As filed with the Securities and Exchange Commission on August 26, 2008

Registration No. 333-151559

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

AMENDMENT NO. 1

TO

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

Mistras Group, Inc.

(Exact name of registrant as specified in its charter)

 

 

195 Clarksville Road

Princeton Junction, New Jersey 08550

(609) 716-4000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

Sotirios J. Vahaviolos, Ph.D.

Chairman, President and Chief Executive Officer

195 Clarksville Road

Princeton Junction, New Jersey 08550

(609) 716-4000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

With copies to:

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement is declared effective.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

 

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

 

 

CALCULATION OF REGISTRATION FEE

 

 

 

 

The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

SUBJECT TO COMPLETION, DATED AUGUST 26, 2008

 

          Shares

 

Mistras Group, Inc.

 

Common Stock

 

 

Prior to this offering, there has been no public market for our common stock. The initial public offering price of the common stock is expected to be between $      and $      per share. We intend to apply to list our common stock on the New York Stock Exchange under the symbol “    ”.

 

We are selling           shares of common stock and the selling stockholders are selling           shares of common stock. We will not receive any of the proceeds from the shares of common stock sold by the selling stockholders.

 

The underwriters have an option to purchase a maximum of           additional shares to cover over-allotments of shares.

 

Investing in our common stock involves risks.  See “Risk Factors” on page 11.

 

 

 

Delivery of the shares of common stock will be made on or about          , 2008.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

 

 

 

 

 

The date of this prospectus is          , 2008.

TABLE OF CONTENTS

 

 

 

 

 

You should rely only on the information contained in this document or to which we have referred you. We have not authorized anyone to provide you with information that is different. This document may only be used where it is legal to sell these securities. The information in this document may only be accurate on the date of this document.

 

Industry and Market Data

 

This prospectus includes market and industry data and forecasts that we obtained from internal research, publicly available information and industry publications and surveys. Industry publications and surveys generally state that the information contained therein has been obtained from sources believed to be reliable. Unless otherwise noted, statements as to our market position relative to our competitors are approximated and based on the above-mentioned third-party data and internal analysis and estimates as of the date of this prospectus. Although we believe the industry and market data and statements as to market position to be reliable as of the date of this prospectus, we have not independently verified this information and it could prove inaccurate. Industry and market data could be wrong because of the method by which sources obtained their data and because information cannot always be verified with certainty due to the limits on the availability and reliability of raw data, the voluntary nature of the data gathering process and other limitations and uncertainties. In addition, we do not know all of the assumptions regarding general economic conditions or growth that were used in preparing the forecasts from sources cited herein.

 

Dealer Prospectus Delivery Obligation

 

Until          , 2008 (25 days after the commencement of the offering), all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to unsold allotments or subscriptions.

 

 

 

 

PROSPECTUS SUMMARY

	•	Extending the Useful Life of Aging Infrastructure.  The prohibitive cost and challenge of building new infrastructure has resulted in the significant aging of existing infrastructure and led to a desire by companies to extend the useful life of existing assets. Because aging infrastructure requires relatively higher levels of maintenance and repair, as well as more frequent, extensive and ongoing testing requirements, companies and public authorities are spending billions of dollars to ensure the operational and structural integrity of this infrastructure.

	•	Outsourcing of Non-Core Activities and Technical Resource Constraints.  While some of our customers have historically performed NDT services in-house, the increasing sophistication and automation of NDT, together with a decreasing supply of skilled professionals and stricter governmental regulations, has led many of them to outsource NDT to providers that have the necessary engineering skills, technical workforce, technology and proven track-record of performance to effectively meet their increasing requirements.

	•	Increasing Capacity Utilization.  Due to high energy prices and the limited construction of new infrastructure, existing infrastructure in some of our target markets is being used at higher capacities, which accelerates deterioration and limits downtime for repair or replacement. In order to sustain high capacity utilization rates, customers are increasingly using NDT solutions to ensure the integrity and safety of their assets. NDT customers have also experienced productivity enhancements for their infrastructure as a result of reduced maintenance-related downtime.
	•	Increasing Corrosion from Low-Quality Inputs.  High commodities prices and increasing energy demands have led to the use of lower grade inputs, such as low-grade coal or petroleum, in the refinery

		and power generation processes. These lower grade inputs more rapidly corrode the infrastructure they come into contact with, which in turn increases the need for NDT solutions to identify such corrosion and enable infrastructure owners to combat the problems they cause.

	•	Increasing Use of Advanced Materials.  NDT customers in our target markets are increasingly utilizing advanced materials and other unique technologies in the manufacturing and construction of new infrastructure. As a result, they require increasingly advanced testing, inspection and maintenance technologies to protect these assets. We believe that demand for NDT solutions will increase as companies and public authorities continue to use NDT solutions, not only during the maintenance lifecycle of their assets, but also during the design and construction phases by incorporating NDT technologies such as embedded sensors.
	•	Meeting Safety Regulations.  Owners and operators of infrastructure assets increasingly face strict government regulations and safety requirements. Failure to meet these standards can result in significant financial liabilities, increased scrutiny by the Occupational Safety & Health Administration (OSHA) and other regulators, higher insurance premiums and tarnished corporate brand value. As a result, these owners and operators are seeking highly reliable NDT suppliers with a proven track record of providing NDT products and services to assist them in meeting these increasingly stringent regulations.
	•	Expanding Addressable End-Markets.  Advances in NDT sensor technologies and software solutions, and the continued emergence of new technologies, are creating increased demand for NDT solutions in applications where existing NDT techniques were previously ineffective. Further, we expect increased demand in relatively new markets with infrastructure that is only now aging to a point where significant maintenance of infrastructure is required, such as pharmaceuticals, food processing and other industries.
	•	Expanding Addressable Geographies.  We believe that a substantial driver of incremental demand will come from international markets, as companies and governments in these markets build and maintain infrastructure and applications that require the use of advanced NDT solutions.

	•	One-Stop Shop for NDT Solutions Worldwide.  We believe we are the only vendor with a comprehensive suite of proprietary and integrated NDT services, software and products worldwide, which positions us to be the leading single source provider for a customer’s NDT requirements. In addition, collaboration between our services teams and product design engineers generates enhancements to our services, software and products, which provides a source of competitive advantage compared to companies that provide only NDT services or products to their customers.

	•	Trusted Provider to a Diversified and Growing Customer Base.  By providing critical and reliable NDT services, software and products for more than 30 years, we have become a trusted partner to a large and growing customer base across numerous infrastructure-intensive industries. We leverage our strong relationships to sell additional solutions to our existing customers and attract new customers. As NDT becomes an increasingly strategic asset for our customers, we believe our reputation and history of successful execution will differentiate us from our competitors. Seven of our top 10 customers by revenues in fiscal 2008 have used our solutions for at least ten years.

	•	Repository of Customer-Specific Inspection Data.  Our enterprise software solutions enable us to capture and store our customers’ testing and inspection data in a centralized database. As a result, we have accumulated large amounts of proprietary information that allows us to provide our customers with value-added services, such as predictive maintenance, inspection scheduling, data analytics and regulatory compliance. We believe our ability to provide these customized products and services, along with the high cost of switching to an alternative vendor, provide us with significant competitive advantages.

	•	Proprietary Products, Software and Technology Packages.  We have developed systems that have become the cornerstone of several unique NDT applications. These proprietary products allow us to efficiently and effectively provide complex solutions to our customers, resulting in a significant competitive advantage versus our competition. In addition to the products we sell to our customers, we also develop a range of proprietary sensors, instruments, systems and software used exclusively by our Services group.

	•	Deep Domain Knowledge and Extensive Industry Experience.  We are an industry leader in developing advanced NDT solutions, including acoustic emission (AE) testing for non-intrusive on-line inspection of storage tanks and pressure vessels, portable corrosion mapping ultrasonic testing (UT) systems, on-line plant asset integrity management with sensor fusion, enterprise software solutions for plant-wide inspection data archiving and management, advanced and thick composites inspection and ultrasonic phased array inspection of thick wall boilers. In addition, many of the members of our team have been instrumental in developing the testing standards followed by international standards-setting bodies, such as the American Society of Non-Destructive Testing and comparable associations in other countries.
	•	Collaborating with Our Customers.  Our NDT solutions have historically been designed in response to our customers’ unique performance specifications and are supported by our proprietary technologies. Our sales and engineering teams work closely with our customers’ research and design staff during the design phase of our products in order to incorporate our products into specified infrastructure projects. As a result, we believe that our close, collaborative relationships with our customers provide us a significant competitive advantage.
	•	Experienced Management Team.  Our management team has a track record of leadership in NDT, averaging approximately 20 years experience in the industry. These individuals also have extensive experience in growing businesses organically and in acquiring and integrating companies, which we believe is important to facilitate future growth in the fragmented NDT industry.

	•	Continue to Develop Software-Enabled Services and Products.  We intend to maintain and enhance our technological leadership by continuing to invest in the internal development of new services, software and products while opportunistically acquiring key technologies and solutions that address the highly specialized needs of our target markets. We intend to capitalize on our extensive proprietary technology to develop customized solutions for markets that we expect will significantly increase their use of NDT solutions in the future, such as alternative energy and agriculture.
	•	Increase Revenues from Our Existing Customers.  Many of our customers are global corporations with NDT requirements from multiple divisions at multiple locations across the globe. Currently, we capture a relatively small portion of their overall expenditures on NDT. We believe our superior services, software and other products, combined with the trend of outsourcing NDT solutions to a small number of trusted service providers, positions us to significantly expand both the number of divisions and locations that we serve as well as the types of solutions we provide.

	•	Add New Customers in Existing Target Markets.  Our customer base, which we define as the approximately 4,000 customers to which we have provided NDT solutions during fiscal 2008, represents a small fraction of the total number of companies in our target markets with NDT and asset integrity management requirements. Our scale, scope of products and services and expertise in creating technology-enabled solutions have allowed us to build a high-quality reputation and increase customer awareness about us and our NDT solutions. We intend to continue to leverage our competitive strengths to win new business as customers in our existing target markets continue to seek a single source and trusted provider of advanced NDT solutions.

	•	Expand Our Customer Base into New End Markets.  We believe we have significant opportunities to rapidly grow our customer base in relatively new end markets, including the shipping, alternative energy, natural gas transportation and healthcare industries and the market for public infrastructure, such as highways and bridges. The expansion of our addressable markets is being driven by the increased recognition and adoption of NDT products and services, new NDT technologies enabling further applications to address additional end-market needs and the aging of infrastructure.
	•	Continue to Capitalize on Acquisitions.  We intend to continue employing a disciplined acquisition strategy to broaden and enhance our product and service offerings, add new customers and certified personnel, supplement our internal development efforts and accelerate our expected growth. We believe the market for NDT solutions is highly fragmented with a large number of potential acquisition opportunities. We have a proven ability to integrate complementary businesses, as demonstrated by the success of our past acquisitions. We believe we have improved the operational performance and profitability of our acquired businesses by successfully integrating and selling a comprehensive suite of solutions to the customers of these acquired businesses.

