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, 2007
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 N. 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 shortened 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 X Non-Accelerated Filer
----- ----- -----
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 8, 2007.
$0.001 Par Value Common Stock 27,020,203 shares
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2007
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, 2007 and September 30, 2006 3
Consolidated Statements of Comprehensive Income for the Three Months Ended
And Nine Months Ended September 30, 2007 and September 30, 2006 4
Condensed Consolidated Balance Sheets at September 30, 2007 and December 31, 2006 5
Condensed Consolidated Statements of Cash Flows for the Nine Months 6
Ended September 30, 2007 and September 30, 2006
Notes to Condensed Consolidated Financial Statements 8-15
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16-29
Item 3. Quantitative and Qualitative Disclosures About Market Risk 30
Item 4. Controls and Procedures 30-33
Part II. Other Information
Item 1. Legal Proceedings 33
Item 1A. Risk Factors 33
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 For the Nine Months
Ended September 30, Ended September 30,
------------------------------------------------
(Dollars in Thousands)
2007 2006 2007 2006
--------- --------- --------- ---------
Operating Revenue $ 96,826 $ 82,503 $ 268,061 $ 224,196
--------- --------- --------- ---------
Operating Expenses:
Direct cost 80,487 77,954 224,225 200,697
Selling, general and administrative 7,722 6,411 21,338 18,921
Depreciation and amortization 881 393 2,299 1,150
--------- --------- --------- ---------
Total operating expenses 89,090 84,758 247,862 220,768
--------- --------- --------- ---------
Operating income 7,736 (2,255) 20,199 3,428
Other Income (Expense):
Other income (53) (20) 462 389
Interest income (expense), net (636) (371) (1,896) (786)
--------- --------- --------- ---------
Total other income (expense) (689) (391) (1,434) (397)
--------- --------- --------- ---------
Income before Provision for Income Taxes 7,047 (2,646) 18,765 3,031
---------
Provision for Income Taxes 3,072 (1,076) 7,722 1,036
--------- --------- --------- ---------
Net Income $ 3,975 $ (1,570) $ 11,043 $ 1,995
========= ========= ========= =========
Net Income Per Common Share:
Basic $ 0.15 $ (0.06) $ 0.41 $ 0.08
Diluted $ 0.14 $ (0.06) $ 0.40 $ 0.07
Weighted Average Shares Used in Computing Net
Income Per Share:
Basic 26,953 26,646 26,877 26,475
Fully Diluted 27,417 26,646 27,278 27,028
See accompanying notes to interim condensed consolidated financial statements.
3
ENGlobal Corporation
Consolidated Statements of Comprehensive Income
(Unaudited)
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
-------------------------------------------
(Dollars in Thousands)
2007 2006 2007 2006
------- ------- ------- -------
Net Income $ 3,975 $(1,570) $11,043 $ 1,995
------- ------- ------- -------
Other Comprehensive Income (Loss):
Foreign currency translation adjustment -- (10) -- 3
Income tax effect -- 4 -- (1)
------- ------- ------- -------
Net other comprehensive income -- (6) -- 2
------- ------- ------- -------
Net Comprehensive Income $ 3,975 $(1,576) $11,043 $ 1,997
======= ======= ======= =======
See accompanying notes to interim condensed consolidated financial statements.
4
ENGlobal Corporation
Condensed Consolidated Balance Sheets
(Unaudited)
ASSETS
------
Current Assets: September 30, December 31,
2007 2006
--------- ---------
(Dollars in Thousands)
Cash $ 1,103 $ 1,403
Trade receivables, net 70,668 60,248
Prepaid expenses and other current assets 1,036 1,724
Current portion of notes receivable 153 52
Costs and estimated earnings in excess of billings on uncompleted contracts 8,174 5,390
Deferred tax asset 2,310 2,310
Federal and state income taxes receivable -- 1,148
--------- ---------
Total Current Assets 83,444 72,275
Property and Equipment, net 7,001 8,725
Goodwill 20,182 19,202
Other Intangible Assets, net 4,486 5,427
Long term notes receivable, net of current portion 10,632 129
Other Assets 1,045 469
--------- ---------
Total Assets $ 126,790 $ 106,227
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current Liabilities:
Accounts payable $ 10,393 $ 14,672
Federal and state income taxes 1,769 --
Accrued compensation and benefits 15,486 12,807
Notes payable -- 1,110
Current portion of long-term debt 1,564 1,418
Deferred rent 588 679
Billings in excess of costs and estimated earnings on uncompleted contracts 2,297 540
Other liabilities 2,423 5,862
--------- ---------
Total Current Liabilities 34,520 37,088
Long-Term Debt, net of current portion 37,795 27,162
Deferred Tax Liability 944 1,114
--------- ---------
Total Liabilities 73,259 65,364
--------- ---------
Commitments and Contingencies (Note 11)
Stockholders' Equity:
Common stock - $0.001 par value; 75,000,000 shares authorized; 27,010,825
and 26,807,460 shares issued and outstanding at September 30, 2007 and
December 31, 2006, respectively 28 27
Additional paid-in capital 32,751 31,147
Retained earnings 20,760 9,717
Accumulated other comprehensive loss (8) (30)
--------- ---------
Total Stockholders' Equity 53,531 40,861
--------- ---------
Total Liabilities and Stockholders' Equity $ 126,790 $ 106,227
========= =========
See accompanying notes to interim condensed consolidated financial statements.
5
ENGlobal Corporation
Condensed Consolidated Statements Of Cash Flows
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------
2007 2006
----------- ----------
(Dollars in Thousands)
Cash Flows from Operating Activities:
Net income $ 11,043 $ 1,995
Adjustments to reconcile net income to net cash used in operating activities -
Depreciation and amortization 3,410 1,925
Share based compensation expense 947 895
(Gain) Loss on disposal of property, plant and equipment (552) 99
Deferred income tax benefit (170) (134)
Changes in current assets and liabilities, net of acquisitions -
Trade receivables (10,421) (4,576)
Notes receivable, net of reserves (9,179) --
Costs and estimated earnings in excess of billings (2,784) (5,405)
Prepaid expenses and other assets (668) 345
Accounts payable (4,279) 311
Inventories -- 154
Accrued compensation and benefits 2,679 802
Billings in excess of costs and estimated earnings 1,757 (2,721)
Other liabilities (5,027) 217
Income taxes receivable (payable) 3,850 (667)
-------- --------
Net cash used in operating activities (9,394) (6,760)
-------- --------
Cash Flows from Investing Activities:
Property and equipment acquired and construction in progress (1,842) (2,789)
Proceeds from sale of equipment -- 13
Proceeds from sale of other assets 516 50
Proceeds from note receivable 55 15
Business acquired in purchase transaction, net of cash acquired 18 (5,966)
Partnership distribution -- 350
Insurance proceeds -- 68
-------- --------
Net cash used in investing activities (1,253) (8,259)
-------- --------
Cash Flows from Financing Activities:
Net borrowings (payments) on line of credit 11,782 15,929
Proceeds from issuance of common stock 656 724
Long-term debt repayments (2,113) (727)
-------- --------
Net cash provided by financing activities 10,325 15,926
-------- --------
Effect of Exchange Rate Changes on Cash 22 4
-------- --------
Net change in cash (300) 911
Cash, at beginning of period 1,403 159
-------- --------
Cash, at end of period $ 1,103 $ 1,070
======== ========
Supplemental Disclosures:
Interest paid $ 1,829 $ 449
======== ========
Income taxes paid $ 6,167 $ 1,759
======== ========
See accompanying notes to interim condensed consolidated financial statements.
6
ENGlobal Corporation
Condensed Consolidated Statements Of Cash Flows
(Unaudited)
(Continued)
For the Nine Months Ended
September 30,
-------------------------
2007 2006
-------- -------
(Dollars in Thousands)
Non-Cash:
Issuance of note for purchase of WRC Corporation $ -- $ 2,400
======== =======
Issuance of common stock for purchase of WRC Corporation $ -- $ 1,400
======== =======
Issuance of note for ATI assets $ -- $ 1,000
======== =======
Acceptance of note for Constant Power assets $ -- $ (216)
======== =======
Acceptance of note from Oak Tree $ (1,480) $ --
======== =======
Acceptance of note from South Louisiana Ethanol $(10,379) $ --
======== =======
See accompanying notes to interim condensed consolidated financial statements.
7
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
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, 2007 and 2006. 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, 2006, included in the
Company's Annual Report on Form 10-K filed with the Securities and Exchange
Commission on March 16, 2007 and as amended on Form 10K/A filed with the
Securities and Exchange Commission on March 29, 2007 (as amended, the "2006
Annual Report on Form 10-K"). The Company believes that the disclosures
made herein are adequate to make the information presented not misleading.
NOTE 2 - CRITICAL ACCOUNTING POLICIES
A summary of critical accounting policies is disclosed in Note 2 to the
Consolidated Financial Statements included in our 2006 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 2006 Annual
Report on Form 10-K.
The Company's adoption of SFAS No. 123(R), "Share-Based Payment," became
effective January 1, 2006 and is further described in Note 3, below.
On July 13, 2006, the FASB issued FIN 48, "Accounting for Uncertainty in
Income Taxes, and Related Implementation Issues," which provides guidance
on the financial statement recognition, measurement, presentation and
disclosure of uncertain tax positions that a company has taken or expects
to take on a tax return. Under FIN 48, financial statements should reflect
expected future tax consequences of such positions presuming the taxing
authorities have full knowledge of the position and all relevant facts.
This interpretation also revises the disclosure requirements and was
adopted by the Company effective as of January 1, 2007. There are currently
no material tax positions identified as uncertain for the Company or its
subsidiaries. As of September 30, 2007, we have not recognized interest or
penalties relating to any uncertain tax positions.
