The following Management's Discussion and Analysis ("MD&A") provides a narrative
of our results of operations for the years ended
† Forward-Looking Statements † Overview † Consolidated Results of Operations † Segment Results of Operations † Liquidity and Capital Resources † Critical Accounting Estimates † 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 if Item 1 of this Report.
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 its 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.
† Services provides asset protection solutions in
† International offers services, products and systems similar to those of the other segments to global markets, principally in
† Products and Systems designs, manufactures, sells, installs and services the Company's asset protection products and systems, including equipment and instrumentation, predominantly in
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), natural gas, fossil and nuclear power, transmission and distribution, alternative and renewable energy, public infrastructure, chemicals, aerospace and defense, transportation, primary metals and metalworking, pharmaceutical/biotechnology, food processing industries and research and engineering institutions. As of
Table of Contents
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 have worked to build 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.
The global economy continues to be fragile. Global financial markets continue to experience uncertainty, including tight liquidity and credit availability, relatively low consumer confidence, slow economic growth, persistently high unemployment rates 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, to acquire and develop new technologies in order to aggressively expand our proprietary portfolio of customized solutions, 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 2014, 2013 and 2012: For the year ended May 31, 2014 2013 2012 ($ in thousands) Revenues
$ 623,447 $ 529,282 $ 436,875Gross profit 172,943 148,371 129,690 Gross profit as a % of Revenue 28 % 28 % 30 % Total operating expenses 134,648 120,817 93,592 Operating expenses as a % of Revenue 22 % 23 % 21 % Income from operations 38,295 27,554 36,098 Income from operations as a % of Revenue 6 % 5 % 8 % Interest expense 3,192 3,288 3,132 Gain on extinguishment of long-term debt - - (671 ) Income before provision for income taxes 35,103 24,266 33,637 Provision for income taxes 12,528 12,627 12,291 Net income 22,575 11,639 21,346 Less: net (income) loss attributable to noncontrolling interests, net of taxes (57 ) 7 7 Net income attributable to Mistras Group, Inc. $ 22,518 $ 11,646 $ 21,35333
Table of Contents
Our EBITDA and Adjusted EBITDA, non-GAAP measures explained below, for the years ended
For the year ended May 31, 2014 2013 2012 ($ in thousands) Net income attributable to Mistras Group, Inc.
$ 22,518$ 11,646 $ 21,353Interest expense 3,192 3,288 3,132 Provision for income taxes 12,528 12,627 12,291 Depreciation and amortization 28,429 26,647 22,024 EBITDA $ 66,667$ 54,208 $ 58,800Share-based compensation expense 6,261 6,285 5,097 Acquisition-related expense, net (2,657 ) (2,141 ) 1,980 Goodwill impairment - 9,938 Gain on extinguishment of debt - - (671 ) Adjusted EBITDA $ 70,271$ 68,290 $ 65,206Note about Non-GAAP Measures
EBITDA and Adjusted EBITDA are performance measures used by management that are not calculated in accordance with U.S. generally accepted accounting principles (GAAP). EBITDA is defined in this Report as net income attributable to
Our management uses EBITDA and Adjusted EBITDA as a measure of operating performance to assist in comparing performance from period to period on a consistent basis, 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 our executive and employee incentive compensation programs.
Later in this report, the non-GAAP financial performance measures "Segment and Total Company Income from Operations before Acquisition-Related Expense (Benefit), net" is used, with tables reconciling the measures to financial measures under GAAP. These non-GAAP measures exclude from the GAAP measures income from operations (a) transaction expenses related to acquisitions, such as professional fees and due diligence costs and (b) the net changes in the fair value of acquisition-related contingent consideration liabilities. These items have been excluded from the GAAP measures because these expenses and credits are not related to the Company's or Segment's core business operations and are related solely to the Company's or Segment's acquisition activities. Changes in the fair value of acquisition-related contingent consideration liabilities can be a net expense or credit in any given period, and fluctuate based upon the then current value of cash consideration the Company expects to pay in the future for prior acquisitions, without impacting cash generated from the Company's business operations.
