**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

**FORM 10-Q**

**(MarkOne)**

**x**                               QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from                   to**

**Commission File Number 000-30819**

**Particle Drilling Technologies, Inc.**(Exact name of registrant as specifiedin its charter)

| **Nevada**                       |   | **20-1563395**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**11757 Katy Freeway, Suite 1300Houston, Texas 77079**(Address of principal executive offices)

(Zip Code)

**713-223-3031**

(Registrant’s telephonenumber, including area code)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x  No o

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

Large acceleratedfiler o                            Accelerated filer x                      Non-acceleratedfiler o

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

The number of shares of the registrant’s common stock,$.001 par value, outstanding as of February 1, 2007 was 30,093,200.

 

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**PARTICLE DRILLINGTECHNOLOGIES, INC.(a development stage enterprise)**

**FORM 10-QFOR THE QUARTER ENDED DECEMBER 31, 2006**

**INDEX**
| **Part I—Financial Information** |       |                                                                                                                                                                     |   |
|---------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| ** **                            | ** ** | ** **                                                                                                                                                               |   |   |   |
| Item  1.                              |       | Financial  Statements                                                                                                                                                    |   |   |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Consolidated  Balance Sheets at December 31, 2006 (Unaudited) and September 30, 2006                                                                                     |   | 3 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Consolidated Statements of Operations (Unaudited) —  Three Months Ended December 31, 2006 and 2005, and from June 9, 2003 (date of  inception) to December 31, 2006 |   | 4 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Consolidated Statements of Stockholders’ Equity for  the period from September 30, 2006 to December 31, 2006                                                        |   | 5 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Consolidated Statements of Cash Flows (Unaudited) —  Three Months Ended December 31, 2006 and 2005, and from June 9, 2003 (date of  inception) to December 31, 2006 |   | 6 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Notes to Consolidated Financial Statements (Unaudited)                                                                                                                   |   | 7 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item 2.                               |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                                              |   | 10 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item 3.                               |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                                                              |   | 14 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item  4.                              |       | Controls  and Procedures                                                                                                                                                 |   | 14 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| **Part  II—Other Information**   |       |                                                                                                                                                                     |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item 2.                               |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                                                             |   | 14 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item  5.                              |       | Other  Information                                                                                                                                                       |   | 14 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
| Item 6.                               |       | Exhibits                                                                                                                                                                 |   | 15 |   |
|                                  |       |                                                                                                                                                                     |   |   |   |
|                                  |       | Signatures                                                                                                                                                               |   | 16 |   |

 

2

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**PARTICLE DRILLING TECHNOLOGIES,INC.**

**(a development stage enterprise)**

**CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                             | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                             | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| **ASSETS**                                                                                                                                                                                                                             | ** ** | ** **                  | ** ** | ** **                   | ** ** |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Current assets:                                                                                                                                                                                                                        |       |                        |       |                         |       |
| Cash and cash  equivalents                                                                                                                                                                                                             |       | $                           | 11,188,221 |                         | $          | 2,291,586 |   |
| Short-term  investments                                                                                                                                                                                                                |       | —                      |       | 385,839                      |       |
| Prepaid expenses                                                                                                                                                                                                                       |       | 212,998                     |       | 234,488                      |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Total current  assets                                                                                                                                                                                                                  |       | 11,401,219                  |       | 2,911,913                    |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Property, plant &  equipment, net                                                                                                                                                                                                  |       | 1,203,586                   |       | 1,326,713                    |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Intangibles, net                                                                                                                                                                                                                       |       | 1,257,669                   |       | 1,230,086                    |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Other assets                                                                                                                                                                                                                           |       | 15,370                      |       | 14,650                       |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Total assets                                                                                                                                                                                                                           |       | $                           | 13,877,844 |                         | $          | 5,483,362 |   |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                         | ** ** | ** **                  | ** ** | ** **                   | ** ** |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Current liabilities:                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Accounts payable                                                                                                                                                                                                                       |       | $                           | 804,498    |                         | $          | 830,552 |   |
| Short-term notes  payable                                                                                                                                                                                                              |       | 103,149                     |       | 179,143                      |       |
| Current portion  of long-term debt                                                                                                                                                                                                     |       | 16,626                      |       | 19,270                       |       |
| Accrued  liabilities                                                                                                                                                                                                                   |       | 430,226                     |       | 471,463                      |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Total current  liabilities                                                                                                                                                                                                             |       | 1,354,499                   |       | 1,500,428                    |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Long-term debt                                                                                                                                                                                                                         |       | 12,780                      |       | 15,305                       |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Commitments and  contingencies — Note 8                                                                                                                                                                                           |       |                        |       |                         |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Stockholders’ equity:                                                                                                                                                                                                             |       |                        |       |                         |       |
| Common stock,  $.001 par value, 100,000,000 shares authorized, 33,096,286 shares issued and  30,093,200 shares outstanding at December 31, 2006, and 28,013,291 shares  issued and 25,010,205 shares outstanding at September 30, 2006 |       | 33,097                      |       | 28,014                       |       |
| Additional  paid-in capital                                                                                                                                                                                                            |       | 36,615,535                  |       | 25,239,221                   |       |
| Treasury stock  at cost, 3,003,086 shares at December 31, 2006 and September 30, 2006                                                                                                                                                  |       | (1,511,817                  | )          | (1,511,817                   | )          |
| Deficit  accumulated during the development stage                                                                                                                                                                                      |       | (22,626,250                 | )          | (19,787,789                  | )          |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Total  stockholders’ equity                                                                                                                                                                                                       |       | 12,510,565                  |       | 3,967,629                    |       |
|                                                                                                                                                                                                                                   |       |                        |       |                         |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                       |       | $                           | 13,877,844 |                         | $          | 5,483,362 |   |

 

The accompanying notes are an integral part of thesestatements.

