Quarterly Report — Small Business — Form 10-QSB Filing Table of Contents
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(Exact
name of registrant as specified in its charter)
Nevada
75-2263732
(State
of other jurisdiction of incorporation)
(I.R.S.
Employer Identification No.)
15473
East Freeway
Channelview,
Texas
77530
(Address
of Principal Executive Office)
(Zip
Code)
Registrant’s
telephone number, including area code: (281)
862-2201
Securities
registered pursuant to Section 12 (b) of the Act: NONE
Securities
registered pursuant to Section 12 (g) of the Act: Common
Stock $0.01 par value
Check
whether the issuer (1) 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
such shorter period that the registrant was required to file such reports),
and
(2) has been subject to such filing requirement for the past 90 days. Yes
[X]
No
[ ]
Check
if
there is no disclosures of delinquent filers in response to Item 405 of
Regulations S-B not contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB. [ ]
Indicate
by checkmark whether the registrant is a shell company (as defined in Rule
12b-2
of the Exchange Act). Yes [ ] No [X]
At
August15, 2007, the issuer had outstanding 67,870,171 shares of Common Stock, par
value $0.01 per share.
Transitional
Small Business Disclosure Format: Yes
[ ] No [X]
Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds
20
Item
3. Defaults Upon Senior Securities
20
Item
4. Submission of Matters to a Vote of Security
Holders
20
Item
5. Other Information.
20
Item
6. Exhibits
21
SIGNATURES
22
PART
I - FINANCIAL INFORMATION
Forward-Looking
Information
The
statements contained in this Quarterly Report on Form 10-QSB that are not
historical fact are forward-looking statements (as such term is defined in
the
Private Securities Litigation Reform Act of 1995), within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. The forward-looking statements contained
herein are based on current expectations that involve a number of risks and
uncertainties. These statements can be identified by the use of forward-looking
terminology such as “believes,”“expects,”“may,”“will,”“should,”“intend,”“plan,”“could,”“is likely,” or “anticipates,” or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy
that
involve risks and uncertainties. Deep Down wishes to caution the reader that
these forward-looking statements that are not historical facts are only
predictions. No assurances can be given that the future results indicated,
whether expressed or implied, will be achieved. While sometimes presented with
numerical specificity, these projections and other forward-looking statements
are based upon a variety of assumptions relating to the business of Deep Down,
which, although considered reasonable by Deep Down, may not be realized. Because
of the number and range of assumptions underlying Deep Down’s projections and
forward-looking statements, many of which are subject to significant
uncertainties and contingencies that are beyond the reasonable control of Deep
Down, some of the assumptions inevitably will not materialize, and unanticipated
events and circumstances may occur subsequent to the date of this report. These
forward-looking statements are based on current expectations and Deep Down
assumes no obligation to update this information. Therefore, the actual
experience of Deep Down and the results achieved during the period covered
by
any particular projections or forward-looking statements may differ
substantially from those projected. Consequently, the inclusion of projections
and other forward-looking statements should not be regarded as a representation
by Deep Down or any other person that these estimates and projections will
be
realized, and actual results may vary materially. There can be no assurance
that
any of these expectations will be realized or that any of the forward-looking
statements contained herein will prove to be accurate.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
1: Description of
Business
Deep
Down, Inc, (“Deep Down”) a Nevada corporation, provides installation management,
engineering services, support services and storage management services for
the
subsea controls, umbilicals & pipeline industries offshore. Deep Down also
fabricates component parts for subsea distribution systems and
assemblies.
On
June29, 2006, Subsea Acquisition Corporation (“Subsea”) was formed with the intent
to acquire service providers to the offshore industry, and designers and
manufacturers of subsea equipment, surface equipment and offshore rig equipment
that are used by major integrated, large independent and foreign national oil
and gas companies in offshore areas throughout the world. On November 21, 2006,
Subsea acquired Deep Down, Inc, a Delaware corporation founded in 1997. Under
the terms of this transaction, all of Deep Down, Inc.’s shareholders transferred
ownership of all of Deep Down, Inc.’s common stock to Subsea in exchange for
5,000 shares of Subsea’s Series D Preferred Stock and 5,000 shares of Subsea’s
Series E Preferred Stock resulting in Deep Down, Inc. becoming a wholly owned
subsidiary of Subsea. On the same day, Subsea then merged with Deep Down, with
the surviving company operating as Deep Down Inc. The purchase price based
on
the fair value of the Series D and E Preferred stock was $7,865,471.
On
April2, 2007, Deep Down purchased all of the assets and certain liabilities of
Electrowave USA, Inc. a Texas Corporation. Deep Down formed a wholly-owned
subsidiary, ElectroWave USA, Inc., (“ElectroWave”),
a
Nevada
corporation, to complete the acquisition. ElectroWave offers products and
services in the fields of electronic monitoring and control systems for the
energy, military, and commercial business sectors.
Basis
of Presentation
All
accounts of Deep Down and its wholly owned subsidiaries are included in the
consolidated financial statements for the appropriate periods. All significant
inter-company transactions and accounts have been eliminated in consolidation.
Since Deep Down was formed on June 29, 2006, comparative financial statements
are not presented.
The
accompanying unaudited financial statements as of June 30, 2007 and for the
six
months then ended have been prepared in accordance with generally accepted
accounting principles for interim financial information. Accordingly, they
do
not include all of the information and footnotes required by generally accepted
accounting principles for audited financial statements. In the opinion of Deep
Down’s management, the interim information includes all adjustments, consisting
only of normal recurring adjustments, necessary for a fair presentation of
the
results for the interim periods. The footnote disclosures related to the interim
financial information included herein are also unaudited. Such financial
information should be read in conjunction with the consolidated financial
statements and related notes thereto as of December 31, 2006 and for the year
then ended included in Deep Down’s annual report on Form 10-KSB/A for the fiscal
year ended December 31, 2006.