	•	our business currently depends on certain significant customers and any reduction of business with these customers would harm our future operating results;
	•	an accident or incident involving our NDT solutions could expose us to claims, harm our reputation and adversely affect our ability to compete for business;
	•	material weaknesses identified in our internal controls relating to the lack of technical accounting and financial reporting oversight in prior financial statements and an inadequate level of accounting personnel in the past have resulted, and if not properly remediated, could in the future result in material misstatements of our financial statements;
	•	an ability to attract, develop and retain a sufficient number of trained engineers, scientists and other highly skilled workers as well as members of senior management;
	•	strengths and actions of our competitors;
	•	our current dependence on customers in the oil and gas industry;
	•	the timing, size and integration success of potential future acquisitions; and
	•	catastrophic events, including natural disasters, could disrupt our business or the business of our customers, which could significantly harm our operations, financial results and cash flow.

Common stock offered by
Us		shares of common stock
Selling stockholders		shares of common stock
Total		shares of common stock
Over-allotment option
Us		shares of common stock
Selling stockholders		shares of common stock
Total		shares of common stock
Common stock to be outstanding after the offering		shares of common stock
Use of proceeds		We estimate that the net proceeds to us from this offering will be approximately $     . We plan to use these net proceeds for general corporate purposes, including working capital and possible acquisitions. We will not receive any proceeds from the sale of shares by the selling stockholders. See “Use of Proceeds.”
Dividend policy		We currently have no plans to pay dividends on our common stock.
Risk factors		You should carefully read and consider the information set forth under “Risk Factors,” together with all of the other information set forth in this prospectus, before deciding to invest in shares of our common stock.

Listing		We intend to apply to list our common stock on the New York Stock Exchange under the symbol “     ”.

	•	reflects a     -for-      stock split, effected on          ;
	•	reflects the conversion of all outstanding shares of our preferred stock into an aggregate of           shares of common stock upon the completion of this offering;
	•	assumes no exercise of the underwriters’ over-allotment option;
	•	excludes           shares of common stock issuable upon the exercise of stock options outstanding as of          , at a weighted average exercise price of $      per share; and
	•	excludes           shares of common stock reserved for future awards under the 2008 Long-Term Incentive Plan.

		Fiscal
		2008				2007				2006
		(In thousands, except share and
		per share data)
Statement of Operations Data:
Revenues		$	152,268			$	122,241			$	93,741
Cost of revenues			90,990				75,702				55,908
Depreciation			6,847				4,666				3,013
Gross profit			54,431				41,873				34,820
Selling, general and administrative expenses			32,463				26,408				24,748
Research and engineering expenses			1,034				703				660
Depreciation and amortization			4,576				4,025				4,165
Income from operations			16,358				10,737				5,247
Other expenses:
Interest expense			3,531				4,482				4,225
Loss on extinguishment of long-term debt			—				460				—
Income before provision for income taxes and minority interest			12,827				5,795				1,022
Provision for income taxes			5,380				208				503
Income before minority interest			7,447				5,587				519
Minority interest, net of taxes			(8	)			(199	)			(17	)
Net income			7,439				5,388				502
Accretion of preferred stock			(32,872	)			(3,520	)			(2,922	)
Net (loss) income available to common shareholders		$	(25,433	)		$	1,868			$	(2,420	)
Weighted average number of shares outstanding:
Basic			1,000,000				991,348				977,115
Diluted			1,000,000				1,007,803				977,115
(Loss) earnings per common share:
Basic		$	(25.43	)		$	1.88			$	(2.48	)
Diluted		$	(25.43	)		$	1.85			$	(2.48	)
Pro forma diluted earnings (loss) per common share(1)		$	4.82			$	3.56			$	0.35
Other Financial Data:
Net cash from operating activities		$	12,851			$	14,006			$	6,208
Net cash used in investing activities		$	(19,446	)		$	(4,259	)		$	(2,387	)
Net cash provided by (used in) financing activities		$	6,320			$	(8,122	)		$	(2,654	)
EBITDA(2)		$	27,773			$	18,769			$	12,408

		As of May 31,
		2008
		Actual				As Adjusted(3)
Balance Sheet Data:
Cash and cash equivalents		$	3,555
Total assets			119,822
Total long-term debt, including current portion			48,270
Obligations under capital leases, including current portion			11,842
Redeemable convertible preferred stock			63,869
Total stockholders’ (deficit) equity			(24,475	)

(1)		Pro forma diluted earnings per share gives effect to the assumed conversion of our preferred stock for all periods presented. It is computed by dividing net income by the pro forma number of weighted average shares outstanding used in the calculation of diluted earnings (loss) per share, but after assuming conversion of our preferred stock and exercise of any dilutive stock options. The calculation for this, as well as our basic and diluted (loss) earnings per common share, follows:

(2)		EBITDA, a performance measure used by management, is defined in this prospectus as net income plus: interest expense, provision for income taxes and depreciation and amortization, as shown in the table below. In this prospectus, EBITDA is not adjusted to exclude the non-cash loss on extinguishment of long-term debt of $0.5 million that we incurred in fiscal 2007.

		Our management uses EBITDA as a measure of operating performance to assist in comparing performance from period to period on a consistent basis, as a measure for planning and forecasting overall expectations and for evaluating actual results against such expectations, and as a performance evaluation metric off which to base executive and employee incentive compensation programs.

		We believe investors and other external users of our financial statements benefit from the presentation of EBITDA in evaluating our operating performance because it provides them with an additional tool to compare our operating performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our core operations. For instance, EBITDA generally excludes interest expense, taxes and depreciation and amortization, which can vary substantially from company to company depending upon accounting methods and the book value and age of assets, capital structure, capital investment cycles and the method by which assets were acquired.

		Although EBITDA is widely used by investors and securities analysts in their evaluations of companies, you should not consider it either in isolation or as a substitute for analyzing our results as reported under U.S. generally accepted accounting principles (GAAP). EBITDA is generally limited as an analytical tool because it excludes, among other things, the statement of operations impact of depreciation and amortization, interest expense and the provision for income taxes and therefore does not necessarily represent an accurate measure of profitability, particularly in situations where a company is highly leveraged or has a disadvantageous tax structure. As a result, EBITDA is of particularly limited value in evaluating our operating performance because (i) we use a significant amount of capital assets and depreciation and amortization expense is a necessary element of our costs and ability to generate revenue; (ii) we have a significant amount of debt and interest expense is a necessary element of our costs and ability to generate revenue; and (iii) we generally incur significant U.S. federal, state and foreign income taxes each year and the provision for income taxes is a necessary element of our costs. EBITDA also does not reflect historical cash expenditures or future requirements for capital expenditures or contractual commitments, changes in, or cash requirements for, our working capital needs and all non-cash income or expense items that are reflected in our statements of cash flows. Furthermore, because EBITDA is not defined under GAAP, our definition of EBITDA may differ from, and therefore may not be comparable to, similarly titled measures used by other companies, thereby limiting its usefulness as a comparative measure.

		Because of these limitations, EBITDA should not be considered as the primary measure of our operating performance or as a measure of discretionary cash available to us to invest in the growth of our business. We strongly urge you to review the GAAP financial measures included in this prospectus, our consolidated

		financial statements, including the notes thereto, and the other financial information contained in this prospectus, and not to rely on any single financial measure to evaluate our business.

		The following table provides a reconciliation of net income to EBITDA:

(3)		The as adjusted column is unaudited and gives effect to:

	•	the conversion of all outstanding shares of our preferred stock into shares of our common stock upon the completion of this offering and a   -for-   stock split of our common stock; and

	•	the sale by us of           shares of our common stock in this offering at the initial public offering price of $          per share (the midpoint of the range shown on the cover page of this prospectus), after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

An investment in our common stock involves a high degree of risk. You should carefully read and consider the risks described below, together with the other information contained in this prospectus, including our financial statements and the notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” before making an investment decision. If any of these risks actually occur, our business, financial condition, results of operations and future growth prospects may be adversely affected. As a result, the trading price of our common stock would likely decline, and you may lose all or part of your investment.

 

Risks Related to Our Business

 

Our operating results could be adversely affected by a reduction of business with our significant customers.

 

We derive a significant amount of revenues from a few customers. For instance, various divisions or business units of BP were responsible for 16.7%, 16.5% and 9.5% of our revenues for fiscal 2008, 2007 and 2006, respectively. Taken as a group, our top 10 customers were responsible for 35.2%, 38.6% and 31.1% of our revenues for fiscal 2008, 2007 and 2006, respectively. Generally, our customers do not have an obligation to make purchases from us and may stop ordering our products and services at any time without financial penalty. The loss of any of our significant customers, any substantial decline in sales to these customers or any significant change in the timing or volume of purchases by our customers could result in lower revenues and could harm our business, financial condition or results of operations.

 

An accident or incident involving our NDT solutions could expose us to claims, harm our reputation and adversely affect our ability to compete for business and, as a result, harm our operating performance.

 

We are exposed to liabilities arising out of the solutions we provide. For instance, we furnish the results of our NDT inspections for use by our customers in their assessment of aspects of their assets, facilities, plants and other structures. Such results may be incorrect or incomplete, whether as a result of poorly designed inspections, malfunctioning testing equipment or our employees’ failure to adequately test or properly record data. For example, one of our clients recently claimed one of our x-ray inspection crews had improperly recorded inspection data about a portion of its infrastructure, requiring us to provide a new team to inspect that infrastructure over a period of three months at our expense. Further, if an accident or incident involving a structure we tested occurs and causes personal injuries or property damage, such as the collapse of a bridge or explosion in a plant or facility, and particularly if these injuries or damage could have been prevented by our customers had we provided them with correct or complete results, we may face significant claims by injured persons or related parties and claims relating to any property damage or loss. Even if our results are correct and complete, we may face claims for such injuries or damage simply because we tested the structure or facility in question. An example of litigation arising out of such an accident or incident is the lawsuits brought by private parties and the Massachusetts Attorney General against our wholly owned subsidiary, Conam Inspection and Engineering Services, Inc. (Conam). Staveley Services North America, Inc., the company from which we acquired the Conam assets in 2003, had performed tests on parts of the ceiling that collapsed in the Boston Central Artery/Tunnel Project in 2006. This collapse resulted in numerous injuries, deaths and property damage. We believe that because we did not assume any liabilities for prior testing by Staveley Services North America, Inc. when we purchased these assets, the lawsuits will be dismissed with respect to Conam; however, we have incurred expenses defending these lawsuits. Our insurance coverage may not be adequate to cover the damages from any such claims, forcing us to bear these uninsured damages directly, which could harm our operating results and may result in additional expenses and possible loss of revenues. An accident or incident for which we are found partially or fully responsible, even if fully insured, may also result in negative publicity, which would harm our reputation among our customers and the public, cause us to lose existing and future contracts or make it more difficult for us to compete effectively, thereby significantly harming our operating performance. Such an accident or incident might also make it more expensive or impossible for us to insure against similar events in the future. Even unsuccessful claims relating to accidents could result in substantial costs to us and diversion of our management resources.

