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ENGlobal Corporation (NASDAQ:ENG)

Q2 2008 Earnings Call

August 7, 2008 11:00 am ET

Executives

Bill Coskey - Chairman & Chief Executive Officer

Bob Raiford - Chief Financial Officer & Treasurer

Natalie Hairston - Vice President of Investor Relations & Chief Governance Officer

Analysts

Rich Wesolowski - Sidoti & Company

Craig Bell - SMH Capital

Graham Madison - Lazard Capital Markets

Operator

Welcome to the ENGlobal Corporation second quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Natalie Hairston, Vice President of Investor Relations and Chief Governance Officer for ENGlobal Corporation.

Natalie Hairston

With me on the call are Bill Coskey, Chairman and Chief Executive Officer of ENGlobal and Bob Raiford, Chief Financial Officer and Treasurer. In a moment I will turn the call over to Bill Coskey who will highlight management’s perspective on our financial results for the quarter ended June 30, 2008. Bob Raiford will then review other financial points of interests for the quarter and in particular there are topics that relate to our balance sheet and cash flow.

Before we begin, I would like to remind everyone that some of the information discussed on this call would contain forward-looking statements that involve risks and uncertainty. These statements are based on current expectations. Actual results may differ materially from those set forth in such statements. Additional information concerning factors that may cause actual results to differ is contained in the Risk Factor section of our previously filed Form 10-K and 10-Q. All of those filings are available on the Inventor Relations page of ENGlobal’s website at in englobal.com. Our filings with the SEC are also available on the SEC’s website at sec.gov.

In addition, non-GAAP measures maybe referenced during this conference call. Pro forma data is provided for informational purposes only and is not a measure of financial performance under GAAP. This data does not represent and should not be considered as an alternative to net income, operating income, net cash provided by operating activities or any other measure for determining operating performance or liquidity calculated in accordance with GAAP.

After our opening remarks we will have a question-and-answer session. In order to give as many callers as possible the chance to ask a question, please limit yourself to one question and then one follow-up if necessary and now I would like to introduce our Chairman and Chief Executive Officer, Mr. Coskey.

Bill Coskey

I would like to start by thanking and also congratulating ENGlobal's management team for their excellent performance. Underlying the many financial numbers we will discuss this morning, you should be able to see some obvious signs of what our management team and employees have been able to accomplish. They definitely deserve the credit for the records.

Today, we reported earnings of $0.24 per diluted share for the second quarter of 2008 which represents a 72% increase from the prior year period. In terms of the big picture, our earnings expansion is mostly being driven by a combination of two factors. First factor is that ENGlobal is benefiting from a healthy market for our services with our top line growing, adding exceptional rate, 52% in the latest quarter and all of this growth was internally generated which makes it even better.

Second is something that the Company has talked about for several years. This being our efforts overtime to improve our operating profitability. In the latest quarter, we are proud to report that our operating margin increased to 8.5%, an increase from 7.7%. Most of you have already know that ENGlobal has stated a compound annual revenue growth target of 25% together with an operating margin goal of 8.0% for the full year 2008. We are on track to either meet or exceed both of these targets this year. In our press release this morning, we provided two tables which I believe provide a very good view or our Company's current business.

The first table on page one is the detail of revenue and profitability about segment then on page two of the press release we have provided a list of the four operations that provided us with substantially all of our $46 million of revenue increase for the second quarter. These operations are first our inspection operation where growth is directly related to the number of inspection personnel we now have working on pipeline construction sprints. It is a good indicator of the strong trends for domestic pipeline activity.

Number two is our detailed design category that includes personnel who works in-house at ENGlobal offices and performs engineering, design and other support function of both midstream and downstream projects. The revenue increase in this area is up so much due to additional personnel as it is to increasing salaries that drive higher billing rates. Third is our procurement subcontracting activity, which showed a $12 million increase. This is a call plus activity at a low margin and sometimes referred to as procurement pass-through revenue. We expect this increase level of procurement pass-through activity to continue into the third quarter of 2008. Finally our land group has added staff that provides right-of-way acquisition support mainly on pipeline and electric power transmission project.