The Company is subject to Federal and state income tax audits from time to
time that could result in proposed assessments. The Company cannot predict
with certainty the timing of such audits, how these audits would be
resolved and whether the Company would be required to make additional tax
payments, which may or may not include penalties and interest. The Company
was subject to a Federal tax audit for the years 2002 and 2003. That
examination has been closed with no significant tax impact on the Company.
WRC Corporation, which was acquired by the Company on May 26, 2006,
recently underwent a Federal tax audit for the pre-acquisition fiscal year
ended September 30, 2005. This audit was closed on July 12, 2007, with no
significant tax impact on the Company. The Company does not have any
on-going Internal Revenue Service examinations, and the open years
currently subject to audit are tax years 2004-2006. For most states where
the Company conducts business, the Company is subject to examination for
the preceding three to six years.
NOTE 3 - 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 an expense
over the requisite service period (usually a vesting period). The Company
selected the modified prospective method of adoption described in SFAS No.
8
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
123(R). The fair values of the stock awards are determined at the grant
date and are recognized as compensation expense on a straight-line basis
over the vesting period.
In accordance with the provisions of SFAS No. 123(R), total stock-based
compensation expense was recorded in selling, general and administrative
expense. The total stock-based compensation and related income tax benefits
for the reporting periods are as follows:
September 30, September 30,
2007 2006
-------- --------
(Dollars in Thousands)
Stock Compensation Expense
For the Three Months Ended $492,144 $403,560
For the Nine Months Ended $947,252 $894,758
Income Tax Benefit
For the Three Months Ended $128,470 $ 59,847
For the Nine Months Ended $205,488 133,736
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.
Stock Option and Incentive Plans
The Company maintains a stock option plan (the "Option Plan") under which
the Company may issue stock options to employees, non-employee directors,
and other persons who perform valuable services for the Company. On March
30, 2007, the Board of Directors approved (subject to stockholder approval
which occurred on June 14, 2007) an amendment to the Option Plan to
increase the number of shares available for issuance under the Plan from
2,650,000 to 3,250,000. The Company intends to issue stock-based awards
under the option plan in order to enhance its ability to attract, retain
and compensate employees and non-employee directors of outstanding ability.
As of September 30, 2007, 600,806 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
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.
Stock options have been granted with exercise prices at or above the market
price on the date of grant. The granted options have vested generally over
one year for non-employee directors and ratably over four years for
officers and employees. The options generally have a ten-year term.
Compensation expense of $1.8 million related to previously granted stock
option awards which are not vested had not yet been recognized at September
30, 2007. This compensation expense is expected to be recognized over a
weighted-average period of approximately 12 months.
9
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
The following summarizes stock option activity for the third quarter of
2007:
Weighted Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic *
Options Price Term (Years) Value (000's)
--------- -------- ---------------- -------------
Balance at December 31, 2006 1,422,494 $ 5.16 7.9 $ 2,871
Granted 150,000 10.93 9.7 -
Exercised 203,365 3.20 - 1,204
Canceled or expired 20,000 2.05 - -
--------- -------- ---------------- -------------
Balance at September 30, 2007 1,349,129 $ 6.14 7.8 $ 3,458
========= ======== ================ =============
Exercisable at September 30, 2007 1,072,294 $ 5.27 7.6 $ 4,974
========= ======== ================ =============
Intrinsic values of exercise are based on the average market price in the
quarter the option was exercised. Average market prices for 2007 and the
comparable 2006 periods are as follows:
2007 2006
-------- --------
Average market price per share:
At Third Quarter Year-to-Date $ 8.52 $ 9.22
Third Quarter $ 10.64 $ 7.02
Second Quarter $ 8.83 $ 9.53
First Quarter $ 6.00 $ 11.14
NOTE 4 - FIXED FEE CONTRACTS
Costs, estimated earnings and billings on uncompleted contracts consisted
of the following at September 30, 2007 and December 31, 2006:
September 30, December 31,
2007 2006
------------------------
(in thousands)
------------------------
Costs incurred on uncompleted contracts $ 77,829 $ 75,317
Estimated earnings (losses) on uncompleted contracts (6,761) (7,390)
-------- --------
Earned revenues 71,068 67,927
Less: Billings to date 65,191 63,077
-------- --------
Net costs and estimated earnings in excess of billings
on uncompleted contracts $ 5,877 $ 4,850
======== ========
Costs and estimated earnings in excess of billings on uncompleted contracts $ 8,174 $ 5,390
Billings and estimated earnings in excess of cost on uncompleted contracts (2,297) (540)
-------- --------
Net costs and estimated earnings in excess of billings
on uncompleted contracts $ 5,877 $ 4,850
======== ========
NOTE 5 - 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
10
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
and recognized directly as a component of stockholders' equity. Adjustments
to comprehensive income have arisen from foreign currency translation
adjustments relating to our Canadian subsidiaries. With the values of the
Canadian dollar currently closely aligned with the U.S. dollar, any
comprehensive income adjustments are negligible and are currently less than
$1,000.
NOTE 6 - GOODWILL
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets,"
goodwill is no longer amortized over its estimated useful life, but rather
is subject to at least an annual assessment for impairment. SFAS 142 also
requires that intangible assets with estimable useful lives be amortized
over their respective estimated useful lives to their estimated residual
values and reviewed for impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." Goodwill
has been allocated to the Company's two reportable segments. The test for
impairment was made on each of these reporting segments at December 31,
2006, at which time no impairment was determined. No additional impairment
testing of goodwill has been performed in the interim.
Reference is made to NOTE 16 - ACQUISITIONS, in the Company's 2006 Annual
Report on Form 10K. A valuation of intangible assets was performed relating
to the Company's acquisition of WRC Corporation. A portion of the goodwill
was allocated to intangible assets based on the value and nature of certain
agreements entered into in connection with the acquisition and is being
amortized accordingly over the term of the agreements. This valuation was
revised in the first quarter of 2007 resulting in approximately $669,000 of
intangible assets being re-allocated back to goodwill. As a result, in
2006, we amortized $70,000 more of intangibles than we would have amortized
based on the revised valuation. The Company's amortization of the affected
intangible assets will be adjusted over the remaining five year term of
those assets and will not have a material effect on the current or future
period financial results.
NOTE 7 - LINE OF CREDIT AND DEBT
Effective August 8, 2007, the Company entered into a new credit agreement
(the "New Credit Agreement") with Comerica Bank. The New Credit Agreement
provides a three-year, $50 million senior secured revolving credit
facility. The New Credit Agreement is guaranteed by substantially all of
Company's subsidiaries and is secured by substantially all of the Company's
assets. The New Credit Agreement replaced a $35 million senior revolving
credit facility that would have expired in July 2009. The outstanding
balance on the New Credit Agreement as of September 30, 2007 was $35.7
million. The remaining borrowings available under the New Credit Agreement
as of September 30, 2007 were $14.3 million after consideration of loan
covenant restrictions.
At the Company's option, amounts borrowed under the New Credit Agreement
will bear interest at LIBOR or an Alternate Base Rate, plus in each case,
an additional margin based on the Leverage Ratio. The Alternate Base Rate
is the greater of the Prime Rate or the Fed Funds Effective Rate, plus
1.0%. The additional margin ranges from 0% on the Alternate Base Rate loans
and 1.50% to 2.0% on the LIBOR-based loans.
Upon maturity, the LIBOR debt will automatically roll into the Revolver
unless the Company elects to renew, at which time a new maturity date and
interest rate will be set.
The New Credit Agreement requires the Company to maintain certain financial
covenants as of the end of each calendar month, including the following:
o Leverage Ratio not to exceed 3.00 to 1.00;
o Asset Coverage Ratio to be less than 1.00 to 1.00; and
o Net Worth must be greater than the sum of $40.1 million plus 75%
of positive Net Income earned in each fiscal quarter after
January 1, 2007 plus 100% of the net proceeds of any offering,
sale or other transfer of any capital stock or any equity
securities.
The New Credit Agreement also contains covenants that place certain
limitations on the Company including limits on new debt, mergers, asset
sales, investments, fixed price contracts, and restrictions on certain
distributions. The Company was in compliance with all covenants under the
New Credit Agreement as of September 30, 2007.
11
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
Details of this line of credit at September 30, 2007 are as follows:
Amount of Interest
Debt Rate
--------------------
($ in thousands)
--------------------
LIBOR-1, maturing November 18, 2007 $ 5,000 6.99%
LIBOR-2, maturing February 15, 2008 20,000 6.64
Revolver - Alternate Base Rate, expiring August 2010 10,745 7.75
------- ------
$35,745 7.02%
Unused Balance 14,255 0.25%
-------
New Credit Agreement $50,000
September 30, December 31,
2007 2006
---------------------------
(in thousands)
---------------------------
Schedule of Long-Term Debt:
Total Comerica Credit Agreement - 7.02% weighted average at September 30, 2007,
maturing August 2010; 8.25% at December 31, 2006 35,745 23,963
Sterling Planet and EDGI - Notes payable, interest at 5%, principal payments in
installments of $15,000 plus interest due quarterly, maturing in December 2008 75 120
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 847 1,109
InfoTech Engineering, Inc. - Note payable, interest at 5%, principal payments in
installments of $75,000 plus interest due annually, maturing in November 2008 75 75
A.T.I. Inc. - Note payable, interest at 6%, principal payments in installments of
$30,422 including interest due monthly, maturing in January 2009 467 713
Michael Lee - Note payable, interest at 5%, principal payments in installments of
$150,000 plus interest due quarterly, maturing in July 2010 1,650 2,100
Watco Management, Inc. - Note payable, interest at 4%, principal payments in
installments of $137,745 including interest annually, maturing in October 2010 500 500
-------- --------
Total long-term debt 39,359 28,580
Less: Current maturities (1,564) (1,418)
-------- --------
Long-term debt, net of current portion $ 37,795 $ 27,162
======== ========
NOTE 8 - SEGMENT INFORMATION
The Company operates in two business segments: (1) engineering, which
comprises such components as providing engineering, procurement,
construction, inspection, construction management and land management
services primarily to major companies involved 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, to customers that, for the most part, are located in the United
States.
