ITEM 1. BUSINESS
FORWARD-LOOKING STATEMENTS
This Report on Form 10-K contains forward-looking statements regarding us and our business, financial condition, results of operations and prospects within the meaning of Section 27A of the Securities Act of 1933 (Securities Act), and Section 21E of the Securities Exchange Act of 1934 (Exchange Act). Such forward-looking statements include those that express plans, anticipation, intent, contingency, goals, targets or future development and/or otherwise are not statements of historical fact. These forward-looking statements are based on our current expectations and projections about future events and they are subject to risks and uncertainties known and unknown that could cause actual results and developments to differ materially from those expressed or implied in such statements.
In some cases, you can identify forward-looking statements by terminology, such as “goals,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “may,” “could,” “should,” “would,” “predicts,” “appears,” “projects,” or the negative of such terms or other similar expressions. Factors that could cause or contribute to differences in results and outcomes from those in our forward-looking statements include, without limitation, those discussed elsewhere in this Report in Part I, Item 1A.
ITEM 1A. RISK FACTORS
This section describes the major risks to us, our business and our common stock. You should carefully read and consider the risks described below, together with the other information contained in this Annual Report, including our financial statements and the notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”(MD&A) before making an investment decision. The statements contained in this section constitute cautionary statements under the Private Securities Litigation Reform Act of 1995. If any of these risks actually occur, our business, financial condition, results of operations and future growth prospects may be adversely affected. As a result, the trading price of our common stock would likely decline, and you may lose all or part of your investment. You should understand that it is not possible to predict or identify all risk factors that could impact us. Accordingly, you should not consider the following to be a complete discussion of all risks and uncertainties pertaining to us and our common stock.
Risks Related to Our Business
Our growth strategy includes acquisitions. We may not be able to identify suitable acquisition candidates or integrate acquired businesses successfully, which may adversely impact our results. Furthermore, acquisitions that we do complete could expose us to a number of unanticipated operational and financial risks.
A significant factor in our growth has been and will continue to be based upon our ability to make acquisitions and successfully integrate these acquired businesses. We intend to continue to seek additional acquisition opportunities, both to expand into new markets and to enhance our position in existing markets. This strategy has provided us with many benefits and has helped fuel our growth, but also carries with it many risks. Some of the risks associated with our acquisition strategy include:
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whether we successfully identify suitable acquisition candidates, negotiate appropriate acquisition terms, and complete proposed acquisitions
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whether we can successfully integrate acquired businesses into our current operations, including our accounting, internal control and information technology systems, marketing and other key infrastructure
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whether we can adequately capture opportunities that an acquired business may offer, including the expansion into new markets in which we have no prior experience
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whether we value an acquired business properly when determining the purchase price, terms and whether we are able to achieve the returns on the investment we expect
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whether an acquired business can achieve levels of revenues, profitability, productivity or cost savings we expect
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whether an acquired business is compatible with our culture and philosophy of doing business
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unexpected loss of key personnel and customers of an acquired business;
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the assumption of liabilities and risks (including environmental-related costs) of an acquired business, some of which may not be anticipated; and
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the potential disruption of our ongoing business and distraction of management and other personnel of us and the acquired business resulting from the efforts to acquire then integrate an acquired business
Our ability to undertake acquisitions is limited by our financial resources, including available cash and borrowing capacity. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of substantial additional indebtedness and other expenses, any of which could adversely impact our financial condition and results of operations. Although management intends to: (i) evaluate the risks inherent in any particular transaction, (ii) assume only risks management believes to be acceptable, and (iii) develop plans to mitigate such risks, there are no assurances that we will properly ascertain or accurately assess the extent of all such risks. Difficulties encountered with acquisitions may adversely impact our business, financial condition and results of operations.
In addition, we have a significant amount of goodwill and other intangible assets on our balance sheet as a result of our acquisitions. This will increase as we complete more acquisitions. If our acquisitions do not perform as planned and we do not realize the benefits and profitability we expect, we could incur significant write-downs and impairment charges to our earnings due to the impairment of the goodwill and other intangible assets we have acquired.
Our international operations are subject to risks relating to non-U.S. operations.
In fiscal 2016, 2015 and 2014 we generated approximately 28%, 31% and 35% of our revenues outside the United States, respectively. We may choose to increase our international presence over time. Our primary operations outside the United States are in Canada, Germany, the United Kingdom, France and Brazil. We also have operations in the Netherlands, India, Belgium and Switzerland. There are numerous risks inherent in doing business in international markets, including:
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fluctuations in currency exchange rates and interest rates;
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varying regional and geopolitical business and economic conditions and demands;
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compliance with applicable foreign regulations and licensing requirements, and U.S. laws and regulation with respect to our business in other countries, including export controls and anti-bribery laws;
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the cost and uncertainty of obtaining data and creating solutions that are relevant to particular geographic markets;
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the need to provide sufficient levels of technical support in different locations;
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the complexity of maintaining effective policies and procedures in locations around the world;
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political instability and civil unrest;
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restrictions or limitations on outsourcing contracts or services abroad;
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the impact of the United Kingdom exiting the European Union;
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restrictions or limitations on the repatriation of funds; and
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potentially adverse tax consequences.
Due to our dependency on customers in the oil and gas industry, we are susceptible to prolonged negative trends relating to this industry that could adversely affect our operating results.
Our customers in the oil and gas industry (including the petrochemical market) have accounted for a substantial portion of our historical revenues. Specifically, they accounted for approximately 56%, 52% and 49% of our revenues for fiscal 2016, 2015 and 2014, respectively. Although we have expanded our customer base into industries other than the oil and gas industry, we
still receive approximately half of our revenues from this industry. While our services are vital to the operators of plants and refineries, economic slowdowns or reductions in oil prices could result in cutbacks in contracts for our services. If the oil and gas industry were to suffer a prolonged or significant downturn, our revenues, profits and cash flows may be reduced. While we continue to expand our market presence in the power generation and transmission, and the chemical processing industries, among others, these markets are also cyclical in nature and as such, are subject to economic downturns.
We expect to continue expanding and our success depends on how effectively we manage our growth.
We expect to continue experiencing growth in the number of employees and the scope of our operations. To effectively manage our anticipated future growth, we must continue to implement and improve our managerial, operational, compliance, financial and reporting systems and capabilities, expand our facilities and continue to recruit and train additional qualified personnel. We expect that all of these measures will require significant expenditures and will demand the attention of management. Failure to manage our growth effectively could lead us to over or under-invest in technology and operations, result in weaknesses in our infrastructure, systems, compliance programs or controls, give rise to operational mistakes, loss of business opportunities, the loss of employees and reduced productivity among remaining employees. Our expected growth could require significant capital expenditures and may divert financial resources from other projects, such as the development of new solutions. If our management is unable to effectively manage our expected growth, our expenses may increase more than expected, our profit margins may suffer, our revenues could decline or may grow more slowly than expected and we may be unable to implement our business strategy as anticipated.
Our operating results could be adversely affected by a reduction in business with our significant customers.
We derive a significant amount of revenues from a few customers. For instance, various divisions or business units of our largest customer were responsible for approximately 10% of our revenues for fiscal 2016. Taken as a group, our top ten customers were responsible for approximately 36%, 33% and 38% of our revenues for fiscal 2016, 2015 and 2014, respectively. This concentration pertains almost exclusively to our Services segment, which accounted for more than 70% of our revenues for each of the last three fiscal years and are primarily in the oil and gas sector. Generally, our customers do not have an obligation to make purchases from us and may stop ordering our products and services or may terminate existing orders or contracts at any time with little or no financial penalty. The loss of any of our significant customers, any substantial decline in sales to these customers or any significant change in the timing or volume of purchases by our customers could result in lower revenues and could harm our business, financial condition or results of operations.
An accident or incident involving our asset protection solutions could expose us to claims, harm our reputation and adversely affect our ability to compete for business and, as a result, harm our operating performance.
We could be exposed to liabilities arising out of the solutions we provide. For instance, we furnish the results of our testing and inspections for use by our customers in their assessment of their assets, facilities, plants and other structures. If such results were to be incorrect or incomplete, as a result of, for instance, poorly designed inspections, malfunctioning testing equipment or our employees’ failure to adequately test or properly record data, we could be subject to claims. Further, if an accident or incident involving a structure we tested occurs and causes personal injuries or property damage, such as the collapse of a bridge or an explosion in a facility, and particularly if these injuries or damages could have been prevented by our customers had we provided them with correct or complete results, we may face significant claims relating to personal injury, property damage or other losses. Even if our results are correct and complete, we may face claims for such injuries or damage simply because we tested the structure or facility in question. While we do have insurance, our insurance coverage may not be adequate to cover the damages from any such claims, forcing us to bear these uninsured damages directly, which could harm our operating results and may result in additional expenses and possible loss of revenues. An accident or incident for which we are found partially or fully responsible, even if fully insured, or even an incident at a customer for which we provide services although we were found not to be responsible, may also result in negative publicity, which would harm our reputation among our customers and the public, cause us to lose existing and future contracts or make it more difficult for us to compete effectively, thereby significantly harming our operating performance. In addition, the occurrence of an accident or incident might also make it more expensive or extremely difficult for us to insure against similar events in the future.
Many of the sites at which we work are inherently dangerous workplaces. If we fail to maintain a safe work environment, we may incur losses and lose business.
Many of our customers, particularly in the oil and gas and chemical industries, require their inspectors and other contractors working at their facilities to have good safety records because of the inherent danger at these sites. If our employees are injured at the work place, we will incur costs for the injuries and lost productivity. In addition, safety records are impacted by the number and amount of workplace incidents involving a contractor’s employees. If our safety record is not within the levels
required by our customers, or compares unfavorably to our competitors, we could lose business, be prevented from working at certain facilities or suffer other adverse consequences, all of which could negatively impact our business, revenues, reputation and profitability.
Most of our computer and communications hardware is located at a single facility, the failure of which would harm our business and results of operations.
Most of our computer and communications hardware is located at a single facility. We have a back-up data-center and storage in a different geographic area. Should a natural disaster or some other event occur that damages our primary data center or significantly disrupts its operation, such as human error, fire, flood, power loss, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events, we could suffer temporary interruption of key functions and capabilities before the back-up facility is fully operational.
If we are unable to attract and retain a sufficient number of trained certified technicians, engineers and scientists at competitive wages, our operational performance may be harmed and our costs may increase.
We believe that our success depends, in part, upon our ability to attract, develop and retain a sufficient number of trained certified technicians, engineers and scientists at competitive wages. The demand for such employees fluctuates as the demand for NDT and inspection services fluctuate. There is a reduced demand for technicians because of a slowdown of spending in the oil and gas industry. However, if the demand for qualified technicians increases, we will likely experience increased labor costs. The markets for our products and services require us to use personnel trained and certified in accordance with standards set by domestic or international standard-setting bodies, such as the American Society of Non-Destructive Testing or the American Petroleum Institute. Because of the limited supply of these certified technicians, we expend substantial resources maintaining in-house training and certification programs. If we fail to attract sufficient new personnel or fail to motivate and retain our current personnel, our ability to perform under existing contracts and orders or to pursue new business may be harmed, preventing us from growing our business or causing us to lose customers and revenues, and the costs of performing such contracts and orders may increase, which would likely reduce our margins.
We operate in competitive markets and if we are unable to compete successfully, we could lose market share and revenues and our margins could decline.
We face strong competition from NDT and a variety of niche asset protection providers, both larger and smaller than we are. Some of our competitors have greater financial resources than we do and could focus their substantial financial resources to develop a competing business model or develop products or services that are more attractive to potential customers than what we offer. Some of our competitors are business units of companies substantially larger than us and could attempt to combine asset protection solutions into an integrated offering to customers who already purchase other types of products or services from them. Our competitors may offer asset protection solutions at lower prices than ours in order to attempt to gain market share. Smaller niche competitors with small customer bases could be aggressive in their pricing in order to retain customers. These competitive factors could reduce our market share, revenues and profits.
Events such as natural disasters, industrial accidents, epidemics, war and acts of terrorism, and adverse weather conditions could disrupt our business or the business of our customers, which could significantly harm our operations, financial results and cash flow.
Our operations and those of our customers are susceptible to the occurrence of catastrophic events outside our control, ranging from severe weather conditions to acts of war and terrorism. Any such events could cause a serious business disruption that reduces our customers’ need or interest in purchasing our asset protection solutions. For example, significant wild fires in the Fort McMurray vicinity in Canada resulted in a reduction in revenue and earnings for our Canadian operations in the fourth quarter of fiscal 2016. In the past, such events have resulted in order cancellations and delays because customer equipment, facilities or operations have been damaged, or are not then operational or available. A large portion of our customer base has operations in the Gulf of Mexico, which is subject to hurricanes in the first and second quarters of our fiscal year. Hurricane-related disruptions to our customers’ operations have adversely affected our revenues in the past. Such events in the future may result in substantial delays in the provision of solutions to our customers and the loss of valuable equipment. In addition, our third quarter fiscal results can be adversely impacted by severe winter weather conditions, which can result in lost work days and temporary closures of customer facilities or outdoor projects. Any cancellations, delays or losses due to such events may significantly reduce our revenues and harm our operating performance.
If we lose key members of our senior management team upon whom we are dependent, we may be less effective in managing our operations and may have more difficulty achieving our strategic objectives.
Our future success depends to a considerable degree upon the availability, contributions, vision, skills, experience and effort of our senior management team. We have in place various compensation programs, such as an annual cash incentive program, equity incentive program and a severance policy, each designed to incentivize and retain our key senior managers. We have also made changes to our senior management structure so that executive officers other than our founder, Dr. Sotirios Vahaviolos, provide executive leadership for operational, business development and strategy matters. At this time, we do not have any reason to believe that we may lose the services of any of these key persons in the foreseeable future and we believe our compensation programs will help us retain these individuals. We believe we have sufficient depth in our executive management to continue our success if we were to lose the services of an executive. However, an unplanned loss or interruption of the service of two or more key members of our senior management team could harm our business, financial condition and results of operations and could significantly reduce our ability to manage our operations and implement our strategy.
Deteriorations in economic conditions in certain markets or other factors may cause us to recognize impairment charges for our goodwill.
As of May 31, 2016, the carrying amount of our goodwill was approximately $169 million, of which approximately $36 million relates to our International segment. A significant portion of our international operations are concentrated in Europe and Brazil. Significant deterioration in industry or economic conditions in which we operate, disruptions to our business, not effectively integrating acquired businesses, or other factors, may cause impairment charges to goodwill in future periods.
The success of our businesses depends, in part, on our ability to develop new asset protection solutions, increase the functionality of our current offerings and meet the needs and demands of our customers.
The market for asset protection solutions is impacted by technological change, uncertain product lifecycles, shifts in customer demands and evolving industry standards and regulations. We may not be able to successfully develop and market new asset protection solutions that comply with present or emerging industry regulations and technology standards. Also, new regulations or technology standards could increase our cost of doing business.
From time to time, our customers have requested greater value and functionality in our solutions. As part of our strategy to enhance our asset protection solutions and grow our business, we continue to make investments in the research and development of new technologies, inspection tools and methodologies. We believe our future success will depend, in part, on our ability to continue to design new, competitive and broader asset protection solutions, enhance our current solutions and provide new, value-added services. Many traditional NDT and inspection services are subject to price competition by our customers. Accordingly, the need to demonstrate our value-added services is becoming more important. Developing new solutions will require continued investment, and we may experience unforeseen technological or operational challenges. In addition, our asset protection software is complex and can be expensive to develop, and new software and software enhancements can require long development and testing periods. If we are unable to develop new asset protection solutions or enhancements that meet market demands on a timely basis, we may experience a loss of customers or otherwise be likely to lose opportunities to earn revenues and to gain customers or access to markets, and our business and results of operations will be adversely affected.
