General corporate services, including accounting, audit, and contract management, are provided to the segments which are reported as intersegment transactions 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 corporate and eliminations.
Segment income from operations is determined based on internal performance measures used by the Chief Executive Officer, who is the chief operating decision maker, to assess the performance of each business in a given period and to make decisions as to resource allocations. In connection with that assessment, the Chief Executive Officer may exclude matters such as charges for stock-based compensation and certain other acquisition-related charges and balances, technology and product development costs, certain gains and losses from dispositions, and litigation settlements or other charges. Certain general and administrative costs such as human resources, information technology and training are allocated to the segments. Segment income from operations also 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 depreciation on the corporate office facilities and equipment, administrative charges related to corporate personnel and other charges that cannot be readily identified for allocation to a particular segment.
Revenues by operating segment include intercompany transactions, which are eliminated in corporate and eliminations.
Selected consolidated financial information by segment for the periods shown was as follows:
Operating income by operating segment includes intercompany transactions, which are eliminated in corporate and eliminations.
This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (“Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Forward-looking statements reflect our current estimates, expectations and projections about our future results, performance, prospects and opportunities. Forward-looking statements include, among other things, the information concerning our possible future results of operations, business and growth strategies, financing plans, our competitive position and the effects of competition, the projected growth of the industries in which we operate, the benefits and synergies to be obtained from our completed and any future acquisitions, and statements of m anagement’s goals and objectives, and other similar expressions concerning matters that are not historical facts. Words such as “may,” “should,” “could,” “would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” “appears,” “projects” and similar expressions, as well as statements in the future tense, identify forward-looking statements. Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, such performance or results will be achieved. Forward-looking information is based on information available at the time and management’s good faith belief with respect to future events, and is subject to risks and uncertainties that coul d cause actual performance or results to differ materially from those expressed in the statements. Important factors that could cause such differences include, but are not limited to the factors discussed under the “Risk Factors” section.
The following is a discussion and analysis of our financial condition and results of operations and should be read together with our condensed consolidated financial statements and related notes to the condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q and our audited consolidated financial statements and related notes to the audited consolidated financial statements included in our prospectus filed pursuant to Rule 424(b)(4) under the Securities Act with the Securities and Exchange Commission (“SEC”)Annual Report on October 9, 2009 (“IPO Prospectus”).Form 10-K. In this quarterly 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, 20092010 is referred to as “fiscal 2009”2010”), and unles sunless otherwise specified or the context otherwise requires, “Mistras,” “the Company,” “we,” “us” and “our”“our ” refer to Mistras Group, Inc. and its consolidated subsidiaries.
Overview
We are a leading “one source” global provider of technology-enabled asset protection solutions used to evaluate the structural integrity of critical energy, industrial and public infrastructure. Mission criticalWe combine 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, are delivered globallyranging from routine inspections to complex, plant-wide asset integrity assessments and provide customers themanagement. These mission critical solutions enhance our customers’ ability to extend the useful life of their assets, improveincrease productivity, and profitability,minimize repair costs, comply with governmentgovernmental safety and environmental regulations, manage risk and enhance risk management operational decisions. We combine our industry leading products and technologies - 24/7 on-line monitoring of critical assets; mechanical integrity (MI) and non-destructive testing (NDT) services; and its proprietary world class data warehousing and analysis software - to provide comprehensive and competitive products, systems and services solutions from a single source provider.avoid catastrophic disasters. Given the rol erole our services play ini n 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, fossil and nuclear power, public infrastructure, chemicals, aerospace and defense, transportation, primary metals and metalworking, pharmaceuticals and food processing industries. During the first nine months of fiscal 2010, we provided our asset protection solutions to approximately 3,0004,800 customers. As of MarchAugust 31, 2010, we had approximately 2,3002,400 employees, including 3032 Ph.D.’s and more than 100 other degreed engineers and highly-skilled, certified technicians, in 6874 offices across 15 countries. We have established long-term relationships as a critical solutions provider to many leading companies in our target markets. Our current principal market is the oil and gas industry, including petrochemicals, which accounted for approximately 62%61% and 63% of our revenues info r the thirdfirst quarter of fiscal 2010.2011 and 2010, respectively.
OverFor the last three fiscalseveral years, and during the first nine months of fiscal 2010, 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 has, in general, increased, creating demand from which our entire industry has benefited. We have experienced compounded annual growth rate (CAGR) for revenue of 30.7%31% over the last three fiscal years, (2007-2009), including the impact of acquisitions and currency fluctuations. During the same period, revenues from our customers in the oil and gas market, including petrochemicals, historically our largest target market, had a CAGR of 39.0%40%. DuringAll of our other target markets, collectively, had a CAGR of 19%. We believe further growth can be realized in all of our target markets. Concurrent with this period, the demand for outsourced asset protection solutions has, in general, increased, creating demand from which our entire industry has benefited.
For the last fifteen months, however, the global economy continues to experience an economic downturn or slowdown. Global financial markets have experienced disruptions, including diminished liquidity and credit availability, declines in consumer confidence and in economic growth, high unemployment rates, volatility in interest and currency exchange rates and overall uncertainty about economic stability. Many of the end markets we serve have experienced profit declines and we in turn we have been impacted by these factors both asworked to build our revenuesinfrastructure to profitably absorb additional growth and profitabilityhave made a number of small acquisitions in fiscal 2009an effort to leverage our fixed costs, grow our base of experienced personnel, expand our technical capabilities and to a lesser extent for the first nine months of fiscal 2010. Although some ofincrease our customers have delayed or reduced the scope of turnaround projects and other large-scale inspection projects, they have historically seldom postponed such projects indefinitel y.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 successful and seamless integration of acquired companies. These acquisitions have provided us with additional products, technologies, resources and customers that have enhanced our sustainable competitive advantages over our competition.
The global economy continues to be fragile. Global financial markets continue to experience uncertainty, including severely diminished liquidity and credit availability, low consumer confidence, slow economic growth, persistently high unemployment rates, volatile currency exchange rates and continued uncertainty about economic stability. There may be further deterioration and volatility in the global economy, the global financial markets, and consumer confidence. However, we believe this marketit also has also allowed us to capitalize on this opportunity to selectively hire new talented individuals that otherwise might not have been available to us, to acquire and develop new technology in order to aggressively expand our proprietary portfolio of customized solutions, and to make acquisitions of complementary businesses at reasonable valuations. In addition, we have increased our revenues by obtaining market share through our acquisitions, growing our business 26% through the first nine months of fiscal 2010. We believebe lieve we will be able to derive additional revenues from these strategic investments with favorable gross margins in future periods, which we believe would at least in part offset any further negative revenue impact we incur from the economic downturn during those periods.