Revenue and operating income for each segment are set forth in the
following table. The amount shown as "Corporate" includes those activities
not allocated to operating segments. It includes costs related to business
development, executive function, finance, accounting, investor
relations/governance, project controls, information technology, legal,
safety and human resources not specifically identifiable to the operating
segments. Inter-company elimination includes the amount of administrative
12
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
costs allocated to the segments. Corporate functions support the business
operating segments and therefore cannot be specifically assigned to either.
Significant portions of Corporate cost are allocated to each segment based
on each segment's revenues and eliminated in consolidation.
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2007 2006 2007 2006
--------- --------- --------- ---------
(in thousands)
------------------------------------------------
Revenue:
Engineering $ 92,529 $ 76,768 $ 253,235 $ 209,268
Systems 4,655 6,291 15,950 16,244
Less intercompany revenue (358) (556) (1,124) (1,316)
--------- --------- --------- ---------
Total revenue $ 96,826 $ 82,503 $ 268,061 $ 224,196
========= ========= ========= =========
Operating income (loss):
Engineering $ 11,802 $ 702 $ 31,798 $ 12,196
Systems (287) (281) (527) (408)
Corporate (3,779) (2,676) (11,072) (8,360)
--------- --------- --------- ---------
Total operating income $ 7,736 $ (2,255) $ 20,199 $ 3,428
========= ========= ========= =========
Financial information about geographic areas
--------------------------------------------
Revenue from the Company's non-U.S. operations is currently not material.
Long-lived assets (principally leasehold improvements and computer
equipment) outside the United States were $98,539 as of September 30, 2007,
net of accumulated depreciation.
NOTE 9 - FEDERAL INCOME TAXES
The components of income tax expense (benefit) for the three and nine
months ended September 30, 2007 and 2006 were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ------------------
2007 2006 2007 2006
------- ------- ------- -------
(in thousands)
----------------------------------------
Current $ 3,200 $ (942) $ 7,927 $ 1,096
Deferred (128) (134) (205) (60)
------- ------- ------- -------
Total tax provision $ 3,072 $(1,076) $ 7,722 $ 1,036
======= ======= ======= =======
13
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
NOTE 10 - 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,
--------------- ---------------
2007 2006 2007 2006
------ ------ ------ ------
(in thousands)
-----------------------------------
Weighted average shares outstanding
(denominator used to compute basic EPS) 26,953 26,646 26,877 26,475
Effect of employee and outside director stock options 464 * 401 553
------ ------ ------ ------
Denominator used to compute diluted EPS 27,417 26,646 27,278 27,028
====== ====== ====== ======
* since a net loss was recognized, shares were not diluted
NOTE 11 - CONTINGENCIES
Employment Agreements
The Company has employment agreements with certain of its executive
officers, the latest of which expires in February 2009. The agreements
provide for minimum salary levels. If the Company terminates the employment
of the employee for any reason other than 1) termination for cause, 2)
voluntary resignation, or 3) employee's death, the Company is obligated to
provide a severance benefit equal to six months of the employee's salary,
and, at its option, an additional six months at 50% to 100% of the
employee's salary in exchange for an extension of a non-competition
provision. These agreements are renewable for one year at the Company's
option. The Company has employment agreements with certain other officers
which contain the elements of those agreements with its executive officers
but are in effect from three to five years.
Litigation
From time to time, the Company is involved in various legal proceedings
arising in the ordinary course of business alleging, among other things,
breach of contract or tort in connection with the performance of
professional services, the outcome of which cannot be predicted with
certainty. As of the date of this filing, we are party to several legal
proceedings for which we have reserves, which are covered by insurance, or
that, if determined adversely to us individually or in the aggregate, would
not have a material adverse effect on our results of operations or
financial position.
Insurance
The Company carries a broad range of insurance coverage, including general
and business automobile liability, commercial property, professional errors
and omissions, workers' compensation insurance and a general umbrella
policy. The Company is not aware of any claims in excess of insurance
recoveries. ENGlobal is partially self-funded for health insurance claims.
Provisions for expected future payments are accrued based on the Company's
experience. Specific stop loss levels provide protection for the Company
with $175,000 per occurrence and approximately $12.1 million in aggregate
in each policy year being covered by a separate insurance policy.
Unapproved Change Orders and Claims
At September 30, 2007, the Company had outstanding unapproved change
orders/claims of approximately $8.0 million. The Company recorded $1.0
million in revenue, which did not include any profit component, related to
these claims for the year ended December 31, 2006. No additional amounts
have been recognized during 2007 related to these claims. During the
quarter, one claim was settled with the revenue recorded during the year
ended December 31, 2006. Generally, collection of amounts related to
unapproved change orders and claims is expected within twelve months.
However, in most cases clients generally will not pay these amounts until a
final resolution is reached related to these claims, thus accordingly,
14
Notes to Condensed Consolidated Financial Statements
----------------------------------------------------
collection of these amounts may extend beyond one year. In the future, if
the Company determines collection of any unapproved change order/claim is
not probable, a charge will be taken against earnings in the period such
determination is made.
NOTE 12 - SUBSEQUENT EVENT
In the fourth quarter of 2006, ENGlobal Engineering, Inc. ("EEI") began
site preparation and preliminary engineering work on a cost reimbursable
basis to provide an estimate for the re-design and modification of a 20
year old ethanol plant located in Belle Chasse, Louisiana. In March 2007,
EEI and the client executed an agreement (the "EPC Agreement") under which
EEI was to provide the client with engineering services on a fixed price
basis and procurement and construction services on a cost reimbursable
basis. Late in the third quarter of 2007, the client asked the Company to
suspend work to allow it time to seek permanent financing necessary to
complete the project. The client has informed the Company that it is
actively seeking financing for the project, and expressed its belief that
it would be able to obtain financing as well as its intention to resume
construction as soon as it has raised the necessary funds.
As a result of these developments, EEI requested security for the amounts
that the client owed to EEI. Accordingly, on August 31, 2007, the client
executed a $15,000,000 promissory note and a collateral pledge agreement as
security for payments due by the client for all current and future invoices
for services and materials provided. In accordance with Louisiana law, this
note and pledge agreement were later supplemented with a "hand note" in the
principal amount of $12.3 million and an additional collateral agreement
which we believe give EEI priority over certain other creditors.
The client's note accrues interest at the rate of 10% per annum on the
unpaid principal balance and is payable in quarterly installments of
interest only, commencing January 22, 2008. The client, at its option, may
elect to forgo any quarterly interest payment at a deferred interest rate
of 15% per annum until the first anniversary of the note, at which time all
accrued interest will become due and payable. On the first anniversary of
the note, the client must begin to make equal monthly payments of principal
and interest, with interest at 12% per annum. The payments are based on a
20-year amortization, and a balloon payment of all remaining principal and
interest is due on October 22, 2010.
In order to obtain additional security, during October 2007, the Company
presented the client with a Notice of Contract Termination which allowed
ECR, another subsidiary of ENGlobal and a subcontractor to EEI, to file a
Material Man's and Mechanic's Lien on the property, securing $8.6 million
of the amount due. Under Louisiana law, ECR's lien is subordinate to
governmental and laborers' liens and to bona fide mortgages. A lien search
conducted on November 1, 2007 did not uncover any liens that we believe to
be superior to ECR's Material Man's and Mechanic's Lien, but liens that
have priority could be discovered or could be filed in the future.
Based on these facts, as of September 30, 2007, the Company re-classified
accounts receivable and unbilled receivables relating to the client's
obligation to a long-term note receivable in the amount, net of reserves,
of $9.2 million. Management currently believes that the client will be
successful in obtaining financing and completing the project. In addition,
management believes that even if the project is not completed, the
underlying collateral supporting the note receivable and the Material Man's
and Mechanic's lien will be sufficient to ensure full payment of the note
receivable and the interest accruing thereon.
However, despite management's belief to the contrary, there can be no
guarantee that (i) the client will pay the amount due, (ii) if the client
defaults on the note, EEI and ECR will be able to enforce their liens,
(iii) liens having priority over the liens of EEI or ECR will not be
discovered or will not be filed in the future, or (iv) if EEI and ECR
successfully enforce their liens, the value of the collateral will provide
sufficient funds for full payment of the note receivable. In addition,
there is no guarantee that the reserves taken by the Company with respect
to the note receivable will be sufficient. In any such case, the Company
would incur a significant loss.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
--------------------------
Certain information contained in this Quarterly Report on Form 10-Q, the
Company's 2006 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 within 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; planned
capital expenditures; business strategy and other plans for future
operations; the future mix of revenues and business; customer retention;
project reversals; commitments and contingent liabilities; the ability to
collect past due accounts receivable or notes receivable; 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 and specific
risk factors set forth in this Quarterly Report on Form 10-Q, the specific
risk factors identified in the Company's 2006 Annual Report on Form 10-K
and those described from time to time in our future reports to be 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 Quarterly Report on Form 10-Q
and the Company's 2006 Annual Report on Form 10-K.
MD&A Overview
-------------
The following list sets forth a general overview of the more significant
changes in the Company's financial condition and results of operations for
the three and nine months ended September 30, 2007, compared to the
corresponding period in 2006.