Even if we develop new solutions, if our customers, or potential customers, do not see the value our solutions have over competing products and services, our operating results could be adversely impacted. In addition, because the asset protection solutions industry is rapidly evolving, we could lose insight into trends that may be emerging, which would further harm our competitive position by making it difficult to predict and respond to customer needs. If the market for our asset protection solutions does not continue to develop, our ability to grow our business would be limited and we might not be able to maintain profitability. If we cannot convince our customers of the advantages and value of our advanced NDT services we could lose large contracts or suffer lower profit margin.
If our software or system produces inaccurate information or are incompatible with the systems used by our customers and make us unable to successfully provide our solutions, it could lead to a loss of revenues and customers.
Our software and systems are complex and, accordingly, may contain undetected errors or failures. Software or system defects or inaccurate data may cause incorrect recording, reporting or display of information related to our asset protection solutions. Any such failures, defects and inaccurate data may prevent us from successfully providing our asset protection solutions, which could result in lost revenues. Software or system defects or inaccurate data may lead to customer dissatisfaction and could cause our customers to seek to hold us liable for any damages incurred. As a result, we could lose customers, our reputation may be harmed and our financial condition and results of operations could be materially adversely affected.
We currently serve a commercial, industrial and governmental customer base that uses a wide variety of constantly changing hardware, software solutions and operating systems. Our asset protection solutions need to interface with these non-standard systems in order to gather and assess data. Our business depends on the following factors, among others:
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our ability to integrate our technology with new and existing hardware and software systems;
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our ability to anticipate and support new standards, especially Internet-based standards; and
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our ability to integrate additional software modules under development with our existing technology and operational processes.
If we are unable to adequately address any of these factors, our results of operations and prospects for growth and profitability would be adversely impacted.
The seasonal nature of our business reduces our revenues and profitability in our first and third fiscal quarters.
Our business, primarily in our Services segment, is seasonal. Our first and third fiscal quarter revenues for our Services segment are typically lower than our revenues in the second and fourth fiscal quarters because demand for our asset protection solutions from the oil and gas as well as the fossil and nuclear power industries increases during their non-peak production periods. For instance, U.S. refineries’ non-peak periods are generally in our second fiscal quarter, when they are retooling to produce more heating oil for winter, and in our fourth fiscal quarter, when they are retooling to produce more gasoline for summer. As a result of these trends, we generally have reduced cash flows in our second and fourth fiscal quarters, as collections of receivables lag behind revenues, possibly requiring us to borrow under our credit agreement. In addition, most of our operating expenses, such as employee compensation and property rental expense, are relatively fixed over the short term. Moreover, our spending levels are based in part on our expectations regarding future revenues. As a result, if revenues for a particular quarter are below expectations, we may not be able to proportionately reduce operating expenses for that quarter. We expect that the impact of seasonality will continue.
Our business, and the industries we currently serve, are currently subject to governmental regulation, and may become subject to modified or new government regulation that may negatively impact our ability to market our asset protection solutions.
We incur substantial costs in complying with various government regulations and licensing requirements. For example, the transportation and overnight storage of radioactive materials used in providing certain of our asset protection solutions such as radiography are subject to regulation under federal and state laws and licensing requirements. Our Services segment is currently licensed to handle radioactive materials by the U.S. Nuclear Regulatory Commission (NRC) and over 20 state regulatory agencies. If we allegedly fail to comply with these regulations, we may be investigated and incur significant legal expenses associated with such investigations, and if we are found to have violated these regulations, we may be fined or lose one or more of our licenses or permits, which would prevent or restrict our ability to provide radiography services. In addition, while we are investigated, we may be required to suspend work on the projects associated with our alleged noncompliance, resulting in loss of profits or customers, and damage to our reputation. Many of our customers have strict requirements concerning safety or loss time occurrences and if we are unable to meet these requirements it could result in lost revenues. In the future, federal, state, provincial or local governmental agencies may seek to change current regulations or impose additional regulations on our business. Any modified or new government regulation applicable to our current or future asset protection solutions may negatively impact the marketing and provision of those solutions and increase our costs and the price of our solutions.
Additionally, greenhouse gases that result from human activities, including burning of fossil fuels, have been the focus of increased scientific and political scrutiny and are being subjected to various legal requirements. International agreements, national laws, state laws and various regulatory schemes limit or otherwise regulate emissions of greenhouse gases, and additional restrictions are under consideration by different governmental entities. We derive a significant amount of revenues and profits from such industries, including oil and gas, power generation and transmission, and chemicals processing. Such regulations could negatively impact our customers, which could negatively impact the market for the services and products we provide. This could materially adversely affect our business, financial condition, results of operations and cash flows.
We rely on certification of our NDT solutions by industry standards-setting bodies. We and/or our subsidiaries currently have International Organization for Standardization (ISO) 9001:2008 certification, ISO 14001:2004 certification and OHSAS 18001:2007 certification. In addition, we currently have Nadcap (formerly National Aerospace and Defense Contractors Accreditation Program) and similar certifications for certain of our locations. We continually review our NDT solutions for
compliance with the requirements of industry specification standards and the Nadcap special processes quality requirements. However, if we fail to maintain our ISO, Nadcap or other certifications, our business may be harmed because our customers generally require that we have these certification before they purchase our NDT solutions.
Intellectual property may impact our business and results of operations.
Our ability to compete effectively depends in part upon the maintenance and protection of the intellectual property related to our asset protection solutions. Patent protection is unavailable for certain aspects of the technology and operational processes important to our business and any patent or patent applications, trademarks or copyrights held by us or to be issued to us, may not adequately protect us. Some of our trademarks that are not in use may become available to others. To date, we have relied principally on copyright, trademark and trade secrecy laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our intellectual property. However, we have not obtained confidentiality agreements from all of our customers and vendors. Although we obligate all of our employees to confidentiality, we cannot be certain that these obligations will be honored or enforceable.
We may require additional capital to support business growth, which might not be available.
We intend to continue making investments to support our business growth and may require additional funds to respond to business challenges or opportunities, including the need to develop new, or enhance our current, asset protection solutions, enhance our operating infrastructure or acquire businesses and technologies. Accordingly, we may need to engage in equity or debt financings to secure additional funds. If we raise additional funds through further issuances of equity or convertible debt securities, our current stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock. While our current bank financing is meeting our current need, any debt financing secured by us in the future could involve restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. In addition, no assurance can be given that adequate or acceptable financing will be available to us, in which case we may not be able to grow our business or respond to business challenges.
Our credit agreement contains financial and operating restrictions that may limit our access to credit. If we fail to comply with financial or other covenants in our credit agreement, we may be required to repay indebtedness to our existing lenders, which may harm our liquidity.
Our credit agreement contains financial covenants that require us to maintain compliance with specified financial ratios. If we fail to comply with these covenants, the lenders could prevent us from borrowing under our credit agreement, require us to pay all amounts outstanding, require that we cash collateralize letters of credit issued under the credit agreement and restrict us from making acquisitions. If the maturity of our indebtedness is accelerated, we then may not have sufficient funds available for repayment or the ability to borrow or obtain sufficient funds to replace the accelerated indebtedness on terms acceptable to us, or at all.
Our current credit agreement also imposes restrictions on our ability to engage in certain activities, such as creating liens, making certain investments, incurring more debt, disposing of certain property, paying dividends and making distributions and entering into a new line of business. While these restrictions have not impeded our business operations to date, if our plans change, these restrictions could be burdensome or require that we pay fees to have the restrictions waived.
Any real or perceived internal or external electronic security breaches in connection with the use of our asset protection solutions could harm our reputation, inhibit market acceptance of our solutions and cause us to lose customers.
We and our customers use our asset protection solutions to compile and analyze sensitive or confidential customer-related information. In addition, some of our asset protection solutions allow us to remotely control and store data from equipment at commercial, institutional and industrial locations. Our asset protection solutions rely on the secure electronic transmission of proprietary data over the Internet or other networks. The occurrence or perception of security breaches in connection with our asset protection solutions or our customers’ concerns about internet security or the security of our solutions, whether warranted or not, would likely harm our reputation or business, inhibit market acceptance of our asset protection solutions and cause us to lose customers, any of which would harm our financial condition and results of operations.
We may come into contact with sensitive information or data when we perform installation, maintenance or testing functions for our customers. Even the perception that we have improperly handled sensitive, confidential information would have a negative effect on our business. If, in handling this information, we fail to comply with privacy or security laws, we could incur
civil liability to government agencies, customers and individuals whose privacy is compromised. In addition, third parties may attempt to breach our security or inappropriately harm our asset protection solutions through computer viruses, electronic break-ins and other disruptions. If a breach is successful, confidential information may be improperly obtained, for which we may be subject to lawsuits and other liabilities.
Risks Related to Our Common Stock
Our stock price could fluctuate for numerous reasons, including variations in our results.
Our quarterly operating results have fluctuated in the past and may do so in the future. Accordingly, we believe that period-to-period comparisons of our results of operations may be the best indicators of our business. You should not rely upon the results of one quarter as an indication of future performance. Our revenues and operating results may fall below the expectations of securities analysts or investors in any future period. Our failure to meet these expectations may cause the market price of our common stock to decline, perhaps substantially. Our quarterly revenues and operating results may vary depending on a number of factors, including those listed previously under “Risks Related to Our Business.” In addition, the price of our common stock is subject to general economic, market, industry, and competitive conditions, the risk factors discussed below and numerous other conditions outside of our control.
A significant stockholder controls the direction of our business. The concentrated ownership of our common stock may prevent other stockholders from influencing significant corporate decisions.
Dr. Sotirios J. Vahaviolos, our Chairman, Chief Executive Officer and President, owns approximately 43% of our outstanding common stock. As a result, Dr. Vahaviolos effectively controls our Company and has the ability to exert substantial influence over all matters requiring approval by our shareholders, including the election and removal of directors, amendments to our certificate of incorporation, and any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. This concentration of ownership could be disadvantageous to other shareholders with differing interests from Dr. Vahaviolos.
We currently have no plans to pay dividends on our common stock.
We have not declared or paid any cash dividends on our common stock to date, and we do not anticipate declaring or paying any dividends on our common stock in the foreseeable future. To the extent we do not pay dividends on our common stock, investors must look solely to stock appreciation for a return on their investment.
Shares eligible for future sale may cause the market price for our common stock to decline even if our business is doing well.
Future sales by us or by our existing shareholders of substantial amounts of our common stock in the public market, or the perception that these sales may occur, could cause the market price of our common stock to decline. This could also impair our ability to raise additional capital in the future through the sale of our equity securities. Under our second amended and restated certificate of incorporation, we are authorized to issue up to 200,000,000 shares of common stock, of which approximately 28,955,000 shares of common stock were outstanding as of August 5, 2016. In addition, we have approximately 3,118,000 shares of common stock reserved for issuance related to stock options and restricted stock units that were outstanding as of August 5, 2016. We cannot predict the size of future issuances of our common stock or the effect, if any, that future sales and issuances of shares of our common stock, or the perception of such sales or issuances, would have on the market price of our common stock.
Provisions of our charter, bylaws and of Delaware law could discourage, delay or prevent a change of control of our company, which may adversely affect the market price of our common stock.
Certain provisions of our second amended and restated certificate of incorporation and amended and restated bylaws could discourage, delay or prevent a merger, acquisition, or other change of control that stockholders may consider favorable, including transactions in which our stockholders might otherwise receive a premium for their shares. These provisions also could limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. Stockholders who wish to participate in these transactions may not have the opportunity to do so. Furthermore, these provisions could prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions:
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allow the authorized number of directors to be changed only by resolution of our board of directors;
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require that vacancies on the board of directors, including newly created directorships, be filled only by a majority vote of directors then in office;
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authorize our board of directors to issue, without stockholder approval, preferred stock that, if issued, could operate as a “poison pill” to dilute the stock ownership of a potential hostile acquirer to prevent an acquisition that is not approved by our board of directors;
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require that stockholder actions must be effected at a duly called stockholder meeting by prohibiting stockholder action by written consent;
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prohibit cumulative voting in the election of directors, which may otherwise allow holders of less than a majority of stock to elect some directors; and
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establish advance notice requirements for stockholder nominations to our board of directors or for stockholder proposals that can be acted on at stockholder meetings and limit the right to call special meetings of stockholders to the Chairman of the Board, the Chief Executive Officer, the board of directors acting pursuant to a resolution adopted by a majority of directors or the Secretary upon the written request of stockholders entitled to cast not less than 35% of all the votes entitled to be cast at such meeting.
In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may, unless certain criteria are met, prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a prescribed period of time.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
As of May 31, 2016, we operated approximately 120 offices in 14 countries, with our corporate headquarters located in Princeton Junction, New Jersey. Our headquarters in Princeton Junction is our primary location, where most of our manufacturing and research and development is conducted. While we lease most of our facilities, as of May 31, 2016, we owned properties located in Monroe, North Carolina; Trainer, Pennsylvania; LaPorte, Texas; Burlington, Washington; Gillette, Wyoming; and Jonquiere, Quebec. Our Services segment, utilizes approximately 80 offices throughout North America (including Canada). Our Products and Systems segment’s primary location is in our Princeton Junction, NJ facility. Our International segment has approximately 40 offices including locations in Belgium, Brazil, France, Germany, Greece, India, the Netherlands, and the United Kingdom. We believe that all of our facilities are well maintained and are suitable and adequate for our current needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are subject to periodic legal proceedings, investigations and claims that arise in the ordinary course of business. See “Litigation” in Note 18 - Commitments and Contingencies to our audited consolidated financial statements contained in Item 8 of this report for a description of legal proceedings involving us and our business, which is incorporated herein by reference.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
None.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES
Market for Common Stock
Our common stock currently trades on the New York Stock Exchange (NYSE) under the ticker symbol “MG”. The following table sets forth for the periods indicated the range of high and low sales prices of our common stock.
Holders of Record
As of August 5, 2016, there were 9 holders of record of our Common Stock. The number of record holders was determined from the records of our transfer agent and does not include beneficial owners of common stock whose shares are held in the names of various security brokers, dealers, and registered clearing agencies. The transfer agent of our common stock is American Stock Transfer & Trust Company, 6201 15th Avenue, Brooklyn, New York 11219.
Dividends
No cash dividends have been paid on our Common Stock to date. We currently intend to retain our future earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends in the foreseeable future.
Purchases of Equity Securities
The following sets forth the shares of our common stock we acquired during the fourth quarter of fiscal 2016 pursuant to the surrender of shares by employees to satisfy minimum tax withholding obligations in connection with the vesting of restricted stock units.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data for each of the last five fiscal years. This selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The following Management’s Discussion and Analysis (“MD&A”) provides a narrative of our results of operations for the years ended May 31, 2016, 2015 and 2014, respectively, and our financial position as of May 31, 2016 and 2015, respectively. The MD&A should be read together with our consolidated financial statements and related notes included in Item 8 in this Annual Report on Form 10-K. In this annual report, our fiscal years, which end on May 31, are identified according to the calendar year in which they end (e.g., the fiscal year ended May 31, 2016 is referred to as “fiscal 2016”), and unless otherwise specified or the context otherwise requires, “Mistras,” “the Company,” “we,” “us” and “our” refer to Mistras Group, Inc. and its consolidated subsidiaries. The MD&A includes the following sections:
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Forward-Looking Statements
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Overview
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Consolidated Results of Operations
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Segment Results of Operations
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Liquidity and Capital Resources
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Critical Accounting Estimates
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Recent Accounting Pronouncements
Forward-Looking Statements
This report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (Securities Act), and Section 21E of the Securities Exchange Act of 1934 (Exchange Act). Such forward-looking statements include those that express plans, anticipation, intent, contingency, goals, targets or future development and/or otherwise are not statements of historical fact. See “Forward-Looking Statements” at the beginning of Item 1 of this Report.