3

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**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**CONSOLIDATED STATEMENTSOF OPERATIONS**

**(Unaudited)**
| ** **                                                                     | ** ** | ** **                       | ** ** | ** **             | ** ** | **Period from**       | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                     | ** ** | ** **                       | ** ** | ** **             | ** ** | **June 9, 2003** | ** ** |
| ** **                                                                     | ** ** | ** **                       | ** ** | ** **             | ** ** | **(date of**          | ** ** |
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** | **inception) to** | ** ** |
| ** **                                                                     | ** ** | **December 31,**            | ** ** | **December 31,**  | ** ** |
| ** **                                                                     | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **2006**                   | ** ** |
| ** **                                                                     | ** ** | ** **                       | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Revenues                                                                       |       | $                                | —     |                   | $          | —                     |       | $ | — |   |
|                                                                           |       |                             |       |                   |       |                       |       |
| Operating expenses:                                                            |       |                             |       |                   |       |                       |       |
| Research and  development                                                      |       | 1,664,843                        |       | 1,285,485              |       | 11,092,814                 |       |
| General and  administrative                                                    |       | 1,298,544                        |       | 990,962                |       | 12,248,642                 |       |
|                                                                           |       |                             |       |                   |       |                       |       |
| Total operating  expenses                                                      |       | 2,963,387                        |       | 2,276,447              |       | 23,341,456                 |       |
|                                                                           |       |                             |       |                   |       |                       |       |
| Loss from  operations                                                          |       | (2,963,387                       | )          | (2,276,447             | )          | (23,341,456                | )          |
|                                                                           |       |                             |       |                   |       |                       |       |
| Other income (expenses)                                                        |       |                             |       |                   |       |                       |       |
| Interest income                                                                |       | 127,898                          |       | 86,041                 |       | 598,117                    |       |
| Rental income —  related party                                            |       | —                           |       | 23,282                 |       | 73,727                     |       |
| Gain on debt  extinguishment                                                   |       | —                           |       | —                 |       | 35,283                     |       |
| Gain on  assignment of lease — related party                              |       | —                           |       | —                 |       | 55,614                     |       |
| Interest expense                                                               |       | (2,972                           | )          | (859                   | )          | (47,535                    | )          |
|                                                                           |       |                             |       |                   |       |                       |       |
| Total other  income                                                            |       | 124,926                          |       | 108,464                |       | 715,206                    |       |
|                                                                           |       |                             |       |                   |       |                       |       |
| Net loss                                                                       |       | $                                | (2,838,461 | )                      | $          | (2,167,983                 | )          | $ | (22,626,250 | ) |
|                                                                           |       |                             |       |                   |       |                       |       |
| Net loss per common  share, basic and diluted                                  |       | $                                | (0.10      | )                      | $          | (0.09                      | )          | $ | (1.16 | ) |
|                                                                           |       |                             |       |                   |       |                       |       |
| Weighted average number of common shares outstanding — basic and  diluted |       | 29,094,418                       |       | 24,296,472             |       | 19,541,211                 |       |

 

The accompanying notes are an integral part of thesestatements.

 

4

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**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

**Forthe Period from September 30, 2006 to December 31, 2006**

**(Unaudited)**

** **
| ** **                                                                                                                | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | **Deficit**     | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-----------------|------------|------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                                                | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                                                | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional**         | ** ** | **During**      | ** ** | **Total**  | ** ** |
| ** **                                                                                                                | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-in** | ** ** | **Development** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Shares**  | ** ** | **Amount**      | ** ** | **Capital**            | ** ** | **Stage**       | ** ** | **Equity** | ** ** |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Balance, September 30,  2006                                                                                              |       | 28,013,291            |       | 28,014                  |       | (3,003,086  | )          | (1,511,817      | )          | 25,239,221             |       | (19,787,789     | )          | 3,967,629  |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Common stock issued in  private placement for cash at $2.35 per share in October 2006, less offering  expense of $996,950 |       | 5,000,000             |       | 5,000                   |       | —      |       | —          |       | 10,748,050             |       | —          |       | 10,753,050 |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Restricted stock issued  to an employee at $1.99 per share in October 2006                                                |       | 3,000                 |       | 3                       |       | —      |       | —          |       | (3                     | )          | —          |       | —     |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Restricted stock issued  to employees at $2.85 per share in October 2006                                                  |       | 68,250                |       | 68                      |       | —      |       | —          |       | (68                    | )          | —          |       | —     |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Common stock issued  upon exercise of warrants at $0.12 per share in October 2006                                         |       | 5,745                 |       | 6                       |       | —      |       | —          |       | (6                     | )          | —          |       | —     |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Common stock issued for  cash at $0.12 per share upon exercise of employee stock options in November  2006                |       | 6,000                 |       | 6                       |       | —      |       | —          |       | 714                    |       | —          |       | 720        |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Stock-based employee  compensation                                                                                        |       | —                |       | —                  |       | —      |       | —          |       | 627,627                |       |            |       | 627,627    |       |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Net loss                                                                                                                  |       | —                |       | —                  |       | —      |       | —          |       | —                 |       | (2,838,461      | )          | (2,838,461 | )          |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
| Balance,  December 31, 2006                                                                                               |       | 33,096,286            |       | $                       | 33,097     |        | (3,003,086 | )               | $          | (1,511,817             | )          | $               | 36,615,535 |       | $          | (22,626,250 | ) | $ | 12,510,565 |   |
|                                                                                                                      |       |                  |       |                    |       |        |       |            |       |                   |       |            |       |       |       |
|                                                                                                                           |            |                       |            |                         |            |             |            |                 |            |                        |            |                 |            |            |            |  |  |  |  |  |

 

The accompanying notes are an integral part of thesestatements.

 