We believe investors and other users of our financial statements benefit from the presentation of EBITDA, Adjusted EBITDA and "Segment and Total Company Income from Operations before Acquisition-Related Expense (Benefit), net" in evaluating our operating performance because it provides additional tools to compare our operating performance on a consistent basis and measure underlying trends and results in our business. EBITDA and Adjusted EBITDA remove 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 Segment and Total Company Income from Operations before Acquisition-Related Expense (Benefit), net, provides investors with useful information and more meaningful period over period comparisons by identifying and excluding these acquisition-related costs 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
Table of Contents
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. EBITDA and 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. Segment and Total Company Income from Operations before Acquisition-Related Expense (Benefit), net, are not metrics used to determine incentive compensation for executives or employees.
Our revenues by segment for fiscal 2014, 2013 and 2012 were as follows:
For the year ended May 31, 2014 2013 2012 ($ in thousands) Revenues Services
$ 443,229 $ 380,851 $ 349,793International 161,395 126,840 59,466 Products and Systems 33,544 33,301 40,083
Corporate and eliminations (14,721 ) (11,710 ) (12,467 )
$ 623,447 $ 529,282 $ 436,875
Our growth rates for fiscal 2014, 2013 and 2012 were as follows:
For the year ended May 31, 2014 2013 2012 ($ in thousands) Revenue growth
$ 94,165 $ 92,407 $ 98,286% Growth over prior year 17.8 % 21.2 % 29.0 % Comprised of: % of organic growth 8.5 % 3.1 % 15.6 % % of acquisition growth 9.0 % 18.7 % 13.2 %
% foreign exchange increase (decrease) 0.3 % (0.6 )% 0.2 %
17.8 % 21.2 % 29.0 % Fiscal 2014
Our fiscal 2014 revenue was
We continued to experience growth in many of our target markets in fiscal 2014. Our largest target market was oil and gas which represented approximately 49% and 50% of revenues in fiscal 2014 and 2013, respectively. Oil and gas revenues grew by 15% in fiscal 2014, led by growth in the downstream section of the industry. We also experienced growth in several of our other target markets outside of oil and gas, including aerospace and defense, power generation, industrial, process industries which include chemical and pharmaceutical, and infrastructure. Taken as a group, revenues for all target markets other than oil and gas grew approximately 20% over the prior year. Our top ten customers represented approximately 38% of our revenues for fiscal 2014 compared to 34% in fiscal 2013. No customer accounted for 10% or more of our revenues in fiscal 2014.
Table of Contents Fiscal 2013
Our fiscal 2013 revenue was
We continued to experience growth in many of our target markets in fiscal 2013. Our largest target market was oil and gas which represented approximately 50% and 54% of revenues in fiscal 2013 and 2012, respectively. Oil and gas revenues grew by 11% in fiscal 2013, led by growth in the midstream section of the industry. We also experienced growth in several of our other target markets outside of oil and gas, including aerospace and defense, industrial, process industries which include chemical and pharmaceutical, power generation, and infrastructure markets. Taken as a group, revenues for all target markets other than oil and gas grew approximately 34% over the prior year. Our top ten customers represented approximately 34% of our revenues for fiscal 2013 compared to 39% in fiscal 2012. Our largest customer in both periods accounted for approximately 11% and 16% of our revenues in fiscal 2013 and 2012, respectively. No other customer accounted for 10% or more of our revenues in fiscal 2013 or 2012.
Gross Profit. Our gross profit by segment for fiscal 2014, 2013 and 2012 was as follows: For the year ended May 31, 2014 2013 2012 ($ in thousands) Gross profit Services
$ 114,182 $ 98,907 $ 94,413International 44,893 32,319 19,106 Products and Systems 14,495 16,947 18,578 Corporate and eliminations (627 ) 198 (2,407 ) $ 172,943 $ 148,371 $ 129,690Fiscal 2014
Gross profit increased
The slight 2014 decrease of 30 basis points in gross profit as a percentage of revenues was primarily attributable to several events that impacted the Company during its third quarter ("Q3 Items"), including bad weather conditions in
Gross profit increased
The 170 basis point decrease in gross profit as a percentage of revenues was primarily attributable to several international acquisitions made during fiscal 2013 that reduced the International Segment's gross margin rate from 32% in fiscal 2012 to 25% in fiscal 2013.
