UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-K

 

Commission File Number 1-13783

 

Integrated Electrical Services, Inc.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (713) 860-1500

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o     Accelerated Filer o     Non-Accelerated Filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the voting stock of the Registrant on March 31, 2006 held by non-affiliates was approximately $37.9 million.

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of the securities under a plan confirmed by a court.  Yes þ     No o

 

As of December 15, 2006, there were outstanding 15,377,742 shares of common stock of the Registrant (includes 32,272 shares reserved for issuance upon exchange of previously issued shares pursuant to the Company’s Plan of Reorganization approved by the United States Bankruptcy Court for the Northern District of Texas, Dallas Division which became effective on May 12, 2006).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in the Proxy Statement for the Annual Meeting of Stockholders of the registrant to be held on February 8, 2007 is incorporated by reference into Part III of this Form 10-K.

 

 

FORM 10-K

 

INTEGRATED ELECTRICAL SERVICES, INC.
Table of Contents

 

 

Subsidiaries of the Registrant

Consent of Ernst & Young LLP

Rule 13a-14(a)/15d-14(a) Certification of Michael Caliel

Rule 13a-14(a)/15d-14(a) Certification of David A. Miller

Section 1350 Certification of Michael Caliel

Section 1350 Certification of David A. Miller

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K includes certain statements that may be deemed “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, all of which are based upon various estimates and assumptions that the Company believes to be reasonable as of the date hereof. These statements involve risks and uncertainties that could cause the Company’s actual future outcomes to differ materially from those set forth in such statements. Such risks and uncertainties include, but are not limited to:

 

 

 

You should understand that the foregoing, as well as other risk factors discussed in this document, including those listed in Part I. Item 1A. of this report under the heading “Risk Factors” could cause future outcomes to differ materially from those expressed in such forward looking statements. We undertake no obligation to publicly update or revise information concerning the Company’s borrowing availability, or its cash position or any forward-looking statements to reflect events or circumstances that may arise after the date of this report. Forward-looking statements are provided in this Form 10-K pursuant to the safe harbor established under the private Securities Litigation Reform Act of 1995 and should be evaluated in the context of the estimates, assumptions, uncertainties, and risks described herein.

 

In this annual report, the words “IES”, the “Company”, “we”, “our”, “ours”, and “us” refer to Integrated Electrical Services, Inc. and, except as otherwise specified herein, to our subsidiaries. Our fiscal year ends on September 30.

 

We are a leading provider of electrical contracting services in the United States. We provide a broad range of services including competitive bid design, building, maintaining and servicing electrical, data communications and utilities systems for commercial, industrial and residential customers.

 

Our electrical contracting services include design of the electrical distribution systems within a building or complex, procurement and installation of wiring and connection to power sources, end-use equipment and fixtures as well as long-term contract maintenance. We service commercial, industrial and residential markets and have a diverse customer base including: general contractors; property managers and developers; corporations; government agencies and municipalities; and homeowners. We provide services for a variety of projects including: high-rise residential and office buildings, power plants, manufacturing facilities, municipal infrastructure and health care facilities and residential developments. We also offer low voltage contracting services as a complement to our electrical contracting business. Our low voltage services include design and installation of external cables for corporations, universities, data centers and switching stations for data communications companies as well as the installation of fire and security alarm systems. Our utility services consist of overhead and underground installation and maintenance of electrical and other utilities transmission and distribution networks, installation and splicing of high-voltage transmission and distribution lines, substation construction and substation and right-of-way maintenance. Our maintenance services generally provide recurring revenues that are typically less affected by levels of construction activity. We focus on projects that require special expertise, such as design-and-build projects that utilize the capabilities of our in-house engineers or projects that require specific market expertise such as hospitals or power generation facilities, as well as service, maintenance and certain renovation and upgrade work, which tends to either be recurring, have lower sensitivity to economic cycles, or both.

 

As of December 2006, we provide our services from 121 locations currently serving the continental 48 states. We continue to focus internally on integrating our information technology systems to enhance operating controls of our organization, as well as integrating a consolidated procurement program to manage vendors on a national basis.

 

Voluntary Reorganization Under Chapter 11

 

On February 14, 2006, we filed voluntary petitions for reorganization under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division. The Bankruptcy Court jointly administered these cases as “In re Integrated Electrical Services, Inc. et. al., Case No. 06-30602-BJH-11”. On April 26, 2006, the Bankruptcy Court entered an order approving and confirming the plan of reorganization. The plan was filed as Exhibit 2.1 to our current report on Form 8-K, filed on April 28, 2006. We operated our businesses and managed our properties as debtors-in-possession in accordance with the Bankruptcy Code from February 14, 2006 through emergence from Chapter 11 on May 12, 2006.

 

In accordance with the plan:

 

(i) The holders of the senior subordinated notes received on the date we emerged from bankruptcy, in exchange for their total claims (including principal and interest), 82% of the fully diluted new common stock representing 12,631,421 shares, before giving effect to options to be issued under a new employee and director stock option plan which could be up to 10% of the fully diluted shares of new IES common stock outstanding as of the effective date of the plan.

 

(ii) The holders of old common stock received 15% of the fully diluted new common stock representing 2,310,614 shares, before giving effect to the 2006 equity incentive plan.

(iii) Certain members of management received 384,850 restricted shares of new common stock equal to 2.5% of the fully diluted new common stock with an additional 0.5% reserved for new key employees, before giving effect to our 2006 equity incentive plan. The restricted shares of new common stock vest over approximately a three-year period.

 

(iv) $50 million in senior convertible notes were refinanced from the proceeds of the $53 million term loan.

 

(v) All other allowed claims were either paid in full in cash or reinstated.

 

Competitive Strengths

 

Our competitive strengths include the following:

 

 

 

Short Term Initiatives

 

Fiscal year 2006 was a year of transition for IES. We proceeded through and successfully emerged from a voluntary reorganization under Chapter 11. As part of the rebuilding processes we:

 

 

We are focused on strengthening the foundation of the company.

 

During the fall of 2006, under the leadership of our Executive Management Team, we began a systematic program to strengthen our core processes, which will review all key elements of the IES enterprise, including our personnel, processes and business systems. This systematic review is guided by an assembly of expert teams from within our business units supported by our Executive Management Team and operational management.

 

Industry Overview

 

Reviewing the most recently available data from McGraw Hill Construction Analytics, FMI Construction Outlook and the U.S. Census Bureau, we believe inflation is a valid concern but we have not yet seen a significant downturn in residential construction as many economists had predicted. However, according to FMI Construction Outlook there is projected growth in non-residential construction, which is projected to be offset by decreased spending in residential. Using data from all three sources mentioned above, the five-year compounded annual growth rate for non-residential construction is 3.4%, which is an increase over the five-

year compounded annual growth rate for non-residential construction this time last year of 1.4%. The five-year compounded annual growth rate for residential construction is still increasing, but at a reduced rate, of 9.8% versus this time last year with a five-year compounded annual growth rate for residential construction of 11.4%.

 

Over the longer term, the housing market is anticipated to return to a moderate growth rate. Based on research provided by FMI Construction Outlook and McGraw-Hill Construction, residential construction is projected to continue to grow, but at a decreased rate with the projected five-year compounded annual growth rate to be 1.6%. This decreased growth in residential construction is expected to be offset by an increase in non-residential construction. This expected increase in non-residential construction is partly due to price inflation including rising labor and material costs and due to upgrades and the use of higher end materials and increased square footage. The projected five-year compounded annual growth rate for non-residential construction is 4.5%.

 

The Markets We Serve

 

Commercial and Industrial Market.  Our commercial and industrial work consists primarily of electrical, communications, utility installations and upgrade, renovation, replacement and service and maintenance work in:

 

 

Our commercial and industrial customers include:

 

Demand for our commercial and industrial services is driven by construction and renovation activity levels, as well as more stringent local and national electrical codes. From fiscal 2002 through 2006, our compound annual growth rate from commercial and industrial revenue has remained essentially flat compared to the industry average where the non-residential construction industry has grown at a compound annual rate of approximately 4.4% per year. Commercial and industrial work represented approximately 66%, 63% and 58% of our revenues for the years ended September 30, 2004, 2005 and 2006, respectively. For additional segment information for each of the three years ended September 30, 2006, see Note 12 to the Consolidated Financial Statements.

 

New commercial and industrial work begins with either a design request or engineer’s plans from the owner or general contractor. Initial meetings with the parties allow us to prepare preliminary, detailed design specifications, engineering drawings and cost estimates. Projects we design and build generally provide us with higher margins. “Design and build” gives full or partial responsibility for the design specifications of the installation. Design and build is an alternative to the traditional “plan and spec” model, where the contractor builds to the exact specifications of the architect and engineer. We prefer to perform “design and build” work,

because it allows us to use past experience to install a more cost effective project for the customer with higher profitability to us. Once a project is awarded, it is conducted in scheduled phases and progress billings are rendered to our customer for payment, less retention of 5% to 10% of the construction cost of the project. We generally provide the materials to be installed as a part of these contracts, which vary significantly in size from a few hundred dollars to several million dollars and vary in duration from less than a day to more than a year. Actual fieldwork is coordinated during this time, including:

 

 

Our service and maintenance revenues are derived from service calls and routine maintenance contracts, which tend to be recurring and less sensitive to economic fluctuations. Service and maintenance is supplied on a long-term and per-call basis. Long-term service and maintenance is provided through contracts that require the customer to pay an annual or semiannual fee for periodic diagnostic services. Per-call service and maintenance is initiated when a customer requests emergency repair service. Service technicians are scheduled for the call or routed to the customer’s residence or business by the dispatcher. We will then follow up with the customer to schedule periodic maintenance work. Most service work is warranted for thirty days. Service personnel work out of our service vehicles, which carry an inventory of equipment, tools, parts and supplies needed to complete the typical variety of jobs. The technician assigned to a service call:

 

 

We design and install communications and utility infrastructure systems and low voltage systems for the commercial and industrial market as a complement to our primary electrical contracting services. We believe the demand for our communications services is driven by the following factors: the pace of technological change; the overall growth in voice and data traffic; and the increasing use of personal computers and modems, with particular emphasis on the market for broadband internet access. Demand for our utilities services is driven by industry deregulation, limited maintenance or capital expenditures on existing systems and increased loads and supply and delivery requirements. Demand for our low voltage systems is driven by the construction industry growth rate and our ability to cross-sell among our customers.

