their levels of capital expenditures on exploration, drilling and production operations offshore.

Cost of Sales. Cost of sales increased by $8.2 million, or approximately 16.8%, to $57.2 million for the three months ended March 31, 2006 from $48.9 million for the same period in 2005. As a percentage of revenues, cost of sales were approximately 58.2% and 69.9% for the three-month periods ended March 31, 2006 and 2005, respectively. The reduction in cost of sales as a percentage of revenues resulted primarily from changes in product mix, pricing and efficiencies realized from the increased utilization of the Company’s manufacturing facilities.

Selling, General and Administrative Expenses. For the three months ended March 31, 2006, selling, general and administrative expenses increased by approximately $1.7 million or 17.7%, to $11.2 million from $9.5 million in the

2005 period. The increase in selling, general and administrative expenses was primarily due to increased labor and overhead expenses resulting from increased staffing levels in the areas of sales, administration and finance. The Company experienced approximately $39,000 in foreign currency transaction gains in the first quarter of 2006 versus approximately $200,000 in foreign currency transaction losses in the first quarter of 2005. Selling, general and administrative expenses as a percentage of revenues declined from 13.6% in 2005 to 11.4% in 2006.

Engineering and Product Development Expenses. For the three months ended March 31, 2006, engineering and product development expenses decreased by $100,000 or approximately 2% to $4.9 million from $5.0 million in the same period of 2005. This decrease was primarily due to a slight reduction in engineering headcount. Engineering and product development expenses as a percentage of revenues declined from 7.2% in 2005 to 5.0% in 2006.

Interest Income/Expense. Interest income for the three months ended March 31, 2006 was $109,000 as compared to interest expense of $364,000 for the three-month period ended March 31, 2005. This change resulted from the partial use of proceeds from the Company’s December 2005 offering of common stock to pay down debt.

Income tax provision. Income tax expense for the three months ended March 31, 2006 was $7.8 million on income before taxes of $25.1 million, resulting in an effective tax rate of approximately 31%. Income tax expense for the three months ended March 31, 2005 was $1.8 million on income before taxes of $6.2 million, resulting in an effective tax rate of approximately 30%. This increase in the effective tax rate reflects a lower percentage of earnings in foreign jurisdictions with lower tax rates.

Net Income. Net income was approximately $17.3 million for the three months ended March 31, 2006 and $4.3 million for the same period in 2005, for the reasons set forth above.

Liquidity and Capital Resources

The primary liquidity needs of the Company are (i) to fund capital expenditures to improve and expand facilities and manufacture additional rental running tools and (ii) to fund working capital. The Company’s principal sources of funds are cash flows from operations and bank indebtedness.

Net cash provided (used) by operating activities was approximately ($1.5 million) and $2.2 million for the three months ended March 31, 2006 and 2005, respectively. The decline in cash flow from operating activities was principally due to increased working capital requirements attributable to trade receivables, trade accounts payable and accrued expenses offset by net income and inventory.

Capital expenditures by the Company were $4.7 million for each of the three months ended March 31, 2006 and 2005. The expenditures in each period were primarily for facilities, machinery and cost associated with running tools. Principal payments on long-term debt were $194,000 for the three month period ended March 31, 2006 versus principal payments of $244,000 on long-term debt during the same period in 2005. Long-term borrowing totaled $35,000 and $1.6 million in the three months ended March 31, 2006 and 2005 respectively.

The Company has a credit facility with Guaranty Bank, FSB providing an unsecured revolving line of credit of up to $65 million. At the option of the Company, borrowing under this facility bears interest at either a rate equal to LIBOR (London Interbank Offered Rate) plus 1.75% or the Guaranty Bank base rate. The facility calls for quarterly interest payments and terminates on June 1, 2009. The facility also contains certain covenants including maintaining minimum tangible net worth levels, not exceeding specified funded debt amounts and required interest coverage ratios. As of March 31, 2006, the Company had no borrowings under this facility and was in compliance with all loan covenants.

