10-Q 1 englobal905.txt 10-Q 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, 2005 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 ---------------------------------- (I.R.S. Employer Identification No.) 654 North Sam Houston Parkway East, 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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X ----- ----- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of Common Stock as of the close of business of October 26, 2005. $0.001 Par Value Common Stock 26,267,406 shares QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005 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, 2005 and September 30, 2004 3 Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004 4 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and September 30, 2004 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosures about Market Risk 28 Item 4. Controls and Procedures 28 Part II. Other Information Item 1. Legal Proceedings 29 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29 Item 3. Defaults Upon Senior Securities 29 Item 4. Submission of Matters to a Vote of Security Holders 29 Item 5. Other Information 29 Item 6. Exhibits 30 Signature 31 2 PART I. - FINANCIAL INFORMATION ------------------------------- ITEM 1. FINANCIAL STATEMENTS
ENGlobal Corporation Condensed Consolidated Statements of Income (Unaudited) For the Three Months Ended For the Nine Months September 30, Ended September 30, -------------------------------- -------------------------------- 2005 2004 2005 2004 ------------- ------------- ------------- ------------- Operating Revenue $ 59,265,617 $ 37,272,033 $ 163,314,149 $ 102,547,298 ------------- ------------- ------------- ------------- Operating Expenses: Direct cost 51,427,251 32,562,744 142,498,567 89,567,709 Selling, general and administrative 4,815,324 3,256,566 12,991,480 9,535,940 Depreciation and amortization 257,786 210,377 814,178 581,552 ------------- ------------- ------------- ------------- Total operating expenses 56,500,361 36,029,687 156,304,225 99,685,201 ------------- ------------- ------------- ------------- Operating income 2,765,256 1,242,346 7,009,924 2,862,097 Other Income (Expense): Other income 5,809 23,996 79,054 52,064 Interest income (expense), net (199,096) (122,211) (642,647) (418,167) ------------- ------------- ------------- ------------- Total other income (expense) (193,287) (98,215) (563,593) (366,103) ------------- ------------- ------------- ------------- Income before Provision for Income Taxes 2,571,969 1,144,131 6,446,331 2,495,994 Provision for Income Taxes 951,629 389,005 2,385,143 848,638 ------------- ------------- ------------- ------------- Net Income $ 1,620,340 $ 755,126 $ 4,061,188 $ 1,647,356 ============= ============= ============= ============= Net Income Per Common Share: Basic $ 0.07 $ 0.03 $ 0.17 $ 0.07 Diluted $ 0.07 $ 0.03 $ 0.17 $ 0.07 Weighted Average Shares Used in Computing Net Income Per Share: Basic 23,890,842 24,060,689 23,637,345 24,043,734 Diluted 24,898,045 24,216,826 24,460,313 24,199,871 See accompanying notes to interim condensed consolidated financial statements. 3 ENGlobal Corporation Condensed Consolidated Balance Sheets September 30, December 31, 2005 2004 ------------ ------------ (unaudited) ASSETS ------ Current Assets: Cash $ 2,959,313 $ 8,006 Accounts receivable - trade, less allowance for doubtful accounts of approximately $507,000 and $472,000, respectively 31,200,064 30,839,597 Costs and estimated earnings in excess of billings on uncompleted contracts 4,628,852 1,113,330 Prepaid and other 953,537 1,984,274 Inventories 172,332 172,715 Assets held for sale -- 678,106 Deferred tax asset 757,247 640,380 Income taxes receivable -- 118,000 ------------ ------------ Total Current Assets 40,671,345 35,554,408 Property and Equipment, net 6,257,078 5,262,370 Goodwill 15,424,112 15,284,220 Other Assets 933,523 1,159,750 ------------ ------------ Total Assets $ 63,286,058 $ 57,260,748 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current Liabilities: Accounts payable - trade $ 10,461,711 $ 10,512,123 Accrued salaries and benefits 7,169,844 6,059,221 Note payable -- 839,606 Current portion - long-term debt 553,249 622,410 Capital lease payable -- 4,371 Billings and estimated earnings in excess of costs on uncompleted contracts 1,726,454 2,313,954 Income taxes payable 615,268 -- Other liabilities 1,810,926 699,601 ------------ ------------ Total Current Liabilities 22,337,452 21,051,286 Long-Term Debt, net of current portion 1,825,926 15,585,152 Deferred Tax Liability 99,810 573,380 ------------ ------------ Total Liabilities 24,263,188 37,209,818 Contingencies (Note 11) Stockholders' Equity: Series A redeemable convertible preferred stock, $0.001 par value; 2,265,167 shares authorized; 0 shares issued and outstanding -- -- Common stock, $0.001 par value; 75,000,000 shares authorized; 26,201,057 and 23,466,839 outstanding and 26,853,434 and 24,119,216 issued at September 30, 2005 and December 31, 2004, respectively 26,853 24,119 Additional paid-in capital 27,104,257 12,198,215 Accumulated other comprehensive income 1,976 -- Retained earnings 12,482,015 8,420,827 Treasury stock, 652,377 shares at cost (592,231) (592,231) ------------ ------------ Total Stockholders' Equity 39,022,870 20,050,930 ------------ ------------ Total Liabilities and Stockholders' Equity $ 63,286,058 $ 57,260,748 ============ ============ See accompanying notes to interim condensed consolidated financial statements. 4 ENGlobal Corporation Condensed Consolidated Statements of Cash Flows (Unaudited) For the Nine Months Ended September 30, -------------------------------------- 2005 2004 ------------ ------------ Cash Flows from Operating Activities: Net income $ 4,061,188 $ 1,647,356 Adjustments for non-cash items 619,240 860,882 Changes in working capital (229,816) (165,651) ------------ ------------ Net cash provided by operating activities 4,450,612 2,342,587 ------------ ------------ Cash Flows from Investing Activities: Property and equipment acquired (2,184,929) (858,929) Proceeds from sale of equipment 15,400 3,260 Proceeds from sale of assets held for sale 823,350 -- Additional consideration for acquisitions (77,297) -- ------------ ------------ Net cash used in investing activities (1,423,476) (855,669) ------------ ------------ Cash Flows from Financing Activities: Net borrowings (payments) on line of credit (13,529,496) 1,764,448 Proceeds from issuance of common stock 14,663,776 58,429 Short-term note repayments (837,714) (719,395) Capital lease repayments (4,371) (6,186) Long-term debt repayments (370,000) (2,608,163) ------------ ------------ Net cash used in financing activities (77,805) (1,510,867) Effect of Exchange Rate Changes on Cash 1,976 -- ------------ ------------ Net change in cash 2,951,307 (23,949) Cash, at beginning of period 8,006 39,439 ------------ ------------ Cash, at end of period $ 2,959,313 $ 15,490 ============ ============ Supplemental Disclosures: Interest paid $ 605,170 $ 328,386 Income taxes paid $ 2,193,351 $ 701,982 Non-Cash: Issuance of notes for EDGI assets -- $ 300,000 Issuance of note for AmTech assets -- $ 50,000 Record debt for acquisition of treasury stock -- $ 592,231 See accompanying notes to interim condensed consolidated financial statements. 5
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, 2005 and 2004. 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. Certain reclassifications have been made to prior period balances to conform to the current presentation. These reclassifications did not affect net income. 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, 2004, which are included in the Company's annual report on Form 10-K for the year ended December 31, 2004. The Company believes that the disclosures made herein are adequate to make the information presented not misleading. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Revenue Recognition ------------------- The Company's revenue is composed of engineering service revenue and product sales. 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-fee contracts. On occasion, the Company, serving as an agent for the client, procures materials and equipment on behalf of the client and the cost of such materials and equipment is reimbursed with no mark-up or profit. In accordance with Statement of Position (SOP) 81-1, revenue and cost for these types of purchases are not included in total revenue and cost. For financial reporting, this "pass-through" type of transaction is reported net. Pass-through transactions totaled $6.1 million and $16.9 million, respectively, for the three months and nine months ending September 30, 2005. Profits and losses on fixed-fee contracts are recorded on the percentage-of-completion method of accounting, measured by the percentage-of-contract cost incurred to date relative to estimated total direct contract cost. Direct contract cost includes professional compensation and related benefits, materials, subcontractor services and other direct cost of projects. Direct contract cost also includes variable costs such as travel, repairs and maintenance, supplies and depreciation directly related to producing revenues. The cost recognized for labor includes all actual employee compensation plus a burden factor to cover estimated variable labor expenses for the year. These variable labor expenses consist of payroll taxes, self-insured medical expenses, workers compensation insurance, general liability insurance, and employee benefits for paid time off. The actual periodic cost for these expenses is adjusted at the end of each quarter to provide consistent cost recognition throughout the year. On a project that requires the purchase of a large amount of permanent materials, including the cost of these materials in calculating the percentage-of-completion may overstate the actual progress on the project. For these types of projects, the cost-to-cost method does not appropriately reflect the progress of the projects; accordingly, we use alternative methods such as actual labor hours for measuring progress on the project and we recognize revenue accordingly. Under the percentage-of-completion method, revenue recognition is dependent upon the accuracy of a variety of estimates, including the progress of engineering and design efforts, material installation, labor productivity, cost estimates and others. These estimates are based on various professional judgments made with respect to the factors noted and are difficult to accurately determine until projects are significantly underway. Due to uncertainties inherent to the estimation process, it is possible that actual completion costs may vary materially from estimates. Anticipated losses on uncompleted contracts are charged to operations as soon as such losses can be estimated. Changes in job performance, job conditions, estimated profitability and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. Selling, general and administrative cost includes management and staff compensation, office cost such as rents and utilities, depreciation, amortization, travel and other expenses that are unrelated to specific client contracts, but directly relate to the support of each segment's operations. 