The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions
that
affect the reported amount of assets and liabilities at the date of the
financial statements and the reported amount of revenues and expenses during
the
reporting period. Significant estimates and assumptions have been used by
management in conjunction with the estimated useful lives of fixed assets and
the valuation of preferred stock. Actual results could differ from these
estimates. Certain prior period amounts have been revised to conform to the
current period presentation.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
2: Lease
receivable
On
May18, 2007, Deep Down entered into a sales lease agreement with an unrelated
third
party. The leased equipment includes an a-frame, winching system, and hydraulic
power unit, all constructed by Deep Down. The term of the lease is two years,
and includes a purchase option for $35,000 at the conclusion of this term.
Monthly rental payments, in the amount of $34,500 are due beginning May, 2007
through April 2009. The lease has been accounted for as a sales-type lease
under
the rules of FASB No. 13, Accounting for Leases.
In
February 2007, Deep Down entered into a capital lease transaction for the
lease
of a 100-ton mobile gantry crane valued at $525,000, which is included with
Equipment above. Deep Down is constructing office space on its land for
additional office space for ElectroWave, these assets are included above
as
construction in process, and not depreciated until placed in
service.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
4: Acquisition of
ElectroWave USA, Inc.
On
April2, 2007, Deep Down purchased all of the assets and certain liabilities of
Electrowave USA, Inc. a Texas Corporation. Deep Down formed a wholly-owned
subsidiary, ElectroWave USA, Inc., (“ElectroWave”),
a
Nevada
corporation, to complete the acquisition. ElectroWave offers products and
services in the fields of electronic monitoring and control systems for the
energy, military, and commercial business sectors.
The
acquisition of ElectroWave has been accounted for using purchase accounting
as
the company acquired substantially all of the assets, debts, employees,
intangible contracts and business of ElectroWave.
The
purchase price of $171,407 includes the payment of bank and other debts of
ElectroWave totaling $432,475, net of $261,068 received from the factoring
of
ElectroWave’s receivables. The purchase included the assumption of leases of
real and personal property and ongoing accounts payable in exchange for
substantially all of the assets, including inventory, fixed assets and accounts
receivable and the transfer of all employees. The acquisition price was
allocated to the assets acquired and liabilities assumed based upon their
estimated fair values with the excess being recorded in goodwill. The following
table summarizes the estimated fair values of the assets acquired and
liabilities assumed at the date of acquisition:
Purchase
Price:
Cash
paid for third party debt
$
432,475
Cash
received from sale of ElectroWave receivables
(261,068
)
Cash
purchase price
171,407
Accounts
receivable
$
133,587
Construction
in progress
105,723
Property,
plant and equipment, net
45,502
Capitalized
R&D assets
270,094
Goodwill
326,314
Total
assets acquired
$
881,220
Cash
deficit
18,974
Accrued
liabilities
690,839
Total
liabilities acquired
$
709,813
Net
assets acquired
$
171,407
The
allocation of the purchase price was based on preliminary estimates. Estimates
and assumptions are subject to change upon the receipt of management’s review of
the final amounts and final tax returns. This final evaluation of net assets
acquired is expected to be completed no later than one year from the acquisition
date and any future changes in the value of the net assets acquired will be
offset by a corresponding change in goodwill.
In
addition, Deep Down may issue up to an aggregate of 460 shares of convertible
preferred stock over the next three years, as an additional contingent purchase
cost, if the operations of ElectroWave reach certain financial milestones based
on net income for the fiscal years ending December 31, 2007, 2008 and 2009.
This
contingent consideration is not considered in the initial purchase price
allocation due to its uncertain nature.
Capital
lease of equipment, monthly lease payments, interest
imputed at 11.2%
501,858
Total
long-term debt
1,471,041
Current
portion of long-term debt
(468,810
)
Long-term
debt, net of current portion
$
1,002,231
Deep
Down
paid the outstanding bank loans in full in August 2007 with some of the proceeds
of the financing received subsequent to June 30, 2007. See additional discussion
in Note 12 Subsequent Events.
In
February 2007, Deep Down purchased under a seller-financed capital lease, a
100-ton mobile gantry crane and related equipment. The equipment was delivered
and placed into service in March, 2007. In accordance with Financial Accounting
Standards Board SFAS 13 “Accounting for Leases” as amended, the lease was
capitalized and the lease obligation and related assets recognized on Deep
Down’s consolidated balance sheet. The total value of the lease payments
discounted at an 11.2% interest rate, or $525,000, was capitalized and the
offsetting lease obligation was recorded during the first quarter of
2007.
Note
6: Preferred Stock
Series
E and G Classified as Liabilities
The
Series E and G redeemable exchangeable preferred stock have a face value and
liquidation preference of $1,000 per share, no dividend preference, and are
exchangeable at the holder’s option after June 30, 2007 into 6% Subordinated
Notes due three years from the date of the exchange. These shares carry voting
rights equal to 690 votes per share. The Series E and G preferred stock were
valued based on the discounted value of their expected future cash flows (using
a discount rate of 20%). Deep Down evaluated the Series E and G preferred stock
and has classified them as debt instruments from the date of issuance due to
the
fact that they are exchangeable at the option of the Holder into Notes. The
difference between the face value of the Series E and G preferred stock and
the
discounted book value recorded on the balance sheet, or original issue discount,
is deemed to be non-cash interest expense from the date of issuance through
the
term of the Notes.
Deep
Down
has been accreting this original issue discount using the effective interest
method. Interest expense related to the accretion of the original issue discount
totaled $1,211,919 and $1,391,506 for the three and six months ended June 30,2007. The three and six month totals include the accelerated accretion of
approximately $1,102,385 to accrete to face value 4,000 shares of Series E
preferred stock that were redeemed during the quarter ended June 30, 2007.
