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Executives

Chris Strong - President & Chief Executive Officer

Tina Castillo - Chief Financial Officer

Ken Dennard - Investor Relations, DRG&E

Analysts

Max Barrett - Tudor, Pickering, Holt

Ryan Fitzgibbon - Pritchard Capital

Andrea Sharkey - Gabelli & Company

Union Drilling, Inc. (UDRL) Q2 2010 Earnings Call August 5, 2010 11:00 AM ET

Operator

Good day ladies and gentleman. Thank you for standing by. Welcome to the Union Drilling’s second quarter earnings call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions)

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

Ken Dennard

Thank you Luke and good morning everyone. We appreciate you joining us for Union Drilling's conference call today, to review second quarter 2010 results and before I turn the call over to the management, I have the normal house keeping 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 e-mail distribution list, please call our offices at DRG&E, that number is 713-529-6600.

A recorded replay of today's call will be available until August 12. Information for accessing the telephonic replay is in yesterday's release. The replay will also be available via webcast or archived webcast, by going to the company's website, which is of course www.uniondrilling.com.

Please note that information reported on this call speaks only as of today, August 5, 2010 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 the statements accompanied by the 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 on 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 results expressed or implied in these statements, as a result of risks, uncertainties and other factors, included 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 any forward-looking statements to reflect future events, information or circumstances that may 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 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, that we have that out of the way, let me this morning introduce and pass the call to Chris Strong, President and Chief Executive Officer; and Tina Castillo, Union Drilling’s new CFO.

Now I would like to turn the call to Chris.

Chris Strong

Thanks Ken. Good morning everyone and thank you for joining us today. As you saw on yesterday’s press release, our results for the second quarter of 2010 included revenues of $43.7 million, EBITDA of $3.6 million and a net loss of $5.3 million or $0.23 per share.

These all represent slight improvements over the first quarter, but the bottom line is certainly not where we want or expect it to be. Utilization averaged 45% for the quarter, which represents an improvement over 39.6% in Q1 and 34.7% in last years second quarter.

Increases in utilization were driven primarily by the rapid ramp up in West Texas Oil Drilling and to a lesser extent by increased activity in the Arkoma Basil. This was some what offset by atypical weakness in Appalachia, driven by low gas prices, regulatory and permitting uncertainty and a well fire that put one of our rigs out of service.

Regarding that well fire, on June 7, rig 43 was in the early stages of drilling the Marcellus well in Northern West Virginia, prior to setting any casing, when it encountered a pocket of methane gas was ignited and caused a fire at the surface. Since no casing was set, there was no blow up preventer or well control equipment installed and the fire burned to a height of about 40 feet for five days.

Seven workers were injured, including five Union Drilling employees. I am thankful that the workers are progressing well in their recovery from second-degree burns to exposed areas such as their hands, neck and face.

As a result of this fire, the main components of the rig such as derrick, substructure and top drive were destroyed and the State of West Virginia suspended permitting. Given this fire and another substantial Marcellus gas leak in July that did not ignite, it is not surprising the permits are now requiring shallower surface casing strings, so that blow out preventors can be installed earlier in the drilling process.

As a result of that incident, and possibly several other high profile accidents by other operators, the Pennsylvania DEP undertook an investigation of union drillings operating there. We are please to report that this investigation concluded with no violations being found on those rigs. I’ll talk more about our safety programs in a few minutes.

Running through Q2 highlights, we had a partial quarter contribution from rig 228, a 1000 horsepower triple, which we acquired for Texas in March. I mentioned this rig on our last conference call. We purchase rig 229 in Texas in June for $4.3 million. This is a 1000 horsepower triple that was built in 2007 and is currently working in West Texas.

We moved two rigs out of Arkoma, one to Texas and one to Appalachia. Utilization in Texas was excellent during the quarter due to the increase in West Texas oil drilling that we discussed on the last call. While margins have improved from a majority of the rigs that we put to working in West Texas, there are still a few that did not turn the corner and generate acceptable margins.

Towards the end of the quarter, we were able to put through some day rate increases in Texas that were unrelated to wage restoration. If we are unable to improve margins on the several rigs that have been running close to breakeven, the contracts serve a short-term nature and other work is available.