6 Occasionally, it is appropriate under SOP 81-1 to combine or segment contracts. Contracts are combined in those limited circumstances when they are negotiated as a package in the same economic environment with an overall profit margin objective and constitute, in essence, an agreement to do a single project. In such cases, we recognize revenue and cost over the performance period of the combined contracts as if they were one. Contracts are segmented in limited circumstances if the customer had the right to accept separate elements of a contract and the total economic returns of the separate contract elements are similar to the economic returns of the overall contract. For segmented contracts, we recognize revenue and cost as if they were separate contracts over the performance periods of the individual elements or phases. We have three major types of contracts: Cost-Plus, Labor Plus Fixed Mark-up ----------------------------------- Under cost-plus, labor plus fixed mark-up contracts, we charge clients based on actual labor rates plus a fixed mark-up that includes estimated recoverable direct and indirect cost and a profit component, which is applied as a percentage of the recoverable labor, to arrive at a total dollar estimate in negotiating a cost-plus, labor plus fixed mark-up contract. We recognize revenue based on a multiple of the actual total number of labor hours completed on a project multiplied by the actual labor rates and multiplied by the negotiated fixed mark-up percentage, plus other non-labor costs at cost plus a fixed mark-up that we negotiate at the time of contract award. Aggregate revenue from cost-plus, labor plus fixed mark-up contracts may vary in scope and we generally must obtain a change order in order to receive additional revenue relating to any additional costs that exceed the original contract estimate (see "Change Orders"). Cost-Plus, Fixed Labor Rate --------------------------- Under cost-plus, fixed labor rate contracts, we charge clients based on fixed labor rates by work classification (Project Manager, Sr. Engineer, Designer, CADD Operator, etc.) whereby the fixed labor rate includes estimated recoverable direct and indirect cost plus a profit component. In negotiating cost-plus, fixed labor rate contracts the total dollar estimate is a multiple of the fixed labor rates times the recoverable work class labor man-hours estimated to complete the project. We recognize revenues based on a multiple of the fixed labor rates times the actual total number of labor hours completed on a project, plus other non-labor costs at cost plus a fixed rate negotiated at the time of contract award. Aggregate revenues from cost-plus, fixed labor rate contracts may vary in scope and we generally must obtain a change order in order to receive additional revenues relating to any additional cost that exceed the original contract estimate (see "Change Orders"). Fixed Price ----------- Under fixed price contracts, the Company only charges its clients an agreed amount negotiated in advance of a specific scope of work, be it related to engineering service revenue or product sales. We recognize revenue on fixed-price contracts using the percentage-of-completion method described above. Prior to completion, gross profit recognition on any fixed-price contract is dependent upon the accuracy of our estimates and will increase to the extent that current estimates of aggregate actual cost are below the amounts previously estimated. Conversely, if the Company's current estimated cost exceeds prior estimates, gross profit will decrease and we may realize a loss on a project. In order to increase aggregate revenue on a contract, we generally must obtain a change order to receive payment for additional cost (see "Change Orders"). Change Orders ------------- Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. Either we or our clients may initiate change orders. Change orders may include changes in specifications or design, manner of performance, equipment, materials, scope of work and/or the period of completion of the project. Change orders occur when changes are experienced after work on a contract has begun. Change orders are sometimes documented and the terms of change orders are agreed with the client before the work is performed. Other times, circumstances may require that work progress without the client's written agreement before the work is performed. Cost related to change orders is recognized when they are incurred. Change orders are included in the total estimated contract revenue when it is probable that the change orders will result in a bona fide addition to value that can be reliably estimated. 7 Inspection and Acceptance (Cost-plus Contracts) ----------------------------------------------- Generally, clients inspect and accept work as executed based on designated milestones or billing cycles, although such acceptance does not waive the client's right to a claim under a warranty provision for work deficiencies that fail to meet industry standards. If we are required to remedy defective work, the client normally reimburses all cost except for the labor cost necessary to correct such defects. Inspection and Acceptance (Fixed Price Contracts) ------------------------------------------------- Generally, clients inspect and accept work based on designated milestones, although such acceptance does not waive the client's right to a claim under a warranty provision for work deficiencies. If we are required to remedy defective work, the client normally reimburses all costs except for the labor cost necessary to correct such defects. Contract Termination Provisions ------------------------------- Generally, our clients may terminate at any time and for any reason any part of the Company's project work by giving proper notice, specifying the part of the work to be terminated and the effective date of the termination. If any part of the work on a project is terminated, the client, with respect to such work, is required to reimburse the Company for all cost incurred prior to the effective date of termination and for all additional amounts that are directly related to the work performed. The client is required to issue a change order with respect to any termination. NOTE 3 - DEBT AND LINE OF CREDIT Line of credit: At the end of the reporting period, the Company had a Credit Facility (the "Comerica Credit Facility") with Comerica Bank ("Comerica") that consisted of a line of credit maturing on July 27, 2007. The loan agreement positions Comerica as senior to all other debt. The line of credit is limited to $22 million, subject to loan covenant restrictions. The Comerica Credit Facility is collateralized by substantially all the assets of the Company. The outstanding balance on the line of credit as of September 30, 2005 was zero. The remaining borrowings available under the line of credit as of September 30, 2005 were $18.7 million after consideration of loan covenant restrictions and outstanding standby letters of credit aggregating to $3.3 million. The Comerica Credit Facility contains covenants requiring the Company, as of the end of each calendar month, to maintain certain ratios, including the average total outstanding principal balance of the line of credit to EBITDA; the average total outstanding principal balance of the line of credit to total liabilities plus net worth; and the average total outstanding principal balance of the line of credit to accounts/unbilled receivables. The Company is also required, as of the end of each quarter, to maintain minimum levels of net worth, and the Company must comply with an annual limitation on capital expenditures. The Company was in compliance with all covenants under the Comerica Credit Facility as of September 30, 2005. Letters of credit: As of September 30, 2005, the Company had $3.3 million outstanding in standby letters of credit issued to a refining client to cover contractual obligations funded by the client for progress payments made to equipment manufacturers for major project items. We expect obligations under standby letters of credit to increase to approximately $6.7 million during December 2005 and decrease each month following until obligations are released in May 2006. 8
September 30, December 31, 2005 2004 ------------------------------ (in thousands) ------------------------------ Schedule of Long-Term Debt: Comerica Credit Facility - Line of credit, prime (6.75% at September 30, 2005), maturing in July 2007 $ -- $ 13,530 Sterling Planet and EDGI - Notes payable, interest at 5%, principal payments in installments of $15,000 plus interest due quarterly, maturing in December 2008 210 255 Significant PEI Shareholders - Note payable, discounted at 4.5% interest, principal payments in installments of $208,761 due annually, maturing in December 2006 394 385 Cleveland Inspection Services, Inc., CIS Technical Services and F.D. Curtis - Notes payable, discounted at 5% interest, principal in installments of $100,000 due quarterly, maturing in October 2009 1,525 1,762 InfoTech Engineering, Inc. - Note payable, interest at 5%, principal payments in installments of $65,000 plus interest due annually, maturing in December 2007 195 195 Miscellaneous 55 80 -------- -------- Total long-term debt 2,379 16,207 Less: Current maturities (553) (622) -------- -------- Long-term debt, net of current portion $ 1,826 $ 15,585 ======== ======== NOTE 4 - COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) represents net earnings and any revenue, expenses, gains and losses that, under accounting principles generally accepted in the United States of America, are excluded from net earnings and recognized directly as a component of stockholders' equity. The ending accumulated other comprehensive income is as follows: Three Months Ended Nine Months Ended September 30, September 30, --------------------- ------------------------- 2005 2004 2005 2004 ------ ------- ------ ----------- (in thousands) (in thousands) Net income $1,620 $ 755 $4,061 $ 1647 Other comprehensive income: Foreign currency translation adjustment 2 -- 2 -- ------ ------ ------ ------------ Comprehensive income $1,622 $ 755 $4,063 $ 1,647 ====== ====== ====== ============
