Superior Drilling Products, Inc. (NYSE:SDPI) Q2 2022 Results Conference Call August 12, 2022 12:00 PM ET
Craig Mychajluk – Kei Advisors LLC
Troy Meier – Chairman, Chief Executive Officer
Chris Cashion – Chief Financial Officer
Conference Call Participants
John Sturges – Oppenheimer & Company
Ben Piggott – EF Hutton
John Bair – Ascend Wealth Advisors
Matt Reiner – Adirondack Funds
Greetings. Welcome to Superior Drilling Products, Inc. Second Quarter Fiscal Year 2022 Financial Results. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation [Operator Instructions] Please note, this conference is being recorded.
I will now turn the conference over to Craig Mychajluk, Investor Relations for Superior Drilling. Thank you. You may begin.
Thank you. And welcome, everyone to our second quarter 2022 earnings call. We certainly appreciate you time today. Joining me are Troy Meier, our Chairman and Chief Executive Officer; and Chris Cashion, our Chief Financial Officer.
You should have a copy of the financial results that were released before the market this morning. You should also have the slides that accompany our conversation today. If you do not, both documents can be found on our website at sdpi.com.
Turning to Slide 2, I’ll point out that we may make some forward-looking statements during the formal discussion, as well as during the Q&A session. These statements apply to future events that are subject to risks and uncertainties, as well as other factors that could cause actual results to differ materially from what is stated here today. These risks and uncertainties are provided in the earnings release, the slides and other documents filed by the company with the Securities and Exchange Commission. These documents can be found on our website or at sec.gov.
I want to also point out that during today’s call, we will discuss some non-GAAP financial measures, which we believe will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of non-GAAP with comparable GAAP measures in the tables accompanying the earnings release, as well as in the slide deck.
With that, please turn to Slide 3 and I’ll turn it over to Troy to begin. Troy?
Thanks, Craig. And thanks everybody for joining us for our second first quarter of 2022 call. As we look at the second quarter, I’d like to highlight fur items that that we spent a good majority of our time and resources doing. And one of the things that I think first thing to highlight is the hiring and training of new talent. As you all know that as a business grows, we’ve got to bring on more personnel and our management team has been doing a good job, picking up talent and getting them trained and some of the — a lot of the services that we provide here, take a special talent and especially working with heat. And so I want to tell our team good job for what they’ve been doing there, and that we’re building a good strong team here.
So the next thing I’d like to talk to make sure that we mentioned today is securing of additional opportunity with our legacy customer. That’s another biggie that we’ll be talking about. Securing the MENA channel partner is another bullet point I’d like us to discuss or talk about today.
And then also in the second quarter, we get a lot of repair and maintenance of equipment that as you well know, over the last few years we haven’t had the opportunity to get to that. And we’ve spent some resources taking care of the plant and equipment here. So I want you to all be aware of that as well.
So as we look at what we’ve got going on in 2Q or what we had going on in 2Q, a very, very strong demand for our services. When we look at our legacy side of the business on the refurbishment of tools, that is very strong and it’s growing every day. That demand continues to strengthen both on the flagship tool, the Drill-n-Ream, as we see DTI keep a strong presence in the North American markets as they bring on new customers and they’re doing a good job there.
We also have the legacy bit refurbishment, as you know with Baker Hughes and they’ve been they’ve been keeping us very busy as they get stronger and stronger in their position in that market. We see improved market conditions as we see rig count go up, of course there’s more demand for our services. So, I think that even though when we look at rig count, it’s nowhere near where it was a few years back. However, the rigs that are there are drilling a lot of footage. So keep that in mind that the demand for tools at the current rig levels is tremendous. So, be very aware that the footage being drilled per rig is very impressive.
The strengthening of our balance sheet, Chris will talk about that. We continue to keep focused on that. As we pay down debt and build cash, and he’ll talk about that. Then we look at the working to improve capacity and demand, we’ve brought on additional shifts to supply both new tools that we’re manufacturing in our machine shop as well as the — when we look at the people that we need for that, it’s a very talented operator that we’re looking for, that not only do they program and run the CNCs, but they’re very, very talented in the design side as well. And we’ve been picking up some good talent there, and we continue to look. We have issues like everybody else does in the labor market today, finding talent and getting them on board. But our team is doing a good job and they’re doing that every single day, trying to find better ways to attract some good talent.