The
six month total also includes the accelerated accretion of approximately $72,799
to accrete to face value 250 shares of Series E preferred stock that were
redeemed during the quarter ended March 31, 2007.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
In
May
2007, Deep Down executed a Securities Redemption Agreement (the “Agreement”)
with a stockholder (the former CFO of Deep Down) to redeem 4,000 shares of
Series E exchangeable preferred stock at a discounted price of $500 per share
for a total of $2,000,000. The discount of $500 per share from the face value
of
$1,000 was accounted for as a substantial modification of debt, thereby
generating a gain on extinguishment of debt which is reflected in other income.
Deep Down accreted the remaining discount of $1,102,385 attributable to such
shares on the date of redemption. The shareholder placed all 4,000 shares into
an escrow account as of the execution of this agreement. Terms of the payment
to
the shareholder are: 2,800 shares at $500 for a total of $1,400,000 paid in
August, 2007 (See Note 12), with the remaining shares to be redeemed monthly
beginning August 31, 2007 at a minimum rate of 40 shares at $500 per share,
or $20,000 per month. Interest has been imputed on this payable at Deep Down’s
borrowing rate of 12.5%, as a result of a “Secured Credit Agreement” discussed
in Note 12. The amounts are reflected as a payable to shareholder, current
and
long term portions, on the accompanying balance sheets.
All
Series G preferred shares were cancelled and exchanged during the three months
ended March 31, 2007. Accordingly, there is no future discount accretion
relating to the Series G preferred shares. See “Series F and G Cancellation and
Issuance of Additional Series E” below.
Additionally,
in February 2007, Deep Down redeemed 250 shares of Series E exchangeable
preferred stock at the face value of $1,000 per share for a total of $250,000.
Deep Down accreted the remaining discount of $72,799 attributable to such shares
on the date of redemption.
The
unamortized discounts related to the Series E and Series G preferred stock
were
as follows:
Series
E preferred stock - face value at $1,000 per share
$
4,000,000
$
5,000,000
Less
unamortized discount
(931,611
)
(1,513,624
)
Balance
net of unamortized discount
3,068,389
3,486,376
Series
G preferred stock - face value at $1,000 per share
-
1,000,000
Less
unamortized discount
-
(302,725
)
Balance
net of unamortized discount
-
697,275
$
3,068,389
$
4,183,651
Series
F and G Cancellation and Issuance of Additional Series E
On
March20, 2007 Deep Down finalized the terms of an agreement with Daniel L. Ritz,
Jr.
(shareholder and director), who agreed to surrender 25,000,000 shares of common
stock for $250,000 in cash (par value). The market value of those shares was
$7,250,000. Additionally, he surrendered 1,500 shares of Series F convertible
preferred stock with a value of $1,325,773 and 500 shares of Series G
exchangeable preferred stock with a value of $357,615 to Deep Down for
cancellation in exchange for 1,250 shares of Series E exchangeable preferred
stock valued at $945,563. The Series E Preferred Stock was valued based on
the
discounted value of its expected future cash flows (using a discount rate of
20%). The difference between the values of the preferred shares surrendered
and
the newly issued was $737,826 which is reflected in paid in capital on the
accompanying consolidated balance sheet. In addition, Mr. Ritz also kept 500
shares of Series E exchangeable preferred stock he previously owned and agreed
to tender his resignation from the Board.
On
March20, 2007 Deep Down issued 2,000 shares of Series E exchangeable preferred stock
to John C. Siedhoff, then Chief Financial Officer, and director, valued at
$1,512,901 for the surrender of his ownership of 1,500 shares of Series F
convertible preferred stock valued at $1,325,773 and 500 shares of Series G
exchangeable preferred stock valued at $357,616, which were returned to the
transfer agent for cancellation. The Series E Preferred Stock was valued based
on the discounted value of its expected future cash flows (using a discount
rate
of 20%). The difference between the values of the surrendered shares and
the newly issued was $170,489 which is reflected in paid in capital on the
accompanying consolidated balance sheet. Deep Down has treated this as a
modification of a share-based payment in accordance with the provisions of
SFAS
No. 123R, “Share-Based Payments”.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
7: Common
Stock
Private
Placement
On
March20, 2007, Deep Down completed the sale of 10,000,000 shares of common stock
in a
private placement for $1,000,000. A total of 1,025,000 shares were purchased
by
the Chief Executive Officer and director, and his wife, a Vice-President of
Deep
Down. The shares are restricted as defined in Rule 144 of the Securities Act
of
1933 and contain a restrictive legend, which restricts the ability of the
holders to sell these shares for a period of no less than one year.
Funds were used to redeem certain outstanding exchangeable preferred stock
and for working capital.
On
May17, 2007, the former CFO, returned 20,000,000 shares of common stock to the
CEO,
a director and an employee as part of a dispute between such
shareholders.
Note
8: Stock Options
Adoption
of FAS 123(R)
Effective
April 21, 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS
123(R), which is a revision of SFAS 123. SFAS 123(R) supersedes APB 25 and
amends Statement of Accounting Standards No. 95, “Statement of Cash Flows”.
Generally, the approach in SFAS 123(R) is similar to the approach described
in
SFAS 123. However, SFAS123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in Deep Down’s
Statement of Operations based on their fair values. Deep Down adopted the
provisions of SFAS 123(R) in the first quarter of 2007. As Deep Down had no
outstanding stock options at December 31, 2006, the initial adoption of SFAS
123(R) had no impact to Deep Down.
Stock
Options Granted During 2007
Deep
Down
has a stock based compensation plan - the 2003 Directors, Officers and
Consultants Stock Option, Stock Warrant and Stock Award Plan (the “Plan”). The
exercise price of the options, as well as the vesting period, is established
by
Deep Down’s board of directors. The options granted under the Plan have vesting
periods that range from immediate vesting to vesting over five years, and lives
of the options granted are up to ten years. Under the Plan the total number
of
options permitted is 15% of issued and outstanding common shares. As of June30,2007, 5,500,000 options have been granted under the Plan.