Arkoma is a solid market for us. We are seeing increased demand for larger rigs in that market in the 1000 to 1500 horsepower range. Appalachia is the weak link for us right now. While there are permitting and regulatory issues, activity is pretty strong in the Marcellus, that shallow rig utilization remains weak. Based on a term contract recently agreed too, we are in the process of acquiring another 1000 horsepower triple for the Marcellus.

As you may have seen in our press release, earlier this week our Board appointed Tina Castillo, our Controller for the last 14 months, Vice President and Chief Financial Officer. So I have ceased to be acting CFO and have lightened up on direct reports. Let me assure you it is a well-deserved promotion and I am confident we have the right person for the job. I look forward to getting her out on the road to meet our analyst and investors in the coming months.

At this point I’ll have Tina run through the Financials.

Tina Castillo

Thanks Chris and good morning everyone. Revenues for the three months ended June 30, 2010 totaled $43.7 million or $15,010 per revenue day, compared to revenues of $38.9 million or $17,330 per day in the second quarter of 2009. This 12% increase in revenue is primarily attributable to improvement in our utilization, offset by the not unexpected decline in our day rates.

That not unexpected decline in day rates is driven by the large number of rigs we’ve returned to work and the current low day rate environment, compared to last year when we still had a number of rigs, working under term contracts that were signed during the markets peak.

For the second half of 2010, we expect that this trend will continue when compared to the prior year periods. Sequentially comparing first half to the second half, day rates may decline 5% to 10% as a result of our current geographic mix.

Operating cost for the second quarter totaled $33.9 million or $11,652 per revenue day, compared to $25.6 million or 11,394 per day in the second quarter of 2009. Sequentially comparing our OpEx per day in the second quarter to the first quarter, the good news is we did see a decrease. The bad news is that we expected a bigger decrease.

Unfortunately the rig fire cost us $240 in OpEx per day for the quarter, while the rig we moved out of our Arkoma region cost us $150 in OpEx per day. We had a few other discreet items that cost us another $125 per day in OpEx.

For the second half of 2010, as we stated in yesterday’s press release, we do expect to see some upper pressure on OpEx per day as a result of high awareness on safety and the effect of wage restorations that we made in the second quarter. However, we expect those pressures to be offset by the absence of items I just mentioned, as well as the ability to spread cost over a larger number of rig days due to higher utilization. Overall, we expect that the kind of OpEx per day should decline modestly in the second half of the year.

Drilling margin totaled $9.8 million or $3358 per revenue day, compared to $13.3 million or $5936 per day for the second quarter of 2009. Compared to the first quarter of 2010, our margin per day was down approximately $220. As stated in last quarters earnings call, we need margins if we are going to be compressed, but we do expect to see some moderate improvement, as the cost of reactivating rigs in the first half will begin to pay for itself in the second half of 2010.

General and administrative expenses decreased by almost 100,000 compared to the prior year period. That doesn’t sound like much, but when looking at G&A as a percentage of revenue, it’s down about 109 basis points compared to the second quarter of 2009. Sequentially G&A increased due to some cost associated with the new ERP system that we expect to go live in early 2011.

Second quarter EBITDA totaled $3.6 million in 2010, compared to $7.3 million in 2009. We reported a net loss for the quarter of $5.3 million or a loss of $0.23 per share, compare to a net loss of $4.9 million or $0.24 per share in the prior year period. Recall that 2009 results included a $1.6 million or $0.8 per share impairment charge. Also the average share count was about $2.4 million shares higher this year, due our G&T 2009 capital raise.

On the balance sheet, we had $28 million drawn on our revolver as of June 30, compared to $9 million at December 31 and $13.3 million at March 31. Since March 31, we spent approximately $18 million on CapEx, which includes two rig upgrades in Appalachia, the purchase of rig T29 in Texas, cost associated with our new ERP system, as well as other rig enhancement and maintenance across our fleet. Today our revolver balance is approximately $31 million or a $3 million increase over June 30, mostly attributable to the timing of cash flows.

