MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF ENERGY
SERVICES
You
should read the following discussion of the financial condition and results of
operations of Energy Services in conjunction with Energy Services historical
consolidated financial statements and related notes contained elsewhere herein.
Among other things, those historical consolidated financial statements include
more detailed information regarding the basis of presentation for the following
information.
Overview
Energy
Services was formed on March 31, 2006, to serve as a vehicle to effect a
merger, capital stock exchange, asset acquisition or other similar business
combination with an operating business. Energy Services intend to utilize cash
derived from the proceeds of its public offering, Energy Services capital
stock, debt or a combination of cash, capital stock and debt, in effecting a
business combination.
Comparison of
Financial Condition at December 31, 2007 and September 30, 2007
From
September 30, 2007 to December 31, 2007, the assets of Energy Services grew
from $51,526,659 to $51,850,606. This growth was driven primarily by the
increase in cash and cash equivalents held in trust, which increased from $49,711,430
at September 30, 2007 to $50,326,033 at December 31, 2007, due to income earned
on the funds held in trust. Liabilities decreased slightly from $1,349,564 at
September 30, 2007 to $1,318,725, due to a pay down of accrued liabilities. The
value of the Energy Services common stock subject to possible redemption
increased from $10,143,000 at September 30, 2007 to $10,263,000 at December 31,
2007. This increase was due to the increase in the value per share of the funds
held in trust. Equity increased from $40,034,095 at September 30, 2007 to
$40,268,881 at December 31, 2007.
Comparison of
Financial Condition at September 30, 2006 and September 30, 2007
Total
assets increased by $1.3 million from $50,258,554 at September 30, 2006 to
$51,526,659. This increase came primarily in cash, which increased by $679,401
to $756,782 from the September 30, 2006 balance of $77,381 as well as the cash
and cash equivalents held in trust which increased by $562,257 to $49,711,430,
compared to $49,149,173 at September 30, 2006. Liabilities decreased by $97,976
to $1,349,564 at September 30, 2007, compared to $1,447,540 at September 30,
2006. Total stockholders equity increased primarily due to the earnings for
2007 to a balance of $40,034,095 at September 30, 2007, compared to a balance
at September 30, 2006 of $38,822,814.
Comparison of
Operating Results for the three months ended December 31, 2007 and 2006
Net
income for the year to date and quarter ended December 31, 2007 was $354,786,
which consisted of interest from the trust fund totalling $619,160, offset by
$58,374 of expenses, $44,790 of which related to formation and operating cost,
$2,379 of which related to due diligence expenses relating to potential
acquisitions, $11,205 relating to Delaware franchise tax and income taxes of
$206,000. This income compares to an income of $348,312 for the same period the
prior year, which consisted of interest from the trust fund totalling $654,819,
offset by $63,507 of expenses, $30,170 of which related to formation and
operating cost, $18,400 of which related to due diligence expenses relating to
potential acquisitions, $14,937 relating to Delaware franchise tax and income
taxes of $243,000.
Net
income from inception (March 31, 2006) to December 31,2007 was $1,823,268,
which consisted of interest income from the trust fund and other interest
totalling $3,409,168, which was offset
97
by $492,900 of
expenses. $307,567 of the expenses related to formation and operating costs,
$95,576 related to due diligence expenses relating to potential acquisitions,
$89,757 related to Delaware franchise tax and income taxes of $1,093,000.
Comparison of the
Operating Results for the years ended September 30, 2006 and September 30, 2007
For
the year ended September 30, 2007, Energy Services had a net income of
$1,381,062 attributable to interest and dividend income less formation and
operating expenses and federal and state income and capital taxes. Net income
for the year ended September 30, 2006 was $87,420. Net income for 2006 was
lower due to the fact that the public offering was completed on September 6,
2006 and therefore only a partial months interest and expenses were incurred.
Our interest and dividend income for the period ended September 30, 2007 was
$2,612,835, compared to $177,174 for the period ended September 30, 2006. In
both periods, interest and dividend income was primarily derived from money
market funds and Treasury Bills. For the year ended September 30, 2007,
expenses consisted primarily of formation, operating and due diligence expenses
of $385,773 and federal and state income taxes of $846,000. Similar expenses
for the year ended September 30, 2006 were $48,754 for formation and operating
expenses and $41,000 for Federal and state income taxes.
Operating Results
for the Period from March 31, 2006 (Date of Inception) to September 30, 2007
For
the period from March 31, 2006 (inception) through September 30, 2007, we had
net income of $1,468,482, attributable to interest and dividend income less
formation and operating expenses and federal and state income and capital
taxes. Energy Services interest and dividend income of $2,790,009 for the
period ended September 30, 2007 were principally derived from money market funds
and Treasury Bills. For the period ended September 30, 2007, Energy Services
expenses consisted of formation and operating costs of $434,527 and federal and
state income taxes of $887,000.
Liquidity and
Capital Resources
Energy
Services consummated its initial public offering on September 6, 2006. Gross
proceeds from the initial public offering were $51,600,000. Energy Services
paid a total of $4,128,000 in underwriting discounts and commissions, and
approximately $774,000 was paid for costs and expenses related to the offering.
After deducting the underwriting discounts and commissions and the offering
expenses, the total net proceeds to us from the offering that were deposited
into a trust fund were $48,972,000, (or approximately $5.69 per unit sold in
the offering). An additional $1,032,000, representing the underwriters
non-accountable expense allowance, and $2.0 million from the proceeds of the
private placement warrants were also placed in the trust account. As of
December 31, 2007, approximately $51,358,033 (or approximately $5.97 per share
sold in the offering) is being held in the trust account. To the extent that
Energy Services capital stock is used in whole or in part as consideration to
effect a business combination, the proceeds held in the trust fund as well as
any other net proceeds not expended will be used to finance the operations of
the target business. Energy Services working capital will be generated solely
from interest earned on the amount held in trust. Energy Services is limited to
$1,200,000 of such interest (net of taxes) to fund working capital. Energy
Services believes the interest earned on the amount held in trust will be
sufficient to fund our operations. From September 6, 2006 through September 6,
2008, Energy Services anticipates approximately $350,000 of expenses for legal,
accounting and other expenses attendant to the due diligence investigations,
structuring and negotiating of a business combination, $240,000 for expenses
for the due diligence and investigation of a target business, $120,000 in
reimbursement expenses to Chapman Printing Co. ($5,000 per month for two
years), $110,000 of expenses in legal and accounting fees relating to our SEC
reporting obligations and $305,000 for general working capital that will be
used for tax payments, miscellaneous expenses and reserves, including
approximately $100,000 (through January 1, 2008) for director and officer
liability
98
insurance
premiums. Energy Services does not believe it will need to raise additional funds
in order to meet the expenditures required for operating its business.
In
connection with Energy Services initial public offering, Energy Services
issued to the underwriters, for $100, an option to purchase up to a total of
450,000 units at $7.50 per unit. The units issuable upon exercise of this
purchase option are identical to the units Energy Services sold in its initial
public offering except that the warrants included in the option have an
exercise price of $6.25. Energy Services estimated that the fair value of this
option was approximately $1,642,500 ($3.65 per unit underlying such option)
using a Black-Scholes option-pricing model. The fair value of the option
granted to the underwriter was estimated as of the date of grant, using the following
assumptions: (1) expected volatility of 75.7%, (2) risk-free interest rate of
5.1% and (3) expected life of five years.
Off-Balance Sheet
Arrangements
Energy
Services has never entered into any off-balance sheet financing arrangements
and has never established any special purpose entities. Energy Services has not
guaranteed any debt or commitments of other entities or entered into any
options on non-financial assets.
Contractual
Obligations
Energy
Services has no long-term debt, capital lease obligations, operating lease
obligations, purchase obligations or other long-term liabilities.
Quantitative and
Qualitative Disclosures About Market Risk
Market
risk is the sensitivity of income to changes in interest rates, foreign
exchanges, commodity prices, equity prices, and other market-driven rates or
prices. Energy Services is not presently engaged in and, if a suitable business
target is not identified by Energy Services prior to the prescribed liquidation
date of the trust fund, Energy Services may not engage in any substantive
commercial business. Accordingly, Energy Services is not and, until such time
as Energy Services consummates a business combination, will not be exposed to
risks associated with foreign exchange rates, commodity prices, equity prices
or other market-driven rates or prices. The net proceeds of the initial public
offering held in the trust fund have been invested only in money market funds
meeting certain conditions under Rule 2a-7 promulgated under the Investment
Company Act of 1940.
New Accounting Pronouncements
During
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141 (R) is effective for fiscal years beginning after December 15, 2008.
Earlier application is prohibited. Assets and liabilities that arose from
business combinations which occurred prior to the adoption of FASB No. 141(R)
should not be adjusted upon the adoption of SFAS No. 141(R). SFAS No. 141(R)
requires the acquiring entity in a business combination to recognize all (and
only) the assets acquired and liabilities assumed in the business combination;
establishes the acquisition date as the measurement date to determine the fair
value of all assets acquired and liabilities assumed; and requires the acquirer
to disclose to investors and other users all of the information they need to
evaluate and understand the nature and financial effect of the business
combination. As it relates to recognizing all (and only) the assets acquired
and liabilities assumed in a business combination, costs an acquirer expects
but is not obligated to incur in the future to exit an activity of an acquiree
or to terminate or relocate an acquirees employees are not liabilities at the
acquisition date but must be expensed in accordance with other applicable
generally accepted accounting principles. Additionally, during the measurement
period, which should not exceed one year from the acquisition date, any
adjustments that are needed to assets
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acquired and
liabilities assumed to reflect new information obtained about facts and
circumstances that existed as of that date will be adjusted retrospectively.
The acquirer will be required to expense all acquisition-related costs in the
periods such costs are incurred other than costs to issue debt or equity
securities. SFAS No. 141(R) will have no impact on our consolidated financial
position, results of operations or cash flows at the date of adoption, but it
could have a material impact on our consolidated financial position, results of
operations or cash flows in the future when it is applied to acquisitions which
occur in the fiscal year beginning September 20, 2009.
In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements SFAS
No. 157 defines fair value, establishes methods used to measure fair value and
expands disclosure requirements about fair value measurements. SFAS No. 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal periods, as it
relates to financial assets and liabilities that are carried at fair value.
SFAS No. 157 also requires certain tabular disclosures related to results of
applying SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets and SFAS No. 142, Goodwill and Other Intangible Assets. On November
14, 2007, the FASB provided a one year deferral for the implementation of SFAS
No. 157 for non-financial assets and liabilities. SFAS No. 157 excludes from its
scope SFAS No. 123 (R), Share-Based Payment and its related interpretive
accounting pronouncements that address share-based payment transactions. Based
on the assets and liabilities on our balance sheet as of December 31, 2007, we
do not expect the adoption of SFAS No. 157 to have a material impact on our
consolidated financial position, results of operations or cash flows.
In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, including an amendment of FASB
Statement No. 115. SFAS No. 159 permits entities to choose to measure at fair
value many financial instruments and certain other items at fair value that are
not currently required to be measured. Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings. SFAS No.
159 does not affect any existing accounting literature that requires certain
assets and liabilities to be carried at fair value. SFAS No. 159 is effective
for fiscal years beginning after November 15, 2007. Based on the assets and
liabilities on our balance sheet as of December 31, 2007, we do not expect the
adoption of SFAS No. 159 to have any impact on our consolidated financial
position, results of operations or cash flows.