Overall in global headcount has exceeded our expectation reaching approximately 2900 employees in the second quarter of 2008 and we added 300 employees in the second quarter alone, most of which were added to our pipeline inspection group. ENGlobal consolidated growth profit margin decreased 1% each point to 14.9% in the latest quarter from 15.9%. This decrease is primarily a function of our revenue mix and is specially influenced by quarterly changes and the lower margin procurement pass-through revenue I just mentioned. On our pro forma basis and eliminating the procurement pass-through revenue and margin are consolidated gross profit margin on this basis would have increased from the 14.9% that we reported to approximately 16.2%.

However on the other side of the story that are earnings per share would have been reduced by approximately $0.02 under this scenario. ENGlobal selling, general and administrative expense for the second quarter 2008 was $8.7 million, an increase of $1.4 million from the prior year quarter and up roughly the same amount sequentially in the first quarter of this year. Our Company thinks about SG&A spend on an absolute basis with a target of $7.5 million per quarter exclusive of acquisitions. Charges related to bad debt and reserves from possible claims amounted to $1.3 million in the second quarter therefore on the continuing basis and exclusive of these charges which we believe are one time, we were about at our expected level for SG&A expense this quarter.

As previously reported during the third quarter of 2007, ENGlobal terminated a large project due to failure of this client, South Louisiana Ethanol, to obtain permanent financing. As a result of their continued failure to obtain neither financing or project partner, on May 30, 2008 we filed suit in Louisiana Federal Court basically for closing on our mortgage and lien rights, seeking damages of $15.8 million. We continued to be optimistic that given our legal rights together with an independent approval of the force liquidation value of the asset that the Company will be able to recover all of the amounts owned.

One other expected item that we are monitoring closely is the recent chapter 11 bankruptcy announcement by one of our Tulsa client, Syncrude LT which occurred about two weeks ago. Syncrude is the general partner or the White Cliffs Pipeline project for which we are continuing to perform various services. However the White Cliffs Pipeline entity itself has not filed for reorganization. Last Friday, Syncrude paid ENGlobal approximately $940,000 to bring its account current to that date. Accounts receivable from Syncrude are in the $2 million range with substantially all of our receivables being current.

Our expectation is that this pipeline project will be completed by either Syncrude or their lender and that ENGlobal will be paid all amounts owed. Regarding external growth, we continue to target acquisition that equate to roughly 10% additional revenue over the next year. We choose to do these transactions for two reasons, first of all, we have had good success from selling newly acquired capabilities to our existing clients and number two, we are seeking new locations to better serve our clients within North America.

One particular transaction was mentioned in our first quarter call and then this has progressed lower than anticipated. However, we believe this $10 million revenue; automation related transaction will be closed by the end of this quarter. Our preference continues to be for smaller businesses that do not carry the financial or integration risk of larger targets. We do not expect to have to dilute our stockholders in order to carry up our external growth plan.

I would like to close with a few comments about why I am still excited about ENGlobal's future. First of all, our engineering segment. For our anchor business, I really like our consistent and predictable business model as our engineering work mainly consist of alliance relationships, the candid implant personnel and our performance on small to mid sized cost plus projects. Many of our projects is driven by ongoing maintenance issues, record fit of existing facilities or government compliance mandates.

Alternative energy is an exciting growth area because there is now more money being spend on alternative energy projects in North America than on refining or pipeline facilities. I believe our engineering operation is well managed and supported by a top notch group of business development professionals and we also have several interesting internal growth initiatives currently underway. Second with our construction segment. We have recently changed management at our inspection group which should serve to drive the needed margin improvement.

As inspection has really grown and currently represents about 87% of our construction segment. The higher margin piece of our construction group which specializes in managing EPC projects, plant turnarounds and commissioning new facilities is a very aggressive group. Given their many current opportunities, my expectation is that our construction group will continue to be a buffering business with improving profitability overtime given the shift toward our higher margin capability.

In terms of automation. During 2008, we have landed two significant multiyear projects to upgrade control analyzer systems at large refineries. New management with our control fabrication operation has done a great job and what used to be a drain on our Company is now a profit contributor. Financial results from the professional services side of our automation group need to improve which should the work is slowly getting started on the recent awards. Therefore automation's billable hours should increase and variable overhead should decrease over the balance of this year and next.