NOTE 5 - RECENT ACCOUNTING PRONOUNCEMENTS In May 2005 the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3." SFAS 154 requires retrospective application to prior periods' financial statements for changes in accounting principles, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in non-discretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS 154 also requires that a change in depreciation, amortization, or 9 depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date SFAS 154 was issued. The Company is required to adopt the provisions of SFAS 154, as applicable, for the year beginning January 1, 2006. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123, (revised 2004) "Share-Based Payment" ("SFAS 123R"). This statement is a revision of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" as amended ("SFAS 123"), and requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The cost will be recognized over the period during which an employee is required to provide services in exchange for the award (usually the vesting period). SFAS 123R covers various share-based compensation arrangement rights and employee share purchase plans. SFAS 123R eliminates the ability to use the intrinsic value methods of accounting for share options, as provided in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). SFAS 123R was scheduled to be effective as of the beginning of the first interim period that begins after June 15, 2005, with early adoption encouraged. On April 14, 2005, the Securities and Exchange Commission issued a release announcing the adoption of a new rule delaying the required implementation of SFAS No. 123R. Under this rule, SFAS No. 123R is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. We are currently evaluating the provisions of SFAS No. 123R and will adopt the provision beginning in the first quarter of 2006, as required. NOTE 6 - GOODWILL In accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", goodwill is no longer amortized over its estimated useful life, but rather will be subject to at least an annual assessment for impairment. Goodwill has been allocated to the Company's two reportable segments. The test for impairment is made on each of these reporting segments. No impairment of goodwill has been incurred to date. A change in assumptions in the estimation of the fair market value of the segments would unlikely give rise to an impairment of goodwill without deteriorating operating results in the segments. NOTE 7 - FIXED FEE CONTRACTS Costs, estimated earnings and billings on uncompleted contracts consisted of the following at September 30, 2005 and December 31, 2004:
September 30, December 31, 2005 2004 ------------------------ (in thousands) ------------------------- Costs incurred on uncompleted contracts $ 17,827 $ 8,292 Estimated earnings on uncompleted contracts 4,125 1,584 -------- -------- Earned revenues 21,952 9,876 Less billings to date (19,050) (11,077 -------- -------- Net costs and estimated earnings in excess of billings on uncompleted contracts $ 2,902 $ (1,201 ======== ======== Costs and estimated earnings in excess of billings on uncompleted contracts $ 4,629 $ 1,113 Less billings and estimated earnings in excess of cost on uncompleted contracts (1,727) (2,314) -------- -------- Net costs and estimated earnings in excess of billings on uncompleted contracts $ 2,902 $ (1,201) ======== ======== 10 NOTE 8 - STOCK OPTION PLAN The Company accounts for its incentive stock option plan under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Accordingly, no stock-based compensation cost is reflected in net income, as all options granted under the Company's plan had exercise prices equal to or greater than the market value of the Company's stock on the date of grant. The following table illustrates the effect on net income and earnings per share for the three months and nine months ended September 30, 2005 and 2004, respectively, as if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." Three Months Ended Nine Months Ended September 30, September 30, --------------------------- ------------------------- 2005 2004 2005 2004 ----------- ------------ ---------- ----------- (in thousands) (in thousands) Pro forma impact of fair value method (SFAS 148): Net income attributable to common stockholders, as reported $ 1,620 $ 755 $ 4,061 $ 1,647 Less compensation expense determined under fair value method, net of tax (54) (4) (162) (132) ---------- ----------- ---------- ---------- Pro forma net income attributable to common stockholders $ 1,566 $ 751 $ 3,899 $ 1,515 ========== =========== ========== ========== Earnings per share (basic): As reported $ 0.07 $ 0.03 $ 0.17 $ 0.07 Pro forma $ 0.07 $ 0.03 $ 0.16 $ 0.07 Earnings per share (diluted): As reported $ 0.07 $ 0.03 $ 0.16 $ 0.07 Pro forma $ 0.06 $ 0.03 $ 0.16 $ 0.06 Weighted average Black-Scholes fair value assumptions: Risk free interest rate 5.5% 5% 5% 5% Expected life 3-10 years 3-10 years 3-10 years 3-10 years Expected volatility 50% 61% 50% 61% Expected dividend yield 0.0% 0.0% 0.0% 0.0%
NOTE 9 - EMPLOYEE STOCK PURCHASE PLAN On June 17, 2004, ENGlobal shareholders ratified the Company's adoption of the 2004 Employee Stock Purchase Plan ("Plan"). Beginning April 2004, the Company provided eligible employees with the opportunity and a convenient means to purchase shares of the Company's Common Stock as an incentive to exert maximum efforts for the success of the Company. ENGlobal intends that options to purchase stock granted under the Plan qualify as options granted under an "employee stock purchase plan" as defined in Section 423(b) of the Code. The Plan will be construed so as to be consistent with Section 423 of the Code, including Section 423(b)(5) which requires that all participants have the same rights and privileges with respect to options granted under the Plan. The cash deferred by participants into the plan has been used to meet the Company's cash requirements or has been applied to the reduction of the Company's long-term debt. NOTE 10 - EARNINGS PER SHARE For the three months and nine months ended September 30, 2005, the number of shares used in determining weighted average shares used for computing basic and diluted net income per share was reduced by the repurchase by the Company of 652,377 shares of stock in November 2004. 11 NOTE 11 - SEGMENT INFORMATION The Company operates in two business segments: (1) engineering, providing 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, and uninterruptible power systems and battery chargers to customers that, for the most part, are located in the United States. In June 2005, we created a new, indirect subsidiary named ENGlobal Canada ULC ("ENGlobal Canada"), which is operating out of Calgary, Canada. ENGlobal Canada is a wholly-owned subsidiary of ENGlobal Automation Group, Inc. ("EAG"), formerly known as ENGlobal Technologies, Inc., a wholly-owned subsidiary of ENGlobal Engineering, Inc. ("EEI"). ENGlobal Canada is in the early marketing stages and, to date, has not generated revenue. Results will be reported in the engineering segment. Revenue and operating income for each segment are set forth in the following table. The amount under Corporate includes those activities that are not allocated to the operating segments and include costs related to business development, executive function, finance, accounting, safety, investor relations/governance, human resources, project controls and information technology that are not specifically identifiable with the two segments. Inter-company elimination includes the amount of administrative costs allocated to the segments. Corporate functions support both business segments and therefore cannot be specifically assigned to either. Significant portions of Corporate 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, ---------------------------- ---------------------------- 2005 2004 2005 2004 --------- --------- --------- --------- (in thousands) (in thousands) Revenue: Engineering $ 55,132 $ 32,796 $ 149,459 $ 92,730 Systems 4,134 4,476 13,855 9,817 --------- --------- --------- --------- Total revenue $ 59,266 $ 37,272 $ 163,314 $ 102,547 ========= ========= ========= ========= Operating income (loss): Engineering $ 5,236 $ 2,589 $ 13,453 $ 7,672 Systems 19 439 281 134 Corporate 1,018 439 2,940 1,156 Intercompany eliminations (3,508) (2,225) (9,664) (6,100) --------- --------- --------- --------- Total operating income $ 2,765 $ 1,242 $ 7,010 $ 2,862 ========= ========= ========= =========
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 $77,000 as of September 30, 2005. NOTE 12 -CONTINGENCIES Litigation ---------- From time to time, the Company and its subsidiaries become parties to various legal proceedings arising in the ordinary course of normal business activities. While we cannot predict the outcome of these proceedings, in our opinion, and based on reports of counsel, any liability arising from such matters, individually or in the aggregate, are not expected to have a material effect upon the consolidated financial position or operations of the Company. In January 2004, ENGlobal Design Group, Inc. ("EDG") purchased selected assets of Engineering Design Group Inc. ("EDGI"), including certain of EDGI's contract rights with the Department of the Navy. In July 2005, EDG received notification from the Department of the Navy that unresolved 12 liabilities under predecessor contracts with EDGI were interfering with the ability of the Dallas office of the Defense Contract Management Agency ("DCMA") to process novation agreements required by FAR 42.12 and that in order to protect the DCMA's contractual interests, EDG would not be solicited for any future proposals for work under the predecessor contracts until the novation agreements were executed. EDG revenue under these contracts totaled $3.3 million and $1.7 million respectively for the year ended December 31, 2004 and the nine-month period ended September 30, 2005 and represented approximately 92% and 45% respectively of EDG's total revenue during such periods. EDG's current backlog under these contracts is $5.5 million. We do not expect the DCMA's action to have a material effect on the consolidated financial position or operation of ENGlobal and are seeking resolution of this matter. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements -------------------------- Certain information contained in this Form 10-Q, the Company's Annual Report to Stockholders, as well as other written and oral statements made or incorporated by reference from time to time by the Company and its representatives in other reports, filings with the Securities and Exchange Commission, press releases, conferences, or otherwise, may be deemed to be forward-looking statements with the meaning of Section 21E of the Securities Exchange Act of 1934. This information includes, with 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; 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. When used in this report, the words "anticipate," "believe," "estimate," "expect," "may," and similar expressions, as they relate to the Company, its subsidiaries and management, identify forward-looking statements. Actual results could differ materially from the results described in the forward-looking statements due to the risks and uncertainties set forth in this Form 10-Q and the specific risk factors identified in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. The following discussion is qualified in its entirety by, and should be read in conjunction with, the Company's Consolidated Financial Statements, including the notes thereto, included in this Form 10-Q and the Company's Annual Report on Form 10-K for the year ended December 31, 2004. 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 month periods ending September 30, 2005, compared to the corresponding periods in 2004.