Consolidated Results of Operations
ThirdFirst quarter and first nine months of fiscal 20102011 compared to first quarter of fiscal 2010
Our consolidated results of operations for the thirdfirst quarter of fiscal 2011 and fiscal 2010 were as follows:
| | For the three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousands ) | |
Statement of Operations Data | | | | | | |
Revenues | | $ | 68,410 | | | $ | 56,089 | |
Cost of revenues | | | 44,668 | | | | 36,468 | |
Depreciation | | | 2,964 | | | | 2,471 | |
Gross profit | | | 20,778 | | | | 17,150 | |
Selling, general and administrative expenses | | | 15,479 | | | | 13,133 | |
Research and engineering | | | 555 | | | | 483 | |
Depreciation and amortization | | | 1,178 | | | | 1,045 | |
Legal reserve | | | 250 | | | | (297 | ) |
Income from operations | | | 3,316 | | | | 2,786 | |
Interest expense | | | 690 | | | | 1,064 | |
Loss on extinguishment of long-term debt | | | — | | | | 169 | |
Income before provision for income taxes and noncontrolling interest | | | 2,626 | | | | 1,553 | |
Provision for income taxes | | | 1,054 | | | | 694 | |
Net income | | | 1,572 | | | | 859 | |
Net loss (income) attributable to noncontrolling interests, net of taxes | | | 20 | | | | (44 | ) |
Net income attributable to common stockholders | | $ | 1,592 | | | $ | 815 | |
Our EBITDA1 and Adjusted EBITDA1, non-GAAP measures explained below, for the first nine monthsquarter of fiscal 20092011 and fiscal 2010 were as follows:
| | For the three months ended August 31, | |
| | 2010 | | | 2009 | |
EBITDA and Adjusted EBITDA data | | (in thousands) | |
Net income | | $ | 1,592 | | | $ | 815 | |
Interest expense | | | 690 | | | | 1,064 | |
Provision for income taxes | | | 1,054 | | | | 694 | |
Depreciation and amortization | | | 4,142 | | | | 3,516 | |
EBITDA | | $ | 7,478 | | | $ | 6,089 | |
Legal reserve | | | 250 | | | | (297 | ) |
Large customer bankruptcy | | | — | | | | 767 | |
Stock compensation expense | | | 729 | | | | 250 | |
Loss on extinguishment of debt | | | — | | | | 169 | |
Adjusted EBITDA | | $ | 8,457 | | | $ | 6,978 | |
1 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 Quarterly Report as net income plus: interest expense, provision for income taxes and depreciation and amortization. Adjusted EBITDA is defined in this Quarterly Report as net income plus: interest expense, provision for income taxes, depreciation and amortization, stock-based compensation expense, certain acquisition related costs and certain one-time and generally non-recurring items (which items are described in the next paragraph and the reconciliation table below).
Our revenues, gross profit, incomemanagement uses Adjusted EBITDA as a measure of operating performance to assist in comparing performance from operationsperiod to period on a consistent basis, as a measure for planning and net incomeforecasting overall expectations and for evaluating actual results against such expectations. Adjusted EBITDA is also used as a performance evaluation metric off which to base executive and employee incentive compensation programs.
We believe investors and other users of our financial statements benefit from the third quarterpresentation of adjusted EBITDA in evaluating our operating performance because it provides an additional tool 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, amortization, each of which can vary substantially from company to company depending upon accounting methods and the first nine monthsbook value and age of fiscal 2010assets, capital structure, capital investment cycles and fiscal 2009the method by which assets were as follows:acquired. It also eliminates stock-based compensation, which is generally a non-cash expense an d is excluded by management when evaluating the underlying performance of our business operations.
| | Three Months Ended February 28, | | | Nine Months Ended February 28, | |
| | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | (In thousands) | |
| | | | | | | | | | | | |
Revenues | | $ | 64,356 | | | $ | 47,001 | | | $ | 192,334 | | | $ | 153,273 | |
| | | | | | | | | | | | | | | | |
Gross profit | | $ | 17,627 | | | $ | 13,104 | | | $ | 57,793 | | | $ | 51,254 | |
| | | | | | | | | | | | | | | | |
Income (loss) from operations | | $ | 1,632 | | | $ | (303 | ) | | $ | 12,085 | | | $ | 10,577 | |
Interest expense | | | 744 | | | | 1,103 | | | | 2,825 | | | | 3,692 | |
Loss on extinguishment of debt | | | — | | | | — | | | | 387 | | | | — | |
Income (loss) before provision for income taxes and noncontrolling interests | | | 888 | | | | (1,406 | ) | | | 8,873 | | | | 6,885 | |
Provision (benefit) for income taxes | | | 123 | | | | (602 | ) | | | 3,692 | | | | 2,748 | |
Net income (loss) | | | 765 | | | | (804 | ) | | | 5,181 | | | | 4,137 | |
Net loss (income) attributable to noncontrolling interests | | | 9 | | | | 16 | | | | (30 | ) | | | (173 | ) |
Net income (loss) attributable to Mistras Group, Inc. | | $ | 774 | | | $ | (788 | ) | | $ | 5,151 | | | $ | 3,964 | |
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 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.
Revenues. Revenues were $64.4 million for the third quarter of fiscal 2010 compared to $47.0 million for the third quarter of fiscal 2009. Revenues were $192.3$68.4 million for the first nine monthsquarter of fiscal 20102011 compared to $153.3$56.1 million for the first nine monthsquarter of fiscal 2009. 2010.
| | Three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousands) | |
Revenues | | | | | | |
Services | | $ | 55,282 | | | $ | 45,702 | |
Products and Systems | | | 5,310 | | | | 3,625 | |
International | | | 9,040 | | | | 7,751 | |
Corporate and eliminations | | | (1,222 | ) | | | (989 | ) |
| | $ | 68,410 | | | $ | 56,089 | |
We estimate our growth rates for our first three quartersquarter of fiscal 2011 and 2010 are as follows:
| | Three Months Ended | | | Nine Months Ended | |
| | February 28, 2010 | | | February 28, 2010 | |
| | | | | | |
Revenue growth (in thousands) | | $ | 17,355 | | | $ | 39,061 | |
| | | | | | | | |
% Growth over prior year | | | 37 | % | | | 25 | % |
| | | | | | | | |
Comprised of: | | | | | | | | |
% of organic growth | | | 24 | % | | | 14 | % |
% acquisition growth | | | 11 | % | | | 12 | % |
% foreign exchange increase (decrease) | | | 2 | % | | | (1 | %) |
| | | 37 | % | | | 25 | % |
The majority of the revenue increase has been in our Services segment where the growth rates for the third quarter and first nine months of fiscal 2010 have been approximately 41% and 33%, respectively. Although slower to recover from the lingering impacts of the economy, especially as to capital spending patterns, we also had revenue growth in our Products and Systems segment of 12% and in our International segments of 33% in the third quarter compared to the previous year’s quarter. Through the first three quarters of fiscal 2010, these two segments had very similar revenues compared to the same period last year.
Our customer base has historically contracted for our solutions, and particularly our Services, on a regular and recurring basis for multiple years at a time. As a result, we believe our overall revenues are less vulnerable to capital project cycles, and provide predictable leverage for growth. We believe we will create additional growth in revenues by acquiring and developing an ever expanding “toolbox” of asset protection solutions that provide differentiated value to our customers.
The revenue contribution | | For the three months ended August 31, | |
| | 2010 | | | 2009 | |
| | | | | | |
Revenue growth | | $ | 12,321 | | | $ | 9,092 | |
% Growth over prior year | | | 22.0 | % | | | 19.3 | % |
| | | | | | | | |
Comprised of: | | | | | | | | |
% of organic growth | | | 14.5 | % | | | 10.9 | % |
% of acquisition growth | | | 7.9 | % | | | 12.2 | % |
% foreign exchange decrease | | | (0.4 | %) | | | (3.8 | %) |
| | | 22.0 | % | | | 19.3 | % |
Revenues increased $12.3 million, or 22%, for the first quarter of fiscal 2011 compared to the first quarter of fiscal 2010 as a result of growth in all our segments. For the first quarter of fiscal 2011 and the first quarter of fiscal 2010, we estimate that our organic growth rate, as compared to growth driven by acquisitions, was approximately 15% and 11%, respectively. This organic growth was the result of continued demand for our asset protection solutions, including growth from new and existing customers. In the first quarter of fiscal 2011, we estimate that growth from acquisitions was approximately $4.4 million, or approximately 8%, compared to approximately $5.7 million, or approximately 12%, in the first quarter of fiscal 2010. We completed two acquisitions in the first quarter of fiscal 2011 and two acquisitions in the first quarter of fiscal 2010, further increasing our capabilities and adding to our base of qualified technicians.