Income from Operations. The following table shows a reconciliation of the segment income from operations before acquisition-related (benefit) expense, net, to income from operations for fiscal 2014, 2013 and 2012:
Table of Contents For the year ended May 31, 2014 2013 2012 ($ in thousands) Services: Income from operations before acquisition-related expense, net
$ 44,846 $ 41,750 $ 40,506Acquisition-related expense, net 1,625 1,425 574 Income from operations 43,221 40,325 39,932
Income from operations before acquisition-related (benefit) expense, net and goodwill impairment
$ 6,786 $ 2,596 $ 3,944Acquisition-related (benefit) expense, net and goodwill impairment (3,452 ) 10,842 682 Income from operations 10,238 (8,246 ) 3,262 Products and Systems: Income from operations before acquisition-related (benefit), net $ 1,517 $ 4,883 $ 7,648Acquisition-related (benefit), net (1,035 ) (2,403 ) (623 ) Income from operations 2,552 7,286 8,271 Corporate and Eliminations: Income from operations before acquisition-related expense (benefit), net $ (17,511 ) $ (13,878 ) $ (14,020 )Acquisition-related expense (benefit), net 205 (2,067 ) 1,347 Income from operations (17,716 ) (11,811 ) (15,367 ) Total Company Income from operations before acquisition-related (benefit) expense, net and goodwill impairment $ 35,638 $ 35,351 $ 38,078Acquisition-related (benefit) expense, net and goodwill impairment $ (2,657 ) $ 7,797 $ 1,980Income from operations $ 38,295 $ 27,554 $ 36,098Fiscal 2014
Income from operations, exclusive of acquisition-related items, but inclusive of the impact of the Q3 Items, was
Operating expenses for fiscal 2014 increased
Our acquisition-related expense, net for fiscal 2014 decreased by
Income from operations decreased
Table of Contents
statements. As a percentage of revenues, our income from operations was approximately 5% and 8% in fiscal 2013 and fiscal 2012, respectively.
Operating expenses for fiscal 2013 increased
Our acquisition-related expense, net for fiscal 2013 decreased by
Interest expense was
Our effective income tax rate was approximately 36% for fiscal 2014 compared to 52% for fiscal 2013. The effective tax rate for fiscal 2013 was significantly impacted by the goodwill impairment charge that is not deductible for tax purposes. Excluding the impact of the impairment charge, our annual effective rate was approximately 37% for fiscal 2013. The decrease is primarily due to higher foreign income which is taxed at lower rates, offset by the impact of acquisition contingent consideration.
Segment Results of Operations
Services Segment Selected financial information for the Services segment was as follows for fiscal 2014, 2013 and 2012: For the years ended May 31, 2014 2013 2012 ($ in thousands) Services segment Revenues
$ 443,229 $ 380,851 $ 349,793Gross profit $ 114,182 $ 98,907 $ 94,413as a % of segment revenue 26 % 26 % 27 % Operating Expenses $ 70,961 $ 58,582 $ 54,481Income from operations $ 43,221 $ 40,325 $ 39,932as % of segment revenue 10 % 11 % 11 % Income from operations before acquisition-related expense, net $ 44,846 $ 41,750 $ 40,506as % of segment revenue 10 % 11 % 12 % Total depreciation and amortization $ 17,794 $ 18,296 $ 17,763Revenues
In fiscal 2014, our Services revenues increased
Table of Contents
to strong demand, the addition of new customers and increased revenues from existing customers. We increased revenues to existing customers by increasing our penetration on existing service offerings and providing different types of asset protection solutions. Our top ten customers accounted for approximately 48% and 44% of our Services segment revenues during fiscal 2014 and 2013, respectively. Revenues from our two largest customers represented approximately 11% and 10%, respectively, of our revenues for our Services segment in fiscal 2014. Revenues from these two customers as well as most of our larger oil and gas customers, are generated from numerous contracts at multiple sites.