We and our independent registered public accounting firm identified two material weaknesses in our internal controls, which in the past have, and if not properly remediated, could in the future result in material misstatements of our financial statements.

 

In connection with our review of our financial results for fiscal 2008 and 2007, we and our independent registered public accounting firm reported to our Board of Directors two material weaknesses in our internal control over financial reporting. A material weakness is defined by the standards issued by the Public Company Accounting Oversight Board as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. These weaknesses related to our lack of technical oversight in prior financial statements and an inadequate level of accounting personnel. These material weaknesses resulted in, or contributed to, adjustments to our financial statements and, in certain cases, restatement of prior financial statements. These adjustments related primarily to an error in accounting for a capital lease entered into in 1997, which resulted in an increase in net income of $180,000 for fiscal 2006. We also corrected the effect of the adoption of FIN 48, “Uncertain Tax Positions,” from our original estimate. We have developed and are executing a plan to remediate the material weaknesses by implementing additional formal policies and procedures, increasing management review and oversight over the financial statement close and reporting processes and hiring additional accounting personnel. However, if these measures fail to fully remediate the material weaknesses or if additional material weaknesses in our internal controls are discovered in the future, we may be unable to provide required financial information in a timely and reliable manner, or otherwise comply with the standards applicable to us as a public company, and our management may not be able to report that our internal control over financial reporting is effective for fiscal 2010 or thereafter, when we are required to comply with Section 404 of the Sarbanes-Oxley Act of 2002. This may cause a loss of investor confidence in us and the reliability of our financial statements and, as a result, harm our business and the trading price of our common stock.

 

In addition, in August 2008, we began implementing an upgrade to our accounting software system. We intend to transition selected financial processes to the new system and expect to complete the upgrade in fiscal 2009. If we do not effectively and timely implement this system or if the system does not operate as intended, it could adversely impact the effectiveness of our internal control over financial reporting.

 

If we are unable to attract and retain a sufficient number of trained engineers, scientists and other highly skilled workers at competitive wages, our operational performance may be harmed and our costs may increase.

 

We believe that our success depends, in part, upon our ability to attract, develop and retain a sufficient number of trained engineers, scientists and other highly skilled employees at competitive wages. The demand for such employees is currently high, and we project that it may increase substantially in the future. Accordingly, we have experienced increases in our labor costs, particularly in our Services segment, but also, to a lesser extent, in our International segment. Many of the companies with which we compete for experienced personnel have comparatively greater name recognition and resources. In addition, in making employment decisions, job candidates often consider the value of the stock options they are to receive in connection with their employment. Volatility in the future market price of our stock may, therefore, adversely affect our ability to attract or retain key employees. Furthermore, the relatively new requirement to expense stock options may discourage us from granting the size or type of stock option awards that job candidates require to join our company. The markets for our products and services also require us to field personnel trained and certified in accordance with standards set by domestic or international standard-setting bodies, such as the American Society of Non-Destructive Testing. Because of the limited supply of these certified technicians, we expend substantial resources maintaining in-house training and certification programs. If we fail to attract sufficient new personnel or fail to motivate and retain our current personnel, our ability to perform under existing contracts and orders or to pursue new business may be harmed, causing us to lose customers and revenues, and the costs of performing such contracts and orders may increase, which would likely reduce our margins.

If we lose members of our senior management team upon whom we are dependent, we may not be able to manage our operations and achieve our strategic objectives.

 

Our future success depends to a considerable degree upon the availability, contributions, vision, skills, experience and effort of our senior management team. We do not maintain “key person” insurance on any of our employees other than Dr. Sotirios Vahaviolos, our Chairman, President and Chief Executive Officer. We currently have no employment agreements with members of our senior management team. Although we anticipate entering into employment agreements with certain executive officers in connection with this offering, these agreements will likely not guarantee the services of the individual for a specified period of time. All of the agreements with members of our senior management team are expected to provide that their employment is at-will and may be terminated by either us or the employee at any time and without notice. Although we do not have any reason to believe that we may lose the services of any of these persons in the foreseeable future, the loss of the services of any of these persons might impede our operations or the achievement of our strategic and financial objectives. The loss or interruption of the service of members of our senior management team could harm our business, financial condition and results of operations and could significantly reduce our ability to manage our operations and implement our strategy.

 

We operate in highly competitive markets and if we are unable to compete successfully, we could lose market share and revenues.

 

We face strong competition from NDT solutions providers, both larger and smaller than we are. Many of our competitors have greater financial resources than we do. Our competitors could focus their substantial financial resources to develop a competing business model or develop products or services that are more attractive to potential customers than what we offer. Some of our competitors are business units of substantially larger companies than us and have the ability to combine NDT solutions into an integrated offering to customers who already purchase other types of products or services from them. Our competitors may offer NDT solutions at prices below or without cost in order to improve their competitive positions. Any of these competitive factors could make it more difficult for us to attract and retain customers, cause us to lower our prices in order to compete and reduce our market share and revenues, any of which could have a material adverse effect on our financial condition and results of operations.

 

Due to our dependency on customers in the oil and gas industry, we are susceptible to prolonged negative trends relating to this industry that could adversely affect our operating results.

 

Our customers in the oil and gas industry (including the petrochemical market) have accounted for a substantial portion of our historical revenues. Specifically, they accounted for approximately 50%, 52% and 49% of our revenues for fiscal 2008, 2007 and 2006, respectively. We continue to diversify our customer base into industries other than the oil and gas industry, but we may not be successful in doing so. If the oil and gas industry were to suffer a prolonged or significant downturn, our operating performance may be significantly harmed.

 

Our growth strategy includes acquisitions. We may not be able to identify suitable acquisition candidates or integrate acquired businesses successfully, which may inhibit our rate of growth, and any acquisitions that we do complete may expose us to a number of unanticipated operational and financial risks.

 

Our historical growth has depended, and our future growth is likely to continue to depend, to a certain extent, on our ability to make acquisitions and successfully integrate acquired businesses. We intend to continue to seek additional acquisition opportunities, both to expand into new markets and to enhance our position in existing markets globally. We may not be able to successfully identify suitable candidates, negotiate appropriate acquisition terms, obtain necessary financing on acceptable terms, complete proposed acquisitions, successfully integrate acquired businesses into our current operations or expand into new markets. Once integrated, acquired operations may not achieve levels of revenues, profitability or productivity comparable with those achieved by our current operations, or otherwise perform as expected.

Some of the risks associated with our acquisition strategy include:

 

 

Our ability to undertake acquisitions is limited by covenants in our credit agreement and our financial resources, including available cash and borrowing capacity. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of substantial additional indebtedness and other expenses, impairment expenses related to goodwill and impairment or amortization expenses related to other intangible assets, any of which could harm our financial condition. Although management intends to evaluate the risks inherent in any particular transaction, there are no assurances that we will properly ascertain all such risks. Difficulties encountered with acquisitions may harm our business, financial condition and results of operations.

 

Catastrophic events, such as natural disasters, epidemics, war and acts of terrorism, could disrupt our business or the business of our customers, which could significantly harm our operations, financial results and cash flow.

 

Our operations and those of our customers are susceptible to the occurrence of catastrophic events outside our control, ranging from severe weather conditions to acts of war and terrorism. Any such events could cause a serious business disruption that reduces our customers’ ability to or interest in purchasing our NDT solutions, and have in the past resulted in order cancellations and delays because customer equipment, facilities or operations have been damaged, or are not operational or available. For instance, order cancellations and delays due to Hurricanes Katrina and Rita adversely affected our revenues in fiscal 2006. Additionally, such events have resulted and may in the future result in substantial delays in the provision of solutions to our customers and the loss of valuable equipment. Any cancellations, delays or losses due to a catastrophic event may significantly reduce our revenues and harm our operating performance.

 

We expect to continue expanding and investing in our sales and marketing, operations, engineering, research and development capabilities and financial and reporting systems, and as a result, may encounter difficulties in managing our growth, which could disrupt our operations.

 

We expect to experience significant growth in the number of our employees and the scope of our operations. To effectively manage our anticipated future growth, we must continue to implement and improve our managerial, operational, financial and reporting systems, expand our facilities and continue to recruit and train additional qualified personnel. We expect that all of these measures will require significant expenditures and will demand the attention of management. We may not be able to effectively manage the expansion of our operations or recruit and adequately train additional qualified personnel. Failure to manage our growth effectively could lead us to over-invest or under-invest in technology and operations, result in weaknesses in our infrastructure, systems or controls, give rise to operational mistakes, loss of business opportunities, the loss of employees and reduced productivity among remaining employees. Our expected growth could require significant capital expenditures and may divert financial resources from other projects, such as the development of new solutions. If our management is unable to effectively manage our expected growth, our expenses may increase more than expected, our revenues could decline or may grow more slowly than expected and we may be unable to implement our business strategy.

 

The success of our businesses depends, in part, on our ability to develop new NDT solutions and increase the functionality of our current offerings.

 

The market for NDT solutions is impacted by technological change, uncertain product life cycles, shifts in customer demands and evolving industry standards and regulations. We may not be able to successfully

develop and market new NDT solutions that comply with present or emerging industry regulations and technology standards. Also, new regulations or technology standards could increase our cost of doing business.

 

From time to time, our customers have requested greater functionality in our solutions. As part of our strategy to enhance our NDT solutions and grow our business, we plan to continue making substantial investments in the research and development of new technologies. We believe our future success will depend, in part, on our ability to continue to design new, competitive NDT solutions, enhance our current NDT solutions and provide new, value-added services. Developing new solutions will require continued investment, and we may experience unforeseen technological or operational challenges. In addition, NDT-related software is complex and can be expensive to develop, and new software and software enhancements can require long development and testing periods. If we are unable to develop NDT solutions or enhancements to our current NDT offerings, or if the market does not accept such solutions, we will likely lose opportunities to realize revenues and customers and our business and results of operations will be adversely affected.

 

If our software produces inaccurate information or is incompatible with the systems used by our customers and makes us unable to successfully provide our solutions, it could lead to a loss of revenues and customers.

