**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

** **

**(Mark One)**

 

**ý****                                ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For thequarterly period ended March 31, 2006**

** **

**OR**

 

**o****                                ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For thetransition period from                   to                   **

** **

**CommissionFile Number 000-30819**

** **

**Particle DrillingTechnologies, Inc.**

(Exact name of registrant asspecified in its charter)

 

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

 

**11757 KatyFreeway, Suite 1300Houston, Texas 77079**

(Address of principalexecutive offices)(Zip Code)

 

**713-223-3031**

(Registrant’s telephonenumber, including area code)

 

**1021 MainStreet, Suite 2650Houston, Texas 77002**

(Former name, former addressand former fiscal year, if changed since last report)

 

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 ý  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 accelerated filer o                            Accelerated filer ý                      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 ý

 

The number of shares of the registrant’s commonstock, $.001 par value, outstanding as of May 8, 2006 was 24,959,901.

 

 

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

 

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

** **

**INDEX**

** **
| **Part I -  Financial Information** | ** **                                                                                                                                                            |
|-------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                |                                                                                                                                                                  |   |
| Item 1.                             | Financial Statements  (Unaudited)                                                                                                                                     |   |
|                                |                                                                                                                                                                  |   |
|                                | Consolidated Balance Sheets  (Unaudited) at March 31, 2006 and September 30, 2005                                                                                     | 3 |
|                                |                                                                                                                                                                  |   |
|                                | Consolidated Statements of  Operations (Unaudited) - Three and Six Months Ended March 31, 2006 and 2005,  and from June 9, 2003 (date of inception) to March 31, 2006 | 4 |
|                                |                                                                                                                                                                  |   |
|                                | Consolidated Statements of  Cash Flows (Unaudited) - Six Months Ended March 31, 2006 and 2005, and from  June 9, 2003 (date of inception) to March 31, 2006           | 5 |
|                                |                                                                                                                                                                  |   |
|                                | Notes to Consolidated  Financial Statements (Unaudited)                                                                                                               | 6 |
|                                |                                                                                                                                                                  |   |
| Item 2.                             | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                                           | 9 |
|                                |                                                                                                                                                                  |   |
| Item 3.                             | Quantitative and Qualitative  Disclosures about Market Risk                                                                                                           | 14 |
|                                |                                                                                                                                                                  |   |
| Item 4.                             | Controls and Procedures                                                                                                                                               | 15 |
|                                |                                                                                                                                                                  |   |
| **Part II - Other Information**     | **15**                                                                                                                                                                |
|                                |                                                                                                                                                                  |   |
| Item 1.                             | Legal Proceedings                                                                                                                                                     | 15 |
|                                |                                                                                                                                                                  |   |
| Item 2.                             | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                                                          | 16 |
|                                |                                                                                                                                                                  |   |
| Item 4.                             | Submission of Matters to a Vote  of Security Holders                                                                                                                  | 16 |
|                                |                                                                                                                                                                  |   |
| Item 6.                             | Exhibits                                                                                                                                                              | 18 |
|                                |                                                                                                                                                                  |   |
|                                | Signatures                                                                                                                                                            | 19 |

 

2

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**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                          | ** ** | **March 31,  2006** | ** ** | **September 30,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                                          | ** ** | **(Unaudited)**     | ** ** | **(Restated)**          | ** ** |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| **ASSETS**                                                                                                                                                                                                                          |       |                |       |                    |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Current  assets:                                                                                                                                                                                                                    |       |                |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                                                           |       | $                   | 6,612,856  |                    | $          | 10,504,646 |   |
| Accounts receivable - related party                                                                                                                                                                                                 |       | 16,961              |       | 42,330                  |       |
| Prepaid expenses                                                                                                                                                                                                                    |       | 131,194             |       | 229,963                 |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Total current assets                                                                                                                                                                                                                |       | 6,761,011           |       | 10,776,939              |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Property,  plant & equipment, net                                                                                                                                                                                               |       | 1,281,350           |       | 1,277,982               |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Intangibles,  net                                                                                                                                                                                                                   |       | 1,140,778           |       | 1,102,403               |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Other assets                                                                                                                                                                                                                        |       | 391,089             |       | 391,089                 |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Total assets                                                                                                                                                                                                                        |       | $                   | 9,574,228  |                    | $          | 13,548,413 |   |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                       |       |                |       |                    |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Current  liabilities:                                                                                                                                                                                                               |       |                |       |                    |       |
| Accounts payable                                                                                                                                                                                                                    |       | $                   | 955,318    |                    | $          | 1,056,733 |   |
| Short-term notes payable                                                                                                                                                                                                            |       | 5,790               |       | 79,880                  |       |
| Current portion of long-term debt                                                                                                                                                                                                   |       | 22,149              |       | 11,597                  |       |
| Accrued liabilities                                                                                                                                                                                                                 |       | 370,011             |       | 242,633                 |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Total current liabilities                                                                                                                                                                                                           |       | 1,353,268           |       | 1,390,843               |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Long-term  debt                                                                                                                                                                                                                     |       | 24,146              |       | 9,463                   |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Commitments  and contingencies - Note 8                                                                                                                                                                                             |       |                |       |                    |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Stockholders’  equity:                                                                                                                                                                                                         |       |                |       |                    |       |
| Common stock, $.001 par value, 100,000,000  shares authorized, 27,917,401 shares issued and 24,917,401 shares outstanding  at March 31, 2006, and 27,441,472 shares issued and 24,441,472 shares  outstanding at September 30, 2005 |       | 27,917              |       | 27,441                  |       |
| Additional paid-in capital                                                                                                                                                                                                          |       | 24,111,989          |       | 23,218,868              |       |
| Treasury stock at cost, 3,000,000 shares at  March 31, 2006 and September 30, 2005                                                                                                                                                  |       | (1,500,000          | )          | (1,500,000              | )          |
| Deficit accumulated during the development  stage                                                                                                                                                                                   |       | (14,443,092         | )          | (9,598,202              | )          |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Total stockholders’ equity                                                                                                                                                                                                     |       | 8,196,814           |       | 12,148,107              |       |
|                                                                                                                                                                                                                                |       |                |       |                    |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                     |       | $                   | 9,574,228  |                    | $          | 13,548,413 |   |

 

The accompanying notes are an integral part of thesestatements.