 

Residential Market —  Our work for the residential market consists primarily of electrical installations in new single-family housing and low-rise, multi-family housing, for local, regional and national homebuilders and developers. We believe demand for our residential services is dependent on the number of single-family and multi-family home starts in the markets we serve. Single-family home starts are affected by the level of interest rates and general economic conditions. A competitive factor particularly important in the residential market is our ability to develop relationships with homebuilders and developers by providing services in multiple areas of their operations. This ability has become increasingly important as consolidation has occurred in the residential construction industry, and homebuilders and developers have sought out service providers that can provide consistent service in all of their operating regions.

 

We are currently one of the largest providers of electrical contracting services to the U.S. residential construction market. Our residential business has experienced significant growth. Our compound annual growth rate from residential electrical revenue has grown 11.3% from fiscal 2002 through 2006 compared to an industry average of approximately 8.3% over the same period. Residential electrical contracting represented approximately 34%, 37% and 42% of our revenues for the years ended September 30, 2004, 2005 and 2006, respectively.

 

The residential business is generally more profitable and less capital intensive than our commercial and industrial business. It also has lower barriers to entry and has a much lower surety bonding need. For

additional segment information for each of the three years ended September 30, 2006, see Note 12 to the Consolidated Financial Statements. Our results of operations from residential construction are seasonal, depending on weather trends, with typically higher revenues generated during spring and summer and lower revenues during fall and winter.

 

Customers

 

We have a diverse customer base. We will continue our emphasis on developing and maintaining relationships with our customers by providing superior, high-quality service. During the years ended September 30, 2004, 2005 and 2006, no single customer accounted for more than 10% of our revenues.

 

Backlog

 

For the fiscal year ended September 30, 2006, we had backlog associated with our continuing operations of approximately $370.9 million compared to a backlog of approximately $332.5 million for the fiscal year ended September 30, 2005. We had backlog associated with our discontinued operations of approximately $3.7 million for the fiscal year ended September 30, 2006 versus $48.2 million for the fiscal year ended September 30, 2005.

 

Company Operations

 

Employee Screening, Training and Development.  We are committed to providing the highest level of customer service through the development of a highly trained workforce. Employees are encouraged to complete a progressive training program to advance their technical competencies and to ensure that they understand and follow the applicable codes, our safety practices and other internal policies. We support and fund continuing education for our employees, as well as apprenticeship training for technicians under the Bureau of Apprenticeship and Training of the Department of Labor and similar state agencies. Employees who train as apprentices for four years may seek to become journeymen electricians and, after additional years of experience, master electricians. We pay progressive increases in compensation to employees who acquire this additional training, and more highly trained employees serve as foremen, estimators and project managers. Our master electricians are licensed in one or more cities or other jurisdictions in order to obtain the permits required in our business. Some employees have also obtained specialized licenses in areas including security systems and fire alarm installation. In some areas, licensing boards have set continuing education requirements for maintenance of licenses. Because of the lengthy and difficult training and licensing process for electricians, we believe that the number, skills and licenses of our employees constitute a competitive strength in the industry.

 

We actively recruit and screen applicants for our technical positions and have established programs in some locations to recruit apprentice technicians directly from high schools and vocational technical schools. Prior to hiring new employees, we assess their technical competence level, confirm background references and conduct drug testing.

 

Control and Information Systems.  We are committed to performing those controls and procedures that improve our efficiency and the monitoring of our operations. In fiscal 2006, we completed our deployment of a standard financial accounting software to all of our construction companies for their accounting and reporting needs. We believe having this common system is paramount to growing our business. Additionally, we have implemented a financial reporting and planning application to complement the standard financial accounting software that provides a uniform structure and analytical tool for the reporting process. Implementation of this system and the complementary financial reporting application allows us to obtain more timely

results of operating performance and perform a more detailed analysis. In addition to our financial accounting system, other controls and procedures we have in place include but are not limited to:

 

 

Competition

 

The electrical contracting industry is highly fragmented and competitive. Most of our competitors are small, owner-operated companies that typically operate in a limited geographic area. There are few public companies focused on providing electrical contracting services. In the future, we may encounter competition from new market entrants.

 

Regulations

 

Our operations are subject to various federal, state and local laws and regulations, including:

 

 

We believe we have all licenses required to conduct our operations and are in substantial compliance with applicable regulatory requirements. Our failure to comply with applicable regulations could result in substantial fines or revocation of our operating licenses or an inability to perform government work.

 

Many state and local regulations governing electricians require permits and licenses to be held by individuals. In some cases, a required permit or license held by a single individual may be sufficient to authorize specified activities for all our electricians who work in the state or county that issued the permit or license. It is our policy to ensure that, where possible, any permits or licenses that may be material to our operations in a particular geographic area are held by multiple IES employees within that area.

 

Risk Management and Insurance

 

The primary risks in our operations include health, bodily injury, property damage and injured workers’ compensation. We maintain automobile and general liability insurance for third party health, bodily injury and property damage and workers’ compensation coverage, which we consider appropriate to insure against these risks. Our third-party insurance is subject to large deductibles for which we establish reserves and, accordingly, we effectively self-insure for much of our exposures.

 

Employees

 

At September 30, 2006, we had 7,183 employees. We are not a party to any collective bargaining agreements with our employees. We believe that our relationship with our employees is satisfactory.

 

Available Information

 

We file our interim and annual financial reports, as well as other reports required by the Securities Exchange Act of 1934 with the United States Securities and Exchange Commission (the “SEC”). Our annual

report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments and exhibits to those reports are free of charge through our website at www.ies-co.com as soon as it is reasonably practicable after we file them with, or furnish them to, the SEC.

 

We have adopted a Code of Ethics for Financial Executives, a Code of Business Conduct and Ethics for directors, officers and employees (the legal Compliance and Corporate Policy Manual) and established Corporate Governance Guidelines and adopted charters outlining the duties of our Audit, Human Resources and Compensation and Nominating/ Governance Committees, copies of which may be found on our website at www.ies-co.com. Paper copies of these documents are also available free of charge upon written request to us. We have designated an “audit committee financial expert” as that term is defined by the SEC. Further information about this designee may be found in the Proxy Statement for the Annual Meeting of Stockholders of the Company.

 

You should consider carefully the risks described below, as well as the other information included in this document before making an investment decision. Our business, results of operations or financial condition could be materially and adversely affected by any of these risks, and the value of your investment may decrease due to any of these risks.

 

 

Evaluations are made of our internal control over financial reporting and our disclosure controls and procedures, which include a review of the objectives, design, implementation and effect of the controls and the information generated for use in our periodic reports. In the course of our controls evaluation, we sought (and seek) to identify data errors, control problems and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation is conducted on a quarterly basis so that the conclusions concerning the effectiveness of our controls can be reported in our periodic reports.

 

A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be satisfied. Internal control over financial reporting and disclosure controls and procedures are designed to give a reasonable assurance that they are effective to achieve their objectives. We cannot provide absolute assurance that all possible future control issues within our company have been detected. These inherent limitations include the real world possibility that judgments in our decision-making can be faulty, and that isolated breakdowns can occur because of simple human error or mistake. The design of our system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed absolutely in achieving our stated goals under all potential future or unforeseeable conditions. Because of the inherent limitations in a cost-effect control system, misstatements due to error could occur and not be detected.

 

 

Resulting from our inability to timely file a 10-Q for the quarter ended June 30, 2004 and the associated decline in the trading price of our stock, a series of class action securities claims were filed and later consolidated into one action pending in Houston, Texas. We have Directors and Officers insurance that provides coverage for this action. It is difficult to predict liability or any potential range of damages that we might incur in connection with this action. An adverse result could have a material adverse effect on our business, financial condition or cash flows.

 

 

More than half of our business involves the installation of electrical systems in newly constructed and renovated buildings, plants and residences. The construction industry is cyclical and downturns in levels of construction or housing starts could have a material adverse effect on our business, financial condition and results of operations. Our ability to maintain or increase revenues from new installation services will depend on the number of new construction starts and renovations, which will likely correlate with the cyclical nature of the construction industry. The number of new building starts will be affected by local economic conditions, and other factors, including the following:

 

 

A majority of our business is focused in the southeastern and southwestern portions of the United States, concentrating our exposure to local economic conditions in those regions. Downturns in levels of construction or housing starts in these geographic areas could result in a material reduction in our activity levels. The residential construction portion of our business is beginning to see slowed growth and cost pressures which may affect the profitability of that portion of our business in some areas.

 

 

Five companies were closed but work remained at those five companies that had to be completed. This work has continued to lose money as many employees left for other positions before the work was completed. The high turnover resulted in loss of productivity, loss of continuity and familiarity with the job and additional training costs. Although the cost to complete such work is down to less than $4.1 million, there are still potentially future losses. The losses can result in covenant violations under the credit facility and the term loan as both have shut-down covenants.

 

 

The electrical contracting industry is served by many small, owner-operated private companies, public companies and several large regional companies. We could also face competition in the future from new competitors entering these markets because electrical contracting has a relatively low capital requirement for entry. Some of our competitors offer a greater range of services, including mechanical construction, facilities management, plumbing and heating, ventilation and air conditioning services. Competition in our markets depends on a number of factors, including price. Some of our competitors may have lower overhead cost structures and may, therefore, be able to provide services comparable to ours at lower rates than we do. If we are unable to offer our services at competitive prices or if we have to reduce our prices to remain competitive, our profitability would be impaired.