In
April,
2007, Deep Down issued an aggregate of 1,500,000 stock options to various
consultants, of which 300,000 were issued with an exercise price of $0.30,
$0.50, $0.75, $1.00, and $1.25, respectively. All of the shares underlying
the
stock options granted were Incentive Stock Options as defined by the Internal
Revenue Code. Such options expire in five years (or earlier in the event of
termination of employment) and are subject to the following vesting
schedule:
•187,500
vest quarterly through for the following 7 calendar quarters through March31,2009
Deep
Down
estimated that the aggregate fair value of such stock options totaled $125,850
based on the Black-Scholes option pricing model using the following estimates:
5% risk free rate, 55% volatility, expected life of 4 years and zero dividends.
Additionally,
in April, 2007, Deep Down issued an aggregate of 1,000,000 stock options to
various employees with an exercise price of $0.50. All of the shares underlying
the stock options granted were Incentive Stock Options as defined by the
Internal Revenue Code. Such options expire on July 10, 2010 (or earlier in
the
event of termination of employment) and are subject to the following vesting
schedule:
Deep
Down
estimated that the aggregate fair value of such stock options totaled $79,900
based on the Black-Scholes option pricing model using the following estimates:
5% risk free rate, 53.3% volatility, expected life of 3 years and zero
dividends.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Additionally,
in May, 2007, Deep Down issued an aggregate of 3,000,000 stock options to an
officer and director with an exercise price of $0.515. All of the shares
underlying the stock options granted were Incentive Stock Options as defined
by
the Internal Revenue Code. Such options expire on August 10, 2010 (or earlier
in
the event of termination of employment) and are subject to the following vesting
schedule:
Deep
Down
estimated that the aggregate fair value of such stock options totaled $618,300
based on the Black-Scholes option pricing model using the following estimates:
5% risk free rate, 52.7% volatility, expected life of 3 years and zero
dividends.
Since
Deep Down does not have a sufficient trading history to determine the volatility
of its own stock, it based its estimates of volatility on a representative
peer
group consisting of companies in the similar industry, with similar market
capitalizations and similar stage of development. Deep Down is expensing all
stock options on a straight line basis over their respective expected service
periods. Total stock based compensation expense for the six months ended June30, 2007 was $39,565.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
9: Commitments and
Contingencies
Litigation
Deep
Down
is from time to time involved in legal proceedings arising in the normal course
of business. As of the date of this report, there are no pending or threatened
legal proceedings.
Operating
Leases
Deep
Down
leases land and buildings under two non-cancelable operating leases and is
responsible for the related maintenance, insurance and property taxes. One
of
these leases is with a company that is wholly owned by the Chief Executive
Officer and director and his wife, a Vice President and director. This lease
calls for 60 monthly payments of $11,000 and began as of September,
2006.
Capital
Lease
Deep
Down
leases a 100-ton mobile gantry crane under a non-cancelable capital lease and
is
responsible for the related maintenance, insurance and property taxes. The
terms
of the lease require Deep Down to make 84 monthly payments of $8,035 including
sales tax which began March 10, 2007.
Note
10: Earnings per
share
Calculation
of the numerator and denominator used in computing per share amounts is
summarized as follows:
Numerator
for basic and diluted earnings per share:
Net
income
$
949,466
$
840,208
Denominator
for basic earnings per share:
Weighted
average shares outstanding (basic)
67,870,171
74,417,132
Denominator
for diluted earnings per share:
Weighted
average shares outstanding (basic)
67,870,171
74,417,132
Effect
of dilutive securities
25,929,668
25,898,273
Weighted
average shares outstanding (diluted)
93,799,839
100,315,405
Note
11: Related party
transactions
Deep
Down
borrowed $150,000 from an officer, with no stated interest, due on demand,
as of
June 30, 2007 which was used for working capital purposes. Deep Down expects
to
pay the loan balance in full in the third quarter of 2007.
NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL
STATEMENTS
Note
12: Subsequent
Events
Secured
credit agreement
On
August7, 2007 Deep Down, Inc. entered into a $6 million secured credit agreement
(the
“Agreement”) with Prospect Capital Corporation to pay off bank indebtedness,
redeem some of the preferred shares outstanding, payoff $150,000 owing to an
officer, and to provide working capital to accelerate development of its
corporate growth strategies.
The
Agreement provides for a 4-year term, an annual interest rate of 15.5% with
the
ability to defer up to 3.0% through a PIK (paid-in-kind) feature and principal
payments of $75,000 per quarter beginning September 30, 2008, with the remaining
balance outstanding due August 6, 2011. Interest payments are payable monthly,
in arrears, on each month end commencing on August 31, 2007.
Terms
of
the Agreement also include a warrant to purchase up to 4,960,585 shares of
common stock at an exercise price of $0.507 per share. The warrant has a
five-year term and becomes exercisable on the two-year anniversary of the
financing, August 7, 2009.
Under
the
Agreement, Deep Down is required to meet certain covenants and restrictions,
in
addition to maintaining “key man” life insurance with respect to the CEO in the
amount of at least $3.0 million. The financial covenants are reportable each
quarter, and fluctuate over defined time frames, with the initial period being
the quarters ending December 31, 2007 through June 30, 2008. Covenants include
maintaining total debt to consolidated EBITDA in excess of 3.5 to 1,
consolidated EBITDA to consolidated net interest expense on the total debt
of 2
to 1, free cash flow to debt service of 1 to 1, and EBITDA in excess of
$2,000,000 as each term is defined in the credit agreement. Other covenants
include limitations on liens, transactions with affiliates, additional
indebtedness and permitted investments, among others. The Company must also
maintain a debt service reserve account of $375,000. Management expects changes
to these covenants to accommodate additional borrowings for growth capital
and
acquisitions as mutually determined.
