UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File No. 001-14217
ENGlobal Corporation
--------------------
(Exact name of registrant as specified in its charter)
Nevada
------
(State or other jurisdiction of
incorporation or organization)
88-0322261
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(I.R.S Employer Identification No.)
654 North Sam Houston Parkway E., Suite 400, Houston, TX 77060-5914
-------------------------------------------------------- ----------
(Address of principal executive offices) (Zip code)
(281) 878-1000
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (check
one):
Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the close of business of November 9, 2006.
$0.001 Par Value Common Stock 26,706,925 shares
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2006
TABLE OF CONTENTS
Page
Number
------
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Income for the Three Months Ended and Nine
Months Ended September 30, 2006 and September 30, 2005 3
Consolidated Statements of Comprehensive Income for the Three Months Ended
September 30, 2006 and September 30, 2005 4
Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005 5
Condensed Consolidated Statements of Cash Flows for the Nine Months 6-7
Ended September 30, 2006 and September 30, 2005
Notes to Condensed Consolidated Financial Statements 8-14
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15-31
Item 3. Quantitative and Qualitative Disclosures About Market Risk 32
Item 4. Controls and Procedures 32-33
Part II. Other Information
Item 1. Legal Proceedings 34
Item 1A. Risk Factors 34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 34
Item 3. Defaults Upon Senior Securities 34
Item 4. Submission of Matters to a Vote of Security Holders 34
Item 5. Other Information 34
Item 6. Exhibits 34
Signature 35
2
PART I. - FINANCIAL INFORMATION
-------------------------------
ITEM 1. FINANCIAL STATEMENTS
ENGlobal Corporation
Condensed Consolidated Statements of Income
(Unaudited)
For the Three Months Ended For the Nine Months
September 30, Ended September 30,
------------------------------ ------------------------------
2006 2005 2006 2005
------------- ------------- ------------- -------------
Operating Revenue $ 82,503,548 $ 59,265,617 $ 224,196,098 $ 163,314,149
------------- ------------- ------------- -------------
Operating Expenses:
Direct cost 77,954,573 51,427,251 200,696,904 142,498,567
Selling, general and administrative (Note 2) 6,411,171 4,815,324 18,921,412 12,991,480
Depreciation and amortization 393,253 257,786 1,149,654 814,178
------------- ------------- ------------- -------------
Total operating expenses 84,758,997 56,500,361 220,767,970 156,304,225
------------- ------------- ------------- -------------
Operating income (loss) (2,255,449) 2,765,256 3,428,128 7,009,924
Other Income (Expense):
Other income (expense) (19,912) 5,809 389,196 79,054
Interest income (expense), net (371,141) (199,096) (786,283) (642,647)
------------- ------------- ------------- -------------
Total other income (expense) (391,053) (193,287) (397,087) (563,593)
------------- ------------- ------------- -------------
Income before Provision for Income Taxes (2,646,502) 2,571,969 3,031,041 6,446,331
Provision for Income Taxes (1,076,116) 951,629 1,035,849 2,385,143
------------- ------------- ------------- -------------
Net Income (loss) $ (1,570,386) $ 1,620,340 $ 1,995,192 $ 4,061,188
============= ============= ============= =============
Net Income Per Common Share:
Basic $ (0.06) 0.07 $ 0.08 0.17
Diluted $ (0.06) 0.07 $ 0.07 0.17
Weighted Average Shares Used in Computing Net
Income Per Share:
Basic 26,645,830 23,890,842 26,475,353 23,637,345
Diluted 26,645,830 24,898,045 27,027,931 24,460,313
See accompanying notes to interim condensed financial statements
3
ENGlobal Corporation
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
-------------------------- --------------------------
2006 2005 2006 2005
----------- ----------- ----------- -----------
Net Income (loss) $(1,570,386) $ 1,620,340 $ 1,995,192 $ 4,061,188
----------- ----------- ----------- -----------
Other Comprehensive Income (loss):
Foreign currency translation adjustment (9,733) -- 3,433 --
Income tax effect 3,747 -- (1,322) --
----------- ----------- ----------- -----------
Net other comprehensive income (5,986) -- 2,111 --
----------- ----------- ----------- -----------
Net Comprehensive Income (loss) $(1,576,372) $ 1,620,340 $ 1,997,303 $ 4,061,188
=========== =========== =========== ===========
See accompanying notes to interim condensed financial statements
4
ENGlobal Corporation
Condensed Consolidated Balance Sheets
September 30, December 31,
2006 2005
------------ ------------
(unaudited)
ASSETS
------
Current Assets:
Cash $ 1,070,656 $ 159,414
Trade receivables, less allowance for doubtful accounts of approximately $565,000 and
$507,000, respectively 54,998,258 46,248,458
Costs and estimated earnings in excess of billings on uncompleted contracts 9,553,209 4,148,275
Prepaid expenses and other current assets 650,687 1,600,369
Current portion of note receivable 51,258 --
Inventories -- 153,968
Deferred tax asset 305,258 305,258
Federal income taxes receivable 544,139 52,818
------------ ------------
Total Current Assets 67,173,465 52,668,560
Property and Equipment, net 7,959,774 6,861,361
Goodwill 23,160,320 15,454,583
Note receivable, net of current portion 120,760 --
Non-current Deferred Tax Asset 159,192 74,892
Other Assets 810,389 876,534
------------ ------------
Total Assets $ 99,383,900 $ 75,935,930
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current Liabilities:
Accounts payable $ 16,218,653 $ 15,211,331
Accrued compensation and benefits 11,347,907 9,799,074
Deferred rent 708,847 361,292
Current portion of long-term debt 1,612,392 547,934
Billings and estimated earnings in excess of costs on uncompleted contracts 1,054,551 3,775,625
Other liabilities 728,183 1,148,079
------------ ------------
Total Current Liabilities 31,670,533 30,843,335
Long-Term Debt, net of current portion 22,831,222 5,227,976
------------ ------------
Total Liabilities 54,501,755 36,071,311
------------ ------------
Contingencies (Note 10)
Stockholders' Equity:
Preferred stock - $0.001 par value; 2,000,000 shares authorized; none outstanding -- --
Common stock, $0.001 par value; 75,000,000 shares authorized; 26,700,925 and 26,289,567
outstanding and 27,353,302 and 26,941,944 issued at September 30, 2006 and December
31, 2005, respectively 27,353 26,941
Additional paid-in capital 29,656,591 27,230,332
Retained earnings 15,198,399 13,203,208
Treasury stock - none and 652,377 shares at cost at September 30, 2006 and
December 31, 2005, respectively -- (592,231)
Accumulated other comprehensive income (loss) (198) (3,631)
------------ ------------
Total Stockholders' Equity 44,882,145 39,864,619
Total Liabilities and Stockholders' Equity $ 99,383,900 $ 75,935,930
============ ============
See accompanying notes to interim condensed financial statements
5
ENGlobal Corporation
Condensed Consolidated Statements of Cash Flows
(Unaudited)
For the Nine Months Ended
September 30,
----------------------------
2006 2005
------------ ------------
Cash Flows from Operating Activities:
Net income $ 1,995,192 $ 4,061,188
Adjustments to reconcile net income to net cash provided by (used in)
operating activities -
Depreciation and amortization 1,925,266 1,341,409
Share based compensation expense 894,759 --
Loss on disposal of property, plant and equipment 99,281 2,715
(Gain) on assets held for sale -- (134,447)
Deferred income tax benefit/expense (133,736) (590,437)
Changes in current assets and liabilities, net of acquisitions -
Trade receivables (4,576,070) (360,467)
Inventories 153,968 383
Costs and estimated earnings in excess of billings (5,404,934) (3,515,522)
Prepaid expenses and other assets 344,896 1,076,862
Accounts payable 310,730 (50,412)
Accrued compensation and benefits 802,006 1,110,622
Billings in excess of costs and estimated earnings (2,721,074) (587,501)
Other liabilities 216,554 1,117,949
Income taxes receivable (payable) (666,832) 978,270
------------ ------------
Net cash provided by (used in) operating activities (6,759,994) 4,450,612
------------ ------------
Cash Flows from Investing Activities:
Property and equipment acquired (2,496,064) (2,184,929)
Construction in progress (292,482) --
Proceeds from sale of equipment 12,836 15,400
Proceeds from sale of other assets 50,000 823,350
Proceeds from note receivable 15,343 --
Additional consideration for acquisitions 62,117 (77,297)
Business acquired in purchase transaction, net of cash acquired (6,028,585) --
Partnership distribution 350,000 --
Insurance proceeds 68,317 --
------------ ------------
Net cash provided by (used in) investing activities (8,258,518) (1,423,476)
------------ ------------
Cash Flows from Financing Activities:
Net borrowings (payments) on line of credit 15,928,759 (13,529,496)
Proceeds from issuance of common stock converted from options 724,142 663,776
Proceeds from issuance of common stock from private placement -- 14,000,000
Short-term note repayments -- (837,714)
Capital lease repayments -- (4,371)
Long-term debt repayments (726,970) (370,000)
------------ ------------
Net cash provided by (used in) financing activities 15,925,931 (77,805)
------------ ------------
Effect of Exchange Rate Changes on Cash 3,823 1,976
------------ ------------
Net change in cash 911,242 2,951,307
Cash, at beginning of period 159,414 8,006
------------ ------------
Cash, at end of period $ 1,070,656 $ 2,959,313
============ ============
Supplemental Disclosures:
Interest paid $ 448,846 $ 605,170
============ ============
Income taxes paid $ 1,759,202 $ 2,200,614
============ ============
Tax refunds received (314,221) $ (7,263)
============ ============
See accompanying notes to interim condensed financial statements
6
ENGlobal Corporation
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Continued)
Non-Cash:
Issuance of note for purchase of WRC Corporation $ 2,400,000 $ --
=========== ===========
Issuance of common stock for purchase of WRC Corporation $ 1,400,000 $ --
=========== ===========
Issuance of note for ATI assets $ 1,000,000 $ --
=========== ===========
Acceptance of note for Constant Power assets $ (216,000) $ --
=========== ===========
See accompanying notes to interim condensed financial statements
7
NOTE 1 - BASIS OF PRESENTATION
The condensed consolidated financial statements of ENGlobal Corporation
(which may be referred to as "ENGlobal", the "Company", "we", "us", or
"our") included herein, are unaudited for the three month and nine month
periods ended September 30, 2006 and 2005. These financial statements
reflect all adjustments (consisting of normal recurring adjustments), which
are, in the opinion of management, necessary to fairly present the results
for the periods presented. Certain information and note disclosures,
normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States of America,
have been condensed or omitted pursuant to rules and regulations of the
Securities and Exchange Commission. It is suggested that these condensed
financial statements be read in conjunction with the Company's audited
financial statements for the year ended December 31, 2005 included in the
Company's annual report on Form 10-K filed with the Securities and Exchange
Commission on March 31, 2006. The Company believes that the disclosures
made herein are adequate to make the information presented not misleading.