Overview
We offer our customers “one source for asset protection solutions”® and are a leading global provider of technology-enabled asset protection solutions used to evaluate the structural integrity and reliability of critical energy, industrial and public infrastructure. We combine industry-leading products and technologies, expertise in mechanical integrity (MI), Non-Destructive Testing (NDT), Destructive Testing (DT) and predictive maintenance (PdM) services, process and fixed asset engineering and consulting services, proprietary data analysis and our world class enterprise inspection database management and analysis software, PCMS, to deliver a comprehensive portfolio of customized solutions, ranging from routine inspections to complex, plant-wide asset integrity management and assessments. These mission critical solutions enhance our customers’ ability to comply with governmental safety and environmental regulations, extend the useful life of their assets, increase productivity, minimize repair costs, manage risk and avoid catastrophic disasters. Our operations consist of three reportable segments: Services, International and Products and Systems.
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Services provides asset protection solutions predominantly in North America with the largest concentration in the United States along with a growing Canadian services business, consisting primarily of NDT, inspection and engineering services that are used to evaluate the structural integrity and reliability of critical energy, industrial and public infrastructure.
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International offers services, products and systems similar to those of the other segments to global markets, in Europe, the Middle East, Africa, Asia and South America, but not to customers in China and South Korea, which are served by the Products and Systems segment.
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Products and Systems designs, manufactures, sells, installs and services the Company’s asset protection products and systems, including equipment and instrumentation, predominantly in the United States.
Given the role our solutions play in ensuring the safe and efficient operation of infrastructure, we have historically provided a majority of our services to our customers on a regular, recurring basis. We serve a global customer base of companies with asset-intensive infrastructure, including companies in the oil and gas (downstream, midstream, upstream and petrochemical), power generation (natural gas, fossil, nuclear, alternative, renewable, and transmission and distribution), public infrastructure, chemicals, commercial aerospace and defense, transportation, primary metals and metalworking, pharmaceutical/biotechnology and food processing industries and research and engineering institutions. As of May 31, 2016, we had approximately 5,700
employees in approximately 120 offices across 14 countries. We have established long-term relationships as a critical solutions provider to many of the leading companies in our target markets.
For the last several years, we have focused on introducing our advanced asset protection solutions to our customers using proprietary, technology-enabled software and testing instruments, including those developed by our Products and Systems segment. During this period, the demand for outsourced asset protection solutions, in general, has increased, creating demand from which our entire industry has benefited. We believe continued growth can be realized in all of our target markets. Concurrent with this growth, we are working on building our infrastructure to profitably absorb additional growth and have made a number of acquisitions in an effort to leverage our fixed costs, grow our base of experienced, certified personnel, expand our product and technical capabilities and increase our geographical reach.
We have increased our capabilities and the size of our customer base through the development of applied technologies and managed support services, organic growth and the integration of acquired companies. These acquisitions have provided us with additional products, technologies, resources and customers that we believe will enhance our advantages over our competition.
Global financial markets continue to experience uncertainty, including tight liquidity and credit availability, relatively low consumer confidence, slow economic growth, fluctuating oil prices and volatile currency exchange rates. However, we believe these conditions have allowed us to selectively hire new talented individuals that otherwise might not have been available to us, and to make acquisitions of complementary businesses at reasonable valuations.
Consolidated Results of Operations
The following table summarizes our consolidated statements of operations for fiscal 2016, 2015 and 2014:
The Company uses Adjusted EBITDA, a non-GAAP metric, to measure its consolidated operating performance and assist in comparing performance from period to period on a consistent basis. A reconciliation of Adjusted EBITDA to net income is provided below for the fiscal years ended May 31, 2016, 2015 and 2014:
Note about Non-GAAP Measures
Adjusted EBITDA is a performance measure used by management that is not calculated in accordance with U.S. generally accepted accounting principles (GAAP). Adjusted EBITDA is defined in this Report as net income attributable to Mistras Group, Inc. plus: interest expense, provision for income taxes, depreciation and amortization, share-based compensation expense, and certain acquisition-related costs (including transaction due diligence costs and adjustments to the fair value of contingent consideration), foreign exchange (gain) loss and, if applicable, certain special items which are noted.
Our management uses Adjusted EBITDA as a measure for planning and forecasting overall expectations and for evaluating actual results against such expectations. Adjusted EBITDA is also used as a performance evaluation metric for certain of our executive and employee incentive compensation programs.
Later in this MD&A under the heading "Income for Operations", the non-GAAP financial performance measure "Income before special items" is used for each of our three segments and the "Total Company", with tables reconciling the measure to a financial measure under GAAP. This non-GAAP measure excludes from the GAAP measure "Income from Operations" (a) transaction expenses related to acquisitions, such as professional fees and due diligence costs (b) the net changes in the fair value of acquisition-related contingent consideration liabilities and (c) nonrecurring items. These items have been excluded from the GAAP measure because these expenses and credits are not related to the Company’s or Segment’s core business operations. The acquisition related costs and special items can be a net expense or credit in any given period.
In the MD&A section "Liquidity and Capital Resources", we use the term "free cash flow", a non-GAAP measurement. We define free cash flow as cash provided by operating activities less capital expenditures (which are purchases of property, plant and equipment and of intangible assets and classified as an investing activity). Free cash flow, which does not represent residual cash flow available for discretionary expenditures since items such as debt repayments are not deducted in determining such measures, for fiscal 2016 was $51.9 million, consisting of $68.1 million of operating cash flow less $16.2 million of capital expenditures. For fiscal 2015, free cash flow was $33.9 million consisting of $49.8 million of operating cash flow less $16.0 million of capital expenditures.
We believe investors and other users of our financial statements benefit from the presentation Adjusted EBITDA and "Income before special items” for each of our three segments and the "Total Company", and free cash flow in evaluating our operating performance because they provide additional tools to compare our operating performance on a consistent basis and measure underlying trends and results in our business. Adjusted EBITDA removes the impact of certain items that management believes do not directly reflect our core operations. For instance, Adjusted EBITDA generally excludes interest expense, taxes and depreciation and amortization, each of which can vary substantially from company to company depending upon accounting methods and the book value and age of assets, capital structure, capital investment cycles and the method by which assets were acquired. It also eliminates share-based compensation, which is a non-cash expense and is excluded by management when evaluating the underlying performance of our business operations. Similarly, we believe that "Income before special items” for each of our three segments and the "Total Company", provides investors with useful information and more meaningful period over period comparisons by identifying and excluding acquisition-related costs and special items so that the performance of the core business operations can be identified and compared.
While Adjusted EBITDA is a term and financial measurement commonly used by investors and securities analysts, it has limitations. As a non-GAAP measurement, Adjusted EBITDA has no standard meaning and, therefore, may not be comparable with similar measurements for other companies. Adjusted EBITDA is generally limited as an analytical tool because it excludes charges and expenses we do incur as part of our operations. For example, Adjusted EBITDA excludes income taxes, but we generally incur significant U.S. federal, state and foreign income taxes each year and the provision for income taxes is a necessary cost. Adjusted EBITDA should not be considered in isolation or as a substitute for analyzing our results as reported under U.S. generally accepted accounting principles. In addition, acquisitions are a part of our growth strategy, and therefore acquisition-related items are a necessary cost of the Company’s business. "Income before special items” for each of our three segments and for the consolidated company and “free cash flow” are not metrics used to determine incentive compensation for executives or employees.
Revenues
Revenues by segment for fiscal 2016, 2015 and 2014 were as follows:
Fiscal 2016
Revenue was $719.2 million in fiscal 2016, an increase of $7.9 million or 1% compared with fiscal 2015, driven by Services segment growth of $13.1 million or 2%, offset by declines in International revenues of $3.9 million or 3%, and the Products & Systems segment of $1.0 million or 3%. The Services segment increase was driven by low single digit organic growth, plus a lesser amount of acquisition-driven growth, offset in part by low single digit unfavorable impact of foreign exchange rates. The decline in International Segment revenues was driven by a combination of high single digit organic growth that was more than offset by the low double digit unfavorable impact of foreign exchange rates. Products and Systems segment revenues declined due to lower sales volume.
Management believes that inspection industry revenues declined during fiscal 2016, as evidenced by several of the Company's competitors who reported revenue declines that have been driven by customers spending less on inspection due to pressures stemming from low commodities prices. Despite these difficult market conditions, the Company had modest growth in fiscal 2016, as noted above, driven by market share gains in both the Services and International segments. Revenues from oil and gas customers comprised 56% and 52% of revenues in fiscal 2016 and 2015, respectively. Revenues from oil and gas customers grew by 9% in fiscal 2016. Our top ten customers represented approximately 36% of our fiscal 2016 revenues compared with 33% in fiscal 2015. One customer accounted for 10% of fiscal 2016 revenues.
Fiscal 2015
Revenue was $711.3 million in fiscal 2015, an increase of $88 million or 14% compared with fiscal 2014, driven by Services segment growth of $97 million or 22%, that was offset in part by International revenues that declined by $14 million or 9%, and Products and Systems segment revenues that declined by $2 million or 7%. The Services segment increase was driven by a combination of mid-teens acquisition growth and mid-single digit organic revenue growth. The decline in International segment revenues was driven by a combination of unfavorable foreign exchange rates of approximately 7%, modest acquisition growth and a mid-single digit organic decline. Products and Systems segment revenues declined approximately 7% due to lower sales volume.
Robust North American market conditions combined with the Company’s market share gains and acquisitions led Services revenue to grow by 38% over prior year during the first half of fiscal 2015. However, a combination of the 50% drop in the
price of oil and labor union strikes at various customer sites caused market conditions to slow dramatically in the second half of fiscal year 2015, reducing the Services second half year-over-year revenue growth rate to 8%. Revenues from oil and gas customers comprised 52% and 49% of revenues in fiscal 2015 and 2014, respectively. Revenues from oil and gas customers grew by 22% in fiscal 2015, led by organic gains and from an acquisition. Fiscal 2015 revenue growth from customers in other industries, including industrial, process industries which include chemical and pharmaceutical, power generation and infrastructure grew by 6% over prior year. Our top ten customers represented approximately 33% of fiscal 2015 revenues compared with 38% in fiscal 2014. No single customer accounted for 10% or more of fiscal 2015 revenues.
Gross Profit. Gross profit by segment for fiscal 2016, 2015 and 2014 was as follows:
Fiscal 2016
Gross profit increased $18.3 million, or 10% in fiscal 2016 compared to fiscal 2015. As a percentage of revenues, gross profit margin improved by 220 basis points compared with the prior year to 28.2% in fiscal 2016, reversing a four year trend of declining gross profit margins.
The 2016 increase of 220 basis points in gross profit margin was primarily attributable to the International and Services segments. International segment gross margins increased to 30.5% in fiscal 2016 compared with 23.5% in the prior year, driven by improvement in each of our four largest countries, organic revenue growth, prior year management changes and staffing actions that improved technical labor utilization, as well as improvements in sales mix and overhead costs. Services segment gross profit margin improved by approximately 130 basis points compared with fiscal 2015, due primarily to improvements in contract profitability and technician labor utilization. Products and Systems segment gross profit margin improved to 46.3% compared to 45.8% in the prior year driven by cost reductions.
Fiscal 2015
Gross profit increased $11.8 million, or 7% in fiscal 2015 compared to fiscal 2014. As a percentage of revenues, gross profit margin declined to 26.0% in fiscal 2015 from 27.7% in fiscal 2014.
The 2015 decrease of 170 basis points in gross profit margin was primarily attributable to the International and Services segments. International segment gross margins decreased to 23.5% in fiscal 2015 compared with 27.8% in the prior year, due primarily to lower levels of project sales and product sales and lower levels of technical labor utilization. Services segment gross profit margin declined by approximately 80 basis points in fiscal 2015, due primarily to wage increases that exceeded price increases earlier in the Company’s fiscal year and the adverse impact from labor union strikes at various customer sites. Products and Systems segment gross margin improved to 45.8% compared to 43.2% in the prior year driven by a more favorable sales mix which included fewer heavily customized solutions.
Income from Operations. The following table shows a reconciliation of the segment income before special items to income from operations for fiscal 2016, 2015 and 2014:
Fiscal 2016
Income from operations (GAAP) was $43.2 million for fiscal 2016, an increase of $12.8 million, or 42% compared to fiscal 2015 and income before special items (non-GAAP), exclusive of acquisition-related items and nonrecurring items, was $49.2 million for fiscal 2016, an increase of $18.7 million or 61% compared with fiscal 2015. As a percentage of revenues, income before special items improved by 250 basis points to 6.8% in fiscal 2016 from 4.3% in fiscal 2015.
Total operating expenses increased by $5 million, or 4% in fiscal 2016 compared to fiscal 2015, driven by a $6.3 million legal settlement accrual, offset by a $1.3 million, or 1% decline in recurring expenses. The recurring expense decrease was driven by the International segment, which decreased $2.9 million, primarily due to the impact of foreign exchange rates. Offsetting the
International decreases were increases of $1.5 million from the Corporate segment, primarily due to legal and bonus expense. The Services and Products and Systems segments were flat from fiscal 2015 to fiscal 2016.
Fiscal 2015
Income from operations (GAAP) was $30.4 million for fiscal 2015, a $7.9 million decrease compared to fiscal 2014 and income before special items (non-GAAP) was $30.5 million for fiscal 2015, a $5.5 million decrease compared to fiscal 2014. As a percentage of revenues, income before special items dropped to 4.3% in fiscal 2015 from 5.8% in fiscal 2014.
Total operating expenses increased $19.7 million, or 15% in fiscal 2015 vs. fiscal 2014, driven by $18.3 million or 13% increase in recurring expense and a $1.4 million increase in special items, primarily from acquisition related expenses. The recurring expense increase was driven by the Services segment, which incurred a year-on-year operating expense increase of $17.4 million or 25%. Operating expenses incurred by acquired companies accounted for $11.6 million of this increase, and increased compensation and benefits to support growth comprised most of the remaining increase. Corporate operating expenses increased by $3.0 million or 18%, due primarily to increased headcount, insurance cost and foreign exchange losses. Products and Systems segment year-on-year operating expenses decreased $1.2 million, primarily due to headcount reductions, while International segment operating expenses decreased by $0.8 million, as incremental operating expenses of acquired companies was more than offset by the impact of foreign exchange rates.
Interest Expense
Interest expense was $4.8 million in fiscal 2016, $4.6 million in fiscal 2015 and $3.2 million in fiscal 2014. The increase in fiscal 2015 was primarily related to an increase in average borrowings compared to fiscal 2014.
Income Taxes
Our effective income tax rate was 36% for fiscal 2016 compared to 38% for fiscal 2015. The lower effective tax rate was driven by discrete items, including favorability from reserves pertaining to uncertain tax positions and the absence of increases in the valuation allowance for deferred tax assets in 2016.
Our effective income tax rate was 38% for fiscal 2015 compared to 36% for fiscal 2014. The increase was primarily due to a lower amount of foreign income in fiscal 2015 which is taxed at lower rates and an increase in the valuation allowance for deferred tax assets, offset by the impact of acquisition contingent consideration.
Income tax expense varies as a function of pre-tax income and the level of non-deductible expenses, such as certain amounts of meals and entertainment expense, valuation allowances, and other permanent differences. It is also affected by discrete items that may occur in any given year, but are not consistent from year to year. Our effective income tax rate may fluctuate over the next few years due to many variables including the amount and future geographic distribution of our pre-tax income, changes resulting from our acquisition strategy, and increases or decreases in our permanent differences.