 

 

There is a shortage of qualified electricians in the United States. In order to conduct our business, it is necessary to employ electricians and have those electricians qualified in the states where they do business. While overall economic growth has diminished, our ability to increase productivity and profitability may be limited by our ability to employ, train and retain skilled electricians required to meet our needs. Accordingly there can be no assurance, among other things, that:

 

 

 

Our business is subject to seasonal variations in operations and demand that affect the construction business, particularly in residential construction. Untimely weather delay from rain, ice, cold or snow can not only delay our work but can negatively impact our schedules and profitability by delaying the work of other trades on a construction site. Our quarterly results may also be affected by regional economic conditions that affect the construction market. Accordingly, our performance in any particular quarter may not be indicative of the results that can be expected for any other quarter or for the entire year. Additionally, increases in construction materials such as steel and lumber can alter the rate of new construction.

 

 

We currently generate, and expect to continue to generate, more than half of our revenues under fixed price contracts. The cost of gasoline, labor and materials, however, may vary significantly from the costs we originally estimate. Variations from estimated contract costs along with other risks inherent in performing fixed price contracts may result in actual revenue and gross profits for a project differing from those we originally estimated and could result in losses on projects. Depending upon the size of a particular project, variations from estimated contract costs can have a significant impact on our operating results.

 

 

We enter into many contracts at fixed prices and if the cost associated with commodities such as copper, steel, gasoline and certain plastics increase, the companies expect profit may decline under that contract.

 

 

We expect to expend significant time and effort managing and merging existing operations. We cannot guarantee that our systems, procedures and controls will be adequate to support operations, including the timely receipt of financial information. As we have consolidated some support functions of human resources, payroll, estimating, safety, accounting, and other administrative support functions it has offered some cost savings. Those savings only arise after the consolidations and after additional time and effort managing that consolidation.

 

 

Our billings under fixed price contracts are generally based upon achieving certain benchmarks and will be accepted by the customer once we demonstrate those benchmarks have been met. If we are unable to demonstrate compliance with billing requests, or if we fail to issue a project billing, our likelihood of collection could be delayed or impaired, which could have a materially adverse effect on our operations if this occurred over several large projects.

 

 

Our ability to make payments on and to refinance our indebtedness and to fund planned capital expenditures will depend on our ability to generate cash in the future. This is subject to our operational performance, as well as general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.

 

We cannot provide assurance that our business will generate sufficient cash flow from operations or asset sales and that future borrowings will be available to us under our credit facility in an amount sufficient to enable us to pay our indebtedness, or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, on or before maturity. We cannot provide assurance that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. Our inability to refinance our debt on commercially reasonable terms could materially adversely affect our business.

 

 

Our effective tax rate and cash paid for taxes are impacted by numerous tax positions that we have adopted. Taxing authorities may not always agree with the positions we have taken. We believe that we have adequate reserves in the event that a taxing authority differs with positions we have taken, however, there can be no assurance that our results of operations will not be adversely affected.

 

 

When we acquire a business, we record an asset called “goodwill” if the amount we pay for the business, including liabilities assumed, is in excess of the fair value of the assets of the business we acquire. Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets” established

accounting and reporting requirements for goodwill and other intangible assets. SFAS No. 142 requires that goodwill attributable to each of four reporting units be tested at least annually (absent any impairment indicators). The testing includes comparing the fair value of each reporting unit with its carrying value. Fair value is determined using discounted cash flows, market multiples and market capitalization. Significant estimates used in the methodologies include estimates of future cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for each of the reportable units. On an ongoing basis (absent any impairment indicators), we expect to perform impairment tests at least annually during the last fiscal quarter of each year. Impairment adjustments recognized after adoption, if any, generally are required to be recognized as operating expenses. We cannot assure that we will not have future impairment adjustments to our recorded goodwill.

 

 

Hazards related to our industry include, but are not limited to, electrocutions, fires, machinery caused injuries, mechanical failures or transportation accidents. These hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment and may result in suspension of operations. Our insurance does not cover all types or amounts of liabilities. Our third-party insurance is subject to deductibles for which we establish reserves and, accordingly, we effectively self-insure for much of our exposures. No assurance can be given either that our insurance or our provisions for incurred claims and incurred but not reported claims will be adequate to cover all losses or liabilities we may incur in our operations or that we will be able to maintain adequate insurance at reasonable rates.

 

 

The loss of key personnel or the inability to hire and retain qualified employees could have an adverse effect on our business, financial condition and results of operations. Our operations depend on the continued efforts of our current and future executive officers, senior management and management personnel at the companies. We cannot guarantee that any member of management at the corporate or subsidiary level will continue in their capacity for any particular period of time. During these volatile times we have an increased risk of employees departing. If we lose a group of key personnel or even one key person at a company, our operations could be adversely affected. We do not maintain key man life insurance.

 

 

We may not be able to remain in compliance with the covenants in the term loan or the credit facility. We have already been required to amend the credit facility to adjust covenants for the shut down companies. A failure to fulfill the terms may result in a default under one or more of the material agreements.

 

 

Our business is primarily driven by labor. The ability to perform contracts at acceptable margins depends on our ability to deliver substantial labor productivity. We cannot guarantee that productivity will continue at acceptable levels at our corporate office and our operating subsidiaries for a particular period of time. With the increased activity of de-levering our balance sheet and the uncertainty in the market there is an increased difficulty in maintaining morale and focus of employees. The loss of productivity could adversely affect the margins on existing contracts or the ability to obtain new contracts.

 

 

In the construction business there are always claims and litigation. Latent defect litigation is a normal course for residential home builders in some parts of the country. Legislation in other states indicate such litigation may increase to those states. There is also the inherent claims and litigation risk of the number of people that work on construction sites and the fleet of vehicles on the road everyday. Those claims and litigation risks are managed through safety programs, insurance programs, litigation management at the corporate office and the local level and attorneys and law firms throughout the country. Nevertheless, claims

are sometimes made and lawsuits filed and some for amounts in excess of their value or amounts for which they are eventually resolved. Claims and litigation normally follow a predictable course of time to resolution. Because of the large number of claims of a company with so many contracts and employees, there can be periods of time where a disproportionate amount of the claims and litigation may come to the point of resolution through the court system, arbitration, mediation, or settlement all in the same quarter or year. If these matters resolve near the same time then the cumulative effect can be higher than the ordinary level in any one reporting period.

 

Latent defect litigation is increasing in states where we perform work. Such increases can put additional pressure on the profitability of the residential segment of our business.

 

Independent of the normal litigation risks, as a result IES’ inability to timely file its third quarter Form 10-Q and the subsequent events, a class action lawsuit has been filed, and a formal SEC investigation is ongoing. Those matters are discussed in more detail in Item 3 of this document.

 

 

We determined to sell all or substantially all of the assets of certain wholly owned subsidiaries. Those sales were made to facilitate the business needs and purposes of the organization as a whole. Since we were a consolidator of electrical contracting businesses, often the best candidate to purchase those assets was a previous owner of those assets. That previous owner may sometimes still be associated with the subsidiary as an officer of that subsidiary. To facilitate the desired timing, the sales were being made with more than ordinary reliance on the representations of the purchaser, who is often the person most familiar with the business unit being sold. There is the potential in retaining our corporate legal entity where we have sold substantially all of the assets. If the purchaser is unwilling or unable to perform the transferred liabilities, we may be forced to fulfill obligations that were assumed by others. We would then seek reimbursement from the parties that assumed those liabilities.

 

None.

 

We operate a fleet of approximately 2,500 owned and leased service trucks, vans and support vehicles. We believe these vehicles generally are adequate for our current operations.

 

At September 30, 2006, we maintained branch offices, warehouses, sales facilities and administrative offices at 121 locations. Substantially all of our facilities are leased. We lease our corporate office located in Houston, Texas.

 

Our properties are generally adequate for our present needs, and we believe that suitable additional or replacement space will be available as required.

 

Refer to Note 16 of Notes to Consolidated Financial Statements which is incorporated herein by reference.

 

None.

 

Prior to December 15, 2005, our common stock traded on the NYSE under the symbol “IES.” Between December 15, 2005 and May 12, 2006 our common stock traded over-the-counter on the pink sheets under the symbol “IESR.” On May 12, 2006, concurrent with the completion of our restructuring and emergence from bankruptcy, our common stock effectively underwent a reverse stock split which converted 17.0928 shares of old common stock into the right to receive one share of new common stock. On May 15, 2006, our common stock commenced trading on NASDAQ under the ticker symbol “IESC.” The following table sets forth (1) the high and low close price on any given day within the quarter and the close price on the last day of the quarter for our common stock as reported on the NYSE for fiscal 2005 and a portion of the first quarter of fiscal 2006, (2) the high and low bid quotation on any given day within the quarter and the close bid quotation on the last day of the quarter for our common stock as reported in the over-the-counter market on the pink sheets for a portion of the first quarter and the second quarter and a portion of the third quarter of fiscal 2006, and (3) the high and low close price on any given day within the quarter and the close price on the last day of the quarter for our common stock as reported on NASDAQ for a portion of the third quarter and for the fourth quarter of fiscal 2006. The over-the-counter quotations reflect inter-dealer prices, without retail markup, markdown or commissions, and may not necessarily represent actual transactions. The following per share amounts prior to May 1, 2006 have been adjusted for the effect of the 17.0928 to 1 reverse stock split.

 

Predecessor Company

 

 

Successor Company

 

 

As of December 15, 2006, the closing market price of our Common Stock was $15.08 per share and there were approximately 222 holders of record.