Certain amounts in the 2005 financial statements have been reclassified to
more closely conform to the 2006 presentation.
NOTE 2 - SHARE BASED COMPENSATION
The Company currently sponsors a stock-based compensation plan as described
below. Effective January 1, 2006, the Company adopted the provisions of
Statement of Financial Accounting Standards ("SFAS") No. 123 (Revised),
"Share-Based Payment" ("SFAS No. 123(R)"). Under the fair value recognition
provisions of SFAS No. 123(R), stock-based compensation is measured at the
grant date based on the value of the awards and is recognized as expense
over the requisite service period (usually a vesting period). The Company
selected the modified prospective method of adoption described in SFAS No.
123(R). The fair values of the stock awards recognized under SFAS No.
123(R) are determined based on the vested portion of the awards; however,
the total compensation expense is recognized on a straight-line basis over
the vesting period.
In accordance with the provisions of SFAS No. 123(R), total stock-based
compensation expense in the amount of $404,000 and $895,000, respectively,
was recorded in the three and nine months ended September 30, 2006. The
total stock-based compensation expense was recorded in selling, general and
administrative expense. The total income tax benefit recognized in the
condensed consolidated statements of income for the share-based
arrangements for the three and nine months ended September 30, 2006 was
$59,847 and $133,736, respectively.
Prior to January 1, 2006, the Company accounted for stock-based
compensation using the intrinsic value method prescribed in Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. Under APB Opinion No. 25, no
compensation expense was recognized for stock options issued to employees
because the grant price equaled, or was above, the market price on the date
of grant for options issued by the Company.
The total fair value of shares that vested during the nine months ended
September 30, 2006 and 2005 was $5.8 million and $7.8 million,
respectively.
Stock Option and Incentive Plans
The Company maintains a stock option plan (the "Option Plan") under which
the Company may issue incentive stock options to employees and non-employee
directors. Under the Option Plan, a maximum of 2,650,000 shares of our
common stock has been approved to be issued to certain non-employee
directors, and to officers and employees pursuant to stock based awards
granted. Shares with respect to awards under the Option Plan that expire,
are cancelled, or otherwise terminate are added back to the number of
shares issuable under the Option Plan. As of September 30, 2006, options
representing 1,449,620 shares are currently issued and outstanding under
the Option Plan, of which 858,383 shares are vested; 325,806 shares remain
available for grant under the Option Plan.
The Company's policy regarding share issuance upon option exercise takes
into consideration the optionee's eligibility and vesting status. Upon
receipt of an optionee's exercise notice and payment, and the Company's or
the Chairman of the Compensation Committee's subsequent determination of
eligibility, the Company's Chief Governance Officer or the Chairman of the
Compensation Committee instructs our transfer agent to issue shares of our
Common Stock to the optionee.
8
Stock options have been granted with exercise prices at or above the market
price on the date of grant. In most cases, the granted options vest
generally over one year for non-employee directors and ratably over four
years for officers and employees. Beginning in 2006, options granted to
non-employee directors vest ratably and quarterly over one year from the
date of grant. The granted options generally have ten year contractual
terms.
Compensation expense of $1.9 million related to previously granted stock
option awards which are non-vested at September 30, 2006 will be recognized
in future periods. This compensation expense is expected to be recognized
over a weighted-average period of approximately 18 months.
The following summarizes stock option activity for the nine months ended
September 30, 2006.
Weighted Average
Weighted Remaining Aggregate
Number of Average Contractual Intrinsic
Options Exercise Price Term (Years) Value (000's)
---------- -------------- ------------ -------------
Balance at December 31, 2005 1,438,234 3.07
Granted 355,000 10.77
Exercised (222,738) 2.36
Canceled or expired (171,546) 5.99
Balance at September 30, 2006 1,398,950 $ 4.79 7.64 $ 3,124
========== ========= ========== ==========
Exercisable at September 30, 2006 829,750 $ 3.04 6.71 $ 1,853
========== ========= ========== ==========
The total intrinsic value, the difference between the exercise price and
market price on the date of exercise, of options exercised during the three
months and nine months ended September 30, 2006 was $219,000 and $1.0
million, respectively.
Pro Forma Effects
If compensation expense for the stock options that we granted had been
recognized based upon the estimated fair value on the grant date under the
fair value methodology prescribed by SFAS No. 123, as amended by SFAS No.
148 and SFAS No. 123(R), our net income and net income per share for the
three months and nine months ended September 30, 2005 would have been as
follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2005 2005
--------- ---------
(in thousands)
-----------------------------
Net income available for common stock - as reported $ 1,620 $ 4,061
Less compensation expense determined under fair value
method, net of tax (54) (162)
--------- ---------
Net income available for common stock - pro forma $ 1,566 $ 3,899
========= =========
Net income per share - as reported
Basic $ 0.07 $ 0.17
Diluted $ 0.07 $ 0.17
Net income available per share - pro forma
Basic $ 0.07 $ 0.16
Diluted $ 0.06 $ 0.16
9
The fair value of each stock option granted under the Option Plan was
estimated on the date of grant using the Black-Scholes option-pricing
model. The following key assumptions were used to value the option grants
issued during the nine month periods ended September 30, 2005 and 2006.
Weighted Average Average Expected Expected
Risk Free Rate Expected Life Volatility Dividend Yield
-------------- ------------- ---------- --------------
2005 5.5% 3-10 Years 50% 0.00%
2006 4.93 - 5.05% 4 Years 73.8 - 79.1% 0.00%
The Company recognized the pro forma fair value compensation cost on a
straight-line basis over the requisite service period for each separately
vesting portion of each award.
NOTE 3 - FIXED FEE CONTRACTS
Costs, estimated earnings and billings on uncompleted contracts consisted
of the following at September 30, 2006 and December 31, 2005:
September 30, December 31,
2006 2005
-------- --------
(in thousands)
-----------------------
Costs incurred on uncompleted contracts $ 58,153 $ 23,426
Estimated earnings (losses) on uncompleted contracts (968) 4,437
-------- --------
Earned revenues 57,185 27,863
Less billings to date (48,687) (27,490)
-------- --------
Net costs and estimated earnings in excess of billings
on uncompleted contracts $ 8,498 $ 373
======== ========
Costs and estimated earnings in excess of billings on uncompleted contracts $ 9,553 $ 4,148
Less billings and estimated earnings in excess of cost on uncompleted contracts (1,055) (3,775)
-------- --------
Net costs and estimated earnings in excess of billings
on uncompleted contracts $ 8,498 $ 373
======== ========
NOTE 4 - COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) represents net earnings and any revenue,
expenses, gains and losses that, under accounting principles generally
accepted in the United States of America, are excluded from net earnings
and recognized directly as a component of stockholders' equity. For the
nine month period ended September 30, 2006, comprehensive income included a
gain of $3,433 from foreign currency translation adjustments.
NOTE 5 - ACQUISITIONS
The Company's acquisition strategy is focused on developing breadth and
depth of expertise within the organization by continuing to search for
candidates that fit into one of two profiles. First, the Company considers
acquisition candidates with revenues at or over the $10 million that would
provide new service capabilities for its clients. Second, the Company
considers acquisition candidates of various sized operations that have
capabilities similar to those it currently provides and will assist the
Company in gaining a larger position in a given market segment or
geographic location.
The Company purchased Denver-based WRC Corporation ("WRC") on May 25, 2006.
WRC provides integrated land management, engineering, and related services
to the pipeline, power, and transportation industries, among others. WRC
has become a wholly-owned subsidiary of ENGlobal and will now serve as the
Company's provider of land management, environmental compliance and
governmental regulatory services. WRC currently has approximately 200
employees, with revenues in the 12 months prior to the acquisition
exceeding $20 million. The Company expects to utilize WRC's Denver facility
as a beachhead for expansion of its services into the Rocky Mountain and
Western U.S. regions.
10
In exchange for all of the outstanding capital stock of WRC, the Company
paid cash, delivered a promissory note payable over four years, issued
175,000 shares of ENGlobal common stock, and agreed to pay certain
obligations of WRC. At June 30, 2006, goodwill (deductible for tax
purposes) from this transaction was estimated to be $5.9 million. The
acquisition has been accounted for as a purchase in accordance with
Statement of Financial Standards No. 141, "Business Combinations,"
("SFAS141"). The purchase price allocation has been prepared on a
preliminary basis and reasonable changes are expected as additional
information becomes available. Beginning June 2006, ENGlobal included the
WRC operating results in its financial statements.
The unaudited proforma combined historical results, as if the WRC
acquisition had taken place at the beginning of 2006 and 2005,
respectively, are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ---------------------
2006 2005 2006 2005
--------- --------- --------- ---------
(in thousands)
-----------------------------------------------
Revenue as reported $ 59,266 $ 224,196 $ 163,314
Proforma revenues of WRC 4,405 7,146 10,182
--------- --------- ---------
Proforma revenues $ 63,671 $ 231,342 $ 173,496
========= ========= =========
Net income as reported $ 1,620 $ 1,995 $ 4,061
Proforma income (loss) of WRC 12 (804) 130
--------- --------- ---------
Proforma net income $ 1,632 $ 1,191 $ 4,191
========= ========= =========
Basic per share data as reported $ 0.07 $ 0.08 $ 0.17
Proforma basic per share data $ 0.07 $ 0.06 $ 0.18
Diluted per share data as reported $ 0.07 $ 0.07 $ 0.17
Proforma diluted per share data $ 0.07 $ 0.06 $ 0.17
NOTE 6 - GOODWILL
In accordance with Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets", goodwill is no longer amortized
over its estimated useful life, but rather will be subject to at least an
annual assessment for impairment. Goodwill has been allocated to the
Company's two reportable segments. The test for impairment is made on each
of these reporting segments. No impairment of goodwill has been incurred to
date.
NOTE 7 - LINE OF CREDIT AND DEBT
Effective July 27, 2006, the Company and Comerica Bank ("Comerica") entered
into an amendment to the Company's existing Credit Facility (the "Comerica
Credit Facility"). The maturity date of the Comerica Credit Facility was
extended to July 26, 2009 and the limit on the revolving credit note was
increased from $22 million to $30 million, subject to loan covenant
restrictions. The loan agreement positions Comerica as senior to all other
debt. The Comerica Credit Facility is collateralized by substantially all
the assets of the Company. The outstanding balance on the line of credit as
of September 30, 2006 was $19.7 million. The remaining borrowings available
under the line of credit as of September 30, 2006 were $10.3 million after
consideration of loan covenant restrictions.