5

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**PARTICLE DRILLING TECHNOLOGIES, INC.****(a development stage enterprise)****CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)**
| ** **                                                                   | ** ** | ** **                       | ** ** | ** **             | ** ** | **Period from**       | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                   | ** ** | ** **                       | ** ** | ** **             | ** ** | **June 9, 2003** | ** ** |
| ** **                                                                   | ** ** | ** **                       | ** ** | ** **             | ** ** | **(**date of          | ** ** |
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** | **inception to)** | ** ** |
| ** **                                                                   | ** ** | **December 31,**            | ** ** | **December 31,**  | ** ** |
| ** **                                                                   | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **2006**                   | ** ** |
| Cash flows from  operating activities:                                       |       |                             |       |                   |       |                       |       |
| Net loss                                                                     |       | $                                | (2,838,461 | )                      | $          | (2,167,983                 | )          | $ | (22,626,250 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                             |       |                   |       |                       |       |
| Gain on debt  extinguishment                                                 |       | —                           |       | —                 |       | (35,283                    | )          |
| Other                                                                        |       | —                           |       | —                 |       | (54,103                    | )          |
| Depreciation and  amortization expense                                       |       | 188,307                          |       | 154,571                |       | 1,415,369                  |       |
| Short-term note  issued for services                                         |       | —                           |       | —                 |       | 44,000                     |       |
| Common stock  issued for services                                            |       | —                           |       | —                 |       | 931,500                    |       |
| Warrants issued  for services                                                |       | —                           |       | —                 |       | 63,829                     |       |
| Stock-based  employee compensation                                           |       | 627,627                          |       | 390,549                |       | 3,307,817                  |       |
| Changes in  operating assets and liabilities:                                |       |                             |       |                   |       |                       |       |
| Decrease in note  receivable                                                 |       | 385,839                          |       | —                 |       | 385,839                    |       |
| (Increase) in  accounts receivable — related party                      |       | —                           |       | (14,112                | )          | (42,331                    | )          |
| Decrease in  prepaid expenses                                                |       | 20,771                           |       | 29,358                 |       | 152,258                    |       |
| Increase  (Decrease) in accounts payable                                     |       | (26,055                          | )          | (96,525                | )          | 464,559                    |       |
| Increase  (Decrease) in accrued liabilities                                  |       | (41,236                          | )          | 43,695                 |       | 527,024                    |       |
|                                                                         |       |                             |       |                   |       |                       |       |
| Net cash used in  operating activities                                       |       | (1,683,208                       | )          | (1,660,447             | )          | (15,465,772                | )          |
|                                                                         |       |                             |       |                   |       |                       |       |
| Cash flows from  investing activities:                                       |       |                             |       |                   |       |                       |       |
| Payments to  purchase property and equipment                                 |       | (52,556                          | )          | (27,947                | )          | (1,873,175                 | )          |
| Proceeds from  sale of property and equipment                                |       | —                           |       | —                 |       | 20,957                     |       |
| Payments to  purchase intangibles                                            |       | (40,205                          | )          | (26,559                | )          | (648,819                   | )          |
| Payments to  purchase other assets                                           |       | —                           |       | —                 |       | (419,504                   | )          |
| Payments issued  for note receivable                                         |       | —                           |       | —                 |       | (300,783                   | )          |
| Payments issued  for note receivable — related party                    |       | —                           |       | —                 |       | (56,783                    | )          |
|                                                                         |       |                             |       |                   |       |                       |       |
| Net cash used in  investing activities                                       |       | (92,761                          | )          | (54,506                | )          | (3,278,107                 | )          |
|                                                                         |       |                             |       |                   |       |                       |       |
| Cash flows from  financing activities:                                       |       |                             |       |                   |       |                       |       |
| Proceeds from  issuance of common stock                                      |       | 10,753,770                       |       | —                 |       | 31,735,623                 |       |
| Repurchase of  common stock                                                  |       | —                           |       | —                 |       | (1,511,817                 | )          |
| Proceeds from  issuance of convertible notes                                 |       | —                           |       | —                 |       | 553,500                    |       |
| Repayments of  notes payable                                                 |       | (81,166                          | )          | (19,511                | )          | (845,206                   | )          |
| Proceeds from  borrowings under loan agreements — related parties       |       | —                           |       | —                 |       | 23,195                     |       |
| Repayment of  borrowings under loan agreements — related parties        |       | —                           |       | —                 |       | (23,195                    | )          |
|                                                                         |       |                             |       |                   |       |                       |       |
| Net cash  provided by (used in) financing activities                         |       | 10,672,604                       |       | (19,511                | )          | 29,932,100                 |       |
|                                                                         |       |                             |       |                   |       |                       |       |
| Net increase (decrease)  in cash and cash equivalents                        |       | 8,896,635                        |       | (1,734,464             | )          | 11,188,221                 |       |
|                                                                         |       |                             |       |                   |       |                       |       |
| Cash and cash  equivalents — beginning of period                        |       | 2,291,586                        |       | 10,504,646             |       | —                     |       |
|                                                                         |       |                             |       |                   |       |                       |       |
| Cash and cash  equivalents — end of period                              |       | $                                | 11,188,221 |                   | $          | 8,770,182                  |       | $ | 11,188,221 |   |
|                                                                         |       |                             |       |                   |       |                       |       |
| Supplemental  disclosures of cash flow information:                          |       |                             |       |                   |       |                       |       |
| Cash paid for  interest                                                      |       | $                                | 2,972      |                   | $          | 872                        |       | $ | 47,535 |   |
|                                                                         |       |                             |       |                   |       |                       |       |
| Non-cash investing and  financing activities:                                |       |                             |       |                   |       |                       |       |
| Prepaid  insurance acquired with note payable                                |       | $                                | —     |                   | $          | —                     |       | $ | 111,990 |   |
| Common stock  issued as consideration for account payable                    |       | —                           |       | —                 |       | 6,000                      |       |
| Common stock  issued as consideration for note payable                       |       | —                           |       | —                 |       | 50,000                     |       |
| Related party  note receivable exchanged for property and equipment          |       | —                           |       | —                 |       | 56,783                     |       |
| Note payable  converted into common stock                                    |       | —                           |       | —                 |       | 553,500                    |       |
| Property and  equipment acquired with assumed liabilities                    |       | —                           |       | —                 |       | 479,610                    |       |
| Intangibles  acquired with assumed liabilities                               |       | —                           |       | —                 |       | 757,792                    |       |
| Property and  equipment acquired with note payable                           |       | —                           |       | —                 |       | 30,487                     |       |
| Short-term investments  reclassified from other assets                       |       | —                           |       | —                 |       | 385,839                    |       |

 

The accompanying notesare an integral part of these statements.

6

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**PARTICLE DRILLING TECHNOLOGIES,INC.(a development stage enterprise)**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

**1.    BASIS OF PRESENTATION**

The accompanyingunaudited interim consolidated financial statements, which include the accountsof Particle Drilling Technologies, Inc. (which is referred to hereinas “we,” “us,” “our” or the “Company”) and its subsidiary, have been preparedin accordance with generally accepted accounting principles in the UnitedStates of America (“US GAAP”) and pursuant to the rules and regulations ofthe Securities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith US GAAP have been condensed or omitted in accordance with such rules andregulations. The information furnished in the unaudited interim consolidatedfinancial statements includes normal recurring adjustments and reflects alladjustments, which in the opinion of management are necessary for a fairpresentation of such financial statements. Although management believes thedisclosures and information presented are adequate to make the information notmisleading, these unaudited interim consolidated financial statements should beread in conjunction with the Company’s September 30, 2006 auditedconsolidated financial statements and notes thereto on Form 10-K.Operating results for the three months ended December 31, 2006 are notnecessarily indicative of the results that may be expected for the year endingSeptember 30, 2007.

The preparation offinancial statements in conformity with US GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting periods. Actual results could differ from these estimates.

Certain reclassificationshave been made to conform prior period amounts to the current periodpresentation. These reclassifications had no effect on net loss, net loss pershare, or stockholders’ equity.

