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Executives

Ken Dennard - IR, Dennard Rupp Gray & Easterly, LLC

Chris Strong - President and CEO

A.J. Verdecchia – VP, CFO and Treasurer

Analysts

Jeff Tillery - Tudor, Pickering & Holt

Steve Ferazani - Sidoti & Co.

Mark Brown - Pritchard Capital Partners, LLC

Victor Marchon - RBC Capital Markets

Jud Bailey - Jefferies & Co.

Union Drilling, Inc. (UDRL) Q2 2009 Earnings Call Transcript August 4, 2009 10:00 AM ET

Operator

Ladies and gentlemen thank you standing by and welcome to the Union Drilling’s second quarter 2009 earnings conference call. During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator instructions) This conference is being recorded today, Tuesday, August 04, 2009.

And I would now like to turn the conference over to Ken Dennard of DRG&E. Please go ahead, sir.

Ken Dennard

Thank you, Michaela and good morning, everyone. We appreciate you joining us for Union Drilling's conference call today to review second quarter 2009 results.

Before I turn the call over to management I have the normal housekeeping details to run through. You may have received an e-mail of the earnings release yesterday afternoon. If you didn't get your release or you would like to be added to the distribution list, please call DRG&E at 713-529-6600.

Also a recorded replay of today's call will be available until August 11th. Information for accessing the telephonic replay is in the press release that went out yesterday afternoon. There will also be a replay via webcast and you can listen to that by going to the company's website at www.uniondrilling.com.

Please note that information reported on this call, speaks only as of today, August 4, 2009 and therefore you are advised that time sensitive information may no longer be accurate at the time of any replay listening.

Also, statements made on this conference call that are not historical facts, including statements accompanied by words such as may, believe, anticipate, expect, estimate or similar words, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, regarding Union Drilling's plans and performance.

These statements are based upon management's estimates, assumptions, and projections as of the date of this call and they are not guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements, as a result of risks, uncertainties and other factors, including but not limited to the factors set forth in the company's prior filings with the Securities and Exchange Commission.

Union Drilling cautions you not to place undue reliance on forward-looking statements contained in this call. Union Drilling does not undertake any obligation to publicly advise or revise forward-looking statements to reflect future events, information or circumstances that arise after the date of this call. For further information, please refer to the company's filings with the SEC.

During today's call, management will discuss EBITDA and drilling margin, which are non-GAAP financial measures. Please refer to yesterday's press release, which can be found on the Company's website for disclosures about these measures and for reconciliation to the most directly comparable GAAP financial measures.

Now, with that on the way let me turn the call over to Chris Strong this morning, the Company’s President and Chief Executive Officer and A.J. Verdecchia, Chief Financial Officer. Now I would like to turn the call to Chris.

Chris Strong

Thanks Kim. Good morning, everyone and thank you for joining us today. Challenges we experienced in the first quarter continued throughout the second quarter. Revenues totaled $38.9 million and EBITDA came to $7.3 million. We reported a net loss of $4.9 million or $0.24 per share during the quarter, which included a non-cash impairment charge of $1.6 million or $0.06 per share after-tax.

Operationally, we expected the quarter to be a tough one. What surprised us however was that we did not see any appreciable utilization increase among the smaller rigs in Appalachian, following the end of winter and the persistence range in April and early May.

Average utilization for the fleet was 34.7% during the quarter, our lowest utilization in many years. Normally, the third quarter is the heart of the drilling season in the northeast and has the best results, but I did not see that happening this year.

We significantly improved our balance sheet during the quarter with the issuance of 3 million shares in the public offering. We raised approximately 23.2 million net of fees and lowered our debt-to-cap ratio to about 10%. We now have over 75 million of availability under our revolving credit facility that can be used if we started seeing attractive distressed assets deals.

Three of the four new rigs that we’ve discussed on recent calls were operating by mid-May, while the fourth a walking rig built for the Barnett Shale’s generating revenue via tolling agreement until natural gas prices improved. We have no other new build commitments, so capital spending will be reduced to a minimal level of maintenance CapEx.

The Marcellus Shale continues to be a bright spot and we have a number of discussions with customers underway for work later this year or in early 2010. While there appears to be incremental demand, operators remain reluctant to enter long-term contracts that would support the construction of new rigs.