Payment
of bank loans
On
August7, 2007 Deep Down paid the full balances due on the bank loans for a total
of
$936,073, including accrued interest through that date.
Payment
of shareholder payable
On
August16, 2007 Deep Down made the initial payment of $1,400,000 under the terms of
the
securities redemption agreement. See Note 6.
13
Item
2.Management's
Discussion and Analysis
The
following plan of operation discussion and analysis provides information
that
management believes is relevant for an assessment and understanding of our
plans
and financial condition. The following selected financial information is
derived from our historical financial statements and should be read in
conjunction with such financial statements and notes thereto set forth elsewhere
herein and the “Forward-Looking Statements” explanation included herein. This
information should also be read in conjunction with our audited historical
consolidated financial statements which are included in our Form 10-KSB/A
for
the fiscal year ended December 31, 2006 filed with the Securities and Exchange
Commission on April 24, 2007.
Corporate
History
Deep
Down, Inc, (“Deep Down”) a Nevada corporation, provides installation management,
engineering services, support services and storage management services for
the
subsea controls, umbilicals & pipeline industries offshore. Deep Down also
fabricates component parts for subsea distribution systems and
assemblies.
On
June29, 2006, Subsea Acquisition Corporation (“Subsea”) was formed with the intent
to acquire service providers to the offshore industry, and designers and
manufacturers of subsea equipment, surface equipment and offshore rig equipment
that are used by major integrated, large independent and foreign national
oil
and gas companies in offshore areas throughout the world. On November 21,2006,
Subsea acquired Deep Down, Inc, a Delaware corporation founded in 1997. Under
the terms of this transaction, all of Deep Down, Inc.’s shareholders transferred
ownership of all of Deep Down Inc.’s common stock to Subsea in exchange for
5,000 shares of Subsea’s Series D Preferred Stock and 5,000 shares of Subsea’s
Series E Preferred Stock resulting in Deep Down Inc. becoming a wholly owned
subsidiary of Subsea. On the same day, Subsea then merged with Deep Down,
with
the surviving company operating as Deep Down Inc. The purchase price based
on
the fair value of the Series D and E Preferred stock was $7,865,471.
Recent
Developments
On
April2, 2007, Deep Down acquired substantially all of the assets of ElectroWave
USA,
Inc. a Texas corporation. Deep Down formed a wholly-owned subsidiary,
ElectroWave USA, Inc. (“ElectroWave”), a Nevada corporation, to complete the
acquisition. ElectroWave offers products and services in the fields of
electronic monitoring and control systems for the energy, military, and
commercial business sectors.
The
purchase price of $171,407 includes the payment of bank and other debts of
ElectroWave and the assumption of leases of real and personal property and
ongoing accounts payable in exchange for substantially all of the assets,
including inventory, fixed assets and accounts receivable and the transfer
of
all employees. Prior to the date of acquisition, Deep Down paid $432,475
to
three creditors of ElectroWave and received
$261,068 of proceeds from the sale of Electrowave’s receivables.
In
addition, Deep Down may issue up to an aggregate of 460 shares of convertible
preferred stock over the next three years, as an additional contingent purchase
cost, if the operations of ElectroWave reach certain financial milestones
based
on net income for the fiscal years ending December 31, 2007, 2008 and 2009.
On
May15, 2007, Deep Down accepted John C. Siedhoff’s resignation from the board of
directors and his resignation as Chief Financial Officer, effective April30,2007. On
June5, 2007, Deep Down engaged Eugene L. Butler to serve as its new Chief Financial
Officer. Mr. Butler will also fill a vacancy on the board of directors.
Additionally, Mary L. Budrunas was appointed to the board of
directors.
During
the second quarter, Deep Down executed a Securities Redemption Agreement
(the
“Agreement”) with the former CFO of Deep Down to redeem 4,000 shares of Series E
exchangeable preferred stock at a discounted price of $500 per share for
a total
of $2,000,000. The discount of $500 per share from the face value of $1,000
was
accounted for as a substantial modification of debt, thereby generating a
gain
on extinguishment of debt which is reflected as other income on the income
statement. Deep Down accreted the remaining discount of $1,102,385 attributable
to such shares on the date of redemption. On
August16, 2007 Deep Down made the initial payment of $1,400,000 under the terms
of the
securities redemption agreement.
On
August7, 2007 Deep Down, Inc. entered into a $6 million secured credit agreement
(the
“Agreement”) with Prospect Capital Corporation to pay off bank indebtedness,
redeem some of the preferred shares outstanding, payoff $150,000 owing to
an
officer and to provide working capital to accelerate development of its
corporate growth strategies. The
Agreement provides for a 4-year term, an annual interest rate of 15.5% with
the
ability to defer up to 3.0% through a PIK (paid-in-kind) feature and principal
payments of $75,000 per quarter beginning September 30, 2008, with the remaining
balance outstanding due August 6, 2011. Interest payments are payable monthly,
in arrears, on each month end commencing on August 31, 2007. The Agreement
requires Deep
Down
to maintain certain reporting and financial covenants.
Terms of
the Agreement also include a warrant to purchase up to 4,960,585 shares of
common stock at an exercise price of $0.507 per share. The warrant has a
five-year term and becomes exercisable on the two-year anniversary of the
financing.
14
On
June21, 2007 Deep Down, Inc. entered into a non-binding Letter of Intent to purchase
Mako Technologies, Inc., a Louisiana corporation for a total acquisition
price
of approximately $14,500,000 consisting of a combination of cash, unsecured
notes, and common stock. This transaction has not been completed as of the
filing of this report. Completion of this acquisition is subject to satisfactory
due diligence and financing.