During the three month period During the nine month period -------------------------------------------------------------- Revenue Increased 59% Increased 59% Operating income Increased 133% Increased 141% As a percentage of revenue Increased 42% Increased 54% Net income Increased 100% Increased 156% As a percentage of revenue Increased 40% Increased 56%
Long-term debt, net of current portion, decreased 89%, or $13.8 million, from $15.6 million as of December 31, 2004 to $1.8 million at September 30, 2005, and as a percentage of stockholders' equity, long-term debt decreased from 78% to 5% during the same periods. Total stockholders' equity increased 94%, or $18.9 million, from $20.1 million as of December 31, 2004 to $39.0 million as of September 30, 2005. In general, the increase in revenue during the three months and nine months ended September 30, 2005 relates to the growth in activity at both our Tulsa, Oklahoma and Dallas, Texas offices from clients in the refining industry relating to expansion and low-sulfur diesel projects, combined with the added effect of the growth in inspection services as a result of our acquisitions of AmTech in September 2004 and Cleveland Inspection in October 2004. ENGlobal Corporation is a leading provider of engineering services and systems principally to the petroleum refining, petrochemical, pipeline, production and process industries throughout the United States and internationally. The services provided by our multi-disciplined staff 14 span the lifecycle of a project and include feasibility studies, design, procurement services and construction management. We also supply automation, control process analyzer and uninterruptible electrical power systems to our clients worldwide. The Company was incorporated as Industrial Data Systems Corporation in the State of Nevada in June 1994. In December 2001, the Company merged with Petrocon Engineering, Inc. and, in June 2002, it changed its name from Industrial Data Systems Corporation to ENGlobal Corporation. Effective June 16, 2002, the Company's trading symbol for its Common Stock, traded on the American Stock Exchange, changed from IDS to ENG. The Company streamlined its organizational structure and took steps to increase name recognition in 2003. As part of its restructuring, the Company sold selected assets of its manufacturing segment and reorganized its subsidiaries into two segments. In addition, substantially all of the Company's wholly-owned subsidiaries and operating divisions adopted the ENGlobal name. Our business is managed under two reportable segments: engineering and systems. The engineering segment provides engineering consulting services primarily to major oil and gas companies through six subsidiary companies, including ENGlobal Engineering, Inc., RPM Engineering, Inc. d/b/a ENGlobal Engineering, Inc., ENGlobal Construction Resources, Inc., ENGlobal Automation Group, Inc., ENGlobal Canada ULC, and ENGlobal Design Group, Inc. The engineering segment earns revenue primarily from fees for professional and technical services. As a service company, we are labor rather than capital intensive and our income is derived from our ability to generate revenues and collect cash under cost reimbursable contracts based on our employees' time in excess of any subcontract expense, the cost of pass-through materials and equipment, non-labor costs, and our selling, general and administrative ("SG&A") expenses. Our systems segment designs, assembles, programs, installs, integrates and services control and instrumentation systems for specific applications in the energy and process-related industries. The systems segment currently consists of one company, ENGlobal Systems, Inc. ("ESI"). The systems segment earns revenue primarily from fees on contracts for the design and assembly of control and instrumentation systems. Income from the systems segment is derived from our ability to generate revenue and collect cash on fixed price contracts in excess of our costs for labor, materials and equipment and transportation costs, plus our SG&A expenses. Hurricane Rita -------------- Mandatory evacuation orders related to the anticipated landfall of Hurricane Rita and the resulting damages from the storm caused the facilities in Beaumont, Texas and Lake Charles, Louisiana to close from September 22, 2005 to October 6, 2005 and October 10, 2005, respectively. The primary loss to the Company is revenue and gross profits lost due to our inability to work on projects at the effected locations. Our administrative operations have been temporarily relocated to our Houston corporate offices as a result of the extensive damage to our administrative offices in Beaumont, Texas. Our human resources and safety departments have already returned to Beaumont along with a portion of our accounting department staff. The balance of our accounting staff is scheduled to return to the Beaumont area by mid-November. We estimate that Hurricane Rita negatively impacted our third quarter income by approximately $217,000 on an after-tax basis. The loss was related to a decrease in billable man-hours and subsequent earnings in the Beaumont, Texas and Lake Charles, Louisiana. We expect the loss attributable to Hurricane Rita in the fourth quarter 2005 to be less than that estimated in the third quarter 2005. 15 Results of Operations --------------------- The following table presents, for the periods indicated, the approximate percentage of total revenue and operating income or loss attributable to our reportable segments:
Three Months Ended Nine Months Ended September 30, September 30, ---------------------- --------------------- 2005 2004 2005 2004 ------ ------ ------ ------ Revenue: Engineering 93.0 % 88.0 % 91.5 % 90.4 % Systems 7.0 % 12.0 % 8.5 % 9.6 % Operating income (loss): Engineering 99.6 % 85.5 % 98.0 % 98.3 % Systems 0.4 % 14.5 % 2.0 % 1.7 %
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 cost incurred bear to total estimated contract cost. Revenue and gross margin on contracts are subject to revision throughout the lives of the contracts and any required adjustments are made in the period in which the revisions become known. Losses on contracts are recorded in full as they are identified. For internal analytical purposes only, we review total revenue less 1) revenue received from non-labor material, equipment and subcontractor costs, and 2) revenue received from material assets or companies acquired during the current year, as well as revenue received from acquisitions of material assets or companies during the first 12 months following their respective dates of acquisition. In the course of providing our services, we routinely provide major engineering materials, equipment and subcontract services. Generally, these materials, equipment and subcontractor costs are passed through to our clients and, in accordance with industry practice and generally accepted accounting principles, are included in revenue. Because subcontractor services can change significantly from project to project, changes in non-labor revenue may not be indicative of our core business trends. Revenue recognized from acquired assets of companies during the first 12 months after closing is referred to as "Acquisition" revenue. We also review gross profit and SG&A expense from material asset or Company acquisitions on the same basis as we review total revenue. Gross profit includes the gross margin on contracts, less indirect variable labor and non-labor expenses not directly related to projects. The primary indirect labor expenses include compensation and benefit costs for indirect technical support staff, for employees on stand-by time and for time required for technical staff to prepare cost estimates and project schedules for proposals requested through business development representatives. Operating SG&A expense includes management and staff compensation, office cost, 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 of cost related to business development, executive function, finance, accounting, safety, investor relations/governance, human resources, project controls, and information technology functions, as well as depreciation and amortization and other cost generally unrelated to specific client projects. Critical Accounting Policies: A summary of significant accounting policies is disclosed in Note 2 to the Consolidated Financial Statements included in our 2004 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 2004 Annual Report on Form 10-K. There have been no changes in the nature of our critical accounting policies or the application of those policies since December 31, 2004. Additional disclosure regarding specific policies is as follows: 16 Revenue Recognition: Because the majority of the Company's revenue is recognized under cost-plus contracts, significant estimates are generally not involved in determining revenue recognition. In addition, most of our contracts are with Fortune 500 companies. As a result, collection risk is generally not a relevant factor in the recognition of revenue. Goodwill: A change in assumptions in the estimation of the fair market value of the segments would unlikely give rise to an impairment of goodwill without deteriorating operating results in the segments. Change Orders: Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. Either we or our clients may initiate change orders. Change orders may include changes in specifications or design, manner of performance, equipment, materials, scope of work, and/or the period of completion of the project. Change orders occur when changes are experienced once a contract is begun. Change orders are sometimes documented and the terms of change orders are agreed on with the client before the work is performed. Other times, circumstances may require that work progress before the client provides written consent. Costs related to change orders are recognized when they are incurred. Change orders are included in the total estimated contract revenue when it is probable that the change orders will result in a bona fide addition to value that can be reliably estimated. We have a favorable history of negotiating and collecting for work performed under change orders and our bi-weekly billing cycle has proven to be timely enough to properly account for change orders. Depreciation: Depreciation is calculated using a straight-line method over the estimated useful lives of the related assets. The useful life is estimated to be 3 years for computers and autos, 5 years for software, furniture and fixtures, 10 years for machinery and equipment and 39 years for buildings. Depreciation expense related to those assets (specifically machinery and equipment, autos, trucks and computer hardware) that are used in the production of service revenue are charged to contract cost. Operating SG&A expense includes depreciation expense for assets that are generally related to administrative operations. 17