INFORMATION
ABOUT ST PIPELINE
Business Overview
ST
Pipeline, Inc. was organized in 1990 as a corporation under the laws of the
State of West Virginia and is engaged in the construction, replacement and
repair of natural gas pipelines for utility companies and private natural gas
companies. The majority of ST Pipelines customers are located in West Virginia
and the surrounding Mid-Atlantic states. ST Pipeline builds, but does not own
natural gas pipelines for its customers that are part of both interstate and
intrastate pipeline systems that move natural gas from producing regions to
consumption regions. ST Pipeline is involved in the construction of both
interstate and intrastate pipelines, with an emphasis on the latter. ST
Pipeline also constructs storage facilities for its natural gas customers. ST
Pipelines other services include liquid pipeline construction, pump station
construction, production facility construction and other services related to
pipeline construction. Since 2002, ST Pipeline has completed over 225 miles of
pipeline, with its longest project consisting of 69 miles of pipeline. ST
Pipeline is not directly involved in the exploration, transportation or
refinement of natural gas.
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Set
forth below is information regarding the sales, assets and operating income of
ST Pipelines business.
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Year Ended December 31,
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2007
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2006
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2005
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Sales
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$
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100,385,098
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$
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49,771,580
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$
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22,936,383
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Assets
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33,413,342
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11,137,798
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10,137,954
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Operating Income
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27,889,843
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3,353,235
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1,418,221
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At
December 31, 2007, ST Pipelines largest current project consists of a 69 mile
pipeline construction and installation project for Equitrans in Kentucky.
Our
services include the removal of and/or repair of existing pipelines,
installation of new pipelines, construction of pump stations, site work for
pipelines and various other services relating to pipelines.
ST
Pipeline is subject to extensive state and federal regulation, particularly in
the areas of the siting and construction of new pipelines. The work performed
by ST Pipeline on many projects relates to lines that are regulated by the US
Department of Transportation and therefore the work must be performed within
the rules and guidelines of the US Department of Transportation. In addition,
work at the various sites must comply with all environmental laws, whether it
be federal, state or local.
Customers and Marketing
ST
Pipeline customers include Equitable Resources and various of its subsidiaries,
Nisource/Columbia Gas Transmission, Nisource/Columbia Gas of Ohio and Dominion
Resources. During the year ended December 31, 2007, Equitable Resources/
Equitrans was ST Pipelines largest customer, accounting for approximately 92%
of total revenues. There can be no assurance that Equitable Resources/
Equitrans or any of ST Pipelines other principal customers will continue to
employ ST Pipelines services or that the loss of any of such customers or
adverse developments affecting any of such customers would not have a material
adverse effect on ST Pipelines financial condition and results of operations.
However, due to the nature of ST Pipelines operations, the major customers and
sources of revenues may change from year to year.
ST
Pipelines sales force consists of industry professionals with significant
relevant sales experience who utilize industry contracts and available public
data to determine how to most appropriately market ST Pipelines line of
products. We rely on direct contact between our sales force and our customers
engineering and contracting departments in order to obtain new business. Due to
the occurrence of inclement weather during the winter months, the business of
ST Pipeline, i.e., the construction of pipelines, is somewhat seasonal in that
most of the work is performed during the non-winter months.
Backlog/New Business
A
companys backlog represents orders which have not yet been processed. At December
31, 2007, ST Pipeline had a backlog of work to be completed on contracts of
$5.4 million. At December 31, 2006, ST Pipeline had a backlog of work on
contracts of $57.3 million. Due to the timing of ST Pipelines construction
contracts and the long-term nature of some of our projects, portions of our
backlog may not be completed in the current fiscal year. Between January 1,
2008 and February 21, 2008, ST Pipeline entered into additional contracts with
estimate revenues of approximately $16 million.
101
Types of Contracts
Our
contracts are usually awarded on a competitive and negotiated basis. While
contracts may be of a lump sum for a project or one that is based upon time and
materials, most of the work is bid based upon unit prices for various portions
of the work. The actual revenues produced from the project will be dependent
upon how accurate the customer estimates are as to the units of the various
items.
Raw Materials and Suppliers
The
principal raw materials that we use are metal plate, structural steel, pipe,
fittings and selected engineering equipment such as pumps, valves and
compressors. For the most part, the largest portion of these materials are
supplied by the customer. The materials that ST Pipeline purchases would
predominately be those of a consumable nature on the job, such as small tools
and environmental supplies. We anticipate being able to obtain these materials
for the foreseeable future.
Industry Factors
ST
Pipelines revenues, cash flows and earnings are substantially dependent upon,
and affected by, the level of natural gas exploration development activity and
the levels of integrity work on existing pipelines. Such activity and the
resulting level of demand for pipeline construction and related services are
directly influenced by many factors over which ST Pipeline has no control. Such
factors include, among others, the market prices of natural gas, market
expectations about future prices, the volatility of such prices, the cost of
producing and delivering natural gas, government regulations and trade
restrictions, local and international political and economic conditions, the
development of alternate energy sources and the long-term effects of worldwide
energy conservation measures. Substantial uncertainty exists as to the future
level of natural gas exploration and development activity.
ST
Pipeline cannot predict the future level of demand for its pipeline
construction services, future conditions in the pipeline construction industry
or future pipeline construction rates.
ST
Pipeline maintains banking relationships with three financial institutions and
has lines of credit borrowing facilities with these institutions. These lines
of credit facilities are due to expire in June and July of 2008. ST Pipeline
expects to renew these facilities and has no reason to believe that they will
not be renewed. ST Pipelines facilities have been sufficient to provide ST
Pipeline with the working capital necessary to complete their ongoing projects.
ST Pipeline also has an irrevocable standby letter of credit in the amount of
$950,542.
Competition
The
pipeline construction industry is a highly competitive business characterized
by high capital and maintenance costs. Pipeline contracts are usually awarded
through a competitive bid process and, while ST Pipeline believes that
operators consider factors such as quality of service, type and location of
equipment, or the ability to provide ancillary services, price and the ability
to complete the project in a timely manner are the primary factors in
determining which contractor is awarded a job. There are a number of regional
and national competitors that offer services similar to ours. Certain of ST
Pipelines competitors have greater financial and human resources than ST
Pipeline, which may enable them to compete more efficiently on the basis of
price and technology. Our largest competitors are Otis Eastern, LA Pipeline and
Apex Pipeline.
102
Operating Hazards and Insurance
ST
Pipelines operations are subject to many hazards inherent in the pipeline
construction business, including, for example, operating equipment in
mountainous terrain, people working in deep trenches and people working in
close proximity to large equipment. These hazards could cause personal injury
or death, serious damage to or destruction of property and equipment,
suspension of drilling operations, or substantial damage to the environment,
including damage to producing formations and surrounding areas. ST Pipeline
seeks protection against certain of these risks through insurance, including
property casualty insurance on its equipment, commercial general liability and
commercial contract indemnity, commercial umbrella and workers compensation insurance.
ST
Pipelines insurance coverage for property damage to its equipment is based on
ST Pipelines estimate of the cost of comparable used equipment to replace the
insured property. There is a deductible per occurrence on rigs and equipment of
$10,000, except for underground occurrence which is $25,000 per occurrence and
$2,500 for miscellaneous tools. ST Pipelines third party liability insurance
coverage under the general policy is $1.0 million per occurrence, $2.0 million
in the aggregate with a self insured retention of $500,000 per occurrence. ST
Pipelines commercial umbrella policy coverage consists of $5.0 million primary
umbrella insurance and $5.0 million second layer umbrella per occurrence. ST
Pipeline believes that it is adequately insured for public liability and
property damage to others with respect to its operations. However, such
insurance may not be sufficient to protect ST Pipeline against liability for
all consequences of well disasters, extensive fire damage or damage to the
environment.
Government Regulation and Environmental
Matters
General.
ST
Pipelines operations are affected from time to time in varying degrees by
political developments and federal, state and local laws and regulations. In
particular, natural gas production, operations and economics are or have been
affected by price controls, taxes and other laws relating to the natural gas
industry, by changes in such laws and by changes in administrative regulations.
Although significant capital expenditures may be required to comply with such
laws and regulations, to date, such compliance costs have not had a material
adverse effect on the earnings or competitive position of ST Pipeline. In
addition, ST Pipelines operations are vulnerable to risks arising from the
numerous laws and regulations governing the discharge of materials into the
environment or otherwise relating to environmental protection.
Environmental Regulation.
ST Pipelines activities are subject to existing federal, state and local laws
and regulations governing environmental quality, pollution control and the
preservation of natural resources. Such laws and regulations concern, among
other things, the containment, disposal and recycling of waste materials, and
reporting of the storage, use or release of certain chemicals or hazardous
substances. Numerous federal and state environmental laws regulate drilling
activities and impose liability for discharges of waste or spills, including
those in coastal areas. ST Pipeline has conducted pipeline construction in or
near ecologically sensitive areas, such as wetlands and coastal environments,
which are subject to additional regulatory requirements. State and federal
legislation also provide special protections to animal and marine life that
could be affected by ST Pipelines activities. In general, under various
applicable environmental programs, ST Pipeline may potentially be subject to
regulatory enforcement action in the form of injunctions, cease and desist
orders and administrative, civil and criminal penalties for violations of
environmental laws. ST Pipeline may also be subject to liability for natural
resource damages and other civil claims arising out of a pollution event. ST
Pipeline would be responsible for any pollution event that was caused by its
actions. It has insurance that it believes is adequate to cover any such
occurrences.
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Environmental
regulations that affect ST Pipelines customers also have an indirect impact on
ST Pipeline. Increasingly stringent environmental regulation of the natural gas
industry has led to higher drilling costs and a more difficult and lengthy well
permitting process.
The
primary environmental statutory and regulatory programs that affect ST
Pipelines operations include the following: Department of Transportation
regulations, regulations set forth by agencies such as Federal Energy
Regulatory Commission and various environmental agencies including state,
federal and local government.
Health And Safety Matters.
ST Pipelines facilities and operations are also governed by various other laws
and regulations, including the federal Occupational Safety and Health Act,
relating to worker health and workplace safety. As an example, the Occupational
Safety and Health Administration has issued the Hazard Communication Standard.
This standard applies to all private-sector employers, including the natural
gas exploration and producing industry. The Hazard Communication Standard
requires that employers assess their chemical hazards, obtain and maintain
certain written descriptions of these hazards, develop a hazard communication
program and train employees to work safely with the chemicals on site. Failure
to comply with the requirements of the standard may result in administrative,
civil and criminal penalties. ST Pipeline believes that appropriate precautions
are taken to protect employees and others from harmful exposure to materials
handled and managed at its facilities and that it operates in substantial
compliance with all Occupational Safety and Health Act regulations. While it is
not anticipated that ST Pipeline will be required in the near future to make
material expenditures by reason of such health and safety laws and regulations,
ST Pipeline is unable to predict the ultimate cost of compliance with these
changing regulations.
Research and Development/Intellectual
Property
ST
Pipeline has not made any material expenditures for research and development.
ST Pipeline does not own any patents, trademarks or licenses.
Legal Proceedings
ST
Pipeline is not a party to any legal proceedings, other than in the ordinary
course of business, that if decided in a manner adverse to ST Pipeline would be
materially adverse to ST Pipelines financial condition or results of
operations.
Facilities and Other Property
ST
Pipeline operates from its main office at 5 Youngstown Drive, Clendenin, West
Virginia. This property is leased at a cost of $3,750 per month. In addition,
ST Pipeline is currently leasing a warehouse lot in Prestonsburg, Kentucky. The
lease payment on the lot is $300 per month. ST Pipeline believes that its
properties are adequate to support its operations.
Employees
As
of December 31, 2007, ST Pipeline had approximately 226 employees, of which
approximately 27 were salaried and approximately 199 were employed on an hourly
basis. A number of ST Pipelines employees are represented by trade unions
represented by any collective bargaining unit. ST Pipelines management believes
that ST Pipelines relationship with its employees is good.
104
ST
Pipeline may from time to time be involved in litigation arising in the
ordinary course of business. At December 31, 2007, ST Pipeline was not involved
in any material legal proceedings, the outcome of which would have a material
adverse effect on its financial condition or results of operations.