For many operators, this is a play that is still in the exploratory phase and I expect that as it becomes more developmental pad drilling rigs will be in greater demand. To satisfy the type of demand that currently exist, we are looking at the possibility of retrofitting some of our Arkoma fleet for Marcellus drilling at a much lower cost than a fit per purpose new build.

Now, I will turn the call over to A.J. to run through the numbers before I finish up with some comments about the second half of 2009.

A.J. Verdecchia

Thanks Chris. Revenues for the three months ended June 30, 2009 totaled $38.9 million or 17,330 per revenue day, compared to revenues of $75.4 million or 16,790 per day in the second quarter of 2008.

The increase in average day rates is due to the lower utilization among our smaller rigs rather than improved market conditions. About $800,000 or $400 per day of revenue was the result of two rigs operating under tolling agreement with one customer.

Operating costs for the second quarter totaled $25.6 million or 11,394 per revenue day compared to $49.1 million or 10,925 per day in the second quarter of 2008.

Drilling margin totaled $13.3 million or 5,936 per revenue day compared to $26.3 million or 5,865 per day for the second quarter of ’08. The consistent average daily margin reflects our ability to reduce direct operating cost rapidly in response to declining revenues.

General and administrative expenses decreased to $6 million compared to $8 million in the previous year's second quarter. The majority of the reduction in G&A is due to reduced payroll expense and lower recruiting cost. In addition, bad debt expense was almost 5,000 lower in Q2 ’09 compared to the prior year.

Second quarter EBITDA totaled $7.3 million in 2009 compared to $17.4 million in 2008. EBITDA excludes $1.6 million non-cash charge for impairment. The effective tax rate for the quarter was 29%. As discussed on prior calls, our effective tax rate is negatively impacted because certain expenses from yields and incidentals are not fully deductible for income tax purposes.

Depreciation and amortization for the quarter totaled $12.3 million, up from $11.1 million last year. Depreciation and amortization will increase slightly in Q3 to reflect a full-quarter of the four new rigs being in service and then flat now based on our plans to curtain capital spending.

We reported a net loss for the quarter of $4.9 million or a loss of $0.24 per share compared to net income of $3.4 million or $0.15 per share in the prior year period. Excluding the $1.6 million non-cash impairment charge, the after-tax net loss would have been $3.8 million or $0.18 per share.

On the balance sheet, we had $24 million drawn on our revolver as of June 30th, which is the significant decline compared to the March 31 balance of 47 million. This is as a result of the capital infusion from our equity offering in June.

In July, we received a $6 million refund from the IRS, as a result of accelerated tax depreciation taken on our 2008 tax return. In addition to paying down the revolver, we also paid off $2.5 million of equipment loans that had above market interest rates.

The total remaining amount outstanding on these equipment loans was $90,000 on June 30th. The revolver balance, it is 14 million today and should stay relatively flat based on current utilization and CapEx plans.

Capital expenditures for the second quarter totaled $5.8 million of which $1.9 million was designated as maintenance CapEx and $3.9 million was for equipment required to place the new rigs in service.

We added four new rigs during the second quarter and we also decommissioned four older rigs that had minimal net book values, therefore the total rig count remains at 71. We currently have 31 rigs in Appalachian, 21 in Arkoma, and 19 in Texas.

I’ll now turn the call back the Chris.

Chris Strong

Thank you A.J. It is unlikely that we will see significant improvement in the third quarter compared to the second. Well the overall rig count appears to be bottoming, natural gas drilling remains very weak. The slight pick-up in the last few weeks has been driven by oil drilling, which is not a major market for us.

There is not much to be positive about the Barnett Shale right now either, in the Barnett, if you don’t have its own contract you are basically not drilling. The Fayetteville Shale appears to have somewhat better economics than the Barnett, but sub $4 gas is taken a toll on utilization there as well.

Compared to last quarter though, there has been increased telephone traffic with current and potential customers. This hasn’t led to increased rig count, there are at least some operators that are beginning to think about and plan for a higher gas price environment and a higher rig count.