Consolidated Results of Operations (unaudited) Three Months Ended Nine Months Ended September 30, September 30, -------------------------------------------- -------------------------------------------- 2005 2004 2005 2004 --------------------- --------------------- --------------------- --------------------- (in thousands) (in thousands) Revenue: Engineering - labor $ 30,507 51.5% $ 20,429 54.8% $ 86,791 53.2% $ 57,507 56.1% Engineering - non-labor 19,579 33.0% 10,790 28.9% 51,443 31.5% 30,349 29.5% Systems 4,123 7.0% 4,060 10.9% 13,845 8.5% 8,468 8.3% Acquisition 5,057 8.5% 1,993 5.4% 11,235 6.8% 6,223 6.1% --------- ----- --------- ----- --------- ----- --------- ----- Total revenue $ 59,266 100.0% $ 37,272 100.0% $ 163,314 100.0% $ 102,547 100.0% ========= ========= ========= ========= Gross profit: Engineering $ 6,850 13.7% $ 3,698 11.9% $ 18,023 13.0% $ 10,865 12.4% Systems 510 12.4% 737 18.2% 1,734 12.5% 1,092 12.9% Acquisition 478 9.5% 274 13.7% 1,059 9.4% 1,023 16.4% --------- --------- --------- --------- Total gross profit 7,838 13.2% 4,709 12.6% 20,816 12.7% 12,980 12.7% --------- --------- --------- --------- SG&A expense: Engineering 1,937 3.9% 957 3.1% 4,859 3.5% 2,773 3.2% Systems 495 12.0% 311 7.7% 1,458 10.5% 1,012 12.0% Corporate 2,368 4.0% 1,786 4.8% 6,722 4.1% 4,944 4.8% Acquisition 273 5.4% 413 20.7% 767 6.8% 1,389 22.3% --------- --------- --------- --------- Total SG&A expense 5,073 8.6% 3,467 9.3% 13,806 8.5% 10,118 9.9% --------- --------- --------- --------- Operating income: Engineering 4,913 9.8% 2,741 8.8% 13,164 9.5% 8,092 9.2% Systems 15 0.4% 426 10.5% 276 2.0% 80 0.9% Corporate (2,368) (4.0)% (1,786) (4.8)% (6,722) (4.1)% (4,944) (4.8)% Acquisition 205 4.1% (139) (7.0)% 292 2.6% (366) (5.9)% --------- --------- --------- --------- Total operating income 2,765 4.7% 1,242 3.3% 7,010 4.3% 2,862 2.8% --------- --------- --------- --------- Other income (expense), net (193) (0.3)% (98) (0.3)% (564) (0.3)% (366) (0.4)% Tax provision (952) (1.6)% (389) (1.0)% (2,385) (1.5)% (849) (0.8)% --------- --------- --------- --------- Net income $ 1,620 2.8% $ 755 2.0% $ 4,061 2.5% $ 1,647 1.6% ========= ========= ========= =========
Other financial comparisons: September 30, December 31, ---------------------------- 2005 2004 ------- ------- Working capital $18,334 $14,503 Total assets $63,286 $57,261 Long-term debt, net of current portion $ 1,826 $15,585 Stockholders' equity $39,023 $20,051 In the results presented for the three and nine months ended September 30, 2005, "Acquisition" totals include the combined results of operations related to assets acquired from Cleveland Inspection Services, Inc. ("Cleveland"). In the results for the three and nine months ended September 30, 2004, "Acquisition" totals are the combined results of operations related to assets acquired from Amtech, Petro-Chem, Senftleber, and EDG. For analytical purposes only, results from acquired companies or acquired assets are shown separately for the first 12 months after closing. 18 Industry Overview: Many ENGlobal offices have benefited from the strong refinery market. We expect significant capital projects to be generated by refinery operations over the next several years and we will continue to research other markets that value our services. Overall, projects related to refining capacity and environmental mandates have trended upward. Higher margins in the energy industry were recently spurred by the associated impact of Hurricanes Katrina and Rita. As stated in our 2003 annual letter to stockholders, the global demands for oil products has tightened the supply of both crude oil as well as refinery products. With this current demand, we believe each of ENGlobal's business segments are well positioned within the industry should refinery capacity be added in the United States of America and the overseas markets continue to rise. The petrochemical industry has recently been a good source of projects for ENGlobal. We have seen an increase in both maintenance and capital spending after several years of relative inactivity. The petrochemical industry along the Gulf Coast continues to struggle with the aftermath of the hurricanes. Although it will take several years to rebuild, we expect that we will assist our clients with repairs to regional petrochemical facilities in order to resolve current supply limitations. Despite past downturns in the industry, pipeline projects have remained constant for the most part, and we have recently seen an increase in project activity. Pipeline projects tend to require less engineering man hours as the scope of engineering work is typically smaller than for similar sized downstream projects. In addition, the project awards in the pipeline segment are smaller in nature than those in other industries. In addition to the refinery and petrochemical markets, we have offered assistance to clients in the pipeline operations market along the Gulf Coast that were affected by Hurricanes Katrina and Rita. Revenue: Revenue increased $22.0 million, or approximately 59%, to $59.3 million for the three months ended September 30, 2005 from $37.3 million for the comparable prior year period. Revenue increased $60.8 million, or approximately 59%, to $163.3 million for the nine months ended September 30, 2005 from $102.5 million for the comparable prior year period. Excluding non-labor engineering revenue, the Company's adjusted revenue for the three months ended September 30, 2005 increased $13.2 million, or approximately 50%, over comparable revenue for the three months ended September 30, 2004 and the Company's adjusted revenue for the nine months ended September 30, 2005 increased $39.7 million, or approximately 55%, over comparable revenue for the nine months ended September 30, 2004. Acquisition revenue contributed $3.1 million, or 23%, and $5.0 million, or 13% of the increase in adjusted revenue for the three and nine months ended September 30, 2005, respectively, compared to the comparable periods in 2004. The increases in engineering revenue reflect the economic impact of increased oil and crude prices. The increased profits generated by the increase in prices as well as regulatory compliance mandates have led many clients to begin capital improvement projects. For example, we have contracts with clients who are improving their clean fuel refining capabilities. Two new contracts in 2005, providing services for ultra low sulfur diesel fuel projects through our Tulsa office, have contributed $21.8 million to our revenue for the current year. This has helped expand our growth in revenue. Revenue from our materials procurement services were $16.4 million and $39.1 million for the three months and nine months ended September 30, 2005, respectively as compared to $9.9 million and $26.8 million for the comparable prior year periods. Procurement services provide low or no margins and are provided in addition to engineering and subcontractor services. Revenue in the systems segment decreased slightly in the three months ended September 30, 2005, compared to the three months ended September 30, 2004. Continued spending by the segment's customers on capital projects to meet environmental requirements and increasing capacities contributed to the increase in revenue for the nine months ended September 30, 2005, compared to the same period in the prior year. Gross Profit: Gross profit increased $3.1 million, or approximately 66%, to $7.8 million for the three months ended September 30, 2005 from $4.7 million for the comparable prior year period. Acquisition gross profit contributed $0.5 million, or approximately 6%, of the total gross profit for the three 19 months ended September 30, 2005. Gross profit increased $7.8 million, or approximately 60%, to $20.8 million for the nine months ended September 30, 2005 from $13.0 million for the comparable prior year period. Acquisition gross profit contributed $1.1 million, or approximately 5%, of the total gross profit for the nine months ended September 30, 2005. As a percentage of revenue, gross profit increased to 13.2% for the three months ended September 30, 2005 from 12.6% for the quarter ended September 30, 2004 and remained at 12.7% for the nine months ended September 30, 2005 and September 30, 2004, respectively. Gross profit percentages in the engineering segment continue to be affected by low margins on the procurement services portion of EPC projects. Margins on procurement services range from no markup to 6.5% markup. Selling, General, and Administrative: As a percentage of revenue, SG&A expense decreased to 8.6% for the three months ended September 30, 2005 from 9.3% for the three months ended September 30, 2004 and 8.5% for the nine months ended September 30, 2005 from 9.9% for the nine months ended September 30, 2004. SG&A expense increased $1.6 million, or approximately 46%, to $5.1 million for the three months ended September 30, 2005 from $3.5 million for the comparable prior year period and increased $3.7 million, or approximately 37%, to $13.8 million for the nine months ended September 30, 2005 from $10.1 million for the comparable prior year period. Each reporting area except acquisitions incurred additional costs for the three and nine months ended September 30, 2005 (Engineering - $1 million and $2.1 million, respectively; Systems - $0.2 million and $0.5 million, respectively; Corporate - $0.6 million and $1.8 million, respectively, and Acquisition - $(0.1) million and $(0.6) million, respectively). Corporate SG&A expense increased $0.6 million, or approximately 33%, to $2.4 million for the three months ended September 30, 2005 from $1.8 million for the comparable prior year period. This increase is primarily due to an increase in accrued incentive plan compensation ($146,000 and $294,000 for the three months ended September 30, 2004 and 2005, respectively), and an increase in salaries and burden ($908,000 and $1.3 million, respectively for the nine months ended September 30, 2004 and 2005, respectively). As a percentage of total revenue, corporate SG&A expense decreased to 4% for the three months ended September 30, 2005 from 4.8% for the comparable prior year period and decreased to 4.1% for the nine months ended September 30, 2005 from 4.8% for the comparable prior year period. Corporate SG&A expense increased $1.8 million, or approximately 37%, to $6.7 million for the nine months ended September 30, 2005 from $4.9 million for the comparable prior year period. Operating Income: Operating income increased $1.6 million, or approximately 133%, to $2.8 million for the three months ended September 30, 2005 from $1.2 million in the same period in 2004 and increased $4.1 million, or approximately 141%, to $7.0 million for the nine months ended September 30, 2005 from $2.9 million in the same period in 2004. As a percentage of revenue, operating income increased to 4.7% for the three months ended September 30, 2005 from 3.3% for the comparable prior year period and increased to 4.3% for the nine months ended September 30, 2005 from 2.8% for the comparable prior year period. Other Income/Expense, net: Other expense increased 97% and 54%, respectively, for the three and nine month periods ended September 30, 2005 from the comparable prior year periods. The increases are due to increased interest expense on our credit facility as interest rates have increased from 4.75% at September 30, 2004 to 6.75% at September 30, 2005. As a result paying off the line of credit at the end of the third quarter of 2005, the Company expects a significant reduction of interest expense in the fourth quarter of 2005 Tax Provision: Income tax expense increased $0.6 million, or approximately 150%, to $1.0 million for the three months ended September 30, 2005 from $0.4 million for the comparable prior year period and increased $1.5 million, or approximately 166%, to $2.4 million for the nine months ended September 30, 2005 from $0.9 million for the comparable prior year period. The estimated effective tax rate was 37% for the three-month and nine-month periods ended September 30, 2005 compared to 34% for the comparable prior year periods. 20 Net Income: Net income for the three months ended September 30, 2005 increased $0.8 million, or approximately 100%, to $1.6 million from $0.8 million for the comparable prior year period. For the nine months ended September 30, 2005, net income increased $2.5 million, or approximately 156%, to $4.1 million from $1.6 million for the comparable prior year period. As a percentage of revenue, net income increased to 2.8% for the three-month period ended September 30, 2005 from 2.0% for the three-month period ended September 30, 2004 and increased to 2.5% for the nine-month period ended September 30, 2005 from 1.6% for the period ended September 30, 2004.