In fiscal 2013, our Services revenues increased
Our Services segment gross profit margin was 26% of segment revenues in both fiscal years 2014 and 2013. Services gross profit increased by
Our Services segment gross profit margin was 27% of segment revenues in fiscal 2012. The 100 basis point decrease that occurred during fiscal 2013 was attributed primarily to a lower mix of advanced services margins and higher unbillable direct labor.
Income from Operations
Services segment income from operations was
Segment operating expenses rose by
Services segment income from operations was
Operating expenses in our Services segment increased
Selected financial information for our International segment was as follows for fiscal 2014, 2013 and 2012:
Table of Contents For the years ended May 31, 2014 2013 2012 ($ in thousands) International segment Revenues
$ 161,395126,840 59,466 Gross profit $ 44,89332,319 19,106 as % of segment revenue 28 % 25 % 32 % Operating Expenses $ 34,655 $ 40,565 $ 15,844Income (loss) from operations $ 10,238 $ (8,246 )3,262 as % of segment revenue 6 % (7 )% 5 % Income from operations before acquisition-related expense, net $ 6,786 $ 2,596 $ 3,944as % of segment revenue 4 % 2 % 7 % Total depreciation and amortization $ 8,065 $ 6,200 $ 2,342Revenues
Our International segment revenues rose by
International segment revenues increased
International segment gross profit for fiscal 2014 was
Our International segment gross profit for fiscal 2013 was
Income (loss) from Operations
International segments income from operations was
Segment operating expenses were
In fiscal 2013, our International segment recognized a loss from operations of
Table of Contents
operations. Excluding the goodwill impairment charge and acquisition-related items, income from operations from our International segment was
Products and Systems Segment
Selected financial information for the Products and Systems segment was as follows for fiscal 2014, 2013 and 2012:
For the years ended May 31, 2014 2013 2012 ($ in thousands) Products and Systems segment Revenues
$ 33,544 $ 33,301 $ 40,083Gross profit $ 14,495 $ 16,947 $ 18,578as % of segment revenue 43 % 51 % 46 % Operating Expenses $ 11,943 $ 9,661 $ 10,307Income from operations $ 2,552 $ 7,286 $ 8,271as % of segment revenue 8 % 22 % 21 % Income from operations before acquisition-related expense, net $ 1,517 $ 4,883 $ 7,648as % of segment revenue 5 % 15 % 19 % Total depreciation and amortization $ 2,373 $ 2,229 $ 1,831Revenues
Products and Systems segment revenues for fiscal 2014 were
Products and Systems segment revenues decreased
Products and Systems segment gross profit decreased by
Products and Systems segment gross profit decreased
Income from Operations
Products and Systems income from operations for fiscal 2014 decreased
Products and Systems segment operating expenses increased by
Table of Contents
primarily attributed to higher research and engineering expenses of
Our income from operations from our Products and Systems segment of
Segment operating expenses were
Corporate and Eliminations
The elimination of revenues and cost of revenues primarily relates to the elimination in consolidation of revenues from sales of our Products and Systems segment to our International and Services segments. The other major item in the Corporate and eliminations grouping are the general and administrative costs not allocated to the other segments. These costs primarily include those for non-segment management, accounting and auditing, legal, human resources, acquisition transactional costs, 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 2014, 2013 and 2012, respectively. The increase in operating expenses in fiscal 2014 and 2013 primarily related to higher compensation and additional staff to support our growth and other increases in general expenses at our corporate offices.
Liquidity and Capital Resources
We have funded our operations through cash provided from operations, bank borrowings, stock offerings and capital lease financing transactions. We have used these proceeds to fund our operations, develop our technology, expand our sales and marketing efforts to new markets and acquire small companies or assets, primarily to add certified technicians and enhance our capabilities and geographic reach. We believe that our existing cash and cash equivalents, our anticipated cash flows from operating activities, and our available borrowings under our credit agreement will be sufficient to meet our anticipated cash needs over the next 12 months.