Despite the prolonged downturn in the global economy, we continued to experience growth in many of our segments fortarget markets in the periods presented isfirst quarter of fiscal 2011 as follows:
| | Three Months Ended February 28, | | | Nine Months Ended February 28, | |
| | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | (% of Total Revenues) | |
| | | | | | | | | | | | |
Source of Revenues: | | | | | | | | | | | | |
Services | | | 82.2 | % | | | 80.0 | % | | | 83.0 | % | | | 78.6 | % |
Products and Systems | | | 7.4 | % | | | 9.1 | % | | | 6.8 | % | | | 8.5 | % |
International | | | 12.6 | % | | | 12.9 | % | | | 12.1 | % | | | 15.3 | % |
Corporate and eliminations | | | (2.2 | %) | | | (2.0 | %) | | | (1.9 | %) | | | (2.4 | %) |
Total | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % |
During bothcompared to the first quarter of fiscal 2010. The largest dollar increase was attributable to customers in the oil and nine-months ended February 28, 2010, we increasedgas market which was achieved globally on several new and existing projects, including an increase in our portfolio of “run and maintain” outsourced contracts compared to lastand new work, some of which were obtained through our acquisitions. Overall the oil and gas market provided approximately 61% and 63% of our total revenues for the first quarter of fiscal year2011 and had2010, respectively. We also experienced high growth in several of our other target markets, including oil and gas, chemical, fossil and nuclear power. These increases were partially offset by certain projects being completed, some declines in capital projects, turn around work and reduced pipeline, aerospace and industrial parts inspection activity compared to the prior year. We expect these latter markets to improve as the economy further stabilizes.
Thean d infrastructure markets. Our largest dollar increase was attributable to customers in our oil and gas market including petrochemical, whichcustomer accounted for approximately 92%18% and 88% of our revenue growth for the quarter and nine months ended February 28, 2010, respectively. As a percentage of total revenues, the oil and gas market accounted for approximately 62% of both our third quarter and first nine months of the fiscal 2010, respectively. This compares to approximately 56% of total revenues for the same periods in fiscal 2009. For the nine months ended February 28, 2010, we estimate that approximately 35%-40% of our total revenues is downstream or refinery business, in which our customers’ profitability has been impacted by the economy.
Our top ten customers represented 47%22% of our revenues forin the thirdfirst quarter of fiscal 2011 and 2010, compared to 36% for the third quarter of fiscal 2009. For the nine months ended February 28, 2010, our top ten customers represented 44% of our revenues compared to 35% for the same period in fiscal 2009. One customer at various locations accounted for 17% of our third quarter fiscal revenues in both fiscal 2010 and 2009. For the first nine months of fiscal 2010, this customer accounted for 19% of our revenues compared to 15% in the same period last fiscal year.respectively. No other customer accounted for more than 6%8% of our revenues in anythe first quarter of fiscal 2010.2011.
Gross profit. Our gross profit was $17.6$20.8 million and increased $4.5$3.6 million, or 34.5%21% in the thirdfirst quarter of fiscal 20102011 compared to $13.1$17.2 million in the thirdfirst quarter of fiscal 2009. For the first three quarters of fiscal 2010, our gross profit was $57.8 million, an increase of $6.5 million, or 12.8%, compared to $51.3 million in the third quarter of fiscal 2009.2010. As a percentage of revenues, our gross profit and its components are as follows:
| | For the three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousand) | |
Gross profit | | $ | 20,778 | | | $ | 17,150 | |
| | | | | | | | |
Gross profit % comprised of: | | | | | | | | |
Revenues | | | 100.0 | % | | | 100.0 | % |
Cost of revenues | | | 65.3 | % | | | 65.0 | % |
Depreciation | | | 4.3 | % | | | 4.4 | % |
Total | | | 30.4 | % | | | 30.6 | % |
Gross profit % decrease from prior year quarter | | | (0.2 | %) | | | (4.7 | %) |
| | Three Months Ended | | | Nine Months Ended | |
| | February 28, | | | February 28, | |
| | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | (% of Total Revenues) | |
| | | | | | | | | | | | |
Gross profit: | | | | | | | | | | | | |
Revenues | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % | | | 100.0 | % |
Cost of revenues | | | (68.3 | %) | | | (67.2 | %) | | | (65.9 | %) | | | (62.5 | %) |
Depreciation | | | (4.3 | %) | | | (4.9 | %) | | | (4.1 | %) | | | (4.1 | %) |
Total | | | 27.4 | % | | | 27.9 | % | | | 30.0 | % | | | 33.4 | % |
Change from last year | | | (0.5 | %) | | | | | | | (3.4 | %) | | | | |
ForOur gross profit by segment for the thirdfirst quarter of 2010, we estimated that almost all of the gross profit percentage change compared to the prior year was related to the accelerated growth in the Services segment, which has lower margins relative to our other segments. Also, in the quarter ended February 28, 2010, some of our customers began managing project activity and turnarounds differently than in the past, stopping planned work abruptly more often than in the past, which has created inefficiencies in the planning and utilization of labor. The third quarter in fiscal 2009 was similarly impacted. For the nine months ended February 28, 2010, the decrease in the percentage of gross margin of revenues this fiscal year of approximately 3.4% can also be partially attributed to the large growth in revenues from our Services segment, but other changes in mix, pric ing and start-up costs on several new large multi-year contracts also contributed to the decrease. Depreciation expense included in gross profit for the third quarter and first nine months of fiscal2011and 2010, was $2.7 million and $7.9 million, respectively, compared to $2.3 million and $6.2 million, respectively, for the same periods last fiscal year.as follows:
Income (loss) from operations. Our income from operations was $1.6 million in the third quarter of fiscal 2010, an increase of $1.9 million compared to a third quarter loss of $0.3 million in fiscal 2009. | | Three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousands) | |
Gross profit | | | | | | |
Services | | $ | 15,001 | | | $ | 12,528 | |
Products and Systems | | | 2,569 | | | | 1,688 | |
International | | | 3,271 | | | | 3,046 | |
Corporate and eliminations | | | (63 | ) | | | (112 | ) |
| | $ | 20,778 | | | $ | 17,150 | |
As a percentage of revenues, our gross profit was approximately 30% for each of the thirdfirst quarter of fiscal 2011 and the first quarter of fiscal 2010. Cost of revenues, excluding depreciation, as a percentage of revenues was approximately 65% in each of the first quarter of fiscal 2011 and the first quarter of fiscal 2010. Depreciation expense included in the determination of gross profit for the first quarter of fiscal years 2011 and 2010 was $3.0 million, or 4% of revenues, and $2.5 million, or 4% of revenues, respectively.
With our income (loss) from operations was 2.5% of our revenues compared to (0.6%) of ourincrease in revenues for the same period infirst quarter of fiscal 2009. For2011, our gross profit as a percentage of revenues remained fairly consistent at approximately 30% as compared to the first nine monthsquarter of fiscal 2010. While overall gross profit as a percentage of segment revenues remained fairly consistent, we incurred a slight decrease in gross profit percentage in the Services segment that was primarily attributable to sales derived from several new contracts, which drove market share growth but were competitive from a pricing perspective in the short term. Historically, by introducing more advanced NDT tools to new customers, margin enhancement follows. This slight decrease was offset by improved efficiencies in our utilization rates when compared to the first quarter of fiscal 2010. In addition, our Products and Systems segment& #8217;s gross profit percentage increased slightly as a result of an increase in sales volume of its products, which generally yield higher margins.