3

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** **        | ** ** | ** ** | ** ** | **Period from**  | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|-------------------|------------|------------|------------|------------------|------------|
| ** **                                                                | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** **        | ** ** | ** ** | ** ** | **June 9, 2003** | ** ** |
| ** **                                                                | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** **        | ** ** | ** ** | ** ** | **(date of**     | ** ** |
| ** **                                                                | ** ** | ** **                       | ** ** | ** **                     | ** ** | **inception) to** | ** ** |
| ** **                                                                | ** ** | **Three Months Ended March 31,** | ** ** | **Six Months Ended March 31,** | ** ** | **March 31,**     | ** ** |
| ** **                                                                | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2005**   | ** ** | **2006**         | ** ** |
| ** **                                                                | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** **        | ** ** | ** ** | ** ** | **(Restated)**   | ** ** |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Revenues                                                                  |       | $                                | —     |                           | $          | —            |       | $          | —     |             | $          | — |   | $ | — |   |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Operating  expenses:                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Research and development                                                  |       | 1,448,107                        |       | 807,247                        |       | 2,733,592         |       | 990,403    |       | 6,197,125        |       |
| General and administrative                                                |       | 1,381,209                        |       | 420,950                        |       | 2,372,171         |       | 1,113,987  |       | 8,740,666        |       |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Total operating expenses                                                  |       | 2,829,316                        |       | 1,228,197                      |       | 5,105,763         |       | 2,104,390  |       | 14,937,791       |       |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Loss from operations                                                      |       | (2,829,316                       | )          | (1,228,197                     | )          | (5,105,763        | )          | (2,104,390 | )          | (14,937,791      | )          |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Other income  (expenses)                                                  |       |                             |       |                           |       |              |       |       |       |             |       |
| Interest income                                                           |       | 74,255                           |       | 45,377                         |       | 160,296           |       | 45,377     |       | 369,601          |       |
| Rental income - related party                                             |       | 23,283                           |       | —                         |       | 46,565            |       | —     |       | 73,727           |       |
| Gain on debt extinguishment                                               |       | —                           |       | 26,990                         |       | —            |       | 26,990     |       | 35,283           |       |
| Gain on assignment of lease - related party                               |       | 55,614                           |       | —                         |       | 55,614            |       | —     |       | 55,614           |       |
| Interest expense                                                          |       | (743                             | )          | (3,900                         | )          | (1,602            | )          | (10,452    | )          | (39,526          | )          |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Total other income                                                        |       | 152,409                          |       | 68,467                         |       | 260,873           |       | 61,915     |       | 494,699          |       |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Net loss                                                                  |       | $                                | (2,676,907 | )                              | $          | (1,159,730        | )          | $          | (4,844,890 | )                | $          | (2,042,475 | ) | $ | (14,443,092 | ) |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Net loss per  common share, basic and diluted                             |       | $                                | (0.11      | )                              | $          | (0.05             | )          | $          | (0.20      | )                | $          | (0.10 | ) | $ | (0.81 | ) |
|                                                                      |       |                             |       |                           |       |              |       |       |       |             |       |
| Weighted average number of common shares  outstanding - basic and diluted |       | 24,436,820                       |       | 21,581,538                     |       | 24,365,875        |       | 19,912,443 |       | 17,801,213       |       |

 

Theaccompanying notes are an integral part of these statements.

 

4

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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**     | ** ** |
| ** **                                                                         | ** ** | ** **                     | ** ** | **inception) to** | ** ** |
| ** **                                                                         | ** ** | **Six Months Ended March 31,** | ** ** | **March 31,**     | ** ** |
| ** **                                                                         | ** ** | **2006**                       | ** ** | **2005**          | ** ** | **2006**         | ** ** |
| ** **                                                                         | ** ** | ** **                     | ** ** | ** **        | ** ** | **(Restated)**   | ** ** |
|                                                                               |       |                           |       |              |       |             |       |
| Cash flows  from operating activities:                                             |       |                           |       |              |       |             |       |
| Net loss                                                                           |       | $                              | (4,844,890 | )                 | $          | (2,042,475       | )          | $ | (14,443,092 | ) |
| Adjustments to reconcile net loss to net  cash used in operating  activities: |       |                           |       |              |       |             |       |
| Gain on debt extinguishment                                                        |       | —                         |       | (26,990           | )          | (35,283          | )          |
| Gain on assignment of lease - related party                                        |       | (55,614                        | )          | —            |       | (55,614          | )          |
| Depreciation and amortization expense                                              |       | 324,590                        |       | 120,466           |       | 863,466          |       |
| Short-term note issued for services                                                |       | —                         |       | —            |       | 44,000           |       |
| Common stock issued for services                                                   |       | —                         |       | (66,500           | )          | 931,500          |       |
| Warrants issued for services                                                       |       | —                         |       | 57,999            |       | 63,829           |       |
| Stock-based employee compensation                                                  |       | 887,147                        |       | 161,800           |       | 1,552,861        |       |
| Changes in operating assets and  liabilities:                                      |       |                           |       |              |       |             |       |
| (Increase) decrease in accounts receivable  - related party                        |       | (15,451                        | )          | —            |       | (57,781          | )          |
| (Increase) decrease in prepaid expenses                                            |       | 98,769                         |       | 11,918            |       | (19,204          | )          |
| Increase (decrease) in accounts payable                                            |       | (101,415                       | )          | (153,889          | )          | 615,380          |       |
| Increase (decrease) in accrued liabilities                                         |       | 223,812                        |       | (55,114           | )          | 466,445          |       |
|                                                                               |       |                           |       |              |       |             |       |
| Net cash used in operating activities                                              |       | (3,483,052                     | )          | (1,992,785        | )          | (10,073,493      | )          |
|                                                                               |       |                           |       |              |       |             |       |
| Cash flows  from investing activities:                                             |       |                           |       |              |       |             |       |
| Payments to purchase property and equipment                                        |       | (272,232                       | )          | (394,271          | )          | (1,455,921       | )          |
| Proceeds from sale of property and  equipment                                      |       | —                         |       | —            |       | 20,957           |       |
| Payments to purchase intangibles                                                   |       | (63,614                        | )          | (10,106           | )          | (494,058         | )          |
| Payments to purchase other assets                                                  |       | —                         |       | (389,983          | )          | (391,089         | )          |
| Payments issued for note receivable                                                |       | —                         |       | —            |       | (300,783         | )          |
| Payments issued for note receivable -  related party                               |       | —                         |       | —            |       | (56,783          | )          |
|                                                                               |       |                           |       |              |       |             |       |
| Net cash used in investing activities                                              |       | (335,846                       | )          | (794,360          | )          | (2,677,677       | )          |
|                                                                               |       |                           |       |              |       |             |       |
| Cash flows  from financing activities:                                             |       |                           |       |              |       |             |       |
| Proceeds from issuance of common stock                                             |       | 6,450                          |       | 18,647,666        |       | 20,982,216       |       |
| Repurchase of common stock                                                         |       | —                         |       | (1,500,000        | )          | (1,500,000       | )          |
| Proceeds from issuance of convertible notes                                        |       | —                         |       | —            |       | 553,500          |       |
| Repayments of notes payable                                                        |       | (79,342                        | )          | (277,550          | )          | (671,690         | )          |
| 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                               |       | (72,892                        | )          | 16,870,116        |       | 19,364,026       |       |
|                                                                               |       |                           |       |              |       |             |       |
| Net increase  (decrease) in cash and cash equivalents                              |       | (3,891,790                     | )          | 14,082,971        |       | 6,612,856        |       |
|                                                                               |       |                           |       |              |       |             |       |
| Cash and  cash equivalents - beginning of period                                   |       | 10,504,646                     |       | 20,363            |       | —           |       |
|                                                                               |       |                           |       |              |       |             |       |
| Cash and  cash equivalents - end of period                                         |       | $                              | 6,612,856  |              | $          | 14,103,334       |       | $ | 6,612,856 |   |
|                                                                               |       |                           |       |              |       |             |       |
| Supplemental  disclosures of cash flow information:                                |       |                           |       |              |       |             |       |
| Cash paid for interest                                                             |       | $                              | 1,427      |              | $          | 11,756           |       | $ | 40,128 |   |
|                                                                               |       |                           |       |              |       |             |       |
| 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                         |       | —            |       | 30,487           |       |

 

The accompanying notes arean integral part of these statements.