Three months ended Nine months ended
September 30, 2007 September 30, 2007
compared to three months ended compared to nine months ended
September 30, 2006 September 30, 2006
($ in millions) % ($ in millions) %
--------------- ----------- --------------- -----------
Revenue $ 14.3 17.3% $ 43.9 19.6%
Gross profit 11.8 262.2% 20.3 86.4%
SG&A expense 1.8 26.5% 3.5 17.4%
Operating income 10.0 434.8% 16.8 494.1%
Net income 5.6 350.0% 9.0 450.0%
Long-term debt, net of current portion, increased 39.0%, or $10.6 million,
from $27.2 million at December 31, 2006 to $37.8 million at September 30,
2007, and as a percentage of stockholders' equity, long-term debt increased
to 70.7% from 66.5% at these same dates. The primary reason for the
increase in long-term debt relates to the negative cash impact resulting
from the re-classification of $10.4 million from accounts receivable and
unbilled receivables to a long-term note receivable (see additional
discussion at Note 12 - Subsequent Events and Item 3); timing difference
related to meeting short-term bi-weekly payroll obligations due to growth;
and longer collection periods on receivables from our clients. On average,
our accounts receivable days outstanding is 66 days for the three months
ended September 30, 2007, compared to 60 days for the three months ended
September 30, 2006. The re-classification of $10.4 million from accounts
receivable and unbilled receivables to a long-term note receivable lowered
16
our accounts receivable days outstanding by nine days for the three months
ended September 30, 2007. The Company is continuing its efforts to work
toward improving billing and collection processes.
Total stockholders' equity increased 30.8%, or $12.6 million, from $40.9
million as of December 31, 2006 to $53.5 million as of September 30, 2007.
17
Management's Discussion and Analysis
------------------------------------
Consolidated Results of Operations for the Three and Nine Months
Ended September 30, 2007 and 2006
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------ -----------------------------------------
2007 (1) 2006 (1) 2007 (1) 2006 (1)
------------------- ------------------- ------------------- -------------------
(dollars in thousands)
--------------------------------------------------------------------------------------
Revenue:
Engineering $ 92,299 95.3 % $ 76,616 92.9 % $ 252,386 94.2 % $ 208,955 93.2 %
Systems 4,527 4.7 % 5,887 7.1 % 15,675 5.8 % 15,241 6.8 %
---------- ------- ---------- ------- ---------- ------- ---------- -------
Total revenue $ 96,826 100.0 % $ 82,503 100.0 % $ 268,061 100.0 % $ 224,196 100.0 %
========== ========== ========== ==========
Gross profit:
Engineering $ 16,208 16.8 % $ 4,426 5.4 % $ 43,204 16.1 % $ 22,412 10.0 %
Systems 131 0.1 % 123 0.1 % 632 0.2 % 1,087 0.5 %
---------- ------- ---------- ------- ---------- ------- ---------- -------
Total gross profit 16,339 16.9 % 4,549 5.5 % 43,836 16.3 % 23,499 10.5 %
---------- ---------- ---------- ----------
SG&A expense:
Engineering 4,406 4.6 % 3,724 4.5 % 11,406 4.3 % 10,215 4.6 %
Systems 418 0.4 % 404 0.5 % 1,159 0.4 % 1,496 0.7 %
Corporate 3,779 3.9 % 2,676 3.2 % 11,072 4.1 % 8,360 3.7 %
---------- ------- ---------- ------- ---------- ------- ---------- -------
Total SG&A expense 8,603 8.9 % 6,804 8.2 % 23,637 8.8 % 20,071 9.0 %
---------- ---------- ---------- ----------
Operating income:
Engineering 11,802 12.2 % 702 0.8 % 31,798 11.8 % 12,197 5.4 %
Systems (287) (0.3)% (281) (0.3)% (527) (0.2)% (409) (0.2)%
Corporate (3,779) (3.9)% (2,676) (3.2)% (11,072) (4.1)% (8,360) (3.7)%
---------- ------- ---------- ------- ---------- ------- ---------- -------
Total operating income 7,736 8.0 % (2,255) (2.7)% 20,199 7.5 % 3,428 1.5 %
---------- ---------- ---------- ----------
Other income (expense), net (689) (0.7)% (391) (0.5)% (1,434) (0.5)% (397) (0.2)%
Tax provision (3,072) (3.2)% 1,076 1.3 % (7,722) (2.9)% (1,036) (0.4)%
---------- ------- ---------- ------- ---------- ------- ---------- -------
Net income $ 3,975 4.1 % $ (1,570) (1.9)% $ 11,043 4.1 % $ 1,995 0.9 %
========== ========== ========== ==========
(1) Percentages represent percentage of total revenue in the periods indicated.
Other financial comparisons:
----------------------------
As of September 30,
-------------------
2007 2006
-------- --------
(in thousands)
-------------------
Working capital $ 48,924 $ 35,503
Total assets $126,790 $ 99,384
Long-term debt, net of current portion $ 37,795 $ 22,831
Stockholders' equity $ 53,531 $ 44,882
18
Management's Discussion and Analysis
------------------------------------
We recorded net income of $4.0 million, or $0.14 per diluted share for the
three months ended September 30, 2007, compared to net loss of $1.6
million, or $(0.06) per diluted share for the corresponding period last
year.
We recorded net income of $11.0 million, or $0.40 per diluted share for the
nine months ended September 30, 2007, compared to net income of $2.0
million, or $0.07 per diluted share for the corresponding period last year.
The following table presents, for the periods indicated, the approximate
percentage of total revenues attributable to our reportable segments and
reporting segment operating income (loss) as a percentage of total
revenues:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- --------------------
2007 2006 2007 2006
-------- -------- -------- --------
Revenue:
Engineering 95.3 % 92.9 % 94.2 % 93.2 %
Systems 4.7 % 7.1 % 5.8 % 6.8 %
Operating income (loss):
As a % of Total Revenues
Engineering 12.2 % 0.8 % 11.8 % 5.4 %
Systems (0.3)% (0.3)% (0.2)% (0.2)%
The Company's revenue is derived from engineering, construction and
procurement service revenue, systems, land/management and related product
sales, and design and implementation of systems. The Company recognizes
service revenue as soon as the services are performed. The majority of the
Company's engineering services have historically been provided through
cost-plus contracts whereas a majority of the Company's product sales are
earned on fixed-price contracts. However, our engineering segment
recognized approximately $14.0 million in fixed-price revenue in the nine
months ended September 30, 2007, compared to $27.2 million of similar
revenue in the same period in 2006.
Revenue 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 amounts of the adjustments
become known. Losses on contracts are recorded in full as they are
determined.
In the course of providing our services, we routinely provide engineering,
materials, and equipment and may provide construction services on either a
subcontracted or direct hire basis. Generally, these materials, equipment
and subcontractor costs are passed through to our clients and reimbursed,
along with fees, which in the aggregate, are at margins lower than those of
our core business. In accordance with industry practice and generally
accepted accounting principles, all costs and fees are included in revenue.
The use of subcontractor services can change significantly from project to
project; therefore, changes in revenue may not be indicative of business
trends.
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, investor relations/governance, finance,
accounting, safety, human resources, project controls, legal and
information technology departments and other costs generally unrelated to
specific client projects, but which are incurred to support corporate
activities and initiatives.
19
Management's Discussion and Analysis
------------------------------------
Industry Overview:
Many ENGlobal offices have benefited from the strong refinery market. We
expect significant capital projects to continue to be generated by refinery
operations over the next several years given increasing demand for refined
products, improved margins, and an aging refining infrastructure in the
U.S. Overall, projects that relate to expanding capacity at existing
refineries or those projects that relate to processing lower cost grades of
crude have trended upward. Given that global demand for energy has
tightened the supply of both crude oil as well as refined products, we
believe each ENGlobal business segment is well positioned within the
industry.
The petrochemical industry has historically been a good source of projects
for ENGlobal. We continue to see a small increase in both maintenance and
capital spending on domestic facilities after several years of relative
inactivity. Large capital projects in the petrochemical industry are
currently being undertaken outside the U.S., in areas of the world with
increasing product demand or lower cost feedstock.
The Company is also currently seeing a significant increase in North
American pipeline project activity. It is projected that this activity in
terms of pipeline miles built will increase approximately 70% in 2007, when
compared to 2006. Moving products through cross country pipelines requires
other installations on which the Company performs services, such as pump
stations, gas compression facilities, tank farms, metering and surveillance
installations. As a general rule, pipeline projects tend to require less
engineering man hours than for similar sized downstream projects.
ENGlobal is seeing significant increased activity on projects related to
alternative and renewable energy. In many cases, our clients for these
projects are new project developers, compared to our historical client base
of larger developers with longer operating histories. In this area, the
Company primarily focuses its marketing efforts on facilities that will
utilize biomass technologies, including those related to ethanol,
biodiesel, coal to liquids and utilization of refinery petroleum coke as an
energy source.
Revenue:
Revenue increased $43.9 million, or 19.6%, to $268.1 million for the nine
months ended September 30, 2007 from $224.2 million for the comparable
prior year period. Approximately $43.4 million of the increase is
attributable to our engineering segment and $0.5 is attributable to our
systems segment, the details of which are discussed further in our segment
information.
Revenue increased $14.3 million, or 17.3%, to $96.8 million for the three
months ended September 30, 2007 attributable to $82.5 million for the
comparable prior year period. Approximately $15.7 million of the increase
is attributable to our engineering segment reduced by losses of $1.4
million is attributable to our systems segment, the details of which are
discussed further in our segment information.
Gross Profit:
Gross profit increased $20.3 million, or 86.4%, to $43.8 million for the
nine months ended September 30, 2007 from $23.5 million for the comparable
prior year period. As a percentage of revenue, gross profit increased 5.8%
from 10.5% for the nine months ended September 30, 2006 to 16.3% for the
nine months ended September 30, 2007. Of the overall $20.3 million increase
in gross profit, approximately $4.6 million was primarily due to the $43.8
million increase in revenue and approximately $15.7 million was due to
equivalent lower costs, primarily related to the reduced use of
subcontractors and efficiencies related to materials.