Income from operations. Our income from operations by segment for the first quarter of fiscal 2011 and 2010, was as follows:
| | Three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousands) | |
Income from operations | | | | | | |
Services | | $ | 3,848 | | | $ | 3,232 | |
Products and Systems | | | 791 | | | | (70 | ) |
International | | | 1,028 | | | | 1,262 | |
Corporate and eliminations | | | (2,351 | ) | | | (1,638 | ) |
| | $ | 3,316 | | | $ | 2,786 | |
Our income from operations of $3.3 million for the first quarter of fiscal 2011 increased $0.5 million, or 19%, compared to the first quarter of fiscal 2010. As a percentage of revenues, our income from operations was $12.1 million, or 6.3% of revenues, as compared to $10.6 million, or 6.9% of revenues5% in the first nine months of fiscal 2009. For the third quarter of fiscal 2010,2011 and fiscal 2010.
As a percentage of revenues, selling, general and administrative expenses as a percentage of revenues decreased to 21.9% as compared to 25.4% infor the thirdfirst quarter of fiscal 2009. This decrease was2011 were 23%, consistent with the first quarter of fiscal 2010. Our selling, general and administrative expenses for the first quarter of fiscal 2011 increased approximately $2.3 million, or 18%, over the first quarter of fiscal 2010, primarily due to the positive impactcost of the higher revenue and leveraging the fixed costs in this category of expenses. For the first nine months of fiscal 2010, these expenses were 21.3% of revenues compared to 22.2% of revenues for the first nine months of fiscal 2009. For the nine months ended February 28, 2010, these costs increased by $6.9 million. The primary increases included additional costs and investments, including personnel,infrastructure to support our growth, fromincluding new locations obtained through our acquisitions. Our recent acquisitions and to support several new specialties within our asset protection solutions, or “centersaccounted for approximately $0.5 million of excellence.”this increase. Stock compensation costs increased approximately $0.5 million in the first quarter of fiscal 2011 over the first quarter of fiscal 2010. Other increases in our selling, general and administrative expenses included higher compensation and benefit expenses over the previous year attributedattribu ted to normal salary increases, as well as our investment in additional management and corporate staffstaff. A significant portion of these increases (as well as other increases in cost of revenues) supported our development of new and stock compensation expenseexisting centers of $1.9 approximately million. Operating incomeexcellence. Our professional fees increased in the previous fiscal year included a $2.1 million provision for a lawsuit settled in the secondfirst quarter of fiscal 2010 that2011, which related primarily to increased costs associated with operating as a publicly traded company, including Sarbanes-Oxley Act compliance. These increases were offset by decreases in professional fees related to our IPO in 2009 and our provision for bad debts. Income from operations was subsequently reducedalso impacted by a legal provision of $0.3 million upon final settlement.
in the quarter as compared to a reversal of a legal provision in the first quarter of 2010. Depreciation and amortization included in the determination of income from operations for the thirdfirst quarter of fiscal 2011 and the first nine monthsquarter of fiscal 2010 was $1.2 million, or 2.0%2% of revenues, and $3.6$1.0 million, or 1.8%, respectively. For the same periods in fiscal 2009, these expenses were $0.9 million or 1.9%2% of revenues, and $3.1 million, or 2.0%, respectively. A reconciliation of our income from operations on a percentage of revenues basis from last fiscal year is as follows:
| | Three Months Ended February 28, | | | Nine Months Ended February 28, | |
| | | | | | |
Income from operations as percentage of revenues fiscal 2009 | | | (0.6 | %) | | | 6.9 | % |
| | | | | | | | |
Percentage of revenue (decreases or unfavorable) increases or favorable: | | | | | | | | |
| | | | | | | | |
Gross margin | | | (0.5 | %) | | | (3.4 | %) |
Large customer bankruptcy | | | 2.5 | % | | | 0.4 | % |
Stock compensation expense | | | (1.2 | %) | | | (0.9 | %) |
Other selling general and administrative expenses | | | 2.2 | % | | | 1.7 | % |
Legal settlement | | | — | | | | 1.5 | % |
All other | | | 0.1 | % | | | 0.1 | % |
Income from operations as percentage of revenues fiscal 2010 | | | 2.5 | % | | | 6.3 | % |
Interest expenseexpense. . Interest expense was $0.7 million and $1.1 million for the thirdfirst quarter of fiscal 2011 and the first quarter of fiscal 2010, respectively. The decrease in the first quarter of fiscal 2011 interest expense related directly to our repayment of approximately $66.4 million in borrowings in October 2009, which was the primary use of the net proceeds we received from our initial public offering. In each of the three months ended August 31, 2010 and 2009, respectively. Forwe incurred additional expense related to the market rate adjustments to our interest rate swaps, as the fixed rate on these swaps was higher than market rates during both annual periods. The total interest expense adjustments for these swap arrangements in each of the first nine monthsquarter of fiscal 2011 and the first quart er of fiscal 2010 and 2009, the interest expense was $2.8 million and $3.7 million, respectively. The decreases in interest expense in fiscal 2010 compared to the comparable periods in fiscal 2009 related to the repayment of our bank debt in connection with our public offering. We will continue to pay interest on debt related to our acquisitions and capital leases.approximately $0.1 million.
Loss on ExtinguishmentNet loss (income) attributable to noncontrolling interests, net of debttaxes. . The decrease in net income attributable to noncontrolling interests relates primarily to a decrease in net income from Diapac, our subsidiary in Russia, and the net loss on extinguishment of debt of $0.4 million for the nine months ended February 28, 2010 relates to the write-off of previously deferred costs associated with the July 2009 refinancing and subsequent repaymentincurred by IPS, our recently acquired subsidiary in France, offset by an increase in net income of our senior credit facility in October 2009.Brazilian subsidiary, PASA.
Income taxestaxes. . The provision for income taxes was $0.1 million for the third quarter of fiscal 2010 and $3.7 million for the first nine months of fiscal 2010. This compares to a $0.6 million tax benefit and $2.7 million tax provision for the same periods in fiscal 2009. Our effective income tax rate was approximately 40% for the three months ended February 28, 2010 and 2009 was approximately 14% and 43%, respectively. This rate decrease relates primarily to an adjustment to reflect current estimates as to the distribution of taxable income to various tax jurisdictions. This adjustment also considered the filing of our fiscal 2009 income tax returns during thisfirst quarter as well as other adjustments to tax timing differences that are no longer applicable. Our effective income tax rate for the nine months ended February 28, 2010 and 2009 was approximately 42% and 40%, respectively. The primary reason for this rate increase relates to the sources of our operating income. In the first nine months of fiscal 2010, a higher percentage of our operating income came from our operations in the United States, which are generally subject to higher tax rates. Our effective income tax rate for the fiscal year ending May 31, 2010 is currently estimated to be approximately 42%2011 compared to approximately 45% for fiscal 2010. The decrease was primarily due to the fiscal year ending May 31, 2009.impact of permanent tax differences and an adjustment to our liabilities related to uncertain tax provisions offset by higher state taxes and U.S. federal taxes on our foreign profits.