**2.     FINANCIALCONDITION AND MANAGEMENT PLANS**

The Company is currentlya development stage company and its continued existence is dependent upon theCompany’s successful development of the PID technology and our ability tosuccessfully commercialize this technology. The Company has yet to generate cashflow from operations, and untilrevenues commence, the Company is highly dependent upon debt and equityfunding.  Should continuing fundingrequirements not be met, the Company’s operations may cease to exist.  Management cannot provide any assurance thatany such financing will be available on acceptable terms or at all.

**3.    SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

*Impairmentof Long-Lived Assets.  *We evaluate our long-livedassets for indicators of possible impairment by comparison of the carryingamounts to future net undiscounted cash flows expected to be generated by suchassets when events or changes in circumstances indicate the carrying amount ofan asset may not be recoverable.  Should an impairment exist, theimpairment loss would be measured based on the excess carrying value of theasset over the asset’s fair value or discounted estimates of future cashflows.  We also evaluate the capitalized costs for patents and patentapplications filed but not issued for possible impairments. We have notidentified any such impairment losses to date. The evaluation of capitalizedcosts for patents and patent applications is based on a subjective cash flowforecast which is subject to change. We will reassess our cash flow forecasteach time there are fundamental changes in the underlying potential use of thepatents or patent applications in terms of performance, customer acceptance orother factors that may affect such cash flow forecasts.

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*New Accounting Pronouncements**.  ***In July 2006, the FASB issued FASBInterpretation No. 48, *Accounting forUncertainty in Income Taxes — An Interpretation of FASB Statement No. 109*(“FIN48”).  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with SFAS No. 109, *Accountingfor Income*Taxes*.*  It prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return.  This new standard also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  Theprovisions of FIN 48 are to be applied to all tax positions upon initialadoption of this standard.  Only taxpositions that meet the more-likely-than-not recognition threshold at theeffective date may be recognized or continue to be recognized upon adoption ofFIN 48.  The cumulative effect ofapplying the provisions of FIN 48 should be reported as an adjustment to theopening balance of retained earnings (or other appropriate components of equityor net assets in the statement of financial position) for that fiscal year.  The provisions of FIN 48 are effective forfiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yetissued financial statements, including interim financial statements, in theperiod of adoption.  The Company believesthat the adoption of FIN 48 will not have a material impact on our financialposition, results of operations or cash flows.

In September 2006,the FASB issued SFAS No. 157, Fair Value Measurements.  SFAS No. 157clarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing an asset or liability andestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions.  Under the standard, fair value measurementswould be separately disclosed by level within the fair value hierarchy. SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those fiscalyears, with early adoption permitted.  The Company believes that theadoption of SFAS No. 157 will not have a material impact on its financialposition, results of operations or cash flows.

In September 2006,the FASB issued FSP No. AUG AIR-1, Accounting for Planned Major MaintenanceActivities.  FSP No. AUG AIR-1 prohibits the use of the accrue-in-advancemethod for accounting for major maintenance activities and confirms theacceptable methods of accounting for planned major maintenanceactivities.  FSP No. AUG AIR-1 is effective the first fiscal yearbeginning after December 15, 2006.  The Company believes that the adoptionof FSP No. AUG AIR-1 will not have a material impact on its financial position,results of operations or cash flows.

InSeptember 2006, the SEC issued SAB 108, “Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements”**(“ SAB 108”)*.*SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of prior year misstatementsshould be considered in quantifying a current year misstatement. Thepronouncement prescribes an approach whereby the effect of all unrecordedidentified errors should be considered on all of the financial statementsrather than just either the effect on the balance sheet or the incomestatement. The Company will adopt the provisions of SAB 108 beginning in fiscal2007. The adoption of SAB 108 did not have a material impact on the Company’sConsolidated Financial Statements.

**4.     REVERSE ACQUISITION WITH MEDXLINK, CORP**

On July 14, 2004,MedXLink, Corp. (“MXLK”, or the “Parent”), a Nevada corporation and an inactivepublicly-traded company, entered into an Agreement and Plan of Reorganizationwith Particle Drilling Technologies, Inc., a Delaware corporation (“PDTI-DE”),whereby MXLK agreed to acquire PDTI-DE by merging PDTI Acquisition Corp. (“MergerSub”), a newly formed Delaware corporation and wholly owned subsidiary of MXLK,with and into PDTI-DE and issued common stock of MXLK in exchange for all theoutstanding shares of PDTI-DE. On January 14, 2005, MXLK closed itsacquisition of PDTI-DE and issued 16,698,094 shares of common stock (including3,381,538 shares of common stock issued upon conversion of the same number ofshares of Series A Convertible Preferred Stock of PDTI-DE) to holders ofcommon stock of PDTI-DE and reserved for issuance (1) 228,000 shares ofcommon stock pursuant to outstanding warrants to purchase common stock ofPDTI-DE, and (2) 3,205,000 shares of common stock pursuant to outstandingoptions to purchase common stock of PDTI-DE. In addition, 1,342,404 issued andoutstanding shares of common stock of the Parent were cancelled for noadditional cash consideration in connection with the Merger. Following themerger, the Parent had 18,248,094 shares of common stock issued and outstanding(which included 3,381,538 shares of common stock issued upon conversion of thesame number of shares of Series A Convertible Preferred Stock of PDTI-DE)and an additional 3,433,000 shares of common stock reserved for issuance uponexercise of warrants and options as described above. Following the merger,PDTI-DE continued as the surviving corporation under the name ofParticle Drilling Technologies, Inc. as a subsidiary of Parent, theParent changed its name to Particle Drilling Technologies, Inc., andits stock trading symbol changed from MXLK.OB to PDRT.OB. On June 28,2005, the Company’s shares of common stock began trading on The NASDAQ CapitalMarket® under the symbol PDRT.

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**5.     NET LOSS PER COMMON SHARE**

The Company has presentedbasic and diluted net loss per share pursuant to SFAS No. 128, *Earnings Per Share*. In accordance withSFAS No. 128, basic and diluted net loss per share has been computed usingthe weighted-average number of shares of common stock outstanding during theperiod. Dilutive net loss per share would give affect to the dilutive effect ofcommon stock equivalents consisting of options and warrants. Potentiallydilutive securities have been excluded from the net loss per common sharecalculation as the effects would be antidilutive. Potentially dilutivesecurities not included in the computation of weighted average diluted sharesof common stock were 2,054,643 and 2,701,790 shares for the three months endedDecember 31, 2006 and 2005, respectively.

**6.     COMMON STOCK**

InOctober 2006, the Company issued 5,745 shares of its common stock upon a netcashless exercise of warrants at $0.12 per share.

InOctober 2006, the Company issued 71,250 shares of its restricted stock toseveral of its employees.