Because there is so much uncertainty as to the timing of our recovery, we have taken a very conservative approach to our operations and finances. Costs have been cut more dramatically than either the 1997 or 2001 downturns and we have held our drilling margin percentage close to what it was last year with far fewer assets in the field.

Our balance sheet is clean. We have invested about 280 million in the fleet since 2006 and currently have about 15 million of debt. That investment has transitioned the fleet from less than 20% to now over 60% seeing new or substantially upgraded in the last five years.

While we will continue to assess the fleet for impairment on a quarterly basis and may have further write-down’s, I am pleased to say that our strategy of not chasing old iron at the top of the market has resulted in a relatively small reduction to our fixed assets and shareholders equity in this difficult market.

And with that Michaela we are ready for Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Jeff Tillery with Tudor, Pickering & Holt. Please go ahead.

Jeff Tillery - Tudor, Pickering & Holt

Hi good morning.

Chris Strong

Good morning Jeff.

Jeff Tillery - Tudor, Pickering & Holt

Chris, I was just interested on your comment on Appalachian utilization expectations, I mean just looking through rig data, it looks like activity thus far in the third quarter is up about 10 rigs or so in Appalachian versus the second quarter. I guess, is that all Marcellus and some deeper rigs, so you don't really have any ideal rigs able to do that work, I just wanted to get a little more color on the Q3 Appalachian utilization commentary?

Chris Strong

Yes. What we are Jeff is that some of the traditional work that we have done for many years particularly in the (inaudible) play in Pennsylvania has really has gone away this year. We were are using some of those rigs to do Vertical Marcellus work and probably have a either one or two more of those going out, but that was a chunk of the fleet where we had a eight or nine rigs where you'd see all of them basically down during the rainy season in April and May, and then most of them would come back up on to working through the summer doing that kind of work and we really haven't seen that.

Similarly, in southern West Virginia, some of the horizontal coalbed methane work that we had done in the past is not there this year. Some lot of the shallow work is, what is not coming back just kind of price point.

Some of it is being replaced by vertical Marcellus's work. We also have a couple of rigs that are transitioning. We had a rig that was doing storage field work, which will probably not be a deeper rig that was doing storage work that will probably transition a Marcellus work, but that is probably not going to do much for us in the third quarter and we had a rig that was actually released from contracts as a large customer in the Marcellus brought new pad drilling rigs in recently.

And that one will probably also not do much for us in the third quarter, but maybe on higher with a different customer in the fourth.

Jeff Tillery - Tudor, Pickering & Holt

Okay that is helpful. Regarding the increase in marketing discussions with customers, can you give us an indication for non-Appalachian where you think this spot market is currently?

Chris Strong

Sure. You know as I said in my comment I really don't see much at all in the Barnett. We are talking out in West Texas with some folks about doing some oil drilling that may be good for a couple of rigs again probably not a lot in the third quarter maybe it gives us something in the fourth.

That is not going to be terribly high margin work compared to what we were getting in the Barnett, you know we’ve also in the Arkoma have about four rigs that are not on hire that we are chatting with different folks about – and there are different size ranges, but I would say the scene there is probably down 3,500 a day may be as high as 4,000 a day from what we would have been able to gather in a robust market last year.

We have had internal discussions with our operations guys and I guess our general view is that once you start bidding a rig below say 2000 a day of margin, you really have to look at it very closely because especially with some of the more expensive rigs in the fleet, you probably are not actually making any cash flow, you're just eating away and creating deferred maintenance, but that may be about the number on say $7 million or $8 million rig that you need on the maintenance CapEx side to replenish drill pipe engines, things that generally wear out.

So, it may be that we will see some competitors come in and bid work for less than that number as far as the margin per day just to show some P&L, but I don't know that it is a particularly good idea if you want to sustain your fleet over time.

Operator

Thank you. Our next question comes from the line of Steve Ferazani with Sidoti & Co. Please go ahead.

Steve Ferazani - Sidoti & Co.

Good morning Chris, good morning AJ. Can you just sort of run through rigs that were left under contract and timing of exploration?

A.J. Verdecchia

Sure Steve. We got 21 under contract today, including the two rigs that are under tolling agreement and we will have 14 under contract at the end of the year. So that means six will roll-off in Q3 and Q4.