Net income (loss) attributable to Mistras Group, Inccommon shareholders. Net income attributable to Mistras Group, Inc.common shareholders for the thirdfirst quarter of fiscal 20102011 was $0.8$1.6 million, or 1.2%2% of our revenues, which is greater than our net lossincome attributable to Mistras Group, Inc.common shareholders for the thirdfirst quarter of fiscal 2009,2010, which was a loss of $0.8 million, or a negative 1.7%1% of revenues. For the first nine months of fiscal 2010 and fiscal 2009,This increase in net income attributable to Mistras Group, Inc. was $5.2 million, or 2.7%primarily the result of revenues,our revenue growth and $4.0 million, or 2.6% of revenues, respectively. Net income attributable to Mistras Group, Inc. increased $1.6 million and $1.2 million for the third quarter and nine-month period, respectively, compared to the prior year. The overall increases to net income attributable to Mistras Gr oup, Inc. are attributed to factors that were discussed above and summarized below:
| | Three Months Ended | | | Nine Months Ended | |
| | February 28, 2010 | | | February 28, 2010 | |
| | compared to | | | compared to | |
| | Three Months Ended | | | Nine Months Ended | |
| | February 28, 2009 | | | February 28, 2009 | |
| | (In thousands) | |
Items increasing net income attributable to Mistras Group, Inc.: | | | | | | |
Increase in gross profit | | $ | 4,523 | | | $ | 6,539 | |
Lower expenses related to legal settlement, net | | | 89 | | | | 2,437 | |
Decreased provision for large customer bankruptcy1 | | | 1,163 | | | | 396 | |
Lower interest expense | | | 359 | | | | 867 | |
Reduced income attributable to non-controlling interests | | | — | | | | 143 | |
| | | | | | | | |
| | | 6,134 | | | | 10,382 | |
| | | | | | | | |
Items decreasing net income attributable to Mistras Group, Inc.: | | | | | | | | |
Increased other selling, general and administrative expenses1 | | | 2,553 | | | | 5,570 | |
Increased stock compensation expense1 | | | 777 | | | | 1,764 | |
Increased research and engineering expense | | | 102 | | | | 89 | |
Increased amortization | | | 408 | | | | 441 | |
Increased loss on extinguishment of debt | | | — | | | | 387 | |
Increased provision for income taxes | | | 725 | | | | 944 | |
Increased income attributable to non-controlling interests | | | 7 | | | | — | |
| | | | | | | | |
| | | 4,572 | | | | 9,195 | |
Change in net income attributable to Mistras Group, Inc. | | $ | 1,562 | | | $ | 1,187 | |
1 Collectively these items comprise the increase tolower interest expense, offset by higher selling, general and administrative expense and research and engineering expenses.
Our cash flows are summarized in the table below:
Segment Data | | For the three months ended August 31, | |
| | 2010 | | | 2009 | |
| | (in thousands) | |
Net cash provided by (used in): | | | | | | |
Operating Activities | | $ | 8,281 | | | $ | 5,483 | |
Investing Activities | | | (7,240 | ) | | | (15,358 | ) |
Financing Activities | | | (3,101 | ) | | | 10,401 | |
Effect of exchange rate changes on cash and cash equivalents | | | (122 | ) | | | (159 | ) |
Net change in cash and cash equivalents | | $ | (2,182 | ) | | $ | 367 | |
Segment Results for Third quarter of Fiscal 2010 and 2009
Segment discussions that follow provide supplemental information regarding the significant factors contributing to the changes in results for each of our business segments.
| | Three Months Ended February 28, | | | Nine Months Ended February 28, | |
| | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | (In thousands) | |
Revenues1 | | | | | | | | | | | | |
Services | | $ | 52,912 | | | $ | 37,603 | | | $ | 159,552 | | | $ | 120,439 | |
Products and Systems | | | 4,768 | | | | 4,258 | | | | 13,137 | | | | 13,055 | |
International | | | 8,092 | | | | 6,065 | | | | 23,322 | | | | 23,382 | |
Corporate and eliminations | | | (1,416 | ) | | | (925 | ) | | | (3,667 | ) | | | (3,603 | ) |
| | $ | 64,356 | | | $ | 47,001 | | | $ | 192,344 | | | $ | 153,273 | |
Gross Profit | | | | | | | | | | | | | | | | |
Services | | $ | 11,898 | | | $ | 8,771 | | | $ | 41,831 | | | $ | 34,270 | |
Products and Systems | | | 2,711 | | | | 2,055 | | | | 7,217 | | | | 6,648 | |
International | | | 3,222 | | | | 2,310 | | | | 9,212 | | | | 10,490 | |
Corporate and eliminations | | | (204 | ) | | | (32 | ) | | | (467 | ) | | | (154 | ) |
| | $ | 17,627 | | | $ | 13,104 | | | $ | 57,793 | | | $ | 51,254 | |
| | | | | | | | | | | | | | | | |
Income (loss) from Operations | | | | | | | | | | | | | | | | |
Services | | $ | 2,257 | | | $ | (99 | ) | | $ | 13,114 | | | $ | 8,130 | |
Products and Systems | | | 980 | | | | 322 | | | | 2,021 | | | | 1,583 | |
International | | | 527 | | | | 441 | | | | 2,597 | | | | 4,299 | |
Corporate and eliminations | | | (2,132 | ) | | | (967 | ) | | | (5,647 | ) | | | (3,435 | ) |
| | $ | 1,632 | | | $ | (303 | ) | | $ | 12,085 | | | $ | 10,577 | |
| | | | | | | | | | | | | | | | |
Depreciation and Amortization | | | | | | | | | | | | | | | | |
Services | | $ | 3,363 | | | $ | 2,702 | | | $ | 9,527 | | | $ | 7,872 | |
Products and Systems | | | 252 | | | | 258 | | | | 752 | | | | 748 | |
International | | | 397 | | | | 195 | | | | 1,036 | | | | 641 | |
Corporate and eliminations | | | 32 | | | | 26 | | | | 94 | | | | 66 | |
| | $ | 4,044 | | | $ | 3,181 | | | $ | 11,409 | | | $ | 9,327 | |
1 Revenues by operating segment includes intercompany transactions, which are eliminated in corporate and eliminations.
Services
Seasonality. Our first and third quarters are traditionally seasonally slower quarters for the Services segment. These quarters coincide with the production schedules of many of our largest customers and are a time when less maintenance and inspection services is typically performed. In addition, the Services segment historically generates fewer billable hours during these quarter due to the timing of vacation and holidays taken by our personnel.
Revenues. In the third quarter of fiscal 2010, our Services segment revenues were $52.9 million, which is an increase of $15.3 million, or 40.7%, compared to $37.6 million for the third quarter of fiscal 2009. During this period, we estimate the organic growth was 26% and growth from acquisitions was 14%. In the same quarter in fiscal 2009, work at many customer locations was rescheduled, or cancelled, because of the economy and we estimate that revenues for these existing customers increased approximately 10% in the third quarter of fiscal 2010. The remaining organic increase was a result of new multi-year contracts obtained during the year, growth in the power generation and transmission industry, as well as growth from new service offerings. We continued to have growth from o ur centers of excellence including mechanical integrity and tube inspection. We expect that this higher level of activity will continue through our fourth quarter. Declines in pipeline, aerospace, infrastructure and industrial parts inspection activity were continuing; however, we would expect these latter markets to improve as the economy further stabilizes.
For the first nine months of fiscal 2010, our Services segment revenues were $159.6 million, which is an increase of $39.1 million, or 32.5%, compared to $120.4 million for the first three quarters of fiscal 2009. For this nine month period, we estimate the organic growth was 17% and growth from our acquisitions was 15%. During fiscal 2010, we experienced pricing pressure, especially on new multi-year contracts and renewals. We estimate that in the first nine months of the year we lost no more than 1% to 2% of our segment revenues solely due to competition from lower pricing, which was more than replaced by other business. Although our customers are always price sensitive, the overall pressure due to the economy has lessened from existing customers, but we would expect continued price sensitivity on new base business, especially as ou r competition attempts to regain lost market share; however, we believe that our market differentiation should help prevent any significant erosion of profitability.