Gross profit increased $11.8 million, or 262%, to $16.3 million for the
three months ended September 30, 2007 from $4.5 million for the comparable
prior year period. As a percentage of revenue, gross profit increased 11.4%
from 5.5% for the three months ended September 30, 2006 to 16.9% for the
three months ended September 30, 2007. Of the overall $11.8 million
increase in gross profit, approximately $1.0 million was primarily due to
the $14.3 million increase in revenue and approximately $11.0 million was
due to equivalent lower costs, primarily related to the reduced use of
subcontractors and efficiencies related to materials.
Selling, General, and Administrative:
As a percentage of revenue, total SG&A expense decreased 0.2% to 8.8% for
the nine months ended September 30, 2007 from 9.0% for the comparable prior
year period. Total expense for SG&A increased $3.5 million, or 17.4%, to
20
Management's Discussion and Analysis
------------------------------------
$23.6 million for the nine months ended September 30, 2007 from $20.1
million for the comparable prior year period. About half of the $3.5
million increase for the nine months ended September 30, 2007, was related
to salaries.
As a percentage of revenue, total SG&A expense increased 0.7% to 8.9% for
the three months ended September 30, 2007 from 8.2% for the comparable
prior year period. Total expense for SG&A increased $1.8 million, or 26.5%,
to $8.6 million for the three months ended September 30, 2007 from $6.8
million for the comparable prior year period. About half of the $1.8
million increase for the three months ended September 30, 2007, was related
to salaries.
As a percentage of revenue, Corporate SG&A expense increased 0.4% to 4.1%
for the nine months ended September 30, 2007 from 3.7% for the comparable
prior year period. Corporate SG&A expense increased approximately $2.7
million, or 32.1%, to $11.1 million for the nine months ended September 30,
2007 from $8.4 million for the comparable prior year period. Of the $2.7
million year-over-year increase in Corporate SG&A, approximately $2.1
million was related to increased salaries due to the addition of a total of
twelve new employees in the Business Development, Human Resources,
Accounting and IT departments to support the overall growth of the Company.
Facilities expenses of more than $100,000 were incurred over this timeframe
to add additional office space in Houston and Denver and to add to our
office network. The Company also had increases of more than $100,000 due to
SOX compliance and tax compliance efforts.
As a percentage of revenue, Corporate SG&A expense increased 0.7% to 3.9%
for the three months ended September 30, 2007 from 3.2% for the comparable
prior year period. Corporate SG&A expense increased approximately $1.1
million, or 40.7%, to $3.8 million for the three months ended September 30,
2007 from $2.7 million for the comparable prior year period. Of the $1.1
million quarter-over-quarter increase in Corporate SG&A, approximately $1.1
million was related to increased salaries due to additional personnel.
Operating Income:
Operating income increased approximately $16.8 million, or 494%, to $20.2
million for the nine months ended September 30, 2007 from $3.4 million for
the same period in 2006. As a percentage of revenue, operating income
increased 6.0% to 7.5% for the nine months ended September 30, 2007 from
1.5% for the comparable prior year period.
Operating income increased approximately $10.0 million, or 435%, to $7.7
million for the three months ended September 30, 2007 from a loss of $2.3
million for the same period in 2006. As a percentage of revenue, operating
income increased 10.7% to 8.0% for the three months ended September 30,
2007 from (2.7)% for the comparable prior year period.
Other Expense, net:
Other expense increased $1.0 million for the nine months ended September
30, 2007 from the comparable prior year period. Interest expense increased
$1.1 million due to an increased outstanding balance on our line of credit.
Other income increased $106,000 due to a gain of $483,000 recorded for the
sale of our office building located in Baton Rouge, Louisiana. Other income
for the nine months ended September 30, 2006 was mainly from insurance
proceeds related to Hurricane Rita damage.
Other expense increased $0.3 million for the three months ended September
30, 2007 from the comparable prior year period. Interest expense, due to an
increased outstanding balance on our line of credit, made up the majority
of this increase.
Tax Provision:
Income tax expense increased $6.7 million, or 670.0%, to $7.7 million for
the nine months ended September 30, 2007 from $1.0 million for the
comparable prior year period. The estimated effective tax rate was 41.0%
for the nine months ended September 30, 2007 compared to 37.2% for the
comparable prior year period. The change in the effective tax rate is
partly the result of increasing state income taxes, but in large part
reflects the lower federal tax rate associated with our lower net income in
2006.
Income tax expense increased $4.2 million, or 382%, to $3.1 million for the
three months ended September 30, 2007 from a refund position of $1.1
million for the comparable prior year period. The estimated effective tax
21
Management's Discussion and Analysis
------------------------------------
rate was 41.0% for the three months ended September 30, 2007 compared to
36.9% for the comparable prior year period. The change in the effective tax
rate is partly the result of increasing state income taxes, but in large
part reflects the lower federal tax rate associated with our lower net
income in 2006.
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 included the effect of non-recurring
differences in tax estimates from the 2005 year end. Estimates at September
30, 2007 are based on results of the 2006 year end and adjusted for
estimates of non-recurring differences from the prior year, as well as
anticipated book to tax differences for 2007.
Net Income:
Net income for the nine months ended September 30, 2007 increased $9.0
million, or 450%, to $11.0 million from $2.0 for the comparable prior year
period. As a percentage of revenue, net income increased 3.2% to 4.1% for
the nine months ended September 30, 2007 from 0.9% for the nine months
ended September 30, 2006.
Net income for the three months ended September 30, 2007 increased $5.6
million, or 350%, to $4.0 million from a loss of $1.6 million for the
comparable prior year period. As a percentage of revenue, net income
increased 6.0% to 4.1% for the three months ended September 30, 2007 from
(1.9)% for the three months ended September 30, 2006.
Liquidity and Capital Resources
-------------------------------
Effective August 8, 2007, the Company entered into a new credit agreement
(the "New Credit Agreement") with Comerica Bank. The New Credit Agreement
provides a three-year, $50 million senior secured revolving credit
facility. The New Credit Agreement is guaranteed by substantially all of
Company's subsidiaries and is secured by substantially all of the Company's
assets. The New Credit Agreement replaced a $35 million senior revolving
credit facility that would have expired in July 2009. The outstanding
balance on the New Credit Agreement as of September 30, 2007 was $35.7
million. The remaining borrowings available under the New Credit Agreement
as of September 30, 2007 were $14.3 million after consideration of loan
covenant restrictions.
At the Company's option, amounts borrowed under the New Credit Agreement
will bear interest at LIBOR or an Alternate Base Rate, plus in each case,
an additional margin based on the Leverage Ratio. The Alternate Base Rate
is the greater of the Prime Rate or the Fed Funds Effective Rate, plus
1.0%. The additional margin ranges from 0% on the Alternate Base Rate loans
and 1.50% to 2.0% on the LIBOR-based loans.
Upon maturity, the LIBOR debt will automatically roll into the Revolver
unless the Company elects to renew, at which time a new maturity date and
interest rate will be set.
The New Credit Agreement requires the Company to maintain certain financial
covenants as of the end of each calendar month, including the following:
o Leverage Ratio not to exceed 3.00 to 1.00;
o Asset Coverage Ratio to be less than 1.00 to 1.00; and
o Net Worth must be greater than the sum of $40.1 million plus 75% of
positive Net Income earned in each fiscal quarter after January 1,
2007 plus 100% of the net proceeds of any offering, sale or other
transfer of any capital stock or any equity securities.
The New Credit Agreement also contains covenants that place certain
limitations on the Company including limits on new debt, mergers, asset
sales, investments, fixed price contracts, and restrictions on certain
distributions. The Company was in compliance with all covenants under the
New Credit Agreement as of September 30, 2007.
22
Management's Discussion and Analysis
------------------------------------
Details of this line of credit at September 30, 2007 are as follows:
Amount of Interest
Debt Rate
--------- ---------
($ in thousands)
LIBOR-1, maturing November 18, 2007 $ 5,000 6.99%
LIBOR-2, maturing February 15, 2008 20,000 6.64
Revolver - Alternate Base Rate, expiring August 2010 10,745 7.75
------- ------
$35,745 7.02%
Unused Balance 14,255 0.25%
-------
New Credit Agreement $50,000
September 30, December 31,
2007 2006
---------------------------
(in thousands)
-------------------------
Schedule of Long-Term Debt:
Total Comerica Credit Agreement - 7.02% weighted average at September 30, 2007,
maturing August 2010; 8.25% at December 31, 2006 35,745 23,963
Sterling Planet and EDGI - Notes payable, interest at 5%, principal payments in
installments of $15,000 plus interest due quarterly, maturing in December 2008 75 120
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 847 1,109
InfoTech Engineering, Inc. - Note payable, interest at 5%, principal payments in
installments of $75,000 plus interest due annually, maturing in November 2008 75 75
A.T.I. Inc. - Note payable, interest at 6%, principal payments in installments of
$30,422 including interest due monthly, maturing in January 2009 467 713
Michael Lee - Note payable, interest at 5%, principal payments in installments of
$150,000 plus interest due quarterly, maturing in July 2010 1,650 2,100
Watco Management, Inc. - Note payable, interest at 4%, principal payments in
installments of $137,745 including interest annually, maturing in October 2010 500 500
-------- --------
Total long-term debt 39,359 28,580
Less: Current maturities (1,564) (1,418)
-------- --------
Long-term debt, net of current portion $ 37,795 $ 27,162
======== ========
We are not currently subject to any obligations under standby letters of
credit, guarantees, repurchase obligations or other commitments. We have no
off-balance sheet arrangements.
As of September 30, 2007, management believes the Company's cash position
is sufficient to meet its working capital requirements for at least the
next twelve months. Any future decrease in demand for the Company's
services or products would reduce the availability of funds through
operations.
Cash Flow
---------
The Company believes that it has available the necessary cash required for
operations for the next 12 months. 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, if project mix
shifts from cost reimbursable to fixed-cost contracts during significant
periods of growth, if the Company was to lose one or more of its major
customers, if demand for the Company's services decreases, or if the
Company is not able to meet the covenants of the Comerica Credit Facility.