The total margin under contract for 2009 is 42 million and the total margin under contract for 2010 is 15 million. So that kind of gives you an idea of the number of rigs and the margin. By the end of ‘10, in ‘10 we will have eight rolling off, so that would go from 14 down to six.

Steve Ferazani - Sidoti & Co.

Okay. With six rolling off in the next quarter, what is the – are those going to continue to work its spot rates and what sort of the diminishment there, you know given that you are not generating a lot of revenues from rigs that aren't under contract or didn’t in Q2?

Chris Strong

I think it is a mixed bag Steve. I think we will have some replacement from some of the rigs up in the Marcellus where we will put some more outdoors that aren’t working right now.

However, you will see some of those term contract rigs say in the Barnett that probably are simply going to go away in this market. I don't know that we will be putting them back out. They may in fact miss out.

Operator

Thank you. (Operator instructions) Our next question comes from the line of Mark Brown with Pritchard Capital. Please go ahead.

Mark Brown - Pritchard Capital Partners, LLC

Hi Chris and AJ. Just wanted to check on the previous question that was eight rigs rolling off by the end of 2010, I don't know if you can give as the average rigs maximum contract for 2010 and for Q3 and Q4 of ‘09?

A.J. Verdecchia

Q3 and Q4 of ’09 it is basically three and three, so they roll of ratably over the remainder of ’09. In 2010, basically they roll-off two in Q1, five in Q2, one in Q3. So, you could probably do the math I guess on a weighted average.

Mark Brown - Pritchard Capital Partners, LLC

Okay. That is great, thank you. And just in terms of the equity offering in June, could you, I mean I guess the question is just what was the strategy, was it looking to do that when the stock price reached $10 where you would be able to get a good valuation or was it for -- and that was for an opportunistic financing even though clearly you had a good balance sheet going in there, I don't know if you can comment on that?

Chris Strong

Sure. No -- I think part of it was set up by the fact that we purchased in 2 million shares that we completed in January in the low fives. So the thought was, if we sold 3 million shares, the real incremental dilution was a net of 1 million shares and if you looked at the 2 million that has been done at five and 2 million that has been sold back in eight, if you look at looked at – if you looked at it in terms of the $1 million where did that price out?

It was a pretty good trade for us. Also, as I've said in my comments there is, it is difficult for us really to assess the timing of the recovery of cash flows. I think we will have utilization come back and probably we are going to see a little bit better utilization in the fourth quarter and in the next year, but it can be a recovery in utilization with a lot of – without a lot of recovery in earnings, where you have just the scenario that AJ was alluding to, with some of the higher margins term contracts rolling off, they will probably get utilization that is higher, but will that result in earnings acceleration?

You know it may take a while for that to come and we would rather be in a position where we are not having issues with our covenants, we are not having issues with our debt payments, and if it does take longer, you know we are going to be in better position to get through it, and maybe in better position to take advantage of our balance sheet and pickup other assets from drilling contracts that are forced to sell assets to raise cash.

Operator

Thank you. (Operator instructions) We have a follow-up question from the line of Jeff Tillery from Tudor, Pickering & Holt. Please go ahead.

Jeff Tillery - Tudor, Pickering & Holt

Hi. I missed the number when guys were going through it original in terms of the daily impact of the tolling agreement on the revenue per day, is there something you could repeat?

A.J. Verdecchia

Yes Jeff, I said $400 per day for Q2 of incremental revenue from the tolling – the two rigs under the tolling agreement, and about 800,000 of revenue.

Jeff Tillery - Tudor, Pickering & Holt

Where there any contracts where some term was trade-off for day rate intra quarter, any change to the existing basis?

Chris Strong

We are doing some of that Jeff and we're actually doing some worst [ph] trading, of a different nature as well where we may be spending a little more CapEx on rigs that are under an existing day rate rather than talking about some sort of re-trade on the rate.

We have -- say for instance one of our large rigs we have up in Appalachian doing Marcellus drilling that we put in the field last summer. That is on a three-year deal and there has been some discussion about, you know this customer partnering with, a JV partner that brings in more cash and more rigs.