 

We do not anticipate paying cash dividends on or repurchasing our common stock in the foreseeable future. We expect that we will utilize all available earnings generated by our operations, proceeds from sales of operations and borrowings under our credit facility for the development and operation of our business. Any future determination as to the payment of dividends will be made at the discretion of our Board of Directors and will depend upon our operating results, financial condition, capital requirements, general business conditions and such other factors as the Board of Directors deems relevant. Our debt instruments restrict us from paying cash dividends on the common stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

 

The following selected consolidated historical financial information for IES should be read in conjunction with the audited historical consolidated financial statements of Integrated Electrical Services, Inc. and subsidiaries and the notes thereto included in Item 8, “Financial Statements and Supplementary Data.”

 

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in the Form 10-K. See “Disclosure Regarding Forward-Looking Statements”.

 

General

 

The terms, “IES”, the “Company”, “we”, “our”, and “us”, when used with respect to the periods prior to our emergence from Chapter 11, are references to the Predecessor, and when used with respect to the period commencing after our emergence, are references to the Successor, as the case may be, unless otherwise indicated or the context otherwise requires.

 

Voluntary Reorganization Under Chapter 11

 

On February 14, 2006, we filed voluntary petitions for reorganization under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division. The Bankruptcy Court jointly administered these cases as “In re Integrated Electrical Services, Inc. et. al., Case No. 06-30602-BJH-11”. On April 26, 2006, the Bankruptcy Court entered an order approving and confirming the plan of reorganization. The plan was filed as Exhibit 2.1 to our current report on Form 8-K, filed on April 28, 2006. Capitalized terms used in this section but not defined herein shall have the meaning set forth in the plan. We operated our businesses and managed our properties as debtors-in-possession in accordance with the bankruptcy code from February 14, 2006 through emergence from Chapter 11 on May 12, 2006.

 

Basis of Presentation

 

In accordance with Statement of Position 90-7 “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP 90-7”), we applied “fresh-start” accounting as of April 30, 2006. Fresh-start accounting requires us to allocate the reorganization value to our assets and liabilities in a manner similar to that which is required under Statement of Financial Accounting Standards No. 141 (SFAS 141), “Business Combinations”.  Under the provisions of fresh-start accounting, a new entity has been deemed created for financial reporting purposes. References to “Successor” in the financial statements are in reference to reporting dates on and after May 1, 2006. References to “Predecessor” in the financial statements are in reference to reporting dates through April 30, 2006 including the impact of plan provisions and the adoption of fresh-start reporting. As such, our financial information for the Successor is presented on a basis different from, and is therefore not comparable to, our financial information for the Predecessor for the period ended and as of April 30, 2006 or for prior periods. For further information on fresh-start accounting, see Note 2 to our Consolidated Financial Statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included.

 

References to year-to-date 2006 financial information throughout this discussion combine the periods of October 1, 2005 to April 30, 2006 (Predecessor) with May 1, 2006 to September 30, 2006 (Successor). A reconciliation is provided to that effect. Management believes that providing this financial information is the most relevant and useful method for making comparisons to the twelve months ended September 30, 2004, September 30, 2005 and September 30, 2006.

 

The Plan of Reorganization

 

The plan was approved by the Bankruptcy Court on the confirmation date, April 26, 2006. In accordance with the plan:

 

(i) The holders of the senior subordinated notes received on the date we emerged from bankruptcy, in exchange for their total claims (including principal and interest), 82% of the fully diluted new common stock representing 12,631,421 shares, before giving effect to options to be issued under a new employee

and director stock option plan which could be up to 10% of the fully diluted shares of new IES common stock outstanding as of the effective date of the plan.

 

(ii) The holders of old common stock received 15% of the fully diluted new common stock representing 2,310,614 shares, before giving effect to the 2006 equity incentive plan.

 

(iii) Certain members of management received restricted shares of new common stock equal to 2.5% of the fully diluted new common stock with an additional 0.5% reserved for new key employees, before giving effect to the 2006 equity incentive plan. The restricted shares of new common stock vest over approximately a three-year period.

 

(iv) The $50 million in senior convertible notes were refinanced from the proceeds of the $53 million term loan (see Note 9 to our Consolidated Financial Statements).

 

(v) All other allowed claims were either paid in full in cash or reinstated.

 

Reorganization Items

 

Reorganization items refer to revenues, expenses (including professional fees), realized gains, losses and provisions for losses that are realized or incurred as a result of the bankruptcy proceedings. The following table summarizes the components included in reorganization items on the consolidated statements of operations for the seven months ended April 30, 2006 (Predecessor) and for the five months ended September 30, 2006 (Successor) (in thousands):

 

 

 

 

Delisting from the NYSE

 

As previously disclosed, on December 15, 2005, in our current report on Form 8-K filed with the SEC, the NYSE suspended trading of our common stock and informed us of the NYSE’s intent to submit an application to the SEC to delist our common stock after completion of applicable procedures, including any appeal by us of the NYSE’s staff’s decision. We appealed the NYSE’s staff’s decision. On April 11, 2006, we

received notification from the NYSE that a meeting was held on April 5, 2006 to consider the appeal. In this meeting, the NYSE staff’s decision was affirmed to suspend and delist the common stock. In addition, the NYSE staff was directed to submit an application to the SEC to strike the common stock from listing in accordance with Section 12 of the Securities Exchange Act of 1934. On June 26, 2006, our listing on the NYSE was removed.

 

Listing on NASDAQ

 

We submitted the initial application to list our new common stock on NASDAQ upon emerging from Chapter 11 and was approved and listed for quotation commencing on May 15, 2006. Our new common stock now trades under the ticker symbol IESC.

 

Costs Associated with Exit or Disposal Activities

 

As a result of disappointing operating results, the Board of Directors directed us to develop alternatives with respect to certain underperforming subsidiaries. These subsidiaries are included in our commercial and industrial segment. On March 28, 2006, we committed to an exit plan with respect to those underperforming subsidiaries. The exit plan committed to a shut-down or consolidation of the operations of these subsidiaries or the sale or other disposition of the subsidiaries, whichever came earlier. Further information can be obtained by referring to Part II, Item 7. “Discontinued Operations” for a summary of the exit plan.

 

Surety

 

The Chubb Surety Agreement

 

We are party to an underwriting, continuing indemnity and security agreement, dated May 12, 2006 and related documents, with Chubb, which provides for the provision of surety bonds to support our contracts with certain of our customers.

 

In connection with our restructuring and the order confirming our plan of reorganization under Chapter 11 of the Bankruptcy Code, we entered into a post-confirmation financing agreement with Chubb. Effective June 1, 2006, this agreement provides Chubb (1) in its sole and absolute discretion to issue up to an aggregate of $70 million in new surety bonds, with not more than $10 million in new surety bonds to be issued in any given month; (2) no single bond will be issued under the facility with a penal sum in excess of $3 million, or with respect to a contract having a completion date more than 18 months from the commencement of work thereunder, and (3) to give permission for our use of cash collateral in the form of proceeds of all contracts as to which Chubb has issued surety bonds. We paid a facility fee of $1.0 million to Chubb at inception of this agreement. This fee was capitalized and is being amortized over the life of the agreement. The Chubb exit agreement expires on December 31, 2006. As of September 30, 2006, we had $43.7 million bonded costs to complete under outstanding Chubb bonds.

 

On October 30, 2006, we entered into an amendment to the surety agreement with Chubb. Under the amendment, we agreed to pay a facility fee of $500,000, of which $250,000 was paid concurrently with the entry into the amendment and the balance will be paid on or before January 2, 2007. The amendment allows us to have up to $80 million cost to complete on bonded projects at any time. At September 30, 2006, bonded cost to complete was $43.7 million. The amendment deletes the expiration date for issuance of bonds under the surety agreement and deletes the cap on the aggregate amount of bonds that may be issued in any calendar month. The amendment also provides for the reduction of the existing pledged cash collateral amount to $14.0 million by January 2, 2007. This $14.0 million in cash collateral is recorded in other non-current assets, net at September 30, 2006. Together with the existing letters of credit, the total collateral that will continue to be held by the surety will be $35.0 million as of January 2, 2007. The excess collateral amount of approximately $4.8 million was returned to us on November 1, 2006. This $4.8 million is in prepaid expenses and other current assets at September 30, 2006. The amendment removes prior restrictions on writing bonds to two of our subsidiaries. The amendment reduces the bond premium from $17.50 per $1,000.00 to $15.00 per $1,000.00. Additionally, the amendment amends the definition of “surety loss” to exclude certain professional

fees incurred before October 31, 2006. Further details can be obtained on the amendment in our Form 8-K dated October 30, 2006.

 

The SureTec Bonding Facility

 

We are party to a general agreement of indemnity dated September 21, 2005 and related documents, with SureTec Insurance Company, which provides for the provision of surety bonds to support our contracts with certain of its customers.

 

The SureTec facility provides for SureTec in its sole and absolute discretion to issue up to an aggregate of $10 million in surety bonds. Bonding in excess of $5 million is subject to SureTec’s receipt of additional collateral in the form of an additional irrevocable letter of credit from Bank of America in the amount of $1.5 million. As of September 30, 2006, we had $0.5 million bonded cost to complete under the SureTec bonding facility.

 

The Scarborough Bonding Facility

 

We are party to a general agreement of indemnity dated March 21, 2006 and related documents, with Edmund C. Scarborough, Individual Surety, to supplement the bonding capacity under the Chubb facility and the SureTec facility.

 

Under the Scarborough facility, Scarborough has agreed to extend aggregate bonding capacity not to exceed $50 million in additional bonding capacity with a limitation on individual bonds of $15 million. Scarborough is an individual surety (as opposed to a corporate surety, like Chubb or SureTec), and these bonds are not rated. However, the issuance of Scarborough’s bonds to an obligee/contractor is backed by an instrument referred to as an irrevocable trust receipt issued by First Mountain Bancorp as trustee for investors who pledge assets to support the irrevocable trust receipt and the related bond. The bonds are also reinsured.