If cash and the availability of cash become materially restricted, the
Company would be forced to consider alternative financing options.
23
Management's Discussion and Analysis
------------------------------------
Operating activities:
Net cash used in operating activities was $9.4 million for the nine months
ended September 30, 2007, compared with net cash used of $6.8 million in
the same period in 2006.
Amounts outstanding under the credit facility increased from $24.0 million
as of December 31, 2006 and from $19.7 million as of September 30, 2006 to
$35.8 million as of September 30, 2007.
Our average days of sales outstanding ("DSO") was 66 days for the three
months ended September 30, 2007 compared to 60 days for the comparable
three month period in 2006 and 69 days for the period ended December 31,
2006. The re-classification of $10.4 million from accounts receivable and
unbilled receivables to a long-term note receivable lower our accounts
receivable days outstanding by nine days for the three months ended
September 30, 2007. The Company is continuing its efforts to work toward
improving billing and collection processes. The Company revised the method
used for calculating DSO changing from annualized average revenue and
accounts receivable totals to average quarterly revenue and accounts
receivable totals. The average DSO for all periods referenced herein and
for all future periods have been and will be calculated under the new
method.
On September 30, 2007, the Company re-classified Accounts Receivable and
Unbilled Receivable balances to a long-term Note Receivable in the amount
of $10.4 million, with a reserve of $1.2 million. Full details related to
the note receivable can be found under Note 12 - Subsequent Event.
Investing activities:
Net cash used in investing activities was $1.3 million for the nine months
ended September 30, 2007, compared with net cash used of $8.3 million in
the same period in 2006. In 2006, the Company acquired the assets of ATI,
Inc. for $750,000 cash and a note payable of $1 million and the Company
acquired the assets of WRC for $10.1 million. The WRC transaction included
$4.3 million assumption of debt, $2 million in cash, notes payable of $2.4
million and ENGlobal shares of common stock valued at $1.4 million. The
Company also used cash for capital expenditures in the nine months ended
September 30, 2007 of $1.8 million and $2.8 million in the comparable prior
year period.
Financing activities:
Net cash provided by financing activities was $10.3 million for the nine
months ended September 30, 2007, compared with net cash provided of $15.9
million in the same period in 2006. During 2007, the Company increased the
amounts outstanding on its credit facility by $11.8 million for working
capital needs compared to an increase in the amount outstanding in the
credit facility of $15.9 million in the same period in 2006.
Asset Management
----------------
The Company's cash flow from operations has been affected primarily by the
timing of its collection of trade accounts receivable. The Company
typically sells its products and services on short-term credit terms and
seeks to minimize its credit risk by performing credit checks and
conducting its own collection efforts. In addition, the Company has
obtained security for payments due by a client for all current and future
invoices for services and materials provided. See Note 12 - Subsequent
Event. The Company had net trade accounts receivable of $70.7 million and
$60.2 million at September 30, 2007 and December 31, 2006, respectively.
The DSO in trade accounts receivables was 66 days at September 30, 2007 and
69 days at December 31, 2006.
24
Engineering Segment Results
---------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------- -------------------------------------
2007 (1) 2006 (1) 2007 (1) 2006 (1)
----------------- ----------------- ----------------- -----------------
(dollars in thousands)
-----------------------------------------------------------------------------
Gross revenue $ 92,529 $ 76,768 $ 253,235 $ 209,268
Less intercompany revenue (230) (152) (849) (313)
--------- --------- --------- ---------
Total Revenue: $ 92,299 100% $ 76,616 100% $ 252,386 100% $ 208,955 100%
Gross profit: $ 16,208 17.6% $ 4,426 5.8% $ 43,204 17.1% $ 22,412 10.7%
Operating SG&A expense: $ 4,406 4.8% $ 3,724 4.9% $ 11,406 4.5% $ 10,215 4.9%
Operating income: $ 11,802 12.8% $ 702 0.9% $ 31,798 12.6% $ 12,197 5.8%
(1) Percentages represent percentage of engineering segment revenue for
the periods indicated.
Overview of Engineering Segment:
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 sector continues to be very
active, supplying a large percentage of the Company's 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.
Even though some of our subsidiary entities may focus more on one
discipline than another, each of the entities provides services to our
clients in the petrochemical and energy industries. As our clients have
downsized and began limiting the number of vendors and subcontractors, we
have attempted to become a "one-stop shop" integrated solution for an
entire project or large portion of that project often with more than one of
our subsidiaries providing a portion of the work for a single project,
while other times only one entity may provide one or more portions of the
entire project. For example, we may have a project in which WRC provides
right of way services, EEI provides engineering and design services, and
ECR provides construction management and inspection services. We and the
client would view the work as one project under one contract. We provide
these services based on the client requirements.
We provide services to a wide range of industrial sectors including:
petroleum refining, gas processing, pipeline and product movement,
petrochemical, production, sulfur processing, manufacturing, chemical
exploration, and co-generation. Each of our subsidiaries can service
customers in these industries. The various entities also share similar
processes for delivery of services.
All of our entities are greatly impacted by the general availability of
qualified engineers and other technical professional staff and employees
are often shared among entities as needed.
Revenue
Year over year revenue increased $43.4 million, or 20.8%, to $252.4 million
for the nine months ended September 30, 2007 from $209.0 million for the
comparable prior year period. The increase in engineering revenue resulted
primarily from increased activity in the engineering and construction
markets. Refining related activity has been particularly strong, including
projects to satisfy environmental mandates, expand existing facilities and
utilize heavier sour crude. Capital spending in the pipeline area is also
trending higher, with numerous projects in North America currently underway
to deliver crude oil, natural gas, petrochemicals and refined products.
Renewable energy appears to be an emerging area of activity and potential
growth, with the Company currently performing a variety of services for
ethanol, biodiesel, coal to liquids, petroleum coke to ammonia, and other
biomass processes. As the price per barrel of oil is nearing $100, we
expect to see increasing interest in renewable energy. The acquisition of
WRC in May 2006, together with our clients' increased demand for in-plant
and inspection resources, stimulated growth in our staffing services
division.
25
Engineering Segment Results (continued)
---------------------------------------
The following table illustrates the composition of the Company's revenue
mix quarter over quarter for the nine months ended September 30, 2007 and
2006, and provides a comparison of the changes in revenue and revenue
trends period over period.
Nine Months Ended September 30,
-------------------------------------------------------------
2007 % rev 2006 % rev $ change % change
-------- -------- -------- --------
(dollars in millions)
Detail-design $ 107.4 43% $ 89.9 43% $ 17.5 19 %
Field services & inspection 114.8 45% 73.7 35% 41.1 56 %
Procurement & construction 16.2 6% 18.2 9% (2.0) (11)%
Design-build fixed price 14.0 6% 27.2 13% (13.2) (49)%
-------- -------- --------
$ 252.4 100% $ 209.0 100% $ 43.4 21 %
======== ======== ========
o The largest increase in revenue came from field services and
inspection activity which increased $41.1 million, or approximately
56%, to $114.8 million for the nine months ended September 30, 2007
from $73.7 million for the comparable prior year period.
o Detail-design services increased $17.5 million, or approximately 19%
for the nine months ended September 30, 2007. Core engineering
activities accounted for approximately 88% of engineering's total
revenue mix during the nine months ended September 30, 2007 compared
to approximately 78% for the comparable prior year period.
o Revenue from non-labor procurement and construction activity decreased
$2.0 million from $18.2 million during the nine months ended September
30, 2006 to $16.2 million during the nine months ended September 30,
2007.
o The design-build fixed price revenue decreased $13.2 million, or 49%,
from $27.2 million for the nine months ended September 30, 2006 to
$14.0 million for the same period in 2007 and accounted for
approximately 6% of engineering's total revenue.
Quarter over quarter revenue increased $15.7 million, or 20%, to $92.3
million for the three months ended September 30, 2007 from $76.6 million
for the comparable prior year period. The following table illustrates the
composition of the Company's revenue mix quarter over quarter for the three
months ended September 30, 2007 and 2006, and provides a comparison of the
changes in revenue and revenue trends period over period:
Three Months Ended September 30,
---------------------------------------------------------------
2007 % rev 2006 % rev $ change % change
------- ------ ------- ------ -------- --------
(dollars in millions)
Detail-design $ 35.5 38% $ 33.9 44% $ 1.6 5 %
Field services & inspection 41.4 45% 29.0 38% 12.4 43 %
Procurement & construction 9.4 10% 1.3 2% 8.1 623 %
Design-build fixed price 6.0 7% 12.4 16% (6.4) (52)%
------- ------- -------
$ 92.3 100% $ 76.6 100% $ 15.7 20 %
======= ======= =======
Gross Profit:
Gross profit increased $20.8 million, or 92.9%, to $43.2 million for the
nine months ended September 30, 2007 from $22.4 million for the comparable
prior year period. As a percentage of engineering revenue, gross profit
increased by 6.4% to 17.1% from 10.7% for the nine months ended September
30, 2007 and 2006, respectively. Of the overall $22.4 million increase in
gross profit, approximately $4.7 million was attributable to the $43.4
million increase in total revenue, and approximately $16.1 million was
attributable to improved margins. The increase in margins can be attributed
to low margin/high dollar procurement projects being replaced with higher
margin core revenue derived from labor activity. Included in gross profit
for the nine months ended September 30, 2007, were $572,000 of additional
losses related to the completion of the two fixed price contracts. Losses
for these same projects were $6.7 million for the nine months ending
September 30, 2006.