MANAGEMENTS
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF ST PIPELINE
You
should read the following discussion of the financial condition and results of
operations of ST Pipeline in conjunction with ST Pipelines historical combined
financial statements and related notes contained elsewhere herein. Among other
things, those historical combined financial statements include more detailed
information regarding the basis of presentation for the following information.
Forward-Looking Statements
Within
ST Pipelines financial statements and this discussion and analysis of the
financial condition and results of operations, there are included statements
reflecting assumptions, expectations, projections, intentions or beliefs about
future events that are intended as forward-looking statements under the
Private Securities Litigation Reform Act of 1995. You can identify these
statements by the fact that they do not relate strictly to historical or
current facts. They use words such as anticipate, estimate, project,
forecast, may, will, should, could, expect,
believe, intend and
other words of similar meaning.
These
forward-looking statements are not guarantees of future performance and involve
or rely on a number of risks, uncertainties, and assumptions that are difficult
to predict or beyond our control. ST Pipeline has based it s forward-looking
statements on managements beliefs and assumptions based on information
available to the management at the time the statements are made. Actual
outcomes and results may differ materially from what is expressed, implied and
forecasted by the forward-looking statements and that any or all of the
forward-looking statements may turn out to be wrong. They can be affected by
inaccurate assumptions and by known or unknown risks and uncertainties.
ST
Pipelines forward-looking statements, whether written or oral, are expressly
qualified by these cautionary statements and any other cautionary statements
that may accompany such forward-looking statements or that are otherwise
included in this report. In addition, ST Pipeline does undertake and expressly
disclaims any obligation to update or revise any forward-looking statements to
reflect events or circumstances after the date of this report or otherwise.
Introduction
ST
Pipeline is a regional provider of contracting services to the natural gas
industry and the oil industry. ST Pipeline derives its revenues from one
reportable segment. ST Pipeline customers are primarily natural gas and oil
companies. ST Pipeline had total revenues of $100.4 million for the year ended
December 31, 2007, which primarily came from the natural gas industry.
ST
Pipelines customers include many of the leading companies in the natural gas
and oil industries. ST Pipeline strives to make and keep strong relationships
with all its customers and where possible to maintain and keep a status as a
preferred vendor. ST Pipeline enters into various types of contracts, including
competitive unit price, cost-plus (or time and materials basis) and fixed price
(lump sum) contracts. The terms of the contracts will vary greatly from job to
job and customer to customer though most contracts are on the basis of either
the unit pricing in which we agree to do the work for a price per unit of work
performed or for a fixed amount for the entire project. Most of ST Pipelines
projects are completed within one year from the start of the work. Some of ST
Pipelines customers
105
require ST
Pipeline to post performance and/or payment bonds upon execution of the
contract, depending upon the nature of the work performed.
ST
Pipeline generally recognizes revenue on its unit price and cost-plus contracts
when units are completed or services are performed. For fixed price contracts,
ST Pipeline usually records revenues as work on the contract progresses on a
percentage of completion basis. Under this valuation method, revenue is
recognized based on the percentage of total costs incurred to date in
proportion to total estimated costs to complete the contract. Many contracts
also include retainage provisions under which a percentage of the contract
price is withheld until the project is complete and has been accepted by our
customer.
ST
Pipeline is taxed as an S-Corporation. Accordingly, the financial statements do
not contain any provision for income taxes.
Seasonality and cyclical nature: Fluctuation
of Results
ST
Pipelines revenues and results of operations can and usually are subject to
seasonal variations. These variations are the result of weather, customer
spending patterns, bidding seasons and holidays. The first quarter of the year
typically produces the lowest revenues because inclement weather conditions
cause delays in production and customers usually do not plan large projects
during that time. The second quarter often has some inclement weather which can
cause delays in production. The third quarter usually is least impacted by
weather and usually has the largest number of projects underway. The fourth
quarter is usually lower than the third due to the various holidays. Many
projects are completed in the fourth quarter and revenues are often impacted by
customers seeking to either spend their capital budget for the year or scale
back projects due to capital budget overruns. However, in rare circumstances in
which the weather is less inclement in the first and second quarters, those
quarters could perform better than normal while if there would occur more
inclement weather in the third or fourth quarter or customers cut back on their
spending, the performances in those quarters could be less.
In
addition to the fluctuations discussed above, our industry can be highly
cyclical. As a result, ST Pipelines volume of business may be adversely
affected by where customers are in the cycle and thereby their financial
condition as to their capital needs and access to capital to finance those needs.
For example ST Pipeline would normally be bidding and getting contracts in the
first quarter of the year. However, going into 2007, ST Pipeline had the
contract for the large project in place and had a backlog of $57.3 million
going into the year. For 2008, ST Pipeline is in a more normal position with a
backlog of $5.4 million and will be bidding for many contracts during the first
quarter.
Accordingly,
ST Pipelines operating results in any particular quarter or year may not be
indicative of the results that can be expected for any other quarter or any
other year. Please see
Understanding Gross
Margins
and
Outlook
below for discussions of trends and challenges that may affect ST Pipelines
financial condition and results of operations.
Understanding Gross Margins
ST
Pipelines gross margin is gross profit expressed as a percentage of revenues.
Cost of revenues consists primarily of salaries, wages and some benefits to
employees, depreciation, fuel and other equipment, equipment rentals,
subcontracted services, portions of insurance, facilities expense, materials
and parts and supplies. Various factors, some of which are controllable (e.g.,
our fixed costs) and some of which are not (e.g., weather-related delays)
impact ST Pipelines gross margin on a quarterly or annual basis.
106
Seasonal.
As discussed above, seasonal patterns can have a
significant impact on gross margins. Usually, business is slower in the winter
months versus the warmer months. Competition for projects may be greater during
the winter months when most contractors are experiencing slower amounts of
business.
Weather.
Adverse or favorable weather conditions can impact
gross margin in a given period. Periods of wet weather, snow or rainfall, as
well severe temperature extremes can severely impact production and therefore
negatively impact revenues and margins. Conversely, periods of dry weather with
moderate temperatures can positively impact revenues and margins due to the
opportunity for increased production and efficiencies.
Revenue
Mix.
The mix of revenues between customer types and
types of work for various customers will impact gross margins. Some projects
will have more margins while others that are extremely competitive in bidding
may have narrower margins.
Service
and Maintenance Compared to Installation.
In general,
installation work has a higher gross margin than maintenance work. This is due
to the fact that installation work usually is more of a fixed price nature and
therefore has higher risks involved. Accordingly, a higher portion of the
revenue mix from installation work typically will result in higher margins.
Subcontract
work
. Work that is subcontracted to other service
providers generally has lower gross margins. Increases in subcontract work as a
percentage of total revenues in a given period may contribute to a decrease in
gross margin.
Materials
and Labor
. Typically materials supplied on projects
have smaller margins than labor. Accordingly, projects with a higher material
cost in relation to the entire job will have a lower overall margin.
Depreciation.
Depreciation is included in our cost of revenue. This
is a common practice in ST Pipelines industry, but can make comparability to
other companies difficult.
Selling, General and Administrative Expenses
Selling,
general and administrative expenses consist primarily of compensation and
related benefits to management, administrative salaries and benefits, marketing,
communications, office and utility costs, professional fees, bad debt expense,
letter of credit fees, general liability insurance and miscellaneous other
expenses.
107
Results of Operations
The
following table sets forth the statements of operations data and such data as a
percentage of revenues for the years indicated (dollars in thousands):
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|
|
|
|
|
|
2007
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
|
Amount
|
|
Percent
|
|
Amount
|
|
Percent
|
|
Amount
|
|
Percent
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
100,385
|
|
|
100.0
|
%
|
$
|
49,772
|
|
|
100.0
|
%
|
$
|
22,936
|
|
|
100.0
|
%
|
Cost of Revenue
|
|
|
70,948
|
|
|
70.7
|
%
|
|
(45,123
|
)
|
|
90.7
|
%
|
|
20,538
|
|
|
89.4
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross Profit
|
|
|
29,437
|
|
|
29.3
|
%
|
|
4,649
|
|
|
9.3
|
%
|
|
2,398
|
|
|
10.5
|
%
|
Selling, general and administrative expenses
|
|
$
|
1,547
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|
|
1.5
|
%
|
$
|
1,296
|
|
|
2.6
|
%
|
$
|
980
|
|
|
4.3
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income from operations
|
|
|
27,890
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|
|
27.8
|
%
|
|
3,353
|
|
|
6.7
|
%
|
|
1,418
|
|
|
6.2
|
%
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense
|
|
|
(299
|
)
|
|
0.3
|
%
|
|
(289
|
)
|
|
0.6
|
%
|
|
(72
|
)
|
|
0.3
|
%
|
Interest income
|
|
|
45
|
|
|
0.0
|
%
|
|
(60
|
)
|
|
(0.1
|
)%
|
|
17
|
|
|
(0.1
|
)%
|
Net other
|
|
|
308
|
|
|
(0.3
|
)%
|
|
212
|
|
|
(1.4
|
)%
|
|
287
|
|
|
(1.3
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before tax
|
|
|
27,944
|
|
|
27.8
|
%
|
|
3,336
|
|
|
6.7
|
%
|
|
1,650
|
|
|
7.2
|
%
|
Provision for income taxes
|
|
|
|
|
|
0.0
|
%
|
|
|
|
|
0.0
|
%
|
|
|
|
|
0.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
|
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|
|
Net income
|
|
$
|
27,944
|
|
|
27.8
|
%
|
$
|
3,336
|
|
|
6.7
|
%
|
$
|
1,650
|
|
|
7.2
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comparison
of Operating Results of the years ended December 31, 2007 and 2006
Revenues.
Revenues increased by $50.6 million or 101.6% to
$100.4 million for the year ended December 31, 2007. This increase was
primarily due to the fact that ST Pipeline was the successful bidder on a $92
million contract for 69 miles of 20 inch pipe and substantially completed that
project during 2007.
Cost
of Revenues
. Cost of revenues increased for 2007 by
$25.8 million or 57.2% to $70.9 million for the year ended December 31, 2007
from $45.1 million for the year ended December 31, 2006. This increase was
directly attributable to the large project referenced above.
Gross
Profit.
Gross profit increased $24.8 million, or 538%
to $29.4 million for the year ended December 31, 2007. As a percentage of
revenue, gross profit increased from 9.3% to 29.3%. The primary driver of this
increase was the increased revenues that occurred because of the large job and
the fact that the Companys fixed costs did not increase proportionately. Also,
due to the added risk in the larger job, it had much higher margins built into
it.
Selling,
General and Administrative Expenses.
Selling, general
and administrative expenses increased by $251,000, or 19.4% to $1.5 million for
the year ended December 31, 2007. This increase was primarily due to legal and professional fees associated
with our initial audit and other accounting and legal matters.
Income
from Operations.
Income from operations increased $24.5 million or 731.7% to $27.9
million for the year ended December 31, 2007 from $3.3 million for the year
ended December 31, 2006. As with the gross profit, the increased
revenues were associated with the large project referenced above as well as ST
Pipelines fixed costs not increasing proportionately.
Interest
Expense.
Interest expense increased $10,000 to
$300,000 for the year ended December 31, 2007. This increase was driven
primarily by the periodic borrowings from an existing line of credit to finance
the initial costs of new projects added revenue volumes.
108
Income
taxes.
Income taxes have not been provided because ST Pipeline by consent of
its shareholders has elected to be taxed as an S-Corporation. Accordingly,
income or loss is passed through to its shareholders, who are taxed at their
individual rates.
Net
Income.
Net
income increased by $24.6 million or 737.6% to $27.9 million for the year ended
December 31, 2007, from net income of $3.3 million for the year ended December
31, 2006. The increased revenue volume and margin of profitability as discussed
in the gross margin section was the primary reasons for this increased net
income.