Segment Results of Operations
Services Segment
Selected financial information for the Services segment was as follows for fiscal 2016, 2015 and 2014:
Revenues
In fiscal 2016, Services revenues increased $13.1 million, or 2% compared with fiscal 2015. This increase was driven by low single digit organic revenue growth, and to a lesser extent, acquisition-driven growth, offset in part by a low single digit unfavorable impact of foreign exchange rates. Management believes that inspection industry revenues declined during fiscal 2016, driven by customers spending less due to pressures stemming from low commodities prices. Despite these difficult market conditions, the Services segment experienced positive organic growth in fiscal 2016, driven by market share gains.
Oil and gas customers accounted for approximately 67% and 64% of Services segment revenues in fiscal 2016 and fiscal 2015, respectively. Services' top ten customers accounted for approximately 44% and 42% of Services segment revenues during fiscal 2016 and 2015, respectively. Revenues from Services' largest customer represented approximately 13% of segment revenues in fiscal 2016 and 12% in fiscal 2015.
In fiscal 2015, Services revenues increased $97.0 million, or 22% compared with fiscal 2014. The increase was driven by mid-teens acquisition growth and mid-single digit organic growth. Strong market conditions combined with Services' market share gains and acquisitions drove 38% growth in first half revenues. However, the sudden 50% drop in oil prices combined with labor union refinery strikes caused market conditions to slow dramatically in the second half of the fiscal year, reducing Services' second half revenue growth rate to 8% over prior year.
Gross Profit
Services segment gross profit margin was 26.3% and 25.0% in fiscal 2016 and fiscal 2015, respectively. The 130 basis point increase in Services segment gross profit margin was primarily due to improvements in contract profitability and technician labor utilization.
Our Services segment gross profit margin was 25.0% and 25.8% in fiscal 2015 and fiscal 2014, respectively. The 80 basis point decrease in Services segment gross profit margin was due primarily to wage increases that exceeded price increases earlier in the Company’s fiscal year, as well as market conditions that deteriorated in the second half of fiscal 2015.
Income from Operations
Services segment income from operations (GAAP) improved by $3.4 million, or 7% to $52.6 million and income before special items (non-GAAP) improved by $9.5 million, or 20% to $58.0 million in fiscal 2016. Services operating profit margin before special items improved by 150 basis points to 10.5% in fiscal 2016, driven primarily by the 130 basis point improvement in gross profit margin for the segment.
In fiscal 2016, Services segment operating expenses rose by $6.7 million, or 8%, due primarily to a $6.3 million settlement of a class action lawsuit involving labor claims. (See Note 18 of our audited consolidated financial statements contained in Item 8 of this report for details of this case). Services' operating expenses exclusive of the legal settlement costs were nearly flat with prior year.
Services segment income from operations (GAAP) improved by $5.9 million, or 14% to $49.1 million and income before special items (non-GAAP) improved by $3.7 million or 8%, to $48.5 million in fiscal 2015. Services' operating profit margin before special items declined by 110 basis points to 9.0% in fiscal 2015, driven primarily by the 80 basis point reduction in gross profit margin for the segment.
In fiscal 2015, Services segment operating expenses rose by $15 million, or 21%, Operating expenses incurred by acquired companies accounted for $10.8 million of this increase and increased compensation and benefits to support growth comprised most of the remaining increase, offset by acquisition-related benefit.
International Segment
Selected financial information for our International segment was as follows for fiscal 2016, 2015 and 2014:
Revenues
International segment revenues declined by $3.9 million, or 3% during fiscal 2016, driven by a combination of high single digit organic growth that was more than offset by the low double digit unfavorable impact of foreign exchange rates. Each of the Company’s four largest international subsidiaries experienced positive organic growth during fiscal 2016. Industries with the largest revenue concentrations in fiscal 2016 were aerospace and defense (39%), oil and gas (21%) and industrials (15%).
International segment revenues declined by $14.4 million, or 9% during fiscal 2015 driven by a combination of unfavorable foreign exchange rates of approximately 7%, modest acquisition growth and a mid-single digit organic decline. Industries with the largest revenue concentrations in fiscal 2015 were aerospace and defense (41%), oil and gas (17%) and industrials (15%).
Gross Profit
International segment gross profit for fiscal 2016 increased by $9.0 million or 26% and comprised 30.5% of revenues. The International gross profit margin improved by 700 basis points in fiscal 2016, as improvement in each of the Company's four largest country locations were driven by organic revenue growth, prior year management changes and staffing actions that improved technical labor utilization, improvements in sales mix and reduced overhead costs.
International segment gross profit for fiscal 2015 decreased by $10.3 million or 23% and comprised 23.5% of revenues. International gross profit margin fell by 430 basis points in 2015, due primarily to lower levels of project and product sales and lower levels of technician labor utilization.
Income (loss) from Operations
International segment income from operations (GAAP) was $9.3 million in fiscal 2016, compared to a loss from operations of $0.6 million in fiscal 2015. International segment income before special items (non-GAAP) was $9.7 million, compared to loss before special items of $1.5 million in fiscal 2015. As a percentage of revenues, the income before special charges was approximately 7% in fiscal 2016, compared with (1)% in fiscal 2015.
Segment operating expenses, exclusive of acquisition-related items and special items, declined by $2.9 million, or 8% during fiscal 2016, driven by the impact of lower foreign exchange rates, costs reductions and reduced foreign exchange losses. Recurring operating expenses were 24% and 25%, of segment revenues in fiscal 2016 and 2015, respectively.
International segment loss from operations (GAAP) was $0.6 million in fiscal 2015, compared to income from operations of $10.2 million in fiscal 2014. International segment loss before special items (non-GAAP) was $1.5 million in fiscal 2015 compared to income before special items of $7.1 million in fiscal 2014. As a percentage of revenues, the loss before special charges was approximately (1)% in fiscal 2015 compared with 4% in fiscal 2014.
Segment operating expenses, exclusive of acquisition-related items and special items, decreased by $0.8 million from fiscal 2014 to fiscal 2015, as incremental operating expenses of acquired companies was more than offset by the impact of foreign exchange rates.
Products and Systems Segment
Selected financial information for the Products and Systems segment was as follows for fiscal 2016, 2015 and 2014:
Revenues
Products and Systems segment revenues for fiscal 2016 decreased $1.0 million or 3% compared to fiscal 2015 and by $2.3 million or 7% compared to fiscal 2014. The revenue declines were due to lower sales volume.
Gross Profit
Products and Systems segment gross profit margin was 46.3% in fiscal 2016, which represented a 50 basis point improvement over fiscal 2015, and a 310 basis point improvement over fiscal 2014. Because of these gross profit margin improvements, gross profits generated by this segment were consistent from fiscal 2014 to fiscal 2016 despite the sales declines. The gross profit margin improvements were driven in both years by a more favorable sales mix which included fewer heavily customized solutions.
Income from Operations
Products and Systems segment income from operations (GAAP) improved by $0.2 million in fiscal 2016 and decreased by $0.1 million in fiscal 2015. Income before special charges (non-GAAP) improved by over $1.2 million in fiscal 2015 and was flat in fiscal 2016 despite the sales declines experienced. Fiscal 2016 operating profit margins before special charges of 9.0% represented improvements of 30 basis points over fiscal 2015 and of 450 basis points over fiscal 2014. Drivers to these improvements included the improvements in gross profit margin, coupled with operating expense reductions of $1.2 million in fiscal 2015 compared with fiscal 2014, and a further $0.4 million in fiscal 2016 as compared with fiscal 2015. The reductions in operating expenses were driven by lower headcounts in both years.
Corporate and Eliminations
The elimination of revenues and cost of revenues products sales by the Products and Systems segment to the International and Services segments is captured in this segment, as well as operating expenses that have not been allocated to other segments. These costs primarily include the costs of corporate support functions, such as finance, legal, human resources and certain other costs. As a percentage of our total revenues, these costs have generally remained consistent over the last three fiscal years, consisting of approximately 3% of total revenues for each of the fiscal years ended 2016, 2015 and 2014, respectively.
Liquidity and Capital Resources
Overview
The Company has funded its operations from cash provided from operations, bank borrowings and capital lease financings. Management believes that the Company's existing cash and cash equivalents, anticipated cash flows from operating activities, and available borrowings under our credit agreement will be more than sufficient to meet anticipated cash needs over the next 12 months. The Company generated free cash flow, (a non-GAAP measurement defined as operating cash flow reduced by capital expenditures) of $51.9 million in fiscal 2016, compared with $33.9 million in fiscal 2015 and $19.3 million in fiscal 2014. Capital expenditures include both the purchase of property, plant and equipment and of intangible assets.
Cash Flows Table
The following table summarizes our cash flows for fiscal 2016, 2015 and 2014:
Cash Flows from Operating Activities
Cash provided by operating activities in fiscal 2016 improved by $18 million or 37% over the prior fiscal year. This improvement was primarily driven by the Company's $16 million improvement in net income, as adjusted for working capital items and certain non-cash items, most notably the $6 million legal settlement, as well as from reducing Days Sales Outstanding by 2 days.
Cash provided by operating activities in fiscal 2015 improved by $13 million or 35% over the prior fiscal year. The improvement was primarily attributable to the timing of working capital inflows and outflows, namely a $28 million improvement in the timing of collections of accounts receivable, offset in part by incremental net outflows of $15 million related to the timing of payments relating to accounts payable, and accrued expenses and other liabilities.
Cash Flows from Investing Activities
Net cash used in investing activities was $16.8 million in fiscal 2016, principally due to $16.2 million purchases of property, plant and equipment and intangible assets.
Net cash used in investing activities was $49.7 million in fiscal 2015, principally due to acquisitions totaling $34.7 million, net of cash acquired and purchases of property, plant and equipment of $16.0 million.
Cash Flows from Financing Activities
Net cash used in financing activities in fiscal 2016 was $40 million, as compared with cash provided by financing activities of $2 million in fiscal 2015. Net cash used in financing activities during fiscal 2016 consisted primarily of net repayments of debt totaling $36 million.
Net cash provided by financing activities in fiscal 2015 was $2 million, compared to $3 million in fiscal 2014.
Effect of Exchange Rate on Changes in Cash
For fiscal 2016, 2015 and 2014, exchange rate changes (decreased) increased cash by $(0.4) million, $(1.7) million and $0.1 million, respectively.
Cash Balance and Credit Facility Borrowings
As of May 31, 2016, the Company had cash and cash equivalents totaling $21.2 million and available borrowing capacity of up to $101.2 million under its credit agreement (as defined below). Borrowings of $69.0 million and letters of credit of $4.8 million were outstanding under the credit agreement at May 31, 2016. We finance our operations primarily through our existing cash balances, cash collected from operations, bank borrowings and capital lease financing. We believe these sources are sufficient to fund our operations for the foreseeable future.
On October 31, 2014, the Company entered into a Third Amendment and Modification Agreement (the “Amendment”), to our revolving line of credit, the Third Amended and Restated Credit Agreement (“Credit Agreement”), dated December 21, 2011, with its lending group. The Amendment increased the Company's revolving line of credit from $125.0 million to $175.0 million and provides that under certain circumstances the line of credit can be increased to $225.0 million. The Company may continue to borrow up to $30.0 million in non-U.S. Dollar currencies and use up to $10.0 million of the credit limit for the issuance of letters of credit. The Amendment also extended the original maturity date of the Credit Agreement from December 20, 2016 to October 30, 2019.
Loans under the Credit Agreement bear interest at LIBOR plus an applicable LIBOR margin ranging from 1% to 1.75%, or a base rate less a margin of 1.25% to 0.375%, at our option, based upon our Funded Debt Leverage Ratio. Funded Debt Leverage Ratio is generally the ratio of (1) all outstanding indebtedness for borrowed money and other interest-bearing indebtedness as of the date of determination to (2) EBITDA (which is (a) net income, less (b) income (or plus loss) from discontinued operations and extraordinary items, plus (c) income tax expenses, plus (d) interest expense, plus (e) depreciation, depletion, and amortization (including non-cash loss on retirement of assets), plus (f) stock compensation expense, less (g) cash expense related to stock compensation, plus or minus certain other adjustments) for the period of four consecutive fiscal quarters immediately preceding the date of determination. We have the benefit of the lowest margin if our Funded Debt Leverage Ratio is equal to or less than 0.5 to 1, and the margin increases as the ratio increases, to the maximum margin if the ratio is greater than 2.0 to 1. We will also bear additional costs for market disruption, regulatory changes effecting the lenders’ funding costs, and default pricing of an additional 2% interest rate margin on any amounts not paid when due. Amounts borrowed under the Credit Agreement are secured by liens on substantially all of our assets.
The Credit Agreement contains financial covenants requiring that we maintain a Funded Debt Leverage Ratio of no greater than 3.25 to 1 and an Interest Coverage Ratio of at least 3.0 to 1. Interest Coverage Ratio means the ratio, as of any date of determination, of (a) EBITDA for the 12 month period immediately preceding the date of determination, to (b) all interest, premium payments, debt discount, fees, charges and related expenses of us and our subsidiaries in connection with borrowed money (including capitalized interest) or in connection with the deferred purchase price of assets, in each case to the extent treated as interest in accordance with GAAP, paid during the 12 month period immediately preceding the date of determination. The Credit Agreement also limits our ability to, among other things, create liens, make investments, incur more indebtedness, merge or consolidate, make dispositions of property, pay dividends and make distributions to stockholders, enter into a new line of business, enter into transactions with affiliates and enter into burdensome agreements. The Credit Agreement does not limit our ability to acquire other businesses or companies except that the acquired business or company must be in our line of business, we must be in compliance with the financial covenants on a pro forma basis after taking into account the acquisition, and, if the acquired business is a separate subsidiary, in certain circumstances the lenders will receive the benefit of a guaranty of the subsidiary and liens on its assets and a pledge of its stock.
As of May 31, 2016, the Company was in compliance with the terms of the Credit Agreement, and has undertaken to continuously monitor compliance with these covenants.
Liquidity and Capital Resources Outlook
Future Sources of Cash
We expect our future sources of cash to include cash flow generated from our operating activities and borrowings under our Credit Agreement. Our revolving credit facility is available for cash advances required for working capital and for letters of credit to support our operations. Acquisitions are funded through available cash, borrowings under the revolving credit facility and seller notes.
Future Uses of Cash
We expect our future uses of cash will primarily be for acquisitions, international expansion, purchases or manufacture of field testing equipment to support growth, additional investments in technology and software products and the replacement of existing assets and equipment used in our operations. We often make purchases to support new sources of revenues, particularly in our Services segment. In addition, we will need to fund a certain amount of replacement equipment, including our fleet vehicles. We historically spend approximately 2% to 4% of our total revenues on capital expenditures, excluding acquisitions, and expect to fund these expenditures through a combination of cash and lease financing. Our cash capital expenditures, excluding acquisitions, for fiscal 2016, 2015 and 2014 were approximately 2%, 2%, and 3% of revenues, respectively. In addition, we expect to selectively repurchase our common stock, pursuant to the stock repurchase program of up to $50 million, that was approved by the Company's Board of Directors during fiscal 2016.
Our future acquisitions may also require capital. We acquired two companies in fiscal 2016 and four companies in fiscal 2015, with an aggregate cash outlay of $37.5 million. In some cases, additional equipment will be needed to upgrade the capabilities of these acquired companies. In addition, our future acquisition and capital spending may increase as we pursue growth opportunities. Other investments in infrastructure, training and software may also be required to match our growth, but we plan to continue using a disciplined approach to building our business. In addition, we will use cash to fund our operating leases, capital leases, long-term debt repayments and various other obligations as they arise.