 

Our software is complex and, accordingly, may contain undetected errors or failures. Software defects or inaccurate data may cause incorrect recording, reporting or display of information related to our NDT solutions. Any such failures, defects and inaccurate data may prevent us from successfully providing our NDT solutions, which would result in lost revenues. Software defects or inaccurate data may lead to customer dissatisfaction and our customers may seek to hold us liable for any damages incurred. As a result, we could lose customers, our reputation may be harmed and our financial condition and results of operations would be materially adversely affected.

 

We currently serve a commercial, industrial and governmental customer base that uses a wide variety of constantly changing hardware, software solutions and operating systems. Our NDT solutions need to interface with these non-standard systems in order to gather and assess data. Our business depends on the following factors, among others:

 

 

If we are unable to adequately address any of these factors, our results of operations and prospects for growth and profitability would be harmed.

 

If we fail to successfully educate current and potential customers regarding the benefits of our NDT solutions or the market for these solutions otherwise fails to develop, our ability to grow our business could be adversely impacted.

 

Our future success depends on continued and growing commercial acceptance of our NDT solutions and our ability to obtain additional contracts. We anticipate that revenues related to our NDT solutions will constitute a substantial portion of our revenues for the foreseeable future. If we are unable to educate our potential customers about the advantages our solutions have over competing products and services, or our current customers stop purchasing our NDT solutions, our operating results could be significantly harmed. In addition, because the NDT solutions sector is rapidly evolving, we could lose insight into trends that may be emerging, which would further harm our competitive position by making it difficult to predict and respond to customer needs. If the market for our NDT solutions does not continue to develop, our ability to grow our business would be limited and we might not be able to maintain profitability.

Our results of operations could be harmed if our operating expenses do not correspond with the timing of our revenues.

 

Most of our operating expenses, such as employee compensation and property rental expense, are relatively fixed over the short-term. Moreover, our spending levels are based in part on our expectations regarding future revenues. As a result, if revenues for a particular quarter are below expectations, we would not be able to proportionately reduce operating expenses for that quarter without a substantial disruption to our business. This shortfall in revenues could adversely affect our operating results for that quarter and could cause the market price of our common stock to decline substantially.

 

The seasonal nature of our business reduces our revenues in our first and third fiscal quarters.

 

Our business is seasonal. Our first and third fiscal quarter revenues are typically lower than our revenues in the second and fourth fiscal quarters because demand for our NDT services from the oil and gas as well as the fossil and nuclear power generation and transmission industries increases during their non-peak production periods. For instance, U.S. refineries’ non-peak periods are generally in our second fiscal quarter, when they are retooling to produce more heating oil for winter, and in our fourth fiscal quarter, when they are retooling to produce more gasoline for summer. As a result of these trends, we generally have reduced cash flows in our second and fourth fiscal quarters, which may require us to borrow under our credit agreement or otherwise, to discontinue planned operations, or to curtail our operations. We expect that the negative impact of seasonality on our first and third fiscal quarter revenues and second and fourth fiscal quarter cash flows will continue.

 

Growth in revenues from our Services segment or traditional NDT services relative to revenues from our Software and Products and International segments, may reduce our overall gross profit margin.

 

Our gross profit margin on revenues from our Services segment has historically been lower than our gross profit margin on revenues from our other segments because our services have higher labor-related costs. For instance, the gross profit margin in our Services segment for fiscal 2008 was 30.9%, while our gross profit margin in our Software and Products segment and in our International segment was 50.2% and 41.9%, respectively. Our overall gross profit margin was 35.7% during the same period. Moreover, our gross profit margin on traditional NDT services has historically been lower than our gross profit margin in our Services segment as a whole. As a result, we expect our overall gross profit margin will be lower in periods when revenues from our services, and particularly from traditional NDT services, has increased as a percentage of total revenues and will be higher in periods when revenues from our International or Software and Products segments has increased as a percentage of total revenues. Fluctuations in our gross profit margin may affect our level of profitability in any period, which may negatively affect the price of our common stock.

 

Our business is currently subject to governmental regulation, and may become subject to modified or new government regulation that may negatively impact our ability to market our NDT solutions.

 

We incur substantial costs in complying with various government regulations and licensing requirements. For example, the transportation and overnight storage of radioactive materials used in providing certain of our NDT solutions is subject to regulation under federal and state laws and licensing requirements. Conam is currently licensed to handle radioactive materials by the U.S. Nuclear Regulatory Commission (NRC) and 15 state regulatory agencies. If we allegedly fail to comply with these regulations, we may be investigated and incur significant legal expenses associated with such investigations, and if we are found to have violated these regulations, we may be fined or lose one or more of our licenses to perform further projects. While we are investigated, we may be required to suspend work on the projects associated with our alleged noncompliance, resulting in loss of profits or customers, and damage to our reputation. For instance, in January, 2007, we were investigated due to an incident involving radiation exposure resulting from the misconduct of one of our employees. As a result, our customer required us to briefly suspend work on the associated project. We were found to have violated regulations governing the handling of radioactive materials, and as a result we incurred significant legal expenses and will likely incur a fine. A more serious violation could result in lost profits and damage to our reputation. In the future, federal, state, provincial or local governmental agencies may seek to change current regulations or impose additional regulations on our business. Any modified or new government

regulation applicable to our current or future NDT solutions may negatively impact the marketing and provision of those solutions and increase our costs and the price of our solutions.

 

A significant stockholder controls the direction of our business. The concentrated ownership of our common stock may prevent you and other stockholders from influencing significant corporate decisions.

 

Dr. Sotirios J. Vahaviolos, our Chairman, President and Chief Executive Officer., will own approximately     % of our outstanding common stock after this offering. As a result, Dr. Vahaviolos will have the ability to exert substantial influence over all matters requiring approval by our stockholders, including the election and removal of directors, amendments to our certificate of incorporation, and any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. This concentration of ownership could be disadvantageous to other stockholders with differing interests from Dr. Vahaviolos.

 

An inability to protect our intellectual property could negatively affect our business and results of operations.

 

Our ability to compete effectively depends in part upon the maintenance and protection of the intellectual property related to our NDT solutions. Patent protection is unavailable for certain aspects of the technology and operational processes important to our business. Any patent held by us or to be issued to us, or any of our pending patent applications, could be unenforceable, challenged, invalidated or circumvented. Some of our trademarks that are not in use may become available to others. To date, we have relied principally on copyright, trademark and trade secrecy laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our intellectual property. However, we have not obtained confidentiality agreements from all of our customers and vendors, and although we have entered into confidentiality agreements with all of our employees in our Software and Products segment and certain of our other employees involved in the development of our intellectual property, we cannot be certain that these agreements will be honored or enforceable. Some of our confidentiality agreements are not in writing, and some customers are subject to laws and regulations that require them to disclose information that we would otherwise seek to keep confidential. Although we do not transfer ownership of some of our more advanced NDT software or other products and, instead, sell to our customers services using these products, in part, in an effort to protect the intellectual property upon which they are based, this strategy may not be successful and our customers or third parties may reverse engineer or otherwise derive this intellectual property and use it without our authorization. Policing unauthorized use of our intellectual property is difficult and expensive. The steps that we have taken or may take might not prevent misappropriation of the intellectual property on which we rely. In addition, effective protection may be unavailable or limited in jurisdictions outside the United States, as the intellectual property laws of foreign countries sometimes offer less protection or have onerous filing requirements. From time to time, third parties may infringe our intellectual property rights. Litigation may be necessary to enforce or protect our rights or to determine the validity and scope of the rights of others. Any litigation could be unsuccessful, cause us to incur substantial costs, divert resources away from our daily operations and result in the impairment of our intellectual property. Failure to adequately enforce our rights could cause us to lose valuable rights in our intellectual property and may negatively affect our business.

 

We may be subject to damaging and disruptive intellectual property litigation related to allegations that our NDT solutions infringe on the intellectual property of others, which could prevent us from offering those solutions.

 

Third-party patent applications and patents may be applicable to our NDT solutions. As a result, third parties may in the future make infringement and other allegations that could subject us to intellectual property litigation relating to our solutions. Such litigation would be time consuming and expensive, divert attention and resources away from our daily operations, impede or prevent delivery of our solutions and require us to pay significant royalties, licensing fees and damages. In addition, parties making infringement and other claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to provide our solutions and could cause us to pay substantial damages. In the event of a successful claim of infringement, we may need to seek one or more licenses from third parties in order to continue to offer the

related solution, which may not be available at a reasonable cost, or at all. For example, in 2004 a competitor brought a patent infringement lawsuit against us based on our use of certain sensor technology in our inspection of a bridge. We incurred approximately $629,000 in expenses to defend against and settle this lawsuit, and to enter into a license to use this technology. Under this license agreement, we have paid the competitor immaterial amounts for fees and royalties for use of the technology, which we no longer use in our business.

 

We may require additional capital to support business growth, which might not be available.

 

We intend to continue making investments to support our business growth and may require additional funds to respond to business challenges or opportunities, including the need to develop new, or enhance our current, NDT solutions, enhance our operating infrastructure or acquire complementary businesses and technologies. Accordingly, we may need to engage in equity or debt financings to secure additional funds. If we raise additional funds through further issuances of equity or convertible debt securities, our current stockholders, including investors in this offering, could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. In addition, we may not be able to obtain additional financing on terms favorable to us, if at all. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

 

Our credit agreement contains financial and operating restrictions that may limit our access to credit. If we fail to comply with financial or other covenants in our credit agreement, we may be required to repay indebtedness to our existing lenders, which may harm our liquidity.

 

Provisions in our credit agreement with Bank of America, N.A. and JPMorgan Chase Bank, N.A., impose restrictions on our ability to, among other things:

 

 

Our credit agreement also contains financial covenants that require us to maintain compliance with specified financial ratios. We may not be able to comply with these covenants in the future. Our failure to comply with these covenants may result in the declaration of an event of default, which could prevent us from borrowing under our credit agreement. In addition to preventing additional borrowings under our credit agreement, an event of default, if not cured or waived, may result in the acceleration of the maturity of indebtedness outstanding under the agreement, which would require us to pay all amounts outstanding and, in addition, our lenders may require us to cash collateralize letters of credit issued thereunder. If an event of default occurs, we may not be able to cure it within any applicable cure period, if at all. If the maturity of our indebtedness is accelerated, we then may not have sufficient funds available for repayment or the ability to borrow or obtain sufficient funds to replace the accelerated indebtedness on terms acceptable to us, or at all.

We may become subject to commercial disputes or product liability claims, that could harm our business by distracting our management from the operation of our business, by increasing our expenses and, if we do not prevail, by subjecting us to potential monetary damages and other remedies.