Comparison
of Operating Results of the Years ended December 31, 2006 and 2005
Revenues.
Revenues increased by $26.8 million, or 117.0%, to
$49.8 million for the year ended December 31, 2006. The increase was due to an
increase in the number of larger projects awarded to ST Pipeline and an
increase in the overall number of projects initiated for customers.
Cost
of Revenues
. Cost of revenues increased by $24.5
million, or 120.0%, to $45.1 million for the year ended December 31, 2007, from
$ 20.5 million for the year ended December 31, 2006. The increase was primarily
due to the increase in contracts discussed above, with the cost of revenue
percentage remaining relatively unchanged from the prior year.
Gross
Profit.
Gross profit increased $2.2 million, or 93.9%,
to $4.6 million for the year ended December 31, 2006. As a percentage of
revenue, gross profit decreased from 10.5% to 9.3%. The primary reason for this
decrease was the mix of jobs that ST Pipeline performed during the year,
including some projects with lower margins due to unanticipated higher costs of
completion.
Selling,
General and Administrative Expenses.
Selling, general
and administrative expenses increased by $315,000, or 32.2%, to $1.3 million
for the year ended December 31, 2006. This increase was primarily due to
increased General Liability insurance as the number and size of the projects ST
Pipeline worked on increased.
Income
from Operations.
Income from operations increased by $1.9
million, or 136.7%, to $3.4 million for the year ended December 31, 2006, from
$1.4 million for the year ended December 31, 2005. This increase was due to
larger, new projects and an increase in the projects awarded to ST Pipeline.
Interest
Expense.
Interest Expense increased $217,000 to
$289,000 at December 31, 2006. This increase was a result of the increased use
of the lines of credit to maintain new projects as the number and size of our
projects increased.
Income
Taxes
. Income taxes have not been provided because ST
Pipeline by consent of its shareholders has elected to be taxed as an
S-Corporation. Accordingly, income or loss is passed through to its
shareholders and taxed at their individual rates.
Net
Income
. Net income increased by $1.7 million to $3.3
million for the year ended December 31, 2006, from $1.7 million for the year
ended December 31, 2005. This increase was the result of additional revenues
from the increase in the number and size of the projects ST Pipeline worked on.
Comparison of
Financial Condition at December 31, 2007 and 2006
Assets.
Assets increased by $22.3 million to $33.4
million at December 31, 2007, from $11.1 million at December 31, 2006. The
increase was due in large part to accounts receivable, which increased by $19.7
million to $26.4 million due to the increased revenues in 2007.
109
Liabilities.
Liabilities
increased from $6.3 million at December 31, 2006 to $9.7 million at December
31, 2007. This increase was due primarily to the increased utilization of
existing lines of credit and accounts payable related to the increase in ST
Pipelines revenues.
Stockholders
Equity.
Stockholders equity increased from $4.9 million at December 31, 2006 to $23.7
million at December 31, 2006 due to the increased net income for 2007 of $27.9
million, partially offset by $9.1 million of distributions to stockholders. It
is the intention of ST Pipeline to distribute all of its 2007 net income,
excluding $4.2 million, to shareholders prior to the closing of the acquisition
of ST Pipeline by Energy Services Acquisition Corp. in accordance with the
Agreement and Plan of Merger.
Liquidity and Capital Resources
Cash Requirements
Our
cash and cash equivalents at December 31, 2007 was $3.9 million. The cash and
cash equivalents, along with our available credit facilities and our
anticipated future cash flows from operations, should provide sufficient cash
to meet our operating needs. However, with the current high energy demand and
the resulting increased demand for our services, we could need significant
additional working capital.
Sources and Uses of Cash
As
of December 31, 2007, we had $3.9 million in cash, working capital of $21.1
million and long term debt net of current maturities of $176,000. The long term
debt consists primarily of term debt for equipment purchases. The maturities of
the total long term debt is as follows:
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|
|
|
|
|
|
|
2008
|
|
2009
|
|
2010
|
|
|
|
|
|
$
|
262,247
|
|
$
|
122,704
|
|
$
|
53,292
|
Off-Balance Sheet transactions
Due
to the nature of our industry, we often enter into certain off-balance sheet
arrangements in the ordinary course of business that result in risks not
directly reflected in our balance sheets. Though most of the following
off-balance sheet arrangements are not material in nature, they include:
Leases.
Our work often requires us to lease various
facilities, equipment and vehicles. These leases are usually short term in
nature (one year or less) though we occasionally may enter into longer term
leases when warranted. By leasing equipment, vehicles and facilities, we are
able to reduce are capital outlay requirements for equipment vehicles and
facilities that we may only need for short periods of time. ST Pipeline rents
real estate from its stockholders-officers under long-term lease agreements.
The lease agreement requires monthly rental payments of $3,750 and extends
through January 1, 2012. ST Pipeline believes these rental payments are at
market rates.
Letters
of Credit.
Certain of ST Pipelines customers and
vendors may require letters of credit to secure payments that the vendors are
making on its behalf or to secure payments to subcontractors, vendors, etc. on
various customer projects. At December 31, 2007, ST Pipeline was contingently
liable on an irrevocable letter of credit for $825,280 to guarantee payments of
insurance premiums to the group captive insurance company through which ST
Pipeline obtains its general liability insurance.
Performance
Bonds
. Some customers, particularly new ones or
governmental agencies require ST Pipeline to post bid bonds, performance bonds
and payment bonds. These bonds are obtained through
110
insurance
carriers and guarantee to the customer that ST Pipeline will perform under the
terms of a contract and that ST Pipeline will pay subcontractors and vendors.
If ST Pipeline fails to perform under a contract or to pay subcontractors and
vendors, the customer may demand that the insurer make payments or provide
services under the bond. ST Pipeline must reimburse the insurer for any
expenses or outlays it is required to make. Depending upon the size and
conditions of a particular contract, ST Pipeline may be required to post
letters of credit or other collateral in favor of the insurer. Posting of these
letters or other collateral will reduce ST Pipelines borrowing capabilities.
Historically, ST Pipeline has never had a payment made by an insurer under
these circumstances and does anticipate any claims in the foreseeable future.
At December 31, 2007, ST Pipeline had no bonds issued by the insurer
outstanding.
Contractual
Obligations
. At December 31, 2007, ST Pipeline had
future contractual obligations as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2008
|
|
2009
|
|
2010
|
|
2011
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Long Term
Debt
|
|
$
|
262,247
|
|
$
|
122,704
|
|
$
|
53,292
|
|
$
|
|
|
Lease
Payments
|
|
|
45,000
|
|
|
45,000
|
|
|
45,000
|
|
|
45,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
307,247
|
|
$
|
167,704
|
|
$
|
98,292
|
|
$
|
45,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Concentration
of Credit Risk
.
In the ordinary
course of business ST Pipeline grants credit under normal payment terms,
generally without collateral, to our customers, which include natural gas and
oil companies, general contractors, and various commercial and industrial
customers located within the United States. Consequently, ST Pipeline is
subject to potential credit risk related to business and economic factors that
would affect these companies. However, ST Pipeline generally has certain
statutory lien rights with respect to services provided. Under certain
circumstances such as foreclosure, ST Pipeline may take title to the underlying
assets in lieu of cash in settlement of receivables. ST Pipeline had only one
customer that exceeded ten percent of revenues for the year ended December 31,
2007. This was Equitrans LP which accounted for 92% of revenues for the year
ended December 31, 2007.
Litigation.
ST Pipeline is a
party from time to time to various lawsuits, claims and other legal proceedings
that arise in the ordinary course of business. These actions typically seek,
among other things, compensation for alleged personally injury, breach of
contract and/or property damages, punitive damages, civil penalties or other
losses, or injunctive or declaratory relief. With respect to all such lawsuits,
claims, and proceedings, ST Pipeline records reserves when it is probable that
a liability has been incurred and the amount of loss can be reasonably
estimated. ST Pipeline does not believe that any of these proceedings,
separately or in aggregate, would be expected to have a material adverse effect
on its financial position, results of operations or cash flows.
Related
Party Transactions
. Other than the lease of certain
buildings by ST Pipeline from its principal owners, there are no related party
transactions. The annual rental payment during 2007 was $45,000, which ST
Pipeline believes is at the market rate.
Inflation
Due
to relatively low levels of inflation during the years ended December 31, 2005,
2006 and 2007, inflation did not have a significant effect on ST Pipelines
results.
111
New Accounting Pronouncements
In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements SFAS
No. 157 defines fair value, establishes methods used to measure fair value and
expands disclosure requirements about fair value measurements. SFAS No. 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal periods, as it
relates to financial assets and liabilities that are carried at fair value.
SFAS No. 157 also requires certain tabular disclosures related to results of
applying SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets and SFAS No. 142, Goodwill and Other Intangible Assets. On November
14, 2007, the FASB provided a one-year deferral for the implementation of SFAS
No. 157 for non-financial assets and liabilities. SFAS No. 157 excludes from
its scope SFAS No. 123 (R), Share-Based Payment and its related interpretive
accounting pronouncements that address share-based payment transactions. Based
on the assets and liabilities on ST Pipelines balance sheet as of December 31,
2007, ST Pipeline does not expect the adoption of SFAS No. 157 to have a
material impact on its consolidated financial position, results of operations
or cash flows.
In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, including an amendment of FASB
Statement No. 115. SFAS No. 159 permits entities to choose to measure at fair
value many financial instruments and certain other items at fair value that are
not currently required to be measured. Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings. SFAS No.
159 does not affect any existing accounting literature that requires certain
assets and liabilities to be carried at fair value. SFAS No. 159 is effective
for fiscal years beginning after November 15, 2007. Based on the assets and
liabilities on ST Pipelines balance sheet as of December 31, 2007, ST Pipeline
does not expect the adoption of SFAS No. 159 to have any impact on its
consolidated financial position, results of operations or cash flows.
Critical Accounting Policies
The
discussion and analysis of ST Pipelines financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles generally
accepted in the United States. The preparation of these consolidated financial
statements requires us to make estimates and assumptions that affect the
reported amounts of assets and liabilities, disclosures of contingent assets
and liabilities known to exist at the date of the consolidated financial
statements and reported amounts of revenues and expenses during the reporting
period. ST Pipeline evaluates its estimates on an ongoing basis, based on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances. There can be no assurance that actual
results will not differ from those estimates. ST Pipelines management believes
the following accounting policies affect its more significant judgments and
estimates used in the preparation of its consolidated financial statements.
Revenue
Recognition.
ST Pipeline recognizes revenue when
services are performed except when work is being performed under a fixed price
contract. Revenue from fixed price contracts are recognized under the
percentage of completion method, measured by the percentage of costs incurred to
date to total estimated costs for each contract. Such contracts generally
provide that the customer accept completion of progress to date and compensate
us for services rendered, measured typically in terms of units installed, hours
expended or some other measure of progress. Contract costs typically include
all direct material, labor and subcontract costs and those indirect costs
related to contract performance, such as indirect labor, supplies, tools,
repairs and depreciation. Cost provisions for the total estimated losses on
uncompleted contracts are made in the period in which such losses are
determined. Changes in job performance, job conditions, estimated profitability
and final contract settlements may result in revisions to costs and income and
their effects are recognized in the period in which the revisions are
determined.
112
Self
Insurance.
ST Pipeline is insured for general
liability insurance through a captive insurance company. While ST Pipeline
believes that this arrangement has been very beneficial in reducing and
stabilizing insurance costs, ST Pipeline does have to maintain a letter of
credit to guarantee payments of premiums. Should the captive insurance company
experience severe losses over an extended period, it could have a detrimental
affect on ST Pipeline.
Current
and Non Current Accounts Receivable and Provision for Doubtful Accounts.