We also expect to use cash to support our working capital requirements for our operations, particularly in the event of further growth and due to the impacts of seasonality on our business. Our future working capital requirements will depend on many factors, including the rate of our revenue growth, our introduction of new solutions and enhancements to existing solutions and our expansion of sales and marketing and product development activities. To the extent that our cash and cash equivalents and future cash flows from operating activities are insufficient to fund our future activities, we may need to raise additional funds through bank credit arrangements, public or private equity financings, or debt financings. We also may need to raise additional funds in the event we determine in the future to effect one or more acquisitions of businesses, technologies or products that will complement our existing operations. In the event additional funding is required, we may not be able to obtain bank credit arrangements or effect an equity or debt financing on acceptable terms.
Contractual Obligations
We generally do not enter into long-term minimum purchase commitments. Our principal commitments, in addition to those related to our long-term debt discussed below, consist of obligations under facility leases for office space and equipment leases and contingent consideration obligations in connection with our acquisitions.
The following table summarizes our outstanding contractual obligations as of May 31, 2016:
________________________________
(1)
Consists primarily of borrowings from our senior credit facility and seller notes payable in connection with our acquisitions and includes the current portion outstanding.
(2)
Includes estimated cash interest to be paid over the remaining terms of the leases.
(3)
Consists of payments deemed reasonably likely to occur in connection with our acquisitions
Off-Balance Sheet Arrangements
During fiscal 2016, 2015 and 2014, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. The accounting policies that we believe require more significant estimates and assumptions include: revenue recognition, valuations of accounts receivable, long-lived assets, goodwill, and deferred tax assets and uncertain tax positions. We base our estimates and assumptions on historical experience, known or expected trends and various other assumptions that we believe to be reasonable. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates, which may cause our future results to be significantly affected.
We believe that the following critical accounting policies comprise the more significant estimates and assumptions used in the preparation of our consolidated financial statements.
Revenue Recognition
Revenue is generally recognized when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the fee is fixed or determinable, and collectability is reasonably assured, as summarized below.
Services
Revenue is primarily derived from providing services on a time and material basis. Service arrangements generally consist of inspection professionals working under contract for a fixed period of time or on a specific customer project. Revenue is generally recognized when the service is performed in accordance with terms of each customer arrangement, upon completion of the earnings process and when collection is reasonably assured. At the end of any reporting period, revenue is accrued for services that have been earned which have not yet been billed. Reimbursable costs, including those related to travel and out-of-pocket expenses, are included in revenue, and equivalent amounts of reimbursable costs are included in cost of services.
Products and Systems
Sales of products and systems are recorded when the sales price is fixed and determinable and the risks and rewards of ownership are transferred (generally upon shipment) and when collectability is reasonably assured.
These arrangements occasionally contain multiple elements or deliverables, such as hardware, software (that is essential to the functionality of the hardware) and related services. We recognize revenue for delivered elements as separate units of accounting, when the delivered elements have standalone value, uncertainties regarding customer acceptance are resolved and there are no refund or return rights for the delivered elements. We establish the selling prices for each deliverable based on our vendor-specific objective evidence (“VSOE”), if available, third-party evidence, if VSOE is not available, or estimated selling price (“ESP”) if neither VSOE nor third-party evidence is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. Third-party evidence of selling price is established by evaluating largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. We determine ESP by considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and industry technology life cycles. When determining ESP, we apply management judgment to establish margin objectives and pricing strategies and to evaluate market conditions and product life cycles. Changes in the aforementioned factors may result in a different allocation of revenue to the deliverables in multiple element arrangements and therefore may change the pattern and timing of revenue recognition for these elements, but will not change the total revenue recognized for the arrangement.
A portion of our revenue is generated from engineering and manufacturing of custom products under long-term contracts that may last from several months to several years, depending on the contract. Revenues from long-term contracts are recognized on the percentage-of-completion method of accounting. Under the percentage-of-completion method of accounting revenues are recognized as work is performed. The percentage of completion at any point in time is generally based on total costs or total labor dollars incurred to date in relation to the total estimated costs or total labor dollars estimated at completion. The percentage of completion is then applied to the total contract revenue to determine the amount of revenue to be recognized in the period. Application of the percentage-of-completion method of accounting requires the use of estimates of costs to be incurred for the performance of the contract. Contract costs include all direct materials, direct labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs, and all costs associated with operation of equipment. The cost estimation process is based upon the professional knowledge and experience of our engineers, project managers and financial professionals. Factors that are considered in estimating the work to be completed include the availability and productivity of labor, the nature and complexity of the work to be performed, the effect of change orders, the availability of materials, the effect of any delays in our project performance and the recoverability of any claims. Whenever revisions of estimated contract costs and contract values indicate that the contract costs will exceed estimated revenues, thus creating a loss, a provision for the total estimated loss is recorded in that period.
Long-Lived Assets
We perform a review of long-lived assets for impairment when events or changes in circumstances indicate the carrying value of such assets may not be recoverable. If an indication of impairment is present, we compare the estimated undiscounted future cash flows to be generated by the asset to its carrying amount. If the undiscounted future cash flows are less than the carrying amount of the asset, we record an impairment loss equal to the excess of the asset’s carrying amount over its fair value. We estimate fair value based on valuation techniques such as a discounted cash flow analysis or a comparison to fair values of similar assets. As of May 31, 2016 and 2015, we had $78.7 million and $79.3 million in net property, plant and equipment, respectively, and $43.5 million and $51.3 million in intangible assets, net, respectively. There were no long-lived asset impairment charges recorded during the years ended May 31, 2016, 2015 or 2014.
Long-lived assets, net, outside of the U.S. totaled $104.8 million and $105.9 million as of May 31, 2016 and 2015, respectively.
Goodwill
Goodwill represents the excess purchase price of acquired businesses over the fair values attributed to underlying net tangible assets and identifiable intangible assets. We test the carrying value of goodwill for impairment at a “reporting unit” level (which for the Company is represented by (i) our Services segment, (ii) our Products and Systems segment, and (iii) the European component and (iv) Brazilian component of our International segment), using a qualitative assessment for its Services reporting unit and a two-step approach for its remaining reporting units, annually as of March 1, or whenever an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. If the fair value of a reporting unit is less than its carrying value, this is an indicator that the goodwill assigned to that
reporting unit may be impaired. In this case, a second step is performed to allocate the fair value of the reporting unit to the assets and liabilities of the reporting unit as if it had just been acquired in a business combination, and as if the purchase price was equivalent to the fair value of the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is referred to as the implied fair value of goodwill. The implied fair value of the reporting unit’s goodwill is then compared to the actual carrying value of goodwill. If the implied fair value is less than the carrying value, an impairment loss would be recorded to reduce the carrying value of goodwill to its implied fair value. We consider the income and market approaches to estimating the fair value of our reporting units, which requires significant judgment in evaluation of economic and industry trends, estimated future cash flows, discount rates and other factors. The Company believes that the fair values of each of its reporting units are substantially in excess of their respective carrying amounts.
Significant deterioration in industry or economic trends, disruptions to our business, inability to effectively integrate acquired businesses, or other factors, may cause these fair value to decline, possibly resulting in impairment charges to goodwill in future periods.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for fiscal years and interim periods within those fiscal years beginning December 15, 2017, as a result of a one year deferral in the standard issued by the FASB in August 2015 with ASU 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures.
In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments. This amendment will simplify the accounting for adjustments made to provisional amounts recognized in a business combination and eliminates the requirement to retrospectively account for those adjustments in previous reporting periods. This update will require on the face of the income statement or in the notes to the financial statements the amount recorded in current-period earnings that would have previously been recorded if the adjustment to the provisional amounts had been recognized as of the acquisition date. ASU 2015-16 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2015. This update should be applied prospectively and earlier adoption is permitted for financial statements that have not been issued. The Company is evaluating the effect that ASU 2015-16 will have on its consolidated financial statements and related disclosures.
In November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This amendment will simplify the presentation of deferred tax assets and liabilities on the balance sheet and require all deferred tax assets and liabilities to be treated as non-current. ASU 2015-17 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2016, with early adoption permitted. The Company is evaluating the effect that ASU 2015-17 will have on its consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This amendment supersedes previous accounting guidance (Topic 840) and requires all leases, with exception of leases with a term of 12 months or less, to be recorded on the balance sheet as lease assets and lease liabilities. ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018, with early adoption permitted. The standard requires lessees and lessors to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Company is evaluating the effect that ASU 2016-02 will have on its consolidated financial statements and related disclosures.
In March 2016, the FASB issues ASU No. 2016-09, Stock Compensation (Topic 718). This amendment will simplify certain aspects of accounting for share-based payment transactions, which include accounting for income taxes and the related impact on the statement of cash flows, an option to account for forfeitures when they occur in addition to the existing guidance to estimate the forfeitures of awards, classification of awards as either equity or liabilities and classification on the statement of cash flows for employee taxes paid to tax authorities on shares withheld for vesting. ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2016, with early adoption permitted. The Company is evaluating the effect that ASU 2016-09 will have on its consolidated financial statements and related disclosures.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Sensitivity
The company’s investment portfolio primarily includes cash equivalents for which the market values are not significantly affected by changes in interest rates. Our interest rate risk results primarily from our variable rate indebtedness under our credit facility, which is influenced by movements in short-term rates. Borrowings under our $175.0 million revolving credit facility are based on an LIBOR, plus an additional margin based on our Funded Debt Leverage Ratio. Based on the amount of variable rate debt, $69.0 million at May 31, 2016, an increase in interest rates by one hundred basis points from our current rate would increase annual interest expense by approximately $0.7 million.
Foreign Currency Risk
We have foreign currency exposure related to our operations in foreign locations. This foreign currency exposure, particularly the Euro, British Pound Sterling, Brazilian Real, Canadian Dollar and the Indian Rupee, arises primarily from the translation of our foreign subsidiaries’ financial statements into U.S. Dollars. For example, a portion of our annual sales and operating costs are denominated in British Pound Sterling and we have exposure related to sales and operating costs increasing or decreasing based on changes in currency exchange rates. If the U.S. Dollar increases in value against these foreign currencies, the value in U.S. Dollars of the assets and liabilities originally recorded in these foreign currencies will decrease. Conversely, if the U.S. Dollar decreases in value against these foreign currencies, the value in U.S. Dollars of the assets and liabilities originally recorded in these foreign currencies will increase. Thus, increases and decreases in the value of the U.S. Dollar relative to these foreign currencies have a direct impact on the value in U.S. Dollars of our foreign currency denominated assets and liabilities, even if the value of these items has not changed in their original currency. We do not currently enter into forward exchange contracts to hedge exposures denominated in foreign currencies. An unfavorable 10% change in the average U.S. Dollar exchange rates for fiscal 2016 would cause a decrease in consolidated operating income of approximately $1.1 million and a favorable 10% change would cause an increase of approximately $1.3 million. We may consider entering into hedging or forward exchange contracts in the future, as sales in international currencies increase due to growth in our International segment.
Fair Value of Financial Instruments
We do not have material exposure to market risk with respect to investments, as our investments consist primarily of highly liquid investments purchased with a remaining maturity of three months or less. We do not use derivative financial instruments for speculative or trading purposes; however, this does not preclude our adoption of specific hedging strategies in the future.
Effects of Inflation and Changing Prices
Our results of operations and financial condition have not been significantly affected by inflation and changing prices.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Mistras Group, Inc.:
We have audited the accompanying consolidated balance sheets of Mistras Group, Inc. and subsidiaries (the Company) as of May 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income (loss), equity, and cash flows for each of the years in the three-year period ended May 31, 2016. We also have audited the Company’s internal control over financial reporting as of May 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mistras Group, Inc. and subsidiaries as of May 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended May 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of May 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ KPMG LLP
New York, New York
August 15, 2016
Mistras Group, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
Mistras Group, Inc. and Subsidiaries
Consolidated Statements of Income
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
Mistras Group, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss)
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Mistras Group, Inc. and Subsidiaries
Consolidated Statements of Equity
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Mistras Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Mistras Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(tabular dollars in thousands, except share and per share data)
1. Description of Business and Basis of Presentation
Description of Business
Mistras Group, Inc. and subsidiaries (the Company) is a leading “one source” global provider of technology-enabled asset protection solutions used to evaluate the structural integrity and reliability of critical energy, industrial and public infrastructure. The Company combines industry-leading products and technologies, expertise in mechanical integrity (MI) and non-destructive testing (NDT) services and proprietary data analysis software to deliver a comprehensive portfolio of customized solutions, ranging from routine inspections to complex, plant-wide asset integrity assessments and management. These mission critical solutions enhance customers’ ability to extend the useful life of their assets, increase productivity, minimize repair costs, comply with governmental safety and environmental regulations, manage risk and avoid catastrophic disasters. The Company serves a global customer base of companies with asset-intensive infrastructure, including companies in the oil and gas, fossil and nuclear power, alternative and renewable energy, public infrastructure, chemicals, commercial aerospace and defense, transportation, primary metals and metalworking, pharmaceutical/biotechnology and food processing industries and research and engineering institutions.
Principles of Consolidation
The accompanying audited consolidated financial statements include the accounts of Mistras Group, Inc. and its wholly and majority-owned subsidiaries. For subsidiaries in which the Company’s ownership interest is less than 100%, the noncontrolling interests are reported in stockholders’ equity in the accompanying consolidated balance sheets. The noncontrolling interests in net income, net of tax, is classified separately in the accompanying consolidated statements of income.
All significant intercompany accounts and transactions have been eliminated in consolidation. Mistras Group, Inc.’s and its subsidiaries’ fiscal years end on May 31 except for the subsidiaries in the International segment, which end on April 30. Accordingly, the Company’s International segment subsidiaries are consolidated on a one-month lag. Therefore, in the quarter and year of acquisition, results of acquired subsidiaries in the International segment are generally included in consolidated results for one less month than the actual number of months from the acquisition date to the end of the reporting period. Management does not believe that any events occurred during the one-month lag period that would have a material effect on the Company’s consolidated financial statements for fiscal 2016. As discussed in Note 7 - Acquisitions and Dispositions, during the lag period in fiscal 2015, the Company sold an international subsidiary, and decided to sell two additional international subsidiaries. Management does not believe that any additional events occurred during the fiscal 2015 one-month lag period that would have a material effect on the Company’s consolidated financial statements. Reference to a fiscal year means the fiscal year ended May 31.
Reclassifications
Certain amounts in prior periods have been reclassified to conform to the current year presentation. Such reclassifications did not have a material effect on the Company's financial condition or results of operations as previously reported.
Immaterial Correction
Subsequent to the issuance of its consolidated financial statements as of and for the year ended May 31, 2015, the Company identified errors related to the classification of amounts reported in the Consolidated Statement of Cash Flows for that period. In accordance with the SEC Staff Accounting Bulletin (SAB) No. 99, Materiality, and SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, management evaluated the materiality of the errors from qualitative and quantitative perspectives, and concluded that the errors were immaterial. Accordingly, management has corrected the presentation of the affected line items of the accompanying Consolidated Statement of Cash Flows for the year ended May 31, 2015, as summarized below. These changes did not impact the Company’s net income, balance sheet, or stockholders’ equity for any periods previously reported.