Segment Results --------------- Engineering ----------- Three Months Ended Nine Months Ended September 30, September 30, ------------------------------------------ ------------------------------------------ 2005 2004 2005 2004 ------------------- -------------------- ------------------- -------------------- (in thousands) (in thousands) Revenue: Engineering - labor $ 30,507 55.3% $ 20,429 62.3% $ 86,791 58.1% $ 57,507 62.0% Engineering - non-labor 19,579 35.5% 10,790 32.9% 51,443 34.4% 30,349 32.7% Acquisition 5,057 9.2% 1,577 4.8% 11,235 7.5% 4,874 5.3% -------- ----- -------- ----- -------- ----- -------- ----- Total revenue $ 55,143 100.0% $ 32,796 100.0% $149,469 100.0% $ 92,730 100.0% ======== ======== ======== ======== Gross profit: Engineering $ 6,850 13.7% $ 3,698 11.9% $ 18,023 13.0% $ 10,865 12.4% Acquisition 478 9.5% 209 13.3% 1,059 9.4% 788 16.2% -------- -------- -------- -------- Total gross profit 7,328 13.3% 3,907 11.9% 19,082 12.8% 11,653 12.6% -------- -------- -------- -------- Operating SG&A expense: Engineering 1,937 3.9% 957 3.1% 4,859 3.5% 2,773 3.2% Acquisition 273 5.4% 361 22.9% 767 6.8% 1,208 24.8% -------- -------- -------- -------- Total SG&A expense 2,210 4.0% 1,318 4.0% 5,626 3.8% 3,981 4.3% -------- -------- -------- -------- Operating income: Engineering 4,913 9.8% 2,741 8.8% 13,164 9.5% 8,092 9.2% Acquisition 205 4.1% (152) (9.6)% 292 2.6% (420) (8.6)% -------- -------- -------- -------- Total operating income $ 5,118 9.3% $ 2,589 7.9% $ 13,456 9.0% $ 7,672 8.3% -------- -------- -------- --------
Overview: The Beaumont, Texas, and Lake Charles and Baton Rouge, Louisiana engineering offices have increased their proposal activity as the result of Hurricanes Katrina and Rita. We expect to be more involved in our client's assessment of the storm damage. At present, we are assisting several clients with conceptual front-end loading studies for preliminary engineering on new capital projects. Specifically, we have been asked to scope a large central control room project for a refinery expansion project in Port Arthur, Texas. Employees based in the Beaumont and Lake Charles areas will contribute to this project through the first two quarters of 2006. The engineering segment's profitability has shown a significant increase for both the three months and nine months ended September 30, 2005. The Company's Tulsa location experienced the largest increase with a $4.1 million growth, or 286% increase through September 30, 2005 as compared to the same period in 2004. This increase is the result of the two projects that were announced in the first quarter of 2005 and continue to provide a significant revenue stream for the Company. 21 The Sulfur Group, based in Dallas, has seen significant growth during the third quarter of 2005 and will provide preliminary engineering services for the construction of a sulfur recovery facility for a large West Coast refinery. As previously reported, we estimate the contract award to be valued at approximately $19 million. The facility will be designed and constructed as modularized units, with the project consisting of a sulfur recovery unit, a tail gas treating unit and an incineration unit with waste heat recovery. In addition to design engineering, we will provide material procurement and construction services, with the entire project scheduled to be completed in the third quarter of 2006. The Houston office has sustained its profitability by concentrating on pipeline engineering projects; however, the office has recently expanded its business development efforts to help diversify its workload to other energy industry segments.. ENGlobal's newest and first international subsidiary, ENGlobal Canada, was opened in September 2005 as a part of our ongoing internal growth initiative.. ENGlobal Canada, a division of ENGlobal Automation Group, Inc. ("EAG"), is based in Calgary and will spotlight a multitude of projects in Northern Alberta, specifically in the oil sands area. Initial business development efforts to date have led to several strong alliances with vendors offering distributed control systems (DCS) services and specific partnerships to facilitate the pursuit of projects. EAG has increased its proposal activity over the third quarter of 2005. For the nine months ended September 30, 2005, we have incurred approximately $142,000 in losses through EAG and ENGlobal Canada. These losses have reduced gross margin and increased SG&A expenses in the engineering segment in 2005. The field services staffing operation, which includes ENGlobal Construction Resources, Inc., increased its overall profit by 69% to $2.9 million for the nine months ended September 30, 2005 compared to the same period in 2004. The increase resulted in part from the acquisitions of AmTech in September 2004 and Cleveland in October 2004, which contributed an aggregate $397,000, or 33% of the increase, to the overall field services operations. The additional 66% of the increase in field services can be attributed to the increased demand for outsourced technical personnel at other field services locations. Acquisition totals for the three and nine months ended September 30, 2005 relate to assets acquired from Cleveland Inspection. For the three and nine month periods ended September 30, 2004, acquisition totals relate to assets acquired from AmTech, Petro-Chem and EDG. Revenue: Revenue increased $22.3 million, or 68%, to $55.1 million for the three months ended September 30, 2005 from $32.8 million for the comparable prior year period. Revenue increased $56.8 million, or 61%, to $149.5 million for the nine months ended September 30, 2005 from $92.7 million for the comparable prior year period. Excluding non-labor revenue, revenue for the three months ended September 30, 2005 increased $13.6 million, or 62%, over comparable revenue for the three months ended September 30, 2004. Revenue for the nine months ended September 30, 2005 increased $35.6 million, or 57%, over comparable revenue for the nine months ended September 30, 2004. Of this increase, acquisition revenue accounted for $3.5 million and revenue from internal growth accounted for $10.1 million for the three-month period ended September 30, 2005, and acquisition revenue accounted for $6.4 million and revenue from internal growth accounted for $29.3 million for the nine-month period ended September 30, 2005. Revenue from internal growth, not related to acquisitions or non-labor items, for the three months ended September 30, 2005 represented a 50% increase over such revenue for the comparable period in 2004. For the nine months ended September 30, 2005, such revenue represented a 51% increase over that for the comparable period in 2004. Non-labor revenue represented 36% of the total engineering revenue for the quarter ended September 30, 2005 and increased $8.8 million to $19.6 million from $10.8 million for the three months ended September 30, 2004. This increase in non-labor revenue represented 39% of our total engineering revenue increase in the third quarter of 2005 compared to the same period in 2004. Non-labor revenue represented 34% of the total engineering revenue for the nine months ended September 30, 2005 and increased $21.1 million to $51.4 million from $30.3 million for the nine months ended September 30, 2004. This increase in non-labor revenue represented 37% of the total engineering revenue increase in the nine months ended September 30, 2005 compared to the same period in 2004. 22 Field services staffing operations contributed $39 million in labor revenue and $1.9 million in non-labor revenue for the first nine months of 2005 which represents 69% and 297% revenue increase, respectively, over the same periods in 2004. The increase was largely due to the acquisitions of AmTech in September 2004 and Cleveland Inspection in October 2004, which contributed $10.6 million in labor revenue and $1.3 million in non-labor revenue to the overall field services operation. Gross Profit: Gross profit increased $3.4 million, or 87%, to $7.3 million for the three months ended September 30, 2005 from $3.9 million for the comparable period in 2004. Gross profit increased $7.4 million, or 63%, to $19.1 million for the nine months ended September 30, 2005 from $11.7 million for the same period in 2004. The increase in gross profit is attributable to an increase in work under both existing and new contracts during the 2005 periods. As a percentage of revenue, excluding acquisitions, engineering gross profit increased to 13.7% from 11.9% for the three-month period ended September 30, 2005 as compared to the prior year period, and increased to 13.0% from 12.4% for the nine-month period ended September 30, 2005 as compared to the same period in 2004. Gross profit includes non-project variable labor expenses for internal growth initiatives related to low sulfur diesel, polymers, advanced automation and integrated controls, plus the additional cost of technical staff to produce cost estimates and project schedules to cover increased proposal activity. These costs increased to $0.9 million for the three-month period ended September 30, 2005 from $0.5 million for the comparable period ended September 30, 2004, and to $2.9 million for the nine-month period ended September 30, 2005 from $1.6 million for the comparable period in 2004. Acquisition gross profit increased $269,000, or 129%, to $478,000 for the three months ended September 30, 2005 from $209,000 for the three months ended September 30, 2004. For the nine months ended September 30, 2005, gross profit from acquisitions increased $271,000, or 34%, to $1,059,000 from $788,000 for the same period in 2004. Selling, General, and Administrative: As a percentage of revenue, excluding non-labor revenue, SG&A expense increased to 6.2% for the quarter ended September 30, 2005 from 6.0% for the comparable prior year period and decreased to 5.7% for the nine-month period ended September 30, 2005 from 6.4% for the same period in 2004. SG&A expense increased $0.9 million overall, or 69%, to $2.2 million for the three months ended September 30, 2005 from $1.3 million for the comparable prior year period. This increase was primarily related to expansion of our office space (rents - $588,000) and administrative support staff (salaries - $218,000), plus $94,000 in other support activities. As a percentage of revenue, excluding non-labor revenue, SG&A expense increased 40% to $5.6 million for the nine months ended September 30, 2005 from $4.0 million for the comparable prior year period primarily to expansion of our office space (rents - $1.1 million) and administrative support staff (salaries - $706,000). Operating Income: Operating income increased $2.5 million, or 96%, to $5.1 million for the quarter ended September 30, 2005 compared to the third quarter of 2004 and increased $5.8 million, or 75%, to $13.5 million for the nine months ended September 30, 2005 compared to the same period in 2004. As a percentage of revenue, operating income increased to 9.3% for the three months ended September 30, 2005 from 7.9% for the comparable prior year period and increased to 9.0% for the nine months ended September 30, 2005 from 8.3% for the comparable prior year period. 23