Recent
Sales of Unregistered Securities
On
March20, 2007, Deep Down completed the sale of 10,000,000 shares of common stock
in a
private placement for $1,000,000. A total of 1,025,000 shares were purchased
by
the Chief Executive Officer, and director and his wife, a Vice-President
of Deep
Down. The shares are restricted as defined in Rule 144 of the Securities
Act of
1933 and contain a restrictive legend, which restricts the ability of the
holders to sell these shares for a period of no less than one year. Funds
will
be used to redeem certain outstanding exchangeable preferred stock and for
working capital.
On
March20, 2007 Deep Down finalized the terms of an agreement with Daniel L. Ritz,
Jr.
(shareholder and director), who agreed to surrender 25,000,000 shares of
common
stock for $250,000 in cash (par value). The market value of those shares
was
$7,250,000. Additionally, he surrendered 1,500 shares of Series F convertible
preferred stock with a value of $1,325,773 and 500 shares of Series G
exchangeable preferred stock with a value of $357,615 to Deep Down for
cancellation in exchange for 1,250 shares of Series E exchangeable preferred
stock valued at $945,563. The Series E Preferred Stock was valued based on
the
discounted value of its expected future cash flows (using a discount rate
of
20%). The difference between the values of the preferred shares
surrendered and the newly issued was $737,826 which is reflected in paid
in
capital on the accompanying consolidated balance sheet. In addition, Mr.
Ritz
also kept 500 shares of Series E exchangeable preferred stock he previously
owned and agreed to tender his resignation from the Board.
On
March20, 2007 Deep Down issued 2,000 shares of Series E exchangeable preferred
stock
to John C. Siedhoff (Chief Financial Officer, and director) valued at $1,512,901
for the surrender of his ownership of 1,500 shares of Series F convertible
preferred stock valued at $1,325,773 and 500 shares of Series G exchangeable
preferred stock valued at $357,616, which were returned to the transfer agent
for cancellation. The Series E Preferred Stock was valued based on the
discounted value of its expected future cash flows (using a discount rate
of
20%). The difference between the values of the surrendered shares and the
newly issued was $170,489 which is reflected in paid in capital on the
accompanying consolidated balance sheet. Deep Down has treated this as a
modification of a share-based payment in accordance with the provisions of
SFAS
No. 123R, “Share-Based Payments”.
The
offers and sales of the securities in the private placement are exempt from
the
registration requirements of the Securities Act of 1933 (the “Act”) pursuant to
Rule 506 and Section 4(2) of the Act. In connection with the offers and sales,
we did not conduct any general solicitation or advertising, and we complied
with
the requirements of Regulation D relating to the restrictions on the
transferability of the shares issued.
15
Executive
Overview
We
are an
installation engineering and management company focused on the offshore segment
of the energy industry. We can custom design and manufacture product or modify
existing equipment to meet customer specifications. We design, manufacture,
fabricate, sell and service highly-engineered subsea equipment, surface
equipment and offshore rig equipment for use in deepwater, harsh environment
and
severe service applications. Our principal products consist of flying lead
installation, maintenance and termination systems; buoyancy and rigging systems;
high and low pressure testing and monitoring systems; latch systems; lay
chutes;
rollers; tensioners; and offshore storage and space management systems. We
also
provide installation, retrieval, storage and management services in connection
with the use of our products.
Deep
Down
has developed its broad line of subsea equipment, surface equipment and offshore
rig equipment primarily through internal product development efforts. In
many
cases, these products were developed in direct response to customer requests
for
solutions to critical problems in the field. We are instrumental in achieving
solutions for our clients to simplify installation procedures and reduce
costs.
The
acquisition of ElectroWave has expanded our product lines to include products
and services in the fields of electronic monitoring and control systems for
the
energy, military, and commercial business sectors. ElectroWave designs,
manufactures, installs, and commissions integrated PLC and SCADA based
instrumentation and control systems, including ballast control and monitoring,
drilling instrumentation, vessel management systems, marine advisory systems,
machinery plant control and monitoring systems, and closed circuit television
systems.
Product
and service innovations and capabilities during the first six months of 2007
include the following highlights:
·
Use
of nine new Rapid Deployment Cartridges (“RDC”) increased productivity for
the installation of Steel Flying Leads (“SFLs”) and greatly improved the
ability to carry more flying leads on the deck of an installation
vessel,
saving valuable vessel time and reducing the number of trips to and
from
the dock. Deep Down can carry up to eighteen SFLs within a very small
footprint on the deck of a marine vessel with these RDCs.
·
Successful
installation of new Electrical Hydraulic Loose Tube SFLs. This new
product
innovation greatly extends the typical range for delivering electronic
capabilities in SFLs up to 10,000 feet and reduces the need for in-field
umbilicals in certain applications.
·
Successful
installation of umbilical bend stiffeners on the Independence HUB
has
established a new standard in the BS Latcher design for ultra high
bending
moment applications in 8,000 foot and deeper water
depths.
·
Successful
completion of the relocation of the ElectroWave assets, operations
and
personnel to Deep Down’s headquarters during April and the commencement of
operations in that location.
Deep
Down
generated revenue of $7,243,182 for the six months ended June 30, 2007, with
cost of sales of $4,545,402 for a gross profit of $2,697,780, or 37.3%. Revenues
for the second quarter ended June 30, 2007 were $5,144,788, up 145% from
$2,098,394 in revenue reported for the three months ended March 31, 2007.
Gross
profit for the second quarter ended June 30, 2007 was $1,851,475, or 36.0%
of
revenue, up from $846,305 in gross profit, or 40.3% of revenue, reported
for the
three months ended March 31, 2007. While gross profit was up 119%, gross
margins
declined from 40.3% to 36.0%. This decline in profit margins was due in part
to
increased third-party subcontracting costs incurred to meet delivery schedules
on certain products. The increase in revenue resulted from the inclusion
of
ElectroWave revenue of approximately $950,000 during the second quarter,
combined with increased activity from our offshore subsea business. Excluding
Electrowave revenue, our core business was still up over 100% with revenue
of
approximately $4,194,788 for the three months ended June 30, 2007, compared
to
$2,098,394 for the three months ended March 31, 2007.