The Comerica Credit Facility contains covenants requiring the Company, as
of the end of each calendar month, to maintain certain ratios, including
the total funded debt to EBITDA; to total liabilities plus net worth; and
to total funded debt to accounts/unbilled receivables. The Company is also
required, as of the end of each quarter, to maintain minimum levels of net
11
worth, and the Company must comply with an annual limitation on capital
expenditures. The Company was in compliance with all covenants under the
Comerica Credit Facility as of September 30, 2006.
As of September 30, 2006, all standby letters of credit previously issued
to a refining client to cover contractual obligations for progress payments
made to equipment manufacturers for major project items had expired.
September 30, December 31,
2006 2005
--------- --------
(in thousands)
------------------------
Schedule of Long-Term Debt:
Comerica Credit Facility - Line of credit, $12,703,000 at prime and $7,000,000 at
30 day LIBOR plus 150 bps (8.25% and 6.83% respectively at September 30, 2006),
maturing in July 2009 $ 19,703 $ 3,774
Sterling Planet and EDGI - Notes payable, interest at 5%, principal payments in
installments of $15,000 plus interest due quarterly, maturing in December 2008 150 195
Significant PEI Shareholders - Note payable, discounted at 4.5% interest, principal
payments in installments of $208,761 due annually, maturing in December 2006 203 188
Cleveland Inspection Services, Inc., CIS Technical Services and F.D. Curtis - Notes
payable, discounted at 5% interest, principal in installments of $100,000 due
quarterly, maturing in October 2009 1,194 1,444
InfoTech Engineering, Inc. - Note payable, interest at 5%, principal payments in
installments of $65,000 plus interest due annually, maturing in December 2007 130 130
A.T.I. Inc. - Note payable, interest at 6%, principal payments in installments of
$30,422 including interest due monthly, maturing in January 2009 793 --
Michael H. Lee - Note payable, interest at 5%, principal payments in installments of
$150,000 plus interest due quarterly, maturing June 10, 2010 2,250 --
Miscellaneous 20 45
-------- --------
Total long-term debt 24,443 5,776
Less: Current maturities (1,612) (548)
-------- --------
Long-term debt, net of current portion $ 22,831 $ 5,228
======== ========
NOTE 8 - SEGMENT INFORMATION
The Company operates in two business segments: (1) engineering, providing
services primarily to major companies in the hydrocarbon and chemical
processing industries, pipelines, oil and gas development, and cogeneration
units that, for the most part, are located in the United States; and (2)
systems, providing design and implementation of control systems for
specific applications primarily in the energy and process industries, that,
for the most part, are located in the United States.
Beginning January 1, 2006, the Company re-assigned all advanced automation
and integrated controls projects previously reported under the systems
segment to the newly created ENGlobal Automation Group, Inc. ("EAG") within
the engineering segment. Results presented have been reclassified to
reflect the re-assignment.
Results attributable to the activity of the latest acquisition, WRC, are
included in the engineering segment.
Revenue and operating income for each segment are set forth in the
following table. The amount in Corporate includes those activities that are
not allocated to the operating segments and includes costs related to
business development, executive function, finance, accounting, safety,
12
investor relations/governance, human resources, project controls and
information technology that are not specifically identifiable with the two
segments. Intercompany elimination includes the amount of administrative
costs allocated to the segments. Corporate functions support both business
segments and therefore cannot be specifically assigned to either.
Significant portions of Corporate costs are allocated to each segment based
on each segment's labor revenues and eliminated in consolidation.
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2006 2005 2006 2005
--------- --------- --------- ---------
(in thousands)
------------------------------------------------
Revenue:
Engineering $ 76,617 $ 55,923 $ 208,955 $ 152,111
Systems 5,887 3,343 15,241 11,203
--------- --------- --------- ---------
Total revenue $ 82,504 $ 59,266 $ 224,196 $ 163,314
========= ========= ========= =========
Operating income (loss):
Engineering $ 705 $ 5,548 $ 12,192 $ 14,340
Systems (281) (293) (409) (608)
Corporate 348 1,017 749 2,942
Intercompany eliminations (3,027) (3,507) (9,104) (9,664)
--------- --------- --------- ---------
Total operating income $ (2,255) $ 2,765 $ 3,428 $ 7,010
========= ========= ========= =========
Financial information about geographic areas
--------------------------------------------
Revenues from the Company's non-U.S. operations for the three months and
nine months ended September 30, 2006 were $1.5 million and $2.5 million,
respectively. Long-lived assets (principally leasehold improvements and
computer equipment) outside the United States were $94,000 as of September
30, 2006.
NOTE 9 - EARNINGS PER SHARE
The following table reconciles the denominator used to compute basic
earnings per share to the denominator used to compute diluted earnings per
share ("EPS").
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2006 2005 2006 2005
---------- ---------- ---------- ----------
(in thousands)
-------------------------------------------------
Weighted average shares outstanding
(denominator used to compute basic EPS) 26,645,830 23,890,842 26,475,353 23,637,345
Effect of employee and outside director stock options -- 1,007,203 552,578 822,968
---------- ---------- ---------- ----------
Denominator used to compute diluted EPS 26,645,830 24,898,045 27,027,931 24,460,313
========== ========== ========== ==========
NOTE 10 - CONTINGENCIES
Litigation
----------
From time to time, the Company and its subsidiaries become parties to
various legal proceedings arising in the ordinary course of normal business
activities. While we cannot predict the outcome of these proceedings, in
our opinion, and based on reports of counsel, any liability arising from
such matters, individually or in the aggregate, are not expected to have a
material effect upon the consolidated financial position or operations of
the Company.
13
NOTE 11 - SUBSEQUENT EVENTS
On October 6, 2006, the Company, through its wholly-owned subsidiary,
ENGlobal Construction Resources, Inc. ("ECR"), acquired certain assets of
WATCO Management, Inc. ("WATCO"), a Houston-based business providing
construction management, turnaround management, asset management and
project commissioning and start-up services and related services for
projects and facilities located in process plants. The addition of WATCO
will provide ECR with opportunities to expand its current services to
existing WATCO clients in addition to a complementary business allowing
expansion of current services to both existing and future clients. The
aggregate purchase price was $1.0 million, including $500,000 in cash and
an unsecured promissory note in the principal amount of $500,000 payable in
four equal annual installments, bearing interest at the rate of 4% per
annum. The estimate, fair values of the acquired assets include
approximately $800,000 in intellectual property, $52,000 in fixed assets
and $148,000 in goodwill. The Company is in the process of obtaining
third-party valuations of the certain intangible assets; thus the
allocation of the purchase price is subject to adjustment.
In September 2006, the Company, through its wholly-owned subsidiary,
ENGlobal Engineering, Inc., entered into two agreements with SchmArt
Engineering, Inc. based in Beaumont, Texas ("SchmArt"): (1) a one year,
non-exclusive License Agreement on SchmArt's Relief++Software, and (2) a
Hiring Agreement covering the Company's hiring of any SchmArt employee in
the future. In October 2006, the Company responded to two "Notice of Levy"
advisements from the Department of Treasury - Internal Revenue Service
related to taxes owed by SchmArt. The Company has responded to each notice
and fully expects to comply with all requirements of such notices.
Effective September 1, 2006, we entered into an Investment and Development
Agreement (the "Agreement") with US Syngas, LLC, a Delaware limited
liability company ("USS") relating to USS's development of Stage Three of a
coke-to-ammonia plant (the `Project"). The Agreement contemplates an
additional agreement between USS and one of its wholly owned subsidiaries
(the "Subsidiary") to sell the Project's production. Under the Agreement,
ENGlobal invested $100,000 cash, agreed to license sell certain software
valued at $243,750 one month after Project kick-off, and agreed to invest
an additional $156,250 in cash four months after Project kick-off. Two
other investors have invested an aggregate of $4 million in the Project. In
order to meet the milestones required for construction financing, USS will
need to raise significant additional construction financing and the
Subsidiary will need to enter into agreements for an unspecified amount of
debt financing and equity financing (the "Equity Financing").
The Agreement contemplates the formation of a limited liability company in
which USS will own all of the common Unites and ENGlobal and other
investors will own Preferred Units. ENGlobal will receive interest at the
rate of 7% per annum on the Preferred Units, or if ENGlobal fully funds its
required investment, the Preferred Units will be redeemed at 175% of
ENGlobal's investment. USS will have a right to convert ENGlobal's
investment into securities to be issued in the equity financing. In
addition, ENGlobal will have a right to invest in the Equity Financing.
On May 25, 2006, the Company, through its wholly-owned subsidiary ENGlobal
Corporate Services, Inc., purchased a one-third partnership interest in PEI
Investments, A Texas Joint Venture ("PEI"), from Michael L. Burrow, the
Company's President and CEO, and another one-third interest from a
stockholder who owns less than 1% of the Company's common stock. The
partnership interests were purchased for a total of $69,000. The remaining
one-third interest was already held by the Company through its wholly-owned
subsidiary EEI. PEI owns the land on which our Beaumont, Texas office
building, destroyed by Hurricane Rita in September 2005, was located. The
remains of the building were razed in July 2006. In September 2006, the
Company acquired approximately 1.2 acres immediately adjacent to the former
facility and is developing plans to construct a new facility utilizing both
parcels of land. On October 26, 2006, the Company received final proceeds
in the amount of $200,456 from an insurance claim for the building.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
--------------------------
Certain information contained in this Form 10-Q, the Company's Annual
Report on Form 10-K, as well as other written and oral statements made or
incorporated by reference from time to time by the Company and its
representatives in other reports, filings with the Securities and Exchange
Commission, press releases, conferences, or otherwise, may be deemed to be
forward-looking statements with the meaning of Section 21E of the
Securities Exchange Act of 1934. This information includes, without
limitation, statements concerning the Company's future financial position
and results of operations; business strategy and other plans for future
operations; the future mix of revenues and business; customer retention;
project reversals; commitments and contingent liabilities; and future
demand and industry conditions. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable,
it can give no assurance that such expectations will prove to have been
correct. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. Generally, the words "anticipate," "believe,"
"estimate," "expect," "may," and similar expressions, identify
forward-looking statements, which generally are not historical in nature.
Actual results could differ materially from the results described in the
forward-looking statements due to the risks and uncertainties set forth in
this Form 10-Q, the specific risk factors identified in the Company's
Annual Report on Form 10-K for the year ended December 31, 2005 and those
described from time to time in our future reports filed with the Securities
and Exchange Commission.
The following discussion is qualified in its entirety by, and should be
read in conjunction with, the Company's Consolidated Financial Statements,
including the notes thereto, included in this Form 10-Q and the Company's
Annual Report on Form 10-K for the year ended December 31, 2005.
MD&A Overview
-------------
The following list sets forth a general overview of the more significant
changes in our Company's financial condition and results of operations for
the three and nine month periods ended September 30, 2006, compared to the
corresponding periods in 2005.