2. Summary of Significant Accounting Policies
Revenue Recognition
Revenue is generally recognized when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the fee is fixed or determinable, and collectability is reasonably assured. Shipping and handling costs are included in cost of revenues. Taxes collected from customers and remitted to governmental authorities are presented in the consolidated statements of income on a net basis. One customer accounted for 10% of our revenues in fiscal 2016, which primarily were generated from the Services segment. No customer accounted for 10% or more of our revenues in fiscal 2015 and 2014. The following revenue recognition policies define the manner in which we account for specific transaction types:
Services
Revenue is primarily derived from providing services on a time and material basis. Service arrangements generally consist of inspection professionals working under contract for a fixed period of time or on a specific customer project. Revenue is generally recognized when the service is performed in accordance with terms of each customer arrangement, upon completion of the earnings process and when collection is reasonably assured. At the end of any reporting period, revenue is accrued for services that have been earned which have not yet been billed. Reimbursable costs, including those related to travel and out-of-pocket expenses, are included in revenue, and equivalent amounts of reimbursable costs are included in cost of services.
Products and Systems
Sales of products and systems are recorded when the sales price is fixed and determinable and the risks and rewards of ownership are transferred (generally upon shipment) and when collectability is reasonably assured.
These arrangements occasionally contain multiple elements or deliverables, such as hardware, software (that is essential to the functionality of the hardware) and related services. The Company recognizes revenue for delivered elements as separate units of accounting, when the delivered elements have standalone value, uncertainties regarding customer acceptance are resolved and there are no refund or return rights for the delivered elements. The Company establishes the selling prices for each deliverable based on its, vendor-specific objective evidence (“VSOE”), if available, third-party evidence, if VSOE is not available, or estimated selling price (“ESP”) if neither VSOE nor third-party evidence is available. The Company establishes VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. Third-party evidence of selling price is established by evaluating largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. The Company determines ESP, by considering Internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and Industry technology life cycles. When determining ESP, the Company applies management judgment to
establish margin objectives and pricing strategies and to evaluate market conditions and product life cycles. Changes in the aforementioned factors may result in a different allocation of revenue to the deliverables in multiple element arrangements and therefore may change the pattern and timing of revenue recognition for these elements, but will not change the total revenue recognized for the arrangement.
A portion of the Company’s revenue is generated from engineering and manufacturing of custom products under long-term contracts that may last from several months to several years, depending on the contract. Revenues from long-term contracts are recognized on the percentage-of-completion method of accounting. Under the percentage-of-completion method of accounting revenues are recognized as work is performed. The percentage of completion at any point in time is generally based on total costs or total labor dollars incurred to date in relation to the total estimated costs or total labor dollars estimated at completion. The percentage of completion is then applied to the total contract revenue to determine the amount of revenue to be recognized in the period. Application of the percentage-of-completion method of accounting requires the use of estimates of costs to be incurred for the performance of the contract. Contract costs include all direct materials, direct labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs, and all costs associated with operation of equipment. The cost estimation process is based upon the professional knowledge and experience of our engineers, project managers and financial professionals. Factors that are considered in estimating the work to be completed include the availability and productivity of labor, the nature and complexity of the work to be performed, the effect of change orders, the availability of materials, the effect of any delays in our project performance and the recoverability of any claims. Whenever revisions of estimated contract costs and contract values indicate that the contract costs will exceed estimated revenues, thus creating a loss, a provision for the total estimated loss is recorded in that period.
Use of Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires that the Company make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and disclosure of contingent assets and liabilities at the date of financial statements. The accounting policies that the Company believes require more significant estimates and assumptions include: revenue recognition, valuations of accounts receivable, long lived assets, goodwill, and deferred tax assets and uncertain tax positions. The Company bases its estimates and assumptions on historical experience, known or expected trends and various other assumptions that it believes to be reasonable. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates, which may cause the Company’s future results to be significantly affected.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Accounts Receivable
Accounts receivable are stated net of an allowance for doubtful accounts and sales allowances. Outstanding accounts receivable balances are reviewed periodically, and allowances are provided at such time that management believes it is probable that such balances will not be collected within a reasonable period of time. The Company extends credit to its customers based upon credit evaluations in the normal course of business, primarily with 30-day terms. Bad debts are provided for based on historical experience and management’s evaluation of outstanding accounts receivable. Accounts are generally written off when they are deemed uncollectible. One customer accounted for 11% of our accounts receivable in fiscal 2016. No customer accounted for 10% or more of our accounts receivable in fiscal 2015.
Inventories
Inventories are stated at the lower of cost, as determined by using the first-in, first-out method, or market. Work in process and finished goods inventory include material, direct labor, variable costs and overhead.
Purchased and Internal-Use Software
The Company capitalizes certain costs that are incurred to purchase or to create and implement internal-use software, which includes software coding, installation and testing. Capitalized costs are amortized on a straight-line basis over three years, the estimated useful life of the software.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost. Depreciation of property, plant and equipment is computed utilizing the straight-line method over the estimated useful lives of the assets. Amortization of leasehold improvements is computed utilizing the straight-line method over the shorter of the remaining lease term or estimated useful life. Repairs and maintenance costs are expensed as incurred.
Goodwill
Goodwill represents the excess purchase price of acquired businesses over the fair values attributed to underlying net tangible assets and identifiable intangible assets. The Company tests the carrying value of goodwill for impairment at a “reporting unit” level (which for the Company is represented by (i) our Services segment, (ii) our Products and Systems segment, and (iii) the European component and (iv) Brazilian component of our International segment), using a qualitative assessment for its Services reporting unit and a two-step approach for its remaining reporting units, annually as of March 1, or whenever an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. If the fair value of a reporting unit is less than its carrying value, this is an indicator that the goodwill assigned to that reporting unit may be impaired. In this case, a second step is performed to allocate the fair value of the reporting unit to the assets and liabilities of the reporting unit as if it had just been acquired in a business combination, and as if the purchase price was equivalent to the fair value of the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is referred to as the implied fair value of goodwill. The implied fair value of the reporting unit’s goodwill is then compared to the actual carrying value of goodwill. If the implied fair value is less than the carrying value, an impairment loss would be recorded to reduce the carrying value of goodwill to its implied fair value. The Company considers the income and market approaches to estimating the fair value of our reporting units, which requires significant judgment in evaluation of economic and industry trends, estimated future cash flows, discount rates and other factors. The Company believes that the fair values of each of its reporting units are substantially in excess of their respective carrying amounts.
Significant deterioration in industry or economic trends, disruptions to our business, inability to effectively integrate acquired businesses, or other factors, may cause these fair value to decline, possibly resulting in impairment charges to goodwill in future periods.
Impairment of Long-lived Assets
The Company reviews the recoverability of its long-lived assets on a periodic basis in order to identify indicators of a possible impairment. The assessment for potential impairment is based primarily on the Company’s ability to recover the carrying value of its long-lived assets from expected future undiscounted cash flows. If the total expected future undiscounted cash flows are less than the carrying amount of the assets, a loss is recognized for the difference between fair value (computed based upon the expected future discounted cash flows) and the carrying value of the assets.
Research and Engineering
Research and product development costs are expensed as incurred.
Advertising, Promotions and Marketing
The costs for advertising, promotion and marketing programs are expensed as incurred and are included in selling, general and administrative expenses. Advertising expense was approximately $1.8 million, $2.2 million and $1.8 million for fiscal 2016, 2015 and 2014, respectively.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and other financial current assets and liabilities approximate fair value based on the short-term nature of the items. The carrying value of long-term debt approximates fair value due to the variable-rate structure of the debt. The fair value of the Company’s notes payable and capital lease obligations approximate their carrying amounts as those obligations bear interest at rates which management believes would currently be available to the Company for similar obligations.
Foreign Currency Translation
The financial position and results of operations of the Company’s foreign subsidiaries are measured using their functional currencies, which, is their local currency. Assets and liabilities of foreign subsidiaries are translated into the U.S. Dollar at the exchange rates in effect at the balance sheet date. Income and expenses are translated at the average exchange rate during the period. Translation gains and losses are reported as a component of other comprehensive income (loss) for the period and included in accumulated other comprehensive income (loss) within stockholders’ equity.
Foreign currency (gains) and losses arising from transactions denominated in currencies other than the functional currency are included in net income, reported in SG&A expenses, and were approximately $(0.1) million, $1.5 million and $0.1 million in fiscal 2016, 2015 and 2014, respectively.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable. At times, cash deposits may exceed the limits insured by the Federal Deposit Insurance Corporation. The Company believes it is not exposed to any significant credit risk or risk of nonperformance of financial institutions.
Self-Insurance
The Company is self-insured for certain losses relating to workers’ compensation and health benefits claims. The Company maintains third-party excess insurance coverage for all workers compensation and health benefit claims in excess of approximately $0.3 million to reduce its exposure from such claims. Self-insured losses are accrued when it is probable that an uninsured claim has been incurred but not reported and the amount of the loss can be reasonably estimated at the balance sheet date.
Share-based Compensation
The value of services received from employees and directors in exchange for an award of an equity instrument is measured based on the grant-date fair value of the award. The computed value is recognized as a non-cash cost on a straight-line basis over the period the individual provides services, which is typically the vesting period of the award with the exception of awards containing an internal performance measure which is recognized on a straight-line basis over the vesting period subject to the probability of meeting the performance requirements and adjusted for the number of shares expected to be earned. As share-based compensation expense is based on awards ultimately expected to vest, the amount of expense has been reduced for estimated forfeitures. The cost of these awards is recorded in selling, general and administrative expense in the company’s consolidated statements of income.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided if it is more likely than not that some or all of a deferred income tax asset will not be realized. Financial accounting standards prescribe a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. These standards also provide guidance on de-recognition, measurement, and classification of amounts relating to uncertain tax positions, accounting for and disclosure of interest and penalties, accounting in interim periods and disclosures required. Interest and penalties related to unrecognized tax positions are recognized as incurred within “provision for income taxes” in the consolidated statements of income.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for fiscal years and interim periods within those fiscal years beginning December 15, 2017, as a result of a one year deferral in the standard issued by the FASB in August 2015 with ASU 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date. Early application is not permitted. The standard
permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures.
In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments. This amendment will simplify the accounting for adjustments made to provisional amounts recognized in a business combination and eliminates the requirement to retrospectively account for those adjustments in previous reporting periods. This update will require on the face of the income statement or in the notes to the financial statements the amount recorded in current-period earnings that would have previously been recorded if the adjustment to the provisional amounts had been recognized as of the acquisition date. ASU 2015-16 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2015. This update should be applied prospectively and earlier adoption is permitted for financial statements that have not been issued. The Company is evaluating the effect that ASU 2015-16 will have on its consolidated financial statements and related disclosures.
In November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This amendment will simplify the presentation of deferred tax assets and liabilities on the balance sheet and require all deferred tax assets and liabilities to be treated as non-current. ASU 2015-17 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2016, with early adoption permitted. The Company is evaluating the effect that ASU 2015-17 will have on its consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This amendment supersedes previous accounting guidance (Topic 840) and requires all leases, with exception of leases with a term of 12 months or less, to be recorded on the balance sheet as lease assets and lease liabilities. ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018, with early adoption permitted. The standard requires lessees and lessors to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Company is evaluating the effect that ASU 2016-02 will have on its consolidated financial statements and related disclosures.
In March 2016, the FASB issues ASU No. 2016-09, Stock Compensation (Topic 718). This amendment will simplify certain aspects of accounting for share-based payment transactions, which include accounting for income taxes and the related impact on the statement of cash flows, an option to account for forfeitures when they occur in addition to the existing guidance to estimate the forfeitures of awards, classification of awards as either equity or liabilities and classification on the statement of cash flows for employee taxes paid to tax authorities on shares withheld for vesting. ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2016, with early adoption permitted. The Company is evaluating the effect that ASU 2016-09 will have on its consolidated financial statements and related disclosures.
3. Earnings per Share
Basic earnings per share is computed by dividing net income attributable to common shareholders by the weighted average number of shares outstanding during the period. Diluted earnings per share is computed by dividing net income attributable to common shareholders by the sum of (1) the weighted average number of shares of common stock outstanding during the period, and (2) the dilutive effect of assumed conversion of equity awards using the treasury stock method. With respect to the number of weighted average shares outstanding (denominator), diluted shares reflects: (i) only the exercise of options to acquire common stock to the extent that the options’ exercise prices are less than the average market price of common shares during the period and (ii) the pro forma vesting of restricted stock units.
The following table sets forth the computations of basic and diluted earnings per share:
The following potential common shares were excluded from the computation of diluted earnings per share, as the effect would have been anti-dilutive:
4. Accounts Receivable, net
Accounts receivable consist of the following:
The Company had $18.8 million and $15.0 million of unbilled revenues accrued as of May 31, 2016 and 2015, respectively. Unbilled revenues as of May 31, 2016 are expected to be billed in the first quarter of fiscal 2017.
5. Inventories
Inventories consist of the following:
6. Property, Plant and Equipment, net
Property, plant and equipment consist of the following:
Depreciation expense was approximately $22.9 million, $22.2 million and $19.2 million for the years ended May 31, 2016, 2015 and 2014, respectively.
7. Acquisitions and Dispositions
Acquisitions
During fiscal 2016, the Company completed two acquisitions. The Company purchased a U.S.-based company that provides unmanned aerial systems and NDT services and a Canadian-based company that provides engineering and NDT services. In these acquisitions, the Company acquired 100% of the common stock of each acquiree in exchange for aggregate consideration of $1.8 million in cash and contingent consideration estimated to be $1.0 million to be earned based upon the acquired business achieving specific performance metrics over various periods during the initial four years of operations from the acquisition date. The Company accounted for these transactions in accordance with the acquisition method of accounting for business combinations. The estimated total potential contingent consideration for these acquisitions ranges from zero to $0.3 million as of May 31, 2016.
During fiscal 2015, the Company completed the acquisition of four companies. One of the acquired companies is located in the U.S. and provides maintenance and inspection services primarily on offshore platforms. This acquisition expanded the service offerings within the Services segment, allowing the Company to provide services to the upstream operations of its customers. The Company also purchased a group of asset protection businesses located in Quebec, Canada and an asset inspection business in Florida to complement service offerings within the Company’s Services segment and continue its market expansion strategy. The Company’s International Segment completed an acquisition of an asset inspection business located in the United Kingdom. In these acquisitions, the Company acquired 100% of the common stock or certain assets of each acquiree in exchange for aggregate consideration of approximately $35.8 million in cash and $20.5 million in notes payable over two years. The Company accounted for such transactions in accordance with the acquisition method of accounting for business combinations. In addition to the cash consideration related to these acquisitions, the Company accrued a liability of approximately $2.3 million, which represents the estimated fair value of contingent consideration expected to be payable in the event that the acquired companies achieve specific performance metrics during various periods over the next three years of operations. The estimated total potential contingent consideration for these acquisitions ranges from zero to $3.2 million as of May 31, 2015.
Assets and liabilities of the acquired businesses were included in the consolidated balance sheets as of May 31, 2016 based on their estimated fair value on the date of acquisition as determined in a purchase price allocation, using available information and making assumptions management believes are reasonable. The results of operations of each of the acquisitions completed in fiscal 2016 and 2015 are included in each respective operating segment’s results of operations from the date of acquisition. The Company’s allocation of purchase price for these acquisitions is included in the table below. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed and any subsequent adjustments made during the fiscal year ended May 31, 2016:
The amortization period for intangible assets acquired ranges from two to twelve years. The Company recorded $2.7 million and $46.3 million of goodwill in connection with its fiscal 2016 and 2015 acquisitions, respectively, reflecting the strategic fit and revenue and earnings growth potential of these businesses. The goodwill recorded in fiscal 2016 and 2015 relates primarily to the acquisition of the common stock of the acquirees, which is generally not deductible for tax purposes.
We are continuing our review of our fair value estimate of assets acquired and liabilities assumed for two entities acquired in fiscal 2016 disclosed above. This process will conclude as soon as we finalize information regarding facts and circumstances that existed as of the acquisition date. Goodwill for these two entities totaled $2.7 million. These measurement periods will not exceed one year from the respective acquisition dates.