We spent a lot of time in the international side of the business. You all know that we signed on a channel partner in the MENA region, the Bin Zayed Petroleum Group, and we work with them on a weekly basis as our teams are getting to know one another and how we’re going to work together to saturate the market with the Drill-n-Ream technology and other technologies that they may need to expand. It’s been a very refreshing opportunity to deal with such world-class organization, we’re very pleased with the individuals we deal with and we think it’s going to be good sure steady steps as we go forward.
Keep in mind, we talked about the turnkey process. We purchased a new machining center. It was a million dollar machining center that we’ve put into place, we now have it in place. We’ve made — we’re making the jigs and fixtures that are going to allow us to do this turnkey process that we’ve talked about where in the — right now today, we machine new product but we don’t — we don’t finish the product. We ship it off to Houston, where it’s braised and hard faced. This new turnkey process that this machine will be addressing is going to keep those products that we machine and then keep them here so that we can also finish this product and then ship it out.
We think it’s going to be a great opportunity for this company. And I say that machine’s in place and we’re running the programs right now. And we will start turning our first products off of there this month actually. So we’re excited for that.
With that being said, I’m going to go ahead and turn it over to Chris to talk about the financials. Chris?
Thank you, Troy, and welcome, everyone. Let’s continue our review by turning to Slide 4, where we will review our strength in top-line. Q2 revenue rose 34% to $4.5 million over the prior year period and grew 10% sequentially. While we are certainly benefiting from the continued improvement in the oil and gas industry, we also equate our success to our manufacturing processes and business development effort that have resulted in obtaining additional business with existing customers.
North America revenue was about 89% of our total revenue, which has been increasing thanks to improving industry conditions, the growing demand for pother related tool and contract services and more rigs utilizing our flagship tool, the Drill-n-Ream which continues to demonstrate its value to operators by improving drilling efficiencies, which serve to reduce oil and gas drilling and production costs.
The U.S. rig count continues to increase leading to a number of customers recognizing the value of our technologies and expertise. The average U.S. rig count of 715 in Q2 2022 was up 82 rigs sequentially or 13% and up 264 rigs since last year’s second quarter, a 59% increase. We expect this steady trend in North America to continue. And as of last Friday, the U.S. rig count was 764.
Over the last year, the international market growth has been at a slower rate compared to our domestic growth due to ongoing pandemic related restrictions, which have impacted travel and labor recruitment in that part of the world.
We are really excited about our new marketing and distribution agreement with Bin Zayed as Troy mentioned. We believe this will accelerate our international growth. As we previously announced, this agreement provides that Bin Zayed Petroleum will initially purchase the company’s existing Middle East drilling rig tool fleet, and they will purchase new drilling rig tools as they penetrate the Middle East and North African markets. The company will repair and maintain Bin Zayed’s purchase tool fleet and will share in the revenue that Bin Zayed receives from the rental of the tools to the end users.
In total, through the purchase of tools and a revenue share model, the company expects to realize roughly $13 million in revenue over the 12 month period beginning July 2022 through its relationship with Bin Zayed. The initial tranche of purchased inventory of approximately $4 million will be recognized in revenue in the third quarter of this year. Market penetration expectations are still being agreed and will be adjusted on an annual basis.
Now, please turn to Slide 5 to review our tool and contract services revenue, which are both appreciably higher. Total tool revenue, which is the sum of other related tool revenue and tool sales and rental revenue, increased 27% to $2.9 million from the prior year period and was largely driven by higher Drill-n-Ream royalty and repair revenue, given the increase in the end users of the tool. Contract services were up 47% to $1.6 million as we have leveraged our improved capacity to support our customers’ increasing demand. They continue to recognize the value of our high quality PDC bits and other tool manufacturing capabilities as well as our PDC bit refurbishment services.
On Slide 6, you will see that our costs and expenses have increased. We are working hard to keep up with the demand for our products in the face of global inflationary headwinds, which specifically have impacted us in payroll expenses, raw materials used in our manufacturing operations, supplies and repair and maintenance costs. We’ve also expanded our workforce to accommodate our current growth with talent being added to quality, safety and general manufacturing support areas.