 

We face potential liability for, among other things, contract, negligence and product liability claims related to our provision of NDT solutions. For instance, our customers may assert that we have failed to perform under our agreements with them, or our customers or third parties may claim damages arising out of misuse of our products, the malfunctioning of our products due to design or manufacturing flaws, or the use of our products with components or systems not manufactured or sold by us. We currently do not carry product liability insurance and we may not have sufficient resources to satisfy any liability resulting from product liability or other claims. Any of these claims or disputes could result in monetary damages and equitable or other remedies that could harm our financial position or operations. Even if we prevail in or settle these claims or disputes, they may distract our management from operating our business and the cost of defending or settling them could harm our operating results, financial position and cash flows.

 

We rely on a limited number of suppliers to provide us radioisotopes and a material interruption in supply could prevent or limit our ability to fill orders for our products.

 

We depend upon a limited number of third-party suppliers for the radioisotopes we use to provide certain advanced NDT solutions. Our principal suppliers are Industrial Nuclear Company, QSA Global Inc. and Source Production & Equipment Co., Inc. We also utilize other commercial isotope manufacturers located in the United States and overseas. To date, we have been able to obtain the required radioisotopes for our NDT solutions without any significant delays or interruptions. If we lose any of these suppliers, we may be required to find and enter into supply arrangements with one or more replacement suppliers. Obtaining alternative sources of supply could involve significant delays and other costs and these supply sources may not be available to us on reasonable terms or at all. Any disruption of supplies could delay delivery of our products that use radioisotopes, which could adversely affect our business and financial results and result in lost or deferred sales.

 

NDT sales cycles can be lengthy, unpredictable and require significant employee time and financial resources with no assurances that we will realize revenues.

 

Our sales cycles are often long and unpredictable. Many of our current and potential customers have extended budgeting and procurement processes. We believe that they also tend to be risk averse and follow industry trends rather than be the first to purchase new products or services, which can extend the lead time for or prevent acceptance of new products or services. Accordingly, they may take longer to reach a decision to purchase our solutions. This extended sales process, which often lasts between three and six months, requires the dedication of significant time and financial resources, with no certainty of success or recovery of our related expenses. It is not unusual for our current and potential customers to go through the entire sales process and not make any purchases.

 

Any real or perceived internal or external electronic security breaches in connection with the use of our NDT solutions could harm our reputation, inhibit market acceptance of our solutions and cause us to lose customers.

 

We and our customers use our NDT solutions to compile and analyze sensitive or confidential customer-related information. In addition, some of our NDT solutions allow us to remotely control equipment at commercial, institutional and industrial locations. Our NDT solutions rely on the secure electronic transmission of proprietary data over the Internet or other networks. Well-publicized compromises of Internet security could have the effect of substantially reducing confidence in the Internet as a medium of data transmission. The occurrence or perception of security breaches in connection with our NDT solutions or our customers’ concerns about Internet security or the security of our solutions, whether warranted or not, would likely harm our reputation or business, inhibit market acceptance of our NDT solutions and cause us to lose customers, any of which would harm our financial condition and results of operations.

We may come into contact with sensitive consumer information or data when we perform installation, maintenance or testing functions for our customers. Even the perception that we have improperly handled sensitive, confidential information would have a negative effect on our business. If, in handling this information, we fail to comply with privacy or security laws, we could incur civil liability to government agencies, customers and individuals whose privacy is compromised. In addition, third parties may attempt to breach our security or inappropriately harm our NDT solutions through computer viruses, electronic break-ins and other disruptions. If a breach is successful, confidential information may be improperly obtained, for which we may be subject to lawsuits and other liabilities.

 

Our international operations are subject to risks relating to non-U.S. operations.

 

In fiscal 2008, 2007 and 2006, we generated approximately 19.6%, 20.5% and 21.3%, respectively, of our revenues outside the United States and we expect to increase our international presence over time. Our primary operations outside the United States are in Europe, Asia and South America. There are numerous risks inherent in doing business in international markets, including:

 

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We are expanding our sales and marketing efforts in certain emerging markets, such as Brazil, Russia, India and China. Expanding our business into emerging markets may present additional risks beyond those associated with more developed international markets. For example, in China and Russia, we may encounter risks associated with the ongoing transition from state business ownership to privatization. In any emerging market, we may face the risks of working in cash-based economies, dealing with inconsistent government policies and encountering sudden currency revaluations.

 

We rely on certification of our NDT solutions by industry standards-setting bodies.

 

We currently have International Organization for Standardization (ISO) 9001-2000 certifications for each of Conam, Physical Acoustics Corporation (PAC) and Physical Acoustics Limited and we have ISO 14001:2004 certification for Conam. In addition, we currently have Nadcap (formerly National Aerospace and Defense Contractors Accreditation Program) certification for four of our locations in Auburn, Massachusetts; Springfield, Massachusetts; Heath, Ohio; and Kent, Washington. We continually review our NDT solutions for compliance with the requirements of industry specification standards and the Nadcap special processes quality requirements. However, if we fail to maintain our ISO or Nadcap certifications, our business may be harmed because our customers generally require that we have ISO and Nadcap certification before they purchase our NDT solutions.

Risks Related to Our Common Stock and this Offering

 

We expect our quarterly revenues and operating results to fluctuate. If we fail to meet the expectations of market analysts or investors, the market price of our common stock could decline substantially.

 

Our quarterly operating results have fluctuated in the past and are expected to do so in the future. Accordingly, we believe that period-to-period comparisons of our results of operations may be misleading. You should not rely upon the results of one quarter as an indication of future performance. Our revenues and operating results may fall below the expectations of securities analysts or investors in any future period. Our failure to meet these expectations would likely cause the market price of our common stock to decline, perhaps substantially.

 

Our quarterly revenues and operating results may vary depending on a number of factors, including:

 

 

We currently have no plans to pay dividends on our common stock.

 

We have not declared or paid any cash dividends on our common stock to date, and we do not anticipate declaring or paying any dividends on our common stock in the foreseeable future. We currently intend to retain all available funds and any future earnings for use in the development, operation and growth of our business. In addition, our credit agreement prohibits us from paying dividends and future loan agreements may also prohibit the payment of dividends. Any future determination relating to our dividend policy will be at the discretion of our board of directors and will depend on our results of operations, financial condition, capital requirements, business opportunities, contractual restrictions and other factors deemed relevant. To the extent we do not pay dividends on our common stock, investors must look solely to stock appreciation for a return on their investment.

 

There is no existing market for our common stock, and a trading market that will provide you with adequate liquidity may not develop. The price of our common stock may fluctuate significantly, and you could lose all or part of your investment.

 

Prior to this offering, there has been no public market for our common stock. We cannot predict the extent to which investor interest will lead to the development of an active and liquid trading market in our common stock on the New York Stock Exchange or otherwise. If an active and liquid trading market does not develop, you may have difficulty selling any of our common stock.

The initial public offering price for the shares will be determined by negotiations between us and the representatives of the underwriters and may not be indicative of the market price of the common stock on the New York Stock Exchange after the offering. The market price of our common stock may decline below the initial public offering price. The market price of our common stock may also be influenced by many factors, some of which are beyond our control, including:

 

 

The stock markets have generally experienced extreme price and volume fluctuations. This volatility has had a significant impact on the market price of securities issued by many companies, including those in our industry. These changes frequently appear to occur without regard to the operating performance of these companies. The price of our common stock could fluctuate for reasons that have little or nothing to do with our company, and these fluctuations could materially reduce our stock price.

 

In the past, some companies that have had volatile market prices for their securities have been subject to class action or derivative lawsuits. The filing of a lawsuit against us, regardless of the outcome, could have a material adverse effect on our business, financial condition and results of operations, as it could result in substantial legal costs and a diversion of our management’s attention and resources.

 

Shares eligible for future sale may cause the market price for our common stock to decline even if our business is doing well.

 

Future sales by us or by our existing stockholders of substantial amounts of our common stock in the public market, or the perception that these sales may occur, could cause the market price of our common stock to decline. This could also impair our ability to raise additional capital in the future through the sale of our equity securities. Under our second amended and restated certificate of incorporation that will be in effect upon the completion of this offering, we are authorized to issue up to           shares of common stock, of which           shares of common stock will be outstanding following this offering. Of these shares, the shares of common stock sold in this offering will be freely transferable without restriction or further registration under the Securities Act of 1933, as amended (Securities Act), by persons other than “affiliates,” as that term is defined in Rule 144 under the Securities Act. In addition,           shares of common stock will become freely tradeable immediately upon the termination of the lock-up agreements described below and an additional           shares of common stock will become freely tradeable thereafter, assuming no exercise of any outstanding warrants or options as of          . Certain of our stockholders will be able to cause us to register common stock that they own under the Securities Act pursuant to registration rights that are described in “Certain Relationships and Related Transactions — Registration Rights.” We also intend to register all shares of common stock that we may issue under our Restricted Stock Purchase Plan and 2008 Long-Term Incentive Plan.

 

Our executive officers and directors and certain of our stockholders have entered into lock-up agreements described under the caption “Underwriting,” pursuant to which they have agreed, subject to certain exceptions and extensions, not to sell or transfer, directly or indirectly, any shares of our common stock for a period of 180 days from the date of this prospectus or to exercise registration rights during such period with respect to such shares. However, after the lock-up period expires, or if the lock-up restrictions are waived by the representatives, such persons will be able to sell their shares and exercise registration rights to cause them to

be registered. We cannot predict the size of future issuances of our common stock or the effect, if any, that future sales and issuances of shares of our common stock, or the perception of such sales or issuances, would have on the market price of our common stock. See “Shares Eligible for Future Sale.”

 

We have not determined any specific use for a significant portion of the proceeds from this offering and we may use the proceeds in ways with which you may not agree.

 

Our management will have considerable discretion in the application of the net proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether the proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that may not improve our financial condition and results of operations or increase our stock price. See “Use of Proceeds.”

 

Purchasers of common stock will experience immediate and substantial dilution.

 

Based on the initial public offering price of $      per share (the midpoint of the price range shown on the cover page of this prospectus), purchasers of our common stock in this offering will experience an immediate and substantial dilution in the net tangible book value per share of common stock of $      per share from the offering price. Investors purchasing common stock in this offering will contribute approximately     % of the total amount invested by stockholders since inception, but will only own approximately     % of the shares of common stock outstanding. In addition, following this offering we will also have a significant number of outstanding warrants and options to purchase our common stock, with the options having exercise prices significantly below the initial public offering price of our common stock. You will incur further dilution if outstanding options or warrants to purchase common stock are exercised. In addition, our second amended and restated certificate of incorporation that will be in effect upon the completion of this offering allows us to issue significant numbers of additional shares, including shares that may be issued under the Restricted Stock Purchase Plan and 2008 Long-Term Incentive Plan, which could result in further dilution to purchasers of our common stock in this offering.