 

Scarborough’s obligation to issue new bonds will be discretionary, and the aggregate bonding was subject to Scarborough’s receipt of $2.0 million in collateral to secure all of our obligations to Scarborough. Bank of America and Scarborough have entered into an inter-creditor agreement. As of September 30, 2006, we had $22.4 million in aggregate face value of bonds issued under the Scarborough bonding facility.

 

Financing

 

Pre-Petition Credit Facility

 

On August 1, 2005, we entered into a three-year $80 million pre-petition asset-based revolving credit facility with Bank of America, N.A., as administrative agent. The pre-petition credit facility replaced our existing revolving credit facility with JPMorgan Chase Bank, N.A., which was scheduled to mature on August 31, 2005.

 

The pre-petition credit facility allowed us and our subsidiaries to obtain revolving credit loans and provided for the issuance of letters of credit. The amount available at any time under the pre-petition credit facility for revolving credit loans or the issuance of letters of credit was determined by a borrowing base calculated as a percentage of accounts receivable, inventory and equipment. The borrowings were limited to $80 million.

 

We amended the pre-petition credit facility several times between August 2005 and February 2006 prior to filing for Chapter 11 bankruptcy. The pre-petition credit facility was replaced by a debtor-in-possession credit facility on February 14, 2006.

 

Further details can be obtained from the Loan and Security Agreement dated as of August 1, 2005, and filed as exhibit 10.1 to the Form 8-K dated August 4, 2005.

Debtor-in-Possession Financing

 

On February 14, 2006, in connection with the Chapter 11 cases, we entered into the debtor-in-possession loan and security agreement with Bank of America. The debtor-in-possession credit facility was approved by the Bankruptcy Court on an interim basis on February 15, 2006, and on a final basis on March 10, 2006.

 

The debtor-in-possession credit facility provided for an aggregate financing of $80 million while we were in bankruptcy, consisting of a revolving credit facility of up to $80 million, with a $72 million sub-limit for letters of credit. All letters of credit and other obligations outstanding under the pre-petition credit facility constituted obligations and liabilities under the debtor-in-possession credit facility. Accordingly, we wrote off approximately $3.8 million in unamortized deferred financing costs related to the pre-petition credit facility during the quarter ended March 31, 2006.

 

We utilized the debtor-in-possession credit facility to issue letters of credit for (1) certain insurance programs; (2) our surety programs; and (3) certain projects.

 

On our emergence from bankruptcy, in accordance with the plan, the debtor-in-possession credit facility was replaced by a new credit facility. As a result, previously capitalized deferred issuance costs of $0.7 million were written off to interest expense and are reflected in the statements of operations for the seven months ended April 30, 2006. Amortization during the seven months ended April 30, 2006 was $1.0 million.

 

The Revolving Credit Facility

 

On the date we emerged from bankruptcy, May 12, 2006, we entered into a revolving credit facility with Bank of America and certain other lenders. The revolving credit facility provides us access to revolving borrowings in the aggregate amount of up to $80 million, with a $72 million sub-limit for letters of credit, for the purpose of refinancing the debtor-in-possession credit facility and to provide letters of credit and financing subsequent to confirmation of the plan.

 

On October 13, 2006, we entered into an amendment and waiver to the loan and security agreement, dated May 12, 2006, with Bank of America (see Form 8-K filed on October 13, 2006). The amendment amends the loan agreement to change the minimum amount of the Shutdown EBIT (defined in Exhibit 10.1 to our current report on Form 8-K, filed on May 17, 2006) for the period of October 1, 2005 through September 30, 2006 from $18.0 million to $21.0 million. The amendment also provides a waiver of any violation of the loan and security agreement resulting from our failure to achieve the minimum Shutdown EBIT on the August 31, 2006 measurement date.

 

On November 30, 2006, we entered into an amendment, dated October 1, 2006, with Bank of America. The amendment changes the minimum amount of the EBIT permitted for the companies associated with the exit plan (See Part II, Item 7, “Costs Associated with Exit or Disposal Activities” below for a summary of the exit plan) for the period beginning on October 1, 2006 and thereafter from zero to negative $2.0 million. The amendment also deletes the covenant requiring the subsidiaries associated with the exit plan to have certain minimum amounts of cash in order to convert a minimum amount of their aggregate net working capital into cash. Additionally, the definition of Consolidated Fixed Charge Conversion Ratio was modified. Further details can be obtained by referencing our Form 8-K dated December 5, 2006.

 

On December 11, 2006, we entered into an amendment to the loan and security agreement, dated May 12, 2006 with Bank of America. The amendment amends the loan agreement to change the minimum amount of the Shutdown EBIT (as defined in the loan and security agreement filed as Exhibit 10.1 to our Form 8-K dated May 17, 2006) for the period of October 1, 2005 through September 30, 2006 from $21.0 million to $22.0 million.

 

Loans under the credit facility bear interest at LIBOR plus 3.5% or the base rate plus 1.5% on the terms set in the credit agreement. In addition, we are charged monthly in arrears (1) an unused line fee of either 0.5% or 0.375% depending on the utilization of the credit line, (2) a letter of credit fee equal to the applicable per annum LIBOR margin times the amount of all outstanding letters of credit and (3) certain other fees and charges as specified in the credit agreement.

The credit facility will mature on May 12, 2008. The credit facility is guaranteed by our subsidiaries and is secured by first priority liens on substantially all of our and our subsidiaries existing and future acquired assets, exclusive of collateral provided to sureties. The credit facility contains customary affirmative, negative and financial covenants binding us as described below.

 

The financial covenants, as amended, require us to:

 

 

The Term Loan

 

On the date we emerged from bankruptcy, May 12, 2006, we entered into a $53 million senior secured term loan with Eton Park Fund L.P. and an affiliate and Flagg Street Partners LP and affiliates for refinancing the senior convertible notes.

 

On November 30, 2006, we entered an amendment agreement, dated October 1, 2006, with Eton Park Fund, L.P. and an affiliate, Flagg Street Partners LP and affiliates, and Wilmington Trust Company as administrative agent. This amendment to the term loan changes the amount of EBIT permitted for the companies associated with the exit plan (See Part II, Item 7, “Costs Associated with Exit or Disposal Activities” above for a summary of the exit plan) from not less than zero to not less than negative $2.0 million. The covenant requiring these subsidiaries to have certain minimum amounts of cash in order to convert a minimum amount of their aggregate net working capital into cash was deleted. Additionally, the definition of Consolidated Fixed Charge Conversion Ratio was modified. Further details can be obtained by referencing our Form 8-K dated December 5, 2006.

 

The term loan bears interest at 10.75% per annum, subject to adjustment as set forth in the term loan agreement. Interest is payable in cash, in arrears, quarterly, provided that, in our sole discretion, until the third anniversary of the closing date that we have the option to direct that interest be paid by capitalizing that interest as additional loans under the term loan. As of September 30, 2006, we have capitalized interest as additional loans of $2.6 million. Subject to the term loan lenders’ right to demand repayment in full on or after the fourth anniversary of the closing date, the term loan will mature on the seventh anniversary of the closing date at which time all principal will become due. The term loan contains customary affirmative,

negative and financial covenants binding on us, including, without limitation, a limitation on indebtedness of $90 million under the credit facility with a sub-limit on funded outstanding indebtedness of $25 million, as more fully described in the term loan agreement. Additionally, the term loan includes provisions for optional and mandatory prepayments on the conditions as set in the term loan agreement. The term loan is guaranteed by our subsidiaries, is secured by substantially the same collateral as the revolving credit facility and is second in priority to the liens securing the revolving credit facility. The adjusted interest rate on the term loan for the three months ended September 30, 2006 was 12.3% as a result of our performance during the six months ended June 30, 2006.

 

The term loan has many of the same financial covenants as the credit facility beginning October 1, 2006. In addition, the term loan prohibits the EBITDA minus Capex Level (as defined) to be less than negative $20.0 million for any fiscal quarter or on a cumulative basis at each quarter end beginning January 1, 2006 and ending December 31, 2006.

 

Investment in Energy Photovoltaics, Inc.

 

On July 16, 2006, we entered into a stock purchase agreement with Tontine Capital Overseas Master Fund, L.P. (“Tontine”). Tontine, together with its affiliates, owns approximately 34% of our outstanding stock. Joseph V. Lash, a member of Tontine Associates, LLC, an affiliate of Tontine, is a member of our Board of Directors.

 

Pursuant to the stock purchase agreement, on July 17, 2006 we issued 58,072 shares of our common stock to Tontine for a purchase price of $1.0 million in cash. The purchase price per share was based on the closing price of our common stock quoted on the NASDAQ Stock Market on July 14, 2006. The proceeds of the sale were used to make a new $1.0 million investment in Energy Photovoltaics, Inc. (“EPV”), a company in which we, prior to this new investment, held and continue to hold a minority interest. The IES common stock was issued to Tontine in reliance on the exemption from registration contained in Section 4(2) of the Securities Act of 1933, as amended.

 

We had previously accounted for our original investment in EPV under the equity method of accounting and accordingly recorded our share of EPV’s losses of $0.9 million, $1.4 million and zero for the years ended September 30, 2004, 2005 and 2006, respectively. The carrying amount of the original investment prior to this new investment was zero at September 30, 2005 as a result of recording our pro-rata share of losses and an impairment charge of $0.7 million. Additionally, we had a note receivable from EPV of $1.8 million that was completely written off prior to September 30, 2005. In conjunction with the new investment of $1.0 million in exchange for EPV common stock, we converted the previous note receivable investment and the previous preferred stock investment into common stock of EPV. After our new investment in EPV of $1.0 million, we owned 17.64% of EPV common stock, which can be diluted down to 15.81% assuming full exercise of all available stock options for grant and the exercise of all outstanding warrants. We began accounting for this new investment in EPV using the cost method of accounting in July 2006.