Our total CapEx budget for the year now stands at $60 million, of which $37 million we’ll spend in the first six months. This budget includes the expected purchase of the rig for the Marcellus that Chris just mentioned.

Looking at term contracts, which redefines contract spending at least six months or six wells, since our last earnings call on May 5, we’ve added seven new term contracts. That means, of the 41 rigs currently working today, 21 are on term, while 20 are on a well-to-well basis. For the rest of the year assuming no new term contracts, we currently have one term contract expiring in Q3, 9 in Q4, which would leave us with 11 term contracts heading into 2011.

I will now turn the call back over to Chris.

Chris Strong

Thank you Tina. As I mentioned I’d like to talk about safety for a couple of minutes. There had been a number of high profile incidents in the industry recently, both onshore and offshore. As you know, a strong safety record is critical to a company like Union Drilling from the standpoint of being able to attract and retain both employees and customers and now it’s become a hot topic politically as well.

Union Drilling has had a solid safety record for the past several years, better than the industry average according to insurance statistics, but we have been less than perfect. As a company we strive to continually improve our safety culture and practices, in order to ensure the well being of our employees.

With that in mind, we have retained the services of an outside consulting firm EDN, which is a subsidiary of Moody international. EDN is in the process of evaluating our current situation, identifying areas for improvement and in stilling a deep-seated safety-first culture across our entire organization.

Over the next year they will be conducting training programs across our entire fleet. They’ve already started with our Texas division and so far the feedback from every level of the organization has being excellent.

For the remainder of 2010, we expect cost associated with this program to total approximately $1.3 million. We believe this is a highly important investment for Union Drilling. While it’s hard to qualify, I am hoping some of that expenditure will be offset by lower turn over.

Looking out over the remainder of the year, we expect revenue increases to begin out pacing cost increases. On the top line, utilization continues to improve. July utilization came in at 52% compared to 45% for all of Q2, and the tightening rig market, especially for medium and large rigs, should lead to further increases in day rates. Since the end of Q2, we’ve raised many of our Texas rigs day rates by an average of about 500 a day and we are seeing some opportunities to push pricing up in Appalachia.

In the expense category, higher labor costs and unstacking expenses have largely offset the modest day rate gains we’ve seen through the first half of the year. We expect those pressures to moderate, although the enhanced focus on safety will likely continue putting upward pressure on expenses across the industry, but overall, we should see an improving bottom line in the second half of 2010.

As you just heard from Tina, and as you no doubt heard from our competitors, the tightening rig market is also leading to more opportunities for term contracts. Most of the contracts we are signing at this point are in the six months range, because we believe there is additional up side in day rates and we don’t want to get too locked at these rates.

However, we are beginning to see relatively more attractive opportunities. For example, we just signed the 12-month contract with one customer that will begin October 1, requiring us to purchase a 1000 horsepower triple rig that meets the customer specifications. While the rig acquisition has been included in what Tina reported, it was our CapEx budget. It has not been included in the term numbers that Tina reported.

With that Luke, we are ready to take questions.

Question-and-Answer Session

Operator

(Operators Instructions) Our next question comes from the line of Max Barrett with Tudor Pickering Holt. Please go ahead.

Max Barrett – Tudor, Pickering, Holt

Thanks. Good morning and congratulations Tina.

Tina Castio

Thank you.

Max Barrett – Tudor, Pickering, Holt

First, I just wanted to talk about the day rate expectations for the newly acquired rigs. Is high teens a good assumption for those rigs?

Chris Strong

No, as we mentioned, these are fairly low dollar rigs. We are talking rigs that we purchased for $5 million. So we don’t need high teem with an $11,000, the OpEx type structure to get a decent return on the capital, and frankly the pricing out in West Texas is really not in that high teem area at this point. We are seeing more of that up in the Marcellus.

Tina Castio

Now for the Marcellus rig that Chris mentioned, we do expect higher teens for that rig.

Chris Strong

Absolutely, but that’s going to be a higher dollar rig.

Tina Castio

Yes.

Max Barrett – Tudor, Pickering, Holt

Okay, and then just as it relates to new builds, several of your peers are obviously building here and the rates on those contracts backing the rigs seem to be pretty solid. Is the cause for your hesitation the length of the term customers are willing to commit to at this point?