We continue to demonstrate strong leverage on the SG&A line, which declined 160 basis points as a percent of revenue from the prior year. Depreciation and amortization expense decreased approximately $180,000 or 31% year-over-year, primarily as a result of fully amortizing a portion of our intangible assets and fully depreciating some of our manufacturing center equipment. We remain focused on our cost control efforts and are making the necessary investments to help capture the tremendous demand for our products and services.
Inflationary pressures are expected to endure for at least the near-term. But our teams are working to optimize processes and build relationships to expand our global presence. And while we have had some success in adding talent, labor constraints are still an issue as we move forward and prepare for additional demand.
To help combat the inflationary headwinds around — headwinds around materials and labor, we implemented customer price increases effective July, 2022, and expect to make further pricing adjustments this fall and into next year.
Now, let’s go to Slide 7. And we see that our bottom line and adjusted EBITDA were pressured by these increased costs as we just noted on the previous slide. Net loss for the quarter was near breakeven, slightly negative. Adjusted EBITDA of $831,000 was 18% of sales.
Now moving to Slide 8, we see that our balance sheet remains strong with reduced debt and stable cash levels. For the first half of this year, our cash balances exceeded our debt. Cash generated from operations for the year to date period was $1.4 million, compared with $335,000 in the year ago period, largely reflecting the improvement in net income.
We have utilized some of our cash to support and increasing capital plan, which to date $1.2 million spent in the first six months of 2022. This reflects the down payment of roughly $300,000 to secure a new CNC machine in Q1 of this year, an increase in maintenance and capacity improvement projects and an increase in our Middle East drilling rig tool fleet.
CapEx for the comparable period of 2021 was $55,000. We expect our increased level of capital spending to continue into the rest of this year, in total approximately $2 million to $2.5 million over the last two quarters. Troy will review our capital priorities in just a few moments as he goes over our outlook.
Total debt of $2.4 million was 2% lower from the end of calendar year 2021. We have sufficient cash and expect to pay off our Hard Rock Note — our final payment on our Hard Rock Note I might add, of $750,000 and we’ll make that payment in October and that will retire this portion of our debt. In addition, with the cash from Stage 1 drilling rig inventory sell to Bin Zayed, we will consider retiring other high interest rate debt.
Now let’s continue on Slide 9 and take a look at our guidance going forward for the rest of this year. We’re guiding 2022 revenue of between $22 million and $25 million. As a point of reference, I might add in 2021, we did $13 million in revenue for the year. We believe SG&A expenses will be between $7 million and $7.3 million. We believe adjusted EBITDA will be between $6 million and $8 million and our capital expenditures for the year will be between $3 million and $4 million.
As we would like to note in Q3, as we mentioned, we will be selling roughly $4 million of our existing inventory in the Middle East to Bin Zayed Petroleum, and we expect that to happen this quarter, Q3. And with that sale of tools, our revenue in Q3 will be between $8 million and $9 million. And adjusted EBITDA in Q3 will be between $3.5 million to $4 million.
So now with that, I’m going to turn the presentation back over to Troy, as he goes through our outlook and opportunities.
Thanks, Chris. So as we look at our opportunities that we see throughout the remainder of this year, like I said earlier, there’s a tremendous need for our legacy skill set, what we’ve been doing and we’ve — we’re building out that part of our business. When you look at the facility here, we’re increasing our braise capacity, we’re building new braise stations, we’re moving some equipment from one building into another as we as we find more efficiencies and teaming up with the braise stations from the Drill-n-Ream and then into the drill bit side of things.
So we’re going to see some CapEx spending there, we’re going to — we’re looking at bringing on a — another large 5 Axis machining center to support the activities that we have there. You’re all aware of that we’ve got several large, we call them 5 Axis but they’re 7 and actually 9 Axis machining centers. We’re going to be duplicating the two large ones due to the backlog and whip that we have on those machines. And it also gives us a good backup machine in case something was to happen on these two main machines.
So there’ll be some CapEx spending there as well. And with that, when we bring these machines in, we also got to do some work to our foundations to support these large machines that allow us to keep the accuracy that we keep. We do modifications, we cut out the existing floor and then lay in a really good support structure for these machines.
We’ll also going to be — we’ve got to get a refurbishment service center done and running in MENA in Dubai. So our team is very focused on that, we’re identifying the equipment that we’ve got to get purchased and get over there and get installed as well as getting a workforce over there trained to refurbish the tools, inspect and refurbish. Along the same lines as what we do here and you know, of course that’ll start off being for the Drill-n-Ream tools, but there is a lot of drill bits that get run over there as well. So I’m sure that’ll come in right behind the Drill-n-Ream that need to also service those type of tools.