Dril-Quip (Europe) Limited has a credit agreement with the Bank of Scotland dated March 21, 2001 in the original amount of U.K. Pounds Sterling 4.0 million (approximately U.S. $7.0 million). Borrowing under this facility bears interest at the Bank of Scotland base rate, which was 4.5% at March 31, 2006, plus 1%, and is repayable in 120 equal monthly installments, plus interest. Substantially all of this facility was used to finance capital expenditures in Norway. The outstanding balance of this facility at March 31, 2006 was approximately U.S. $3.5 million. The facility is secured by land and buildings in Aberdeen, Scotland and contains no restrictive financial covenants.

The Company believes that cash generated from operations plus cash on hand and its existing line of credit will be sufficient to fund operations, working capital needs and anticipated capital expenditure requirements in 2006. Cash needs may also be met by issuing securities in the capital markets. However, any significant future declines in hydrocarbon prices could have a material adverse effect on the Company’s liquidity. Should market conditions result in unexpected cash requirements, the Company believes that additional borrowing from commercial lending institutions would be readily available and more than adequate to meet such requirements.

Critical Accounting Policies

Refer to our Annual Report on Form 10-K for the year ended December 31, 2005 for a discussion of our critical accounting policies. During the three months ended March 31, 2006 there were no material changes in our judgements and assumptions associated with the development of our critical accounting policies.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company is currently exposed to certain market risks related to interest rate changes and fluctuations in foreign exchange rates. The Company does not believe that these risks are material. The Company does not engage in any material hedging transactions, forward contracts or currency trading which could be subject to market risks inherent to such transactions.

Foreign Exchange Rate Risk

Through its subsidiaries, the Company conducts a portion of its business in currencies other than the United States dollar, principally the British pound sterling. The Company has not experienced significant transaction gains or losses associated with changes in currency exchange rates and does not anticipate such exposure to be material in the future. There is no assurance that the Company will be able to protect itself against currency fluctuations in the future.

Interest Rate Risk

As described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” the Company has entered into two credit facilities or loans that require the Company to pay interest at a floating rate. These floating-rate obligations expose the Company to the risk of increased interest expense in the event of increases in the short-term interest rates. Based upon the March 31, 2006 balance of approximately $3.5 million related to these floating rate obligations, each 1.0% rise in interest rates would result in additional annual interest expense to the Company of approximately $35,000, or $9,000 per quarter.

Item 4. Controls and Procedures

In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company’s Co-Chief Executive Officers and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2006 to provide reasonable assurance that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and such information is accumulated and communicated to management, including the Company’s Co-Chief Executive Officers and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.

“Management’s Annual Reports on Internal Control over Financial Reporting” appears on page 30 of the 2005 annual report on Form 10-K.

There has been no change in the Company’s internal controls over financial reporting that occurred during the three months ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

PART II—OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is involved in a number of legal actions arising in the ordinary course of business. Although no assurance can be given with respect to the ultimate outcome of such legal actions, in the opinion of management, the ultimate liability with respect thereto will not have a material adverse effect on the Company’s financial position and results of operations.

Item 1A. Risk Factors.

There have been no material changes from the risk factors disclosed in the Company’s annual report on Form 10-K for the year ended December 31, 2005.

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

None.

Item 3. Defaults Upon Senior Securities.

None.

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

No matters were submitted to a vote of security holders of the Company during the quarter ended March 31, 2006.

Item 5. Other Information.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes certain statements that may be deemed to be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Statements contained in all parts of this document that are not historical facts are forward-looking statements that involve risks and uncertainties that are beyond Dril-Quip’s control. You can identify the Company’s forward-looking statements by the words “anticipate,” “estimate,” “expect,” “may,” “project,” “believe” and similar expressions. These forward-looking statements include the following types of information and statements as they relate to the Company:

•

future operating results and cash flow;

•

scheduled, budgeted and other future capital expenditures;

•

working capital requirements;

•

the availability of expected sources of liquidity;

•

the introduction into the market of the Company’s future products;

•

the market for the Company’s existing and future products;

•

the Company’s ability to develop new applications for its technologies;

•

the exploration, development and production activities of the Company’s customers;

•

compliance with present and future environmental regulations and costs associated with environmentally related penalties, capital expenditures, remedial actions and proceedings;

•

effects of pending legal proceedings; and

•

future operations, financial results, business plans and cash needs.