The oil and gas industry accounted for approximately 73% of our Services segment revenues during the third quarter and 68% of segment revenues for the first nine months of fiscal 2010. This compares to approximately 61% and 60%, respectively for the same periods in the prior fiscal year. Our top ten Services segment customers accounted for approximately 56% and 53% of our segment revenues during the third quarter and first nine months of fiscal 2010, respectively. This compares to approximately 45% and 43%, respectively, for the same periods in the prior fiscal year. Under different contracts and at multiple sites, one customer represented 21% and 23% of our segment revenues for the third quarter and first nine months of fiscal 2010. This same customer represented 21% and 19% for the same periods in fiscal 2009, respectively.
Gross profit. For the third quarter and first nine months of fiscal 2010, our segment gross profit was $11.9 million, or 22.5% of segment revenues, and $41.8 million, or 26.2% of segment revenues, respectively. This compares to $8.8 million, or 23.3% of segment revenues, and $34.3 million, or 28.5% for the same periods in fiscal 2009. For the third quarter and first nine months of fiscal 2010, our cost of segment revenues, excluding depreciation expense, was 73.1% and 69.7%, respectively. This compares to 71.5% and 67.2% for the same periods in fiscal 2009. For the third quarter and first nine months of fiscal 2010, our depreciation expense used in determining our gross profit was $2.3 million, or 4.4% of revenues and $6.5 million, or 4.1% of revenues, respectively. This compare s to $1.9 million, or 5.1% of revenues and $5.2 million, or 4.4% for the same periods in fiscal 2009.
The pricing pressure noted above in the discussion of revenues, the mix of our revenues and intake of new traditional business, including start-up costs on new multi-year, contracts has led to lower profitability on our time and material billings. Although unbillable time decreased from the third quarter of 2009, when many of our customers significantly stopped or curtailed work during the December time frame, unbillable time remained above targeted levels. In the third quarter this year, certain of our customers were managing project activity and turnarounds differently than in the past, stopping or changing planned work schedules more abruptly or frequently than in the past, which has created inefficiencies in the planning and utilization of labor. We also modified our vacation and sick day policies, which changed the timing of thes e expenses. The impact was to increase our expenses in the fiscal 2010 periods reported; however, this change should benefit our profitability next December. Compared to last year, our complement of certified technicians and related fringe benefit costs has increased. However, we believe this increase in technical staff gives us the ability to further leverage our existing resources and related costs by through revenue growth.
Income (loss) from operations. Our Services segment income(loss) from operations during the third quarter of fiscal 2010 and 2009 was $2.3 million, or 4.3% of revenues, and ($0.09) million, or (0.3)% of revenues, respectively. Income from operations during the first nine months of fiscal 2010 and 2009 was $13.1 million, or 8.2% of revenues, and $8.1 million, or 6.8% of revenues, respectively. The most significant change in both the quarterly and first nine months was $2.1 million recorded in fiscal 2009 to provide for estimated legal expenses related to a class action lawsuit, since settled. Segment selling, general and administrative expenses, excluding this one-time charge, for the third quarter of fiscal 2010 and 2009 were 16.1% and 21.3% of segment revenues, respectively. Fo r the first nine months of fiscal 2010 and fiscal 2009, these expenses were 16.2% and 17.7%, respectively. These expenses increased $0.5 million for the third quarter in fiscal 2010 compared to fiscal 2009 and increased $4.5 million for the first nine months of fiscal 2010. Except for a first quarter 2010 provision of $0.8 million for bad debt expense related to changes in our collectability estimate for a large customer bankruptcy, which is now fully reserved, the reasons for the dollar increases are the same in both periods. The majority of the selling, general and administrative expenses relates to costs associated with additional infrastructure to support our growth, including several new locations obtained through our acquisitions, and costs to develop and support our centers of excellence. A smaller portion of the increase was driven by higher compensation and benefit expenses for normal salary increases, additional corporate staff and professional fees. In the third quarter of fiscal 2010, segment dep reciation and amortization expense used in determining segment income from operations increased $0.3 million to $1.1 million, or 2.0% of segment revenues from $0.8 million, also 2.0% of segment revenues in the third quarter of fiscal 2009. For the nine months ended February 28, 2010, the segment depreciation and amortization expense used in determining segment income from operations was $3.0 million, or 1.9% of revenues as compared to $2.6 million, or 2.2% of segment revenues for the same period of fiscal 2009. The increase in all periods related to increased amortization from acquisitions made in fiscal 2010.
Products and Systems
Revenues. Revenues in the Products and Systems segment were $4.8 million in the third quarter of fiscal 2010 compared to $4.3 million for the third quarter of fiscal 2009. With a 12% increase over the same quarter last year and increased bookings, this segment appears to have rebounded after a 5% decrease in revenues in the first half of the fiscal year caused by slower capital spending by our customers due to continuing concerns over the economy. For the first nine months of fiscal 2010, revenues were $13.1 million and on par with the $13.1 million in the first nine months of the prior fiscal year. Several large orders received in the quarter, as well as expansion of our sales distribution channels by hiring additional industry-focused sales representatives should continue the trend of gradual sales growth.
Gross profit. Gross profit was $2.7 million, or 56.9% of revenue compared to $2.1 million, or 48.3% of revenue in the same quarter last fiscal year. For the first nine months of fiscal 2010, gross profit was $7.2 million, or 54.9% of revenues compared to $6.6 million, or 50.9% of revenues in the first nine months of the prior fiscal year. The 4% improvement in gross margin percentage during the first nine months of fiscal 2010 was attributed to sales of higher margin products and several cost cutting initiatives implemented. Depreciation expense used in determining segment gross profit for the third quarter of fiscal 2010 and 2009 was $0.2 million, or 4.2% of revenues, and $0.2 million, or 4.9% of revenues, respectively. Depreciation expense used in determining segment gross pro fit for the first nine months of fiscal 2010 and 2009 was $0.6 million, or 4.5% of revenues, and $0.6 million, or 4.4% of revenues, respectively.
Income (loss) from operations. Our Products and Systems segment income from operations during the third quarter of fiscal 2010 was $1.0 million, or 20.6% of segment revenues, compared to income from operations of $0.3 million, or 7.6% of revenues, for the third quarter of fiscal 2009. The $0.7 million increase in the gross profit for our third quarter in fiscal 2010 was the primarily reason for the increase. Our segment operating income for the first nine months of fiscal 2010 and 2009 was $2.0 million, or 15.4% of revenue and $1.6 million, or 12.1% of revenue, respectively. The improvement in gross profit was the principal driver of the operating income improvement. Our selling, general and administrative expenses in the third quarter of fiscal 2010 were 24.0% of revenues compa red to 28.1% of revenues in the third quarter the previous fiscal year. For the first nine months of fiscal 2010 and 2009, these costs as a percentage of revenues were 27.3% and 26.6%, respectively. For all periods, the depreciation and amortization expense in determining segment income from operations was less than 1.3%.
International
Basis of Reporting. Our International segment’s reporting year end is April 30, while our other segments’ year ends are May 31. Similarly, all three month reporting periods reflect a lag of one month. For example, for the International segment, the reported third quarter of fiscal 2010 represents the three months ended January 31. Historically, the effect of this difference in timing of reporting foreign operations on the consolidated results of operations and consolidated financial position has not been significant.
Revenues. For the third quarter in fiscal 2010, revenues in our International segment were $8.1 million compared to $6.1 million the third quarter last year. The 33.4% increase is comprised of 19.3% of organic growth and 14.1% related to foreign exchange impacts as the dollar weakened against the basket of currencies in which we operated compared to the same quarter last year. All of our entities had organic growth in the quarter except France. Our Brazilian subsidiary led with growth exceeding 30% as they provided advanced services to a major customer, while several of our other smaller subsidiaries also experienced double digit growth. In the quarter, we also provided for a customer sales allowance in Russia that related to the scope of work performed on a blanket sales order. We are hopeful of recovering all or a portion of the $0.3 million provided.