16
Deep
Down
had selling, general and administrative (“SG&A”) expenses of $1,747,331, or
24.1 % of revenue, for the six months ended June 30, 2007. SG&A expenses for
the second quarter ended June 30, 2007 were $1,087,680, or 21.1% of revenue,
as
compared to $659,651, or 31.4 % of revenue, for the first quarter ended March31, 2007. The increase in SG&A expense was related to the addition of
ElectroWave personnel and other personnel to meet the increasing demands
of the
offshore subsea business. SG&A expense included approximately $438,500 of
expenses for SEC, Legal, and Accounting costs related to meeting its initial
filing requirements as a public company.
Interest
expense for the six months ended June 30, 2007 totaled $1,508,657, of which
$117,151 was cash interest expense related to bank loans and capital lease
financing. The remaining non-cash interest expense of $1,391,506 was related
to
the accretion of the Series E and G preferred stock, including the accelerated
accretion of $1,102,385 for the remaining discount on 4,000 shares of Series
E
preferred stock redeemed in May 2007 and the accelerated accretion of $72,799
for the remaining discount on 250 shares of Series E preferred stock redeemed
in
March 2007.
During
the second quarter, we executed a Securities Redemption Agreement (the
“Agreement”) with the former CFO of Deep Down to redeem 4,000 shares of Series E
exchangeable preferred stock at a discounted price of $500 per share for
a total
of $2,000,000. The discount of $500 per share from the face value of $1,000
was
accounted for as a substantial modification of debt, thereby generating a
gain
on extinguishment of debt which is reflected as other income on the income
statement. Deep Down accreted the remaining discount of $1,102,385 attributable
to such shares on the date of redemption.
Net
income for the six months ended June 30, 2007 totaled $840,208, net of tax
expense of $447,363. Included in net income is a one-time gain of $2,000,000
related to the extinguishment of debt, and non-cash interest expense of
$1,102,385, associated with the 4,000 shares of Series E preferred stock
that
was redeemed at a 50% discount to face value. Excluding this one-time gain,
earnings before depreciation, interest, amortization, taxes and other non-cash
charges for the three months ended June 30, 2007 was $763,795, up 309% from
$186,654 for the three months ended March 31, 2007.
Liquidity
and Capital Resources
During
the six months ended June 30, 2007, we had operating cash flows of $427,319.
Deep Down incurred capital expenditures of approximately $442,788 for equipment
purchases. During the first quarter, we raised $1,000,000 from a private
placement of common stock. We redeemed 250 shares of the Series E preferred
stock for $250,000, and an additional $250,000 was used as part of the stock
exchange agreement with a former director of Deep Down. At June 30, 2007,
we had
cash totaling $263,305 and working capital of $97,853 net of the accrued
payable
for the redemption of Series E preferred stock, which will be paid using
the
funds provided by the secured credit agreement.
Management
believes that operating cash flows exceeds the Company’s operating costs. On
August 6, 2007 Deep Down entered into a secured credit agreement for
$6,000,000. These funds provided significant working capital for the growth
and
expansion of the business as well as for the redemption of $4,000,000 of
debt
related to the Series E preferred stock at a 50% discount to face
value.
Sources
and Uses of Cash
We
use
cash to pay for materials and payroll related costs to build the equipment
our
customers have ordered prior to receipt of related progress payments. On
occasion we may use cash to sub-contract fabrication to meet specific contract
deadlines. The cash provided from operations exceeds operating costs, capital
expenditures and debt requirements.
Deep
Down, with the $6,000,000 credit agreement, has secured adequate financing
to
retire the debt associated with the Series E preferred stock redemption
completed in the second quarter. See “Recent Developments” above for additional
discussion of the terms of the financing agreement and the preferred stock
redemption. On August 16, 2007 Deep Down made the initial payment of $1,400,000
under the terms of the securities redemption agreement. Additionally, on
August7, 2007 Deep Down paid the full balances due on the bank loans for a total
of
$936,073, including accrued interest through that date.
We
believe we have raised sufficient capital to finance our operations. However,
we
may strategically seek sources of financing to expand our product development
efforts and pursue strategic acquisitions. Additionally, unanticipated events
may negatively impact our ability to increase revenue-generating activities
and
we may need to obtain future sources of financing to continue existing
operations. Such future sources may include cash from equity offerings, exercise
of warrants and stock options and proceeds from debt instruments. There can
be
no assurance that such equity or borrowings will be available or, if available,
will be at rates or prices acceptable to us.
17
Analysis
of Cash flows
During
the six months ended June 30, 2007, we had net operating cash flows of $427,319.
We had net income from continuing operations of $1,287,571 for the six months
ended June 30, 2007, which included non-cash expenses of depreciation of
$154,221 and amortization of debt discount of $1,391,506 on the Series E
and G
preferred stock. While we had significant changes in various operating assets
and liabilities, these changes did not have a significant impact on our
operating cash flows as the impacts largely offset each other.
Deep
Down
had investing outflows of $633,169, consisting of the purchase of equipment
of
$442,788 and payment of ElectroWave debt of $432,475 and cash deficit from
the
purchase of ElectroWave of $18,974, which was partially offset by the sale
of ElectoWave’s receivables for $261,068.
We
had
financing cashflows of $456,693 for the six months ended June 30, 2007. We
received proceeds from a private placement offering of stock for $1,000,000,
which were partially used to redeem 250 shares of Series E preferred shares
for
$250,000 and a cash payment to a shareholder for the cancellation of common
stock totaling $250,000. Deep Down borrowed $150,000 from an officer, with
no
stated interest, due on demand, as of June 30, 2007 which was used for working
capital purposes. Deep Down expects to pay this loan balance in full in the
third quarter of 2007. Also, Deep Down entered into an 84 month capital lease
for a 100-ton mobile gantry crane, where the equipment and offsetting capital
lease liability of $525,000 were reflected as noncash investing and financing
activities.