Chris Strong

We had any number of conversations. I think obviously with our debt to cap we are in good shape to go ahead and enter into new build contracts, and I think as I said, the market is starting to tighten and its harder to get a hold of 1000 to 1500 horsepower rigs. So, I think we may very well see some more tightening, where the terms will become a bit more attractive to the drillers.

Max Barrett – Tudor, Pickering, Holt

Okay, and then last one from me, if you could generalize across regions, I guess what would you say the current spread is between the day rates of your higher end rigs and smaller mechanical rigs.

Chris Strong

No, you’re probably in the 5000 range. We have some of the shallow rigs that are still speeding out a couple of thousand as their margin, but this is the largely depreciated smaller rigs that have lower operating expenses, but some of those rigs maybe 12,000 a day, 11,500, but you are still able to manage the cost structures on those, where you are well below 10,000 a day in OpEx.

Then the larger rigs, yes you are starting to -- we have not cracked 20 yet on anything new, but obviously I’ve heard that some of our competitors have, but mid high teens or not uncommon for the right rig at this point, especially those that are set up with the top driver or maybe walking package, that sort of thing.

Max Barrett – Tudor, Pickering, Holt

Thank you very much.

Operator

Thank you. Our next question comes from the line of Ryan Fitzgibbon with Pritchard Capital. Please go ahead.

Ryan Fitzgibbon - Pritchard Capital

Hey, good morning Chris, and again congrats to Tina. First question starting off, you guys talked a lot on the last call about the bifurcation and your rig fleet utilization up tick you guys are looking for. Is that going to be primarily for the larger rigs or is it lower end or I guess middle end?

Chris Strong

The larger rigs Ryan are pretty well sold out and why I think pricing is at hand is, we are getting calls from people we haven’t done business with before, and I’m assuming they’ve called the people they usually have worked with and they are out of rigs as well.

So although we picked up a couple of rigs on this, that I thought were extremely good buys, actually they were over in East Texas and a 1000 horsepower maybe a little small for the Haynesville, but it is something we are at in West Texas, given that you are starting to see more horizontal oil drilling that kind of mirrors what you see in the Barnet Shale. They need a bit larger iron out there for the Wolfberry play in particular.

I think there have been some opportunities for picking up some of those rigs and up in Appalachia, as I said pricing is stronger there and pretty decent demand in the say of bill as well. I mean we’ve got good utilization, but again it’s the single engine 450, 500 horsepower rigs where utilization is challenging, and I think you can see that in the Baker Hughes rig count, just the vertical versus horizontal splits.

Ryan Fitzgibbon - Pritchard Capital

Sure, makes sense, but I guess you guys will have made three rig acquisitions this year once the Marcellus rig closes. When you look at those economics as opposed to the new build, what do you guys favor moving forward? Should we expect more of one offs or…

Chris Strong

We continue to work with our customers, talk to new customers, utilization is pretty good. Actually we proposed on this rig we are taking into the Marcellus. We had a proposal at a higher day rate on a fancy or electric rig and that customer said, ‘well, we think a mechanical rig with the top driver will work just fine.’ and we quoted them a somewhat lower day rate, because there was a lower capital cost associated with that particular asset. I certainly enjoyed building larger AC rigs for the Marcellus, but I am a little leery of laying out $15 million to $17 million on rig against a one-year contract.

Ryan Fitzgibbon - Pritchard Capital

That makes sense. And I guess lastly if you have the information available, can you give us the utilization breakdown for your three markets?

Chris Strong

We prefer not to do that. That’s an often asked question, but that really gets us down the slippery slope of segment reporting, which we’d like to avoid.

Ryan Fitzgibbon - Pritchard Capital

Okay. Fair enough. I’ll turn it back over. Thanks for your time.

Chris Strong

Thank you, Ryan.

Operator

(Operator Instructions) Our next question comes from the line of Andrea Sharkey with Gabelli & Company. Please go ahead.

Andrea Sharkey – Gabelli & Company

Hi! Good morning. Tina congratulations!

Tina Castillo

Thank you.