 

5

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**(Unaudited)**

 

**1.  ****    ****BASIS OF PRESENTATION**

 

The accompanying unaudited interim consolidatedfinancial statements, which include the accounts of Particle DrillingTechnologies, Inc. (which is referred to herein as “we,” “us,” “our” orthe “Company”) and its subsidiary, have been prepared in accordance withgenerally accepted accounting principles in the United States of America (“USGAAP”) and pursuant to the rules and regulations of the Securities andExchange Commission. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with US GAAP have beencondensed or omitted in accordance with such rules and regulations. Theinformation furnished in the unaudited interim consolidated financialstatements includes normal recurring adjustments and reflects all adjustments,which in the opinion of management are necessary for a fair presentation ofsuch financial statements. Although management believes the disclosures andinformation presented are adequate to make the information not misleading,these unaudited interim consolidated financial statements should be read inconjunction with the Company’s September 30, 2005 audited consolidatedfinancial statements and notes thereto on Form 10-K/A. Operating resultsfor the three months and six months ended March 31, 2006 are not necessarilyindicative of the results that may be expected for the year endingSeptember 30, 2006.

 

The preparation of financial statements inconformity with US GAAP requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting periods.Actual results could differ from these estimates.

 

Certain reclassifications have been made to conformprior period amounts to the current period presentation. Thesereclassifications had no effect on net loss, net loss per share, orstockholders’ equity.

 

**2.  ****    ****RESTATEMENT OF FINANCIALSTATEMENTS**

 

The historical information in this quarterly reporton Form 10-Q for the Consolidated Balance Sheet as of September 30,2005 has been restated. In addition, certain historical information included inthe period from June 9, 2003 (date of inception) to March 31, 2006 for theConsolidated Statement of Operations and Consolidated Statement of Cash Flowshas been restated. These financial statements have been restated afterdetermining that the Company’s policy of recording stock-based employeecompensation upon vesting of the underlying equity award was inconsistent withthe guidelines set forth under Statements of Financial Accounting Standards (“SFAS”)No. 123(R), *Share-Based Payment*.

 

On February 7, 2006, the Company receivedcomments from the Staff of the Securities and Exchange Commission (“SEC”) toits annual report on Form 10-K for the year ended September 30, 2005that was originally filed on December 14, 2005. As a result of one ofthese comments, the Company undertook a detailed analysis of its policies inconnection with the recording of stock-based employee compensation related toequity incentive awards under SFAS No. 123(R). Following the completion ofthat analysis and further consultation with the Company’s independentregistered public accountants, the Company determined that its policy forrecording equity compensation was inconsistent with the guidance set forthunder SFAS No. 123(R). Historically, the Company has calculated thecompensation expense associated with equity awards using the Black-Scholesmodel and amortized that expense over the service period as the equity awardsvest, commencing with the first vesting dates of the awards. To fully complywith the guidance set forth in SFAS No. 123(R), the Company is now recordingsuch expense on a straight line basis over the relevant service periods,commencing with the dates of grant of the awards. On February 9, 2006,following an analysis of the impact of this error on the Company’s previouslyreleased financial statements, the Audit Committee of the Company’s Board ofDirectors determined that it was necessary to restate the financial statementscontained in the Company’s original annual report on Form 10-K for theperiod ended September 30, 2005 originally filed with the SEC onDecember 14, 2005.

 

6

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As a result of the restatement, net loss for theyear ended September 30, 2005 was increased by $437,350 resulting in anincrease to the deficit accumulated during the development stage and additionalpaid-in-capital of $437,350 as of September 30, 2005. The ConsolidatedStatements of Operations and the Consolidated Statements of Cash Flowspresented in this report on Form 10-Q compares the three months and sixmonths ended March 31, 2006 and 2005. The historical information for the threemonths and six months ended March 31, 2006 and 2005 was not affected by therestatement due to the accounting error described above, and therefore, notrestated.

 

**3.   SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

 

*Impairment of Long-LivedAssets.  *Weevaluate our long-lived assets for indicators of possible impairment bycomparison of the carrying amounts to future net undiscounted cash flowsexpected to be generated by such assets when events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable.  Shouldan impairment exist, the impairment loss would be measured based on the excesscarrying value of the asset over the asset’s fair value or discounted estimatesof future cash flows.  We also evaluate the capitalized costs for patentsand patent applications filed but not issued for possible impairments. We havenot identified any such impairment losses to date. The evaluation ofcapitalized costs for patents and patent applications is based on a subjectivecash flow forecast which is subject to change. We will reassess our cash flowforecast each time there are fundamental changes in the underlying potentialuse of the patents or patent applications in terms of performance, customeracceptance or other factors that may affect such cash flow forecasts.

 

**4.  ****    ****REVERSE ACQUISITION WITHMEDXLINK, CORP**

 

On July 14, 2004, MedXLink, Corp. (“MXLK”, orthe “Parent”), a Nevada corporation and an inactive publicly-traded company,entered into an Agreement and Plan of Reorganization withParticle 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 noconsideration in connection with the Merger. Following the merger, the Parenthad 18,248,094 shares of common stock issued and outstanding (which included3,381,538 shares of common stock issued upon conversion of the same number ofshares of Series A Convertible Preferred Stock of PDTI-DE) and anadditional 3,433,000 shares of common stock reserved for issuance upon exerciseof warrants and options as described above. Following the merger, PDTI-DEcontinued as the surviving corporation under the name of Particle DrillingTechnologies, Inc. as a subsidiary of Parent, the Parent changed its nameto Particle Drilling Technologies, Inc., and its stock trading symbolchanged from MXLK.OB to PDRT.OB. On June 28, 2005, the Company’s shares ofcommon stock began trading on The NASDAQ Capital Market® under the symbol PDRT.

 

**5.  ****    ****NET LOSS PER COMMON SHARE**

 

The Company has presented basic and diluted net lossper share pursuant to SFAS No. 128, *EarningsPer Share*. In accordance with SFAS No. 128, basic and dilutednet loss per share has been computed using the weighted-average number ofshares of common stock outstanding during the period. Dilutive net loss pershare would give affect to the dilutive effect of common stock equivalentsconsisting of options and warrants. Potentially dilutive securities have beenexcluded from the net loss per common share calculation

 

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asthe effects would be antidilutive. Potentially dilutive securities not includedin the computation of weighted average diluted shares of common stock becausethe impact of these potentially dilutive securities were antidilutive were 2,547,858and 2,275,508 shares for the three months ended March 31, 2006 and 2005,respectively, and 2,577,151 and 1,797,572 shares for the six months ended March31, 2006 and 2005, respectively.

 

**6.  ****    ****COMMON STOCK**

 

In January 2006, theCompany issued 53,750 shares of its common stock for cash upon exercise ofoptions at $0.12 per share.

 

In January 2006, theCompany issued 9,721 shares of its common stock upon a net cashless exercise ofwarrants at $2.00 per share.

 

In January 2006, theCompany issued 150,000 shares of its restricted stock to its Chief ExecutiveOfficer.

 

In February 2006, theCompany issued 176,458 shares of its common stock upon a net cashless exerciseof warrants at $2.00 per share.

 

In February 2006, theCompany issued 20,000 shares of its restricted stock to one of its employee.

 

In March 2006, the Companyissued 66,000 shares of its common stock upon a net cashless exercise ofwarrants at $2.00 per share.

 

At March 31, 2006, the Company had 24,917,401 sharesof common stock outstanding and has outstanding options and warrants topurchase up to 5,536,641 additional shares of the Company’s common stock in theaggregate.