During the three month period During the nine month period
ended September 30, 2006 ended September 30, 2006
-------------------------------------------------------------
Revenue Increased 39.2% Increased 37.3%
Gross profit Decreased 42.0% Increased 12.9%
SG&A expense Increased 34.1% Increased 45.4%
Operating income Decreased 181.6% Decreased 51.1%
Net income Decreased 196.9% Decreased 50.9%
Long-term debt, net of current portion, increased 337%, or $17.6 million,
from $5.2 million at December 31, 2005 to $22.8 million at September 30,
2006, and as a percentage of stockholders' equity, long-term debt increased
from 13.1% to 50.9% at these same dates. The increase in long-term debt is
primarily attributable to approximately $10.4 million used to acquire the
assets of ATI and the stock of WRC, additional investments in capital
equipment totaling approximately $2.8 million, plus delays in collections
of fees, primarily on a new alliance contract, totaling approximately $5.6
million. The increase in the ratio of long-term debt as a percentage of
stockholders' equity for the comparable periods is primarily the result of
the increase in total long-term debt along with the negative impact to
stockholders' equity as a result of the Company's current reporting period
loss.
Primarily due to losses incurred on two fixed-price contracts, we recorded
a net loss of $1.6 million, or $(0.06) per diluted share for the three
months ended September 30, 2006, compared to net income of $1.6 million, or
$0.07 per diluted share for the corresponding period last year. We recorded
15
net income of $2.0 million, or $0.07 per diluted share for the nine months
ended September 30, 2006, compared to net income of $4.1 million, or $0.17
per diluted share for the corresponding period last year.
We adopted SFAS 123(R) on January 1, 2006, and our results of operations
for the three and nine months ended September 30, 2006, respectively,
include $404,000 and $895,000 of expense related to stock options. These
amounts have been included SG&A expense in the accompanying Condensed
Consolidated Statements of Income.
Stockholders' equity increased 12.5%, or $5.0 million, from $39.9 million
as of December 31, 2005 to $44.9 million as of September 30, 2006.
Critical Accounting Policies
----------------------------
A summary of critical accounting policies is disclosed in Note 2 to the
Consolidated Financial Statements included in our 2005 Annual Report on
Form 10-K. Our critical accounting policies are further described under the
caption "Critical Accounting Policies" in Management's Discussion and
Analysis of Financial Condition and Results of Operation in our 2005 Annual
Report on Form 10-K. Other than the adoption of SFAS No. 123(R), which is
described in Note 2 to the Interim Condensed Consolidated Financial
Statements included in this Form 10-Q, there have been no changes in the
nature of our critical accounting policies or the application of those
policies since December 31, 2005.
16
Results of Operations
---------------------
The following table illustrates the composition of the Company's revenue
and operating expense mix quarter over quarter for the three and nine-month
periods ended September 30, 2006 and 2005, and provides a comparison of the
changes in revenue and operating expense and trends period over period:
Consolidated Results of Operations for the Three and Nine Months
Ended September 30, 2006 and 2005
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- -----------------------------------------
2006 2005 2006 2005
----------------- ----------------- ------------------- ------------------
(dollars in thousands)
----------------------------------------------------------------------------------
Revenue:
Engineering $ 69,311 84.0 % $ 50,866 85.8 % $ 198,984 88.8 % $ 140,876 86.3 %
Systems 5,887 7.1 % 3,343 5.6 % 15,241 6.8 % 11,203 6.9 %
Acquisition 7,306 8.9 % 5,057 8.6 % 9,971 4.4 % 11,235 6.9 %
-------- -------- --------- ---------
Total revenue $ 82,504 100.0 % $ 59,266 100.0 % $ 224,196 100.0 % $ 163,314 100.0 %
======== ======== ========= =========
Gross profit:
Engineering $ 3,456 5.0 % $ 7,157 14.1 % $ 21,035 10.6 % $ 18,907 13.4 %
Systems 123 2.1 % 203 6.1 % 1,087 7.1 % 850 7.6 %
Acquisition 970 13.3 % 478 9.5 % 1,377 13.8 % 1,059 9.4 %
-------- -------- --------- ---------
Total gross profit 4,549 5.5 % 7,838 13.2 % 23,499 10.5 % 20,816 12.7 %
-------- -------- --------- ---------
SG&A expense:
Engineering 3,203 4.6 % 1,814 3.6 % 9,436 4.7 % 4,859 3.5 %
Systems 404 6.9 % 496 14.9 % 1,496 9.8 % 1,458 13.0 %
Corporate 2,679 3.2 % 2,490 4.2 % 8,355 3.7 % 6,722 4.1 %
Acquisition 518 7.1 % 273 5.4 % 784 7.9 % 767 6.8 %
-------- -------- --------- ---------
Total SG&A expense 6,804 8.2 % 5,073 8.6 % 20,071 8.9 % 13,806 8.5 %
-------- -------- --------- ---------
Operating income:
Engineering 253 0.4 % 5,343 10.5 % 11,599 5.8 % 14,048 10.0 %
Systems (281) (4.8)% (293) (8.8)% (409) (2.7)% (608) (5.4)%
Corporate (2,679) (3.2)% (2,490) (4.2)% (8,355) (3.7)% (6,722) (4.1)%
Acquisition 452 6.2 % 205 4.1 % 593 6.0 % 292 2.6 %
-------- -------- --------- ---------
Total operating income (2,255) (2.7)% 2,765 4.7 % 3,428 1.5 % 7,010 4.3 %
-------- -------- --------- ---------
Other income (expense), net (391) (0.5)% (193) (0.3)% (397) (0.2)% (564) (0.3)%
Tax provision 1,076 1.3 % (952) (1.6)% (1,036 (0.5)% (2,385) (15)%
-------- -------- --------- ---------
Net income $ (1,570) (1.9)% $ 1,620 2.7 % $ 1,995 0.9 % $ 4,061 2.5 %
======== ======== ========= =========
17
Other financial comparisons:
----------------------------
As of September 30,
-------------------
2006 2005
------- -------
(in thousands)
-----------------
Working capital $35,503 $18,334
Total assets $99,384 $63,286
Long-term debt, net of current portion $22,831 $ 1,826
Stockholders' equity $44,882 $39,023
In the results presented for the three and nine months ended September 30,
2006, "Acquisition" totals include the results of operations related to the
acquisition of WRC. All previous acquisitions have been fully integrated
and reported in segment details. In the results presented for the three and
nine months ended September 30, 2005, "Acquisition" totals include the
combined results of operations related to assets acquired from Cleveland
Inspection Services, Inc. ("Cleveland") and AmTech Inspection, LLC
("AmTech"). For analytical purposes only, results from acquired companies
or acquired assets are shown separately for the first 12 months after
closing.
Results presented for the three and nine months ended September 30, 2005
have been reclassified to more closely conform to the 2006 presentation.
Primarily due to losses incurred on two fixed-price contracts, we recorded
a net loss of $1.6 million, or $(0.06) per diluted share for the three
months ended September 30, 2006, compared to net income of $1.6 million, or
$0.07 per diluted share for the corresponding period last year. We recorded
net income of $2.0 million, or $0.07 per diluted share for the nine months
ended September 30, 2006, compared to net income of $4.1 million, or $0.17
per diluted share for the corresponding period last year. We adopted SFAS
123(R) on January 1, 2006, and our results of operations for the three and
nine months ended September 30, 2006, respectively, include $404,000 and
$895,000 of expense related to stock options. These amounts have been
included SG&A expense in the accompanying Condensed Consolidated Statements
of Income.
The following table compares the effects of SFAS 123(R) on net income
(loss) and earnings per share for the three and nine months ended September
30, 2006.
Three Months Nine Months
Ended Ended
---------- ---------
September 30, 2006
-----------------------
(in thousands)
-----------------------
Net income (loss)
As reported $ (1,570) $ 1,995
Effect of SFAS 123(R) (net of tax) 188 417
--------- ---------
Net income (loss) before the effects of SFAS 123(R) $ (1,382) $ 2,412
========= =========
Diluted earnings per share
As reported $ (0.06) $ 0.07
Effect of SFAS 123(R) 0.01 0.01
--------- ---------
Net earnings per share before the effects of SFAS 123(R) $ (0.05) $ 0.08
========= =========
18
The following table presents, for the periods indicated, the approximate
percentage of total revenues and operating income or loss attributable to
our reporting segments:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- -----------------
2006 2005 2006 2005
------ ------ ------ ------
Revenue:
Engineering 92.9% 94.4% 93.2% 93.1%
Systems 7.1% 5.6% 6.8% 6.9%
Operating income (loss):
Engineering 166.3% 105.6% 103.5% 104.4%
Systems (66.3)% (5.6)% (3.5)% (4.4)%
The Company's revenue is composed of engineering, construction and
procurement service revenue and revenue from our manufactured systems
sales. We recognize service revenue as soon as the services are performed.
The majority of our engineering services have historically been provided
through cost-plus contracts whereas a majority of the Company's systems
sales are earned on fixed-price contracts. However, our engineering segment
recognized approximately $12.4 million and $27.2 million in fixed-price
revenue in the three and nine month periods ended September 30, 2006,
compared to approximately $3.3 million and $6.3 million of similar revenues
in each of the same periods in 2005.
Revenue on fixed-price contracts is recorded primarily using the
percentage-of-completion (cost-to-cost) method. Under this method, revenue
on long-term contracts is recognized in the ratio that contract costs
incurred bear to total estimated contract costs. Revenue and gross margin
on contracts are subject to revision throughout the lives of the contracts
and any required adjustments are made in the period in which the revisions
become known. Losses on contracts are recorded in full as they are
identified.
In the course of providing our complement of services, we routinely provide
engineering, materials, and equipment and may provide construction services
on a subcontractor basis. Generally, these materials, equipment and
subcontractor costs are passed through to our clients and reimbursed, along
with fees, which, in total, are at margins much lower than those of our
core business. In accordance with industry practice and generally accepted
accounting principles, all such costs and fees are included in revenue. The
use of subcontractor services and purchase of materials can change
significantly from project to project; therefore, changes in revenue may
not be indicative of business trends.
For analytical purposes only, we segregate from our total revenue the
revenues derived from material assets or companies acquired during the
first 12 months following their respective dates of acquisition and we
refer to such revenue as "Acquisition" revenue. We also segregate gross
profits and SG&A expenses derived from material assets or company
acquisitions on the same basis as we segregate revenues. We elected not to
segregated the revenue, gross profit and SG&A expenses resulting from
acquired assets of ATI primarily because almost immediate following the
close of that transaction those assets and the ATI staff were fully
integrated into the ESI's facility and operation. We analyze, for internal
purposes only, the percentage of our revenue that comes from staffing
services versus the percentage that comes from engineering services, as
engineering services have a higher margin than field or staffing services.