Also promising is that there are several more significant automation proposals pending similar to the ones we have been awarded. I like the fact that our automation business is being driven by our client's need to replace obsolete electronic and pneumatic control system as well as analyzer equipment and this provides a recurring stream of work. And finally our land group. Pretty simply, I see continued strong pipeline activity both for gathering and mainland projects that drives demand for new line of work.

This together with emerging projects to build electric power transmission line should keep our land business busy for the foreseeable future. I will close my portion of the call by commenting on the increased amount of teamwork I have seen throughout our operation. As the Company grows, the importance of operations between business units cannot be overlooked while definitely not a GAAP measurement, I am proud that ENGlobal has not loss side of this important metric for growing a great business. I will now turn the call over to Bob Raiford, our CFO.

Bob Raiford

A lot of the specific details of our second quarter results were disclosed in our press release this morning but I like to highlight some selected item. We recorded approximately $1.3 million in bad debt expense and the claims reserve during the second quarter compared to approximately $174,000 during a comparable quarter of 2007. Approximately $1 million for the second quarter charges where directly related to four claims on project from the prior year.

We expect these specific project reserves to be of a non referring nature and fully expect that the reserves taken during the period will meet all material coverage deductibles, legal expenses and settlement levels. Our operation has generated approximately $4.1 million in this case during the second quarter compared to $523,000 net case generated during the same period in 2007 and approximately $400,000 generated during the first quarter of this year.

At this time, we expect our operations to remain in a positive cash flow position for the balance of the year. The results of our project performance and non cash items were offset by unfavorable change in working capital during the period. The primary unfavorable impact on working capital during the second quarter was again increase in trade receivables and particular in the timing and processing of unbilled receivables as a result of our growth. We have projected approximately $2 million in payments related to the ethanol project to be made during the second quarter but due to delays and execution of final release agreement with various vendors and subcontractors, we have approximately $1.2 million remaining to fully satisfy our current cash commitments to that project. We expect the majority of those payments to be made during the third quarter.

The July 24 payoff of the $1.4 million note receivable for the sale of our office building become a previously owned in Baton Rouge, Louisiana will positively impact cash requirements during the third quarter. Overall our long-term commitments, net of current portion, decreased approximately 13% or approximately $4.1 million from $30.9 million at the end of the first quarter to $26.8 million as with the end of the second quarter.

For this six month period just ended, our overall long-term commitments, net of current portion, decreased approximately 9%, approximately $2.5 million from $29.3 million as of December 31 of 2007. As the percentage of stock owners equity, our overall long term commitments at the end of the second quarter have decreased to 39.2% from 52.5% as of December 31. Total liquidity which includes cash plus availability under our $50 million credit facility was $26.5 million from $6.4 million for the second quarters ended 2008 and 2007 respectively.

The upselling balance of our line of credit at the end of the second quarter was $25.5 million with the remaining borrowings available of $24.2 million. We have one outstanding letter of credit for approximately $300,000 due to expire September 30, 2008. Our average days sales outstanding was 61 days for the second quarter compared to 70 days for the comparable three month period in 2007 and 61 days for the 12 month period ended December 31, 2007.

Although our targeted DSO remains in the mid 50s, we believe more aggressive contract payment terms, improvements in our internal billing process and a more aggressive collection process will be necessary if we are to achieve that goal. We have invested approximately $892,000 in capital asset during the second quarter compared to a prior year quarterly investment of approximately $524,000. Our second quarter investment was approximately doubled the amount invested during the first quarter of the year primarily as a result of the capital list commitment of $500,000 for an infrastructure upgraded needed to meet our growth. We expect a similar capital investment in the third quarter to compete the upgrade.

We do not expect the material change in the level of capital investment for the balance of the year to exceed that as of our investment during the first six month period. Our effective tax rate for the second quarter was 40.4% compared to a rate of 42% during the second quarter last year and a rate of 39.7% for the year ended December 31, 2007. Our tax provision decreased approximately $179,000 during the second quarter of 2008 compared to a similar provision at last year's second quarter tax rate.

Our effective tax rate for the first six months period of 2008 was 40.2% compared to a rate of 39.7% for the comparable prior year period. Our tax provision decreased approximately $94,000 for the first six-month period of 2008 compared to a similar provision at last year's six months tax rate. We do not expect our tax rate for 2008 to fairly change for approximately 40% effective tax rate for the first six month period of the current year.