We’ll also — we expect the Drill-n-Ream demand to increase, which is wonderful. We are making sure we have the equipment and the personnel in place to service that demand. Keep in mind, the turnkey process that we’ve talked about, we expect that to be up and running and by the time we get to Q4, it should be a meaningful addition to the services we provide here. And the contract services like we’ve said, we’ve got a massive demand for that service. So lots of opportunities, we have got to continue to expand our manufacturing capabilities.
But with that again, I think the biggest part of all this expansion is going to be the hiring and training of qualified personnel and we’ll continue to get creative on how we attract the high end workforce and retain this workforce. So with that being said, I’d like to turn it over to Q&A. Thank you.
[Operator Instructions] Our first question is from John Sturges with Oppenheimer & Company. Please proceed.
Thank you very much. Nice quarter gentlemen. I’m curious about if you can provide an update on Strider, where is it in the other tools that you have? Are they — some of them already going to distributorship? And then the second question which fits in with that, fourth quarter typically in U.S. is slower for you. I would imagine Middle East business would offset a bit of that. But with the pace of drilling, fourth quarter may not be that weak. So I’m just curious as to what you are seeing at this point in time versus the fourth quarter.
Okay. So regarding your first question on the Strider, I don’t talk much about that tool just because we kind of put that on the back burner in 2020. We started off Q1 of 2020 and we’re really excited about the Strider, sold our first four tools, and then what happened. But since that time, we have had a very high end customer that took those tools that we sold in Q1of 2020 and actually ran them in Q1 of this year, and they performed very, very well. We’ve since brought that product in.
Everybody that we had that was involved in that product line, we had a — when we did our reduction in force we lost those individuals. And so, it was a pleasant surprise for us. And we’ve now got a manager in that department who has taken that on and we have refurbished those tools that came in, that performed well, and they’ve been — we put them back out and they they’ve performed well, again.
So we know that there’s a need for that product line and we are addressing it. We haven’t put anything in our budget for that, although we are doing it on a small basis, we’ve now gone to — we’re moving that product line instead of having an elastomer power section, is what we started that design with many years ago, the relining and the elastomer in that product line has gotten very expensive. And so we’re moving that to a metal-on-metal, it’s really exciting for us, the metal-on-metal we believe will last at least 10 times longer than the elastomer that we had used. And we’re just now modifying those power sections, we’ve got four of those that we’re going to be getting out here over the next month.
So we’re excited to get those out and get them in the field and see some wonderful performance on those, and we’ll probably be talking a lot more about that in our Q3 in November. But really, we’re — that’s going to be Q4 where we start to see these tools getting out and getting multiple runs on them. And then we start to look at addressing a really good build up in that side of the business starting in Q1, Q2, of next year.
Regarding Q4, and the typical slowdown that you see there, we’re not expecting that at all. In the past, what would really affect the Q4 is the fact that the drilling efficiencies were becoming so great from year to year that these companies, the E&Ps would say, we’re going to drill 100 wells this year, and they were looking at wells that may take them 25 days to — from spud to TD. And then they plan that out throughout the year, and then they find out that they’d have that drilled up because of the efficiencies, it’s drilled up by September, October. And those gains kept happening year after year after year.
And what we’re seeing now is the wells are being drilled very, very efficiently. But we’re not seeing those days come off of wells that we’ve been seeing in years past. So even though they’re getting better at it and more efficient, I think we’re reaching the point where we can only put pipe in the hole so quick. And so the efficiencies of drilling wells are being — they’re being recognized in other places than just days off of wells. So I don’t think we’ll see budgets drilled up come October, I think we’ll continue to see some good activity throughout Q4.
And with the need to — when you look at the rig count, you see it’s trying to get — to get pushed towards that 800 mark. But I think one of the issues that you have with that is, what we see here past 750 now, it seems like we go up a few rigs and we come down a few rigs. And I know when you’re talking to the service — the Serve-Cos when these E&Ps want to put up more rigs, those hands are coming from the service companies.