 

Critical Accounting Policies

 

In response to the SEC’s Release No. 33-8040, “Cautionary Advice Regarding Disclosure About Critical Accounting Policies”, we have identified the accounting principles, which we believe are most critical to our reported financial status by considering accounting policies that involve the most complex or subjective decisions or assessments. We identified our most critical accounting policies to be those related to revenue recognition, the assessment of goodwill impairment, our allowance for doubtful accounts receivable, the recording of our self-insurance liabilities and our estimation of the valuation allowance for deferred tax assets. These accounting policies, as well as others, are described in Note 4 of “Notes to Consolidated Financial Statements” and at relevant sections in this discussion and analysis.

 

As a result of the Chapter 11 bankruptcy proceedings, we prepared our financial statements in accordance with SOP 90-7 from the commencement date through April 30, 2006, the date of adoption of fresh-start reporting. SOP 90-7 requires us to, among other things, (1) identify and disclose separately transactions that are directly associated with the bankruptcy proceedings from those events that occur during the normal course

of business, (2) segregate pre-petition liabilities subject to compromise from those that are not subject to compromise or post-petition liabilities, (3) assess the applicability of fresh-start start accounting upon emergence from bankruptcy and (4) allocate the reorganization value to our assets and liabilities only if fresh-start is applicable. This allocation requires certain assumptions and estimates to determine the fair value of asset groups including estimates about future cash flows, discount rates, among other things.

 

We enter into contracts principally on the basis of competitive bids. We frequently negotiate the final terms and prices of those contracts with the customer. Although the terms of our contracts vary considerably, most are made on either a fixed price or unit price basis in which we agree to do the work for a fixed amount for the entire project (fixed price) or for units of work performed (unit price). We also perform services on a cost-plus or time and materials basis. We currently generate, and expect to continue to generate, more than half of our revenues under fixed price contracts. Our most significant cost drivers are the cost of labor, the cost of materials and the cost of casualty and health insurance. These costs may vary from the costs we originally estimated. Variations from estimated contract costs along with other risks inherent in performing fixed price and unit price contracts may result in actual revenue and gross profits or interim projected revenue and gross profits for a project differing from those we originally estimated and could result in losses on projects. Depending on the size of a particular project, variations from estimated project costs could have a significant impact on our operating results for any fiscal quarter or year. We believe our exposure to losses on fixed price contracts is limited in aggregate by the high volume and relatively short duration of the fixed price contracts we undertake. Additionally, we derive a significant amount of our revenues from new construction and from the southern part of the United States. Downturns in new construction activity in the southern part of the United States could negatively affect our results.

 

We complete most projects within one year. We frequently provide service and maintenance work under open-ended, unit price master service agreements which are renewable annually. We recognize revenue on service, time and material work when services are performed. Work performed under a construction contract generally provides that the customers accept completion of progress to date and compensate us for services rendered measured in terms of units installed, hours expended or some other measure of progress. Revenues from construction contracts are recognized on the percentage-of-completion method in accordance with the American Institute of Certified Public Accountants Statement of Position (SOP) 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”. Percentage-of-completion for construction contracts is measured principally by the percentage of costs incurred and accrued to date for each contract to the estimated total costs for each contract at completion. We generally consider contracts substantially complete upon departure from the work site and acceptance by the customer. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs and depreciation costs. Changes in job performance, job conditions, estimated contract costs, profitability and final contract settlements may result in revisions to costs and income and the effects of these revisions are recognized in the period in which the revisions are determined. Provisions for total estimated losses on uncompleted contracts are made in the period in which such losses are determined.

 

We evaluate goodwill for potential impairment in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Included in this evaluation are certain assumptions and estimates to determine the fair values of reporting units such as estimates of future cash flows, discount rates as well as assumptions and estimates related to the valuation of other identified intangible assets. Changes in these assumptions and estimates or significant changes to the market value of our common stock could materially impact our results of operations or financial position. During the twelve months ended September 30, 2005 and 2006, we recorded goodwill impairments of $53.1 million and $0 million, respectively.

 

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets”, we periodically assess whether any impairment indicators exist. If we determine impairment indicators exist, we conduct an evaluation to determine whether any impairment has occurred. This evaluation includes certain assumptions and estimates to determine fair value of asset groups including estimates about future cash flows, discount rates, among others. Changes in these assumptions and estimates or significant changes to the market value of our common stock could materially impact our results of operations or financial projections. During

the twelve months ended September 30, 2005 and 2006, we recorded a non-cash impairment charge of $6.0 million and $0.4 million, respectively, related to long-lived assets of continuing operations.

 

We provide an allowance for doubtful accounts for unknown collection issues, in addition to reserves for specific accounts receivable where collection is considered doubtful. Inherent in the assessment of the allowance for doubtful accounts are certain judgments and estimates including, among others, our customers’ access to capital, our customers’ willingness to pay, general economic conditions and the ongoing relationships with our customers.

 

In addition to these factors, our business and the method of accounting for construction contracts requires the review and analysis of not only the net receivables, but also the amount of billings in excess of costs and costs in excess of billings integral to the overall review of collectibility associated with our billings in total. The analysis management utilizes to assess collectibility of our receivables includes detailed review of older balances, analysis of days sales outstanding where we include in the calculation, in addition to accounts receivable balances net of any allowance for doubtful accounts, the level of costs in excess of billings netted against billings in excess of costs, and the ratio of accounts receivable, net of any allowance for doubtful accounts plus the level of costs in excess of billings, to revenues. These analyses provide an indication of those amounts billed ahead or behind the recognition of revenue on our construction contracts and are important to consider in understanding the operational cash flows related to our revenue cycle.

 

We are insured for workers’ compensation, automobile liability, general liability, employment practices and employee-related health care claims, subject to large deductibles. Our general liability program provides coverage for bodily injury and property damage that is neither expected nor intended. Losses up to the deductible amounts are accrued based upon our estimates of the liability for claims incurred and an estimate of claims incurred but not reported. The accruals are derived from actuarial studies, known facts, historical trends and industry averages utilizing the assistance of an actuary to determine the best estimate of the ultimate expected loss. We believe such accruals to be adequate. However, self-insurance liabilities are difficult to assess and estimate due to unknown factors, including the severity of an injury, the determination of our liability in proportion to other parties, the number of incidents not reported and the effectiveness of our safety program. Therefore, if actual experience differs from the assumptions used in the actuarial valuation, adjustments to the reserve may be required and would be recorded in the period that the experience becomes known.

 

We regularly evaluate valuation allowances established for deferred tax assets for which future realization is uncertain. We perform this evaluation at least annually at the end of each fiscal year. The estimation of required valuation allowances includes estimates of future taxable income. In assessing the realizability of deferred tax assets at September 30, 2006, we considered that it was more likely than not that some or all of the deferred tax assets would not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.

 

New Accounting Pronouncements

 

In accordance with SOP 90-7, we are required to adopt all new accounting pronouncements upon emergence from bankruptcy, if issued prior to and have effective dates within one year of the date of adoption of fresh-start reporting. We adopted fresh-start reporting on April 30, 2006. These accounting policies, as well as others, are described in Note 4 of “Notes to Consolidated Financial Statements” and at relevant sections in this discussion and analysis.

 

Results of Operations

 

Effective April 30, 2006, we implemented fresh-start reporting in accordance with SOP 90-7. As a result of the application of fresh-start reporting, the financial statements prior to May 1, 2006 are not comparable with the financial statements for the period of May 1, 2006 to September 30, 2006. However, for management’s discussion and analysis of the results of operations, the twelve months ended September 30,

2006 have been compared to the twelve months ended September 30, 2005. We believe this comparison provides a better perspective of our on-going financial and operational performance. References to the twelve months ended September 30, 2006 financial information throughout this discussion combine the periods of October 1, 2005 to April 30, 2006 with May 1, 2006 to September 30, 2006. A reconciliation is provided to that effect.

 

The following table presents selected historical results of operations of IES and its subsidiaries with dollar amounts in millions. These historical statements of operations include the results of operations for businesses acquired through purchases beginning on their respective dates of acquisition.

 

YEAR ENDED SEPTEMBER 30, 2006 COMPARED TO YEAR ENDED SEPTEMBER 30, 2005

 

Revenues

 

 

Total revenue increased $81.1 million, or 9.3%, from $869.1 million for the twelve months ended September 30, 2005, to $950.2 million for the twelve months ended September 30, 2006. This increase in total revenues is primarily the result of our residential segment, which accounted for a $78.3 million increase, or 24.7%, from $317.5 million for the twelve months ended September 30, 2005 to $395.8 million for the twelve months ended September 30, 2006. This increase continues to be as a result of increased demand for new single-family and multi-family housing in the markets we serve as well as our ability to periodically pass on price increases to our customers. Also accounting for the increase in total consolidated revenue is an increase of $2.8 million in the commercial and industrial segment which was $551.6 million for the twelve months ended September 30, 2005 versus $554.4 million for the twelve months ended September 30, 2006. The increase in the commercial and industrial segment is the result of overall growth in segment as well as increased commodity prices.

 

Gross Profit

 

 

Total gross profit increased $10.5 million, or 8.1%, from $129.0 million for the twelve months ended September 30, 2005, to $139.5 million for the twelve months ended September 30, 2006. The improvement in gross profit was as a result of both the residential and commercial and industrial segments having improved revenues which resulted in a $14.3 million increase which was partially offset by a reduction in the gross profit margin in the residential segment of $9.2 million. Commercial and industrial segment had a 100 basis point improvement in their gross profit margin, which resulted in an improvement in gross profit of $5.4 million.