For the nine months ended February 28, 2010 segment revenues were $23.3 million as compared to $23.4 million for the same period last year. For this period, although organic and acquisition growth totaled 5.1%, unfavorable foreign currency impacts offset this amount. On a local currency basis, our Brazilian subsidiary had impressive growth exceeding 25%. In addition, our UK based company with operations in the UK, Holland, India and Greece had positive growth due to increased field inspection and research contracts, as well as acquisition growth. Offsetting this growth were revenue declines in Russia, France and Japan, which were more impacted by the economy.
Gross profit. For the third quarter of fiscal 2010, gross profit was $3.2 million, or 39.8% of revenues as compared to $2.3 million, or 38.1% of revenue in the same quarter last fiscal year. Notwithstanding the Russia sales allowance noted above, margins in the third quarter of fiscal 2010 improved compared to the third quarter of fiscal 2009 due to an increase in revenues from equipment sales. For the first nine months of fiscal 2010 and 2009, the gross profit was $9.2 million, or 39.5% of revenues and $10.5 million, or 44.9% of revenues. In our foreign operations, our cost of revenues tends to be more fixed in nature and the ability to generate higher margins is dependent on achieving consistent revenues. For the nine-month period in fiscal 2010, there were fewer acoustic emis sion product and system sales which have a higher margin profile. Depreciation expense used in determining our segment gross profit for the third quarter of fiscal 2010 and 2009 was $0.2 million, or 2.9% of segment revenues, and $0.1 million, or 2.5% of segment revenues, respectively. Depreciation expense for the first nine months of fiscal 2010 and 2009 was $0.8 million, or 3.3% of segment revenues, and $.4 million, or 1.7% of segment revenues, respectively.
Income (loss) from operations. Income from operations from our International segment for the third quarter of fiscal 2010 and 2009 was $0.5 million and $0.4 million, respectively. As a percentage of segment revenues, segment income from operations was 6.5% and 7.3% in the third quarter of fiscal 2010 and 2009, respectively. For the first nine months of fiscal 2010 and fiscal 2009, the income from operations was $2.6 million, or 11.1% of revenues and $4.3 million, or 18.4% of revenues. Selling, general and administrative expenses, the largest factor in determining segment income from operations for the third quarter of fiscal 2010 and 2009, were $2.5 million, or 30.9% of segment revenues, and $1.8 million, or 29.3% of segment revenues, respectively. For the first nine months of f iscal 2010 and fiscal 2009, these expenses were $6.3 million, or 26.9% of revenues and $5.8 million, or 24.8% of revenues. There was a small increase in these expenses on a local currency basis due to the additional infrastructure related to a small acquisition in Holland that was completed September 1, 2008, as well as additional costs incurred in France and Brazil for additional personnel and training. In addition, professional fees for the first time statutory audit of the European U.K. group were higher than anticipated.
Corporate and Eliminations
The elimination in revenues and cost of revenues primarily relates to the accounting elimination of revenues from sales of our Products and Systems segment to the International segment. 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, acquisition transaction costs, non-cash stock compensation and other similar costs. As a percentage of our total revenues, the net revenue and cost of revenue elimination combined with these administrative costs were 2.3% and 3.0% of total revenues for third quarter of fiscal 2010 and 2009, respectively. On a dollar basis for the third quarter, the costs included in the total selling, general and administrative expenses of th e Company increased $1.0 million which approximates the $0.8 million increase recorded for stock compensation during the third quarter of fiscal 2010. For the first nine months of fiscal 2010 and fiscal 2009, the net revenue and cost of revenue elimination combined with these administrative costs were 2.2% and 3.2% of total revenues. The selling, general and administrative expenses included in this total for the nine months ended February 28, 2010 and 2009 were $5.2 million, or 2.7% of total revenues and $3.4 million, or 2.2% of total revenues, respectively. Increases to the stock compensation expense in fiscal 2010 of $1.9 million primarily accounted for the increase.
Liquidity and Capital Resources
Overview
We have primarily funded our operations through the issuance of preferred stock in a series of financings, bank borrowings, capital lease financing transactions, the issuance of our common stock and cash provided from operations. 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 borrowings under our credit agreement will be sufficient to meet our anticipated cash needs over the next 12 months.
Cash Flows from Operating Activities
During the ninethree months ended February 28,August 31, 2010, cash provided by our operating activities was $12.4$8.3 million, an increase of $5.6$2.8 million from the comparable period of fiscal 2009.2010. Positive operating cash flow was primarily attributable to net income plus depreciationof $1.6 million and amortization and other non-cash charges of $19.0 million. We used $6.6$1.7 million of cash provided by a decrease in our working capital, which primarily related to fund an increase in operating assets primarily forcollections of our trade accounts receivable.
In the nine months ended February 28, 2009, positive operating cash flow was primarily attributable to net income plus depreciation and amortization and other non-cash charges of $14.8 million. During this same period, $8.1 million cash was used to fund net operating assets, primarily for our trade accounts receivable.
Cash Flows from Investing Activities
During the ninethree months ended February 28,August 31, 2010, cash used in investing activities was $15.9$7.2 million compared to $14.1$15.4 million from the comparable period of fiscal 2009.2010. Cash purchases of property, plant and equipment were $1.7$1.9 million and were primarily related to equipment used by our technicians. Cash used in investing activities also included our acquisition of threetwo asset protection businesses for cash payments aggregating $14.3$5.3 million.
CashDuring the three months ended August 31, 2009, cash used in investing activities in the nine months ended February 28, 2009 was $14.1$15.4 million of which $3.5 million was forand included cash purchases of property, plant and equipment of $1.4 million and $10.3 million was related to acquisitionsour acquisition of two asset protection businesses.businesses for cash payments aggregating $14.0 million.
Cash Flows from Financing Activities
Net cash provided byused in financing activities was $11.6$3.1 million for the ninethree months ended February 28,August 31, 2010, an increaseand related primarily to repayments of $4.3 million from the comparable period in fiscal 2009. On October 14, 2009, we completed our initial public offering of 10,000,000 shares of common stock at a price of $12.50 per share. We sold 6,700,000 shares in the offering. The net proceeds to the Company were $74.0 million after deducting underwriters’ commissions and other expenses. The Company used approximately $66.6 million of the net proceeds to repay the outstanding principal balance of the term loan ($25.0 million), outstanding balance of the revolver ($41.4 million) and accrued interest thereon ($0.1 million) on October 14, 2009. Also during this nine-month period, the Company made capital lease payments of $4.6 million.
Netobligations and long-term debt. For the three months ended August 31, 2009 net cash provided by financing activities forof $10.4 million resulted from the nine months ended February 28, 2009 was $7.3 million comprised of $20.0 million in borrowings of long-term debt associated with the July 2008 amendmentrefinancing of our former credit agreement, $0.4 millionfacility in net repayments of our former revolver, $9.0 million in long-term principal repayments, and $3.4 million in capital lease principal payments.July 2009.
Effect of Exchange Rate on Changes inon Cash and Cash Equivalents
ForIn each of the ninethree months ended February 28 of fiscalAugust 31, 2010 and 2009, the effect of exchange rate changes on our cash and cash equivalents was de minimus$0.1 million and $0.2 million, respectively. The fiscal 2009 change was primarily related to the strengthening of the U.S. dollar compared to the other currencies in which we conduct business.