 

**7.  ****    ****STOCK-BASED EMPLOYEECOMPENSATION**

 

In April 2004, the Board of Directors adoptedthe 2004 Stock Incentive Plan (the “2004 Plan”). The 2004 Plan provides for theissuance of incentive stock options, non-statutory stock options and restrictedstock grants to directors, employees and consultants of the Company. Provisionsunder the 2004 Plan allowed for the issuance of up to 3,500,000 shares ofcommon stock pursuant to awards under the 2004 Plan. As of March 31, 2006, the Companyhad 66,250 shares of common stock available for issuance pursuant to awardsunder the 2004 Plan.

 

In March 2005, the Board of Directors adoptedthe 2005 Stock Incentive Plan (the “2005 Plan”). The 2005 Plan provides for theissuance of incentive stock options, non-statutory stock options and restrictedstock grants to directors, employees and consultants of the Company. Provisionsunder the 2005 Plan allow for the issuance of options and restricted stockawards to purchase or issue up to 2,000,000 shares of common stock. As of March31, 2006, the Company had 625,500 shares of common stock available for issuancepursuant to awards under the 2005 Plan.

 

Stock-based employee compensation expense recordedfor awards issued under the 2004 Plan and the 2005 Plan for the three monthsended March 31, 2006 and 2005 was $496,598 and $0, respectively. Stock-basedemployee compensation expense recorded for awards issued under the 2004 Planand the 2005 Plan for the six months ended March 31, 2006 and 2005 was $887,147and $161,800, respectively. Stock-based employee compensation expense recordedfor awards issued under the 2004 Plan and the 2005 Plan since inception(June 9, 2003) to March 31, 2006 was $1,552,861.

 

**8.  ****    ****COMMITMENTS ANDCONTINGINCIES**

 

In March 2006, we assigned our commitments under theprevious lease for our corporate offices that were located at 1021 Main Street,Suite 2650, Houston, Texas 77002 to Energy XXI Services, LLC, an affiliateof John D. Schiller, our former interim President and Chief Executive Officerand currently one of our directors, and of Steve Weyel, who is also currentlyone of our directors. The Exploitation Company, LLP, also an affiliate of Messrs.Schiller and Weyel, had previously subleased a portion of that corporate officespace pursuant to a Sublease Agreement, which agreement was cancelled inconnection with the assignment of the office lease to Energy XXI Services, LLC.

 

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In June 2005, we extended the lease for ourcommercial operating facility that expired June 30, 2005 for oneadditional year. The lease for our commercial operating facility will expireJune 30, 2006. The future minimum lease payments under this lease are $13,500.

 

**9.  ****    ****RELATED PARTY TRANSACTIONS**

 

In March 2005, we entered into a five yearsublease agreement with The Exploitation Company, LLP, an affiliate of John D.Schiller, our former interim President and Chief Executive Officer untilNovember 15, 2005 and currently one of our directors, pursuant to whichThe Exploitation Company, LLP subleased from us approximately 5,200 square feetof our corporate office space, beginning in June 2005. In July 2005,Mr. Steve Weyel, one of our directors, became an executive officer of TheExploitation Company, LLP.

 

In March 2006, we assigned our commitments under theprevious lease for our corporate offices that were located at 1021 Main Street,Suite 2650, Houston, Texas 77002 to Energy XXI Services, LLC. We agreedwith The Exploitation Company, LLP to terminate the sublease agreement inconnection with the assignment of the corporate office lease to Energy XXIServices, LLC.

 

**10.  INCOME TAXES**

 

The Company reports its income taxes in accordancewith SFAS No. 109, *Accounting forIncome 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 March 31, 2006, therewere permanent and temporary differences of approximately $59,000 and $111,000,respectively. At March 31, 2006, we had cumulative net operating losscarryforwards of approximately $14,016,000, which expire in years 2007 through2025. No effect has been shown in the consolidated financial statements for thenet operating loss carryforwards as the likelihood of future tax benefit fromsuch net operating loss carryforwards is not determinable at this time.Accordingly, the potential tax benefits of the net operating loss carryforwards,estimated based upon tax rates at March 31, 2006, have been offset by valuationreserves of the same amount.

 

**11.  SUBSEQUENT EVENTS**

 

In April 2006, the Company entered into a thirteen(13) month lease agreement for new corporate offices that commenced in May2006. We moved our previous corporate offices that were located at 1021 MainStreet, Suite 2650, Houston, Texas 77002, to 11757 Katy Freeway,Suite 1300, Houston, Texas 77079. In April 2006, we delivered to thelessor a security deposit of $9,400. Our future annual minimum lease payment is$112,800.

 

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

 

The following discussion of our financial conditionand results of operations should be read together with the unauditedconsolidated financial statements and related notes that are included elsewherein this report. This discussion may contain forward-looking statements basedupon current expectations that involve risks and uncertainties that could causeactual results to differ materially from the forward-looking statements. Weundertake no obligation to update any forward-looking statements except asrequired by law.

 

**Overview**

 

On January 14, 2005, we acquiredParticle Drilling Technologies, Inc., a privately-held Delawarecorporation (“PDTI”). As a result of this acquisition, our company, whichpreviously had no material operations, acquired the business of PDTI and we arenow engaged in the development of the

 

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Particle ImpactDrilling System, a patented system utilizing a specially designed “fit forpurpose” drill bit fitted with jetting nozzles and polycrystalline diamondcompact cutting structures for use in the oil and gas drilling industry.

 

We are a development-stage company and have alimited operating history. Our predecessor company for financial reportingpurposes was formed on June 9, 2003 to acquire the technology related tothe Particle Impact Drilling System (the “PID technology”). We are stilldeveloping this technology, and to date, we have not generated any revenuesfrom our operations. As we continue to execute our operations plan, we expectour development and operating expenses to increase.

 

*Research anddevelopment.  *We have made and expect to continue to make substantial investments inresearch and development activities in order to develop and market the PIDtechnology. Research and development costs consist primarily of general andadministrative and operating expenses related to research and developmentactivities. We expense research and development costs as incurred except forproperty, plant and equipment related to research and development activity thathave an alternative future use. Property, plant and equipment for research anddevelopment activity that have an alternative future use are capitalized andthe related depreciation is expensed as research and development costs.

 

In our continuing effort to enhance the PIDtechnology, we are developing a more efficient and cost effective shot injectorsystem. The new system is designed to replace the existing shot injector systemwith a simpler, less expensive approach. This system has the potential toreduce both the capital and operating cost of the PID System while providingredundant injection capability.

 

*General andadministrative.  *General and administrative expenses consist primarily of salaries andbenefits, office expense, professional services, and other corporate overheadcosts. We have experienced and expect to continue to experience increases ingeneral and administrative expenses as a result of: (1) becoming subjectto reporting and compliance obligations applicable to publicly-held companiesin January 2005; (2) our continuing efforts to develop, test andprepare the PID technology for commercialization; and (3) the hiring ofadditional personnel.

 

**Results of Operations**

 

***Quarter Ended March 31, 2006 Comparedto Quarter Ended March 31, 2005***

 

*Research anddevelopment.  *Research and development expenses were $1,448,107 and $807,247 for thethree months ended March 31, 2006 and 2005, respectively, representing anincrease of $640,860. This increase was primarily the result of the developmentof a new shot injector system, increased compensation due to the hiring ofadditional personnel, bonus accruals and stock-based compensation for researchand development personnel during the three months ended March 31, 2006.