And so it’s a trade off now of if you want the tools quit taking the hands. But you’ve got to have the hands to stand up the rigs. So it’s really interesting dynamics where we’re at right now with the — with the rigs and the Serve-Cos. So I think we’re going to see a strong Q4 in the drilling activity, and we plan on participating in that with some of the other things that we’ve been talking about with the new product line adoptions that we’re bringing on and the new services that we’re adding. Hope that answered your question.
You did, that was a great — lot of color, I really appreciate that. Just one little follow-up, and that is the duct inventory that was usable, seems to have — they’ve worked it down. So all new production pretty much is coming from fresh greenfield drilling, or something close to that, which would imply just to keep up with current production, you’d have to have either longer laterals or more wells. And I’m just trying to get a sense of what you see along those lines?
It seems to me like a two mile lateral is commonplace now. When we first started getting out there we were doing 1000 foot laterals and then 2000 foot laterals, and now we do laterals that follow property boundaries in a square — but it seems to me that the talk that we hear is a lot about these two mile laterals, and I’m not quite sure how much further they can go to be productive. I know there’s — when you get to the top of a well, which is the end of the lateral, I don’t know if you get as much energy from your frac as you do at the hill. And so we may not have the efficiencies and not get the return if a well gets too long. I’m not an expert in that field but just from talking with people, that’s what I hear.
Our next question is from Ben Piggott with EF Hutton. Please proceed.
Just on Bin Zayed, if we can peel that back a little bit more. I mean, it looks like margins will explode to the upside Q3 as that transition occurs. But just can you talk a little bit more about the longer term implications to just the capital intensity in the margin profile of the business as — if the Middle East looks a lot more like North America? And then a follow on, you mentioned that there could be a nice opportunity to have a drill bit refurbishment business in the Middle East as you open up the center in Dubai, maybe just to find the fairway or how big of an opportunity could that be for the company over the next couple of years? Thanks.
Okay. All right. So when you look at the opportunity that we believe we have with Bin Zayed group, it’s — they’re new into the upstream, right? They sell oil, and they’re now entering into the upstream market. And so they’re — as they go into this market, they’re looking for a lot of support from us. And we’re looking for a lot of support from them. They have the contacts in these oil and gas companies that we didn’t have. We didn’t have those contacts up in these companies that we could just go and call on like maybe we could do here in the U.S. And so that’s always been a struggle for us being foreigners over there and trying to break into a market, and they are very much into that market as you are well aware.
So when they look at the services that they expect from us, not only are they looking at the Drill-n-Ream tool to be one of those first tools that are getting them into the service side or the upstream side of the market, they also have needs for products in their side of the things, in the production and the downstream side of things that they would like us to look at as well. There’s — I’m not quite sure what all those products are. But they are very, very interested in our machining talents that we have here.
And I know they have mentioned that multiple times that as we look past just the Drill-n-Ream and the drilling tools that we may be able to provide them. They have a directional drilling team, a very small directional drilling team that they are going to expand on. And so, as you well know, when a directional drilling team goes out, they need any bits, they need motors, they need rotary steerable systems and they need all that stuff serviced. And so as we set up our service center in Dubai, we will be looking at all of those things. We know what we are going there for, is to service the Drill-n-Ream, but we also know there is a lot of additional opportunities.
Our first trip over into that region, and this will touch on your second question. Our first trip over there, I want to say, it was probably — yes, not even in 2018, no, I think it was around ’16. And it was over there — when we went over there, it was to look at the drill bit refurbishment market for ADNOC, Abu Dhabi. And at the time, when we looked at that we couldn’t really justify going over there and setting up a facility just for the volume that we’d be getting just from the UAE.
But now as we look at the volume that we could be getting from the MENA region, it looks a lot more appealing. So as we set up this facility that we are looking to have open, by year end is our goal. And I’m hoping we can have it up and going by the first week in December, but we still have a lot of issues we are dealing with the supply chain and logistics, putting equipment in sea-cans and trying to get it over there and — there’s no — nobody can give you a time frame on when that sea-can will arrive at its destination, you just kind of — you just kind of got to go along and hope that it gets there in some meaningful manner.
So we’re trying to fabricate the stuff we can over there and try not to get stuff on the sea-can. But When we open up that service center, we are designing things in a way that we know there’s going to be additional products. So when we look at [AMP Ridge], when we look at cleaning stations, when we look at inspection stations, this whole facility is being laid out based upon other tools and equipment coming in there. Did that answer your question, Ben?