Thank you for your time this morning. I will now turn the call back to the operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Rich Wesolowski - Sidoti & Company.

Rich Wesolowski - Sidoti & Company

Bill, in the first quarter, we saw virtually all the growth coming from inspection whereas here in June, it was a lot more broad base. You mentioned also in the press release an increasingly varied client mix, which of the end markets or the customer types that you are now getting business whether it is little or none before?

Bill Coskey

I think what we are seeing is an expansion in the current markets we serve, midstream and downstream that is like we are able to gain more pipeline clients and also more downstream clients. And so it is not like a really new market. It is just more clients within the same market that is what I would say.

Rich Wesolowski - Sidoti & Company

And a follow up, your revenue for average employee has been a very steady number in a 150,000 range even going back to 2005, it is really never been above a 160,000. Now, this quarter, we get almost 200,000 per employee. Your utilization is always been around 90%. So, why was there a big jump this quarter?

Bill Coskey

Well, I could probably point to three reasons. One of them is the contribution from the pass through procurement revenue which comes to our revenue line which I believe, Bob was…

Bob Raiford

Like $17.5 million.

Bill Coskey

Seventeen and a half million dollars this quarter. Another is the fact that our people have been getting some pretty significant pay raises in this active environment in our business and so if you multiply that times of billing factor and our billing rates go up for our clients. And then lastly, improvements in utilization, possibly working some more overtime on projects will contribute to revenues per employees increasing.

Rich Wesolowski - Sidoti & Company

Just a quick follow up to the follow up, you mentioned the pay raises is second on that list. Have you had any increases in the multiples or is that all been the wage inflation passing through with the same multiple?

Bill Coskey

I think what we see is we have probably a base load of long term maybe alliance client that stay at about the same multiplier level. I think what we have is a new generation of clients coming in that we would put under higher billing structures, kind of like our incremental business that we sell would be done at higher billing structure. I think what we have seen over several years a steady increase to our effective multiplier so it is like a needle going from low to high and I think the needle continues to move up slowly in terms of a billing multiplier.

Operator

Your next question comes from Craig Bell - SMH Capital.

Craig Bell - SMH Capital

It is pretty impressive quarter. I am just kind of following up on Rich's question there. Since you are saying that a significant amount of the increase is related to pay raises and billing rates, does that sort of imply that maybe this level of revenue is sustainable going forward because in the past you had good solid increases quarter to quarter but it has been pretty consistent in this quarter such a significant jump up. I mean, you think you can maintain sort of that level?

Bill Coskey

Yes, I do not see anything over the near term taking us off the track we are currently on and I would not be surprised to see our third quarter meter exceed what we did in the second quarter.

Craig Bell - SMH Capital

Okay and then on the last conference call, you talked about the mix of business and that had put some pressure on your gross margin, largely see some improvement here this quarter. Do you see any changes in the second half of this year in terms of mix of business and how it is impacting on margin?

Bill Coskey

No, I really do not see that much change in mix. I guess if I were to analyze ENGlobal, I would probably subtract out the impact of the pass-through procurement revenue and I give you more of a steady state idea of how we are performing in terms of gross profit margins. It debalances I guess those results.

Bob Raiford

Craig, I will follow up probably with that one Bill said, I guess the procurement revenue is US$17.5 million we incurred during the second quarter. If you look at the last year's second quarter, it was about $5 million, I think it was a $12 million increase in that and we think we look to that to continue in the third quarter but beyond that, we cannot be assured this is going to continue because it is based on that one project we are working on right now but that might tell all. So if you make an adjustment in our revenues for the procurement, probably it give you a better steady state look

Craig Bell - SMH Capital

Okay, great and then Bob, what was the amount of receivables in the end of the quarter?

Bob Raiford

I think it was $92 million which includes our R&D and includes everything.

Operator

Your next question comes from Graham Madison - Lazard Capital Markets.

Graham Madison - Lazard Capital Markets

Just quickly, in the past you mentioned that looking at the quarters over the year, the 3Q tends to be better than 2Q. Is there anything that you think would be not be the case this year? I mean was there any projects that moved to the second quarter which help boost the revenue in the performance?

Bill Coskey

I have always equated our second and quarter and equated our first and fourth quarter, I do not know that I really over ranked them to be one, two, three, four but throughout the balance of this year, I would look for our third quarter to be somewhere to our second or our fourth quarter to be somewhere to our first. It is kind of the way our year goes.