ST
Pipeline provides an allowance for doubtful accounts when collection of an
account is considered doubtful. Inherent in the assessment of the allowance for
doubtful accounts are certain judgments and estimates relating to, among
others, our customers access to capital, our customers willingness or ability
to pay, general economic conditions and the ongoing relationship with the customer.
While most of ST Pipelines customers are large well capitalized companies,
should they experience material changes in their revenues and cash flows or
incur other difficulties and not be able to pay the amounts owed, this could
cause reduced cash flows and losses in excess of our current reserves. At
December 31, 2007, the management review deemed that no allowance for doubtful
accounts was necessary.
Outlook
The
following statements are based on current expectations. These statements are
forward-looking, and actual results may differ materially.
With
the current high energy demand, ST Pipelines customers are experiencing high
demand for their products. Accordingly, ST Pipeline anticipates projected
spending for its customers on their transmission and distribution systems
increasing over the next few years. Although ST Pipeline believes it may enter
into substantial new projects during 2008, the backlog at December 31, 2007 was
$5.4 million versus $57.3 million at December 31, 2006 and no assurances can be
given that ST Pipeline will be successful in those bidding processes.
Assuming
this anticipated growth occurs, we will be required to make additional capital
expenditures for equipment. Currently, it is anticipated that in 2008, ST
Pipelines capital expenditures may be between $2.5 and $3.0 million. Assuming
customer demand continues to increase, this requirement could materially
change. Significantly higher capital expenditure requirements will adversely
affect ST Pipelines cash flow and require additional borrowings.
Recent Developments
On
January 22, 2008, ST Pipeline entered into an agreement to be acquired by
Energy Services Acquisition Corp. Management believes that becoming affiliated
with the larger, well capitalized company will enable ST Pipeline to have more
flexibility in meeting the needs of its customers and in financing the
continued anticipated growth. The transaction is conditioned on the approval of
the Energy Services shareholders and less than 20 percent of those
shareholders exercising their right of redemption.
INFORMATION
ABOUT C.J. HUGHES
Business Overview
C.J.
Hughes Construction, Inc. was organized in 1946 as a corporation under the laws
of West Virginia and is primarily engaged in the construction, replacement and
repair of natural gas pipelines for utility companies and private natural gas
companies. In addition, C.J. Hughes also engages in the installation of water
and sewer lines and provides various maintenance and repair services for
customers. The majority of C.J. Hughes customers are located in West Virginia,
Virginia, Ohio, Kentucky and North Carolina. C.J. Hughes builds, but does not
own, natural gas pipelines for its customers that are part of
113
both interstate
and intrastate pipeline systems that move natural gas from producing regions to
consumption regions as well as building and replacing gas line services to
individual customers of the various utility companies. C.J. Hughes is involved
in the construction of both interstate and intrastate pipelines, with an
emphasis on the latter. C.J. Hughes also constructs storage facilities for its
natural gas customers. C.J. Hughes other services include liquid pipeline
construction, pump station construction, production facility construction,
water and sewer pipeline installations, and other services related to pipeline
construction. At December 31, 2007, C.J. Hughes had 156 employees. Since 2002,
C.J. Hughes has completed over 350 miles of pipeline, with its longest project
consisting of 10 miles of 20-inch pipe. C.J. Hughes is not directly involved in
the exploration, transportation or refinement of natural gas.
Acquisition
of Nitro Electric
In
May of 2007, C.J. Hughes acquired Nitro Electric Company LLC. Nitro Electric
has been in business since 1960. Nitro Electric provides a full range of
electrical contracting services to various industries. These services include
substation and switchyard services, including site preparation, packaged buildings,
dry and oil-filled transformer installations and other ancillary work with
regards thereto. Nitro Electric also provides general electrical services such
as underground, conduit/raceway, testing, cable installation, switchgear
lineups as well as a full range of data and communication installation services
such as fiber optics, attenuation and OTDR testing, cell/hub systems and
various other electrical services to the industrial sector. Though Nitro
Electric has numerous customers, its primary focus since becoming part of C.J.
Hughes has been the completion of a large project for Hitachi America. That
project in Council Bluffs, Iowa, was the largest project for Nitro Electric for
2007. For the year ended December 31, 2007, Nitro Electrics operations contributed
$36.1 million of revenue to C.J. Hughes total revenues. Unless otherwise
stated, references to C.J. Hughes include Nitro Electric.
Set
forth below is information regarding the sales, assets and operating income of
C.J. Hughes business.
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Year Ended
December 31
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2007
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2006
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2005
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Sales
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$
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75,305,234
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$
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31,604,911
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$
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29,368,850
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Total assets
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27,248,499
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14,413,914
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12,811,708
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Operating Income
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3,990,841
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|
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451,955
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|
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2,174,147
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Sales by product line
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Pipeline
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$
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39,431,085
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$
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31,604,911
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$
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29,368,850
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Electrical
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36,098,589
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At
December 31, 2007, C.J. Hughes largest current project consists of a project
for Spectra Energy to start in early 2008 to install 11 miles of 30-inch pipe.
C.J.
Hughes is subject to extensive state and federal regulation, particularly in
the areas of the siting and construction of new pipelines. The work performed
by C.J. Hughes on many projects relates to lines that are regulated by the U.S.
Department of Transportation and therefore the work must be performed within
the rules and guidelines of the U.S. Department of Transportation. In addition,
work at the various sites must comply with all Federal, state or local environmental
laws.
C.J.
Hughes has a related company for accounting purposes that is called Contractors
Rental Corporation. A condition of the transaction with Energy Services is that
C.J. Hughes acquires Contractors Rental prior to closing. The primary business
of Contractors Rental is that it acts as a subsidiary to C.J. Hughes and
provides labor and some equipment to complete contracts that C.J. Hughes has
been awarded. Contractors Rentals contributions to C.J. Hughes results of
operations and financial condition are not material.
All of Contractors Rentals
revenue is derived from C.J. Hughes. Contractors Rental is considered a variable
interest entity under FASB Interpretation 46R,
Consolidation
of Variable Interest Entities,
and as such the consolidated
financial statements of C.J. Hughes include the accounts of Contractors Rental.
114
Customers and Marketing
C.J.
Hughes customers include Equitable Resources and various of its subsidiaries,
Nisource/Columbia Gas Transmission, Nisource/Columbia Gas of Ohio and
Pennsylvania, Kentucky American Water, Marathon Ashland Petroleum LLC and
various state, county and municipal public service districts. During the year
ended December 31, 2007, Columbia Gas of Ohio was C.J. Hughes largest
customer, accounting for approximately 20% of total revenues. Other customers
who represented over 10% of revenues in 2007 included Marathon Ashland
Petroleum LLC at 18% and Columbia Gas of Pennsylvania at 12%. C.J. Hughes is
not dependent upon any single customer and C.J. Hughes does not believe that
the loss of any single customer would have a material adverse effect on its
business. There can be no assurance that Columbia Gas of Ohio or any of C.J.
Hughes other principal customers will continue to employ C.J. Hughes services
or that the loss of any of such customers or adverse developments affecting any
of such customers would not have a material adverse effect on C.J. Hughes
financial condition and results of operations.
C.J.
Hughes sales force consists of industry professionals with significant
relevant sales and work experience who utilize industry contacts and available
public data to determine how to most appropriately market C.J. Hughes
services. We rely on direct contact between our sales force and our customers
engineering and contracting departments in order to obtain new business. Due to
the occurrence of inclement weather during the winter months, the business of
C.J. Hughes (i.e., the construction of pipelines) is somewhat seasonal in that
most of the work is performed during the non-winter months.
Nitro
Electrics customers include Hitachi of America, American Electric Power,
Toyota and numerous other local companies. Due to the large job that was
underway in 2007, Hitachi of America was the largest customer of Nitro
Electric, accounting for approximately 63% of total revenues for the period
that Nitro Electric was owned by C.J. Hughes (May through December). Other
customers who represented over 10% of revenues of Nitro Electric included
Toyota (18%) and American Electric Power (11%). While Nitro Electric had a
large portion of its resources devoted to the Hitachi of America project in
2007, it is believed that in 2008 and beyond, there are many opportunities to
widen the customer base. However, there can be no assurance that Hitachi of
Americas business will continue and in fact the above described project should
be completed in early 2008. Further, while it appears likely that most of Nitro
Electrics other customers will continue to do business with Nitro Electric, no
assurances can be given to that occurring.
As
with C.J. Hughes, the sales force for Nitro Electric consists of industry
professionals with significant sales and work experience who utilize industry
contacts and available public data to determine how to most appropriately
market Nitro Electrics services. They rely on direct contact between their
sales force and the customers engineering and contracting departments in order
to obtain new business. While inclement weather can have some effect on Nitro
Electrics business, that effect is much less than the effect of inclement
weather on C.J. Hughes.
Backlog/New Business
A
companys backlog represents orders or contracts which have not yet been
completed. At December 31, 2007, C.J. Hughes had a backlog of work to be
completed on contracts of $54.2 million. At December 31, 2007, Nitro Electric
had a backlog of approximately $16.4 million. At December 31, 2006, C.J. Hughes
had a backlog of work on contracts of $18.6 million. Due to the timing of C.J.
Hughes and Nitro Electric construction contracts and the long-term nature of
some of our projects, portions of our backlog may not be completed in the
current fiscal year.
115
Types of Contracts
The
contracts for C.J. Hughes are usually awarded on a competitive and negotiated
basis. While contracts may be a lump sum for a project or one that is based
upon time and materials, most of the work is bid based upon unit prices for
various portions of the work. The actual revenues produced from the project
will be dependent upon how accurate the customer estimates are as to the units
of the various items.
Raw Materials and Suppliers
The
principal raw materials that we use are metal plate, structural steel, pipe,
fittings and selected engineering equipment such as pumps, valves and compressors.
For the most part, the largest portion of these materials are supplied by the
customer. The materials that C.J. Hughes purchases would predominately be those
of a consumable nature on the job, such as small tools and environmental
supplies. These materials are available from a variety of suppliers. We
anticipate being able to obtain these materials for the foreseeable future.
Industry Factors
C.J.
Hughes revenues, cash flows and earnings are substantially dependent upon, and
affected by, the level of natural gas exploration, development activity and the
levels of integrity work on existing pipelines. Such activity and the resulting
level of demand for pipeline construction and related services are directly
influenced by many factors over which C.J. Hughes has no control. Such factors
include, among others, the market prices of natural gas, market expectations
about future prices, the volatility of such prices, the cost of producing and
delivering natural gas, government regulations and trade restrictions, local
and international political and economic conditions, the development of
alternate energy sources and the long-term effects of worldwide energy
conservation measures. Substantial uncertainty exists as to the future level of
natural gas exploration and development activity.
C.J.
Hughes cannot predict the future level of demand for its pipeline construction
services, future conditions in the pipeline construction industry or future
pipeline construction rates.
Competition
The
pipeline construction industry is a highly competitive business characterized
by high capital and maintenance costs. Pipeline contracts are usually awarded
through a competitive bid process and, while C.J. Hughes believes that
operators consider factors such as quality of service, type and location of
equipment, or the ability to provide ancillary services, price and the ability
to complete the project in a timely manner are the primary factors in
determining which contractor is awarded a job. There are a number of regional
and national competitors that offer services similar to ours. Certain of C.J.
Hughes competitors have greater financial and human resources than C.J.
Hughes, which may enable them to compete more effectively on the basis of price
and technology. Our largest competitors are Otis Eastern, LA Pipeline and Apex
Pipeline.