These statements are based on assumptions and analyses in light of the Company’s experience and perception of historical trends, current conditions, expected future developments and other factors the Company believes were appropriate in the circumstances when the statements were made. Forward-looking statements by their nature involve substantial risks and uncertainties that could significantly impact expected results, and actual future results could differ materially from those described in such statements. While it is not possible to identify all factors, the Company continues to face many risks and uncertainties. Among the factors that could cause actual future results to differ materially are the risks and uncertainties discussed under “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 and the following:

•

the volatility of oil and natural gas prices;

•

the cyclical nature of the oil and gas industry;

•

uncertainties associated with the United States and worldwide economies, including those due to political tensions in the Middle East and elsewhere;

•

current and potential governmental regulatory actions in the United States and regulatory actions and political unrest in other countries;

•

operating interruptions (including explosions, fires, weather-related incidents, mechanical failure, unscheduled downtime, labor difficulties, transportation interruptions, spills and releases and other environmental risks);

•

the Company’s reliance on product development;

•

technological developments;

•

the Company’s dependence on key employees and skilled machinists, fabricators and technical personnel;

•

the Company’s reliance on sources of raw materials;

•

control by certain stockholders;

•

impact of environmental matters;

•

competitive products and pricing pressures;

•

the Company’s reliance on significant customers;

•

creditworthiness of the Company’s customers;

•

access to capital markets; and

•

war and terrorist acts.

Many of such factors are beyond the Company’s ability to control or predict. Any of the factors, or a combination of these factors, could materially affect the Company’s future results of operations and the ultimate accuracy of the forward-looking statements. These forward-looking statements are not guarantees of future performance, and the Company’s actual results and future developments may differ materially from those projected in the forward-looking statements. Management cautions against putting undue reliance on forward-looking statements or projecting any future results based on such statements or present or prior earnings levels. Every forward-looking statement speaks only as of the date of the particular statement, and the Company undertakes no obligation to publicly update or revise any forward-looking statement.

Item 6. Exhibits.

(a) Exhibits

The following exhibits are filed herewith:


Exhibit No.		Description
*3.1		—RestatedCertificate of Incorporation of the Company (Incorporated herein by reference to Exhibit 3.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)).

*3.2		—Bylawsof the Company (Incorporated herein by reference to Exhibit 3.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)).

*4.1		—Certificateof Designations for Series A Junior Participating Preferred Stock (Incorporated herein by reference to Exhibit 3.3 to the Company’s Report on Form 10-Q for the Quarter ended September 30, 1997.))

*4.2		—Formof certificate representing Common Stock (Incorporated herein by reference to Exhibit 4.1 the Company’s Registration Statement on Form S-1 (registration No. 333-33447)).

*4.3		—RegistrationRights Agreement among the Company and certain stockholders (Incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-33447)).

*4.4		—RightsAgreement between the Company and ChaseMellon Shareholders Services, L.L.C., as rights agent (Incorporated herein by reference to Exhibit 4.3 to the Company’s registration Statement on Form S-1 (Registration No. 333-33447)).

31.1		—Rule13a-14(a)/15d-14(a) Certification of Larry E. Reimert.

31.2		—Rule13a-14(a)/15d-14(a) Certification of Gary D. Smith.

31.3		—Rule13a-14(a)/15d-14(a) Certification of J. Mike Walker.

31.4		—Rule13a-14(a)/15d-14(a) Certification of Jerry M. Brooks.

32.1		—Section1350 Certification of Larry E. Reimert.

32.2		—Section1350 Certification of Gary D. Smith.

32.3		—Section1350 Certification of J. Mike Walker.

32.4		—Section1350 Certification of Jerry M. Brooks.

*	Incorporated herein by reference as indicated.

SIGNATURE

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


DRIL-QUIP, INC.

By:		/S/ JERRY M. BROOKS
		Jerry M. Brooks, Chief Financial Officer (Principal Accounting Officer and Duly Authorized Signatory)



Date:		May 9, 2006