InOctober 2006, the Company issued 5,000,000 shares of its common stock from aprivate placement at $2.35 per share.

In November 2006, theCompany issued 6,000 shares of its common stock for cash upon exercise ofoptions at $0.12 per share.

At December 31, 2006, theCompany had 30,093,200 shares of common stock outstanding and has outstandingoptions and warrants to purchase up to 7,173,391 additional shares of theCompany’s common stock in the aggregate.

**7.    STOCK-BASED EMPLOYEE COMPENSATION**

In April 2004,the Board of Directors adopted the 2004 Stock Incentive Plan (the “2004 Plan”).The 2004 Plan provides for the issuance of incentive stock options,non-statutory stock options and restricted stock grants to directors, employeesand consultants of the Company. Provisions under the 2004 Plan allowed for theissuance of up to 3,500,000 shares of common stock pursuant to awards under the2004 Plan. As of December 31, 2006, the Company had 111,250 shares of commonstock available for issuance pursuant to awards under the 2004 Plan.

In March 2005, theBoard of Directors adopted the 2005 Stock Incentive Plan (the “2005 Plan”). The2005 Plan provides for the issuance of incentive stock options, non-statutorystock options and restricted stock grants to directors, employees andconsultants of the Company. Provisions under the 2005 Plan allow for theissuance of options and restricted stock awards to purchase or issue up to2,000,000 shares of common stock. As of December 31, 2006, the Company had388,000 shares of common stock available for issuance pursuant to awards underthe 2005 Plan.

Stock-based employeecompensation expense recorded for awards issued under the 2004 Plan and the2005 Plan for the three months ended December 31, 2006 and 2005 was $627,627and $390,549, respectively.  Stock-basedemployee compensation expense recorded for awards issued under the 2004 Planand the 2005 Plan since inception (June 9, 2003) to December 31, 2006 was$3,307,817.

**8.     COMMITMENTS AND CONTINGENCIES**

In June 2006, weextended the lease for our commercial operating facility that expired onJune 30, 2006 for one additional year. The lease for our commercialoperating facility will expire on June 30, 2007. The total future minimumlease payments under this lease as of December 31, 2006 are $30,000.

In April 2006, theCompany entered into a thirteen (13) month lease agreement for new corporateoffices that commenced in May 2006. We moved our previous corporate officesthat were located at 1021 Main Street, Suite 2650, Houston, Texas 77002,to 11757 Katy Freeway, Suite 1300, Houston, Texas 77079. In April 2006, wedelivered to the lessor a security deposit of $9,400. The total future annualminimum lease payments as of December 31, 2006 are $56,400.

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InJuly 2006, we entered into a contract to purchase a quintaplex frac pump to beused with PID Unit #2 which is currently under construction. In connection withthis contract, we paid $320,499 as a deposit and will pay another $930,000during the assembly phase and upon completion.

**9.     INCOME TAXES**

The Company reports itsincome taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*, which calls for the utilizationof the asset and liability method of accounting for income taxes. Under thismethod, deferred taxes are determined based on differences between financialreporting and tax bases of assets and liabilities and are measured using theenacted marginal tax rates and laws that will be in effect when the differencesreverse. Temporary differences have been created for all stock option plans andare included in our SFAS No. 109 computation. For the quarter endedDecember 31, 2006, there were permanent and temporary differences ofapproximately $6,000 and $283,000, respectively. At December 31, 2006, we hadcumulative net operating loss carryforwards of approximately $19,113,000, whichexpire in years 2007 through 2025. No effect has been shown in the consolidatedfinancial statements for the net operating loss carryforwards as the likelihoodof future tax benefit from such net operating loss carryforwards is notdeterminable at this time. Accordingly, the potential tax benefits of the netoperating loss carryforwards, estimated based upon tax rates at December 31,2006, have been offset by valuation reserves of the same amount.

**Item 2:****               Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

The following discussionof our financial condition and results of operations should be read togetherwith the unaudited consolidated financial statements and related notes that areincluded elsewhere in this report. This discussion may contain forward-lookingstatements based upon current expectations that involve risks and uncertaintiesthat could cause actual results to differ materially from the forward-lookingstatements. We undertake no obligation to update any forward-looking statementsexcept as required by law.

**Overview**

On January 14, 2005,we acquired Particle Drilling Technologies, Inc., a privately-heldDelaware corporation (“PDTI”). As a result of this acquisition, our company,which previously had no material operations, acquired the business of PDTI andwe are now engaged in the development of the Particle Impact DrillingSystem, a patented system utilizing a specially designed “fit for purpose” drillbit fitted with jetting nozzles and polycrystalline diamond compact cuttingstructures for use in the oil and gas drilling industry.

We are adevelopment-stage company and have a limited operating history. Our predecessorcompany for financial reporting purposes was formed on June 9, 2003 toacquire the technology related to the Particle Impact Drilling System (the“PID technology”). We are still developing this technology, and to date, wehave not generated any revenues from our operations. As we continue to executeour operations plan, we expect our development and operating expenses toincrease.

*Researchand development.  *We have made and expect tocontinue to make substantial investments in research and development activitiesin order to develop and market the PID technology. Research and developmentcosts consist primarily of general and administrative and operating expensesrelated to research and development activities. We expense research anddevelopment costs as incurred except for property, plant and equipment relatedto research and development activity that have an alternative future use.Property, plant and equipment for research and development activity that havean alternative future use are capitalized and the related depreciation is expensedas research and development costs.

*Generaland administrative.  *General and administrativeexpenses consist primarily of salaries and benefits, office expense,professional services, and other corporate overhead costs. We have experiencedand expect to continue to experience increases in general and administrativeexpenses as a result of: (1) reporting and compliance obligationsapplicable to publicly-held companies; (2) our continuing efforts todevelop, test and prepare the PID technology for commercialization; and(3) the hiring of additional personnel.

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**Resultsof Operations**

***Three Months Ended December 31, 2006 Compared to ThreeMonths Ended December 31, 2005***

*Researchand development.  *Research and developmentexpenses were $1,664,843 and $1,285,485 for the three months ended December 31,2006 and 2005, respectively, representing an increase of $379,358. Thisincrease was primarily the result of approximately $271,619 for supplies,transportation and other operational costs in connection with our commercialtrials.  The remainder of the increase isrelated to continuing development of a new particle injector system, currentcontstruction of the Company’s second PID Unit, bonus accruals and stock-basedcompensation for research and development personnel during the three monthsended December 31, 2006.

*Generaland administrative.  *General and administrativeexpenses were $1,298,544 and $990,962 for the three months ended December 31,2006 and 2005, respectively, representing an increase of $307,582. Thisincrease was primarily the result of increased costs related to bonus accrualsand stock-based compensation during the three months ended December 31, 2006.