Operating SG&A expense includes management and staff compensation, office
costs such as rents and utilities, depreciation, amortization, travel and
other expenses generally unrelated to specific client contracts, but
directly related to the support of a segment's operation.
Corporate SG&A expense is comprised primarily of marketing costs, as well
as costs related to the executive, governance/investor relations, finance,
accounting, safety, human resources, project controls and information
technology departments and other costs generally unrelated to specific
client projects, but which are incurred to support corporate activities and
initiatives.
19
The Company's acquisition strategy is focused on developing breadth and
depth of expertise within the organization by continuing to search for
candidates that fit into one of two profiles. First, the Company considers
acquisition candidates with revenues at or over the $10 million that would
provide new service capabilities for its clients. Second, the Company
considers acquisition candidates of various sized operations that have
capabilities similar to those it currently provides in order to assist the
Company in gaining a larger position in a given market segment or
geographic location.
Industry Overview:
Downstream
Many ENGlobal offices have benefited from the strong market for refining
related projects. We expect significant capital projects to be generated by
refinery operations over the next several years and we will continue to
research other markets that value our services. Overall, projects in the
U.S. for expanding refining capacity and for utilization of heavy sour
crude as feed-stocks are trending upward, while projects actively related
to environmental mandates have peaked and are trending downward. As stated
in our 2003 annual letter to stockholders, the global demand for oil
products has tightened the supply of both crude oil as well as refinery
products. With this current demand, we believe each of ENGlobal's business
segments are well positioned within the industry if refinery capacity in
the U.S. and the overseas markets continues to rise.
The petrochemical industry has recently been a good source of projects for
ENGlobal. In the last two years, we have seen an increase in petrochemical
capital spending after an extended period of relative inactivity. The
petrochemical industry along the Gulf Coast, has for the most part
recovered from the aftermath of the hurricanes, with construction
contractors and material suppliers being the primary beneficiary of the
recovery effort. Our major workload in the petrochemical area continues to
be smaller capital and maintenance projects for U.S. plants.
Midstream
Capital spending for major pipeline projects is projected to be robust,
after several years of lower activity that resulted in part from pipeline
operators' diversion of their capital budgets to mandated integrity
projects. New pipeline projects are being planned to transport natural gas
from several new LNG plants; for new crude deliveries from Canada to
facilitate new refinery and petrochemical plants; and for fuel supplies to
new co-generation and power plants. In addition, large pipeline capital
projects are currently being planned to deliver natural gas away from the
Rocky Mountain region, and also to deliver refined products to various
locations, but primarily to the Midwest and Northeast U.S. Pipeline
projects tend to require less engineering man hours as the scope of
engineering work is typically smaller than for similarly sized downstream
projects. ENGlobal is positioned to participate in pipeline related land
regulatory services through its 2006 acquisition of WRC, and in inspection
services through its 2004 acquisition of Cleveland Inspection
Upstream
We do not have a significant market presence in the upstream sector.
Currently, our only revenues in the upstream markets come from projects for
remote instrument building and gas processing facilities. However, the
Company will consider acquisition targets in this area to increase the
suite of capabilities already offered to our clients.
Alternative Fuels
High prices for energy related commodities, as well as governmental
initiatives and incentives, have created increasing demand for sources of
alternative energy. Alternative energy sources currently supply
approximately 6% of U.S. energy demand, with approximately 47% of the
alternative sources coming from biomass processes such as ethanol. It is
expected that the number and scope of ENGlobal's alternative energy related
projects will increase along with an expanding market, and that the
Company's participation will primarily be in biomass related processes.
Revenue:
Revenue increased $23.2 million, or 39.2%, to $82.5 million for the three
months ended September 30, 2006 from $59.3 million for the comparable prior
year period, with approximately $20.7 million of the increase coming from
our engineering segment and $2.5 million attributable to our systems
segment.
20
Revenue increased $60.9 million, or 37.3%, to $224.2 million for the nine
months ended September 30, 2006 from $163.3 million for the comparable
prior year period with approximately $56.9 million of the increase coming
from our engineering segment and $4.0 million attributable to our systems
segment.
Gross Profit:
Gross profit decreased $3.3 million, or 42.0%, to $4.5 million for the
three months ended September 30, 2006 from $7.8 million for the comparable
prior year period. As a percentage of revenue, gross profit decreased 7.7%
from 13.2% for the three months ended September 30, 2005 to 5.5% for the
three months ended September 30, 2006. Of the overall $3.3 million decrease
in gross profit, approximately $3.1 million was due to the increase in
revenue and approximately $6.4 million was due to increased costs. The
primary reason for increased costs and the decrease in gross profit during
the period relates to approximately $6.6 million from productivity delays
and cost overruns on two fixed price EPC projects in the Company's
engineering segment.
Gross profit increased $2.7 million, or 12.9%, to $23.5 million for the
nine months ended September 30, 2006 from $20.8 million for the comparable
prior year period. As a percentage of revenue, gross profit decreased 2.2%
from 12.7% for the nine months ended September 30, 2005 to 10.5% for the
quarter ended September 30, 2006. Of the overall $2.7 million increase in
gross profit, approximately $7.8 million was due to the increase in revenue
and approximately $5.1 million was due to increased costs. Again, the
primary reason for increased costs and the decrease in gross profit during
the period relates to approximately $6.6 million from productivity delays
and cost overruns on two fixed price EPC projects in the Company's
engineering segment.
At September 30, 2006, we had outstanding unapproved change orders/claims
of approximately $2.4 million, net of reserves of $1.2 million associated
with ongoing projects. If in the future we determine collection of these
unapproved change orders/claims is not probable, it would result in a
charge to earnings in the period such determination is made.
Selling, General, and Administrative:
As a percentage of revenue, total SG&A expense decreased 0.4% to 8.2% for
the three months ended September 30, 2006 from 8.6% for the comparable
period in 2005. Total expense for SG&A increased $1.7 million, or 34.1%, to
$6.8 million for the three months ended September 30, 2006 from $5.1
million for the comparable prior year period.
As a percentage of revenue, Operating SG&A expense increased 0.6%, from
4.4% to 5.0% and 0.8% from 4.4% to 5.2% for the three and nine month
periods, respectively, ended September 30, 2006 and the comparable 2005
periods. Operating SG&A increased approximately $1.5 million, from $2.6
million to $4.1 million, and $4.6 million, from $7.1 million to $11.7
million for the three and nine month periods ended September 30, 2006
against results for the comparable prior year periods of 2005. The
variances in Operating SG&A expense are discussed in further detail under
segment results.
As a percentage of revenue, Corporate SG&A expense decreased 1.0% to 3.2%
for the three months ended September 30, 2006 from 4.2% for the comparable
prior year period. Corporate SG&A expense increased approximately $200,000,
or 8.0%, to $2.7 million for the three months ended September 30, 2006 from
$2.5 million for the comparable prior year period. The major areas
impacting the quarter over quarter increase in Corporate SG&A expense were
the general investment in support of both our current and long-term growth
plans, plus the addition of stock-based compensation expense offset by
lower executive and key manager incentive plan expense with each
contributing $724,000, $176,000 and ($700,000), respectively. During the
three months ended September 30, 2006, we invested approximately $245,000
towards business development related activities; $131,000 toward investor
relations; $107,000 to our continuing upgrade in the area of information
technology; $68,000 toward ongoing efforts to standardize and improve our
project controls systems and procedures plus approximately $173,000 divided
between the areas of accounting, executive, human resources and safety.
As a percentage of revenue, total SG&A expense increased 0.4% to 8.9% for
the nine months ended September 30, 2006 from 8.5% for the comparable
period in 2005. Total expense for SG&A increased $6.3 million, or 45.4%, to
$20.1 million for the nine months ended September 30, 2006 from $13.8
million for the comparable prior year period.
21
As a percentage of revenue, Corporate SG&A expense decreased 0.4% to 3.7%
for the nine months ended September 30, 2006 from 4.1% for the comparable
prior year period. Corporate SG&A expense increased approximately $1.7
million, or 25.4%, to $8.4 million for the nine months ended September 30,
2006 from $6.7 million for the comparable prior year period. The major
areas impacting the year over year increase in Corporate SG&A expense were
the general investment in support of both our current and long-term growth
plans, plus the addition of stock-based compensation expense offset by
lower executive and key manager incentive plan expense with each
contributing $2,307,000, $393,000 and ($1,000,000), respectively. During
the nine months ended September 30, 2006, we invested approximately
$1,044,000 towards business development related activities; $331,000 to our
continuing upgrade in the area of information technology; $219,000 toward
ongoing efforts to standardize and improve our project controls systems and
procedures; $170,000 toward investor relations and governance plus
approximately $543,000 in the areas of accounting, executive, human
resources and safety.
In the course of providing our services, we routinely provide engineering,
materials, and equipment and may provide construction services on a
subcontractor basis. Generally, these materials, equipment and
subcontractor costs are passed through to our clients and reimbursed, along
with fees, which, in total, are at margins much lower than those of our
normal core business. In accordance with industry practice and generally
accepted accounting principles, all such costs and fees are included in
revenue. The use of subcontractor services and purchase of materials can
change significantly from project to project; therefore, changes in revenue
may not be indicative of business trends.
For analytical purposes, if we adjusted total revenue by excluding these
subcontractor services and all other non-labor revenue, Corporate SG&A as a
percentage of this adjusted revenue would have actually shown a decrease of
2.3% for the three months ended September 30, 2006 and a decrease of 1.2%
for the nine months ended September 30, 2006 when compared to similar
periods in 2005.
Operating Income:
Operating income decreased approximately $5.0 million, or 181.6%, to $(2.3)
million for the three months ended September 30, 2006 from $2.8 million
compared to the same period in 2005. As a percentage of revenue, operating
income decreased 7.4% to (2.7%) for the three months ended September 30,
2006 from 4.7% for the comparable prior year period.
Operating income decreased approximately $3.6 million, or 51.1%, to $3.4
million for the nine months ended September 30, 2006 from $7.0 million
compared to the same period in 2005. As a percentage of revenue, operating
income decreased 2.8% to 1.5% for the nine months ended September 30, 2006
from 4.3% for the comparable prior year period.
Other Income (Expense):
Other expense increased $198,000, to $391,000 for the three month period
ended September 30, 2006 from $193,000 for the comparable prior year period
primarily due to an increase in interest on our debt facility. Other
expense decreased $167,000, to $397,000 for the nine month period ended
September 30, 2006 from $564,000 for the comparable prior year period,
primarily due to receipt of a partnership distribution of $350,000 from
PEI, plus additional proceeds related to insurance claims for building
damages from Hurricane Rita in September 2005 as discussed above.