Systems ------- Three Months Ended Nine Months Ended September 30, September 30, --------------------------------------- ----------------------------------------- 2005 2004 2005 2004 ------------------ ------------------ ------------------ -------------------- (in thousands) (in thousands) Revenue: Systems 4,123 100.0% $ 4,060 90.7% 13,845 100.0% $ 8,468 86.3% Acquisition -- -- % 416 9.3% -- -- % 1,349 13.7% ------- ----- ------- ----- ------- ----- ------- ----- Total revenue $ 4,123 100.0% $ 4,476 100.0% $13,845 100.0% $ 9,817 100.0% ======= ======= ======= ======= Gross profit: Systems 510 12.4% $ 737 18.2% 1,734 12.5% $ 1,092 12.9% Acquisition -- -- % 65 15.6% -- -- % 235 17.4% ------- ------- ------- ------- Total gross profit 510 12.4% 802 17.9% 1,734 12.5% 1,327 13.5% ------- ------- ------- ------- Operating SG&A expense: Systems 495 12.0% 311 7.7% 1,458 10.5% 1,012 12.0% Acquisition -- -- % 52 12.5% -- -- % 181 13.4% ------- ------- ------- ------- Total SG&A expense 495 12.0% 363 8.1% 1,458 10.5% 1,193 12.2% ------- ------- ------- ------- Operating income: Systems 15 0.4% 426 10.5% 276 1.9% 80 0.9% Acquisition -- -- % 13 3.1% -- -- % 54 4.0% ------- ------- ------- ------- Total operating income $ 15 0.4% $ 439 9.8% $ 276 1.9% $ 134 1.4% ------- ------- ------- -------
Overview: For the nine months ended September 30, 2005, new sales awards increased by 8% compared to the nine months ended September 30, 2004. For the three months ended September 30, 2005, new sales awarded were down 52% compared to the first quarter of 2005 and down 39% compared to the second quarter of 2005. Revenue and direct cost continue to increase; however, gross profit has decreased over the past three years. Material, engineering and fabrication labor overruns have contributed to the decreased margins. These overruns negatively impacted the operating income for the period and for the nine months ended September 30, 2005. For the first six months of 2005, the large influx of new work plus lower operating costs as a result of reorganization of the segment offset the reduction in operating income for the nine months ended September 30, 2005. Acquisition totals for the three and nine months ended September 30, 2004 relate to the purchase of Senftleber. There was no Acquisition activity for the three and nine months ended September 30, 2005. Revenue: Revenue decreased $400,000, or 9%, to $4.1 million for the three months ended September 30, 2005 compared to the prior year period and increased $4.0 million, or 41%, to $13.8 million for the nine months ended September 30, 2005 from $9.8 million for the comparable prior year period. Gross Profit: Gross profit decreased $292,000, or 36%, to $510,000 for the three months ended September 30, 2005 from $802,000 for the comparable prior year period and increased $0.4 million, or 31%, to $1.7 million for the nine months ended September 30, 2005 compared to $1.3 million for the prior year period. As a percentage of revenue, gross profit decreased to 12.4% for the three months ended September 30, 2005 from 17.9% for the comparable prior year period and decreased to 12.5% for the nine months ended September 30, 2005 from 13.5% for the comparable prior year period. 24 Selling, General, and Administrative: SG&A expense increased $132,000, or 36%, to $495,000 for the three months ended September 30, 2005 from $363,000 for the comparable prior year period and increased $300,000, or 25%, to $1.5 million for the nine months ended September 30, 2005 from $1.2 million for the same period in 2004. As a percentage of revenue, SG&A expense increased to 12.0% for the three months ended September 30, 2005 from 8.1% for the comparable prior year period and decreased to 10.5% for the nine months ended September 30, 2005 from 12.2% for the same period in 2004. Operating Income: Operating income decreased $424,000, or 97%, to $15,000 for the three months ended September 30, 2005 from $439,000 for the comparable prior year period and increased $142,000, or 106%, to $276,000 for the nine months ended September 30, 2005 from $134,000 for the same period in 2004. Liquidity and Capital Resources ------------------------------- Historically, cash requirements have been satisfied through operation contribution and borrowings under a revolving line of credit, currently in place with Comerica Bank (the "Comerica Credit Facility" or the "Credit Facility"). As of September 30, 2005, we had working capital of $18.1 million. Long-term debt on September 30, 2005 was $2.4 million, with no amounts outstanding under the Comerica Credit Facility. On September 29, 2005, we entered into and closed on a definitive agreement to issue and sell 2,000,000 shares of our $.001 par value per share Common Stock in a private placement to Tontine Capital Partners, L.P., a Delaware limited partnership. The purchase agreement provided $14,000,000 in gross proceeds which were used to pay all of our existing line-of-credit debt. The Comerica Credit Facility is senior to all other debt, and the line of credit is limited to $22.0 million, subject to borrowing base restrictions. The Comerica Credit Facility is collateralized by substantially all the assets of the Company. The Comerica Credit Facility contains covenants requiring the Company, as of the end of each calendar month, to maintain certain ratios, including the average total outstanding principal balance of the line of credit to EBITDA; the average total outstanding principal balance of the line of credit to total liabilities, plus net worth; and the average total outstanding principal balance of the line of credit to accounts/unbilled receivables. The Company is also required, as of the end of each quarter, to maintain minimum levels of net worth, and must comply with an annual limitation on capital expenditures. We are currently in compliance with all loan covenants, although no assurances can be given regarding such compliance in the future. The Company is not currently subject to any guarantees, repurchase obligations or other commitments. We have no off-balance sheet arrangements, other than standby letters of credit. As of September 30, 2005, the Company had $3.3 million outstanding in standby letters of credit issued to a refining client to cover contractual obligations funded by the client for progress payments made to equipment manufacturers for major project items. We expect obligations under standby letters of credit to increase to approximately $6.7 million during December 2005 and decrease each month following until obligations are released in May 2006. The Company has been awarded a significant project with a central states refining company and entered into an Agreement for Engineering and Procurement Services to provide detailed engineering and procurement services on a cost reimbursable basis. We estimate that the agreement will result in a significant amount of revenue attributable to the procurement of materials and equipment. Per the terms of the agreement, any progress payments made by the client for project items must be secured by one or more irrevocable stand-by letters of credit issued on the account of ENGlobal. The project began in January 2005 and is scheduled to be completed in the third quarter of 2006. As of September 30, 2005, letters of credit totaling $3.3 million were outstanding on this project. The requirement of letters of credit will negatively impact the Company's liquidity. As of September 30, 2005, management believes the Company's cash position is sufficient to meet its working capital requirements. However, the Company is exploring options to increase its available cash for acquisitions, internal expansion and working capital in case a future decrease in demand for the Company's services or products was to reduce the availability of funds through operations. 25
The following table summarizes our contractual obligations as of September 30, 2005: Payments Due by Period --------------------------------------------------------- 2009 and 2005 2006 2007 2008 thereafter Total ------- ------- ------- ------- ------- ------- (in thousands) --------------------------------------------------------- Long-term debt(1) $ 408 $ 745 $ 542 $ 542 $ 479 $ 2,716 Operating leases(2) 539 2,218 2,208 1,431 1,195 7,591 ------- ------- ------- ------- ------- ------- Total contractual cash obligations $ 947 $ 2,963 $ 2,750 $ 1,973 $ 1,674 $10,307 ======= ======= ======= ======= ======= =======