 

Provisions of our charter, bylaws and of Delaware law, as well as some of our employment arrangements, could discourage, delay or prevent a change of control of our company, which may adversely affect the market price of our common stock.

 

Certain provisions of our second amended and restated certificate of incorporation and amended and restated bylaws that will be in effect upon the completion of this offering could discourage, delay or prevent a merger, acquisition, or other change of control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions also could limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. Stockholders who wish to participate in these transactions may not have the opportunity to do so. Furthermore, these provisions could prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions:

 

 

 

Some of our employment arrangements and stock option agreements provide for severance payments and accelerated vesting of benefits, including accelerated vesting of restricted stock and options, upon a change of control. This offering will not constitute a change of control under such agreements. These provisions may discourage or prevent a change of control.

 

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may, unless certain criteria are met, prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a prescribed period of time.

 

Being a public company will increase our administrative workload and expenses.

 

As a public company with common stock listed on the New York Stock Exchange, we will need to comply with new laws, regulations and requirements, including certain provisions of the Sarbanes-Oxley Act of 2002, related regulations of the Securities and Exchange Commission (SEC) and the requirements of the New York Stock Exchange, which we are not required to comply with as a private company. Complying with these statutes, regulations and requirements will occupy a significant amount of time of our board of directors and management. The hiring of additional personnel to handle these responsibilities will increase our operating costs. We expect we will need to:

 

 

In addition, we expect that being a public company subject to these rules and regulations will make it more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These factors could also make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our audit and compensation committees.

 

Our internal controls over financial reporting do not currently meet the standards required by Section 404 of the Sarbanes-Oxley Act, and failure to achieve and maintain effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our business and stock price.

 

Our internal controls over financial reporting do not currently meet the standards required by Section 404 of the Sarbanes-Oxley Act, standards that we will be required to meet in the course of preparing our 2010 annual report on Form 10-K. We do not currently have comprehensive documentation of our internal controls, nor do we document or test our compliance with these controls on a periodic basis in accordance with Section 404 of the Sarbanes-Oxley Act. Furthermore, we have not tested our internal controls in accordance

with Section 404 and, due to our lack of documentation, such a test would not be possible to perform at this time.

 

We are in the early stages of addressing our internal controls procedures to satisfy the requirements of Section 404, which requires an annual management assessment of the effectiveness of our internal controls over financial reporting. If, as a public company, we are not able to timely or adequately implement the requirements of Section 404, our independent registered public accounting firm may not be able to attest to the adequacy of our internal controls over financial reporting. If we are unable to maintain adequate internal controls over financial reporting, we may be unable to report our financial information on a timely basis, may suffer adverse regulatory consequences or violations of applicable stock exchange listing rules and may breach the covenants under our credit facilities. There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements.

 

In addition, we expect to incur incremental costs in order to improve our internal controls over financial reporting and comply with Section 404, including increased auditing and legal fees and costs associated with hiring additional accounting and administrative staff. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview.”

 

This prospectus contains forward-looking statements that are based on our management’s beliefs and assumptions and on information currently available to us. The forward-looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” When used in this prospectus, the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “would,” and similar expressions identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in any forward-looking statements are reasonable, these plans, intentions or expectations are based on assumptions, are subject to risks and uncertainties and may not be achieved. Our actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained in this prospectus. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in this prospectus, including under the heading “Risk Factors.” Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this prospectus. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this prospectus. These statements include, among other things, statements relating to:

 

 

Actual events, results and outcomes may differ materially from our expectations due to a variety of factors. Although it is not possible to identify all of these factors, they include, among others, the following:

 

 

Potential investors are urged to carefully consider these factors and the other factors described under “Risk Factors” in evaluating any forward-looking statements and are cautioned not to place undue reliance on these forward-looking statements. Except as required by applicable law, we undertake no obligation to publicly

update any forward-looking statements or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future.

 

We estimate that our net proceeds from the sale of our common stock in this offering, based on the initial public offering price of $      per share (the midpoint of the price range shown on the cover page of this prospectus), will be approximately $      , or $      if the underwriters exercise their over-allotment option in full, after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

We plan to use these net proceeds for general corporate purposes, including working capital and possible acquisitions. We have no present understandings, commitments or agreements to acquire any businesses or technologies. We will not receive any proceeds from the sale of shares by the selling stockholders.

 

We have not yet determined the amount of our remaining net proceeds to be used specifically for any of the foregoing purposes. Accordingly, management will have flexibility in applying our remaining net proceeds of this offering. Pending their use, we intend to invest our net proceeds from this offering in short-term, investment grade, interest-bearing instruments.

 

We have never paid or declared any cash dividends on our common stock. We currently intend to retain all available funds and any future earnings to fund the development and expansion of our business, and we do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements and other factors that our board of directors deems relevant. The terms of our current credit agreement with Bank of America, N.A. and JPMorgan Chase Bank, N.A. preclude us, and the terms of any future debt or credit facility may also preclude us, from paying dividends.

 

The following table sets forth (1) our cash and cash equivalents and (2) our capitalization as of May 31, 2008:

 

 

 

 

For purposes of the pro forma as adjusted column of the capitalization table below, we have assumed the net proceeds from this offering will be $      million after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

In addition, the table excludes the following:

 

 

 

This table should be read in conjunction with our audited consolidated financial statements, including the notes thereto, “Use of Proceeds,” “Selected Historical Consolidated Financial Information,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” all included elsewhere in this prospectus.

 

 

If you invest in our common stock, your interest will be diluted to the extent of the difference between the initial public offering price per share of our common stock and the net tangible book value per share of our common stock immediately after the completion of this offering. Dilution results from the fact that the per share offering price of the common stock is substantially in excess of the book value per share attributable to the existing stockholders for the presently outstanding stock.

 

As of May 31, 2008, our net tangible book deficit was approximately $64.7 million, or approximately $      per share. Net tangible book deficit per share represents the amount of total tangible assets less our total liabilities, including our preferred stock, divided by the number of shares outstanding. On a pro forma basis, after giving effect to the conversion of           shares of our preferred stock into           shares of our common stock and a  -for-   stock split of our common stock, and excluding proceeds from this offering, our pro forma net tangible book value as of May 31, 2008 would have been approximately $      million, or $      per share.

 

On a pro forma as adjusted basis, after giving further effect to the sale of           shares of common stock in this offering at the initial public offering price of $      per share (the midpoint of the price range shown on the cover page of this prospectus) and after deducting underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of May 31, 2008 would have been approximately $      million, or $      per share. This represents an immediate increase in pro forma net tangible book value from this offering of $      per share to our existing stockholders and an immediate dilution of $      per share to new investors purchasing common stock in this offering.

 

The following table illustrates this dilution to new investors on a per share basis:

 

 

The following table summarizes, as of May 31, 2008, the differences between the number of shares of common stock owned by existing stockholders and the number to be owned by new public investors, the aggregate cash consideration paid to us and the average price per share paid by our existing stockholders and to be paid by new public investors purchasing shares of common stock in this offering at the initial public offering price of $      per share (the midpoint of the price range shown on the cover page of this prospectus).

 

 

 

 

The discussion and tables above assume no exercise of the underwriters’ over-allotment option. If the underwriters exercise their over-allotment option in full, the number of shares of common stock held by new investors will increase to approximately           shares, or approximately     % of the total number of

shares of our common stock to be outstanding after this offering, our existing stockholders would own approximately     % of the total number of shares of our common stock to be outstanding after this offering, the pro forma as adjusted net tangible book value per share of common stock would be approximately $      and the dilution in pro forma as adjusted net tangible book value per share of common stock to new investors would be $     .

 

In addition, the above discussion and tables assume no exercise of stock options.

 

As of May 31, 2008, we had outstanding options to purchase a total of           shares of common stock at a weighted average exercise price of $      per share. If all of these outstanding options had been exercised as of May 31, 2008, our pro forma net tangible book value would have been $      per share of common stock, pro forma as adjusted net tangible book value after this offering would be $      per share of common stock and dilution in pro forma as adjusted net tangible book value to investors in this offering would be $      per share of common stock.

 

In addition, if all of these outstanding options as of May 31, 2008 were exercised, on an as adjusted basis after deducting underwriting discounts and estimated offering expenses payable by us, (i) existing stockholders would have purchased           shares representing     % of the total shares for $     , or approximately     % of the total consideration paid, with an average price per share of $      and (ii)            shares purchased by new stockholders in this offering would represent approximately     % of total shares for approximately $     , or approximately     % of the total consideration paid.

 

The following tables set forth our selected historical financial data for the periods indicated. The selected statement of operations and cash flow data for fiscal 2008, 2007 and 2006 and the selected balance sheet data as of May 31, 2008 and 2007 have been derived from our audited financial statements and related notes thereto included elsewhere in this prospectus. The statement of operations and cash flow data for fiscal 2005 and the selected balance sheet data as of May 31, 2005 have been derived from our audited financial statements not included in this prospectus. The statement of operations and cash flow data for fiscal 2004 and the selected balance sheet data as of May 31, 2004 have been derived from our unaudited financial statements not included in this prospectus.

 

The information presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited and unaudited financial statements and the notes thereto included elsewhere in this prospectus.

 

 

 

 

 

 

 

Our management uses EBITDA as a measure of operating performance to assist in comparing performance from period to period on a consistent basis, as a measure for planning and forecasting overall expectations and for evaluating actual results against such expectations, and as a performance evaluation metric off which to base executive and employee incentive compensation programs.

 

We believe investors and other external users of our financial statements benefit from the presentation of EBITDA in evaluating our operating performance because it provides them with an additional tool to compare our operating performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our core operations. For instance, EBITDA generally excludes interest expense, taxes and depreciation and amortization, which can vary substantially from company to company depending upon accounting methods and the book value and age of assets, capital structure, capital investment cycles and the method by which assets were acquired.