The
electrical contracting industry is also a highly competitive business, though
the capital costs are less in that business and the primary costs are labor and
supervision. Electrical contracts are usually awarded through a competitive bid
process. While Nitro Electric believes that operators consider factors such as
quality of service, type and location of equipment, or the ability to provide
ancillary services, price and the ability to complete the project in a timely
manner are the primary factors in determining which contractor is awarded a
job. There are a number of regional and national competitors that offer
services similar to ours. Certain of Nitro Electrics competitors have greater
financial and human
116
resources than
Nitro Electric, which may enable them to compete more effectively on the basis
of price and technology. The largest competitors for Nitro Electric are Green
Electric and Summit Electric, Inc.
Operating Hazards and Insurance
C.J.
Hughes operations are subject to many hazards inherent in the pipeline
construction business, including, for example, operating equipment in
mountainous terrain, people working in deep trenches and people working in
close proximity to large equipment. These hazards could cause personal injury
or death, serious damage to or destruction of property and equipment,
suspension of drilling operations, or substantial damage to the environment,
including damage to producing formations and surrounding areas. C.J. Hughes
seeks protection against certain of these risks through insurance, including
property casualty insurance on its equipment, commercial general liability and
commercial contract indemnity, commercial umbrella and workers compensation
insurance.
C.J.
Hughes and Nitro Electrics insurance coverage for property damage to its
equipment is based on both companies estimates of the cost of comparable used
equipment to replace the insured property. There is a deductible per occurrence
on equipment of $2,500. Third-party liability insurance coverage for both C.J.
Hughes and Nitro Electric under the general policy is $1,000,000 per
occurrence, with a self-insured retention of $0 per occurrence. The commercial
umbrella policy has a self-insured retention of $10,000 per occurrence, with
coverage of $10,000,000 per occurrence.
Government Regulation and Environmental
Matters
General.
C.J.
Hughes operations are affected from time to time in varying degrees by
political developments and federal, state and local laws and regulations. In
particular, natural gas production, operations and economics are or have been
affected by price controls, taxes and other laws relating to the natural gas
industry, by changes in such laws and by changes in administrative regulations.
Although significant capital expenditures may be required to comply with such
laws and regulations, to date, such compliance costs have not had a material
adverse effect on the earnings or competitive position of C.J. Hughes. In
addition, C.J. Hughes operations are vulnerable to risks arising from the
numerous laws and regulations governing the discharge of materials into the
environment or otherwise relating to environmental protection.
Environmental Regulation.
C.J. Hughes and Nitro Electrics activities are subject to existing federal,
state and local laws and regulations governing environmental quality, pollution
control and the preservation of natural resources. Such laws and regulations
concern, among other things, the containment, disposal and recycling of waste
materials, and reporting of the storage, use or release of certain chemicals or
hazardous substances. Numerous federal and state environmental laws regulate
pipeline activities and impose liability for discharges of waste or spills,
including those in coastal areas. C.J. Hughes has conducted pipeline
construction in or near ecologically sensitive areas, such as wetlands and
coastal environments, which are subject to additional regulatory requirements.
State and Federal legislation also provide special protections to animal and
marine life that could be affected by C.J. Hughes activities. In general,
under various applicable environmental programs, C.J. Hughes may potentially be
subject to regulatory enforcement action in the form of injunctions, cease and
desist orders and administrative, civil and criminal penalties for violations
of environmental laws. C.J. Hughes may also be subject to liability for natural
resource damages and other civil claims arising out of a pollution event. C.J.
Hughes would be responsible for any pollution event that was caused by its
actions. It has insurance that it believes is adequate to cover any such
occurrences. While Nitro Electrics business is usually performed in plant type
situations, there are still risks associated with environmental issues that may
occur in those locations.
117
Environmental
regulations that affect C.J. Hughes and Nitro Electrics customers also have
an indirect impact on both companies. Increasingly stringent environmental
regulation of the natural gas industry and the electrical utility companies has
led to higher costs and a more lengthy permitting process.
The
primary environmental statutory and regulatory programs that affect C.J.
Hughes and Nitro Electrics operations include the following: Department of
Transportation regulations, regulations set forth by agencies such and FERC and
various environmental agencies including state, Federal, and local government.
Health and Safety Matters.
C.J. Hughes and Nitro Electrics facilities and operations are also governed
by various other laws and regulations, including the federal Occupational
Safety and Health Act, relating to worker health and workplace safety. As an
example, the Occupational Safety and Health Administration has issued the
Hazard Communication Standard. This standard applies to all private-sector
employers, including the natural gas exploration and producing industry. The
Hazard Communication Standard requires that employers assess their chemical
hazards, obtain and maintain certain written descriptions of these hazards,
develop a hazard communication program and train employees to work safely with
the chemicals on site. Failure to comply with the requirements of the standard
may result in administrative, civil and criminal penalties. C.J. Hughes and
Nitro Electric believe that appropriate precautions are taken to protect
employees and others from harmful exposure to materials handled and managed at
its facilities and that it operates in substantial compliance with all
Occupational Safety and Health Act regulations. While it is not anticipated
that C.J. Hughes or Nitro Electric will be required in the near future to make
material expenditures by reason of such health and safety laws and regulations,
C.J. Hughes and Nitro Electric are unable to predict the ultimate cost of
compliance with these changing regulations.
Research and Development/Intellectual Property
C.J.
Hughes has not made any material expenditures for research and development.
C.J. Hughes does not own any patents, trademarks or licenses.
Properties
C.J.
Hughes owns and operates its main office at 2450 First Avenue, Huntington, West
Virginia 25703. C.J. Hughes will lease temporary locations on an as-needed
basis to accommodate its operations based on the projects it is working on.
Legal Proceedings
C.J.
Hughes is not a party to any legal proceedings, other than in the ordinary
course of business, that if decided in a manner adverse to C.J. Hughes would be
materially adverse to C.J. Hughes financial condition or results of
operations.
118
MANAGEMENTS
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF C.J. HUGHES
Forward-Looking Statements
Within
C.J. Hughes financial statements and this discussion and analysis of the
financial condition and results of operations, there are included statements
reflecting assumptions, expectations, projections, intentions or beliefs about
future events that are intended as forward-looking statements under the
Private Securities Litigation Reform Act of 1995. You can identify these
statements by the fact that they do not relate strictly to historical or
current facts. They use words such as anticipate, estimate, project,
forecast, may, will, should, could, expect,
believe, intend and
other words of similar meaning.
These
forward-looking statements are not guarantees of future performance and involve
or rely on a number of risks, uncertainties, and assumptions that are difficult
to predict or beyond C.J. Hughes control. C.J. Hughes has based its
forward-looking statements on managements beliefs and assumptions, based on
information available to management at the time the statements are made. Actual
outcomes and results may differ materially from what is expressed, implied and
forecasted by forward-looking statements and any or all of C.J. Hughes
forward-looking statements may turn out to be wrong. They can be affected by
inaccurate assumptions and by known or unknown risks and uncertainties.
All
of the forward-looking statements, whether written or oral, are expressly
qualified by these cautionary statements and any other cautionary statements
that may accompany such forward-looking statements or that are otherwise
included in this report. In addition, C.J. Hughes does not undertake and
expressly disclaim any obligation to update or revise any forward-looking
statements to reflect events or circumstances after the date of this report or
otherwise.
Introduction
C.J.
Hughes Construction, Inc. was organized in 1946 as a corporation under the laws
of West Virginia and is primarily engaged in the construction, replacement and
repair of natural gas pipelines for utility companies and private natural gas
companies. In addition, C.J. Hughes also engages in the installation of water
and sewer lines and provides various maintenance and repair services for customers.
The majority of C.J. Hughes customers are located in West Virginia, Virginia,
Ohio, Kentucky and North Carolina. C.J. Hughes builds, but does not own,
natural gas pipelines for its customers that are part of both interstate and
intrastate pipeline systems that move natural gas from producing regions to
consumption regions as well as building and replacing gas line services to
individual customers of the various utility companies. C.J. Hughes is involved
in the construction of both interstate and intrastate pipelines, with an
emphasis on the latter. C.J. Hughes also constructs storage facilities for its
natural gas customers. C.J. Hughes other services include liquid pipeline
construction, pump station construction, production facility construction,
water and sewer pipeline installations, and other services related to pipeline
construction. C.J. Hughes had consolidated revenues of $75.3 million for the
year ended December 31, 2007 of which 48% was attributable to electrical
customers, 30% to natural gas customers, 9% each for the oil industry and
governmental entities and 4% for all other customers.
On
April 30, 2007, C.J. Hughes acquired Nitro Electric Company LLC for $2.7
million dollars in cash. Nitro Electric provides a full range of electrical
contracting services to various industries. These services include substation
and switchyard services, including site preparation, packaged buildings, dry
and oil-filled transformer installations and other ancillary work with regards
thereto.
119
C.J.
Hughes customers include many of the leading companies in the industries it
serves, including Marathon Ashland Petroleum LLC, Spectra Energy and Nisource.
C.J. Hughes enters into various types of contracts, including competitive unit
price, cost-plus (or time and materials basis) and fixed price (lump sum)
contracts. The terms of the contracts will vary from job to job and customer to
customer, though most contracts are on the basis of either unit pricing in
which C.J. Hughes agrees to do the work for a price per unit of work performed
or for a fixed amount for the entire project. Most of C.J. Hughes projects are
completed within one year of the start of the work. On occasion, C.J. Hughes
customers will require the posting of performance and/or payment bonds upon
execution of the contract, depending upon the nature of the work performed.
C.J.
Hughes generally recognizes revenue on unit price and cost-plus contracts when
units are completed or services are performed. Fixed price contracts usually
results in recording revenues as work on the contract progresses on a
percentage of completion basis. Under this accounting method, revenue is
recognized based on the percentage of total costs incurred to date in
proportion to total estimated costs to complete the contract. Many contacts
also include retainage provisions under which a percentage of the contract
price is withheld until the project is complete and has been accepted by C.J.
Hughes customer.
C.J.
Hughes is taxed as an S-Corporation. Accordingly, the financial statements do
not contain any provision for income taxes.
Outlook
The
following statements are based on current expectations. These statements are
forward looking, and actual results may differ materially.
With
the increased demand for energy, C.J. Hughes customers are experiencing high
demand for their products. C.J. Hughes management believes that projected
spending by its customers on their transmission and distribution systems will
increase over the next few years, although there is no assurance that this will
occur.
In
order to be able to take advantage of the growth opportunities that may arise,
C.J. Hughes will be required to make additional capital expenditures. It is
anticipated that in 2008, C.J. Hughes will make capital expenditures of between
$2.5 million and $3.0 million. Significantly higher capital expenditure
requirements will adversely affect C.J. Hughes cash flows and require
additional borrowings.
Recent Developments
On
February 21, 2008, C.J. Hughes entered into an agreement to be acquired by
Energy Services Acquisition Corp. Management believes that becoming affiliated
with the larger, well capitalized company will enable C.J. Hughes to have more
flexibility in meeting the needs of its customers and in financing the
continued anticipated growth in the business. The transaction with Energy
Services Acquisition Corp. is contingent, upon among other things, the approval
of the Energy Services shareholders and less than 20% of those shareholders
exercising their rights of redemption. As described elsewhere, C.J. Hughes and
Energy Services Acquisition Corp. are affiliated companies.
Seasonality: Fluctuation of Results
C.J.
Hughes revenues and results of operations usually are subject to seasonal
variations. These variations are the result of weather, customer spending
patterns, bidding seasons and holidays. The first quarter of the calendar year
typically produces the lowest revenues because inclement weather conditions
frequently cause delays in production and customers tend to not commence large
projects during that
120
time. While
usually better than the first quarter, the second quarter often has some
inclement weather which can cause delays in production. The third quarter
traditionally has the largest number of ongoing projects because it is the
quarter least impacted by weather. Many projects are completed in the fourth
quarter and revenues are often impacted by customers seeking to either spend
their capital budget for the year or scale back projects due to capital budget
overruns.