(1) Long-term debt includes future interest payments assuming the existing long-term debt and revolving credit facility remain outstanding with the interest rate in effect at September 30, 2005. The Company's interest rate on its revolving credit facility fluctuates with the prime rate. At September 30, 2005, the balance of the revolving credit facility was zero. (2) These operating leases are predominantly real estate leases. 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 the project mix shifts from cost reimbursable to fixed costs contracts during significant periods of growth, if the Company was to lose one or more of its major customers, or if the Company is not able to meet the covenants of the Comerica Credit Facility. If any such events occur, the Company would be forced to consider alternative financing options. Due to the impact of Hurricane Rita in late September, the Company has experienced delays in processing client billings. Management expects client billings to be materially current by mid-November and is working to collect from clients whose facilities may have been closed following the Hurricane. On September 29, 2005, we entered into and closed on a definitive agreement to issue and sell 2,000,000 shares of our $.001 par value per share Common Stock in a private placement to Tontine Capital Partners, L.P., a Delaware limited partnership. The purchase agreement provided $14,000,000 in gross proceeds which were used to pay all of our existing line-of-credit debt. Operating activities: Net cash provided by operating activities was $4.4 million for the nine-month period ended September 30, 2005, compared to $2.3 in the same period in 2004. Changes in working capital, due to the timing of collections of trade receivables, payments for trade payables, and accruals, contributed to the strong cash flows from operations in the first nine months of 2005. During the period, the line of credit decreased from $13.5 million as of December 31, 2004, to zero as of September 30, 2005. Net income was the primary driver of the Company's positive cash flows from operations in the first nine months of 2005. Though a decline in revenues would be likely to adversely impact our cash flow from operations, we believe that future cash flows, our ability to manage the timing of acquisitions, and our borrowing capacity under our line of credit will allow us to meet cash requirements in 2005 and beyond. Future uses of cash in operations will continue to be primarily for labor and material costs required in connection with contract performance. Investing activities: Net cash used in investing activities was $1.4 million for the nine-month period ended September 30, 2005, compared with net cash used of $856,000 in the same period in 2004. In the first nine months of 2005, the Company completed the sale of the Thermaire building, receiving $823,000 in cash from the sale. The Company also used cash for capital expenditures in the first nine months of 2005 and 2004 primarily for computers and software. The large increase in property and equipment purchases is a result of 26 growth in our Tulsa, Dallas and Houston offices and an increase in the number of employees. Future investing activities are anticipated to remain consistent with prior years and include capital additions for leasehold improvements, technical applications software, and equipment, such as upgrades to computers. Annual capital expenditures are limited to $2.5 million under the line of credit agreement. Financing activities: Net cash used by financing activities was $78,000 for the nine-month period ended September 30, 2005, compared with $1.5 million used in the same period in 2004. In the first nine months of 2005, we reduced our outstanding line of credit by $13.5 million using cash generated from working capital and the sale of 2,000,000 shares of our Common Stock in a private placement as compared to a net $1.8 million increase in the outstanding line of credit in the same period in 2004. Future cash flows from financing activities are anticipated to be borrowings, payments on the line of credit and payments on long-term debt instruments. Line of credit fluctuations are a function of timing related to operations obligations and payments received on accounts receivable. Payments on long-term debt for the coming year are estimated to be $553,000. Asset Management ---------------- Our cash flow from operations has been affected primarily by the timing of our collection of trade accounts receivable. We typically sell our products and services on short-term credit terms and seek to minimize our credit risk by performing credit checks and conducting our own collection efforts. We had net trade accounts receivable of $31.2 million and $30.8 million at September 30, 2005 and December 31, 2004, respectively. The number of days sales outstanding in trade accounts receivables was 51 days and 62 days at September 30, 2005 and December 31, 2004, respectively. Income Taxes Payable -------------------- Due to the results of a recent audit by the Internal Revenue Service of the Company's Form 1120 filing for the tax-year ended December 31, 2003, we recorded an additional income tax payable (for tax-years 2002, 2003 and 2004) and a deferred tax asset equaling $590,000. The re-classification of the tax liability and deferred tax asset were the result of a re-calculation on the limitation of the net operating loss ("NOL") carry-forwards occurring prior to the merger in 2001. The additional deferred tax asset will be available to offset income in tax-years 2005 through 2009. Interest was assessed in the amount of $56,200, although no penalties were assessed as a result of the audit. During August 2005, we paid the United States Treasury Department approximately $622,000 for the additional tax liability and interest charges. In the third quarter, we recorded a tax benefit of $245,000 with a corresponding addition to paid-in capital as the result of the exercise of non-qualified stock options by a former employee. 27 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our financial instruments include cash and cash equivalents, accounts receivable, accounts payable, notes and capital leases payable, and debt obligations. The book value of cash and cash equivalents, accounts receivable, accounts payable and short-term notes payable are considered to be representative of fair value because of the short maturity of these instruments. We do not utilize financial instruments for trading purposes and we do not hold any derivative financial instruments that could expose us to significant market risk. Our exposure to market risk for changes in interest rates relates primarily to our obligations under the Comerica Credit Facility. As of September 30, 2005, nothing was outstanding under the Credit Facility, which accrues interest at 6.75% per year, excluding amortization of prepaid financing costs. A 10% increase in the short-term borrowing rates on the Credit Facility outstanding as of September 30, 2005 would be 67.5 basis points. Such an increase in interest rates would not increase our annual interest expense, assuming the amount of debt outstanding remains at zero. The Company has no market risk exposure in the areas of interest rate risk from investments because we did not have an investment portfolio as of September 30, 2005. Currently, the Company does not engage in foreign currency hedging activities. With the opening of ENGlobal Canada, we are exposed to foreign currency risks that arise from normal business operations. These risks include the translation of local currency balances of the Canadian operation and transactions with customers, suppliers and employees that are denominated in Canadian dollars. Our objective is to minimize our exposure to these risks through our normal operating activities. Foreign currency transactions gains and losses are recognized in the results of operations based on the difference between the foreign exchange rate on the transaction date and on the settlement date. There were no foreign currency exchange gains or losses recorded as of September 30, 2005. ITEM 4. CONTROLS AND PROCEDURES As of September 30, 2005, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our "disclosure controls and procedures," as such term is defined under Exchange Act Rules 13a-15(e) and 15d-15(e). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2005, such disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and, in reaching a reasonable level of assurance, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. There were no changes in our internal controls over financial reporting during the quarter ended September 30, 2005 that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. 28 PART II. - OTHER INFORMATION ---------------------------- ITEM 1. LEGAL PROCEEDINGS From time to time, the Company and its subsidiaries become parties to various legal proceedings arising in the ordinary course of normal business activities. While we cannot predict the outcome of these proceedings, in our opinion and based on reports of counsel any liability arising from such matters, individually or in the aggregate, are not expected to have a material effect upon the consolidated financial position or operations of the Company. In January 2004, ENGlobal Design Group, Inc. ("EDG") purchased selected assets of Engineering Design Group Inc. ("EDGI"), including certain of EDGI's contract rights with the Department of the Navy. In July 2005, EDG received notification from the Department of the Navy that unresolved liabilities under predecessor contracts with EDGI were interfering with the ability of the Dallas office of the Defense Contract Management Agency ("DCMA") to process novation agreements required by FAR 42.12 and that in order to protect the DCMA's contractual interests, EDG would not be solicited for any future proposals for work under the predecessor contracts until the novation agreements were executed. EDG revenue under these contracts totaled $3.3 million and $1.7 million respectively for the year ended December 31, 2004 and the nine-month period ended September 30, 2005 and represented approximately 92% and 45% respectively of EDG's total revenue during such periods. EDG's current backlog under these contracts is $5.5 million. We do not expect the DCMA's action to have a material effect on the consolidated financial position or operation of ENGlobal and are seeking resolution of this matter. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS On September 29, 2005, we entered into and closed on a definitive agreement to sell 2,000,000 shares of our $.001 par value per share Common Stock in a private placement to Tontine Capital Partners, L.P., a Delaware limited partnership. Additional information regarding this transaction has been included in a Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission on October 5, 2005. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. 29 ITEM 6. EXHIBITS 31.1 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act for 2002 for the Third Quarter 2005 31.2 Certifications Pursuant to Rule 13a - 14(a) of the Exchange Act for 2002 for the Third Quarter 2005 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 2005 30 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 10, 2005 By: /s/ Robert W. Raiford ------------------------- Robert W. Raiford Chief Financial Officer and Treasurer 31