Revenue included in the consolidated statement of operations for fiscal 2016 from these acquisitions for the period subsequent to the closing of the fiscal 2016 transactions were approximately $0.2 million. Aggregate loss from operations included in the consolidated statement of operations for fiscal 2016 from the acquisitions for the period subsequent to the closing of each transaction was approximately $0.3 million. As these acquisitions are not significant to the Company’s fiscal 2016 results, no unaudited pro forma financial information has been included in this report.
Dispositions
On May 22, 2015, the Company completed the sale of one of its Russian subsidiaries and recognized a loss of $0.4 million. On July 31, 2015, the Company completed the sale of its other subsidiary in Russia, as well as its subsidiary in Japan. For the year ended May 31, 2015, the Company recognized impairment charges of $2.1 million related to these sales. Aggregate charges associated with the exit of these three foreign operations was approximately $2.5 million and is included within selling, general and administrative expenses on the consolidated income statement for the year ended May 31, 2015. In the aggregate, the assets and liabilities of these subsidiaries represent 0.6% and 0.3% of consolidated assets and liabilities, respectively, and are included in their natural classifications on the consolidated balance sheet as of May 31, 2015.
Acquisition-Related expense
In the course of its acquisition activities, the Company incurs costs in connection with due diligence, professional fees, and other expenses. Additionally, the Company adjusts the fair value of acquisition-related contingent consideration liabilities on a
quarterly basis. These amounts are recorded as acquisition-related (benefit) expense, net, on the consolidated statements of income and were as follows for fiscal 2016, 2015 and 2014:
The Company’s contingent consideration liabilities are recorded on the balance sheet in accrued expenses and other liabilities.
8. Goodwill
The changes in the carrying amount of goodwill by segment is shown below:
The Company reviews goodwill for impairment on a reporting unit basis on March 1 of each year and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. As of May 31, 2016, the Company did not identify any changes in circumstances that would indicate the carrying value of goodwill may not be recoverable.
The Company's cumulative goodwill impairment as of May 31, 2016, May 31, 2015 and May 31, 2014 was $9.9 million, which is within its International segment.
9. Intangible Assets
The gross carrying amount and accumulated amortization of intangible assets were as follows:
Amortization expense for the years ended May 31, 2016, 2015 and 2014 was approximately $9.6 million, $11.1 million and $9.2 million, respectively, including amortization of software/technology for the years ended May 31, 2016, 2015 and 2014 of $1.0 million, $0.9 million and $0.9 million, respectively.
Amortization expense in each of the five years and thereafter subsequent to May 31, 2016 related to the Company’s intangible assets is expected to be as follows:
10. Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consist of the following:
11. Long-Term Debt
Long-term debt consists of the following:
Senior Credit Facility
On October 31, 2014, the Company entered into a Third Amendment and Modification Agreement (the “Amendment”), of its revolving line of credit, the Third Amended and Restated Credit Agreement (“Credit Agreement”), dated December 21, 2011, with its lending group. The Amendment increased the Company’s revolving line of credit from $125.0 million to $175.0 million and provides that under certain circumstances the line of credit can be increased to $225.0 million. The Company may continue to borrow up to $30.0 million in non-U.S. Dollar currencies and use up to $10.0 million of the credit limit for the issuance of letters of credit. The Amendment also extended the original maturity date of the Credit Agreement from December 20, 2016 to October 30, 2019. At May 31, 2016, the Company had borrowings of $69.0 million and letters of credit of $4.8 million were outstanding under the Credit Agreement. The Company capitalized $0.7 million of costs associated with this debt modification.
Loans under the Credit Agreement bear interest at LIBOR plus an applicable LIBOR margin ranging from 1% to 1.75%, or a base rate less a margin of 1.25% to 0.375%, at the option of the Company, based upon the Company’s Funded Debt Leverage Ratio. Funded Debt Leverage Ratio is generally the ratio of (1) all outstanding indebtedness for borrowed money and other
interest-bearing indebtedness as of the date of determination to (2) EBITDA (which is (a) net income, less (b) income (or plus loss) from discontinued operations and extraordinary items, plus (c) income tax expenses, plus (d) interest expense, plus (e) depreciation, depletion, and amortization (including non-cash loss on retirement of assets), plus (f) stock compensation expense, less (g) cash expense related to stock compensation, plus or minus certain other adjustments) for the period of four consecutive fiscal quarters immediately preceding the date of determination. The Company has the benefit of the lowest margin if its Funded Debt Leverage Ratio is equal to or less than 0.5 to 1, and the margin increases as the ratio increases, to the maximum margin if the ratio is greater than 2.0 to 1. The Company will also bear additional costs for market disruption, regulatory changes effecting the lenders’ funding costs, and default pricing of an additional 2% interest rate margin on any amounts not paid when due. Amounts borrowed under the Credit Agreement are secured by liens on substantially all of the assets of the Company.
The Credit Agreement contains financial covenants requiring that the Company maintain a Funded Debt Leverage Ratio of no greater than 3.25 to 1 and an Interest Coverage Ratio of at least 3.0 to 1. Interest Coverage Ratio means the ratio, as of any date of determination, of (a) EBITDA for the 12 month period immediately preceding the date of determination, to (b) all interest, premium payments, debt discount, fees, charges and related expenses of the Company and its subsidiaries in connection with borrowed money (including capitalized interest) or in connection with the deferred purchase price of assets, in each case to the extent treated as interest in accordance with GAAP, paid during the 12 month period immediately preceding the date of determination. The Credit Agreement also limits the Company’s ability to, among other things, create liens, make investments, incur more indebtedness, merge or consolidate, make dispositions of property, pay dividends and make distributions to stockholders, enter into a new line of business, enter into transactions with affiliates and enter into burdensome agreements. The Credit Agreement does not limit the Company’s ability to acquire other businesses or companies except that the acquired business or company must be in the Company's line of business, the Company must be in compliance with the financial covenants on a pro forma basis after taking into account the acquisition, and, if the acquired business is a separate subsidiary, in certain circumstances the lenders will receive the benefit of a guaranty of the subsidiary and liens on its assets and a pledge of its stock.
As of May 31, 2016, the Company was in compliance with the terms of the Credit Agreement, and has undertaken to continuously monitor compliance with these covenants.
Notes Payable and Other Debt
In connection with certain of its acquisitions, the Company issued subordinated notes payable to the sellers. The maturity of the notes that remain outstanding range from two to five years from the date of acquisition with stated interest rates ranging from 0% to 4%. The Company has discounted these obligations to reflect a 2% to 4% market interest. Unamortized discount on the notes was de minimis as of May 31, 2016 and 2015. Amortization is recorded as interest expense in the consolidated statements of income.
The Company has evaluated current market conditions and borrower credit quality and has determined that the carrying value of its long-term debt approximates fair value. The fair value of the Company’s notes payable and capital lease obligations approximates their carrying amounts based on anticipated interest rates which management believes would currently be available to the Company for similar issues of debt.
Scheduled principal payments due under all borrowing agreements in each of the five years and thereafter subsequent to May 31, 2016 are as follows:
12. Fair Value Measurements
The Company performs fair value measurements in accordance with the guidance provided by ASC 820, Fair Value Measurements and Disclosures. ASC 820 defines fair value as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date. It also establishes a three level hierarchy that prioritizes the inputs used to measure fair value. The three levels of the hierarchy are defined as follows:
Level 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
Level 2 - Observable inputs other than quoted prices included in Level 1, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs derived principally from or corroborated by observable market data.
Level 3 - Unobservable inputs reflecting the Company’s own assumptions about inputs that market participants would use in pricing the asset or liability based on the best information available.
In accordance with the fair value hierarchy described above, the following table shows the fair value of the Company’s financial liabilities that are required to be remeasured at fair value on a recurring basis:
The fair value of contingent consideration liabilities that was classified as Level 3 in the table above was estimated using a discounted cash flow technique with significant inputs that are not observable in the market and thus represents a Level 3 fair value measurement as defined in ASC 820. The significant inputs in the Level 3 measurement not supported by market activity include the probability assessments of expected future cash flows related to the acquisitions, appropriately discounted considering the uncertainties associated with the obligation, and as calculated in accordance with the terms of the acquisition agreements.
13. Share-Based Compensation
The Company has share-based incentive awards outstanding to its eligible employees and Directors under two employee stock ownership plans: (i) the 2007 Stock Option Plan (the 2007 Plan), and (ii) the 2009 Long-Term Incentive Plan (the 2009 Plan). No further awards may be granted under the 2007 Plan, although awards granted under the 2007 Plan remain outstanding in accordance with their terms. Awards granted under the 2009 Plan may be in the form of stock options, restricted stock units and other forms of share-based incentives, including performance restricted stock units, stock appreciation rights and deferred stock rights. The 2009 Plan allows for the grant of awards of up to approximately 2,286,000 shares of common stock, of which approximately 658,000 shares were available for future grants as of May 31, 2016. As of May 31, 2016, there was an aggregate of approximately 2,232,000 stock options outstanding and approximately 902,000 unvested restricted stock units outstanding under the 2009 Plan and the 2007 Plan.
Stock Options
For the fiscal years ended May 31, 2016 and 2015, the Company recognized share-based compensation expense related to stock option awards of less than $0.1 million, respectively, and $0.7 million for the fiscal year ended May 31, 2014. No stock options were granted during the years ended May 31, 2016, 2015 and 2014. As of May 31, 2016, no unrecognized compensation costs remained related to stock option awards. Cash proceeds from, and the intrinsic value of stock options exercised during the years ended May 31, 2016, 2015 and 2014 were as follows:
A summary of the stock option activity, weighted average exercise prices, options outstanding and exercisable as of May 31, 2016 is as follows (in thousands, except per share amounts):
Restricted Stock Unit Awards
The Company recognized approximately $4.4 million of share-based compensation in fiscal 2016, $4.7 million of share-based compensation in fiscal 2015 and $4.0 million of share-based compensation expense in fiscal 2014 related to restricted stock unit awards. As of May 31, 2016, there were approximately $7.0 million of unrecognized compensation costs, net of estimated forfeitures, related to restricted stock unit awards, which are expected to be recognized over a remaining weighted average period of 2.1 years.
Approximately 264,000 restricted stock units were granted in fiscal 2016, 192,000 restricted stock units were granted in fiscal 2015 and 295,000 restricted stock units were granted in fiscal 2014. Approximately 223,000 restricted stock units vested in fiscal 2016, 232,000 restricted stock units vested in fiscal 2015 and 178,000 restricted stock units vested in fiscal 2014. The fair value of these units was $3.5 million, $5.2 million and $3.3 million, respectively. Upon vesting, restricted stock units are generally net share-settled to cover the required minimum withholding tax and the remaining amount is converted into an equivalent number of shares of common stock. Approximately 30,000 shares were forfeited in fiscal 2016, 24,000 shares were forfeited in fiscal 2015 and 44,000 shares were forfeited in fiscal 2014.
During the years ended May 31, 2016, 2015 and 2014, the Company granted approximately 28,000, 21,000 and 19,000 shares, respectively, of fully-vested common stock to its five non-employee directors, in connection with its non-employee director compensation plan. These shares had a grant date fair value of approximately $0.5 million, $0.4 million and $0.4 million, respectively, which is included in the share-based compensation expense recorded during the years ended May 31, 2016, 2015 and 2014.
Performance Restricted Stock Units
In fiscal 2014, the company granted one-year, two-year and three-year performance restricted stock units to its executive and certain other senior officers. These units have requisite service periods of three years and have no dividend rights. The actual payout of these units, before the fiscal 2016 modification as described below, was based on the Company’s performance over one, two and three-year periods (based on pre-established targets) and a market condition modifier based on total shareholder return (TSR) compared to an industry peer group. The one-year and two-year performance conditions of the fiscal 2014 awards were evaluated before modification of the awards and not achieved. The one-year and two-year market conditions of the fiscal 2014 awards were evaluated before modification of the awards and achieved. The one-year and two-year awards related to market conditions will payout at 170% and 105%, respectively, of target once the requisite service period is complete. The three-year performance and market condition awards were surrendered as part of the fiscal 2016 modification described below.
In fiscal 2015, the company granted performance restricted stock units to its executive and certain other senior officers. These units have requisite service periods of three years and have no dividend rights. The actual payout of these units, before the fiscal 2016 modification as described below, was based on the Company’s performance over the three-year period (based on pre-established targets) and a market condition modifier based on (TSR) compared to an industry peer group. The 2015 awards were surrendered as part of the fiscal 2016 modification described below.
In the first quarter of fiscal 2016, the Company modified its equity compensation program and granted 154,000 performance restricted stock units to its executive and certain other senior officers. As a condition for receiving any awards under the revised fiscal 2016 plan, the executive and senior officers surrendered and released all rights to receive any shares under the three-year 2014 awards and three-year 2015 awards with a performance or market condition. The Company has accounted for the fiscal 2016 awards as modifications in accordance with ASC 718, Compensation - Stock Compensation. These units have requisite service periods of five years and have no dividend rights. The actual payout of these units will vary based on the Company’s performance over a one-year period based on three metrics related to the Company’s fiscal 2016 performance: (1) Operating Income, (2) Adjusted EBITDAS, which is consistent with Adjusted EBITDA as disclosed in the financial statements, which is net income before interest, taxes, depreciation, amortization, non-cash stock-based compensation expense, acquisition related items, and other non-routine items as approved by the Company's Compensation Committee and (3) Revenue. There is also a discretionary portion based on individual performance. During the year ended May 31, 2016, the Company evaluated the performance metrics, and due to achievement above target, increased the estimated performance shares expected to be granted by approximately 85,000 units to a total of 239,000 units.
Compensation costs are initially measured assuming that the target performance conditions will be achieved. However, compensation costs related to the performance conditions are adjusted for subsequent changes in the expected outcome of the performance conditions. The discretionary portion of the fiscal 2016 awards are liability-classified and adjusted to fair value each reporting period. Compensation costs for the discretionary portion of the awards are recognized over the same five year requisite service period as the awards based on the Company’s fiscal 2016 performance.
Compensation costs related to the TSR conditions for the one-year and two-year 2014 awards described above were fixed at the measurement date, and not subsequently adjusted.
Compensation expense related to all performance restricted stock units described above was $1.6 million, $1.5 million and $1.2 million for the years ended May 31, 2016, 2015 and 2014. At May 31, 2016, there was $3.2 million of total unrecognized compensation costs related to approximately 328,000 nonvested performance restricted stock units. These costs are expected to be recognized over a weighted-average period of approximately 3.7 years.
For the fiscal years ended May 31, 2016, 2015 and 2014, the income tax benefit recognized on all share based compensation arrangements above was approximately $2.2 million, $2.3 million and $2.3 million, respectively.
14. Income Taxes
Income before provision for income taxes is as follows:
The provision for income taxes consists of the following:
The provision for income taxes differs from the amount computed by applying the statutory federal tax rate to income tax as follows:
Deferred income tax attributes resulting from differences between financial accounting amounts and income tax basis of assets and liabilities are as follows:
As of May 31, 2016, the Company had federal net operating loss carry forwards (NOL’s) in the amount of approximately $0.3 million which may be utilized subject to limitation under Internal Revenue code section 382. The federal NOL's expire at various times from 2029 to 2033. In addition, as of May 31, 2016 the Company had state and foreign NOLs of $3.6 million and $12.1 million, respectively. The state NOLs expire at various times from 2025 to 2036. Approximately $1.7 million of the foreign NOLs expire at various times from 2021 to 2036, while the remainder of the Company's foreign NOLs do not expire.