Tax Provision:
Income tax expense decreased $2.1 million, or 213.0%, to ($1.1) million for
the three months ended September 30, 2006 from $1.0 million for the
comparable prior year period as a result of losses on two fixed-price
contracts.
Income tax expense decreased $1.4 million, or 56.6%, to $1.0 million for
the nine months ended September 30, 2006 from $2.4 million for the
comparable prior year period.
The estimated effective tax rate was 40.7% and 34.2% for the three and
nine-month periods ended September 30, 2006, respectively, compared to 37%
for both comparable prior year periods. The change in the effective tax
rate is affected by the deferred tax benefit arising from recognition of
stock-based compensation on non-qualified options vesting each quarter.
22
The estimated effective tax rates are based on estimates using historical
rates adjusted by recurring and non-recurring book to tax differences.
Estimates at September 30, 2006 include the effect of non-recurring
differences in tax estimates from the 2005 year-end and are based on
results of the 2005 year end, and are adjusted for estimates of
non-recurring differences from the prior year.
Net Income:
Net income for the three months ended September 30, 2006 decreased $3.2
million, or 200.0%, to $(1.6) million from $1.6 million for the comparable
prior year period. As a percentage of revenue, net income decreased to
(1.9)% for the three month period ended September 30, 2006 from 2.7% for
the period ended September 30, 2005.
Net income for the nine months ended September 30, 2006 decreased $2.1
million, or 51.2%, to $2.0 million from $4.1 million for the comparable
prior year period. As a percentage of revenue, net income decreased to 0.9%
for the nine month period ended September 30, 2006 from 2.5% for the period
ended September 30, 2005.
23
Segment Results
---------------
Engineering
The following table illustrates the composition of our engineering segment
revenue and operating expense mix quarter over quarter for the three and
nine-month periods ended September 30, 2006 and 2005, and provides a
comparison of the changes in revenue and operating expense and trends
period over period:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------- -------------------------------------
2006 2005 2006 2005
----------------- ----------------- ----------------- -----------------
(dollars in thousands)
-----------------------------------------------------------------------------
Revenue:
Engineering $ 69,311 90.5% $ 50,866 91.0% $198,984 95.2% $140,876 92.6%
Acquisition 7,306 9.5% 5,057 9.0% 9,971 4.8% 11,235 7.4%
-------- -------- -------- --------
Total revenue $ 76,617 100.0% $ 55,923 100.0% $208,955 100.0% $152,111 100.0%
======== ======== ======== ========
Gross profit:
Engineering $ 3,456 5.0% $ 7,157 14.1% $ 21,035 10.6% $ 18,907 13.4%
Acquisition 970 13.3% 478 9.5% 1,377 13.8% 1,059 9.4%
-------- -------- -------- --------
Total gross profit 4,426 5.8% 7,635 13.7% 22,412 10.7% 19,966 13.1%
-------- -------- -------- --------
Operating SG&A expense:
Engineering 3,203 4.6% 1,814 3.6% 9,436 4.7% 4,859 3.4%
Acquisition 518 7.1% 273 5.4% 784 7.9% 767 6.8%
-------- -------- -------- --------
Total SG&A expense 3,721 4.9% 2,087 3.8% 10,220 4.9% 5,626 3.7%
-------- -------- -------- --------
Operating income:
Engineering 253 0.4% 5,343 10.5% 11,599 6.1% 14,048 10.0%
Acquisition 452 6.2% 205 4.1% 593 6.0% 292 2.6%
-------- -------- -------- --------
Total operating income $ 705 0.9% $ 5,548 10.0% $ 12,192 5.8% $ 14,340 9.4%
-------- -------- -------- --------
Overview:
Summary of financial results during the three and nine-month periods ended
September 30, 2006 compared to the three and nine month periods ended
September 30, 2005
Revenue up 36.7% quarter-over-quarter and 37.4% year-over-year
Gross profit down 42.0% quarter-over-quarter and up 12.3%
year-over-year
Operating SG&A as a percent of revenue up 1.5% quarter-over-quarter
and 1.4% year-over-year
Operating income down 87.3% for quarter-over-quarter and 15.0%
year-over-year
The primary reason for the decline in the overall financial results during
the most recent quarter can be attributed to approximately $6.6 million in
losses on two fixed price EPC projects as a result of material escalation
and productivity delays.
Our engineering segment continues to benefit from a large project load
generated primarily by its downstream clients and to a lesser extent by its
midstream clients. The industry's refining segment continues to be very
active supplying a large percentage of our backlog. ENGlobal is benefiting
from the renewed interest of its chemical/petrochemical clients in
maintenance and retrofit projects as product margins in this marketplace
improve. The Company is also benefiting from increased activity for
pipeline related and alternative energy projects.
24
Beginning January 1, 2006, we re-assigned all advanced automation and
integrated controls projects previously reported under the systems segment
to the newly created EAG within the engineering segment. Results presented
for the first quarter of 2005 have been reclassified to reflect this
re-assignment.
In the results presented for the three and nine months ended September 30,
2006, "Acquisition" totals include the results of operations of WRC.
Acquisition totals for the three and nine months ended September 30, 2005
include results of operations related to assets acquired from Cleveland and
Amtech.
Revenue:
Revenue in our engineering segment increased $20.6 million, or 36.7%, to
$76.6 million for the three months ended September 30, 2006 from $56.0
million for the comparable prior year period.
Revenue increased $56.9 million, or 37.4%, to $209.0 million for the nine
months ended September 30, 2006 from $152.1 million for the comparable
prior year period.
The following table illustrates the composition of our revenue mix quarter
over quarter for the three and nine-month periods ended September 30, 2006
and 2005, and provide a comparison of the changes in revenue and revenue
trends period over period:
Three Months Ended September 30,
----------------------------------------------------
2006 % rev 2005 % rev $ change % change
---- ----- ---- ----- -------- --------
(dollars in millions)
Detail-design $33.9 44% $21.6 39% $ 12.3 57 %
Field services 29.0 38% 14.3 26% 14.7 103 %
Procurement & construction 1.3 2% 16.7 30% (15.4) (92)%
Design-build fixed price 12.4 16% 3.3 5% 9.1 276 %
----- ----- ------
$76.6 100% $55.9 100% $ 20.7
===== ===== ======
Nine Months Ended September 30,
-------------------------------------------------------
2006 % rev 2005 % rev $ change % change
---- ----- ---- ----- -------- --------
(dollars in millions)
Detail-design $ 89.9 43% $ 67.3 44% $ 22.6 34 %
Field services 73.7 35% 39.8 26% 33.9 85 %
Procurement & construction 18.2 9% 38.7 26% (20.5) (53)%
Design-build fixed price 27.2 13% 6.3 4% 20.9 332 %
------ ------ -------
$209.0 100% $152.1 100% $ 56.9
====== ====== =======
The largest increase in revenue came from our core detail-design and field
services, which also includes inspection and land services, activity which
increased $27.0 million, or 75%, to $62.9 million for the third quarter of
2006 from $35.9 million for the comparable period in 2005 and on a combined
basis accounted for approximately 82% and 78% of engineering's total
revenue mix for the three and nine month periods ended September 30, 2006,
respectively. Design-build revenue increased $9.1 million, or 276%, from
$3.3 million for the three month period ended September 30, 2005 to $12.4
million for the same period in 2006 and accounted for approximately 16% of
engineering's total revenue during the three month period. Design-build
revenue increased $20.9 million, or 332%, from $6.3 million to $27.2
million for the nine month period ended September 30, 2006 compared to the
comparable prior year period and during the current nine month period
accounted for approximately 11% of engineering's total revenue. Revenue
from non-labor procurement and construction activity decreased $15.4
million from $16.7 million during the three months ended September 30, 2005
to $1.3 million for the third quarter of 2006 and was down $20.5 million
from $38.7 million during the nine months ended September 30, 2005 to $18.2
million for the comparable period in 2006. Due to projects requiring
procurement or construction support being completed, or nearing completion,
procurement and construction revenue has decreased as a percentage of total
engineering revenue from 30% to 2% and 26% to 9% for the comparable three
and nine month periods ended September 30, 2005 and September 30, 2006.
Individually, our field services revenue was the most significant
contributor to our overall $20.7 million revenue increase for the three
months ended September 30, 2006 adding $14.7 million and increasing its
25
share of our overall revenue from 26% for the three months ended September
30, 2005 to 38% for the third quarter of 2006. Field services revenue was
also a major growth area during the nine month period ended September 30,
2006 increasing $33.9 million to $73.7 million, or 85%, from $39.8 million
for the comparable period in 2005 and grew as a percentage of engineering's
total revenue from 26% during the nine month period ended September 30,
2005 to 35% for the same period during 2006. Field services revenue
includes $7.3 million and $10.0 million related to the acquisition of WRC
for the three and nine month periods ended September 30, 2006,
respectively. Although management anticipates positive trends for all
labor-based revenue, we expect the growth trend in both detail-design and
design-build projects to continue to bring opportunities from both current
and new clients.
Gross Profit:
Gross profit decreased $3.2 million, or 42.0%, to $4.4 million for the
three months ended September 30, 2006 from $7.9 million for the comparable
period in 2005, and, as a percentage of revenue, decreased by 7.4% from
13.7% to 5.8% for the three month periods ended September 30, 2005 and
2006, respectively. Of the overall $3.2 million decrease in gross profit,
approximately $2.8 million was attributable to the $20.7 million increase
in total revenue offset by approximately $6.0 million in higher costs. The
primary reason for increased costs and the decrease in gross profit during
the period relates to approximately $6.6 million from productivity delays
and cost overruns on two fixed price EPC projects. Excluding approximately
$6.6 million of charges related to the two fixed price EPC projects and on
a proforma basis, our engineering segment's gross profit for the three
months ended September 30, 2006 would have been approximately $11.0
million, or approximately 14.3% as a percentage of revenue. Overall, total
losses related to fixed price projects were approximately $6.7 million
during the quarter.
Gross profit increased $2.4 million, or 12.3%, to $22.4 million for the
nine months ended September 30, 2006 from $20.0 million for the comparable
period in 2005, and, as a percentage of revenue, decreased by 2.5% from
13.2% to 10.7% for the nine month periods ended September 30, 2005 and
2006, respectively. Of the overall $2.4 million increase in gross profit,
approximately $7.5 million was attributable to the $56.9 million increase
in total revenue offset by approximately $5.1 million in higher costs. The
primary reason for increased costs and the decrease in gross profit during
the period relates to approximately $6.6 million from productivity delays
and cost overruns on two fixed price EPC projects. Excluding approximately
$6.6 million of charges related to the two fixed price EPC projects and on
a proforma basis, our engineering segment's gross profit for the nine
months ended September 30, 2006 would have been approximately $29.0
million, or approximately 13.9% as a percentage of revenue. Overall, total
losses related to fixed price projects were approximately $7.1 million
during the nine months ended September 30, 2006.