 

Although EBITDA is widely used by investors and securities analysts in their evaluations of companies, you should not consider it either in isolation or as a substitute for analyzing our results as reported under U.S. generally accepted accounting principles (GAAP). EBITDA is generally limited as an analytical tool because it excludes, among other things, the statement of operations impact of depreciation and amortization, interest expense and the provision for income taxes and therefore does not necessarily represent an accurate measure of profitability, particularly in situations where a company is highly leveraged or has a disadvantageous tax structure. As a result, EBITDA is of particularly limited value in evaluating our operating performance because (i) we use a significant amount of capital assets and depreciation and amortization expense is a necessary element of our costs and ability to generate revenue; (ii) we have a significant amount of debt and interest expense is a necessary element of our costs and ability to generate revenue; and (iii) we generally incur significant U.S. federal, state, and foreign income taxes each year and the provision for income taxes is a necessary element of our costs. EBITDA also does not reflect historical cash expenditures or future requirements for capital expenditures or contractual commitments, changes in, or cash requirements for, our working capital needs and all non-cash income or expense items that are reflected in our statements of cash flows. Furthermore, because EBITDA is not defined under GAAP, our definition of EBITDA may differ from, and therefore may not be comparable to,

similarly titled measures used by other companies, thereby limiting its usefulness as a comparative measure.

 

Because of these limitations, EBITDA should not be considered as the primary measure of our operating performance or as a measure of discretionary cash available to us to invest in the growth of our business. We strongly urge you to review the GAAP financial measures included in this prospectus, our consolidated financial statements, including the notes thereto, our pro forma financial statements and the other financial information contained in this prospectus, and not to rely on any single financial measure to evaluate our business.

 

You should read the following discussion together with the financial statements and the notes thereto included elsewhere in this prospectus. This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business and operations. The cautionary statements made in this prospectus should be read as applying to all related forward-looking statements wherever they appear in this prospectus. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements as a result of a number of factors, including but not limited to those we discuss under “Risk Factors” and “Forward-Looking Statements.”

 

Overview

 

We are a leading global provider of proprietary, technology-enabled, NDT solutions used to evaluate the structural integrity of critical energy, industrial and public infrastructure. We combine the skill and experience of our certified technicians, engineers and scientists with our advanced enterprise software and other proprietary product offerings to deliver a comprehensive portfolio of solutions, ranging from routine NDT inspections to complex, plant-wide asset integrity assessment and management solutions. Our enterprise software is at the core of this portfolio because it enables us to integrate all of the NDT solutions we offer. These solutions enhance our customers’ ability to extend the useful life of their assets, increase productivity, minimize repair costs, comply with governmental safety and environmental regulations and, critically, avoid catastrophic disasters. Given the role our services play in ensuring the safe and efficient operation of infrastructure, we have historically provided a majority of our services to our customers on a regular, recurring basis. We serve a global customer base, including companies in the oil and gas, fossil and nuclear power generation and transmission, public infrastructure, chemicals, aerospace and defense, transportation, primary metals and metalworking, pharmaceuticals and food processing industries. During fiscal 2008, we provided our NDT solutions to approximately 4,000 customers. As of August 15, 2008, we had approximately 1,600 employees in 60 offices across 15 countries, through which we have established long-term relationships as a critical solutions provider to many of the leading companies in our target markets. Our current principal market is the oil and gas industry, which accounted for approximately 50%, 51% and 49% of our revenues for fiscal 2008, 2007 and 2006, respectively.

 

During the last three fiscal years, we have principally focused on introducing our advanced NDT solutions to our customers using proprietary, technology-enabled software and testing instruments, including those developed by our Products group. During this period, the demand for outsourced NDT solutions has, in general, increased, creating demand from which our entire industry has benefited. We have experienced compounded annual revenue growth of 23.5% over the last three fiscal years, including the impact of acquisitions. During the same period, revenues from our customers in the oil and gas market, historically our largest target market, had a compounded annual growth rate (CAGR) of 26.7% and revenues from our customers in the fossil and nuclear power generation and transmission market had a CAGR of 41.8%, the highest growth rate of all our target markets. All of our other target markets, which include aerospace and infrastructure, collectively had a CAGR of 13.9%. With a few exceptions, we believe further growth can be realized in all of our target markets. Concurrent with this growth, we have worked to build our infrastructure to profitably absorb additional growth and have made a number of small acquisitions in an effort to leverage our fixed costs, grow our base of experienced personnel, expand our technical capabilities and increase our geographical reach.

 

Since inception, we have increased our capabilities and the size of our customer base through the development of applied technologies, organic growth and the successful integration of acquired companies. Although representing a small percentage of our revenue growth in the periods presented, these acquisitions have provided us with additional products, technologies and resources that have allowed us to build sustainable competitive advantages over our competition. We have accelerated our acquisition activity in fiscal 2008, which we believe will further add to our growth.

 

In connection with our review of our financial results for fiscal 2008 and 2007, we and our independent registered public accounting firm reported to our Board of Directors two material weaknesses in our internal controls over financial reporting. We are executing a plan to remediate the material weaknesses by implementing additional formal policies and procedures, increasing management review and oversight over the financial statement closing and reporting processes and hiring additional accounting personnel. We believe we have made progress in addressing these material weaknesses and expect to complete the remediation in the next year. We do not expect the costs of remediating the material weaknesses to be material.

 

Basis of Presentation

 

Consolidated Results of Operations

 

Segment Definition

 

Although we often offer an integrated suite of NDT solutions incorporating services, software and other products, our Chief Executive Officer currently utilizes three segments to assess the performance of our business. The three segments are:

 

 

We provide general corporate services, including accounting, audit, contract management and human resources management, to our segments, and report certain intersegment transactions as corporate and eliminations. There is no allocation of corporate general and administrative expenses to our segments.

 

Segment income from operations is determined based on internal performance measures used by our Chief Executive Officer to assess the performance of each business in a given period and to make decisions as to resource allocations. In connection with that assessment, the Chief Executive Officer may exclude matters such as certain acquisition-related charges and balances, certain gains and losses from dispositions, stock compensation expense, litigation settlements or other charges.

 

Statement of Operations Overview

 

The following describes certain line items in our statement of operations and some of the factors that affect our operating results.

 

Revenues

 

Our revenues are generated by sales of our services, software and other products. The majority of our revenues are derived under time-and-materials contracts for specified NDT services on a project-by-project basis. The duration of our projects vary depending on their scope. Some of our projects last from a few weeks to a few months, but the more significant projects can last for more than a year and can require long-term deployment of substantial personnel, equipment and resources. The start date of our projects can be postponed or delayed and the duration of our projects can be shortened or increased due to a variety of factors beyond our control. In addition to the timing of these projects and the seasonality of our business, the amount and origination of our revenues often vary from period to period. A percentage of our revenues is usually attributable to recurring work from our existing customers. Although our top ten customers are responsible for a large percentage of our revenues, we generate our revenues from most of these customers by providing NDT solutions to numerous of their business locations. We believe decisions regarding the purchase of our solutions by these customers are made on a location-by-location basis. Also included in our revenues are software license fees and product sales, as well as an estimate for any sales returns and customer allowances. Revenues under our time-and-materials services contracts are based on the hours of service we

provide our customers at negotiated rates, plus any actual costs of materials and other direct expenses that we incur on the project, with little or no mark-up. Because these expenses, such as travel and lodging or subcontracted services, can change significantly from project to project, changes in our revenues may not be indicative of business trends.

 

Cost of revenues

 

Our cost of revenues includes our direct compensation and related benefits to support our sales, together with reimbursable costs, materials consumed or used in manufacturing our products and certain overhead costs, such as non-billable time, equipment rentals, fringe benefits and repair and maintenance.

 

Depreciation included in gross profit

 

Our depreciation represents the expense charge for our capitalized assets. Depending on the nature of the original item capitalized, these depreciation expenses are reported in one of two places in our statement of operations. Depreciation used in determining gross profit is directly related to our revenues and primarily relates to depreciation of the manufacturing portion of our corporate headquarters and of equipment used for the production of our NDT solutions. Other depreciation is included in deriving our income from operations and is discussed below.

 

Gross profit

 

Our gross profit equals our revenues less our cost of revenues and attributed depreciation. Our gross profit, both in absolute dollars and as a percentage of revenues, can vary based on our volume, sales mix, actual manufacturing costs and our utilization of labor. As a result, gross profit may vary from quarter to quarter. For instance, our gross profit can decline during holiday periods when we incur labor costs without any corresponding revenues. Under our time-and-materials contracts, we negotiate hourly billing rates and charge our clients based on the actual time that we expend on a project. Our profit margins on time-and-materials contracts fluctuate based on actual labor and overhead costs that we directly charge or allocate to contracts compared to negotiated billing rates.

 

In recent years, there has been an increasing demand for NDT solutions and a limited supply of certified technicians. Accordingly, we have experienced increases in our cost of labor in our Services segment. The customers of our Services segment are aware of these supply constraints and generally have, to some extent, accepted corresponding price increases for our NDT services. We are uncertain whether our ability to increase prices for our NDT services will continue. In our Software and Products segment, our ability to increase prices for any NDT software or product to offset associated cost increases is based principally on the extent to which its incorporates our proprietary technology. We believe our efforts to develop and offer our customers value-added proprietary solutions instead of commodity-type products help us, in part, to resist margin erosion. Our International segment offers services, software and products similar to those of our other segments, so our ability to increase prices in this segment as costs increase is determined by the same factors affecting the pricing of our other segments, and the relative mix of services, software and products it provides in the applicable period.

 

Selling, general and administrative expenses

 

Our selling, general and administrative expenses are comprised primarily of expenses of our sales and marketing operations, field location administrative costs and our corporate headquarters related to our executive, general management, finance, accounting and administrative functions and legal fees and expenses. These costs can vary based on our volume of business or as expenses are incurred to support corporate activities and initiatives such as training. The largest single category is salaries and related costs. We expect these expenses to increase in the near term, both in absolute dollars and as a percentage of net revenues, in order to support the growth of our business as we expand our sales and marketing efforts, improve our information processes and systems and implement the financial reporting, compliance and other infrastructure required for a public company. Over time, we expect selling, general and administrative expenses to decline as a percentage of our revenues.

Research and engineering

 

Research and engineering expense consists primarily of engineering salaries and personnel-related costs and the cost of products, materials and outside services used in our process and product development activities primarily in our Software and Products segment. Other research and development is conducted in our Services segments by various billable personnel and our management on a collaborative basis. These costs are not separated and are included in cost of revenues. Specific development costs on software are capitalized and amortized in our depreciation and amortization included in our income from operations. From time-to-time, we receive minor grants or contracts for paid research which are recorded in our revenues with the related costs included in cost of revenues. We expect to continue our investment in research and engineering activities and anticipate that our associated expense will increase in absolute terms in the future as we hire additional personnel and increase research and engineering activity. However, as a percentage of revenues, we expect research and engineering expense to decline over time.