 

*General andadministrative.  *General and administrative expenses were $1,381,209 and $420,950 forthe three months ended March 31, 2006 and 2005, respectively, representing anincrease of $960,259. This increase was primarily the result of increased costsrelated to bonus accruals and stock-based compensation during the three monthsended March 31, 2006.  In addition, ourgeneral and administrative expenses increased during the quarter ended March31, 2006 as a result of our reporting and compliance obligations applicable topublicly-held companies, which commenced for us (for financial reportingpurposes) during the second quarter of fiscal 2005. Lastly, we incurredsubstantial legal cost this quarter in connection with our settlement agreementand the related litigation.

 

*Other income(expenses).  *Otherincome was $152,409 and $68,467 for the three months ended March 31, 2006 and2005, respectively, representing an increase in other income of $83,942. Theincrease during the three months ended March 31, 2006 was primarilyattributable to: (1) rental income from our sublease agreement with TheExploitation Company, LLP that commenced in June 2005 and was terminated inMarch 2006; and (2) a gain on assignment of lease of our corporate officeslocated at 1021 Main Street, Suite 2650, Houston, Texas 77002 to Energy XXIService, LLC in March 2006.

 

***Six Months Ended March 31, 2006Compared to Six Months Ended March 31, 2005***

 

*Research and development. *Research and development expenses were$2,733,592 and $990,403 for the six months ended March 31, 2006 and 2005,respectively, representing an increase of $1,743,189. This increase wasprimarily the result of the development of a new shot injector system, increasedcompensation due to the hiring of additional personnel, bonus accruals andstock-based compensation for

 

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researchand development personnel during the six months ended March 31, 2006.  During the six months ended March 31, 2006,we also incurred $371,736 in connection with our field test at Catoosa whichoccurred during the first quarter of fiscal 2006.

 

*General and administrative. *General and administrative expenses were$2,372,171 and $1,113,987 for the six months ended March 31, 2006 and2005, respectively, representing an increase of $1,258,184.   Thisincrease was primarily the result of increased costs related to bonus accrualsand stock-based compensation during the six months ended March 31, 2006.  In addition, our general and administrativeexpenses increased during the six months ended March 31, 2006 as a result ofour reporting and compliance obligations applicable to publicly-held companies,which commenced for us (for financial reporting purposes) during the secondquarter of fiscal 2005. Lastly, we incurred substantial legal cost this quarterin connection with our settlement agreement and the related litigation.

 

*Other Income. *Other income was $260,873 and $61,915 for thesix months ended March 31, 2006 and 2005, respectively, representing anincrease of $198,958.  This increase was primarily the result of anincrease in interest income, rental income, and a gain on assignment of leaseduring the six months ended March 31, 2006. The increase in interestincome for the six months ended March 31, 2006 relates to the investment of theproceeds received from the private placement of our common stock during February2005. The increase in rental income during the six months ended March 31, 2006is attributable from our sublease agreement with The Exploitation Company, LLPthat commenced in June 2005 and was terminated in March 2006. During the sixmonths ended March 31, 2006, we recorded a gain on assignment of lease relatedto the assignment of our corporate offices located at 1021 Main Street, Suite2650, Houston, Texas 77002 to Energy XXI Service, LLC in March 2006.

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity are cash and cashequivalents. Cash requirements through the end of the fiscal year 2006 areprimarily to fund research and development activities, to continue to improveservice capabilities, to expand operations, general and administrative costsand capital expenditures. Our continued existence depends on the successfuldevelopment of the PID technology and our ability to successfully commercializethis technology.  Depending on the timingof these two events, we may need to seek additional funding through the sale orlicensing of assets, or through the issuances of debt or equity securities. We believe that we have adequate funds to meet our cash requirements forthe next twelve months, but will continue to look for efficiencies andmonitor spending.

 

Since inception on June 9, 2003 through March31, 2006, we have financed our operations through private sales of our equityand the issuance of convertible notes payable, totaling net proceeds of $19,364,026.As of March 31, 2006, we had $6,612,856 in cash and cash equivalents.

 

On February 9, 2005, we sold 9,000,000 sharesof our common stock at $2.00 per share in a private placement and receivedgross proceeds of $18,000,000. We paid commissions to the placement agent inthe amount of $600,000, $100,000 for reimbursable expenses, and legal feesrelated to this offering of $315,767. In connection with this privateplacement, we issued ten year warrants to persons associated with the placementagent to purchase 1,500,000 shares of our common stock in the aggregate at$2.00 per share. In addition, we used $1,500,000 of these proceeds torepurchase 3,000,000 shares of our common stock from Prentis B. Tomlinson (PDTI’sformer President and Chief Executive Officer until December 2, 2004). Theseshares were purchased as treasury stock and recorded at cost.

 

*Cash Flows fromOperations.  *Cashflows used for operations are primarily affected by our research anddevelopment progress and business development. Net cash flows used foroperations during the six months ended March 31, 2006 were $3,483,052, comparedto $1,992,785 for the six months ended March 31, 2005. The increase from the sixmonths ended March 31, 2005 to the six months ended March 31, 2006 was theresult of increased compensation due to the hiring of additional personnel andprofessional fees relating to being a publicly traded company.  During the six months ended March 31, 2006,we also incurred costs in the amount of $371,736 in connection with our fieldtest at Catoosa which occurred during the first quarter of fiscal 2006.  No such costs were incurred during the sixmonths ended March 31, 2005. Our working capital since inception (June 9,2003) has been fully funded from cash flows from financing activities.

 

*Cash Flows from InvestingActivities.  *Ourcapital spending for the six months ended March 31, 2006 was $335,846 comparedto $794,360 for the six months ended March 31, 2005. During the six monthsended March 31, 2006, we used capital expenditures for our research and developmentactivities in accordance with our 2006 capital budget.  During the six months ended March 31, 2005, inaddition to capital expenditures for our research and development activities inaccordance with our 2005 capital budget, we used $389,983 to purchase otherassets.  This was primarily related to a $350,000 deposit in the form of aletter of credit we established in connection with our office lease. Ourcapital spending since inception (June 9, 2003) has been fully funded fromcash flows from financing activities. We anticipate that

 

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ourcapital expenditures for the next several months will continue to be fullyfunded from our available cash and cash equivalents.

 

*Cash Flows from FinancingActivities.  *Netcash provided by (used in) financing activities for the six months ended March31, 2006 and 2005 was ($72,892) and $16,870,116, respectively. During the sixmonths ended March 31, 2005, we received net proceeds of $18,647,666 from theissuance of common stock and used $1,500,000 to repurchase 3,000,000 sharesfrom a shareholder, and $277,550 to repay notes payable.  During the six months ended March 31, 2006, weused $72,892 to repay note payables.

 

*ContractualObligations*.In March 2005, we delivered to the lessor of our corporate offices at 1021 MainStreet, Suite 2650, Houston, Texas 77002, a security deposit of $350,000 in theform of an irrevocable letter of credit. Our future annual minimum leasepayments were $186,256. In August 2005, we expanded the corporate officefacility an additional 1,086 square feet for a total of 11,396 square feet. Thefuture annual minimum lease payments for the additional space were $18,758. InMarch 2006, we assigned our commitments under this office lease to Energy XXIServices, LLC, an affiliate of John D. Schiller, our former interim Presidentand Chief Executive Officer and currently one of our directors, and of SteveWeyel, currently one of our directors. The Exploitation Company, LLP hadpreviously subleased a portion of that corporate office space pursuant to aSublease Agreement, which agreement was cancelled in connection with theassignment of the office lease to Energy XXI Services, LLC. Furthermore, EnergyXXI Services, LLC assumed the obligation under the lease to provide a securitydeposit of $350,000 and we were released from the irrevocable letter of creditwe had previously provided. We will not incur any future obligations for leasepayments under this office lease.