At September 30, 2006 we had outstanding unapproved change orders/claims of
approximately $2.4 million, net of reserves of $1.2 million associated with
ongoing projects. If in the future, we determine collection of these
unapproved change orders/claims is not probable, it would result in a
charge of $1.2 million to earnings in the period such determination is
made.
Selling, General, and Administrative:
As a percentage of revenue, SG&A expense increased to 4.9% for the three
month period ended September 30, 2006 from 3.8% for the three month period
ended September 30, 2005. SG&A expense increased approximately $1.6
million, or 78.3%, to $3.7 million for the three months ended September 30,
2006 from $2.1 million for the comparable prior year period. The increase
in SG&A expense includes costs of $322,000 attributable to the support of
expanded facilities to meet both current and projected growth requirements;
$463,000 related to new costs related to the start-up of EAG; $518,000
related to new costs associated to the acquisition of WRC; $128,000 in
stock-compensation expense and $169,000 in other additional costs.
As a percentage of revenue, SG&A expense increased to 4.9% for the nine
month period ended September 30, 2006 from 3.7% for the nine month period
ended September 30, 2005. SG&A expense increased approximately $4.6
million, or 81.7%, to $10.2 million for the nine months ended September 30,
2006 from $5.6 million for the comparable prior year period. The increase
in SG&A expenses included $1,264,000 attributable to the support of
expanded facilities to meet both current and projected growth requirements;
$762,000 in salaries and benefits; $1,157,000 in new costs related to the
start-up of EAG; $784,000 in new costs related to the acquisition of WRC;
$270,000 in stock-compensation expense and $363,000 in additional costs.
26
Operating Income:
Operating income decreased $4.8 million, or 87.3%, to $0.7 million for the
three months ended September 30, 2006 from $5.5 million for the comparable
prior year period. As a percentage of revenue, operating income decreased
to 0.9% for the three months ended September 30, 2006 from 10.0% for the
comparable prior year period. Excluding approximately $6.6 million of
losses related to the two fixed price EPC projects and on a proforma basis,
our engineering segment's operating income for the three months ended
September 30, 2006 would have been approximately $7.3 million, or
approximately 9.5% as a percentage of revenue.
Operating income decreased $2.1 million, or 15.0%, to $12.2 million for the
nine months ended September 30, 2006 from $14.3 million for the comparable
prior year period. As a percentage of revenue, operating income decreased
to 5.8% for the nine months ended September 30, 2006 from 9.4% for the
comparable prior year period. Excluding approximately $6.6 million of
losses related to the two fixed price EPC projects and on a proforma basis,
our engineering segment's operating income for the nine months ended
September 30, 2006 would have been approximately $18.8 million, or
approximately 9.0% as a percentage of revenue.
27
Systems
The following table illustrates the composition of our systems revenue and
operating expense mix quarter over quarter for the three and nine-month
periods ended September 30, 2006 and 2005, and provides a comparison of the
changes in revenue and operating expense and trends period over period:
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- --------------------------------------
2006 2005 2006 2005
------------------ ---------------- ---------------- ------------------
(dollars in thousands)
--------------------------------------------------------------------------------
Revenue: $ 5,887 100 % $ 3,343 100 % $15,241 100 % $ 11,203 100 %
======= ======= ======= ========
Gross profit: $ 123 2.1 % $ 203 6.1 % $ 1,087 7.1 % $ 850 7.6 %
------- ------- ------- --------
Operating SG&A expense: 404 6.9 % 496 14.9 % 1,496 9.9 % 1,458 13.1 %
------- ------- ------- --------
Operating loss: (281) (4.8)% (293) (8.8)% (409) (2.7)% (608) (5.5)%
======= ======= ======= ========
Overview:
Summary of financial results during the three and nine month periods ended
September 30, 2006 compared to the three and nine month periods ended
September 30, 2005
Revenue up 76% quarter-over-quarter and up 36% year-over-year
Gross profit down 39% quarter-over-quarter but up 28% year-over-year
Operating SG&A as a percent of revenue down 8.0% quarter-over-quarter
and down 3.2% year-over-year
Operating loss down 4.1% quarter-over-quarter and down 32.8%
year-over-year
The primary reason for the operating loss in our systems segment's overall
financial results during the most recent quarter can be primarily
attributed to losses in our engineered systems division on projects related
to larger remote instrument enclosures.
Revenue:
Revenue increased approximately $2.5 million, or 78.8%, to $5.9 million for
the three month period ended September 30, 2006 from $3.3 million for the
comparable prior year period and increased approximately $4.0 million, or
35.8%, to $15.2 million for the nine month period ended September 30, 2006
from $11.2 million for the comparable prior year period.
The increases in revenue for both the three and nine month periods ended
September 30, 2006 were primarily the result of growth in our process
analyzer systems fabrication as a result of our acquisition of certain
assets of ATI during the first quarter of this year. The Analytical
Division's revenues total $4.4 million and $9.0 million, respectively, for
the three and nine month periods ended September 30, 2006. Approximately
$18.4 million in project awards directly related to the ATI acquisition has
been received during the current year, and is scheduled to be completed by
the first half of 2007. The majority of the analyzer awards are for
international projects.
Revenues from our Engineered Systems Division have decreased approximately
$2.3 million, or 65.8%, to $1.2 million for the three month period ended
September 30, 2006 from $3.5 million for the comparable prior year period
and decreased approximately $5.1 million, or 45.2%, to $6.2 million for the
nine month period ended September 30, 2006 from $11.3 million for the
comparable prior year period. The decline in Engineered Systems Division
revenues is a result of decreased demand and increased competition for
Remote Instrument Enclosures in the first nine months of 2006. While there
are a number of large projects in the market, which will require Engineered
Systems Division products, most of these projects are still in the early
development phases.
Gross profit:
Gross profit decreased approximately $80,000, or 39.4%, to $123,000 for the
three months ended September 30, 2006 from $203,000 for the comparable
prior year period and, as a percentage of revenue, gross profit decreased
to 2.1% from 6.1% for the respective periods. The primary reason for lower
profits recorded during the quarter related to losses of approximately
$266,000 on seven projects.
28
Three projects in the Engineered Systems Division accounted for losses of
approximately $95,000 primarily as the result of serve delivery extensions
on major construction components and services from third party suppliers.
Lower margins were also recorded in the Analytical Division due to an
incentive plan accrual of approximately $112,000 of which approximately
$87,000 applied to the most recent quarter. Additional accruals for the
incentive plan will continue in future quarters when plan benchmarks are
achieved. Three projects in the Analytical Division also experienced losses
of approximately $135,000. Errors in engineering design and procurement
were the primary reasons for the reversals. The ATI acquisition
significantly strengthened the engineering design capabilities of the
systems segment which we believe will eliminate similar errors in the
future.
One of the projects in the Heat Tracing Division experienced a profit loss
of approximately $36,000.
For the nine month period ended September 30, 2006, gross profit increased
approximately $250,000, or 29.5%, to $1.1 million for the nine months ended
September 30, 2006 from $850,000 for the comparable prior year period and,
as a percentage of revenue, gross profit decreased to 7.1% from 7.6% for
the respective periods. The increased gross profit for nine month period
ended September 30, 2006 was primarily the result of increasing profits in
the Analytical Division offsetting declining profits in the Engineered
Systems Division.
Selling, General, and Administrative:
SG&A expense decreased approximately $92,000, or 18.5%, to $404,000 for the
three months ended September 30, 2006 from $496,000 for the same period in
2005 and, as a percentage of revenue, SG&A expense decreased to 6.9% from
14.9% for the respective periods. The decrease in costs during the most
recent quarter is primarily attributable to a net reduction in compensation
costs and expenses associated with the July I, 2006 transfer of the
marketing department to our corporate business development group with
ENGlobal Corporate Services, offset by the increase in costs associated
with management and associated expenses from the ATI acquisition which was
completed in the first quarter of the year.
SG&A expense increased approximately $38,000, or 2.6%, to $1,496,000 for
the nine months ended September 30, 2006 from $1,458,000 for the same
period in 2005 but, as a percentage of revenue, SG&A expense decreased to
9.9% from 13.1% for the respective periods. The increase in costs during
the most recent nine month period is attributable to increases in
facilities expense of $102,000, which primarily occurred during the first
six months of the year, plus additional depreciation and amortization
expense of approximately $16,000 and other costs of approximately $12,000
offset by costs primarily attributable to a net reduction in compensation
costs and expenses associated with the transfer of the marketing department
to our corporate business development group and the increase in costs
associated with management and associated expenses from the ATI acquisition
completed in the first quarter of the year.
Operating Income:
The systems segment recorded an operating loss of $281,000 for the three
months ended September 30, 2006 compared to an operating loss of $293,000
for the three month period ended September 30, 2005. An operating loss of
$409,000 was recorded for the nine months ended September 30, 2006 compared
to an operating loss of $608,000 for the nine month period ended September
30, 2005.
Our investment in the internal heat tracing initiative resulted in an
operating loss of $25,000 for the three months ended September 30, 2006 and
has recorded operating losses of $140,000 for the nine month period ended
September 30, 2005. The heat tracing initiative was discontinued at the end
of the third quarter and should not have any material impact on operating
income in future periods.
29
Liquidity and Capital Resources
-------------------------------
Historically, cash requirements have been satisfied through operations and
borrowings under a revolving line of credit, which is currently in effect
with Comerica Bank (the "Comerica Credit Facility"). Terms of an amendment,
effective as of July 27, 2006, modified the Comerica Credit Facility to
extend the maturity date to July 26, 2009 and enlarged the revolving credit
note from $22 million to a limit of $30 million. As of September 30, 2006,
we had working capital of $35.8 million. Long-term debt, net of current
portion, was $22.8 million as of September 30, 2006, including $19.7
million outstanding under the Comerica Credit Facility.
The Comerica Credit Facility is senior to all other debt, and the $30
million line of credit continues to be subject to borrowing base
restrictions. The Comerica Credit Facility is collateralized by
substantially all of the assets of the Company. The Comerica Credit
Facility contains covenants requiring the Company, as of the end of each
calendar month, to maintain certain ratios, including total funded debt to
EBITDA; total funded debt to total liabilities, plus net worth; and total
line of credit to accounts and unbilled receivables. The Company is also
required, as of the end of each quarter, to maintain minimum levels of net
worth, and the Company must comply with an annual limitation on capital
expenditures. The Company is currently in compliance with all loan
covenants, although no assurances can be given regarding future compliance.