26
Engineering Segment Results (continued)
---------------------------------------
Gross profit increased $11.8 million, or 268%, to $16.2 million for the
three months ended September 30, 2007 from $4.4 million for the comparable
prior year period. As a percentage of engineering revenue, gross profit
increased by 11.8% to 17.6% from 5.8% for the three months ended September
30, 2007 and 2006, respectively. Of the overall $11.8 million increase in
gross profit, approximately $1.0 million was attributable to the $15.7
million increase in total revenue, and approximately $10.8 million was
attributable to improved margins. The increase in margins can be attributed
to low margin/high dollar procurement projects being replaced with higher
margin core revenue derived from labor activity. Included in gross profit
for the three months ended September 30, 2007 was $115,000 of losses
related to the completion of two fixed price contracts. Losses for these
same projects were $6.7 million for the nine months ending September 30,
2006.
At September 30, 2007, the Company had outstanding unapproved change
orders/claims of approximately $8.0 million. The Company recorded $1.0
million in revenue, which did not include any profit component, related to
these claims, for the year ended December 31, 2006. No additional amounts
have been recognized during 2007 related to these claims. During the
quarter, one claim was settled with the revenue recorded during the year
ended December 31, 2006. Generally, collection of amounts related to
unapproved change orders and claims is expected within twelve months.
However, clients generally will not pay these amounts until final
resolution of related claims, thus accordingly, collection of these amounts
may extend beyond one year. In the future, if the Company determines
collection of any unapproved change order/claim is not probable, it will
post a charge to earnings in the period such determination is made.
Selling, General, and Administrative:
As a percentage of engineering revenue, SG&A expense decreased 0.4% to 4.5%
for the nine months ended September 30, 2007 from the comparable prior year
period. SG&A expense increased $1.2 million, or 11.8%, to $11.4 million for
the nine months ended September 30, 2007 from $10.2 million for the
comparable prior year period. This increase is primarily attributed to the
acquisition of WRC in May 2006, as 2006 numbers reflect only four months of
WRC's expenses, while 2007 numbers include a full nine months of WRC's
expenses. Also contributing to the increase is the additional bad debt
expense posted to create the reserve in connection with the note
receivable. This note receivable is described in Note 12 - Subsequent
Event. If further impairment of the note is determined in the future,
additional bad debt expense could be posted.
As a percentage of engineering revenue, SG&A expense decreased 0.1% to 4.8%
for the three months ended September 30, 2007 from 4.9% for the comparable
prior year period. SG&A expense increased $0.7 million, or 18.9%, to $4.4
million for the three months ended September 30, 2007 from $3.7 million for
the comparable prior year period. This increase is mainly related to
additional bad debt expense posted to create the reserve in connection with
the note receivable. This note receivable is described in Note 12 -
Subsequent Event.
Operating Income:
Operating income increased $19.6 million, or 160.7%, to $31.8 million for
the nine months ended September 30, 2007 from $12.2 million for the
comparable prior year period. As a percentage of engineering revenue,
operating income increased to 12.6% for the nine months ended September 30,
2007 from 5.8% for the comparable prior year period. The increase in
operating income is attributable to the completion of the EPC projects on
which the Company had incurred substantial losses in 2006.
Operating income increased $11.1 million, or over 1,000%, to $11.8 million
for the three months ended September 30, 2007 from $0.7 million for the
comparable prior year period. As a percentage of engineering revenue,
operating income increased to 12.8% for the three months ended September
30, 2007 from 0.9% for the comparable prior year period. The increase in
operating income is attributable to the completion of the EPC projects on
which the Company had incurred substantial losses in 2006.
27
Systems Segment Results (continued)
-----------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------------------- -----------------------------------------
2007 2006 2007 2006
------------------ ------------------ ------------------ -------------------
(dollars in thousands)
-------------------------------------------------------------------------------------
$ 4,655 $ 6,291 $ 15,950 $ 16,244
Gross revenue
Less intercompany revenue (128) (404) (275) (1,003)
-------- -------- -------- ---------
Total revenue: $ 4,527 100.0 % $ 5,887 100.0 % $ 15,675 100.0 % $ 15,241 100.0 %
Gross profit: $ 131 2.9 % $ 123 2.1 % $ 632 4.0 % $ 1,087 7.1 %
-------- -------- -------- ---------
Operating SG&A expense: 418 9.2 % 404 6.9 % 1,159 7.4 % 1,496 9.8 %
-------- -------- -------- ---------
Operating income: (287) (6.3)% (281) (4.8)% (527) (3.4)% (408) (2.7)%
======== ======== ======== =========
Overview of Systems Segment:
The systems segment began a detailed review process in the fourth quarter
of 2006. As a continuation of this process in the first nine months of
2007, the Company initiated more detailed project cost control/forecasting
on all active lump sum projects in order to identify potential areas of
remediation and improve financial results. The Company also implemented
more detailed project review processes to analyze projects on a more timely
basis. The increased client spending for expansion projects in the United
States and international grass roots projects are expected to improve
growth in our systems segment.
Revenue:
Revenue increased approximately $0.5 million, or 3.3%, to $15.7 million for
the nine months ended September 30, 2007 from $15.2 million for the
comparable prior year period.
Revenue decreased approximately $1.4 million, or (23.7)%, to $4.5 million
for the three months ended September 30, 2007 from $5.9 million for the
comparable prior year period. This is due primarily to a delay in receiving
certain parts and materials.
Gross profit:
Gross profit decreased approximately $0.5 million, or (45.5)%, to $0.6
million for the nine months ended September 30, 2007 from $1.1 million for
the comparable prior year period. As a percentage of systems revenue, gross
profit decreased to 4.0% from 7.1% for the respective periods. Lower
margins on fixed price work accounted for the majority of the decrease.
Gross margins were affected by increased labor costs due to a shortage of
available experienced staff, as well as material cost increases, in
particular related to copper wire. The remainder was caused by increased
project management costs and increased variable costs associated with labor
to perform proposals.
Gross profit remained steady at approximately $0.1 million for the three
months ended September 30, 2007 and comparable prior year period. As a
percentage of systems revenue, gross profit increased 0.8% to 2.9% for the
three months ended September 30, 2007, from 2.1% for the comparable prior
year period.
Selling, General, and Administrative:
SG&A expense decreased approximately $0.3 million, or 20%, to $1.2 million
for the nine months ended September 30, 2007 from $1.5 million for the same
period in 2006 and, as a percentage of systems revenue, SG&A expense
decreased to 7.4% from 9.8% for the respective periods. Salaries and
related expenses decreased by $703,000 for a variety of reasons. The
expenses of four sales persons were moved to Corporate SG&A from
Operations; some salaries were moved to direct costs variable; and the
Company's Systems segment personnel decreased. Amortization expense
increased by $424,000 as a result of the non-compete intangible related to
the ATI acquisition.
28
Systems Segment Results (continued)
-----------------------------------
SG&A expense remained steady at approximately $0.4 million for the three
months ended September 30, 2007, compared to the three months ended
September 30, 2006. As a percentage of systems revenue, SG&A expense
increased to 9.2% from 6.9% for the respective periods. The move of the
sales personnel and decrease in personnel occurred at the end of the second
quarter 2006 so there were no significant changes between the third quarter
of 2006 and 2007, except for the amortization expense increase related to
the non-compete intangible asset for the ATI acquisition.
Operating Income:
The systems segment recorded an operating loss of $527,000 for the nine
months ended September 30, 2007 compared to an operating loss of $409,000
for the nine months ended September 30, 2006.
The systems segment recorded an operating loss of $287,000 for the three
months ended September 30, 2007 compared to operating income of $281,000
for the three months ended September 30, 2006.
As stated earlier, the Company has implemented more detailed project review
processes to analyze projects on a more timely basis. Once we improve and
update our bidding processes and our project management processes, we
expect to see increased efficiencies in our Systems segment.
29
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our financial instruments include cash and cash equivalents, accounts
receivable, accounts payable, notes receivable, notes and capital leases
payable, and debt obligations. The book value of cash and cash equivalents,
accounts receivable, accounts payable, notes receivables 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 new Credit Agreement Facility. As of September
30, 2007, $35.7 million had been borrowed under the new Credit Agreement,
accruing interest at 7.02% per year, excluding amortization of prepaid
financing costs. A 10% increase in the short-term borrowing rates on the
new Credit Agreement outstanding as of September 30, 2007 would be 70 basis
points. Such an increase in interest rates would increase our annual
interest expense by approximately $250,000, 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 engage in foreign currency
hedging activities.
ITEM 4. CONTROLS AND PROCEDURES
a. Evaluation of Disclosure Controls and Procedures
Our management is responsible for establishing and maintaining our
disclosure controls and procedures. As of September 30, 2007, 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 or "disclosure controls." Disclosure controls are
controls and procedures designed to ensure that information required to be
disclosed in our reports filed under the Securities Exchange Act of 1934 is
properly recorded, processed, summarized, and reported within the time
periods specified in the U.S. Securities and Exchange Commission's rules
and regulations. Disclosure controls include processes to accumulate and
evaluate relevant information and communicate such information to
management, including the CEO and CFO, as appropriate to allow timely
decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and
management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
Based on the controls evaluation, our CEO and CFO have concluded that, as a
result of the matters discussed below with respect to our internal control
over financial reporting, our disclosure controls as of September 30, 2007,
were not effective. However, the Company has taken significant steps to
remediate this situation, as detailed below.
A material weakness in internal control over financial reporting is a
significant deficiency, or combination of significant deficiencies, that
results in more than a remote likelihood that a material misstatement of
the annual or interim financial statements will not be prevented or
detected. Management's assessment identified the following material
weaknesses in our internal control over financial reporting as of December
31, 2006, some of which remained outstanding as of September 30, 2007:
o Deficiencies in the Company's Control Environment. Our control
environment did not sufficiently promote effective internal control
over financial reporting throughout the organization. Specifically, we
had a shortage of support and resources in our accounting department,
which resulted in insufficient: (i) documentation and communication of
our accounting policies and procedures; and (ii) internal audit
processes of our accounting policies and procedures.
30
o Deficiencies in the Company's Information Technology Access Controls.