There has been some discussions about well if the bring on some incremental rigs with you guys will you do something on the day rate on that existing contract. That one probably ends up where we spend 600,000 or 700,000 on the rig to finish of the skidding package where we built the rig, where the substructure was built to accommodate the skidding set up, but it was on a purchase.

Now the customer a is ready to move more into the pad drilling phase of things and wants that package and we have said, alright we will supply the package and spend the money with the thought that that will result in an incremental rig or rigs down the road.

Similar -- actually we are doing some of that work here in the Barnett on our ideal rigs, we have an ideal rig that is down, we are spending some money or we have already spent most of the money to put a walking package on that rig, so that it is something we can duplicate on the other ideal rig since the market improves down here.

Other deals, you know it is usually trading down on some term contract rate for some incremental rigs. We did that in the second quarter with the two new electric rigs that were delivered into the Arkoma. We came down a little on the rate there and have a couple of rigs that where coming up to the end of their terms that then were picked up.

Operator

Thank you. Our next question comes from the line of the Victor Marchon with RBC Capital Markets. Please go ahead.

Victor Marchon - RBC Capital Markets

Thank you and good morning.

Chris Strong

Good morning Victor.

Victor Marchon - RBC Capital Markets

Chris, first is just on your comments regarding the conversations you're having with customers and into your picking up there and some rigs later this year in 2010.

Just wanted to get yours sense as in to what they are specifically looking for, are they just trying to get past injection season and also want to get your sense as into their comfort level with service cost where they are right now, are they still putting downward pressure on the rates or is it more being driven by the contractors themselves?

Chris Strong

You know, I think the telephone traffic is the mix. I mean there is some tire kickers [ph] out there Victor that are may be trying to put together AFE’s and trying to gauge the markets to put those AFE’s together. I think there are some folks that are more long-term customers that are saying, you know October is coming, maybe fourth quarter, I guess some renewed budgetary funds, we are planning to do some things and as I mentioned you have had a couple deals up in Appalachian recently where existing E&P companies have brought on partners that have deeper pockets and I think some of that is more genuine, as far as incremental rig demand.

Taxes on the oil side, I think the margins are going to be pretty skinning out oil taxes, you know we will probably take a more serious look at that. We do have a little bit of activity out there, but we may even see that go to footage rate through day rates. You know the market is heavily supplied with idle rigs and idle labor. So, it may be that pricing moves sufficiently to the advantage of E&P companies out in the oil plays that we start to see some footage work again.

Victor Marchon - RBC Capital Markets

And the follow-up I had was just an update if you could on what you're seeing out there from a asset purchase opportunity standpoint is that still a few quarters away? And just want to see, if you could talk a little bit more on the retrofit opportunities as into, you know the numbers that could possibly be, is that one or two rigs or could it be something more than that as you look forward?

A.J. Verdecchia

Sure. On the deal side, I mean there has been more traffic recently. I have actually seen several drilling companies that are in trouble with their lenders, and people said hey the lenders might take some equity, some blend of equity and cash – you know I am not, you know even though you may look at the rigs and say, all right they were 12 million or 13 million a piece when they bought them, well that might have been at the height of the market.

In these days you could buy one of those, you know maybe you could buy it for ten brand-new from the builder or the rig manufacturer. And -- so because it is going for five or six, is that a good deal? You know if you sit on it, you need to sit on it for while, until you can put it to work and start having cash.

I'm not really so sure because a lot of what we are seeing, certainly here in the Barnett were we build the walking rig and we are retrofitting one ideal rig with the thought that we can retrofit all six fairly quickly for pad drilling, with the walking feature is that, you know the technology may be moving in the rig that was running well last summer, may not be in its high demand.

We have had some preliminary discussions with a customer about, not only a rig that walks, but a rig where the rig floor can fly five or so feet in any direction, so that if you are putting the substructure and sliding it over the cage above an existing wellhead and need to position the rig floor slightly (inaudible) to that to get to the next location, they want some of those options.

So, it is really going to be a challenge looking at deploying capital whether you chase after some of those deals and then do you have rigs that are really early cycle rigs or not. So, the retrofit opportunity versus the deals opportunity it is an interesting one, I think as I mentioned on the comments there may be some of our smaller triples in the Arkoma that are of a size that we can move around more easily up in Appalachian, but we don't have a huge number of those rigs maybe it is two or three that might fit the bill out of the Arkoma, to take us to the Marcellus, but – you know it is an option given that as I said earlier, we're not getting a lot of people right now saying, yes build me that walking rig for $15 million and I will give you a multiyear deal to -- so that it will cash flow out for you nicely.