Graham Madison - Lazard Capital Markets

And then just looking at some of the margin improvements in the other segments outside of engineering, what was driving that? Was that more would you say on broader scope that is more of an impact of better contracting terms that you are signing up or is it more results of the better management execution and operational execution that you talked about in prior quarters?

Bill Coskey

I think it is a little both. I think we are continually working on better contracts. The new business would bring in just provide better margins for our Company. I think we have just made some efforts to improve our efficiencies, improve utilization. Bob, do you have anything to add to that? It is a lot of blocking and tackling. It is not any one magic bullet.

Graham Madison - Lazard Capital Markets

Well, there is nothing to think that some of these margins would not, as you had mentioned earlier, be sustainable going forward?

Bill Coskey

No, I would see margins to be sustainable going forward especially after you back up the impact of these past two revenues.

Operator

The next question is a follow from Rich Wesolowski - Sidoti & Company.

Rich Wesolowski - Sidoti & Company

Bill, I just want to clarify the statement you made in your prepared remarks that the pass-through revenue, the inclusion depressed gross margin but increased earnings, I assume you are talking about the earnings contribution from the project which carries that pass-through and what earnings for the Company would have been without that contribution.

Bill Coskey

I was talking about earnings per share and as an example of we had against $16 million or $17 million of pass-through revenue and we marked that up maybe 5% or 6%.

Rich Wesolowski - Sidoti & Company

So, it is not completely pass-through. There was a little bit of margin on there.

Bill Coskey

There is a little bit of margin and so that incremental margin improved our earnings per share but it depressed our gross profit margin as the percentage.

Rich Wesolowski - Sidoti & Company

Your margins within each segment as you now define to have been all over the map. If you go back to the data from 2006, can you give us maybe a gross margin for each segment that you would consider to be strong and realistic performance in today's environment?

Bill Coskey

I think what I would say as far as engineering segment is going to be right around that same area on ongoing basis possibly taking up very incrementally. I would expect to see some pretty good improvement in our automation and construction group just based on project awards, especially on the construction group where we have this continued mix of inspections, pipeline inspection revenue which by nature is low margin and as we tend to change that mix over the sum of our higher value services like managing EPC projects or managing turnaround projects, my belief is that overtime that mix will change from 8713 to much more favorable on hot margin side.

I believe our land groups should be pretty steady going forward and it is kind of “it is what it is” today if we may take some incremental improvements. So engineering and land talking about the same slightly improving but we have the opportunity to make same pretty significant improvements in automation and construction.

Rich Wesolowski - Sidoti & Company

Okay, that is very helpful, thank you. Just a little bit point of confusion, you mentioned that the 300 headcount that you add in the quarter, most of that was in pipeline inspection. Can you reconcile that with the expectation that the other part of construction is going to be going up as the percentage of that revenue?

Bill Coskey

It was based on my knowledge and some opportunities they have and also based on my knowledge of efforts that are being made to raise margins within the inspection group itself after the change in management. I believe we are going on to two things. We are going to improve the inspection margins plus we are going to change the mix. It is just based on some opportunities we have here.

Operator

Your next question is a follow-up from Graham Madison - Lazard Capital Market.

Graham Madison - Lazard Capital Markets

Hey guys just to follow up on the inspection and construction margin then you have made the personnel changes, did we see any of the margin improvement or the benefit from that personnel change in this quarter or that will be something we will see in coming quarters more?

Bill Coskey

I think that is something you should look forward in coming quarter. That is a fairly recent change and I do not believe that have any impact yet at the second quarter.

Graham Madison - Lazard Capital Markets

Okay great and then on the land group, I mean would it be fair to say that we could see revenue growth sort of consistently drive up with the increase in pipeline or what is going on out there?

Bill Coskey

There are limiting factors to the ability to access wide range for the project. I think they are more limited by the ability to add staff and then I think there is more project and staff but yes, there is many, many opportunities especially with this emerging build up on electric power transmission that we could participate in. That is another area.

Operator

There are no further questions

Natalie Hairston

I will be available to answer any follow up questions this afternoon and you can always email me directly at IR@ENGlobal.com. Thank you for being on the call today and thank you as always for your continued support at ENGlobal.

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