We did not maintain effective controls over preventing access by
unauthorized personnel to end-user spreadsheets and other information
technology programs and systems.
o Deficiencies in the Company's Accounting System Controls. We did not
effectively and accurately close the general ledger in a timely manner
and we did not provide complete and accurate disclosure in our notes
to financial statements, as required by generally accepted accounting
principles.
o Deficiencies in the Company's Controls Regarding Purchases and
Expenditures. We did not maintain effective controls over the tracking
of our commitments and actual expenditures with third-party
subsidiaries on a timely basis.
o Deficiencies in the Company's Controls Regarding Fixed-Price Contract
Information. We did not maintain effective controls over the complete,
accurate, and timely processing of information relating to the
estimated cost of fixed-price contracts.
o Deficiencies in the Company's Revenue Recognition Controls. We did not
maintain effective policies and procedures relating to revenue
recognition of fixed price contracts, which accounted for
approximately 11% of the Company's revenues in 2006.
o Deficiencies in the Company's Controls over Income Taxes. We did not
maintain sufficient internal controls to ensure that amounts provided
for in our financial statements for income taxes accurately reflected
our income tax position as of December 31, 2006.
o Management assessed the effectiveness of our internal control over
financial reporting as of December 31, 2006, but management did not
complete its assessment until March 2, 2007. Due to the lack of
adequate time to permit Hein to audit management's assessment, Hein
was unable to render an opinion on our assessment of the effectiveness
of our internal control over financial reporting as of December 31,
2006. Accordingly, management identified this as a material weakness.
Management's assessment process did not conclude in adequate time to
permit Hein to audit management's assessment due to a number of
factors, including: (i) our failure to prepare and plan for a timely
completion of management's assessment, including adding the resources
necessary to do so; and (ii) our failure to ensure that our accounting
department was adequately staffed and sufficiently trained to meet
deadlines.
Except as noted below under the heading "Remediation Initiatives," no
change in our internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) occurred during the
quarter ended September 30, 2007, that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
b. Remediation Initiatives
Management, with oversight from the Audit Committee of the Board of
Directors, has been addressing the material weaknesses disclosed in its
2006 Annual Report on Form 10-K/A and is committed to effectively
remediating known weaknesses as expeditiously as possible. While progress
has been made, these remedial steps have not been completed; however, the
Company has performed additional analysis and procedures in order to ensure
that the consolidated financial statements contained in this Quarterly
Report on Form 10-Q were prepared in accordance with generally accepted
accounting principles in the United States of America. Although the
Company's remediation efforts are underway, control weaknesses will not be
considered remediated until new internal controls over financial reporting
are implemented and operational for a sufficient period of time to allow
for effective testing and are tested, and management and its independent
registered certified public accounting firm conclude that these controls
are operating effectively. In 2007, management, its outside consultants,
and the Audit Committee of the Company's Board of Directors have worked
with the Company's auditors to determine the most effective way to
implement the remedial measures listed below, and, if necessary, to develop
additional remedial measures to address the internal control deficiencies
identified above. The Company is monitoring the effectiveness of planned
actions and will make any other changes and take such other actions as
management or the Audit Committee determines to be appropriate. The
Company's remediation plans include:
31
o We are hiring additional personnel to assist us with documenting and
communicating our accounting policies and procedures to ensure the
proper and consistent application of those policies and procedures
throughout the Company. While some positions have been filled,
recruitment for these positions has begun and the selection process is
ongoing.
o We have begun implement formal processes requiring periodic
self-assessments, independent tests, and reporting of our personnel's
adherence to our accounting policies and procedures.
o We plan to design effective policies and procedures to control
security of and access to spreadsheet information. If necessary, we
will also consider implementing a software solution with automatic
control checkpoints for day-to-day business processes.
o We have begun (i) to require additional training for our current
accounting personnel; (ii) to hire additional accounting personnel to
enable the allocation of job functions among a larger group of
accounting staff; (iii) to engage outside consultants with technical
accounting expertise, as needed; and (iv) to consider restructuring
our accounting department, each to increase the likelihood that our
accounting personnel will have the resources, experience, skills, and
knowledge necessary to effectively perform the accounting system
functions assigned to them. During the second quarter, the Company
conducted training for the accounting staff, with an emphasis on
improving various accounting functions going forward. And in the third
quarter, conferences were held with senior management regarding
improving the quality and timeliness of information flow to and from
accounting to enhance efficiencies in financial reporting and
decision-making.
o We have begun to improve procurement and operational efficiencies by
implementing a software system and a matrix organization to more
completely, accurately, and timely track commitments on Company-wide
purchase and expenditure transactions.
o We have begun improving revenue recognition policies and procedures
relating to fixed-price contracts by evaluating the level of economic
success achieved by past fixed-price contracts and by stressing
throughout the Company the importance of (i) accurately estimating
costs, (ii) timely updating cost estimates to reflect the accuracy of
the cost savings, (iii) accurately estimating expected profit, (iv)
timely identifying when a project's scope changes, (v) promptly
reporting man hours and costs in excess of those originally estimated;
and (vi) closely scrutinizing the bid process.
o Throughout 2007, we have been training personnel to effectively
implement and evaluate the overall design of the Company's fixed-price
project control processes. Specifically, we are in the process of
evaluating and tightening controls as they relate to the initial bid
process and the attendant recognition and management of risk by only
bidding on large procurement and construction activities on a cost
plus basis.
Management recognizes that many of these enhancements require continual
monitoring and evaluation for effectiveness. The development of these
actions is an iterative process and will evolve as the Company continues to
evaluate and improve our internal controls over financial reporting. In
conjunction with the Company's SOX Section 404 Steering Committee,
management will review progress on these activities on a consistent and
ongoing basis at the Chief Executive Officer and senior management level in
conjunction with our Audit Committee. We have also begun to take additional
steps to elevate Company awareness about and communication of these
important issues through formal channels such as Company meetings,
departmental meetings, and training.
During the second quarter, the Company's external auditors began its review
of the 2007 internal controls audit. In July 2007, the Company hired a
consulting firm to oversee the testing of its internal financial and
information technology controls. A quarterly review by consultants will
assist the Company with its remediation plan will assist the Company's
independent auditor in their preparation for the final assessment in the
third and fourth quarters, allowing for any remediation before December 31,
2007.
32
As of October 29, 2007, the consulting firm has completed its review of the
2006 review of internal controls, planning and scoping for the 2007 review
of internal controls, and process and controls documentation relating to
the 2007 review of internal controls. They have continually advised
ENGlobal management of their progress. In addition, the consulting firm
along with management has discussed certain portions of their review in
order to coordinate with the review that the Company's external auditors
are performing. The consulting firm is currently on-target to perform
testing of the controls and provide their evaluation and report in a timely
manner for our external auditors to express an opinion on the effectiveness
of our internal control over financial reporting as of December 31, 2007.
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, is 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 2006 Annual Report on Form 10-K. 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 conditions or operating results.
ENGlobal Engineering, Inc. ("EEI") has been issued a promissory note in the
principal amount of $12,329,343.53 for past due invoices owed to it by one
of its clients. In the event of a default on the note, the Company may
suffer a significant loss if it is unable to enforce EEI's security
interest or successfully liquidate the collateral.
See Note 12 to the Condensed Consolidated Financial Statements in Part I,
Item 1 of the Company's Form 10-Q for the three months ended September 30,
2007, for further detail on the following discussion. In August 2007, EEI
received a promissory note and a collateral agreement as security for
payments due by the client for all current and future invoices for services
and materials provided. This note and pledge agreement were later
supplemented with a "hand note" in the principal amount of $12.3 million
and an additional collateral agreement. Management believes that these
agreements give EEI priority over certain other creditors. To obtain
additional security, ECR, another subsidiary of ENGlobal and a
subcontractor to EEI, filed a Material Man's and Mechanic's Lien on the
property in October 2007, securing $8.6 million of the amount due. Under
Louisiana law, ECR's lien is subordinate to governmental and laborers'
liens and to bona fide mortgages. A lien search conducted on November 1,
2007, did not reveal any liens that we believe to be superior to ECR's
Material Man's and Mechanic's lien. However, liens that have priority could
be discovered or filed in the future.
Management currently believes that the client will be successful in
obtaining financing and completing the project. In addition, management
believes that even if the project is not completed, the underlying
collateral supporting the note receivable and the Material Man's and
Mechanic's lien will be sufficient to ensure full payment of the note
receivable and the interest accruing thereon. However, there can be no
guarantee that (i) the client will pay the amount due, (ii) if the client
defaults on the note, EEI and ECR will be able to enforce their liens,
(iii) liens having priority over the liens of EEI or ECR will not be
discovered or will not be filed in the future, or (iv) if EEI and ECR
successfully enforce their liens, the value of the collateral will provide
sufficient funds for full payment of the note receivable. In addition,
there is no guarantee that the reserves taken by the Company with respect
to the note receivable will be sufficient. In any such case, the Company
would incur a significant loss.
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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
10.1 Credit Agreement, Dated as of August 8, 2007, between ENGlobal
Corporation and Comerica Bank as Administrative Agent and Lead
Arranger and Certain Financial Institutions, as Lenders for
$50,000,000 Senior Secured Revolving Credit Facility
10.2 Hand Note, Dated October 22, 2007, between South Louisiana Ethanol LLC
and ENGlobal Engineering, Inc. for principal sum of $12,329,343.53
10.3 Collateral Mortgage Note, Dated August 26, 2007, between South
Louisiana Ethanol LLC and ENGlobal Engineering, Inc. for $15,000,000
10.4 Collateral Mortgage, Dated August 31, 2007, between South Louisiana
Ethanol LLC and ENGlobal Engineering, Inc. for $15,000,000
31.1 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act of
2002 for the Third Quarter 2007
31.2 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act of
2002 for the Third Quarter 2007
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 2007
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: November 9, 2007
By: /s/ Robert W. Raiford
-------------------------
Robert W. Raiford
Chief Financial Officer and Treasurer
35