In
addition to the fluctuations discussed above, C.J. Hughes industry can be
highly cyclical. As a result, C.J. Hughes volume of business may be adversely
affected by instances where its customers are adversely affected by lower
energy prices and consequently they reduce their capital projects.
Accordingly,
C.J. Hughes operating results in any particular quarter or year may not be
indicative of the results that can be expected for any other quarter or any
other year. Please see
Understanding Gross
Margins
and
Outlook
for discussions of trends and challenges that may affect C.J. Hughes financial
condition and results of operations.
Understanding Gross Margins
C.J.
Hughes gross margin is gross profit expressed as a percentage of revenues.
Cost of revenues consists primarily of salaries, wages, benefits to employees,
depreciation, fuel and other equipment expenses, equipment rentals,
subcontracted services, portions of insurance, facilities expense, materials,
parts and supplies. Various factors, some of which are controllable (e.g., our
fixed costs), some of which are not (e.g., weather-related delays), impact C.J.
Hughes gross margin on a quarterly or annual basis.
Seasonal.
As discussed above, seasonal patterns can have a
significant impact on gross margins. Usually, C.J. Hughes business is slower
in the winter months as compared with the warmer months.
Weather.
Adverse or favorable weather conditions can impact
gross margin in a given period. Periods of wet weather, snow or rainfall, as
well as severe temperature extremes can severely impact production and
therefore negatively impact revenues and margins. Conversely, periods of dry
weather with moderate temperatures can positively impact revenues and margins
due to the opportunity for increased production and efficiencies.
Revenue
Mix.
The mix of revenues between customer types and
types of work for various customers will impact gross margins. Some projects
will have greater margins while others that are extremely competitive in
bidding may have narrower margins.
Service
and Maintenance Compared to Installation.
In general,
installation work has a higher gross margin than maintenance work. This is due
to the fact that installation work usually is more of a fixed price nature and
has higher risk and therefore is bid with higher markups to compensate for that
risk. Accordingly, a higher portion of the revenue mix from installation work
typically will result in higher gross margins.
Subcontract
Work
. Work that is subcontracted to other service
providers generally has lower gross margins. Increases in subcontract work as a
percentage of total revenues in a given period may contribute to a decrease in
gross margin.
Materials
and Labor
. Typically, materials supplied on projects
have lower margins than labor. Accordingly, projects with a higher material
cost in relation to the entire job will have a lower gross margin.
121
Depreciation.
Depreciation is included in the cost of revenue. This
is a common practice in C.J. Hughes industry, but can make comparisons to
other companies difficult.
Selling, General and Administrative Expenses
Selling,
general and administrative expenses consist primarily of compensation and
related benefits to management, administrative salaries and benefits,
marketing, communications, office and utility costs, professional fees, bad
debt expense, letter of credit fees, general liability insurance and
miscellaneous other expenses.
Results of Operations
The
following table sets forth the statements of operations data and such data as a
percentage of revenues for the years indicated (dollars in thousands):
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|
|
|
|
|
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2007
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
Amount
|
|
Percent
|
|
Amount
|
|
Percent
|
|
Amount
|
|
Percent
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
75,305
|
|
100.0
|
%
|
|
$
|
31,605
|
|
100.0
|
%
|
|
$
|
29,369
|
|
100.0
|
%
|
|
Cost of Revenues
|
|
|
68,096
|
|
90.4
|
%
|
|
|
29,292
|
|
90.3
|
%
|
|
|
25,172
|
|
83.4
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross Profit
|
|
|
7,209
|
|
9.6
|
%
|
|
|
2,313
|
|
9.7
|
%
|
|
|
4,197
|
|
16.6
|
%
|
|
Selling, general and
administrative expense
|
|
|
3,218
|
|
4.3
|
%
|
|
|
1,861
|
|
8.2
|
%
|
|
|
2,023
|
|
9.2
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income from Operations
|
|
|
3,991
|
|
5.3
|
%
|
|
|
452
|
|
1.4
|
%
|
|
|
2,174
|
|
7.4
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest Expense
|
|
|
(1,063
|
)
|
1.4
|
%
|
|
|
(520
|
)
|
1.6
|
%
|
|
|
(238
|
)
|
0.9
|
%
|
|
Interest Income
|
|
|
51
|
|
(0.1
|
%)
|
|
|
30
|
|
(0.1
|
%)
|
|
|
|
|
0.0
|
%
|
|
Net Other
|
|
|
(2
|
)
|
0.0
|
%
|
|
|
|
|
0.1
|
%
|
|
|
(30
|
)
|
0.1
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) Before Taxes
|
|
|
2,977
|
|
4.0
|
%
|
|
|
(38
|
)
|
(0.2
|
%)
|
|
|
1,906
|
|
6.3
|
%
|
|
Provision (benefit) for
income taxes
|
|
|
275
|
|
0.0
|
%
|
|
|
|
|
0.0
|
%
|
|
|
|
|
0.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before
variable interest entity
|
|
|
2,702
|
|
|
|
|
|
(38
|
)
|
|
|
|
|
1,906
|
|
|
|
|
Income (loss) attributable
to variable interest entity
|
|
|
311
|
|
(0.4
|
%)
|
|
|
(20
|
)
|
|
|
|
|
(42
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Income (loss)
|
|
|
3,013
|
|
4.0
|
%
|
|
|
(58
|
)
|
(0.2
|
%)
|
|
|
1,864
|
|
6.3
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comparison of
Operating Results of the years ended December 31, 2007 and 2006
Revenues.
Revenues increased by $43.7 million, or 138.2%, to
$75.3 million for the year ended December 31, 2007, from $31.6 million for the
year ended December 31, 2006. This increase was made up of two components.
First, C.J. Hughes acquired Nitro Electric and its results are included from
the date of acquisition. From May to December of 2007, Nitro Electric had
revenues of $36.1 million. The remainder of the 2007 increase was $6.7 million
(25%) due to revenues from volume increases. The volume increase was spread
across C.J. Hughes customer base.
Cost
of Revenues
. Cost of Revenues increased by $38.8
million, or 132.5%, to $68.1 million for the year ended December 31, 2007, from
$29.3 million for the year ended December 31, 2006. As with the revenue
increases, there were two components. First, the revenues from the acquisition
of Nitro Electric brought added cost of revenues of $33.1 million. The
remaining increase of $5.7 million was due to the revenue volume increases.
122
Gross
Profit.
Gross profit increased $4.9 million, or
211.7%, to $7.2 million for the year ended December 31, 2007, from $2.3 million
for the year ended December 31, 2006. The primary reasons for this increase
were an increase in the number of larger projects and an increase in the
projects initiated for existing customers. The margins for both years were
comparable, due primarily to two factors. The margins for 2006 were lower for
the pipeline work due to the fact that C.J. Hughes had four items that
negatively impacted the margins. First, the company made a decision to exit two
geographic areas and the reduced margins associated with exiting those markets
cost approximately $300,000. Also, two projects incurred losses of
approximately $800,000 due to missing our deadline due to inclement weather on
one project and inaccurate estimates by a subcontractor regarding costs on
another project. In 2007, gross profit margins were lower than they
historically would have been due to the fact that the electrical portion of the
business had lower gross profits (8.2%) than the remainder of the business,
which had a margin of 10.8%. The electrical portion of C.J. Hughes revenues
will likely continue to have lower gross profit margins since this aspect of
C.J. Hughes operations has a higher percentage of costs associated with labor
than the pipeline portion of the business.
Selling,
General and Administrative Expenses.
Selling, general
and administrative expenses increased by $1.4 million (72.9%) to $3.2 million
for the year ended December 31, 2007, from $1.8 million for the year ended
December 31, 2006. This increase is primarily related to the added selling
general and administrative expenses associated with the addition of Nitro
electric and the added revenue volumes. The portion of this increase that
relates to the inclusion of Nitro Electric from the date of acquisition was
$1.3 million. The remaining $100,000 was due to added expenses related to the
increase in projects.
Income
from Operations.
Income from operations increased by
$3.5 million, or 783%, to $4.0 million for the year ended December 31, 2007,
from $500,000 for the year ended December 31, 2006. Of this increase, $1.6
million was derived from income from operations for the Nitro Electric
beginning May 2007. The remaining $1.9 million increase was due to improved
margins on projects completed in 2007.
Interest
Expense.
Interest expense increased $543,000 to $1.1
million for the year ended December 31, 2007, from
$520,000 for the year ended December 31, 2006. This increase was primarily due
to increased interest expense in 2007 relating to the purchase of Nitro
Electric in the amount of $300,000, as well as the financing of added equipment
needed for new projects during the year.
Income
Taxes
. Income taxes have not been provided, except for
income taxes attributable to a variable interest entity consolidated into C.J.
Hughes, because C.J. Hughes has elected by consent of its shareholders to be
taxed as an S-Corporation. Accordingly, income or loss is passed through to its
shareholders and taxed at their individual rates. If C.J. Hughes were taxed at
the corporate rate, its income tax expense for the year ended December 31, 2007
would have been approximately $1.3 million.
Net
Income
. Net income increased by $3.0 million to $3.0
million for the year ended December 31, 2007, from a loss of $57,000 for the
year ended December 31, 2006. $1.4 million of this increase was the net income
derived from Nitro Electric after the date of acquisition. The remaining $1.6
million of increase was from improved profitability on the other revenues of
the company.
Comparison of
Operating Results of the Years ended December 31, 2006 and 2005
Revenues.
Revenues increased by $2.2 million, or 7.6%, to $31.6
million for the year ended December 31, 2006, compared to $29.4 million for the
year ended December 31, 2005.
123
Cost
of Revenues
. Cost of revenues increased for 2006 by
$4.1 million, or 16.4%, to $29.3 million for the year ended December 31, 2006,
compared to $25.2 million for the year ended December 31, 2005. As noted above,
cost of revenues in 2006 were higher as a percentage of revenue due the factors
discussed in the section above, including exiting certain geographic areas and
two projects having poor performances due to inclement weather and adverse
working conditions.
Gross
Profit.
Gross profit decreased $1.9 million, or 81.5%,
to $2.3 million for the year ended December 31, 2006, from $4.2 million for the
year ended December 31, 2005. As a percentage of revenue, gross profit
decreased from 14.3% to 7.3%. The primary reasons for this decrease were the
factors discussed in the Cost of Revenue section above.
Selling,
General and Administrative Expenses.
Selling, general
and administrative expenses decreased by $161,000 or 84.7% to $1.8 million for
the year ended December 31, 2006 from $2.0 million for the year ended December
31, 2005. This decrease was primarily due to slightly lower payroll and related
taxes.
Income
from Operations.
Income from operations decreased $1.7
million or 63% to $500,000 for the year ended December 31, 2006 from $2.2
million for the year ended December 31, 2005. This decline was due to lower
profitability on the projects as previously discussed in the
Costs of Revenues
section above.
Interest
Expense.
Interest expense increased $282,000 to
$520,000 for the year ended December 31, 2006, from $238,000 for the year ended
December 31, 2005. This increase was primarily due to interest expense
associated with our line of credit in addition to additional costs from
financing additional equipment.
Income
Taxes.
Income taxes have not been provided, except for
income taxes attributable to a variable interest entity consolidated into C.J.
Hughes, because C.J. Hughes has elected by consent of its shareholders to be
taxed as an S-Corporation. Accordingly, income or loss is passed through to its
shareholders and taxed at their individual rates. If C.J. Hughes were taxed at
the corporate rate, its income tax expense for the year ended December 31, 2007
would have been approximately $1.3 million.
Net
Income.
Net income decreased by $1.9 million, or 100%,
to a loss of $57,000 for the year ended December 31, 2006, from net income of
$1.9 million for the year ended December 31, 2005. This decrease was due to the
lower profitability on projects completed in 2006, as previously discussed in
the
Gross Profit
section above.
Comparison of
Financial Condition
Assets.