*Otherincome (expenses).  *Other income was $124,926 and$108,464 for the three months ended December 31, 2006 and 2005, respectively,representing an increase in other income of $16,462. The increase was primarilyattributable to the additional funds from the private placement that wascompleted in October 2006.

**Liquidityand Capital Resources**

Our principalsources of liquidity are cash and cash equivalents.  We expect that cash requirements through theend of the fiscal year 2007 will be primarily to fund research and developmentactivities, to continuously improve service capabilities, to expand operations,general and administrative costs and capital expenditures.  We believe we have sufficient cash and cashequivalents to meet our working capital and capital expenditure requirementsfor at least the next 12 months; however, our continued existence dependson the successful development of the PID technology and our ability tosuccessfully commercialize this technology. To date we have not yet generated cashflow from operations, and until wecommence recognizing revenue, we are highly dependant upon debt and equityfunding.  If we are not able to meet ourfunding requirements, our operations may cease to exist.  We cannot provide any assurance that any suchfunding will be available on acceptable terms or at all.

Sinceinception on June 9, 2003 through December 31, 2006, we have financed ouroperations through private sales of our equity and the issuance of convertiblenotes payable, totaling net proceeds of $30,189,968.  As of December 31, 2006, we had $11,188,221in cash and cash equivalents.  In October2006, we completed a private sale of five million shares of our common stockfor $2.35 per share and warrants to purchase 1.5 million shares at $3.25per share, yielding gross proceeds of $11,750,000.

*Cash Flows from Operating Activities. *Cash flow used for operations isprimarily affected by our research and development progress and businessdevelopment.  Net cash flows used inoperating activities during the three months ended December 31, 2006 were $1,683,208compared to $1,660,477 for the three months ended December 31, 2005.  The increase from fiscal 2005 to fiscal 2006was the result of our increased spending on research and development and ourincreased level of general and administrative cost as discussed above.

*Cash Flows from Investing Activities. *Cashflow used in investing activities for the three months ended December 31, 2006was $92,761 compared to $54,506 for the three months ended December 31,2005.  The cash flows used in investingactivities consist of  $52,556 for thepurchase of property, plant and equipment and $40,205 for costs associated withpatent expenses.  We anticipate that ourcapital expenditures for the next year will continue to be fully funded fromour available cash and cash equivalents.

*Cash Flow from Financing Activities. *Net cash provided by (used in) financing activities forthe three months ended December 31, 2006 was $10,672,604 compared to ($19,511)for the three months ended December 31, 2005. On October 19, 2006, the Company completed the sale of five millionshares of its common stock to institutional and other accredited investors at$2.35 per share. The Company received gross proceeds of $11.75 million, whichwe intend to use to manufacture additional PID Systems, to hire and trainqualified personnel, to fund a new particle injection system, to fundadditional research and development, for general corporate purposes and forexpenses associated with the offering.

In addition, theinvestors received warrants to purchase 1.5 million shares of the Company’scommon stock with an exercise price of $3.25 per share. The warrants will beexercisable commencing on April 22, 2007 and will expire on October 19,2011. The Company has valued these warrants at $2,835,000 using theBlack-Scholes option pricing model and this amount was charged to shareholdersequity.

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*ContractualObligations*.  In April2006, we entered into a thirteen month lease agreement for our new corporateoffices at 11757 Katy Freeway, Suite 1300, Houston, Texas 77079, that commencedin May 2006. In connection with the execution of this new lease agreement, wedelivered to the lessor a security deposit of $9,400. The total future minimumlease payments under this lease at December 31, 2006 are $56,400.

InJune 2006, we extended the lease for our commercial operating facilitythat expired June 30, 2006 for one additional year. The lease for ourcommercial operating facility will expire June 30, 2007. The total futureminimum lease payments under this lease at December 31, 2006 are $30,000.

InJuly 2006, we entered into a contract to purchase a quintaplex frac pump to beused with PID Unit #2 which is currently under construction. In connection withthis contract, we paid $320,499 as a deposit and will pay another $930,000during the assembly phase and upon completion.
| ** **                                                                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                                                    | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than 1  year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than 5  years** | ** ** |
| Long-Term Debt  Obligation and Short Term Notes Payable (including current portion) |       | $                                         | 132,555    |   | $ | 119,775 |   | $ | 12,780 |   | $ | — |   | $ | — |   |
| Purchase Obligations                                                                |       | 301,974                                   |       | 301,974 |   |   |   |   |   |   |   |
| Frac Pump                                                                           |       | 930,000                                   |       | 930,000 |   |   |   |   |   |   |   |
| Operating Lease  Obligations                                                        |       | 86,400                                    |       | 86,400 |   | — |   | — |   | — |   |
| Total                                                                               |       | $                                         | 1,450,929  |   | $ | 1,438,149 |   | $ | 12,780 |   | $ | — |   | $ | — |   |
|                                                                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Off-BalanceSheet Arrangements**

Inconnection with the acquisition of the PID technology in January 2004,PDTI entered into a Royalty Agreement with ProDril Services, Incorporated (“PSI”)pursuant to which we are obligated to pay PSI a royalty on a quarterly basisequal to 18% of our earnings before interest, income taxes, depreciation andamortization (“EBITDA”) derived from the use of the PID technology, until anaggregate of $67,500,000 has been paid. PDTI also entered into a RoyaltyAgreement in January 2004 with ProDril Services, International, Ltd. (“PSIL”)pursuant to which we are obligated to pay PSIL a royalty on a quarterly basisequal to 2% of our EBITDA derived from the use of the PID technology, until anaggregate of $7,500,000 has been paid. In addition, we are obligated to payCCORE Technology and Licensing, Ltd. (“CTL”), PSI and PSIL a royalty equal to1.6%, 1.2% and 1.2%, respectively, of our quarterly gross revenue, derived fromthe use of the PID technology.  As ofDecember 31, 2006, we had no revenues or EBITDA; therefore no royalties havebeen paid or accrued.

**CriticalAccounting Policies**

The discussion andanalysis of our financial condition and results of operations is based on ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thepreparation of these consolidated financial statements requires us to makeestimates and judgments that affect the reported amounts of assets, liabilitiesand expenses. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions. We believe the following critical accounting policies affect ourmost significant judgments and estimates used in the preparation of ourconsolidated financial statements.