 

Gross profit in the commercial and industrial segment increased $5.8 million, or 9.1% from $63.4 million for the twelve months ended September 30, 2005, to $69.2 million for the twelve months ended September 30, 2006. Gross profit margin as a percent of revenues increased from 11.5% for the twelve months ended September 30, 2005 to 12.5% for the twelve months ended September 30, 2006. The increase in gross margin is a result of our focus on improving margins, completion of older lower margin projects and passing on increased material costs to our customers. Partially offsetting the improvement in gross profit were losses recorded at three of our subsidiaries of approximately $2.4 million.

Residential gross profit increased $4.7 million, or 7.2%, from $65.6 million for the twelve months ended September 30, 2005, to $70.3 million for the twelve months ended September 30, 2006. Residential gross profit margin as a percentage of revenues decreased from 20.7% for the twelve months ended September 30, 2005, to 17.8% for the twelve months ended September 30, 2006. This increase in residential gross profit is a result of higher revenues partially offset by a reduction in gross margins due to the increase in costs of materials, particularly copper wire, which have been passed on, but not fully passed, to customers as well as losses recorded at one of our subsidiaries associated with the completion of three multi-family projects for one customer. We incurred losses at one subsidiary related to rework and other disputes involving certain multi-family projects with a customer that attributed to a 50 basis point decline in this segment’s gross profit margin.

 

Selling, General and Administrative Expenses

 

Total selling, general and administrative expenses decreased $7.5 million, or 5.7%, from $131.6 million for the twelve months ended September 30, 2005, to $124.1 million for the twelve months ended September 30, 2006. Total selling, general and administrative expenses as a percent of revenues decreased from 15.1% for the twelve months ended September 30, 2005 to 13.1% for the twelve months ended September 30, 2006.

 

This decrease in total selling, general and administrative expenses are the result of a $1.1 million decrease of occupancy expense resulting from the consolidation of offices and renegotiation of more favorable terms in existing locations, a $0.8 million decrease of depreciation expense resulting from the impairment and write down of assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” taken in fiscal year 2005 of $6.0 million, a $0.7 million decrease in insurance expense due to lower claims, a $4.2 million decrease of legal fees which includes $2.3 million in litigation fees incurred in fiscal 2005 not incurred in fiscal 2006, and a $1.7 million decrease of accounting and auditing expenses. These reductions were partially offset by additional employment costs of $2.7 million and bank fees of $0.8 million.

 

Goodwill Impairment Charge

 

During the year ended September 30, 2005, we recorded a charge of $53.1 million related to the impairments to the carrying value of goodwill. These charges were entirely associated with those regions that do not include Houston Stafford Electric, our largest residential subsidiary. See “Liquidity and Capital Resources” below for further information. There was no goodwill impairment charge during the year ended September 30, 2006.

 

Income (loss) From Operations

 

Total income (loss) from operations improved from a loss of $55.7 million for the twelve months ended September 30, 2005, to an operating income of $15.4 million for the twelve months ended September 30, 2006. This improvement in income (loss) from operations was attributed to the impairment to the carrying value of goodwill of $53.1 million at September 30, 2005 and no such impairment at September 30, 2006. There was also an increase in gross margins during the twelve months ended September 30, 2006 over the same period in the prior year improving operating income by $10.5 million. Also attributing to the improvement in income (loss) from operations is the decrease in selling, general and administrative costs of $7.5 million during the twelve months ended September 30, 2006.

 

Reorganization Items

 

During the twelve months ended September 30, 2006, in connection with our restructuring, we recorded income from net reorganization items totaling $26.2 million. Reorganization items incurred include $46.1 million gain on extinguishment of the senior subordinated notes in exchange for common stock of the Successor in accordance with the plan, partially offset by $15.0 million in professional fees related to the bankruptcy, $0.9 million in lease rejection costs, a non-cash charge of $4.0 million to write off certain unamortized debt issuance costs, debt discounts and premiums, and embedded derivative liabilities related to our senior convertible notes and senior subordinated notes and a non-cash fresh-start revaluation gain of $0.05 million.

Net Interest and Other Expense

 

Total interest and other expense decreased $13.9 million, or 45.5%, from $30.8 million for the twelve months ended September 30, 2005, to $16.9 million for the twelve months ended September 30, 2006. The decrease in net interest and other expense was the result of having interest expense on the senior subordinated notes only through February 14, 2006, the date we filed for Chapter 11 bankruptcy (see Part II, Item 7. “The Plan of Reorganization”) versus interest expense for the full twelve months ended September 30, 2005, which resulted in a $11.3 million decrease. There was also $0.7 million in non-cash mark-to-market interest associated with the embedded conversion option within our senior convertible notes; however no such event occurred for the twelve months ended September 30, 2006. This was partially offset by deferred financing costs of $3.8 million associated with the pre-petition credit facility written off in the second quarter 2006 as a result of entering the debtor-in-possession credit facility. In addition, there was $0.5 million in amortization of deferred issuance costs associated with the debtor-in-possession credit facility and $0.7 million written off in the third quarter of 2006 as a result of exiting the debtor-in-possession credit facility.

 

Provision for Income Taxes

 

On May 12, 2006, we had a change in ownership as defined in Internal Revenue Code Section 382. As such, our net operating loss utilization after the change date will be subject to Section 382 limitations for federal income taxes and some state income taxes. We have provided valuation allowances on all net operating losses where it is determined it is more likely than not that they will expire without being utilized.

 

Our effective tax rate from continuing operations increased from a negative rate of 11.6% for the twelve months ended September 30, 2005 to a positive rate of 4.8% for the twelve months ended September 30, 2006. This increase is attributable to a pretax net income, offset by permanent differences required to be added back for income tax purposes, an additional valuation allowance against certain federal and state deferred tax assets and a change in contingent tax liabilities. The provision includes $0.2 million in state tax benefit related to deferred tax assets resulting from the enactment of the Texas Margin Tax on May 18, 2006.

 

YEAR ENDED SEPTEMBER 30, 2005 COMPARED TO YEAR ENDED SEPTEMBER 30, 2004

 

Revenues

 

 

Total revenue increased $31.0 million, or 3.7%, from $838.1 million for the twelve months ended September 30, 2004, to $869.1 million for the twelve months ended September 30, 2005. This increase in total revenues is primarily the result of an increase in residential revenues partially offset by a small decline in commercial and industrial revenues for the twelve months ended September 30, 2005.

 

Revenue in the commercial and industrial segment decreased $3.6 million, or 0.7%, from $555.2 million for the twelve months ended September 30, 2004, to $551.6 million for the twelve months ended September 30, 2005. This is a result of a decline in certain markets resulting from a decrease in the award of bonded projects.

 

Revenue in the residential segment increased $34.6 million, or 12.2%, from $282.9 million for the twelve months ended September 30, 2004 to $317.5 million for the twelve months ended September 30, 2005. This

increase is primarily a result of increased demand for new single-family and multi-family housing in the markets we serve.

 

Gross Profit

 

 

Total gross profit increased slightly by $0.1 million, or 0.1%, from $128.9 million for the twelve months ended September 30, 2004, to $129.0 million for the twelve months ended September 30, 2005. Total gross profit margin as a percent of revenue decreased from 15.4% for the twelve months ended September 30, 2004 to 14.8% for the twelve months ended September 30, 2005. The decline in gross margin was primarily due to increased competition and costs of materials that were not fully passed to customers in our residential segment and decreased award of bonded projects in our commercial and industrial segments. During the year ended September 30, 2005, we recorded $0.2 million additional accumulated amortization in cost of revenues for leasehold improvements. These costs were incurred to correct errors from prior periods where we amortized leasehold improvements over a period longer than the original lease term. We do not believe these errors or the related correction is material to any affected period.

 

Gross profit in the commercial and industrial segment decreased $4.6 million, or 6.8%, from $68.1 million for the twelve months ended September 30, 2004, to $63.5 million for the twelve months ended September 30, 2005. Gross profit margin as a percent of revenues decreased from 12.3% for the twelve months ended September 30, 2004 to 11.5% for the twelve months ended September 30, 2005. This was primarily due to increased costs associated with the procurement of copper wire, steel products and fuel which we were not able to pass along to customers as we generally operate under fixed price contracts.

 

Residential gross profit increased $4.7 million, or 7.7%, from $60.8 million for the twelve months ended September 30, 2004, to $65.5 million or the twelve months ended September 30, 2005. Residential gross profit margin as a percentage of revenues decreased from 21.5% for the twelve months ended September 30, 2004, to 20.6% for the twelve months ended September 30, 2005. The increase was due to gross profit on a higher revenue base earned year over year of approximately $7.1 million, offset by increased costs associated with the procurement of copper wire, steel products and fuel.

 

Selling, General and Administrative Expenses

 

Total selling, general and administrative expenses increased $11.6 million, or 9.7%, from $120.0 million for the twelve months ended September 30, 2004, to $131.6 million for the twelve months ended September 30, 2005. Total selling, general and administrative expenses as a percent of revenues increased from 14.3% for the twelve months ended September 30, 2004 to 15.1% for the twelve months ended September 30, 2005.

 

We recorded a $2.3 million charge to settle a lawsuit during the fourth quarter ended September 30, 2005. There was also an increase in legal fees of $2.2 million, increased accounting fees of $1.8 million related to the annual audit, $2.1 million related to Sarbanes-Oxley implementation and $0.8 million related to tax and internal audit. During the year ended September 30, 2005, we recorded $0.5 million in additional accumulated amortization for leasehold improvements. These costs were incurred to correct errors from prior periods where we amortized leasehold improvements over a period longer than the original lease term. We do not believe these errors or the related correction is material to any affected period.