 

In April 2006, we entered into a thirteenmonth lease agreement for our new corporate offices at 11757 Katy Freeway,Suite 1300, Houston, Texas 77079, that commenced in May 2006. In connectionwith the execution of this new lease agreement, we delivered to the lessor asecurity deposit of $9,400. Our future annual minimum lease payment is $112,800.

 

**Off-Balance Sheet Arrangements**

 

In connection with the acquisition of the PIDtechnology in January 2004, PDTI entered into a Royalty Agreement withProDril Services, Incorporated (“PSI”) pursuant to which we are obligated topay PSI a royalty on a quarterly basis equal to 18% of our earnings beforeinterest, income taxes, depreciation and amortization (“EBITDA”) derived fromthe use of the PID technology, until an aggregate of $67,500,000 has been paid.PDTI also entered into a Royalty Agreement in January 2004 with ProDrilServices, International, Ltd. (“PSIL”) pursuant to which we are obligated topay PSIL a royalty on a quarterly basis equal to 2% of our EBITDA derived fromthe use of the PID technology, until an aggregate of $7,500,000 has been paid.In addition, we are obligated to pay CCORE Technology and Licensing, Ltd. (“CTL”),PSI and PSIL a royalty equal to 1.6%, 1.2% and 1.2%, respectively, of ourquarterly gross revenue, derived from the use of the PID technology. As of March31, 2006, we had no revenues or EBITDA; therefore no royalties have been paidor accrued.

 

**Related Party Transactions**

 

In March 2005, we entered into a five yearsublease agreement with The Exploitation Company, LLP, an affiliate of John D.Schiller, our former interim President and Chief Executive Officer andcurrently one of our directors, pursuant to which The Exploitation Company, LLPsubleased from us approximately 5,200 square feet of our corporate office space,beginning in June 2005. In July 2005, Mr. Steve Weyel, one ofour directors, became an executive officer of The Exploitation Company, LLP.

 

In March 2006, we assigned our commitments under theprevious lease for our corporate offices that were located at 1021 Main Street,Suite 2650, Houston, Texas 77002 to Energy XXI Services, LLC. We agreedwith The Exploitation Company, LLP to terminate the sublease agreement inconnection with the assignment of the corporate office lease to Energy XXIServices, LLC.

 

We believe that the transaction described above wasnegotiated on an arm’s length basis and that the terms of the transaction wasat least as favorable to us as those that could have been obtained from anunaffiliated third party.

 

**Critical Accounting Policies**

 

The discussion and analysis of our financialcondition and results of operations is based on our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of theseconsolidated financial statements requires us to make estimates and judgmentsthat affect the reported amounts of assets, liabilities and expenses. We baseour estimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these estimates under different assumptions or conditions. We believe thefollowing critical accounting policies affect our most significant judgmentsand estimates used in the preparation of our consolidated financial statements.

 

*Reverse Acquisition.  *The acquisition of PDTI in January 2005was accounted for as a reverse acquisition. Pursuant to the guidance inAppendix B of SEC Accounting Disclosure Rules and Practices OfficialText, we believe the acquisition of PDTI was a merger of a private operatingcompany into a

 

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non-operatingpublic shell corporation with nominal net assets which typically results in theowners and management of the private company having actual or effectiveoperating control of the combined company after the transaction, with theshareholders of the former public shell continuing only as passive investors.These transactions are considered by the staff of the Securities and ExchangeCommission to be capital transactions in substance, rather than businesscombinations. That is, the transaction is equivalent to the issuance of stockby the private company for the net monetary assets of the shell corporation,accompanied by a recapitalization. Accordingly, the reverse acquisition hasbeen accounted for as a recapitalization. For accounting purposes, PDTI isconsidered the acquirer in 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.

 

*Impairment of Long-LivedAssets.  *Weevaluate our long-lived assets for indicators of possible impairment bycomparison of the carrying amounts to future net undiscounted cash flowsexpected to be generated by such assets when events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable.  Shouldan impairment exist, the impairment loss would be measured based on the excesscarrying value of the asset over the asset’s fair value or discounted estimatesof future cash flows.  We also evaluate the capitalized costs for patentsand patent applications filed but not issued for possible impairments. We havenot identified any such impairment losses to date.  The evaluation of capitalized costs forpatents and patent applications is based on a subjective cash flow forecastwhich is subject to change.  We willreassess our cash flow forecast each time there are fundamental changes in theunderlying potential use of the patents or patent applications in terms ofperformance, customer acceptance or other factors that may affect such cashflow forecasts.

 

*Stock-BasedCompensation.  *In December 2004, the Financial Accounting Standards Board (“FASB”)issued a revision to SFAS No. 123, *Share-BasedPayment*. This statement establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. It also addresses transactions in which an entity incurs liabilitiesin exchange for goods or services that are based on the fair value of theentity’s equity instruments or that may be settled by the issuance of thoseequity instruments. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement does not change the accounting guidancefor share-based payment transactions with parties other than employees providedin SFAS No. 123 as originally issued. This statement is effective for newawards and those modified, repurchased or cancelled in interim or annualreporting periods beginning after June 15, 2005. We early adopted thisstandard upon inception.

 

*Research andDevelopment.  *The costs of materials and equipment or facilities that are acquired orconstructed for research and development activities and that have alternativefuture uses are capitalized as tangible assets when acquired or constructed.The cost of such materials consumed in research and development activities andthe depreciation of such equipment or facilities used in those activities areresearch and development costs. However, the costs of materials, equipment, orfacilities acquired or constructed for research and development activities thathave no alternative future uses are considered research and development costsand are expensed at the time the costs are incurred.

 

*Income Taxes.  *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 March 31, 2006, therewere permanent and temporary differences of approximately $59,000 and $111,000,respectively. At March 31, 2006, we had cumulative net operating losscarryforwards of approximately $14,016,000, which expire in years 2007 through2025. No effect has been shown in the consolidated financial statements for thenet operating loss carryforwards as the likelihood of future tax benefit fromsuch net operating loss carryforwards is not determinable at this time.Accordingly, the potential tax benefits of the net operating losscarryforwards, estimated based upon tax rates at March 31, 2006, have beenoffset by valuation reserves of the same amount.

 

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*Net Loss per Share.  *The Company has presented basic and dilutednet loss per share pursuant to SFAS No. 128, *Earnings Per Share*. In accordance with SFAS No. 128,basic and diluted net loss per share has been computed using theweighted-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 antidilutive were 2,547,858 and 2,275,508 shares for the three monthsended March 31, 2006 and 2005, respectively, and 2,577,151 and 1,797,572 sharesfor the six months ended March 31, 2006 and 2005, respectively.

 

**Forward-Looking Statements**

 

Statements in this quarterly report onForm 10-Q that are not historical facts (including any statementsconcerning plans and objectives of management for future operations or economicperformance, or assumptions or forecasts related thereto) are forward-lookingstatements subject to Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. These statements canbe identified by the use of forward-looking terminology including “forecast,” “may,”“believe,” “expect,” “anticipate,” “estimate,” “continue” or other similarwords. These statements discuss future expectations, contain projections ofresults 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.

 

These forward-looking statements are made based uponour management’s current plans, expectations, estimates, assumptions andbeliefs concerning future events impacting us and therefore involve a number ofrisks and uncertainties. We caution that forward-looking statements are notguarantees and that actual results could differ materially from those expressedor implied in the forward-looking statements as a result of certain factors,including but not limited to dependence upon energy industry spending, the volatilityof oil and gas prices, weather interruptions, the results of testing of ourproducts, the availability of capital resources and the other factors describedunder “Item 1A. Risk Factors” in Amendment No. 1 to our annual report onForm 10-K/A for the year ended September 30, 2005 and filed with theSEC on February 15, 2006. We undertake no obligation to update anyforward-looking statements except as required by law.

 

**Item 3.****                         ****Quantitative and QualitativeDisclosures about Market Risk**

 

We believe that we do not have any material exposureto financial market risk and we do not enter into foreign currency or interestrate transactions.

 

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**Item 4.****                         ****Controls and Procedures**

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our reports under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported within thetime periods specified in the rules and forms promulgated by the Securities andExchange Commission (“SEC”), and that such information is accumulated andcommunicated to management, including our Chief Executive Officer and ChiefFinancial Officer, to allow timely decisions regarding required disclosure. Thedesign of any system of control is based in part upon certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving our stated purpose under all potential futureconditions. As required by Rule 13a-15(b) of the Securities Exchange Act of1934, an evaluation was performed under the supervision and with theparticipation of our Chief Executive Officer and Chief Financial Officer of theeffectiveness of the design and operation of our “disclosure controls andprocedures” (as defined under Rule 13a-15(e) and Rule 15d-15(e)) as of the endof the period covered by this Quarterly Report on Form 10-Q filed with the SEC.Based upon that evaluation, and solely as a result of our failure to timelyfile a Current Report on Form 8-K during the three months ended March 31, 2006,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures, as of March 31, 2006, were not effective intimely alerting them to material company information required to be included inour periodic filings with the SEC.

 

Inconnection with our acquisition of PDTI in January 2005, we assumed certainwarrants to purchase common stock that had previously been issued by PDTI and,in connection therewith, such warrants became warrants to purchase anequivalent number of shares of our common stock at the same exercise price. Wedisclosed the assumption of these warrants under Item 3.02 of our CurrentReport on Form 8-K filed with the SEC on January 20, 2005. In addition, weissued warrants to purchase shares of our common stock to persons affiliatedwith the placement agent in connection with the private placement of our commonstock in February 2005. We disclosed the issuance of these warrants under Item3.02 of our Current Report on Form 8-K filed with the SEC on February 10, 2005.As described below under Part II, Item 2 of this Quarterly Report on Form 10-Q,holders of several of the warrants described above exercised their warrants ona cashless exercise basis over the course of the three months ended March 31,2006. During the preparation of this Quarterly Report on Form 10-Q, we realizedthat we had inadvertently failed to file a Current Report on Form 8-K todisclose under Item 3.02 the aggregate issuance of unregistered equitysecurities representing more than 1% of the outstanding shares of our commonstock in connection with the exercise of the warrants up to and including thewarrant exercised on March 20, 2006. The information that would have been setforth in such a Current Report on Form 8-K is set forth in Part II, Item 2 ofthis Quarterly Report on Form 10-Q.

 

We have taken remedial steps to improve ourtracking of the aggregate number of unregistered equity securities issued in connectionwith the exercise of our outstanding warrants in order for us to make moretimely disclosure of this information. We will continue to evaluate ourdisclosure controls and procedures in an effort to improve such disclosurecontrols and procedures where we deem necessary or advisable.

 

There was no change in our internal control overfinancial reporting during our second quarter of fiscal 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**Part II—Other Information**

 

**Item 1.****                         ****Legal Proceedings**

 

OnFebruary 17, 2006, PDTI closed a settlement agreement, entered into on February8, 2006, related to certain litigation styled Cause No. 2004-63506, *Particle Drilling Technologies, Inc. vs. Harry B.Curlett, Curlett Family Limited Partnership, Ltd., CCore Technology andLicensing, Ltd., and Deep Heat Energy Corporation,* in the 333rd JudicialDistrict Court of Harris County, Texas. As part of the settlement agreement, all parties released all claimsagainst each other, and, on February 21, 2006, the Court dismissed all claimsamong the parties with prejudice.  TheCourt’s dismissal became final on March 24, 2006, thereby concluding thelitigation.

 

Aspart of the settlement agreement, PDTI and Curlett Family Limited Partnership,Ltd. (“CFLP”) amended the Exclusive License Agreement between PDTI’spredecessor, ProDril Acquisition Company, and CFLP, dated June 1, 2003, tolimit the parties’ respective obligations to share technical information witheach other regarding the PID technology and to terminate, as of February 18,2006, the parties’ respective rights to the other party’s improvements to thePID technology.  The settlement agreementprovided that the parties would integrate these amendments into an AmendedExclusive License Agreement by March 10, 2006.

 

Duringefforts to draft an Amended Exclusive License Agreement reflecting theamendments made in the settlement agreement, CFLP took the position that PDTIhas a greater obligation to share technical information with it than providedin the amendments and that CFLP has greater rights in PDTI’s improvements tothe PID technology than provided in the amendments.  On March 20, 2006, PDTI and CFLPunsuccessfully mediated their dispute over these issues but nonetheless put inplace a process through which they believed that they could resolve thatdispute.  Prior to the conclusion of thatprocess, however, CFLP filed the lawsuit described hereafter.

 

OnMarch 24, 2006, CFLP filed Civil Action No. 4:06-CV-01012, *CurlettFamily Limited Partnership, Ltd. v. Particle Drilling Technologies, Inc., aDelaware Corporation, and Particle Drilling Technologies, Inc., a NevadaCorporation*, in the United States District Court for the SouthernDistrict of Texas, Houston Division.  Inthat lawsuit, CFLP requests the Court to construe the Exclusive LicenseAgreement, as amended by the settlement agreement, as imposing a greaterobligation on PDTI to share information with CFLP than PDTI believes exists andas giving CFLP greater rights in PDTI’s improvements than PDTI believesexists.  In addition, primarily becausePDTI does not agree with CFLP’s construction of the Exclusive LicenseAgreement, as amended by the settlement agreement, CFLP claims that PDTI hasbreached the settlement agreement and Exclusive License Agreement.  CFLP seeks specific performance of thoseagreements and claims lost profits damages of $26,000,000 per month for thisalleged breach.

 

PDTIbelieves that the construction sought by CFLP of the Exclusive LicenseAgreement, as amended by the settlement agreement, is inconsistent with theplain language of those agreements and inconsistent with the objective intentof the parties.  PDTI also believes thatCFLP’s lost profits damages claim is factually unsupportable, legallyunsupportable, and frivolous.  PDTIintends to defend against all claims asserted by CFLP, prosecute allappropriate counterclaims against CFLP, and seek sanctions against CFLP for itsdamages claim.  On April 18, 2006, PDTIanswered CFLP’s complaint and counterclaimed against CFLP with a request thatthe Court construe the Exclusive License Agreement, as amended by thesettlement agreement, as limiting the parties’ respective obligations to shareinformation with each other

 

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andas terminating, as of February 18, 2006, the parties’ respective rights to theother party’s improvements to the PID technology.  On April 19, 2006, PDTI advised CFLP of theunsupportable nature of CFLP’s damages claim and of PDTI’s intention to pursuesanctions if CFLP does not withdraw that claim.