Andrea Sharkey – Gabelli & Company

So, one of my questions have been answered, but I was just curious, if you were to decide to go ahead and build a new rig for a customer for a contract, maybe longer than a year and on terms that were more attracted to you. Do you have any sense of what the lead time would be to get that new rig available and up and running?

Chris Strong

The short answer is it depends. There are some rigs that are sitting in yards where rig builders have built them and they are pretty good candidates. They are not ideal candidates, but they are also priced a little better and those could be had almost immediately.

Then there are some much more, I would say advanced designs where cranes aren’t required on the location to disassemble the rig, more compact designs for the Marcellus in particular, those rigs, the folks who have differences designs, a lot of them haven’t build any yet. They will say five months, but to me, that maybe covered for something more like 10 months to 12.

You wouldn’t hear that from the rig builders, but often these things start with a trickle and then all of a sudden there are a whole bunch of new rig orders when the market realizes its really actually tied out there and somebody with a program is left without a rig.

The catalyst there when you get to that kind of utilization can sometimes be fairly strong, and then there are a lot of new rig orders and then the rig manufacturers really aren’t tooled up for that and certainly, sales people, their job is to build backlog and they will -- I’ve been through this before Andrea, where it was told five months and it turned into a year. So that’s my take on it.

Andrea Sharkey – Gabelli & Company

Thanks. That’s helpful. And then I think you’ve sort of touched on this already, that a lot of the larger rigs are pretty much booked out, but without considering the new acquisitions and potential new builds, do you have any rigs still sitting around that could go to work in shale regions?

Chris Strong

Precious few. We’ll have rigs that come off contract and go to another customer. We’ll have rigs that are in the yard to have something done on them, but really the utilization in Texas is extremely high. The utilization up in the Arkoma of the larger rigs are pretty much booked up there and Appalachia is similar. We may have a couple more going out up there.

Actually some of what’s going up may indicate some pricing power and new built opportunities, since that we have some of those small shallow rigs that are being employed to drill the vertical section of the Marcellus ahead of larger rigs, which generally isn’t the optimal way to drill the wells.

But if you only have so many larger rigs knocking out the vertical section with a smaller rig and then bringing in the bigger rig, can get essentially more horizontal drilling utilization out of the larger rigs. So we’ve got some of that activity as well going on up in Pennsylvania.

Andrea Sharkey – Gabelli & Company

Great! Yes, I have heard about that a little bit, and then I guess the last question for me is, Tina had mentioned I think seven new term contracts that you added, and I was curious if you could give some sort of sense of the day rates on those versus spot market day rates, and day rates on contracts that are rolling off, and also maybe a sense of geographic region of where those contracts are going?

Chris Strong

Well, that’s probably a little more detail than we are comfortable with giving out since we don’t give guidance Andrea, but in general what I would say is that, yes, we still have some higher dollar rigs out there from the good old days that are earning well in excess of 20,000 a day, and those are some that will be rolling off.

And at this point, as I mentioned in my scripted comments, some of this that we are getting is where we are saying, ‘yeah, we’ll do six month,’ but we really don’t want to go out a year, because we still think the pricing environment is fairly low, given the utilization of the medium and larger rigs, not only in our fleet, but across the industry right now.

So, I was a lot more worried that things might roll over in the gas market at the end of the summer, and that we have a lot of the utilization in general with the larger rigs and the rig fleet that would rollover before we ever got to pricing power. It seems in part with the shift of a lot of equipment into either oil or the weather higher liquids content part of the natural gas place. It looks a lot more sustainable than I thought it would be at the beginning of the year.

Andrea Sharkey – Gabelli & Company

Okay, great. Thanks a lot.

Chris Strong

You’re welcome.

Operator

Thank you, and there is no further questions in the queue. Management, please proceed.

Chris Strong

Well, thank you all very much for attending the call this morning and we look forward to speaking with you when we have our third quarter results. Good bye.

Operator

Ladies and gentleman, this concludes the Union Drilling second quarter earnings call. If you would like to listen to a replay of today’s conference, please dial 303-590-3030, with the access code 4322383. ACT would like to thank you for your participation. You may now disconnect.

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Source: Union Drilling, Inc. Q2 2010 Earnings Call Transcript
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