*ReverseAcquisition.  *The acquisition of PDTI inJanuary 2005 was accounted for as a reverse acquisition. Pursuant to theguidance in Appendix B of SEC Accounting Disclosure Rules andPractices Official Text, we believe the acquisition of PDTI was a merger of aprivate operating company into a non-operating public shell corporation withnominal net assets which typically results in the owners and management of theprivate company having actual or effective operating control of the combinedcompany after the transaction, with the shareholders of the former public shellcontinuing only as passive investors. These transactions are considered by thestaff of the Securities and Exchange Commission to be capital transactions insubstance, rather than business combinations. That is, the transaction isequivalent to the issuance of stock by the private company for the net monetaryassets of the shell corporation, accompanied by a recapitalization.Accordingly, the reverse acquisition has been accounted for as arecapitalization. For accounting purposes, PDTI is considered the acquirer in 

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the reverse acquisition. The historical financialstatements are those of PDTI. Net loss per share for periods prior to themerger in January 2005 is restated to reflect the number of equivalentshares received by the acquiring company.

*Impairmentof Long-Lived Assets.  *We evaluate our long-livedassets for indicators of possible impairment by comparison of the carryingamounts to future net undiscounted cash flows expected to be generated by suchassets when events or changes in circumstances indicate the carrying amount ofan asset may not be recoverable.  Should an impairment exist, theimpairment loss would be measured based on the excess carrying value of theasset over the asset’s fair value or discounted estimates of future cashflows.  We also evaluate the capitalized costs for patents and patentapplications filed but not issued for possible impairments. We have notidentified any such impairment losses to date. The evaluation of capitalized costs for patents and patent applicationsis based on a subjective cash flow forecast which is subject to change.  We will reassess our cash flow forecast eachtime there are fundamental changes in the underlying potential use of thepatents or patent applications in terms of performance, customer acceptance orother factors that may affect such cash flow forecasts.

*Stock-BasedCompensation.  *In December 2004, theFinancial Accounting Standards Board (“FASB”) issued a revision to SFASNo. 123, *Share-Based Payment*.This statement establishes standards for the accounting for transactions inwhich an entity exchanges its equity instruments for goods or services. It alsoaddresses transactions in which an entity incurs liabilities in exchange forgoods or services that are based on the fair value of the entity’s equityinstruments or that may be settled by the issuance of those equity instruments.This statement focuses primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. Thisstatement does not change the accounting guidance for share-based paymenttransactions with parties other than employees provided in SFAS No. 123 asoriginally issued. This statement is effective for new awards and thosemodified, repurchased or cancelled in interim or annual reporting periodsbeginning after June 15, 2005. We early adopted this standard uponinception.

*Researchand Development.  *The costs of materials andequipment or facilities that are acquired or constructed for research anddevelopment activities and that have alternative future uses are capitalized astangible assets when acquired or constructed. The cost of such materialsconsumed in research and development activities and the depreciation of suchequipment or facilities used in those activities are research and developmentcosts. However, the costs of materials, equipment, or facilities acquired orconstructed for research and development activities that have no alternativefuture uses are considered research and development costs and are expensed atthe time the costs are incurred.

*IncomeTaxes.  *The Company reports its income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*, which calls for the utilization of the asset andliability method of accounting for income taxes. Under this method, deferredtaxes are determined based on differences between financial reporting and taxbases of assets and liabilities and are measured using the enacted marginal taxrates and laws that will be in effect when the differences reverse. Temporarydifferences have been created for all stock option plans and are included inour SFAS No. 109 computation. For the quarter ended December 31, 2006,there were permanent and temporary differences of approximately $6,000 and$283,000, respectively. At December 31, 2006, we had cumulative net operatingloss carryforwards of approximately $19,113,000, which expire in years 2007through 2025. No effect has been shown in the consolidated financial statementsfor the net operating loss carryforwards as the likelihood of future taxbenefit from such net operating loss carryforwards is not determinable at thistime. Accordingly, the potential tax benefits of the net operating losscarryforwards, estimated based upon tax rates at December 31, 2006, have beenoffset by valuation reserves of the same amount.

*NetLoss per Share.  *The Company has presented basicand diluted net loss per share pursuant to SFAS No. 128, *Earnings Per Share*. In accordance withSFAS No. 128, basic and diluted net loss per share has been computed usingthe weighted-average number of shares of common stock outstanding during theperiod. Dilutive net loss per share would give affect to the dilutive effect ofcommon stock equivalents consisting of options and warrants. Potentiallydilutive securities have been excluded from the net loss per common sharecalculation as the effects would be antidilutive. Potentially dilutivesecurities not included in the computation of weighted average diluted sharesof common stock because the impact of these potentially dilutive securitieswere anti-dilutive were 2,054,643 and 2,701,790 shares for the three monthsended December 31, 2006 and 2005, respectively.

**Forward-LookingStatements**

Statements in thisquarterly report on Form 10-Q that are not historical facts (including anystatements concerning plans and objectives of management for future operationsor economic performance, or assumptions or forecasts related thereto) areforward-looking statements subject to Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934. Thesestatements can be identified by the use of forward-looking terminologyincluding “forecast,” “may,” 

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“believe,” “expect,” “anticipate,” “estimate,” “continue”or other similar words. These statements discuss future expectations, containprojections of results of operations or of financial condition or state other “forward-looking”information. We and our representatives may from time to time make other oralor written statements that are also forward-looking statements.

Theseforward-looking statements are made based upon our management’s current plans,expectations, estimates, assumptions and beliefs concerning future eventsimpacting us and therefore involve a number of risks and uncertainties.  We caution that forward-looking statementsare not guarantees and that actual results could differ materially from thoseexpressed or implied in the forward-looking statements as a result of certainfactors, including but not limited to dependence upon energy industry spending,the volatility of oil and gas prices, weather interruptions, the results oftesting of our products, the availability of capital resources and the otherfactors described under “Item 1A. Risk Factors” in our annual report on Form10-K for the year ended September 30, 2006 and filed with the SEC on December14, 2006.  We undertake no obligation toupdate any forward-looking statements except as required by law.

**Item 3.****                          Quantitativeand Qualitative Disclosures about Market Risk**

We believe that we do nothave any material exposure to financial market risk and we do not enter intoforeign currency or interest rate transactions.

**Item 4.****                          Controlsand Procedures**

As required byRule 13a-15(b) of the Securities Exchange Act of 1934, an evaluation wasperformed under the supervision and with the participation of our ChiefExecutive Officer and Chief Financial Officer of the effectiveness of thedesign and operation of our “disclosure controls and procedures” (as definedunder Rule 13a-15(e) and Rule 15d-15(e)) as of the end of the period covered bythis Quarterly Report on Form 10-Q filed with the SEC. Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective as of December 31,2006.