The consolidated assets of C.J. Hughes increased from
$14.4 million at December 31, 2006 to $27.2 million at December 31, 2007, an
increase of $12.8 million. The primary reason for this increase was the
acquisition of Nitro Electric and the subsequent growth of its assets, which
accounted for $11.8 million of the increase in assets during the year ended
December 31, 2007. The remainder of the increase was primarily due to
additional fixed assets which C.J. Hughes acquired in 2007 to enable it to
accommodate new and larger projects. Net fixed assets (excluding those of Nitro
Electric) increased by $2.8 million to $7.5 million at December 31, 2007, from
$4.7 million at December 31, 2006.
Liabilities.
The consolidated liabilities of C.J. Hughes increased
by $10.1 million to $21.9 million at December 31, 2007, from $11.7 million at
December 31, 2006. $6.0 million of this increase related to the debt assumed by
C.J. Hughes relating to the purchase of Nitro Electric ($2.7 million) and
124
providing
working capital for Nitro Electric ($3.3 million). The remaining increase in
liabilities was due to additional borrowings to finance equipment purchases.
Stockholders
Equity.
Stockholders Equity increased by $3.0 million
to $5.6 million at December 31, 2007, from $2.6 million at December 31, 2006.
This increase derived from the addition of net income for 2007. C.J. Hughes
paid no distributions in 2007. However, it is anticipated that a distribution
of approximately 50% of 2007 net income will be paid to stockholders in 2008.
Nitro Electric
Effective
April 30, 2007, C.J. Hughes acquired Nitro Electric for $2.7 million in cash.
The transaction was accounted for, using the purchase method of accounting for
business combinations. The fair value of the fixed assets acquired were
estimated to be $987,400. The fair value of the liabilities associated with
those assets was $284,287. The purchase price and costs associated with the
acquisition exceeded the preliminary estimated fair value of the assets
acquired, net of liabilities assumed by approximately $2.0 million, which was
accounted for as goodwill. During the period of 2007 that C.J. Hughes owned
Nitro Electric, the latter had revenues of $36.1 million and net income of $1.5
million.
Liquidity and Capital Resources
Cash Requirements
Cash
and cash equivalents on hand at December 31, 2007 totaled $2.3 million. C.J.
Hughes credit facilities consisted of a line of credit with a bank in an
amount not to exceed $2.0 million and, when combined with anticipated future
cash flows from operations, should provide sufficient cash to meet C.J. Hughes
operating needs. However, with the current energy demand and associated
increased demand for C.J. Hughes services, C.J. Hughes may require additional
working capital in order to capitalize on prospective business opportunities.
Sources and Uses of Cash
As
of December 31, 2007, C.J. Hughes had $2.3 million in cash, working capital of
$8.2 million and long-term debt net of current maturities of $13.0 million. The
long-term debt consists of:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2008
|
|
2009
|
|
2010
|
|
2011
|
|
2012 and
thereafter
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Long-Term Debt
|
|
$
|
1,844,192
|
|
$
|
1,899,589
|
|
$
|
1,629,245
|
|
$
|
891,233
|
|
$
|
8,575,276
|
|
Off-Balance Sheet Transactions
Due
to the nature of C.J. Hughes business, it will occasionally enter into certain
off-balance sheet arrangements in the ordinary course of business that result
in risks not directly reflected in its balance sheets. Though for the most part
not material in nature, some of these off-balance sheet arrangements include:
Leases.
C.J. Hughes projects often require leasing various
facilities, equipment and vehicles. These leases usually are short term in
nature, (one year or less), although C.J. Hughes may enter into longer term
leases when warranted. By leasing equipment, vehicles and facilities, C.J.
Hughes is able to reduce its capital outlay requirements for equipment,
vehicles and facilities. C.J. Hughes has a lease for Nitro Electrics offices
that expires on December 31, 2008 but is renewable under the same terms and
conditions through August 31, 2010. C.J. Hughes is evaluating whether or not to
renew that lease.
125
Letters
of Credit
. Certain of C.J. Hughes customers and
vendors may require letters of credit to secure payments that the vendors are
making on C.J. Hughes behalf or to secure payments to subcontractors, vendors,
etc. on various customer projects. At December 31, 2007, C.J. Hughes had no
letters of credit outstanding.
Performance
Bonds.
Some customers, particularly new customers or
governmental agencies, require C.J. Hughes to post bid bonds, performance bonds
and payment bonds. These bonds are obtained through insurance carriers and
guarantee to the customer that C.J. Hughes will perform under the terms of a
contract and that it will pay subcontractors and vendors. If C.J. Hughes fails
to perform under a contract or to pay subcontractors and vendors, the customer
may demand that the insurer make payments or provide services under the bond.
C.J. Hughes must reimburse the insurer for any expenses or outlays it is
required to make. Depending upon the size and conditions of a particular
contract, C.J. Hughes may be required to post letters of credit or other
collateral in favor of the insurer. Posting of these letters or other
collateral will reduce its borrowing capabilities. Historically, C.J. Hughes
has never had a payment made by an insurer under these circumstances and does
not anticipate any claims in the foreseeable future. At December 31, 2007, C.J.
Hughes had no such bonds issued by the insurer outstanding.
Contractual
Obligations
. At December 31, 2007, C.J. Hughes had
future contractual obligations as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2008
|
|
2009
|
|
2010
|
|
2011
|
|
2012 and
thereafter
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Long Term Debt
|
|
$
|
1,844,192
|
|
$
|
1,899,589
|
|
$
|
1,629,245
|
|
$
|
891,233
|
|
$
|
8,575,276
|
|
Lease Payments
|
|
|
111,418
|
|
|
1,040
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
1,955,610
|
|
$
|
1,900,629
|
|
$
|
1,629,245
|
|
$
|
891,233
|
|
$
|
8,575,276
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Concentration
of Credit Risk
.
In
the ordinary course of business, C.J. Hughes grants credit under normal payment
terms, generally without collateral, to its customers, which include gas
companies, electric power companies, governmental entities, general
contractors, and various commercial and industrial customers located within the
United States. Consequently, C.J. Hughes is subject to potential credit risk
related to business and economic factors that would affect these companies.
However, C.J. Hughes generally has certain statutory lien rights with respect
to services provided. Under certain circumstances such as foreclosure, C.J.
Hughes may take title to the underlying assets in lieu of cash in settlement of
receivables. C.J. Hughes had two customers that exceeded ten percent of
revenues for the year ended December 31, 2007. These were Hitachi of America
which accounted for 30.2% of revenues and Columbia Gas of Ohio which accounted
for 10.5% of revenues.
Litigation.
C.J. Hughes is a party from time to time to various
lawsuits, claims and other legal proceedings that arise in the ordinary course
of business. These actions typically seek, among other things, compensation for
alleged personally injury, breach of contract and/or property damages, punitive
damages, civil penalties or other losses, or injunctive or declaratory relief.
With respect to all such lawsuits, claims, and proceedings, C.J. Hughes records
reserves when it is probable that a liability has been incurred and the amount
of loss can be reasonably estimated. C.J. Hughes does not believe that any of
these proceedings, separately or in aggregate, would be expected to have a
material adverse effect on its financial position, results of operations or
cash flows.
Related
Party Transactions
. In the normal course of business,
C.J. Hughes enters into transactions from time to time with related parties.
These transactions typically would not be material in nature and would relate
to vehicle or equipment rentals. However, in 2007 to facilitate the purchase of
126
Nitro Electric, the Company borrowed a total of $6.0 million from
Marshall T. Reynolds, a shareholder of C.J. Hughes. That note is unsecured and
is subject normal and customary business terms.
Inflation
Due to
relatively low levels of inflation during the years ended December 31, 2007,
2006 and 2005, inflation did not have a significant effect on C.J. Hughes
results.
New Accounting Pronouncements
In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements SFAS
No. 157 defines fair value, establishes methods used to measure fair value and
expands disclosure requirements about fair value measurements. SFAS No. 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal periods, as it
relates to financial assets and liabilities that are carried at fair value.
SFAS No. 157 also requires certain tabular disclosures related to results of
applying SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets and SFAS No. 142, Goodwill and Other Intangible Assets. On November
14, 2007, the FASB provided a one year deferral for the implementation of SFAS
No. 157 for non-financial assets and liabilities. SFAS No. 157 excludes from
its scope SFAS No. 123 (R), Share-Based Payment and its related interpretive
accounting pronouncements that address share-based payment transactions. Based
on the assets and liabilities on our balance sheet as of December 31, 2007, we
do not expect the adoption of SFAS No. 157 to have a material impact on our
consolidated financial position, results of operations or cash flows.
In February
2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets
and Financial Liabilities, including an amendment of FASB Statement No. 115.
SFAS No. 159 permits entities to choose to measure at fair value many financial
instruments and certain other items at fair value that are not currently
required to be measured. Unrealized gains and losses on items for which the
fair value option has been elected are reported in earnings. SFAS No. 159 does
not affect any existing accounting literature that requires certain assets and
liabilities to be carried at fair value. SFAS No. 159 is effective for fiscal
years beginning after November 15, 2007. Based on the assets and liabilities on
our balance sheet as of December 31, 2007, we do not expect the adoption of
SFAS No. 159 to have any impact on our consolidated financial position, results
of operations or cash flows.
Critical Accounting Policies
The
discussion and analysis of C.J. Hughes financial condition and results of
operations are based on its consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles generally
accepted in the United States. The preparation of these consolidated financial
statements requires C.J. Hughes to make estimates and assumptions that affect
the reported amounts of assets and liabilities, disclosures of contingent
assets and liabilities known to exist at the date of the consolidated financial
statements and reported amounts of revenues and expenses during the reporting
period. C.J. Hughes evaluates its estimates on an ongoing basis, based on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances. There can be no assurance that actual results will not
differ from those estimates. Management believes the following accounting
policies affect its more significant judgments and estimates used in the
preparation of C.J. Hughes consolidated financial statements.
Revenue
Recognition.
C.J. Hughes recognizes revenue when
services are performed except when work is being performed under a fixed price
contract. Revenue from fixed price contracts are recognized under the
percentage of completion method, measured by the percentage of costs incurred
to date to total
127
estimated costs for each contract. Such contracts generally provide that
the customer accept completion of progress to date and compensates C. J. Hughes
for services rendered, measured typically in terms of units installed, hours
expended or some other measure of progress. Contract costs typically include
all direct material, labor and subcontract costs and those indirect costs
related to contract performance, such as indirect labor, supplies, tools,
repairs and depreciation costs. Provisions for the total estimated losses on
uncompleted contracts are made in the period in which such losses are
determined. Changes in job performance, job conditions, estimated profitability
and final contract settlements may result in revisions to costs and income and
their effects are recognized in the period in which the revisions are determined.
Self
Insurance.
C.J. Hughes is insured on employee health
care subject to a deductible of $40,000 per person. Due to the high level of
unpredictability in these claims, expense related to those claims is normally
recorded as incurred. Payments of expenses incurred are paid twice monthly at
the middle and end of the month. However, in the event that a material claim is
known though not presented, appropriate accruals would be made for such
instances. Management believes that at December 31, 2007, any risks for unknown
claims would not be material to the financial condition or results of
operations of C.J. Hughes and therefore no accrual was recorded at that date.
Current
and Non Current Accounts Receivable and Provision for Doubtful Accounts.
C.J.
Hughes provides an allowance for doubtful accounts when collection of an
account is considered doubtful. Inherent in the assessment of the allowance for
doubtful accounts are certain judgments and estimates relating to, among
others, a customers access to capital, willingness or ability to pay, general
economic conditions and the ongoing relationship with the customer. While most
of C.J. Hughes customers are large well capitalized companies, should they
experience material changes in their revenues and cash flows or incur other
difficulties and not be able to pay the amounts owed, this could cause reduced
cash flows and losses in excess of current reserves.
128