Is it — just trying to dig in on the margins a little bit more, just conceptually, should the margins as you expand the opportunity with these folks in the Middle East, should it be better than the margins in North America or similar or maybe it’s not as good? Just any color on kind of profit profile as incremental growth comes from that part of the business?
I think when you look at the margins, you can consider and look at them to be about the same. When we look at the rental of products over, it is a little higher, we get a little more per foot. But it costs us a little more to do business over there. So I think it’s going to be a wash. We expect good margins on the products that we do over there. But I think they’re going to be a lot. They’re going to be really close to what we get here.
Our next question is from John Bair with Ascend Wealth Advisors.
Given the strong demand on your services, as well as the tools and so forth, I’m wondering how that plays into your pricing environment and whether you’re able to raise prices to accommodate that?
We are — as Chris mentioned, we had a price increase of 10% in July on Drill-n-Ream service part of our business, and we expect a price increase on the bit refurbishment side of our business in September, is what we’re shooting for. And so yes, we — everybody understands that they’re going through the same situation as we are, with the price of steel, the price of saw, the price of cutters, everything that we use is gone up. And they’re sharing that what we’re charging, it’s going on to the end user. So the price of drilling a well is definitely going up. And I think you’re probably very aware that the E&Ps have talked about how the price of drilling a well they expect to continue to rise.
Are you seeing any leveling off in general component prices, metals or so forth?
Metals, we are, they peaked around November, December timeframe. And so we’re starting to see a little bit of easing on metals pricing. I don’t know how that’s going to play into this third and fourth quarter, it’s not a bunch. But when you look at the raw metals per tonne, it’s coming down. I want to say it peaked at 2,000 a metric ton sometime back in November — October, November timeframe. And I think we’re back down to about 800. So it’s come down, it’s come down quite a bit from the foundry but we’re not seeing that big of a price decrease from the supplier.
And then in the last couple of years, you had mentioned that you were having trouble getting folks into the Middle East. How’s the situation there? Is that eased up to — been alleviated somewhat to where you are able to get your folks over there more easily?
Well, in Dubai, we can get people in and out of there. They’ve got less restrictions than say Kuwait. And Kuwait was where we were really strong pre-COVID, is where we were making our best headway, it was in Kuwait. And then that locked down pretty hard. And I think it’s – and it’s just not for our services. Keep in mind that a lot of these wells are being drilled with the support of expats, right.
And so when they went into lockdown mode, some of the expats were over there, had to stay in there a lot longer than what they were planning. And so there’s some concerns with people going over there and maybe getting involved in another lockdown where you maybe have to stay longer than what you wanted. So I think that’s why we’re not seeing a big increase in rig count over there. It’s just the fact that, it’s just not real desirable right now with the new world of pandemics.
But we are seeing — like what you’ve seen in the news here lately, where they’re easing up on what happens with COVID and we’re starting to see a lot of easing here. And I hope that — it seems like the UAE follows really close to what happens here in the U.S. And then when you get into countries like Kuwait, they may follow a little bit later. But I — with the exception of getting materials in and out of there and sea-cans in and out of there, I don’t think we’ll have an issue getting personnel in and out of Dubai. I think it’s that — we’re going to be okay with that, for training purposes.
And remember, you know, we have a whole Drill-n-Ream fleet over there, as it gets used we got to get it repaired, we’re not going to ship it back here to the States like we’ve done in the past, because if you just — you can’t rely on that at all. So there’s tools that need to be repaired and they’re building up, and so we’ve got to get it done. And I think we’ll get it — we’ll get a facility put in place over there and get people moving in and out of there as we hire and train people over there to do this service work.
One last question. That’s just in the past. What opportunities do you see perhaps in South America there seems to be — there’s a robust industry over there Brazil and of course Guyana? Do you see an opportunities there? Looking at that, maybe a channel partner or whatever that can help you break into that market?
We have. We’ve talked to several companies that would like to rep the Drill-n-Ream down there. But one of the issues we have with that is we don’t have a service center down there. And the drilling agreement — the reason it’s — one of the reasons it’s a successful product is we really keep tight reins on the procedures and process that are followed when this tool is — after it’s run. It goes through a really rigorous inspection process and then repair process, and we just don’t hand that off to anybody.