During
the second quarter, we entered into a two year sales lease agreement with
an
unrelated third party. We received cash payments totaling $69,000 from the
lessee during the six months ended June 30, 2007. The equipment sold and
the
offsetting lease receivable of $750,000 and unearned income of $96,710
were
reflected as operating activities.
During
the second quarter, we executed a securities redemption Agreement with the
former CFO of Deep Down to redeem 4,000 shares of Series E exchangeable
preferred stock at a discounted price of $500 per share for a total of
$2,000,000. The discount of $500 per share from the face value of $1,000
was
accounted for as a substantial modification of debt, thereby generating a
gain
on extinguishment of debt which is reflected as other income on the income
statement. Deep Down accreted the remaining discount of $1,102,385 attributable
to such shares on the date of redemption.
We
plan
to meet our cash requirements in 2007 with cash generated from operations
in
addition to the
$1,000,000 raised in the private placement in March 2007, and $6,000,000
from
the secured credit agreement in August 2007. We will continue to expand our
product line offerings, and we are projecting to spend a minimum of $250,000
to
expand our rental fleet and approximately $150,000 to develop new products.
We
continue to evaluate acquisitions and joint ventures in the ordinary course
of
business. When opportunities for business acquisitions meet our standards,
we
believe we will have access to capital sources necessary to take advantage
of
those opportunities.
Critical
Accounting Policies
For
a
discussion of our critical accounting matters, please refer to Item 7,
“Management’s Discussion and Analysis or Plan of Operation,” in our 2006 10-K/A
under the heading “Critical Accounting Policies.”
Inflation
and Seasonality
We
do not
believe that our operations are significantly impacted by inflation. Our
business is not seasonal in nature.
18
Item
3.Controls
and Procedures
We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our Exchange Act reports is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission’s rules and forms, and that such information
is accumulated and communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow for timely
decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls
and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and management
is required to apply its judgment in evaluating the cost-benefit relationship
of
possible controls and procedures.
As
of the
June 30, 2007, (the “Evaluation Date”), we carried out an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer and our Chief Financial Officer, of the effectiveness of
the
design and operation of our disclosure controls and procedures. Based on
the
foregoing, our Chief Executive Officer and Chief Financial Officer concluded
that, as of the Evaluation Date, our disclosure controls and procedures were
not
effective at the reasonable assurance level and in compliance with Section
404
of the Sarbanes-Oxley Act. While conducting the review of the interim financial
statements as of and for the period ended June 30, 2007, our independent
auditors found numerous adjustments that indicated a material weakness in
our
controls over financial reporting. It is our plan with additional funding
to
devote more resources to this very critical function.
To
the
best of our knowledge and belief, there has been no change in our internal
controls over financial reporting during the six months ended June 30, 2007
that
has materially affected, or is reasonably likely to materially affect, our
internal control over financial reports.
19
PART
II - OTHER INFORMATION
Item
1.Legal
Proceedings
We
are
from time to time involved in legal proceedings arising from the normal course
of business. As of the date of this report, we are not currently involved
in any
legal proceedings.
Item
2.Unregistered
Sales of Equity Securities and Use of Proceeds
On
March20, 2007, Deep Down completed the sale of 10,000,000 shares of common stock
in a
private placement for $1,000,000. A total of 1,025,000 shares were purchased
by
the Chief Executive Officer, and director, and his wife, a Vice-President
of
Deep Down. The shares are restricted as defined in Rule 144 of the Securities
Act of 1933 and contain a restrictive legend, which restricts the ability
of the
holders to sell these shares for a period of no less than one year. Funds
were
used to redeem certain outstanding exchangeable preferred stock and for working
capital.
Deep
Down
finalized the terms of an agreement with Daniel L. Ritz, Jr. (shareholder
and
director), who agreed to surrender 25,000,000 shares of common stock for
$250,000 in cash (par value). Additionally, he surrendered 1,500 shares of
Series F convertible preferred stock and 500 shares of Series G exchangeable
preferred stock to Deep Down for cancellation. For these actions, Mr. Ritz
received 1,250 shares of Series E exchangeable preferred stock. In addition,
Mr.
Ritz kept 500 shares of Series E exchangeable preferred stock he previously
owned and agreed to tender his resignation from the Board.
Deep
Down
issued 2,000 shares of Series E exchangeable preferred stock to John C. Siedhoff
(shareholder, Chief Financial Officer, and director) for the surrender of
his
ownership of 1,500 shares of Series F convertible preferred stock and 500
shares
of Series G exchangeable preferred stock, which were returned to the transfer
agent for cancellation.
The
offers and sales of the securities in the private placement are exempt from
the
registration requirements of the Securities Act of 1933 (the “Act”) pursuant to
Rule 506 and Section 4(2) of the Act. In connection with the offers and sales,
we did not conduct any general solicitation or advertising, and we complied
with
the requirements of Regulation D relating to the restrictions on the
transferability of the shares issued.
Item
3.Defaults
Upon Senior Securities
None
Item
4.Submission
of Matters to a Vote of Security Holders.
None
Item
5.Other
Information.
None
20
Item
6.Exhibits.
Exhibit
Number
Description
By
Reference
from
Document
31.1
Certification
of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 of
the
Securities Exchange Act of 1934
*
31.2
Certification
of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 of
the
Securities Exchange Act of 1934
*
32.1
Certification
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of
the Sarbanes-Oxley Act of 2002
*
32.2
Certification
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of
the Sarbanes-Oxley Act of 2002
*
*
Filed
herewith
21
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