 

**Item 2.****                         ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

On January 6, 2006, two holders of outstanding warrants exercised theirright to purchase 7,000 shares of our common stock, in the aggregate, at $2.00per share on a cashless exercise basis. The fair market value of our common stock on the date of exercise was$6.37.  As a result of this cashlessexercise, we issued, in the aggregate, 4,802 shares of our common stock to theholders of the warrants and withheld issuing 2,198 shares of our common stockin satisfaction of the exercise price under the warrants.

 

On January 18, 2006, a holder of an outstanding warrant exercised itsright to purchase 2,192 shares of our common stock at $2.00 per share on acashless exercise basis.  The fair marketvalue of our common stock on the date of exercise was $6.39.  As a result of this cashless exercise, weissued 1,506 shares of our common stock to the holder of this warrant andwithheld issuing 686 shares of our common stock in satisfaction of the exerciseprice under the warrant.

 

On January 25, 2006, a holder of an outstanding warrant exercised itsright to purchase 5,000 shares of our common stock at $2.00 per share on acashless exercise basis.  The fair marketvalue of our common stock on the date of exercise was $6.30.  As a result of this cashless exercise, weissued 3,413 shares of our common stock to the holder of this warrant andwithheld issuing 1,587 shares of our common stock in satisfaction of theexercise price under the warrant.

 

On February 21, 2006, two holders of outstanding warrants exercised theirright to purchase 256,667 shares of our common stock, in the aggregate, at$2.00 per share on a cashless exercise basis. The fair market value of our common stock on the date of exercise was $6.40.As a result of this cashless exercise, we issued, in the aggregate, 176,458shares of our common stock to the holders of the warrants and withheld issuing 80,209shares of our common stock in satisfaction of the exercise price under thewarrants.

 

On March 20, 2006, a holder of an outstanding warrant exercised itsright to purchase 110,000 shares of our common stock at $2.00 per share on acashless exercise basis.  The fair marketvalue of our common stock on the date of exercise was $5.00.  As a result of this cashless exercise, weissued 66,000 shares of our common stock to the holder of this warrant andwithheld issuing 44,000 shares of our common stock in satisfaction of theexercise price under the warrant.

 

On April 4, 2006, a holder of an outstanding warrant exercised itsright to purchase 30,000 shares of our common stock at $0.12 per share on acashless exercise basis.  The fair marketvalue of our common stock on the date of exercise was $5.90.  As a result of this cashless exercise, weissued 29,390 shares of our common stock to the holder of this warrant andwithheld issuing 610 shares of our common stock in satisfaction of the exerciseprice under the warrant.

 

The shares of our common stock issued upon exercise of the warrantsdescribed above were issued in an exchange between us and our existing securityholders in which no commission or other remuneration was paid or given directlyor indirectly for soliciting such exchange. As a result, the issuance of such shares of common stock was exempt fromregistration pursuant to Section 3(a)(9) under the Securities Act of 1933.

 

**Item 4.****                         ****Submission of Matters to aVote of Security Holders**

 

On March 3, 2006, at the Annual Meeting of Shareholders, theshareholders voted, as follows, to elect six directors of the Company andratify UHY Mann Frankfort Stein and Lipp CPAs, LLP as the Company’s independentaccountants.

 

The results of the election of the directors by the shareholders wereas follows:

 
| **Name**               | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|------------------------|------------|---------------|------------|--------------------|------------|
| Kenneth R.  LeSuer     |       | 12,615,662    |       | 74,615             |       |
| Jim B. Terry           |       | 12,689,122    |       | 1,155              |       |
| John D.  Schiller, Jr. |       | 12,689,662    |       | 615                |       |
| Michael S.  Mathews    |       | 12,616,662    |       | 73,615             |       |
| Hugh A.  Menown        |       | 12,689,662    |       | 615                |       |
| Steve A.  Weyel        |       | 12,689,662    |       | 615                |       |

 

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The results of the vote by the shareholders on the proposal to ratifythe selection of UHY Mann Frankfort Stein and Lipp CPAs, LLP as the Company’sindependent accountants were as follows:

 
| Votes  For: 12,688,207 |   | Votes  Against: 645 |   | Abstentions:  1,425 |
|------------------------|--------|---------------------|--------|---------------------|

 

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

 

Exhibits:

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                           |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1             |       | Employment Agreement by and  between Particle Drilling Technologies, Inc. and Jim B. Terry (Incorporated  by reference to Exhibit 10.1 filed with the Securities and Exchange  Commission on January 25, 2006)            |
|             |       |                                                                                                                                                                                                                      |
| 10.2             |       | form of Non-Statutory  Stock Option Agreement (employees) (Incorporated by reference to Exhibit 10.2  filed with the Securities and Exchange Commission on January 25, 2006)                                              |
|             |       |                                                                                                                                                                                                                      |
| 10.3             |       | form of Restricted Stock  Agreement (employees) (Incorporated by reference to Exhibit 10.3 filed with  the Securities and Exchange Commission on January 25, 2006)                                                        |
|             |       |                                                                                                                                                                                                                      |
| 10.4             |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Jon Christopher Boswell  (Incorporated by reference to Exhibit 10.4 filed with the Securities and  Exchange Commission on January 25, 2006) |
|             |       |                                                                                                                                                                                                                      |
| 10.5             |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Thomas E. Hardisty  (Incorporated by reference to Exhibit 10.5 filed with the Securities and  Exchange Commission on January 25, 2006)      |
|             |       |                                                                                                                                                                                                                      |
| 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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*                    Filed herewith

**             Furnished herewith

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                      | PARTICLE DRILLING  TECHNOLOGIES, INC.                                                                                              |
|---------------------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|                      | (Registrant)                                                                                                                            |
|                      |                                                                                                                                    |
|                      |                                                                                                                                    |
| Date:   May 10, 2006 | /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             |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Jim B. Terry  (Incorporated by reference to Exhibit 10.1 filed with the Securities and  Exchange Commission on January 25, 2006)            |
|             |       |                                                                                                                                                                                                                      |
| 10.2             |       | form of Non-Statutory  Stock Option Agreement (employees) (Incorporated by reference to Exhibit 10.2  filed with the Securities and Exchange Commission on January 25, 2006)                                              |
|             |       |                                                                                                                                                                                                                      |
| 10.3             |       | form of Restricted Stock  Agreement (employees) (Incorporated by reference to Exhibit 10.3 filed with  the Securities and Exchange Commission on January 25, 2006)                                                        |
|             |       |                                                                                                                                                                                                                      |
| 10.4             |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Jon Christopher Boswell  (Incorporated by reference to Exhibit 10.4 filed with the Securities and  Exchange Commission on January 25, 2006) |
|             |       |                                                                                                                                                                                                                      |
| 10.5             |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Thomas E. Hardisty  (Incorporated by reference to Exhibit 10.5 filed with the Securities and  Exchange Commission on January 25, 2006)      |
|             |       |                                                                                                                                                                                                                      |
| 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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*                    Filed herewith

**             Furnished herewith

 

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