Cash Flows Table
The following table summarizes our cash flows for fiscal 2014, 2013 and 2012:
Fiscal year 2014 2013 2012 ($ in thousands) Net cash provided by (used in): Operating Activities
$ 36,873 $ 43,503 $ 31,402Investing Activities (38,005 ) (45,479 ) (37,512 ) Financing Activities 3,262 1,144 2,009
Effect of exchange rate changes on cash 88 224 1,632 Net change in cash and cash equivalents
Cash Flows from Operating Activities
Cash provided by our operating activities in fiscal 2014 was
Table of Contents
growth in accounts receivable of approximately
Cash provided by our operating activities in fiscal 2013 was
Cash Flows from Investing Activities
Net cash used in investing in activities was
Net cash used in investing in activities was
Cash Flows from Financing Activities
Net cash provided by financing activities in fiscal 2014 was
Net cash provided by financing activities in fiscal 2013 was
Effect of Exchange Rate on Changes in Cash
For fiscal 2014, 2013 and 2012, exchange rate changes increased our cash by
Cash Balance and Credit Facility Borrowings
Table of Contents
The Credit Agreement contains financial covenants requiring that we maintain a Funded Debt Leverage Ratio of less than 3.0 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.
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 revolving credit facility. Our revolving credit facility is available for cash advances required for working capital and for letters of credit to support our operations. We are currently funding our acquisitions through our available cash, borrowings under our revolving credit facility and seller notes. We have an effective shelf registration statement with the
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 3% 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 2014, 2013 and 2012 were approximately 3%, 2% and 2% of revenues, respectively.
Our future acquisitions may also require capital. We acquired six companies in fiscal 2014 and three companies in fiscal 2013, with an initial cash outlay of
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 terms acceptable to us or at all.
Table of Contents 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, 2014: Fiscal Fiscal Fiscal Fiscal Fiscal 2020 & ($ in thousands) Total 2015 2016 2017 2018 2019 Beyond Long-term debt (1) $ 76,648 $ 8,058 $ 5,901 $ 62,182 $ 140 $ 335 $ 32Capital lease obligations (2) 22,227 8,246 6,256 4,161 2,448 994 122 Operating lease obligations 33,364 8,141 6,317 5,027 3,689 3,401 6,789 Contingent consideration obligations 14,146 4,770 4,464 2,671 2,241 - - Total $ 146,385 $ 29,215 $ 22,938 $ 74,041 $ 8,518 $ 4,730 $ 6,943
(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 2014, 2013 and 2012, 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 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.
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.
Table of Contents
These arrangements generally 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.
Accounts receivable arise from services provided or products and systems sold to the Company's customers. The Company records an allowance for doubtful accounts to provide for losses on accounts receivable due to a customer's inability to pay. The allowance is typically estimated based on an analysis of the historical rate of credit losses or write-offs, specific concerns and known or expected trends. Such analysis is inherently subjective. The Company's earnings will be impacted in the future to the extent that actual credit loss experience differs from amounts estimated. Changes in the financial condition of the Company's customers or adverse developments in negotiations or legal proceedings to obtain payment could result in the actual loss exceeding the estimated allowance.
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
Long-lived assets, net, outside of the U.S. totaled
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 two-step approach, annually as of
Table of Contents
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, we would be required to recognize an impairment loss for that excess. We consider the income and market approaches to estimating the fair value of our reporting units, which requires significant judgment in evaluation of, among other things, economic and industry trends, estimated future cash flows, discount rates and other factors.
Income taxes are accounted for under the asset and liability method. This process requires that we assess temporary differences between the book and tax basis of assets resulting from differing treatment between book and tax of certain items, such as depreciation. Deferred income tax assets and liabilities are recognized based on 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 carryforwards. 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 the deferred income tax assets will not be realized. We consider all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed. Evidence used includes information about our current financial position and our results of operations for the current and preceding years, as well as all currently available information about future years, including our anticipated future performance, the reversal of deferred tax liabilities and tax planning strategies.
Our effective income tax rate was approximately 36%, 52% and 37% for fiscal 2014, 2013 and 2012, respectively. Excluding the goodwill impairment charge in fiscal 2013, our effective income tax rate was approximately 37% for fiscal 2013. 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 significantly 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.
Recent Accounting Pronouncements
Table of Contents
and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.