Goodwill Impairment Charge

 

During the years ended September 30, 2004 and September 30, 2005, we recorded non-cash charges of $65.3 million and $53.1 million, respectively, related to impairments to the carrying value of goodwill. These charges were entirely associated with those regions that do not include Houston Stafford Electric, our largest residential subsidiary. See “Liquidity and Capital Resources” below for further information.

 

Loss from Operations

 

Total loss from operations decreased from an operating loss of $56.4 million for the twelve months ended September 30, 2004, to $55.7 million for the twelve months ended September 30, 2005. As a percentage of revenues, loss from operations decreased from a 6.7% operating loss for the year ended September 30, 2004 to a 6.4% operating loss for the year ended September 30, 2005. This decrease in loss from operations was primarily attributed to the goodwill impairment to the carrying value of goodwill of $65.3 million at September 30, 2004 and $53.1 million at September 30, 2005, offset by the $11.6 million increase in selling, general and administrative expenses. Excluding the impact of the goodwill impairment charge recorded during the year ended September 30, 2004 and September 30, 2005, the income (loss) from operations as a percent of revenues decreased from operating income of 1.1% to an operating loss of 0.3%, respectively.

 

Net Interest and Other Expense

 

Interest and other expense, net increased by $1.6 million or 5.5%, from $29.2 million for the year ended September 30, 2004 to $30.8 million for the year ended September 30, 2005. Cash paid for interest decreased $2.8 million, or 12.0% from $23.4 million for the year ended September 30, 2004 to $20.6 million for the year ended September 30, 2005. This decrease is primarily attributable to a permanent reduction in our senior subordinated debt of $75.0 million offset by a $50.0 million increase in senior secured debt in March 2004 and the timing of interest payments on the senior convertible notes. Other expense decreased by $3.3 million, or 56.9%, from $5.8 million for the year ended September 30, 2005 to $2.5 million for the year ended September 20, 2005. This decrease is primarily attributable to a $5.2 million loss incurred on early extinguishment of debt during the year ended September 30, 2004 offset by an increase in write-offs of an investment during the year ended September 30, 2005 of $1.3 million as compared to the year ended September 30, 2004.

 

Costs incurred during the inception of or amendment to a credit facility or senior note, require the payments of fees upon the execution of the agreement. These fees are capitalized as deferred financing costs and amortized over the life of the facility to interest expense. During the year ended September 30, 2005, we incurred non-cash write-offs to interest expense of deferred financing costs of $7.4 million of this, we recorded a non-cash charge in the quarter ended September 30, 2005 of approximately $0.6 million to write off the remaining deferred financing costs related to the prior credit facility.

 

During the year ended September 30, 2005, we issued $50.0 million of 6.5% senior convertible notes. The senior convertible notes are a hybrid instrument comprised of two components: (1) a debt instrument and (2) certain embedded derivatives. These derivatives will be mark-to-market each reporting period.

 

During the three months ended December 31, 2004, we were required to also value the portion of the notes that would settle in cash because shareholder approval of the notes had not yet been obtained. The initial value of this derivative was $1.4 million and the value at December 31, 2004 was $4.0 million, and consequently, a $2.6 million mark to market loss was recorded. The value of this derivative immediately prior to the affirmative shareholder vote was $2.0 million and accordingly, we recorded a mark to market gain of $2.0 million during the three months ended March 31, 2005. There was no mark to market gain or loss during the three months ended June 30, 2005. At the end of September 30, 2005 there was a mark to market loss of $0.1 million recorded. The calculation of the fair value of the conversion option was performed utilizing the Black-Scholes option pricing model with the following assumptions effective over the year ended September 30, 2005: expected dividend yield of 0.00%, expected stock price volatility of 40.00%, weighted average risk free interest rate ranging from 3.67% to 4.15% for four to ten years, respectively, and an expected term of four to ten years. The valuation of the other embedded derivatives was derived by other valuation methods,

including present value measures and binomial models. At September 30, 2005, the fair value of the two remaining derivatives was $1.5 million. Additionally, we had recorded at March 31, 2005 a net discount of $0.9 million, which is being amortized over the remaining term of the notes.

 

Provision for Income Taxes

 

Our effective tax rate from continuing operations decreased from a negative rate of 9.0% for the twelve months ended September 30, 2004 to a negative rate of 11.6% for the twelve months ended September 30, 2005. This decrease is attributable to a pretax net loss, partially offset by permanent differences required to be added back for income tax purposes, an additional valuation allowance against certain federal and state deferred tax assets and a change in contingent tax liabilities.

 

Cost Drivers

 

As a service business, our cost structure is highly variable. Our primary costs include labor, materials and insurance. Costs derived from labor and related expenses currently account for 44% of our total costs. For the years ended September 30, 2004, 2005 and 2006, our labor-related expenses totaled $341.2 million, $348.1 million and $356.3 million, respectively. As of September 30, 2006, we had 7,183 employees, 5,926 employees were field electricians, the number of which fluctuates depending upon the number and size of the projects undertaken by us at any particular time. The remaining 1,257 employees were project managers, job superintendents and administrative and management personnel, including executive officers, estimators or engineers, office staff and clerical personnel. We provide a health, welfare and benefit plan for all employees subject to eligibility requirements. We have a 401(k) plan pursuant to which eligible employees may contribute through a payroll deduction. We make matching cash contributions of 25% of each employee’s contribution up to 6% of that employee’s salary.

 

Costs incurred for materials installed on projects currently account for 52% of our total costs. This component of our expense structure is variable based on the demand for our services. We generally incur costs for materials once we begin work on a project. We generally order materials when needed, ship them directly to the jobsite, and install them within 30 days. Materials consist of commodity-based items such as conduit, wire and fuses as well as specialty items such as fixtures, switchgear and control panels. For the years ended September 30, 2004, 2005 and 2006, our materials expenses totaled $342.9 million, $364.0 million and $421.8 million, respectively.

 

We are insured for workers’ compensation, employer’s liability, auto liability, general liability and health insurance, subject to large deductibles. Losses up to the deductible amounts are accrued based upon actuarial studies and our estimates of the ultimate liability for claims incurred and an estimate of claims incurred but not reported. The accruals are based upon known facts and historical trends and management believes such accruals to be adequate. Expenses for claims administration, claims funding and reserves funding totaled $37.1 million, $40.5 million and $30.8 million for the years ended September 30, 2004, 2005 and 2006, respectively.

 

Discontinued Operations

 

Costs Associated with Exit or Disposal Activities

 

As a result of disappointing operating results, the Board of Directors directed us to develop alternatives with respect to certain underperforming subsidiaries. These subsidiaries are included in our commercial and industrial segment. On March 28, 2006, we committed to an exit plan with respect to those underperforming subsidiaries. The exit plan committed to a shut-down or consolidation of the operations of these subsidiaries or the sale or other disposition of the subsidiaries, whichever came earlier.

As a result, we incurred total expenditures of $4.8 million and $2.4 million for the seven months ended April 30, 2006 and five months ended September 30, 2006, respectively, which included the following costs included in income (loss) from discontinued operations:

 

 

Remaining net working capital related to these subsidiaries was $14.1 million at September 30, 2006. As a result of inherent uncertainty in the exit plan and in monetizing net working capital related to these subsidiaries, we could experience additional potential losses to our working capital. At September 30, 2006, we believe we have recorded adequate reserves to reflect the net realizable value of the working capital; however, subsequent events such as loss of specific customer knowledge may impact our ability to collect.

 

In our assessment of the estimated net realizable value related to accounts receivable at these subsidiaries, in March 2006 we increased our general allowance for doubtful accounts based on considering various factors including the fact that these businesses were being shut down and the associated increased risk of collection and the age of the receivables. This approach is a departure from our normal practice of carrying general allowances for bad debt based on a minimum fixed percent of total receivables based on historical write-offs. We believe this approach is reasonable and prudent given the circumstances.

 

The exit plan is substantially completed and the operations of these subsidiaries have substantially ceased as of September 30, 2006. We have included the results of operations related to these subsidiaries in discontinued operations for the year ended September 30, 2006 and all prior periods presented have been reclassified accordingly. Revenue for these shut down subsidiaries totaled $293.7 million and $194.1 million for fiscal years 2004 and 2005, respectively. Revenue for these shutdown subsidiaries was $55.8 million for the seven months ended April 30, 2006 and $18.0 million for the five months ended September 30, 2006. Operating losses for these subsidiaries totaled $29.4 million and $27.9 million for fiscal 2004 and 2005, respectively. Operating losses for these subsidiaries were $15.0 million for the seven months ended April 30, 2006 and $9.5 million for the five months ended September 30, 2006.

 

Divestitures

 

During October 2004, we announced plans to begin a strategic realignment including the planned divestiture of certain subsidiaries within our commercial and industrial segment. As of December 31, 2005, the planned divestitures had been completed.

 

During the year ended September 30, 2005, we completed the sale of all the net assets of thirteen of our operating subsidiaries for $54.1 million in total consideration. During the year ended September 30, 2006, we completed the sale of one additional operating subsidiary for $7.1 million in total consideration. Including goodwill impairments, if any, these divestitures generated a pre-tax net loss of $14.1 million and a pre-tax net income of $0.7 million, respectively, and have been recognized as discontinued operations in the consolidated statements of operations for all periods presented.

The discontinued operations disclosures include only those identified subsidiaries qualifying for discontinued operations treatment for the periods presented. Depreciation expense associated with discontinued operations for the years ended September 30, 2004 and 2005 was $4.3 million and $3.5 million, respectively. Depreciation expense for the seven months ended April 30, 2006 was $0.1 million and zero for the five months ended September 30, 2006.

 

Summarized financial data for all discontinued operations are outlined below:

 

 

In connection with the divestitures discussed above, the pre-tax (loss) gain on the sale of the businesses was determined as follows for the years ended September 30, 2005 and 2006 (in thousands):