And so, we have been in talks with companies that would like to support it. Our bandwidth just hasn’t allowed us to get too aggressive with it. When companies run a tool down there, which we have done and they have worked very well, then they are faced with shifting the tool back to the States and having us repair it and it kills that opportunity.
So we are running, we’re just going to be sending some tools down to Guyana on a test well down there for a large company. I think we will be shipping those tools out this month actually. And so, we’ve got four tools going down on an experimental well. This large customer wanted to run that as part of this exploratory process. And we can update you on our next earnings call on that.
Our next question is from Matt Reiner with Adirondack Funds. Please proceed.
Hi, guys. My first question was on the capacity. Obviously, you’re making some big investments in this quarter. And how much or I guess, what can you share with us about like what your current capacity is and what these extra investments will add to it?
Okay. Well, our current capacity, what it is? We have got machines that — that’s not what’s holding our capacity back, it’s been the human capital side of things. And I say that, but we’re going to be investing in machines as well because of the opportunity for turnkey processes and also to facilitate more capacity with units coming through. So that probably sounds real wishy-washy. But what I mean is, if you look at our 750, if you look at the means that make the Drill-n-Reams, we have two machines that produce those tools and they are very unique machines. And the large tools, we only have one machine that produces those tools. So once you start getting over a 10 inches size range, they all get made on this one machine. It’s called the B-750.
And we’re going to duplicate that. Our goal is to get that duplicated and in place before year-end. We’d like to have that done. And what that does is it supports the 750 that we currently have. If it goes down for any reason, whether it’s operator error or maintenance, we can — we’re not stuck with hurting — increasing our backlog or delivery time. But also that machine can be run in simultaneously with an operator running both machines. So that’s why I said it’s — we’re building that machine, but the same operator can run both machines, so that’s a big benefit.
The human side of capital that we’re looking at, let me go back to also your turnkey process, that machine there that we’ve put in place. Right now, we have one manager that’s working all the bugs out and designing and manufacturing the jigs and fixtures that we need for this turnkey process. And once that gets going, now we’re going to run three shifts, we’re looking at going 24/7. And so the people that will be supporting that machine, is going to be the growth in our human capital.
If you look at the current machines that we have, we run — I would imagine — not imagine, when we do run. When we get into second and third shift, we’re running about 40% capacity on those machines. And that’s because we don’t have the operators standing in front of all those machines. We have more operators on day shift that have been doing that, and it’s been it’s been handling the workload that we’ve had to this point. But the demand has become so strong that we now got to look at running all those machines, and putting people in front of them looking more on a 24/7 on those as well.
So current capacity will increase a bunch on the existing equipment that we have by putting more people in front of them on more shifts, and then we also will be increasing our capacity by the additional 750 that we’re looking at as well as the big maze at turning centers that we just put in place. So we’re going to be increasing our capacity quite a bit.
So I guess, maybe this is a question for Chris. But so looking at — from a free cash flow perspective or whatnot as we as we look out at least for the second half of ’22, clearly with the large order in the third quarter, your adjusted EBITDA, if we can go at the midpoint of that, that’s a fairly healthy adjusted EBITDA. You’re also looking at roughly 6 million in CapEx in the back half. So, I’m assuming some of that is going to get eaten up by the CapEx.
And then I was curious as to how much gets eaten up by working capital or however you want to answer that either. If you could tell me how much free cash flow you expect to generate from, in the third quarter, in the back half, or if you want to approach it from a working capital and break it down that way. Either way is fine for me.
I think in terms of doubling our existing cash balance, so another way of saying that is we’re about $3 million right now, June 30. As you just noted, we’ve got the large order in Q3 and we’ll be collecting on that. And just as a point of reference, that’s existing — existing tools, existing fleet of tools that we have on our balance sheets, so that’s monetizing an asset. So that sale will go right to the cash line. But we do have some CapEx that we’re putting in place. So that’s why I say, just think in terms of doubling the cash balance from three to six, by the end of the year.
And you were saying that you may — so besides the Hard Rock note, you may look at taking out some higher interest rate that is, I assume some of that extra cash can go towards that. And how high is the interest rate on that extra debt?
It’s prime plus, and with some fees it’s about 10.5 right now. That’s why we’ll probably take that out. It’s not much money. It’s about a million dollars. So it’s okay. But we would like to pay that off.