So it is hard for us to build the $50 million rate on spec right now, even though I think you're going to see the Marcellus heading that direction that the pads are certainly a lot more efficient and in that market, even though the locations are more expensive to build, you have all the environmental issues were you are looking at a less invasive operation where the -- you know you're cutting fewer location roads to the forests, you only have one location instead of a dozen and I think those things are going to resonate up there overtime.

Operator

Thank you. Our next question comes from the line of Jud Bailey with Jefferies & Co. Please go ahead.

Jud Bailey - Jefferies & Co.

Thanks good morning. I apologize if I had missed this. But A.J. you gave us good detail on the contracts that are rolling over, how should we think about margin per rig day in the next couple of quarters as those roll-off, how much of a decline should we be looking at given the types of rigs that are going to be going of contract?

A.J. Verdecchia

That is an excellent question Jeff. I think you're certainly going to see some roll off in margin. I mean, the math isn't that difficult if you say, okay we are going to take a rig that was earning 7,000 or 8,000 a day of margin out of the mix and yes we have got some other contracts that probably come on and instead of 7,000 or 8,000 a day what if you're replacing that with a couple of rigs in the Marcellus that are – you know may make five, and then a couple of rigs that say you land a couple of these oil deals and you're only making 2,500, and then you pick up something along the way in the Arkoma for 3,000 a day that is very difficult for us to model because a lot of the contracts that are out there -- potentials to replace some of the roll off are in influx.

But you know -- I am trying to give you a general feel for without getting too specific on the numbers here.

Jud Bailey - Jefferies & Co.

Okay, well I guess my follow-up would be that you kind of went around two different regions there, is that a fair characterization of the types of margin differentials you are seeing between regions, so we need to think about where you may pick up a rig, -- where I assume you pick up work here and there?

A.J. Verdecchia

I don't think it is unfair and I guess I may be being overly pessimistic, I think you know at some point the Barnett does come back and the kinds of rigs that come off of termed contract that we have been talking about, which are some of the newer electric rigs and the fleet, those are probably early cycle rigs, even if they're not going to be earning the kinds of margins that they did when we have the multi-year contracts put in place on them in ‘06.

And as I said in the background, we are spending some money to reposition those rigs for more for pad drilling and not a huge expenditure probably in the neighborhood of $1 million per rig to put walking packages on them. But I think that is going to be a significant marketing advantage on some of those larger rigs that roll off contract.

Operator

Thank you. (Operator instructions) We have a follow-up question from the line of Mark Brown with Pritchard Capital. Please go ahead.

Mark Brown - Pritchard Capital Partners, LLC

Hi Chris. Just wanted to clarify that ideal rigs that you're talking about for ’06, are they rolling, -- have they -- are they still on contract or are they rolling off in second half ’09 or second half of 2010, I just wanted to clarify?

Chris Strong

One of that we are working on as I mentioned we are putting a walking package on that’s of contract. We have -- one of the rigs is on a totaling agreement and the other four are out in the field.

Mark Brown - Pritchard Capital Partners, LLC

For the other four, how long are those contracts expanded at this point?

A.J. Verdecchia

I think in Q4 and in Q1 and Q2, when they roll off, basically in line with the timing of the delivery of those rigs.

Mark Brown - Pritchard Capital Partners, LLC

Okay very good. Thank you.

Operator

Thank you. And at this time, I would like to turn the call back over to management for any closing remarks.

Chris Strong

Thank you all for your interest in Union Drilling and we look forward to talking with you after we have our third quarter results. Good bye.

Operator

Ladies and gentlemen, this does conclude the Union Drilling’s second quarter 2009 earnings conference call. This conference will be available for replay after 11 Eastern Standard Time today, through August 11th, at midnight.

You may access the replay system at any time by dialing 303-590-3030 or 1-800- 406-7325 with the access code of 4111-7225#. We thank you for your participation. And at this time, you may now disconnect.

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