In assessing the ability to realize deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. Valuation allowances are provided when management believes the Company's deferred tax assets are not recoverable based on an assessment of estimated future taxable income that incorporates ongoing, prudent and feasible tax planning strategies. At May 31, 2016, the Company has a valuation allowance of approximately $3.4 million primarily against certain state and foreign NOLs and the capital losses generated by the disposals of certain foreign subsidiaries. For the year ended May 31, 2016, the valuation allowance increased $0.2 million attributable to tax losses generated by foreign subsidiaries. Except for those deferred tax assets subject to the valuation allowance, management believes that it will realize all deferred tax assets as a result of sufficient future taxable income in each tax jurisdiction in which we have deferred tax assets.
The following table summarizes the changes in the Company’s gross unrecognized tax benefits, excluding interest and penalties:
The Company has recorded the unrecognized tax benefits in other long-term liabilities in the consolidated balance sheets. As of May 31, 2016 and 2015, there were approximately $0.4 million and $1.1 million of unrecognized tax benefits, respectively, including penalties and interest that if recognized would favorably affect the effective tax rate. Interest and penalties related to unrecognized tax benefits are recorded in income tax expense and are not significant for the years ending May 31, 2016 and 2015. The Company anticipates a decrease to its unrecognized tax benefits of approximately $0.2 million excluding interest and penalties within the next 12 months.
The Company is subject to taxation in the United States and various states and foreign jurisdictions. The Company is no longer subject to U.S. federal income tax examinations for years ending before May 31, 2013 and generally is no longer subject to state, local or foreign income tax examinations by tax authorities for years ending before May 31, 2012.
The Company has not recognized U.S. tax expense on its undistributed international earnings or losses of its foreign subsidiaries since it intends to indefinitely reinvest the earnings outside the United States. Net income (loss) of foreign subsidiaries was $7.5 million and $(0.8) million for fiscal 2016 and 2015, respectively. We have recognized no deferred tax liability for the remittance of such earnings to the U.S. since it is our intention to utilize those earnings in the foreign operations. Determination of the amount of any unrecognized deferred income tax liability on this temporary difference is not practicable because of the complexities of the hypothetical calculation.
15. Employee Benefit Plans
The Company provides a 401(k) savings plan for eligible U.S. based employees. Employee contributions are discretionary up to the IRS limits each year and catch up contributions are allowed for employees 50 years of age or older. Under the 401(k) plan, employees become eligible to participate on the first day of the month after six months of continuous service. Under this plan, the Company matches 50% of the employee’s contributions up to 6% of the employee’s annual compensation, as defined by the plan. There is a five-year vesting schedule for the Company match. The Company’s contribution to the plan was $3.3 million, $2.8 million and $2.5 million for the years ended May 31, 2016, 2015 and 2014, respectively.
The Company participates with other employers in contributing to a union plan, which covers certain U.S. based union employees. The plan is not administered by the Company and contributions are determined in accordance with provisions of a collective bargaining agreement. The Company’s contributions to the plan were $0.2 million, $0.2 million and $0.1 million for the years ended May 31, 2016, 2015 and 2014. The Company has benefit plans covering certain employees in selected foreign countries. Amounts charged to expense under these plans were not significant in any year.
16. Related Party Transactions
The Company leases its headquarters under an operating lease from a shareholder and officer of the Company. On August 1, 2014, the Company extended its lease at its headquarters requiring monthly payments through October 2024. Total rent payments made during fiscal 2016 were approximately $0.9 million. See Note 18 - Commitments and Contingencies for further detail related to operating leases.
The Company has a lease for office space located in France, which is partly owned by a shareholder and officer. Total rent payments made during fiscal 2016 were approximately $0.2 million.
The Company has a lease for office space located in Brazil, which is partly owned by a shareholder and officer. Total rent payments made during fiscal 2016 were approximately $0.1 million.
17. Obligations under Capital Leases
The Company leases certain office space, and service equipment under capital leases, requiring monthly payments ranging from less than $1 thousand to $81 thousand, including effective interest rates that range from approximately 1% to 7% expiring through May 2022. The net book value of assets under capital lease obligations was $19.8 million and $19.9 million at May 31, 2016 and 2015, respectively.
Scheduled future minimum lease payments subsequent to May 31, 2016 are as follows:
18. Commitments and Contingencies
Operating Leases
The Company is party to various noncancelable lease agreements, primarily for its international and domestic office and lab space. Future minimum lease payments under noncancelable operating leases in each of the five years and thereafter subsequent to May 31, 2016 are as follows:
Total rent expense was $11.2 million, $10.6 million and $9.5 million for the years ended May 31, 2016, 2015 and 2014, respectively.
Legal Proceedings and Government Investigations
The Company is subject to periodic legal proceedings, investigations and claims that arise in the ordinary course of business. The Company cannot predict with certainty the ultimate resolution of legal proceedings, investigations and claims asserted against it. Except for the matters described below, the Company does not believe that any currently pending legal proceeding to which the Company is a party will have a material adverse effect on its business, results of operations, cash flows or financial condition. The costs of defense and amounts that may be recovered against the Company may be covered by insurance for certain matters.
Litigation and Commercial Claims
The Company is currently a defendant in a consolidated purported class and collective action, Edgar Viceral and David Kruger v Mistras Group, et al, pending in the U.S. District Court for the Northern District of California. This matter results from the consolidation of two cases originally filed in California state court in April 2015. The consolidated case alleges violations of California statutes, primarily the California Labor Code, and seeks to proceed as a collective action under the U.S. Fair Labor Standards Act. The case is predicated on claims for allegedly missed rest and meal periods, inaccurate wage statements, and failure to pay all wages due, as well as related unfair business practices, and is requesting payment of all damages, including unpaid wages, and various fines and penalties available under California and Federal law.
The parties have reached a settlement of the case, whereby the Company agreed to pay $6 million to resolve the allegations and avoid further distraction that would result if the litigation continued. The settlement is subject to court approval, and a hearing for preliminary approval is currently scheduled for August 18, 2016. The Company recorded a pre-tax charge of $6.3 million in the fourth quarter of fiscal 2016 for the settlement and payment of payroll taxes and other costs related to the settlement. The settlement will cover claims dating back to April 2011 in some cases and involves approximately 4,900 current and former employees.
During fiscal 2013, the Company performed radiography work on the construction of a pipeline project in the U.S. The owner of the pipeline project contends that certain of the radiography images the Company’s technicians prepared regarding the project did not meet the code quality interpretation standards required by the American Petroleum Institute. The project owner is claiming damages as a result of the alleged quality defects of the Company’s radiography images. No lawsuit has been filed at this time, but the Company received a demand for damages of approximately $6 million. The Company is currently unable to determine the likely outcome or reasonably estimate the amount or range of potential liability related to this matter, and accordingly, has not established any reserves for this matter.
The Company’s subsidiary in France has been involved in a dispute with a former owner of a business in France purchased by the Company’s French subsidiary. The former owner received a judgment in his favor in the amount of approximately $0.4 million for payment of the contingent consideration portion of the purchase price for the business. The judgment is being appealed, but the Company recorded a reserve for the full amount of the judgment in the fourth quarter of fiscal 2016.
Government Investigations
In May 2015, the Company received a notice from the U.S. Environmental Protection Agency (“EPA”) that it performed a preliminary assessment at a leased facility the Company operates in Cudahy, California. Based upon the preliminary assessment, the EPA is conducting an investigation of the site, which includes taking groundwater and soil samples. The purpose of the investigation is to determine whether any hazardous materials were released from the facility. The Company has been informed that certain hazardous materials and pollutants have been found in the ground water in the general vicinity of the site and the EPA is attempting to ascertain the origination or source of these materials and pollutants. Given the historic industrial use of the site, the EPA determined that the site of the Cudahy facility should be examined, along with numerous other sites in the vicinity. At this time, the Company is unable to determine whether it has any liability in connection with this matter and if so, the amount or range of any such liability, and accordingly, has not established any reserves for this matter.
In January 2012, the Company received notice of a governmental investigation concerning an environmental incident which occurred in February 2011 outside on the premises of the Cudahy facility. No human injury or property damage was reported or appears to have been caused as a result of this incident. While management cannot predict the ultimate outcome of this matter, based on its internal investigation to date, the Company does not believe the outcome will have a material effect on its financial condition or results of operations. To the Company’s knowledge, this matter has been dormant since fiscal 2012.
Acquisition-related contingencies
The Company is liable for contingent consideration in connection with certain of its acquisitions. As of May 31, 2016, total potential acquisition-related contingent consideration ranged from zero to $16.6 million and would be payable upon the achievement of specific performance metrics by certain of the acquired companies over the next four years of operations. See Note 7 - Acquisitions for further discussion of the Company’s acquisitions.
19. Segment Disclosure
The Company’s three operating segments are:
•
Services. This segment provides asset protection solutions predominantly in North America with the largest concentration in the United States along with a growing Canadian services business, consisting primarily of non-destructive testing, and inspection and engineering services that are used to evaluate the structural integrity and reliability of critical energy, industrial and public infrastructure.
•
International. This segment offers services, products and systems similar to those of the Company’s other segments to global markets, in Europe, the Middle East, Africa, Asia and South America, but not to customers in China and South Korea, which are served by the Products and Systems segment.
•
Products and Systems. This segment designs, manufactures, sells, installs and services the Company’s asset protection products and systems, including equipment and instrumentation, predominantly in the United States.
Costs incurred for general corporate services, including finance, legal, and certain other costs that are provided to the segments are reported within Corporate and eliminations. Sales to the International segment from the Products and Systems segment and subsequent sales by the International segment of the same items are recorded and reflected in the operating performance of both segments. Additionally, engineering charges and royalty fees charged to the Services and International segments by the Products and Systems segment are reflected in the operating performance of each segment. All such intersegment transactions are eliminated in the Company’s consolidated financial reporting.
The accounting policies of the reportable segments are the same as those described in Note 2 - Summary of Significant Accounting Policies. Segment income from operations is one of the primary performance measures used by the Chief Executive Officer, who is the chief operating decision maker, to assess the performance of each segment and make decisions as to resource allocations. Certain general and administrative costs such as human resources, information technology and training are allocated to the segments. Segment income from operations excludes interest and other financial charges and income taxes. Corporate and other assets are comprised principally of cash, deposits, property, plant and equipment, domestic deferred taxes, deferred charges and other assets. Corporate loss from operations consists of administrative charges related to corporate personnel and other charges that cannot be readily identified for allocation to a particular segment.
Selected financial information by segment for the periods shown was as follows (intercompany transactions are eliminated in Corporate and eliminations):
Revenue and long-lived assets by geographic area was as follows:
20. Selected Quarterly Financial Information (unaudited)
The following is a summary of the quarterly results of operations for the years ended May 31, 2016 and 2015:
21. Subsequent Events
Subsequent to May 31, 2016, the Company completed two acquisitions of asset protection businesses for $1.2 million in cash upon closing and $0.3 million of deferred purchase price. In addition to the cash consideration, the acquisitions provide for possible contingent consideration up to $0.6 million to be earned based upon the achievement of specific performance metrics over the next three years of operation. The Company is in the process of completing the preliminary purchase price allocations. These acquisitions were not significant and no pro forma information has been included.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Pursuant to Rule 13a-15(b) under the Exchange Act, our management carried out an evaluation, under the supervision and with the participation of our Chairman, Chief Executive Officer and President and our Executive Vice President, Chief Financial Officer and Treasurer, of the effectiveness of the design and operation of our disclosure controls (as defined in Rule 13a-15(e) of the Exchange Act) and procedures. Based upon that evaluation, our Chairman, Chief Executive Officer and President and our Executive Vice President, Chief Financial Officer and Treasurer concluded that, as of May 31, 2016, our disclosure controls and procedures were effective.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended (the Exchange Act). Our internal control over financial reporting is a process designed by, or under the supervision of, our Chairman, Chief Executive Officer and President and our Executive Vice President, Chief Financial Officer and Treasurer, and effected by the Company’s
board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.
Our management assessed the effectiveness of our internal control over financial reporting as of May 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the updated Internal Control - Integrated Framework issued in 2013. Based on that assessment, our management concluded that, as of May 31, 2016, our internal control over financial reporting was effective.
The effectiveness of the Company’s internal control over financial reporting as of May 31, 2016, has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which appears herein.
Changes in Internal Control over Financial Reporting
During the quarter ended May 31, 2016, we identified deficiencies in general information technology controls (GITCs) that affected the use of a report-writer IT application operated in connection with the Company’s enterprise resource planning systems. Specifically, we did not have effective controls over the configuration of the reports and completeness and accuracy of information presented in the reports. Reports produced by the report-writer IT application are used in preparation of the consolidated financial statements, the measurement of certain significant accounts and the operation of related internal controls. We have determined that these deficiencies in our internal control over financial reporting constituted a material weakness that originated in periods prior to the fourth quarter of 2016. The deficiencies resulted in no misstatements to the current or previously issued financial statements.
In connection with the preparation of the annual consolidated financial statements as of and for the year ended May 31, 2016, management designed and implemented effective controls over the generation of information and reports using the report-writer IT application going forward and retrospectively operated those controls for each instance that the reports were used by management as part of its internal control over financial reporting during fiscal year 2016, thereby remediating the material weakness as of May 31, 2016. Further, we have enhanced the design of our existing general information technology controls over the report-writer application. We will monitor these new controls going forward and implement additional enhancements to our internal control over financial reporting in the next fiscal year.
We have determined that the actions taken to date have sufficiently improved the Company’s internal control over financial reporting such that as of May 31, 2016, there is not a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. Based on the remediation of the deficiencies we concluded that our internal control over financial reporting was effective as of May 31, 2016.
Other than the changes noted above, there has been no change in our internal control over financial reporting during the quarter ended May 31, 2016, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors
The information required by Item 10 is incorporated herein by reference to the information to be included in our definitive proxy statement related to the 2016 annual shareholders meeting. The information concerning our executive officers required by this Item 10 is provided under the caption “Executive Officers of the Registrant” in Part I hereof.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference to the information to be included in our definitive proxy statement related to the 2016 annual shareholders meeting.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 regarding Security Ownership of Certain Beneficial Owners and Management and Related Stockholders is incorporated by reference to the information to be included in our definitive proxy statement related to the 2016 annual meeting of shareholders.
Equity Compensation Plan Information
The following table provides certain information as of May 31, 2016 concerning the shares of our common stock that may be issued under existing equity compensation plans.
________________________________________
(1) Includes all the Company’s plans: 1995 Incentive Stock Option and Restricted Stock Plan, 2007 Stock Option Plan and 2009 Long-Term Incentive Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by Item 13 is incorporated by reference to the information to be included in our definitive proxy statement related to the 2016 annual shareholders meeting.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated by reference to the information to be included in our definitive proxy statement related to the 2016 annual shareholders meeting.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(1) The following financial statements are filed herewith in Item 8 of Part II above:
(2) Financial Statement Schedules
All other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto.
(3) Exhibits
_______________________
Exhibits 10.3 to 10.14 are management contracts or compensatory plans, contracts, or arrangements.
* Filed herewith.
** Furnished herewith.
*** Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability under these sections.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
MISTRAS GROUP, INC.
By:
/s/ DR. SOTIRIOS J. VAHAVIOLOS
Dr. Sotirios J. Vahaviolos
Chairman and Chief Executive Officer
Date: August 15, 2016
We, the undersigned directors and officers of Mistras Group, Inc., hereby severally constitute Dr. Sotirios J. Vahaviolos, Jonathan H. Wolk and Michael C. Keefe, and each of them singly, as our true and lawful attorneys with full power to each of them to sign for us, in our names in the capacities indicated below, any and all amendments to this Annual Report on Form 10-K filed with the Securities and Exchange Commission.
This power of attorney may only be revoked by a written document executed by the undersigned that expressly revokes this power by referring to the date and subject hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.