[Operator Instructions] Our next question is from Brett Davidson, Private Investor.
Well, good morning to you guys. Good afternoon, here out on the East Coast. I’m relatively new to the company and pretty ignorant as far as operation, excuse me, and so on. So you’ll have to excuse me if some of these are a little simplistic on my side here.
Cost of goods sold, I believe you indicated that the equipment that was delivered in the Middle East was — had already been manufactured as existing equipment. How is that going to impact cost of goods sold in this quarter?
Favorably. Our carrying value on that equipment was — had been depreciated quite a bit so that those carrying costs will become COGS when we sell this — when we monetize this asset. And so it’ll be an improvement to the margin, gross margin.
Okay. So would you have a ballpark idea, maybe 25% depreciated or?
Something like that.
All right. Yeah. Good enough. I’m not too interested in the precision. All right, the machine tools you guys have on order and how are the delivery times looking on those? Are you guys getting the stuff in a timely fashion or is that been impacted by supply chain?
You know, we’ve been very fortunate. Our procurement group are still purchasing is, we have a very good team there that’s been out in front of this. We’re continually buying at good prices. And looking ahead, we’re constantly looking for opportunities to buy mill runs, not a full mill run, but what’s left of a mill run. We look at we look at mills, high end mills globally, whether it’s out of South Korea or Ohio or Brazil or Spain, Germany, we tap into all of them. And so our team has done a fantastic job there.
So the steel hasn’t been an issue. We’ve had a couple of scares. But it hasn’t — nothing has tripped us up. The supplies when you look at the PDC cutters, that’s the next big component and probably most expensive, the diamond cutters we put in products, and very fortunate there that we have kept enough suppliers of that product online. But again, we’ve had a couple of scares more so in 2020 — no, 2021 than we have this year.
The toughest thing for us when we try to predict a manufacturing time is probably — well, the hardest area for us is definitely the Mid-East. How do we get things over there, and we can always put it on a jet at a very high expense. Sea-cans are pretty much out of the question right now because of the backup. But we haven’t been hurt with the supply chain, but it has caused a lot of scares, let me put it that way. But we haven’t been hurt with it yet.
So the supply chain, the hang up is all live bodies with pulses then.
It just takes a lot of — a lot more effort on our part. When you go to place an order, this supplier doesn’t have it because of these reasons, and so we’ve got to start really kicking bushes in trying to find what else we can get in a timely manner. And of course, you’ve really got to increase your inventory, which isn’t something we like to do but we do.
And switching back to the production side, so the existing equipment was sold, that’s already booked. Are you currently producing products for the Middle East customer for ship this quarter or at some point next quarter? Is additional production already in place?
No. We have — there are some tools here that we plan on selling in another stage of this agreement that are — that we need to finish — just the — putting the cutters on and then getting them over there. That was — we were looking at that in Stage 3. But most of those tools have been done and sitting over there. As they get their feet under them and start calling on customers, I’m quite certain we will have a demand for new Drill-n-Ream tools. But right now, as we prepared for this, we built up an inventory, we’ve got it in place in various countries, and there was a method to our madness and it’s very beneficial for us now.
So then for the remaining portion of this contract, how do you see it playing out? I mean is it going to start production in fourth quarter for the add-on tools or might extend out further before you guys need to step up and start producing new equipment?
Well, think of the three ways that we get that contract — we get our revenue from that contract. We still get a percentage of every time the tools run, we get our percentage of that revenue. When we repair those tools over in the Mideast, we get paid for that. And then on top of that when we get into next year, and you might see a little bit this year of new tool purchases, but we’re not banking on it. But when you start getting into Q1, Q2 of next year, and they’ve got their customer base growing, that’s when we see that there’s going to be a need for new products.
So you guys got a little cushion before you have to worry about an onslaught of new revenue from a new production?
Correct. And that — and again, you heard me mention earlier, the additional B-750 machining center, that’s also what that’s for.
We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing comments.
Hey again, thanks, everybody for joining us. And we appreciate the support that we get from you. We’re looking forward to visiting again in November regarding Q3, and we’ve got a lot of opportunity ahead of us and we’re going to do our best to capitalize on it. So thanks again. We appreciate it. Thank you.
Thank you. This does conclude today’s conference. You may disconnect your lines at this time and thank you for your participation.
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