All standby letters of credit previously issued to a refining client
covering contractual obligations funded by the client for progress payments
made to equipment manufacturers for major project items matured on August
31, 2006. We are not currently subject to any other guarantees, repurchase
obligations or commitments and have no off-balance sheet arrangements.
As of September 30, 2006, management believes the Company's availability of
cash is sufficient to meet its working capital requirements for the next 12
months. Any future decrease in demand for our services or products would
reduce the availability of funds through operations.
Cash Flow
---------
We believe that we have sufficient available cash required for operations
for the next 12 months. However, cash and the availability of cash could be
materially restricted if circumstances prevent the timely internal
processing of invoices, if amounts billed are not collected or are not
collected in a timely manner, if project mix shifts from cost reimbursable
to fixed costs contracts during significant periods of growth, if the
Company was to lose one or more of its major customers, if the Company
experiences further costs overruns on fixed price contract, or if we not
able to meet the covenants of the Comerica Credit Facility. If any such
event occurs, we would be forced to consider alternative financing options.
Operating activities:
During the first nine months of 2006, our operations used $6.8 million of
cash flows compared with net cash provided of $4.4 million in the same
period in 2005. The change was primarily a result of contract losses during
the three month period ending September 30, 2006, continued timing
differences between payments for labor services, billing our clients for
those services and then collecting our accounts, and in addition to
$134,000 of benefits of tax deductions in excess of recognized compensation
cost from an operating to a financing cash flow as required by SFAS No.
123(R). Although our average for accounts receivable days outstanding
increased to 60 days for the nine month period ended September 30, 2006
from 51 days for the comparable period in 2005 the current year trend has
improved from 64 days at the end of the three month period ended March 31,
2006 and from 63 days at the end of the six month period ended June 30,
2006. Our average for accounts receivable days outstanding was 59 days for
the year ended December 31, 2005. The primary factors impacting the
increase in our need for cash and the year-over-year increase in average
accounts receivable days outstanding were:
1) a past due account balance of approximately $3.7 million as of
September 30, 2006 related to delays in receipts for services on the
start-up of a major alliance agreement that began during the second
quarter of this year;
2) an increase in retention receivables from approximately $1 million
to $2.1 million as of September 30, 2005 and 2006 respectively; and
3) an increase in costs and estimated earnings-in-excess of billings
from approximately $4.1 million to $9.6 million as of September 30,
2005 and 2006, respectively.
30
Although the above factors are all within rights and restrictions of
contractual terms and conditions within client contracts, we are taking
measures to remediate each of these factors and at this time do not expect
their impact to continue beyond the fourth quarter of the year. We have
been able to lower our accounts receivable days outstanding primarily
through an expanded focus on collections of past due accounts.
Investing activities:
Net cash used in investing activities was $8.3 million for the nine-month
period ended September 30, 2006, compared to net cash used of $1.4 million
in the same period in 2005. Approximately $6.0 million in net cash has been
used during the first nine months of 2006 for acquisitions, and we incurred
approximately $2.8 million in capital and construction in progress
expenditures during that same period. During September, the Company
acquired approximately 1.2 acres of land with proceeds to be received from
the final payment on an insurance claim for damages to our Beaumont
facility. We are developing plans to rebuild a new facility and parking
complex covering both the old and newly acquired property.
Annual capital expenditures are limited to $3.25 million under the Comerica
Credit Facility and, at this time, we do not see our capital needs
exceeding that limit. Cash provided by investing activities included
approximately $559,000, primarily from partnership distributions, insurance
proceeds and sales of assets.
We continue to evaluate and selectively seek opportunities to expand our
business through acquisitions of complementary businesses. Completing an
acquisition will involve the use of cash or may require debt or equity
financing.
Financing activities:
Net cash flows provided from financing activities was $16.3 million for the
nine-month period ended September 30, 2006, compared with net cash used of
$78,000 in the same period in 2005. Approximately $15.9 million in proceeds
came from net borrowings and repayments on our line-of-credit while $1.1
million resulted from the issuance of common stock, primarily from the
exercise of stock options and $700,000 was used for repayment of long-term
debt.
As of September 30, 2006, the Company had increased the amount outstanding
on the Comerica Credit Facility by $15.9 million since the beginning of the
year compared to a decrease of $13.5 million in the outstanding line of
credit for the same period in 2005. It should be noted that on September
29, 2005, the Company entered into and closed on a definitive agreement to
issue and sell 2,000,000 shares of Common Stock in a private placement with
the $14,000,000 in gross proceeds used to pay all of the Company's then
existing line-of-credit debt.
Asset Management
----------------
Our cash flow from operations has been affected primarily by the timing of
collection of trade accounts receivable. We typically sell our products and
services on short-term credit terms and seek to minimize credit risk by
performing credit checks and conducting our own collection efforts. As of
September 30, 2006 and December 31, 2005 we had net trade accounts
receivable of $55.0 million and $46.2 million, respectively.
31
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our financial instruments include cash and cash equivalents, accounts
receivable, accounts payable, notes and capital leases payable, and debt
obligations. The book value of cash and cash equivalents, accounts
receivable, accounts payable and short-term notes payable are considered to
be representative of fair value because of the short maturity of these
instruments.
We do not utilize financial instruments for trading purposes and we do not
hold any derivative financial instruments that could expose us to
significant market risk. In the normal course of business, our results of
operations are exposed to risks associated with fluctuations in interest
rates and currency exchange rates.
Our exposure to market risk for changes in interest rates relates primarily
to our obligations under the Comerica Credit Facility. As of September 30,
2006, $19.7 million had been borrowed under the Credit Facility, $7.0
million and $12.7 million accruing interest at 6.83% and 8.25% per year
respectively, excluding amortization of prepaid financing costs. A 10%
increase in the short-term borrowing rates on the Credit Facility
outstanding as of September 30, 2006 would be 82.5 basis points. Such an
increase in interest rates would increase our annual interest expense by
approximately $163,000, assuming the amount of debt outstanding remains
constant.
In general, our exposure to fluctuating exchange rates relates to the
effects of translating the financial statements of our Canadian subsidiary
from the Canadian dollar to the U.S. dollar. We follow the provisions of
SFAS No. 52 - "Foreign Currency Translation" in preparing our consolidated
financial statements. Currently, we do not, nor do we expect to engage in
foreign currency hedging activities.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
----------------------------------
As of September 30, 2006, we carried out an evaluation, under the
supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness
of the design and operation of our "disclosure controls and procedures," as
such term is defined under Exchange Act Rules 13a-15(e) and 15d-15(e).
Based on this evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that, as of September 30, 2006, such disclosure controls
and procedures were effective to ensure that information required to be
disclosed by us in the reports we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission,
and accumulated and communicated to our management, including our Chief
Executive Officer and Chief Financial Officer, as appropriate to allow
timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
----------------------------------------------------
Item 308 of Regulation S-K promulgated under Section 404 of the
Sarbanes-Oxley Act of 2002 requires that public companies annually evaluate
the effectiveness of their internal control over financial reporting at the
end of each fiscal year, and include a management report assessing the
effectiveness of such internal control over financial reporting in all
annual reports. Item 308 of Regulation S-K also requires that the
independent accountants of public companies attest to, and report on,
management's assessment of its internal control over financial reporting.
The initial compliance date with respect to these requirements depends on
whether a company is an "accelerated filer" as determined by Rule 12b-2 of
the Exchange Act.
As previously reported, ENGlobal became an "accelerated filer" effective as
of December 31, 2006 because the aggregate market value of ENGlobal's
common stock held by non-affiliates of ENGlobal as of June 30, 2006 was
greater than $75.0 million. ENGlobal is now required to comply with the
rules regarding management's report on internal control over financial
reporting for fiscal 2006.
ENGlobal continues to make concerted efforts to prepare itself to be able
to comply with such requirements. If we fail to timely complete our
evaluation and testing in order to allow for the assessment by our
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management, or if our independent registered public accounting firm cannot
timely attest to our management's assessment, we could be subject to
regulatory scrutiny and a loss of public confidence in our internal
controls, which could harm our business and our stock price. Further, if
our independent registered public accounting firm are not satisfied with
our internal controls over financial reporting or with the level at which
they are documented, designed, operated or reviewed, it may decline to
attest to management's assessment or may issue a qualified report
identifying a material weakness in our internal controls. This could result
in significant additional expenditures responding to the Section 404
internal control audit, a diversion of management attention and a decline
in our stock price.
We are exposed to increased costs associated with complying with these
requirements, and will be spending management time and resources to
document and test our internal controls in anticipation of Section 404
reporting requirements. Furthermore, our independent registered public
accounting firm, Hein & Associates, will be required to attest to whether
its assessment of the effectiveness of our internal control over financial
reporting is fairly stated in all material respects and separately report
on whether it believes we maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2006.
In addition, ENGlobal acquired WRC on May 26, 2006. WRC utilizes separate
information and accounting systems and processes. The Company intends to
extend its Sarbanes-Oxley Section 404 compliance program to include WRC.
However, management anticipates excluding WRC from the 2006 Assessment in
accordance with the guidance from the Division of Corporation Finance and
Office of the Chief Accountant of the Securities and Exchange Commission.
Management intends to complete its assessment of the effectiveness of
internal control over financial reporting for the acquired WRC business
within 18 months of the date of the acquisition. In the meantime, WRC's
accounting and information systems are currently being converted to the
same platform as the rest of ENGlobal.
Other than the effects of our acquisition of WRC, there were no changes in
our internal controls over financial reporting during the most recent
quarter that materially affected, or are reasonably likely to materially
affect, our internal controls over financial reporting.
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PART II. - OTHER INFORMATION
----------------------------
ITEM 1. LEGAL PROCEEDINGS
From time to time, the Company and its subsidiaries become parties to
various legal proceedings arising in the ordinary course of normal business
activities. While we cannot predict the outcome of these proceedings, in
our opinion and based on reports of counsel any liability arising from such
matters, individually or in the aggregate, are not expected to have a
material effect upon the consolidated financial position or operations of
the Company.
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report, you should
carefully consider the factors discussed in Part I, "Item 1A. Risk Factors"
in our Annual Report on Form 10-K for the year ended December 31, 2005,
which could materially affect our business, financial condition or future
results. The risks described in our Annual Report on Form 10-K are not the
only risks facing our Company. Additional risks and uncertainties not
currently known to us or that we currently deem to be immaterial also may
materially adversely affect our business, financial condition or operating
results.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
31.1 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act for
2002 for the Third Quarter 2006
31.2 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act for
2002 for the Third Quarter 2006
32 Certification Pursuant to Rule 13a - 14(b) of the Exchange Act and
18U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 for the Third Quarter 2006
34
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ENGlobal CORPORATION
Dated: ________
By: /s/ Robert W. Raiford
-------------------------
Robert W. Raiford
Chief Financial Officer and Treasurer
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