There was no change inour internal control over financial reporting during our first quarter offiscal 2007 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**Part II—Other Information**

**Item 2.****                          UnregisteredSales of Equity Securities and Use of Proceeds**

On October 12, 2006, a holder of an outstandingwarrant exercised its right to purchase 6,000 shares of our common stock at$0.12 per share on a cashless exercise basis. The fair market value of our common stock on the date of exercise was$2.78.  As a result of this cashlessexercise, we issued 5,745 shares of our common stock to the holder of thiswarrant and withheld issuing 255 shares of our common stock in satisfaction ofthe exercise price under the warrant.

The shares of our common stock issued upon exercise ofthe warrant described above were issued in an exchange between us and ourexisting security holders in which no commission or other remuneration was paidor given directly or indirectly for soliciting such exchange.  As a result, the issuance of such shares ofcommon stock was exempt from registration pursuant to Section 3(a)(9) under theSecurities Act of 1933.

**Item 5.****                          OtherInformation**

On February 1, 2007, the Compensation Committeerecommended that the Board of Directors approve a new Bonus Plan (the “BonusPlan”) for the fiscal year ending September 30, 2007.  The Bonus Planwas approved by the Board of Directors on the same date.  Under the BonusPlan, bonuses may be awarded to the Company’s employees, including the Company’sexecutive officers, upon the satisfaction of certain goals based on apercentage of annual base salaries.  The goals include attaining measuredresults for some or all of the following categories: cash flow, capital andresearch and development budgets, revenues, research and development andoperations performance, and safety.

 Under the terms of the Bonus Plan, the Company’semployees, including its executive officers, may receive a bonus calculatedbased on a percentage of their annual base salary.  The ultimatepercentage of annual base salary used to calculate bonuses, if any bonuses arepaid, will be at the sole discretion of the Compensation Committee.  Thetarget percentage and 

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thehigh percentage of base salary set by the Compensation Committee to be used forpurposes of calculating bonuses to the Company’s employees, including itsexecutive officers, are as follows:
| ** **                                                    | ** ** | **Target Percentage** | ** ** | **High Percentage** | ** ** |
|---------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| Staff  (Operations, Accounting & Administrative)          |       | 10                         | %          | 20                       | %          |
| Manager                                                       |       | 15                         | %          | 30                       | %          |
| Senior Manager                                                |       | 25                         | %          | 40                       | %          |
| Executive (other  than President and Chief Executive Officer) |       | 40                         | %          | 80                       | %          |
| President and Chief  Executive Officer                        |       | 50                         | %          | 100                      | %          |

 

The annualbase salaries of the Company’s Named Executive Officers that will be used forpurposes of calculating the target and high percentage bonuses under the BonusPlan are as follows:

|                     | ** ** | **Base Salary** | ** ** |
|---------------------|------------|----------------------|------------|
| Jim B. Terry        |       | $                    | 252,000    |   |
| J. Chris Boswell    |       | $                    | 231,000    |   |
| Thomas E.  Hardisty |       | $                    | 189,000    |   |
| Gordon Tibbits      |       | $                    | 150,000    |   |

 

JohnD. Schiller is not expected to be a Named Executive Officer for fiscal 2007.

Alsoon February 1, 2007, the Board of Directors adopted the Particle DrillingTechnologies, Inc. 2007 Stock Incentive Plan (the “2007 Incentive Plan”).  The 2007 Incentive Plan became effective uponits adoption by the Board of Directors so long as the 2007 Incentive Plan isapproved by the stockholders of the Company by February 1, 2008.  The Company has submitted to 2007 IncentivePlan to the stockholders of the Company for approval at the 2007 Annual Meetingof Stockholders to be held on March 5, 2007.

The2007 Incentive Plan provides for the granting from time to time of options andrestricted stock to employees, consultants and directors of the Company and itsaffiliates.  The maximum number of sharesof common stock that will be available for issuance under the 2007 IncentivePlan is 1,500,000 shares (subject to adjustment upon a reorganization, stocksplit, recapitalization, or other change in the Company’s capital structure inaccordance with the terms of the 2007 Plan).

Seethe Company’s definitive proxy statement filed with the Securities and ExchangeCommission on February 2, 2007 for more information about the 2007 IncentivePlan.  A copy of the 2007 Incentive Planis filed herewith and is incorporated herein by reference.

**Item 6.****                          Exhibits**

Exhibits:
| Exhibit  No. | ** ** | ** **                                                                                                                                                           | ** ** | **Description** |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.1         |       | Bonus Plan for fiscal  2007*                                                                                                                                         |
|         |       |                                                                                                                                                                 |
| 10.2         |       | Particle Drilling  Technologies, Inc. 2007 Stock Incentive Plan*                                                                                                     |
|         |       |                                                                                                                                                                 |
| 31.1         |       | Certification of the  Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934.*                               |
|         |       |                                                                                                                                                                 |
| 31.2         |       | Certification of the  Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934.*                               |
|         |       |                                                                                                                                                                 |
| 32.1         |       | Certification of the  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** |
|         |       |                                                                                                                                                                 |
| 32.2         |       | Certification of the Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.** |

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*                    Filedherewith

**             Furnishedherewith

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                              |   | PARTICLE DRILLING TECHNOLOGIES, INC.                                                                                                |
|------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------|
|                         |   | (Registrant)                                                                                                                             |
|                         |   |                                                                                                                                     |
|                         |   |                                                                                                                                     |
| Date:  February 7, 2007 |   | /s/ J. CHRIS BOSWELL                                                                                                                     |
|                         |   | J. Chris Boswell                                                                                                                         |
|                         |   | Senior Vice President and Chief Financial Officer   (authorized officer, principal financial officer and   principal accounting officer) |

 

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**EXHIBIT INDEX**
| Exhibit  No. | ** ** | **Description**                                                                                                                                                      |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                 |
| 10.1         |       | Bonus Plan for fiscal 2007*                                                                                                                                          |
|         |       |                                                                                                                                                                 |
| 10.2         |       | Particle Drilling Technologies, Inc. 2007 Stock  Incentive Plan*                                                                                                     |
|         |       |                                                                                                                                                                 |
| 31.1         |       | Certification of the Chief Executive Officer  pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act  of 1934.*                               |
|         |       |                                                                                                                                                                 |
| 31.2         |       | Certification of the Chief Financial Officer  pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act  of 1934.*                               |
|         |       |                                                                                                                                                                 |
| 32.1         |       | Certification of the Chief Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.** |
|         |       |                                                                                                                                                                 |
| 32.2         |       | Certification of the Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.** |

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*                    Filedherewith

**             Furnishedherewith

17

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