Cash balance and credit facility borrowings
CashAs of August 31, 2010, we had cash and cash equivalents at February 28, 2010 and May 31, 2009 were $13.7totaling $13.9 million and $5.7$55.0 million respectively. Financing foravailable to us under our revolving credit facility. We finance our operations consists primarily ofthrough our net income, bank borrowings and capital lease financing and cash provided from operations which wefinancing. We believe these sources are sufficient to fund our capital expenditures, debt maturities and other business needs.
On July 22, 2009, we entered into our current credit agreement with Bank of America, N.A., JPMorgan Chase Bank, N.A., TD Bank, N.A. and Capital One, N.A., which provided for a $25,000$25.0 million term loan and a $55,000$55.0 million secured revolving credit facility. The proceeds from this transaction were used to repay the outstanding indebtedness of thefrom our former credit facility and to fund acquisitions.
As described in Note 3,In October 2009, we repaid the outstanding principal balance of the term loan was subsequently repaid in connection withand the outstanding balance of the revolving credit facility using the proceeds from our initial public offering andoffering. Credit extended under the term loan may not be re-borrowed under the current credit agreement. We also repaid the outstanding balance ofCredit extended under the revolving credit facility but may re-borrowbe re-borrowed at any time. Borrowings made under the revolving credit facility are payable on July 21, 2012. In December 2009, we signed an amendment to our current credit agreement that, among other things, adjusted certain affirmative and negative covenants including delivery of financial statements, the minimum consolidated debt service coverage ratio, and the procedures for obtaining lender approval in acquisitions.acquisitions and the removal of the minimum EBITDA requirement.
Under the amended agreement, borrowings under the credit agreement bear interest at the LIBOR or base rate, at our option, plus an applicable LIBOR margin ranging from 1.75% to 3.25%, or base rate margin ranging from -0.50% to 0.50%, and a market disruption increase of between 0.0% and 1.0%, if the lenders determine it to be applicable.
The credit agreement also contains financial and other covenants limiting our ability to, among other things, create liens, make investments and certain capital expenditures, incur more indebtedness, merge or consolidate, acquire other companies, 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 agreement’s financial covenants require us to maintain a minimum debt service coverage ratio, and a funded debt leverage ratio, all as defined in the credit agreement. There is a provision in the credit facility that requires us to repay 25% of the immediately preceding fiscal year’s “free cash flow” if our ratio of “funded debt” to EBITDA, as defined in the creditc redit agreement, is lessgreater than a fixedspecified amount on or before October 1 each year.
In the first quarter endedAt August 31, 2009, we capitalized $534 of costs related to the new credit agreement and expensed $169 of deferred financing costs related to our former credit facility. With the repayment and extinguishment of the term loan portion of this new facility in October 2009, we expensed $218 of the financing costs incurred in the first quarter of fiscal 2009. The unamortized balance of these costs is included in net intangible assets in the consolidated balance sheet. The accelerated amounts expensed are classified as loss on extinguishment of debt in the consolidated statement of operations.
At February 28, 2010, we were in compliance with the terms of the credit agreement.
Liquidity and capital resources outlook
Future sources of cash
We expect our future sources of cash to include cash flow from operations, cash borrowed under our revolving credit facility and cash borrowed from leasing companies to purchase equipment and fleet service vehicles. Our revolving credit facility is available for cash advances required for working capital and for letters of credit to support our operations. To meet our short-and long-term liquidity requirements, we expect primarily to rely on cash generated from our operating activities. We are currently funding our acquisitions through our available cash, borrowings under our revolving credit facility when necessary, and seller notes. We may also obtain capital through the issuance of debt or equity securities, or a combination of both.
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, but generally only do so with a high degree of certainty about related customer orders and pricing. In addition, we have a certain amount of replacement equipment, including our fleet vehicles. We historically spend approximately 4% to 5% of our total revenues on capital expenditures, excluding acquisitions, and expect to fund these expenditures through a combination of cash and lease financing.
Our anticipated acquisitions may also require capital. For example, we have completed three acquisitions in fiscal 2011 with an initial cash outlay of approximately $16.8 million, of which approximately $5.0 million was funded by our credit facility. This includes one acquisition completed in October 2010. 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 aggressively 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 and long-term debt repayment and various other obliga tions, including the commitments discussed in the table below, as they arise.
We will also 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 or public or private equity 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, tech nologies 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.
Off-balance sheet arrangements
During the thirdfirst quarter of fiscal 2010,2011, 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.
Foreign Currency Risk
We have foreign currency exposure related to our operations in foreign locations where the functional currency is not the U.S. dollar. This foreign currency exposure, particularly the Euro, British Pound Sterling (GBP), Brazilian Real, Russian Ruble, Japanese Yen 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 GBP 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 i nin 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. For our foreign subsidiaries, assets and liabilities are translated at period ending rates of exchange. Translation adjustments for the assets and liability accounts are included in accumulated other comprehensive income in stockholders’ equity (deficit). We had $0.6approximately $0.2 million of foreign currency translation gainslosses in other comprehensive income for the first ninethree months of fiscal 2010.2011. We do not currently enter into forward exchange contracts to hedge exposures denominated in foreign currencies. We may consider entering into hedging or forward exchange contracts in t hethe future.
Interest Rate Sensitivity
The interest rate on our revolving credit facility is variable. Accordingly, to the extent that we borrow under this facility, we are exposed to the risks associated with increases in interest rates under the facility.
In 2007,From time to time, we enteredenter into two interest rate swap contracts whereby we would receive or pay an amount equal to the difference between a fixed rate and LIBOR on a quarterly basis in order to reduce our exposure to interest rate fluctuations. All gains and losses are recognized as an adjustment to interest expense and the combined fair values are recorded in other liabilities on the consolidated balance sheet. At February 28,August 31, 2010, onlywe had one interest rate swap contract was outstanding with a notional amount of $8.0 million.
We had cash and cash equivalents of $13.7$13.9 million at February 28,August 31, 2010. These amounts are held for working capital purposes and were invested primarily in short-term interest-bearing accounts. In addition, the remaining net proceeds of our initial public offering are invested in short-term, money market funds. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income.
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.
Limitations on Effectiveness of Control.
Our management, including the principal executive and financial officers, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of our control system reflects the fact that there are resource constraints and the benefits of such controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control failures and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is also based in part on certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of management’s assessments of the current effectiveness of our disclosure controls and procedures and its internal control over financial reporting are subject to risks. However, our disclosure controls and procedures are designed to provide reasonable assurance that the objectives of our control system are met.
Evaluation of Disclosure Controls and Procedures.
As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). This evaluation included consideration of the various processes carried out under the direction of our disclosure committee in an effort to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC. This evaluation also considered the work completed relating to our compliance efforts with regards to the requirements of SectionS ection 404 of the Sarbanes-Oxley Act of 2002.
We intend to regularly review and evaluate the design and effectiveness of our disclosure controls and procedures and internal controls over financial reporting on an ongoing basis and to improve these controls and procedures over time.
Changes in Internal Control Over Financial Reporting.
There were no changes in our internal control over financial reporting (as defined in Rules 13a-13(f) and 15d-15(f) of the Exchange Act) that have materially affected or are reasonably likely to materially affect our internal control over financial reporting during the thirdfirst quarter of fiscal 2010.2011.
See Note 11 to the financial statements included in this report for a description of legal proceedings involving us.
In addition to the other information set forth in this report, you should carefully consider the risk factors discussed under the “Risk Factors” section included in our Annual Report on Form 10-K, filed with the IPO Prospectus.SEC on August 17, 2010. There have been no material changes to the risk factors previously disclosed in the IPO Prospectus.Annual Report.
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