 

Depreciation and amortization included in income from operations

 

Our depreciation and amortization used in deriving our income from operations represents the expense charge for our capitalized assets, and primarily relates to buildings and improvements, including our corporate headquarters, office furniture, equipment, or intangibles acquired as part of our acquisitions of other businesses. These intangible assets include, but are not limited to, non-competition agreements, customer lists and trade names. To the extent we ascribe value to identifiable intangible assets that have finite lives, we amortize those values over the estimated useful lives of those assets. Such amortization expense, although non-cash in the period expensed, directly impacts our results of operations. It is difficult to predict with any precision the amount of expense we may record relating to acquired intangible assets. Because many of the intangible assets we acquire are short-lived intangible assets, we would expect to see higher amortization expense in the first 12 to 18 months after an acquisition has been consummated.

 

Income from operations

 

Our income from operations is our gross profit less our selling, general and administrative expenses, research and engineering and depreciation and amortization included in income from operations. We refer to our income from operations as a percentage of our revenues as our operating margin.

 

Interest expense

 

Our interest expense consists primarily of interest paid to our lenders under our credit agreement. Also included is the interest incurred on our capital leases and on subordinated notes issued as part of our acquisitions. We adjust the interest differential on our interest rate swap quarterly to reflect the difference from our current borrowing rate to the notional amount of our interest rate swap contracts.

 

Income taxes

 

Income tax expense varies as a function of income before income tax expense and permanent non-tax deductible expenses, such as certain amounts of meals and entertainment expense, valuation allowance requirements and other permanent differences. Prior to fiscal 2007, we had net operating loss carryforwards (NOLs) for federal and state purposes, but as a result of our pre-tax income in fiscal 2007, we used a majority of these NOLs. As of May 31, 2008 we had $2.3 million of NOLs available to offset state taxable income in future years. These state NOLs will expire, if not utilized, at varying dates beginning in 2011 depending on the laws of each state and we have provided a valuation reserve of $0.2 million. Our effective income tax rate will be subject to many variables, including the absolute amount and future geographic distribution of our pre-tax income. We also plan to continue our acquisition strategy, and, as such, we anticipate that there will be variability in our effective tax rate from quarter to quarter and year to year, especially to the extent that our permanent differences increase or decrease. As a result of any of these factors, our future effective income tax rate may fluctuate significantly over the next few years.

Minority interest, net of taxes

 

Our minority interest represented the minority interest of other stockholders in our international subsidiaries, where 100% ownership is not permitted or de minimis local ownership is helpful for business purposes. For fiscal 2007 and 2006, this amount primarily consisted of the net income of Envirocoustics A.B.E.E., which we first consolidated in fiscal 2006. We acquired this entity on April 25, 2007.

 

Consolidated Results of Operations

 

Fiscal 2008, 2007 and 2006

 

Our revenues, gross profit, income from operations and net income for fiscal 2008, 2007 and 2006 were as follows:

 

 

Fiscal 2008 compared to Fiscal 2007

 

Revenues.  Revenues increased $30.0 million, or 24.6%, for fiscal 2008 compared to fiscal 2007 as a result of growth in all our segments. In fiscal 2008, the largest increase in our revenues was attributable to customers in the oil and gas market, which accounted for nearly 44.5% of our revenue growth. The remainder of the growth in our revenues was broadly distributed among customers in our other target markets, with the largest increases attributable to growth in revenues from customers in the fossil and nuclear power generation and transmission and chemicals markets. In fiscal 2008, we completed a significant number of projects for existing customers in the public infrastructure market. However, there was a small decrease in revenues from customers in this market in fiscal 2008 because we completed a significant new bridge project in fiscal 2007. The increase in fiscal 2008 revenues was largely driven by our Services segment, which represented $24.7 million of the total increase, and resulted primarily from an increase in the overall customer demand for NDT services, and revenue contributed from acquired businesses. We estimate that at least 65% of our total revenue growth in fiscal 2008 was organic.

 

Gross profit.  Our gross profit for fiscal 2008 increased $12.6 million, or 30.0%, over fiscal 2007. As a percentage of revenues, our gross profit was 35.7% and 34.3% in fiscal 2008 and fiscal 2007, respectively. In dollar terms, the increase in our gross profit during our 2008 fiscal year was primarily the result of increased

revenues and our raising prices to keep pace with escalating labor rates, partially offset by increased depreciation expense due to purchases of field test equipment and additional fleet vehicles to support our revenue growth. Our gross profit in fiscal 2008 also benefitted by 0.7% as the Company reduced its estimated accrual for workers compensation claims due to favorable claim experience for the recent year. As a percentage of revenues, depreciation expense included in gross profit for the years ended May 31, 2008 and 2007 were 4.5% and 3.8%, respectively.

 

Income from operations.  Our income from operations of $16.4 million in fiscal 2008 increased $5.6 million, or 52.4%, compared to fiscal 2007. As a percentage of revenues, for fiscal 2008, our income from operations was 10.7%, compared to 8.8% compared to fiscal 2007. This increase was a result of increased revenues and gross profit, offset by increases in selling, general and administrative expenses and depreciation and amortization. Our selling, general and administrative expenses included in the determination of income from operations for fiscal 2008 increased $6.1 million, or 22.9%, over fiscal 2007 due to additional infrastructure costs for several new locations obtained through acquisitions, increases to our international staff and increased audit costs. As a percentage of revenues, our selling, general and administrative expenses in fiscal 2008 were 21.3% compared to 21.6% in fiscal 2007.

 

Interest expense.  Interest expense was $3.5 million and $4.5 million during fiscal 2008 and 2007, respectively. In fiscal 2007, we paid $1.2 million of conditional interest in connection with a bank refinancing, which accounted for most of the $1.0 million decrease in interest expense. The decrease in interest expense was also due to lower market rates of interest in fiscal 2008, offset by the additional expense for an adjustment to our interest rate swaps during this period because the fixed rate on these swaps was higher than market rates during the period. In the last quarter of fiscal 2008 our interest also began to increase as a result of financing our acquisitions.

 

Loss on extinguishment of long-term debt.  The $0.5 million loss on the extinguishment of debt during fiscal 2007 related to the write-off of certain capitalized financing costs related to the refinancing of our debt through a new credit arrangement.

 

Income taxes.  Our effective income tax rate was 41.9% for fiscal 2008. For fiscal 2007, we had an effective rate of 3.6%. This increase was primarily as a result of releasing the deferred tax valuation allowances during fiscal 2007 and the higher international tax rates on the income of certain of our subsidiaries that we do not consolidate for tax purposes.

 

Net income.  Our net income for fiscal 2008 of $7.4 million, or 4.9% of our revenues, was $2.1 million greater than our net income for fiscal 2007, which was $5.4 million, or 4.4% of revenues. This 38.1% increase in net income was primarily as a result of the impact of higher revenues net of higher cost of revenues and operating costs on a percentage basis, lower interest expense and a higher provision for income taxes.

 

Fiscal 2007 compared to Fiscal 2006

 

Revenues.  Revenues increased $28.5 million, or 30.4%, for fiscal 2007 compared to fiscal 2006, which resulted from growth in all of our segments. In fiscal 2007, the largest increase in our revenues was attributable to customers in the oil and gas market, which accounted for approximately 63.5% percent of the growth, as a result of our providing our existing oil and gas customers different types of services, including our advanced NDT solutions. The next highest increase in revenues was attributable to customers in the fossil and nuclear power generation and transmission market, which accounted for 17.8% of the growth in our revenues. We also experienced strong growth in revenues attributable to customers in several of our other target markets, including the public infrastructure market. We estimate that $11.7 million of the increase in revenues for fiscal 2007 was attributable to orders from our largest customer, thought this resulted from our provision of NDT solutions across numerous business locations of this customer and we believe decisions regarding the purchase of our solutions are made on a location-by-location basis. We experienced significant organic growth in most of our domestic and international locations, and estimate that organic growth accounted for at least 60% of our total growth in revenues in fiscal 2007.

 

Gross profit.  Gross profit increased $7.1 million, or 20.3%, for fiscal 2007 as compared to fiscal 2006, which was a direct result of our higher revenues. As a percentage of revenues, our gross profit decreased to 34.3% in fiscal 2007 from 37.1% in fiscal 2006 primarily as a result of two factors. First, revenue growth in our Services segment was greater than in our other segments. We generate lower margins on revenues from our Services segment than our other segments because of the relatively higher labor costs associated with our NDT services. In addition, certain costs on very large projects are passed on to customers at lower mark-ups above cost. In fiscal 2007, we also changed the estimated lives of certain fixed assets, which resulted in an incremental depreciation charge of $1.1 million, or 1.0% of revenues. This change in estimate was based on our evaluation of the actual useful lives of our equipment. Depreciation included in determining gross profit during fiscal 2007 was $4.7 million, or 3.8% of revenues, compared to $3.0 million, or 3.2% of revenues, in fiscal 2006.

 

Income from operations.  Our income from operations increased $5.5 million for fiscal 2007 as compared to fiscal 2006. As a percentage of revenues, our income from operations increased from 5.6% in fiscal 2006 to 8.8% in fiscal 2007. This increase over fiscal 2006 is primarily due to the impact of operating leverage in our business model. Specifically, our operating expenses increased by $1.6 million in fiscal 2007 over fiscal 2006. However, as a percentage of revenues, our operating expenses decreased from 31.5% in fiscal 2006 to 25.5% in fiscal 2007. As a percentage of revenues, the selling, general and administrative expenses included in our operating expenses were 21.6% and 26.4% for fiscal 2007 and 2006, respectively. These expenses primarily reflect our investments in a global network of physical branch and field office locations, and centralized administrative and customer support functions, which involve relatively fixed costs. Moreover, the majority of the dollar increases in these expenses in fiscal 2007 were the result of acquisitions made in fiscal 2007 and the full year impact of one acquisition made mid-year in fiscal 2006.

 

Interest expense.  Interest expense increased $0.3 million during fiscal 2007 as compared to fiscal 2006. Our 2007 interest expense included $1.2 million of conditional interest that was paid in connection with a refinancing of our debt in November 2006. Our overall borrowing levels and interest rates were both lower during 2007 compared to the prior year.

 

Loss on extinguishment of long-term debt.  The $0.5 million loss on the extinguishment of debt during fiscal 2007 related to the write-off of certain capitalized financing costs related to the refinancing of our debt through a new banking arrangement.

 

Income taxes.  Income taxes in fiscal 2007 were at an effective rate of 3.6% compared to an effective tax rate of 49.2% in fiscal 2006. The decrease was primarily due to the release of our valuation allowance for deferred income taxes based on our expected earnings and utilization of our federal tax loss carryforwards in the fiscal 2007 period.

 

Net income.  Primarily as a result of the above factors, our net income for fiscal 2007 increased $4.9 million over net income for fiscal 2006. As a percentage of revenues, our net income was 4.4% and 0.5% in fiscal 2007 and 2006, respectively.

 

Segment Data

 

Selected consolidated financial information by segment for fiscal 2008, 2007 and 2006 was as follows: