Item 1.
Business
Forward-Looking Statements
We are including the following cautionary statements to secure the protection of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 for all forward-looking statements made by us in this Annual Report on Form 10-K. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate, or imply future results, performance, or trends, and may contain the words “believe,” “anticipate,” “expect,” “estimate,” “project,” “will be,” “will continue,” “will likely result,” or words or phrases of similar meaning. In addition, from time to time, we (or our representatives) may make forward-looking statements of this nature in our annual report to shareholders, proxy statement, quarterly reports on Form 10-Q, current reports on Form 8-K, press releases or in oral or written presentations to shareholders, securities analysts, members of the financial press or others. All such forward-looking statements, whether written or oral, and whether made by or on our behalf, are expressly qualified by these cautionary statements and any other cautionary statements which may accompany the forward-looking statements. In addition, the forward-looking statements speak only of our views as of the date the statement was made, and we disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date thereof. Forward-looking statements involve risks and uncertainties which could cause actual results, performance or trends to differ materially from those expressed in the forward-looking statements. We believe that all forward-looking statements made by us have a reasonable basis, but there can be no assurance that management’s expectations, beliefs or projections as expressed in the forward-looking statements will actually occur or prove to be correct. Factors that could cause actual results to differ materially are discussed under Risk Factors.
Business Overview
Recent Developments
On January 28, 2007, we entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with Synatech Holdings, Inc., a Delaware corporation (“Parent”) owned by The Carlyle Group, and Synatech, Inc., a Delaware corporation and wholly-owned subsidiary of Parent (“Merger Sub”) pursuant to which Merger Sub will merge with and into us (the “Merger”). We will continue as the surviving corporation and as a wholly-owned subsidiary of Parent. The Merger Agreement provides that Merger Sub’s Certificate of Incorporation and bylaws will be the Certificate of Incorporation and bylaws of the surviving corporation except that the Certificate of Incorporation shall be amended to provide for the name of the corporation to be Synagro Technologies, Inc.
The Merger Agreement provides that at the effective time of the Merger, each issued and outstanding share of our common stock, par value $.002 per share, other than any such shares owned by us, Parent or any of their respective subsidiaries, shall be cancelled and shall be converted automatically into the right to receive $5.76 in cash, without interest. Also, pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding option to acquire shares of our common stock under any stock option, restricted stock, or incentive plan will be cancelled in exchange for the right to receive, for each share of common stock issuable upon exercise of such option, cash in the amount of the excess, if any, of $5.76 over the exercise price per share of any such option.
The Merger Agreement contains termination rights for both us and Parent, and further provides that, upon termination of the Merger Agreement under specified circumstances, including (i) by us approving or recommending an acquisition proposal, and (ii) our board of director’s withdrawal or modification of its approval of the Merger, we may be required to pay Parent a break-up fee equal to $13.9 million. We may be required to pay Parent its expenses not in excess of $1.5 million if the Merger Agreement is terminated due to a breach of our representations, warranties, or covenants. Parent may be required to pay us liquidated damages of $13.9 million and our expenses not in excess of $1.5 million if the Merger Agreement is terminated due to a breach of Parent’s or Merger Sub’s representations, warranties, or covenants.
The consummation of the Merger is subject to the satisfaction or waiver of certain closing conditions, including, without limitation, the approval of a majority of the votes by our stockholders entitled to vote thereon
(other than those held by Parent and their respective affiliates), and the termination or expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. The Merger Agreement also contains customary representations, warranties, and covenants of Parent, Merger Sub, and us. The Merger is not subject to a financing condition. A special meeting of our stockholders has been scheduled for March 29, 2007 to vote on the approval of the merger.
General
We believe that we are the largest recycler of biosolids and other organic residuals in the United States and we believe that we are the only national company focused exclusively on the estimated $8 billion organic residuals industry, which includes water and wastewater residuals. Incorporated in the state of Delaware in 1996, we serve approximately 600 municipal and industrial water and wastewater treatment accounts with operations in 33 states and the District of Columbia.
Biosolids and other organic residuals are solid or liquid material generated by municipal wastewater treatment facilities or residual management facilities. We provide our customers with services and capabilities that focus on the beneficial reuse of organic nonhazardous residuals, including biosolids, resulting primarily from the wastewater treatment process. We believe that the services we offer are compelling to our customers because they allow our customers to avoid the significant capital and operating costs that they would have to incur if they internally managed their water and wastewater residuals.
We partner with our clients to develop cost-effective and environmentally sound solutions for their residuals processing and beneficial use requirements. Our broad range of services include drying and pelletization, composting, product marketing, incineration, alkaline stabilization, land application, collection and transportation, regulatory compliance, dewatering, and facility cleanout services. We currently operate six heat-drying and pelletization facilities, six composting facilities, three incineration facilities and 35 permanent and 48 mobile dewatering units.
Our existing customer base is comprised primarily of municipal customers, which accounted for approximately 88 percent of our revenues for the year ended December 31, 2006, as well as industrial and commercial waste generators. We also cater to buyers who purchase our fertilizers, soil amendments and other marketed products, which total approximately 3 percent of our revenues. Our size and scale offer significant advantages over our competitors in terms of operating efficiencies and the breadth of services we provide our customers. Approximately 89 percent of our revenues for the year ended December 31, 2006 was derived from sources that we believe are recurring in nature, including contracts, purchase orders and product sales.
Contract revenues accounted for approximately 83 percent of our revenues for the year ended December 31, 2006. These revenues were generated through more than 650 contracts that range from one to twenty-five years in length. Contract revenues are generated primarily from land application, drying and pelletization, incineration, transportation services, composting, dewatering, facility operations and maintenance services. These contracts have an estimated remaining contract value including renewal options, which we call backlog, of approximately $2.1 billion as of December 31, 2006. This backlog represents more than six times our revenues for the year ended December 31, 2006. Our estimated backlog, excluding renewal options, was approximately $1.3 billion as of December 31, 2006. See “ - Backlog.” Our top ten customers, which represent approximately $1.3 billion, or 58 percent of our backlog as of December 31, 2006, have a weighted average of 14 years remaining on their current contracts, including renewal options. We have historically enjoyed high contract retention rates (including both renewals and rebids) of approximately 85 percent to 90 percent of contract revenue value. In 2006, our contract retention rate was approximately 94 percent.
We currently have three significant fixed price contracts that are accounted for under the percentage of completion method of accounting. Two of the contracts are for the removal and disposal of biosolids from lagoons over multi-year periods. We have also entered into a separate contract to operate a dryer facility upon customer acceptance after completion of construction of the dryer. The revenue generated under the percentage of completion method of accounting associated with construction of the new dryer facility is reported as design/build revenue. Once the new dryer commences operations, which is expected in 2007, the operating revenues will be included in contract revenues. The revenue generated under the percentage of completion method of accounting for removing and disposing of bio-solids from lagoons over a multi-year period is reported as contract revenue. See
“Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information about these contracts and their impact on our revenues, earnings and liquidity.
Description of Business by Segment
We evaluate operating results, assess performance and allocate resources on a geographic basis, with the exception of our rail operations and our engineering, facilities and development (“EFD”) group which are separately monitored. Accordingly, we report the results of our activities in three operating segments, which include: Residuals Management Operations, Rail Transportation and EFD.
Residuals Management Operations include our business activities that are managed on a geographic basis in the Northeast, Central, and Southwest regions of the United States. These geographic areas have been aggregated and reported as a segment because they have similar economic characteristics, offer all of our residuals management services, have a similar customer base and operate in a similar regulatory environment. Rail Transportation includes the transfer and rail haul of materials across several states where the material is typically either land applied or landfill disposed. Rail Transportation is a separate segment because it is monitored separately and because it only offers long-distance land application and disposal services to our customers. EFD includes construction management activities and startup operations for certain new processing facilities, as well as the marketing and sale of certain pellets and compost fertilizers.
The table below details total revenues recognized by each of our reportable segments in the three-year period ended December 31, 2006. More information about our results of operations by reportable segment is included in Note 16 to the consolidated financial statements.
Revenues generated from the services that we provide are summarized below:
Land application and disposal includes revenues generated from providing land application, dewatering and disposal services. Facilities operations include revenues generated from providing drying and pelletization, composting and incineration operations services. Cleanout services include revenues generated from lagoon and digester cleanout projects. Product marketing includes revenues generated from selling pellets and compost as organic fertilizers. Design and build services include revenues generated from contracts where we agree to design, build and operate certain processing facilities under a long-term operating contract.
Residuals Management Operations derives its revenues from facilities operations, product marketing, land application and disposal and cleanout services. Rail Transportation derives its revenues from land application and disposal services. EFD derives its revenues from product marketing and design and build services.
Industry Overview
History
We believe that the organic residuals industry, which includes water and wastewater residuals, is approximately $8 billion in size and will continue to grow at four to five percent annually over the next decade. The growth in the underlying volumes of wastewater residuals generated by the municipal and industrial markets is driven by a number of factors, including:
•
Population growth and population served;
•
Pressures to better manage wastewater;
•
More restrictive laws and regulations; and
•
Advances in technology.
Most residential, commercial, and industrial wastewater is collected through an extensive network of sewers and transported to wastewater treatment plants, which are known as publicly owned treatment works (“POTWs”). When wastewater is treated at POTWs or at industrial wastewater pre-treatment facilities, the treatment process normally consists of biological and/or chemical treatment (secondary treatment) followed by some type of clarification (separates the liquid portion of the wastewater from the solids/wastewater residuals). The clarified water may be further treated through disinfection and filtration depending upon effluent limitation requirements contained in the POTW’s National Pollutant Discharge Elimination System permit and discharged - typically into a river or other surface water. Prior to the promulgation of the Title 40 of the Code of Federal Regulations (CFR) Part 503 published in 1993, many POTWs were beneficially recycling their wastewater residuals under Title 40 CFR Part 257 by landfilling, incinerating, or surface disposing. Ocean dumping was banned in 1989 and completely phased out by 1991. The Part 503 Regulations also were much more comprehensive than Part 257, especially in the level of risk assessment done by the EPA to develop the pollutant concentration requirements. The Part 503 Regulations also supported the EPA’s beneficial use policy that was published in 1984 and provided some closure to the regulatory process that had been ongoing since the Clean Water Act amendments of 1977. Once the Part 503 regulations were final, they created significant growth opportunities for the municipal wastewater residuals management industry. To establish beneficial reuse as an option for municipal wastewater generators, the EPA established a classification methodology for municipal wastewater residuals based on how residuals pathogens are treated, vectors reduced and associated pollution levels minimized. Now, in most cases, POTWs further treat wastewater residuals to produce a semisolid, nutrient-rich by-product known as biosolids. We use the term “wastewater residuals” to include both residuals that have been treated pursuant to the Part 503 Regulations and those that have not. Biosolids, as a subset of wastewater residuals, is intended to refer to wastewater residuals that meet either the Part 503 Regulations Class A or Class B standards.
Classes of Biosolids
When treated and processed according to the Part 503 Regulations, biosolids can be beneficially reused and applied to crop land to improve soil quality and productivity due to the nutrients and organic matter that they contain. Biosolids applied to agricultural land, forest, public contact sites, or reclamation sites must meet pollution, pathogen and vector Part 503 Regulation requirements. This classification is determined by the level of treatment the wastewater residuals have undergone. Pursuant to the Part 503 Regulations, there are specific treatment processes available to achieve Class A and Class B standards, otherwise the biosolids are considered Sub-Class B. Class A treatment processes require resulting biosolids to be essentially pathogen free. In general, Class A biosolids require more capital intensive treatment processes, such as composting, heat drying, heat treatment, high temperature digestion and pasteurizations. Class A biosolids have a high market value, are sold as fertilizer or fuel, and can be applied to any type of land or crop.
Class B biosolids are treated to a lesser degree by processes to significantly reduce pathogens such as digestion or alkaline stabilization. Class B biosolids are typically land applied on farmland by professional farmers or agronomists and are monitored to comply with associated federal and state reporting requirements. The Part 503 Regulations, however, regulate the type of agricultural crops for which Class B biosolids may be used.
Finally, in some cases, the POTW does not treat its wastewater residuals to either Class A or Class B standards and such residuals are considered Sub-Class B. Sub-Class B residuals can either be processed to Class A standards or Class B standards by an outside service provider or disposed of through incineration or landfilling.
Market Size/Fragmentation
According to the EPA’s 1999 study entitled Biosolids Generation, Use, and Disposal in the United States, the quantity of municipal biosolids produced in the United States was projected to be approximately 8.2 million dry tons in 2010, processed through approximately 16,000 POTWs. It is estimated that an additional 3,000 POTWs will be built by 2012. It is also estimated that 70 percent of biosolids volumes will be beneficially reused by 2010. An independent 2000 study by the Water Infrastructure Network, entitled Clean & Safe Water for the 21st Century, estimates that municipalities spend more than $22 billion per year on the operations and maintenance of wastewater treatment plants. We estimate that, based on conversations with consulting engineers, up to 40 percent of those annual costs, or $8.8 billion, are associated with the management of municipal wastewater residuals.
Industry sources, including EPA studies and manuals and internal information have led us to estimate that a total volume of 135 million dry tons of organic residuals are processed each year. Therefore, we estimate the total size of the organic residuals industry to be approximately $8 billion.
We believe that the management of wastewater residuals is a highly fragmented industry and we believe that we are the only dedicated provider of a full range of services on a national scale. Historically, POTWs performed the necessary wastewater residuals management services, but this function is increasingly being performed by private contractors in an effort to lower cost, increase efficiency and comply with stricter regulations.
We believe we compete in a stable, recession resistant industry. We provide a necessary service to our municipal and industrial and commercial customers. We derive substantially all of our revenues from municipal water and wastewater utilities. Demand for our industry’s services is promulgated by government regulations defining the use and disposal of wastewater residuals. We believe that population growth, better wastewater management treatment processes and stricter regulations are factors driving growth in the organic residuals industry.
Market Growth
We believe the estimated $8 billion organic residuals industry, which includes water and wastewater residuals, will continue to grow at four to five percent annually over the next decade. The growth in the underlying volumes of wastewater residuals generated by the municipal and industrial markets is driven by a number of factors. These factors include:
Population Growth and Population Served. As the population grows, the amount of biosolids produced by municipal POTWs is expected to increase proportionately. In addition to population growth, the amount of residuals available for reuse should also grow as more of the population is served by municipal sewer networks. As urban sprawl continues and the desire of cities to annex surrounding areas increases, POTWs will treat more wastewater. It is expected that the amount of wastewater residuals managed on a daily basis by municipal wastewater treatment plants will increase to more than 8.2 million dry tons by 2010.
Pressures To Better Manage Wastewater. There is tremendous pressure from many stakeholders, including environmentalists, land owners, and politicians, being applied to municipal and industrial wastewater generators to better manage the wastewater treatment process. The costs (such as regulatory penalties and litigation exposure) of not applying the best available technology to properly manage waste streams have now grown to material levels. This trend should continue to drive the growth of more wastewater treatment facilities with better separation technologies, which increase the amount of residuals ultimately produced.
Stricter Regulations. If the trend continues and laws and regulations that govern the quality of the effluent from wastewater treatment plants become stricter, POTWs and industrial wastewater treatment facilities will be forced to remove more and more residuals from the wastewater, thereby increasing the amount of residuals needing to be properly managed.
Advances in Technology. The total amount of residuals produced annually continues to increase due to advancements in municipal and industrial wastewater treatment technology. In addition to improvements in secondary and advanced treatment methods, which can increase the quantity of residuals produced at a wastewater treatment plant, segregation technologies, such as microfiltration, also result in more residuals being separated from the wastewater.
Market Trends
In addition to the growth of the underlying volumes of wastewater residuals, there is a trend of municipalities converting from Sub-Class B and Class B pathogen and vector treatment processes to Class A pathogen and vector treatment processes. There are numerous reasons for this trend, including:
Decaying Infrastructure. Many municipal POTWs operate aging and decaying wastewater infrastructure. According to the Water Infrastructure Network’s 2000 study, municipalities will need to spend approximately $1 trillion between 2000 and 2020 to upgrade these systems. As this effort is rolled out and POTWs undergo design changes and new construction, opportunities will exist to also upgrade wastewater residuals treatment processes. We expect that the trend toward more facility-based approaches, such as drying and pelletization, will increase with this infrastructure spending. In addition, the need to provide capital for these expenditures should create pressures for more outsourcing opportunities.
Shrinking Agricultural Base and Urbanization. As population density increases, the availability of nearby farmland for land application of Class B biosolids becomes diminished. Under these circumstances, the transportation costs associated with a Class B program may increase to such an extent that the higher upfront infrastructure costs of Class A programs may become attractive to generators. Production of Class A pellets offers significant volume reduction, greatly reduced transportation costs, and the enhanced value of pellets allows, in many cases, revenue realization from product sales.
Public Sentiment. While the Part 503 Regulations provide equal levels of public safety in the management of Class A and Class B biosolids, the public sometimes perceives a greater risk from the use of Class B biosolids. This is particularly true in heavily populated areas. Municipalities are responding to these public and political pressures by upgrading their biosolids programs to the Class A level. Certain municipalities and wastewater agencies have industry leadership mindsets where they endeavor to provide their constituents with the highest level, most advanced pathogen and vector attraction treatment technologies available. These municipalities and agencies will typically fulfill at least a portion of their residuals management treatment portfolio with Class A technologies.
Regulatory Stringency. With the promulgation of the Part 503 Regulations, the EPA and, subsequently, state regulatory agencies have made the distribution of Class A biosolids products largely unrestricted. Utilization requirements for Class B biosolids are significantly more onerous. Based on this, municipalities are moving to Class A programs to reduce the governmental permitting, public hearings, compliance and enforcement bureaucracy required with Class B programs. The regulatory support to reduce and recycle organic residuals and to increase the quality of the biosolids, should be favorable to us.
Our Competitive Strengths
We believe that the following strengths differentiate us in the marketplace:
National, Full-Service Industry Leader. We believe that we are the largest recycler of biosolids and other organic residuals in the United States and we believe that we are the only national company focused exclusively on water and wastewater residuals management. We provide our customers with services and capabilities, including drying and pelletization, composting, product marketing, incineration, alkaline stabilization, land application, collection and transportation, regulatory compliance, dewatering, and facility cleanout services. We believe our broad range of services exceeds those offered by our competitors in the water and wastewater residuals management industry and provides us with a unique and differentiated service offering platform. We believe that our leading market position provides us with more operating leverage and a unique competitive advantage in attracting and retaining customers and employees as compared to our regional and local competitors.
Recurring Revenues and Stable Operating Cash Flows. Approximately 89 percent of our revenue for the year ended December 31, 2006 was derived from sources that we believe are recurring in nature, including long-term contracts primarily with municipal customers. These contracts accounted for approximately 84 percent of our revenue for the year ended December 31, 2006. Our estimated contract expirations are staggered, mitigating the impact of any individual contract loss. Our contract revenue backlog, including renewal options, was approximately $2.1 billion as of December 31, 2006. This backlog represents more than six times our revenue for the year ended December 31, 2006. Our estimated backlog, excluding renewal options, was approximately $1.3 billion as of December 31, 2006. We believe our recurring revenue base, stable capital expenditures requirements and minimal working capital requirements will allow us to maintain predictable and consistent cash flows. See “ - Backlog.”
Significant Land Base. We have a large land base available for the land application of wastewater residuals. As of December 31, 2006, we maintained permits and registration or licensing agreements on more than 960,000 acres of land in 24 states. We feel that this land base provides us with an important advantage when bidding for new work and retaining existing business.
Large Range of Processing Capabilities and Product Marketing Experience. We are one of the largest firms in treating wastewater residuals to meet the EPA’s Class A standards. We currently operate 11 Class A processing facilities and believe that our next two largest Class A competitors operate five and three Class A facilities, respectively. Class A residuals undergo more processing than Class B residuals, and may be distributed and marketed as commercial fertilizer. We have numerous capabilities to achieve Class A standards, and we currently operate six heat-drying facilities and six composting facilities. In addition, we are a leader in marketing Class A biosolids either generated by us or by others. For the year ended December 31, 2006, we marketed 121,000 tons, or approximately 39 percent, of the heat-dried pellets produced in the United States. We also marketed 500,000 tons of compost, which we believe is significantly more than any other producer of municipal based compost materials.
Experienced Sales Force. We have a sales force dedicated to the wastewater residuals market. We market our services via a multi-tiered sales force, utilizing a combination of business developers, engineering support staff, and seasoned operations directors. This group of individuals is responsible for maintaining our existing business and identifying new wastewater residuals management opportunities. On average, these individuals have in excess of ten years of industry experience. We believe that their unique knowledge and longstanding customer relationships gives us a competitive advantage in identifying and successfully securing new business.
Regulatory Compliance and Reporting. An important element for the long-term success of a wastewater residuals management program is the certainty of compliance with local, state and federal regulations. Accurate and timely documentation of regulatory compliance is mandatory. We provide this service, as part of our turn-key operations, through a proprietary integrated data management system (the Residuals Management System) that has been designed to store, manage and report information about our clients’ wastewater residuals programs. We believe that our regulatory compliance and reporting capabilities provide us with an important competitive advantage when presented to the municipal and industrial wastewater generators.
Bonding Capacity. Commercial, federal, state and municipal projects often require operators to post performance and, in some cases, payment bonds at the execution of a contract. The amount of bonding capacity offered by sureties is a function of the financial health of the company requesting the bonding. Operators without adequate bonding may be ineligible to bid or negotiate on many projects. Our national presence and tenure in the market have helped us develop strong bonding relationships with large national sureties that smaller industry participants do not possess. We believe the existing capacity is sufficient to meet bonding needs for the foreseeable future. To date, no payments have been made by any bonding company for bonds issued on our behalf.
Strong, Experienced Management Team. We have a strong and experienced management team at the corporate and operating levels. Our senior management on average has been involved in the environmental services industry for over 20 years. We believe the skill and experience of our management team continue to provide significant benefits to us as we evaluate opportunities to expand our business.
Our Business Strategy
Our goals are to maintain and strengthen our position as the only national company exclusively focused on water and wastewater residuals management. Our business strategy is to increase cash flow from operations and profitability through a combination of organic growth, growth through complementary acquisitions and a disciplined approach to capital expenditures.
Organic Growth. We believe that we have the opportunity to expand our business by providing services for new customers who currently perform their own wastewater residuals management and by increasing the range of services that our existing customers outsource to us. The principal factors contributing to our organic growth include:
•
Developing New Customers. Our sales and marketing efforts focus on adding new customers by marketing our products and services. In many cases, we believe that we can provide the customer with better service at a cost to them that is lower than what it costs them to provide the service internally or with their current service provider. We take a collaborative approach with potential customers where our sales force consults with potential customers and positions us as a solution provider.
•
Expanding Services to Existing Customers. We have the opportunity to provide many of our existing customers with additional services as part of a complete residuals management program. We endeavor to educate these existing customers about the benefits of a complete residuals management solution and offer other services where the value is compelling. These opportunities may provide us with long-term contracts, increased barriers to entry, and better relationships with our customers.
•
Capitalize on Increased Demand for Class A Services. In order to take advantage of operating efficiencies, technology and our comprehensive capabilities, we will endeavor to capitalize on the increased demand for Class A services, including drying and pelletizing, dewatering and composting. We believe this focus will result in more long-term contracts and recurring revenue. In addition, we are building several new facilities, which we expect will also result in longer-term contracts, steady revenue streams, higher barriers to entry for competitors, higher switching costs for the customer and lower seasonality.
Growth Through Complementary Acquisitions. We plan to continue to pursue strategic acquisitions in a disciplined manner in order to achieve further growth. We selectively seek strategic opportunities to acquire businesses that profitably expand our service offerings, increase our geographic coverage or increase our customer base. We believe our strategic acquisitions enable us to gain new industry residuals expertise and efficiencies in our existing operations. Determination of attractive acquisition targets is based on many factors, including the size and location of the business and customers served, existing contract terms, potential operating efficiencies and cost savings.
Disciplined Approach to Capital Expenditures. Whether a new contract or an acquisition, we are focused on the ability to generate the revenues and operating cash flow to validate the capital investment decision. As such, new contracts, renewals and/or acquisitions undergo a comprehensive financial analysis to ensure that our return criteria are being met. In addition, capital expenditures relating to maintenance activities are also subject to rigorous internal review and a formal approval process.
Services and Operations
Today, generators of municipal and industrial residuals must provide sound environmental management practices with limited economic resources. For help with these challenges, municipal and industrial generators throughout the United States have turned to us for solutions.
We partner with our clients to develop cost-effective, environmentally sound solutions to their residuals processing and beneficial use requirements. We provide the flexibility and comprehensive services that generators need, with negotiated pricing, regulatory compliance, and operational performance. We work with our clients to find innovative and cost effective solutions to their wastewater residuals management challenges. In addition, because we do not manufacture equipment, we are able to provide unbiased solutions to our customers’ needs. We provide our customers with complete, vertically integrated services and capabilities, including design/build
services, facility operations, facility cleanout services, regulatory compliance, dewatering, collection and transportation, composting, drying and pelletization, product marketing, incineration, alkaline stabilization, and land application.
1. Design and Build Services. We designed, built, and operate six heat-drying and pelletization facilities and six composting facilities. We recently completed construction on a new drying facility that will begin operations in the second quarter of 2007. We operate three incineration facilities, two of which we significantly upgraded and one that we built. We also operate 35 permanent and 48 mobile dewatering facilities. All of our facility design, construction and operating experience is with biosolids projects.
2. Facility Cleanout Services. Our facility cleanout services focus on the cleaning and maintenance of the digesters at municipal and industrial wastewater facilities. Digester cleaning involves complex operational and safety considerations. Our self-contained pumping systems and agitation equipment remove a high percentage of biosolids without the addition of large quantities of dilution water. This method provides our customers a low bottom-line cost per dry ton of solids removed. Solids removed from the digesters can either be recycled through our ongoing agricultural land application programs or landfilled.
3. Regulatory Compliance. An important element for the long-term success of a wastewater residuals management program is the certainty of compliance with local, state and federal regulations. Accurate and timely documentation of regulatory compliance is mandatory. We provide this service through our proprietary Residuals Management System (“RMS”).
RMS is an integrated data management system that has been designed to store, manage and report information about our clients’ wastewater residuals programs. Every time our professional operations or technical staff performs activities relating to a particular project, RMS is updated to record the characteristics of the material, how much material was moved, when it was moved, who moved it and where it went. In addition to basic operational information, laboratory analyses are input in order to monitor both annual and cumulative loading rates for metals and nutrients. This loading information is coupled with field identification to provide current information for agronomic application rate computations.
This information is used in two ways. First and foremost, it provides a database for regulatory reporting and provides the information required for monthly and annual technical reports that are sent to the EPA and state regulatory agencies. Second, information entered into RMS is used as an important part of the invoicing process. This check and balance system provides a link between our operational, technical and billing departments to ensure correct invoicing and regulatory compliance.
RMS is a tool that gives our clients timely access to information regarding their wastewater residuals management program. We continue to dedicate resources to the continuous improvement of RMS. We believe that our regulatory compliance and reporting capabilities provide us with a competitive advantage when presented to the municipal and industrial wastewater generators.
4. Dewatering. We provide residuals dewatering services for wastewater treatment facilities on either a permanent, temporary or emergency basis. These services include design, procurement, and operations. We provide the staffing to operate and maintain these facilities to ensure satisfactory operation and regulatory compliance of the residuals management program. We currently operate 35 permanent and 48 mobile dewatering units.
5. Collection and Transportation. For our liquid residuals operations, a combination of mixers, dredges and/or pumps are used to load our tanker trailers. These tankers transport the residuals to either a land application site or one of our residuals processing facilities. For our dewatered residuals operations, the dewatered residuals are loaded into trailers by either front end loaders or conveyors. These trailers are then transported to either land application sites or to one of our residuals processing facilities.
6. Composting. For composting projects, we provide a comprehensive range of technologies, operations services and end product marketing through our various divisions and regional offices. All of our composting alternatives provide high-quality Class A products that we market to landscapers, nurseries, farms and fertilizer companies through our Organic Product Marketing Group (“OPMG”) described below. In some cases, fertilizer companies package the product and resell it for home consumer use. We utilize three different types of composting methodologies: aerated static pile, in-vessel, and open windrow. When a totally enclosed facility is not required, aerated static pile composting offers economic advantages. In-vessel composting uses an automated, enclosed system that mechanically agitates and aerates blended organic materials in concrete bays. We also offer the windrow method of composting to clients with favorable climatic conditions. In areas with a hot and dry climate, the windrow method lends itself to the efficient evaporation of excess water from dewatered residuals. This makes it possible to minimize or eliminate any need for bulking agents other than recycled compost. We currently operate five composting facilities.
7. Drying and Pelletization. The heat drying process utilizes a recirculating system to evaporate water from wastewater residuals and creates fertilizer pellets. A critical aspect of any drying technology is its ability to produce a consistent and high quality Class A end product that is marketable to identified end-users. This requires the system to manufacture pellets that meet certain criteria with respect to size, dryness, dust elimination, microbiological cleanliness, and durability. We market heat-dried biosolids products to the agricultural and fertilizer industries through our described below.
We built and currently operate six drying and pelletization facilities with municipalities, including one in Pinellas County, Florida, two in Baltimore, Maryland, one in New York, New York, one in Hagerstown, Maryland and one in Sacramento, California. We have also completed construction phase of a drying and pelletization facility for Honolulu, Hawaii, which is scheduled to be operational in the second quarter of 2007.
8. Product Marketing. In 1992, we formed the OPMG to market composted and pelletized biosolids from our own facilities as well as municipally owned facilities. OPMG currently markets in excess of 982,000 cubic
yards of compost and 121,000 tons of pelletized biosolids annually. OPMG markets a majority of its biosolids products under the trade names Granulite Company and AllGro Company. Based on our experience, OPMG is capable of marketing biosolids products to the highest paying markets. We believe that we are the leader in marketing end-use wastewater residuals products, such as compost and heat-dried pellets used for fertilizers. In 2006, we marketed 121,000 tons or approximately 39 percent of the heat-dried pellets produced in the United States. We also marketed 500,000 tons of compost, which we believe is significantly more than any other producer of municipal based compost materials.
9. Incineration. In the Northeast, we economically and effectively process wastewater residuals through the utilization of the proven thermal processing technologies of multiple-hearth and fluid bed incineration. In multiple-hearth processing, residuals are fed into the top of the incinerator and then mechanically passed down to the hearths below. The heat from the burning residuals in the middle of the incinerator dries the residuals coming down from the top until they begin to burn. Since residuals have approximately the same British thermal unit value as wood chips, very little additional fuel is needed to make the residuals start to burn. The resulting ash by-product is nontoxic and inert, and can be beneficially used as alternative daily cover for landfills. In fluid bed processing, residuals are pumped directly into a boiling mass of super heated sand and air (the fluid bed) that vaporizes the residuals on contact. The top of the fluid bed burns off any remaining compounds resulting in very low air emissions and very little ash by-product. Computerized control of the entire process makes this modern technology fuel efficient, easy to operate, and an environmentally friendly disposal method. We currently operate three incineration facilities.
10. Alkaline Stabilization. We provide alkaline stabilization services by using lime to treat Sub-Class B biosolids to Class-B standards. Lime chemically reacts with the residuals and creates a Class B product. We offer this treatment process through our BIO*FIX process. Due to its very low capital cost, BIO*FIX is used in interim and emergency applications as well as long-term programs. The BIO*FIX process is designed to effectively inactivate pathogenic microorganisms and to prevent vector attraction and odor. The BIO*FIX process combines specific high-alkalinity materials with residuals at low cost.
11. Land Application. The beneficial reuse of municipal and industrial biosolids through land application has been successfully performed in the United States for more than 100 years. Direct agricultural land application has the proven benefits of fertilization and organic matter addition to the soil. Agricultural communities throughout the country are well acquainted with the practice of land application of biosolids and have first hand experience with the associated agricultural and environmental benefits. Currently, we recycle Class B biosolids through agricultural land application programs in 24 states. Our revenues from land application services are the highest among our service offerings.
Contracts
Contract revenues accounted for approximately 83 percent of our revenue for the year ended December 31, 2006. These revenues were generated through more than 650 contracts that range from one to twenty five years in length. Contract revenues are generated primarily from land application, drying and pelletization services, incineration, collection and transportation services, composting, dewatering, facility operations and maintenance services. These contracts have an estimated backlog, including renewal options, of approximately $2.1 billion as of December 31, 2006. In general, our contracts contain provisions for inflation related annual price increases, renewal provisions, and broad force majeure clauses. Our top ten customers have a weighted average of 14 years remaining on their current contracts, including renewal options. We have historically enjoyed high contract retention rates (including both renewals and rebids) of approximately 85 percent to 90 percent of contract revenue value. During 2006, our contract retention rate was approximately 94 percent. See “ - Backlog” for a more detailed discussion.
Our largest customer is the New York City Department of Environmental Protection (“NYDEP”), which accounted for 16 percent of our revenues in 2006. No other customer accounted for more than 10 percent of our revenues in 2006.
Although we have a standard form of agreement, terms may vary depending upon the customer’s service requirements and the volume of residuals generated and, in some situations, requirements imposed by statute or regulation. Contracts associated with our land application business are typically two- to four-year exclusive arrangements excluding renewal options. Contracts associated with drying and pelletizing, incineration or
composting are typically longer term contracts, from five to twenty years, excluding renewal options, and typically include provisions such as put-or-pay arrangements and estimated adjustments for changes in the consumer price index for contracts that contain price indexing. Other services such as cleanout and dewatering typically may or may not be under long-term contract depending on the circumstances.
The majority of our contracts are with municipal entities. Typically, a municipality will advertise a request for proposal and numerous entities will bid to perform the services requested. Often the municipality will choose the best qualified bid by weighing multiple factors, including range of services provided, experience, financial capability and lowest cost. The successful bidder then enters into contract negotiations with the municipality.
Contracts typically include provisions relating to the allocation of risk, insurance, certification of the material, force majeure conditions, change of law situations, frequency of collection, pricing, form and extent of treatment, and documentation for tracking purposes. Many of our agreements with municipalities and water districts provide options for extension without the necessity of going to bid. In addition, many contracts have termination provisions that the customer can exercise; however, in most cases, such terminations create obligations to our customers to compensate us for lost costs and profits.
Our largest contract is with the NYDEP. The contract relates to the New York Organic Fertilizer Company dryer and pelletizer facility and was assumed in connection with the acquisition of Waste Management Inc.’s Bio Gro Division in 2000. The contract provides for the removal, transport and processing of wastewater residuals into Class A product that is transported, marketed and sold to the fertilizer industry for beneficial reuse. We also have a contract with the NYDEP to transport and land apply biosolids. These contracts accounted for 16 percent of our revenues in 2006, and have terms of 15 years and expire in June 2013. These contracts include provisions relating to the allocation of risk, insurance, certification of the material, force majeure conditions, change of law situations, frequency of collection, pricing, form and extent treatment, and documentation for tracking purposes. In addition, these contracts include a provision that allows for the NYDEP to terminate the contract upon notice. See “Risk Factors - Risks Relating to our Business and the Industry - A significant amount of our business comes from a limited number of customers and our revenue and profits could decrease significantly if we lost one or more of them as customers.”
Backlog
At December 31, 2006, our estimated remaining contract value including renewal options, which we call backlog, was approximately $2.1 billion, of which we estimate approximately $234.4 million will be realized in 2007. In determining backlog, we calculate the expected payments remaining under the current terms of our contracts, assuming the renewal of contracts in accordance with their renewal provisions, no increase in the level of services during the remaining term, and estimated adjustments for changes in the consumer price index for contracts that contain price indexing. Assuming the renewal provisions are not exercised, we estimate our backlog at December 31, 2006 would have been approximately $1.3 billion. We believe that the $1.3 billion of estimated backlog excluding renewal provisions is firm. These estimates are based on our operating experience, and we believe them to be reasonable. However, there can be no assurance that our backlog will be realized as contract revenue or earnings. See “Risk Factors - Risks Relating to our Business and Industry - We are not able to guarantee that our estimated remaining contract value, which we call backlog, will result in actual revenues in any particular fiscal period.”
Sales and Marketing
We have a sales and marketing group that has developed and implemented a comprehensive internal growth strategy to expand our business by providing services for new customers who currently perform their own wastewater residuals management and by increasing the range of services that our existing customers outsource to us.
In addition, to maintain our existing market base, we endeavor to achieve a 100 percent renewal rate on expiring service contracts. For 2006, we achieved a renewal rate of approximately 94 percent. We believe that the ability to renew existing contracts is a direct indication of the level of customer satisfaction with our operations.
Although we value our current customer base, our focus is to increase revenues that generate long-term, stable income at acceptable margins rather than simply increasing market share.
Our sales and marketing group also works with our operations staff, which typically responds to requests to proposals for routine work that is awarded to the lowest cost bidder. This allows our sales and marketing group to focus on prospective, rather than reactive, marketing activities. Our sales and marketing group is focused on developing new business from specific market segments that have historically netted the highest returns. These are segments where we believe we should have an enhanced competitive advantage due to the complexity of the job, the proximity of the work to our existing business, or a unique technology or facility that we are able to offer. We seek to maximize profit potential by focusing on negotiated versus low-bid procurements, long-term versus short-term contracts and projects with multiple services. In addition, we are focusing on the rapidly growing Class A market. Our sales incentive program is designed to reward the sales force for success in these target markets.
We proactively approach municipal market segments, as well as new industrial segments, through professional services contracts. We are in a unique industry position to successfully market through professional services contracts because we are an operations company that offers virtually every type of proven service category marketed in the industry today. This means we can customize a wastewater residuals management program for a client with no technology or service category bias.
Acquisitions History
Historically, acquisitions have been an important part of our growth strategy. We completed 18 acquisitions from 1998 through 2006, highlighted by our acquisition in August 2000 of Waste Management’s Bio Gro Division. Bio Gro had been one of the largest providers of wastewater residuals management services in the United States, with 1999 annual revenues of $118 million. Bio Gro provided wastewater residuals management services in 24 states and was the market leader in thermal drying and pelletization. Other acquisitions from 1998 to the present include the following:
Competition
We provide a variety of services relating to the transportation and treatment of wastewater residuals. Although water, land application, fertilizer, farming, consulting and composting companies provide some of the same
services we offer, we believe that we are the only national company to provide a comprehensive suite of services. We are not aware of another company focused exclusively on the management of wastewater residuals from a national perspective. We have several types of direct competitors. Our direct competitors include small local companies, regional residuals management companies, and national and international water and wastewater operations privatization companies.
We compete with these competitors in several ways, including providing quality services at competitive prices, partnering with technology providers to offer proprietary processing systems, and utilizing strategic land application sites. Municipalities often structure bids for large projects based on the best qualified bid, weighing multiple factors, including experience, financial capability and cost. We also believe that the full range of wastewater residuals management services we offer provide a competitive advantage over other entities offering a lesser complement of services.
In many cases, municipalities and industries choose not to outsource their residuals management needs. In the municipal market, we estimate that up to 60 percent of the POTW plants are not privatized. We are actively reaching out to this segment to persuade them to explore the benefits of outsourcing these services to us. For these generators, we can offer increased value through numerous areas, including lower cost, ease of management, technical expertise, liability assumption/risk management, access to capital or technology and performance guarantees.
Federal, State and Local Government Regulation
Federal, state and local environmental authorities regulate the activities of the municipal and industrial wastewater generators and enforce standards for the discharge from wastewater treatment plants (effluent wastewater) with permits issued under the authority of the Clean Water Act, as amended, state water quality control acts and local regulations. The treatment of wastewater produces an effluent and wastewater solids. The treatment of these solids produces biosolids. To the extent demand for our residuals treatment methods is created by the need to comply with the environmental laws and regulations, any modification of the standards created by such laws and regulations may reduce the demand for our residuals treatment methods. Changes in these laws or regulations, or in their enforcement, may also adversely affect our operations by imposing additional regulatory compliance costs on us, requiring the modification of and/or adversely affecting the market for our wastewater residuals management services.
The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) generally imposes strict, joint and several liability for cleanup costs upon various parties, including: (1) present owners and operators of facilities at which hazardous substances were disposed; (2) past owners and operators at the time of disposal; (3) generators of hazardous substances that were disposed at such facilities; and (4) parties who arranged for the disposal of hazardous substances at such facilities. CERCLA liability extends to cleanup costs necessitated by a release or threat of release of a hazardous substance. However, the definition of “release” under CERCLA excludes the “normal application of fertilizer.” The EPA regulations regard biosolids applied to land as a fertilizer substitute or soil conditioner. The EPA has indicated in a published document that it considers biosolids applied to land in compliance with the applicable regulations not to constitute a “release.” However, the land application of biosolids that do not comply with Part 503 Regulations could be considered a release and lead to CERCLA liability. Monitoring as required under Part 503 Regulations is thus very important. Although the biosolids and alkaline waste products may contain limited quantities or concentrations of hazardous substances (as defined under CERCLA), we have developed plans to manage the risk of CERCLA liability, including training of operators, regular testing of the biosolids and the alkaline admixtures to be used in treatment methods and reviewing incineration and other permits held by the entities from which alkaline admixtures are obtained.
Permitting Process
We operate in a highly regulated environment and the wastewater treatment plants and other plants at which our biosolids management services may be provided are usually required to have permits, registrations and/or approvals from federal, state and/or local governments for the operation of such facilities.
Many states, municipalities and counties have regulations, guidelines or ordinances covering the land application of Class B biosolids, many of which set either a maximum allowable concentration or maximum
pollutant-loading rate for at least one pollutant. The Part 503 Regulations also require monitoring Class B biosolids to ensure that certain pollutants or pathogens are below thresholds.
The EPA has considered increasing these thresholds or adding new thresholds for different substances, which could increase our compliance costs. In addition, some states have established management practices for land application of Class B biosolids. In some jurisdictions, state and/or local authorities have imposed permit requirements for, or have prohibited, the land application or agricultural use of Class B biosolids. There can be no assurance that any such permits will be issued or that any further attempts to require permits for, or to prohibit, the land application or agricultural use of Class B biosolids products will not be successful.
Any of the permits, registrations or approvals noted above, or applications therefore may be subject to denial, revocation or modification under various circumstances. In addition, if new environmental legislation or regulations are enacted or existing legislation or regulations are amended or are enforced differently, we may be required to obtain additional, or modify existing, operating permits, registrations or approvals. The process of obtaining or renewing a required permit, registration or approval can be lengthy and expensive and the issuance of such permit or the obtaining of such approval may be subject to public opposition or challenge. Much of this public opposition or challenge, as well as related complaints, relates to odor issues, even when we are generally in compliance with odor requirements and even though we have worked hard to minimize odor from our operations. There can be no assurances that we will be able to meet applicable regulatory requirements or that further attempts by state or local authorities to prohibit, or public opposition or challenge to, the land application, agricultural use of biosolids, thermal processing or biosolids composting will not be successful.
Securities and Exchange Commission
As a public company, we are required to file periodic reports, as well as other information, with the Securities and Exchange Commission (SEC) within established deadlines. Any document we file with the SEC may be viewed or copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Additional information regarding the Public Reference Room can be obtained by calling the SEC at (800) SEC-0330. Our SEC filings are also available to the public through the SEC’s web site located at http://www.sec.gov.
We maintain a corporate Web site at http://www.synagro.com, on which investors may access free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q and amendments to those reports as soon as is reasonably practicable after furnishing such material with the SEC. In addition, we will voluntarily provide electronic or paper copies of our filings free of charge upon request to our Investor Relations department at (713) 369-1700.
Patents and Proprietary Rights
We have several patents and licenses relating to the treatment and processing of biosolids. Our current patents expire between 2008 to 2020. While there is no single patent that is material to our business, we believe that our aggregate patents are important to our prospects for future success. However, we cannot be certain that future patent applications will be issued as patents or that any issued patents will give us a competitive advantage. It is also possible that our patents could be successfully challenged or circumvented by competition or other parties. In addition, we cannot assure that our treatment processes do not infringe patents or other proprietary rights of other parties.
In addition, we make use of our trade secrets or “know-how” developed in the course of our experience in the marketing of our services. To the extent that we rely upon trade secrets, unpatented know-how and the development of improvements in establishing and maintaining a competitive advantage in the market for our services, we can provide no assurances that such proprietary technology will remain a trade secret or that others will not develop substantially equivalent or superior technologies to compete with our services.
Employees
As of March 1, 2007, we had 966 full-time employees. These employees include approximately 13 executive and nonexecutive officers, 105 operations managers, 60 environmental specialists, 50 maintenance
personnel, 167 drivers and transportation personnel, 87 land application specialists, 311 general operation specialists, 30 sales employees and 143 technical support, administrative, financial and other employees. Additionally, we use contract labor for various operating functions, including hauling and spreading services, when it is economically advantageous.
Although we have approximately 33 union employees, our employees are generally not represented by a labor union or covered by a collective bargaining agreement. We believe we have good relations with our employees. We provide our employees with certain benefits, including health, life, dental, and accidental death and disability insurance and 401(k) benefits.
Potential Liability and Insurance
The wastewater residuals management industry involves potential liability risks of statutory, contractual, tort, environmental and common law liability claims. Potential liability claims could involve, for example:
•
personal injury;
•
damage to the environment;
•
violations of environmental permits;
•
transportation matters;
•
employee matters;
•
contractual matters;
•
property damage; and
•
alleged negligence or professional errors or omissions in the planning or performance of work.
We could also be subject to fines or penalties in connection with violations of regulatory requirements.
We carry $51 million of liability insurance (including umbrella coverage), and under a separate policy, $10 million of aggregate pollution legal liability insurance ($10 million each loss) subject to retroactive dates, which we consider sufficient to meet regulatory and customer requirements and to protect our employees, assets and operations. There can be no assurance that we will not face claims under CERCLA or similar state laws resulting in substantial liability for which we are uninsured or could be greater than each policy’s limit and which could have a material adverse effect on our business.
Our insurance programs utilize large deductible/self-insured retention plans offered by commercial insurance companies. Large deductible/self-insured retention plans allow us the benefits of cost-effective risk financing while protecting us from catastrophic risk with specific stop-loss insurance limiting the amount of self-funded exposure for any one loss and aggregate stop-loss insurance limiting the self-funded exposure for health insurance for any one year.
Item 1A.
Item 1A.
Risk Factors
Risk Factors That May Affect Future Results
Federal wastewater treatment and biosolid regulations may restrict our operations and/or increase our costs of operations.
Federal wastewater treatment and wastewater residuals laws and regulations impose substantial costs on us and affect our business in many ways. If we are not able to comply with the governmental regulations and requirements that apply to our operations, we could be subject to fines and penalties, and we may be required to invest significant capital to bring operations into compliance or to temporarily or permanently stop operations that are not permitted under the law. Those costs or actions could have a material adverse effect on our business, financial condition and results of operations.
Federal environmental authorities regulate the activities of the municipal and industrial wastewater generators and enforce standards for the discharge from wastewater treatment plants (effluent wastewater) with permits issued under the authority of the Clean Water Act, as amended. The treatment of wastewater produces an effluent and wastewater solids. The treatment of these solids produces biosolids. The use and disposal of biosolids and wastewater residuals is regulated by 40 CFR Part 503 Regulations promulgated by the EPA pursuant to the Clean Water Act (“Part 503 Regulations”). The Part 503 Regulations also establish use and disposal standards for biosolids and wastewater residuals that are applicable to publicly and privately owned wastewater treatment plants in the United States. Biosolids may be surface disposed in landfills, incinerated, or applied to land for beneficial use in accordance with the requirements established by the regulations. To the extent demand for our wastewater residuals treatment methods is created by the need to comply with the environmental laws and regulations, any modification of the standards created by such laws and regulations, or in their enforcement, may reduce the demand for our wastewater residuals treatment methods. Changes in these laws or regulations and/or changes in the enforcement of these laws or regulations may also adversely affect our operations by imposing additional regulatory compliance costs on us, and requiring the modification of and/or adversely affecting the market for our wastewater residuals management services.
We are subject to extensive and increasingly strict federal, state and local environmental regulation and permitting, which could impose substantial costs on our operations and/or reduce our operational flexibility.
Our operations are subject to increasingly strict environmental laws and regulations, including laws and regulations governing the emission, discharge, treatment, storage, disposal and transportation of certain substances and related odor. Wastewater treatment plants and other plants at which our biosolids management services may be implemented are usually required to have permits, registrations and/or approvals from state and/or local governments for the operation of such facilities. Some of our facilities require air, wastewater, storm water, composting, use or siting permits, registrations or approvals. We may not be able to maintain or renew our current permits, registrations or licensing agreements or to obtain new permits, registrations or licensing agreements, including for the land application of biosolids when necessary. The process of obtaining a required permit, registration or license agreement can be lengthy and expensive. We may not be able to meet applicable regulatory or permit requirements, and therefore may be subject to related legal or judicial proceedings.
Many states, municipalities and counties have regulations, guidelines or ordinances covering the land application of biosolids, many of which set either a maximum allowable concentration or maximum pollutant-loading rate for at least one pollutant. The Part 503 Regulations also require certain monitoring to ensure that certain pollutants or pathogens are below designated thresholds. The EPA has considered increasing these thresholds or adding new thresholds for different substances, which could increase our compliance costs. In addition, some states have established management practices for land application of biosolids. Some members of Congress, some state and local authorities, and some private parties, have sought to prohibit or limit the land application, agricultural use, thermal processing or composting of biosolids. Much of this public opposition and challenge, as well as related complaints, relates to odor issues, even when we are in compliance with odor requirements and even though we have worked hard to minimize odor from our operations. Public misperceptions about our business and any related odor could influence the governmental process for issuing such permits, registrations and licensing agreements or for responding to any such public opposition or challenge. Community groups could pressure local municipalities or state governments to implement laws and regulations which could increase our costs of our operations.
In states where we currently conduct business, certain counties and municipalities have banned the land application of Class B biosolids. Other states and local authorities are reviewing their current regulations relative to land application of biosolids. There can be no assurances that these or other prohibition or limitation efforts will not be successful and have a material adverse effect on our business, financial condition and results of operations. In addition, many states enforce landfill restrictions for nonhazardous biosolids and some states have site restrictions or other management practices governing lands. These regulations typically require a permit to use biosolid products (including incineration ash) as landfill daily cover material or for disposal in the landfill. It is possible that landfill operators will not be able to obtain or maintain such required permits. Any of the permits, registrations or approvals noted above, or related applications may be subject to denial, revocation or modification, or challenge by
a third party, under various circumstances, which could have a material adverse effect on our ability to conduct our business.
We are affected by unusually adverse weather and winter conditions, which may adversely affect our revenues and operational results.
Our business is adversely affected by unusual weather conditions and unseasonably heavy rainfall, which can temporarily reduce the availability of land application sites in close proximity to our business upon which biosolids can be beneficially reused and applied to crop land. Material must be transported to either a permitted storage facility (if available) or to a local landfill for disposal. In either case, this results in additional costs for disposal of the biosolids material. In addition, our revenues and operational results are adversely affected during the winter months when the ground freezes thus limiting the level of land application that can be performed. Long periods of inclement weather could reduce our revenues and operational results causing a material adverse effect on our results of operations and financial position.
Our ability to grow may be limited by direct or indirect competition with other businesses that provide some or all of the same services that we provide.
We provide a variety of services relating to the transportation and treatment of wastewater residuals. We are in direct and indirect competition with other businesses that provide some or all of the same services including small local companies, regional residuals management companies, and national and international water and wastewater operations/privatization companies, technology suppliers, municipal solid waste companies, farming operations and, most significantly, municipalities and industries who choose not to outsource their residuals management needs. Some of these competitors are larger; more firmly established and have greater capital resources than we have.
If our long-term contracts are renewed on less attractive terms, or not renewed at all, or if we are unsuccessful in bidding on new long-term contracts, our operating results and financial condition would be adversely affected.
We derive a substantial portion of our revenue from services provided under municipal contracts. A portion of our contracts expire annually and are sometimes subject to competitive bidding. Any contracts that are successfully renewed may be on less attractive terms and conditions than the expired agreement. We also intend to bid on new municipal contracts. In the event we are unable to renew our existing contracts on attractive terms, or at all, or be successful in bidding on new contracts, our operating results and financial condition would be adversely affected.
If one or more of our customer contracts are terminated prior to the expiration of their term, and we are not able to replace revenues from the terminated contract or receive liquidated damages pursuant to the terms of the contract, the lost revenue would have a material adverse effect on our business, financial condition and results of operations.
A substantial portion of our revenue is derived from services provided under contracts and written agreements with our customers. Some of these contracts, especially those contracts with large municipalities (including our largest contract and at least four of our other top ten customers), provide for termination of the contract by the customer after giving relative short notice (in some cases as little as ten days). In addition, some of these contracts contain liquidated damages clauses, which may or may not be enforceable in the event of early termination of the contracts.
If one or more of our new facilities is not completed as scheduled, and we are not able to replace revenues from the new facility, this could have a material and adverse effect on our financial performance and cash flow.
Our ability to generate revenues and cash flow sufficient to pay dividends on our outstanding common stock and interest on outstanding debt is dependent upon successfully financing and completing two new facilities scheduled to commence operations in 2007. Although permitting processes for the new facilities are complete and construction is in progress or near completion, there can be no assurance that we will be able to complete construction as scheduled (or at all) and begin to operate the facilities without the need to remedy certain defects that may
arise immediately after construction. In addition, as with our other facilities, our relationship is governed by customer contracts which can be terminated prior to the expiration of their term.
A significant amount of our business comes from a limited number of customers and our revenue and profits could decrease significantly if we lost one or more of them as customers.
Our business depends on our ability to provide services to our customers. One or more of these customers may stop buying services from us or may substantially reduce the amount of services we provide them. Any cancellation, deferral or significant reduction in the services we provide these principal customers or a significant number of smaller customers could seriously harm our business, financial condition and results of operations. For the year ended December 31, 2006, our single largest customer accounted for 16 percent of our revenues and our top ten customers accounted for approximately 37 percent of our revenues.
If we were unable to obtain bonding required in connection with certain projects, we would be ineligible to bid on those projects.
Consistent with industry practice, we are required to post performance bonds in connection with certain contracts on which we bid. In addition, we are often required to post both performance and payment bonds at the time of execution of contracts for commercial, federal, state and municipal projects. The amount of bonding capacity offered by sureties is a function of the financial health of the entity requesting the bonding. Although we could issue letters of credit under our credit facility for bonding purposes, if we are unable to obtain bonding in sufficient amounts we may be ineligible to bid or negotiate on projects. As of March 1, 2007, we had a bonding capacity of approximately $235 million with approximately $164 million utilized as of that date.
We could face personal injury, third-party or environmental claims or other damages resulting in substantial liability for which we are uninsured or inadequately insured and which could have a material adverse effect on our business, financial condition and results of operations.
We carry $51 million of liability insurance (including umbrella coverage), and under a separate policy, $10 million of aggregate pollution and legal liability insurance ($10 million each loss) subject to retroactive dates, which we consider sufficient to meet regulatory and customer requirements and to protect our employees, assets and operations. It is possible that we will not be able to maintain such insurance coverage in the future.
Our insurance programs utilize large deductible/self-insured retention plans offered by a commercial insurance company. Large deductible/self-insured retention plans allow us the benefits of cost-effective risk financing while protecting us from catastrophic risk with specific stop-loss insurance limiting the amount of self-funded exposure for any single loss.
We are dependent on the availability and satisfactory performance of subcontractors for our design and build operations and the insufficiency and unavailability of and unsatisfactory performance by these unaffiliated third party contractors could have a material adverse effect on our business, financial condition and results of operations.
We participate in design and build construction operations usually as general contractor. Virtually all design and construction work is performed by unaffiliated third-party subcontractors. As a consequence, we are dependent on the continued availability of and satisfactory performance by these subcontractors for the design and construction of our facilities. Further, as the general contractor, we are legally responsible for the performance of our contracts and/if such contracts are underperformed or nonperformed by our subcontractors, we could be financially responsible. Although our contracts with our subcontractors provide for indemnification if our subcontractors do not satisfactorily perform their contract, such indemnification may not cover our financial losses in attempting to fulfill the contractual obligations.
Fluctuations in fuel costs could increase our operating expenses and negatively impact our net income.
The price and supply of fuel is unpredictable and fluctuates based on events outside our control, including geopolitical developments, supply and demand for oil and gas, actions by OPEC and other oil and gas producers,
war and unrest in oil producing countries, regional production patterns and environmental concerns. Because fuel is needed to run the fleet of trucks that service our customers, our incinerators, our dryers and other facilities, price escalations or reductions in the supply of fuel could increase our operating expenses and have a negative impact on net income. In the past, we have implemented a fuel surcharge to offset increased fuel costs. However, we are not always able to pass through all or part of the increased fuel costs due to the terms of certain customers’ contracts and the inability to negotiate such pass through costs.
If we fail to properly estimate the cost of completing a project, and we cannot pass additional costs through to our customers, we may not generate sufficient revenue from the project to cover the operating costs of such project, which would adversely affect our net income.
Our customer contracts involve performing tasks for a fixed cost (in total or on a per unit basis), and if actual costs end up exceeding anticipated costs, our net income would be adversely affected. Due in part to the technical imprecision inherent in estimating the volume of residuals, we may misestimate the volume of residuals, which may increase our costs. To the extent that unexpected costs may arise in connection with work done pursuant to contracts that do not allow us to fully transfer such costs to our customers, our operating costs would increase and our net income would in turn be negatively affected.
We are not able to guarantee that our estimated remaining contract value, which we call backlog, will result in actual revenues in any particular fiscal period.
Any of the contracts included in our backlog, or estimated remaining contract value, presented herein may not result in actual revenues in any particular period or the actual revenues from such contracts may not equal our backlog. In determining backlog, we calculate the expected payments remaining under the current terms of our contracts, assuming the renewal of contracts in accordance with their renewal provisions, no increase in the level of services during the remaining term, and estimated adjustments for changes in the consumer price index for contracts that contain price indexing. However, part or all of our backlog may not be recognized as revenue or earnings.
If we lose the pending lawsuits we are currently involved in, we could be liable for significant damages and legal expenses.
In the ordinary course of business, we may become involved in various legal and administrative proceedings, including proceedings related to permits, land use or environmental laws and regulations. We are currently subject to several lawsuits relating to our business. Our defense of these claims or any other claims against us may not be successful. If we lose these or future lawsuits, we may have to pay significant damages and legal expenses, and we could be subject to injunctions, court orders, loss of revenues and defaults under our credit and other agreements. See “Item 3. - Legal Proceedings.”
We could face considerable business and financial risk in implementing our acquisition strategy.
As part of our growth strategy, we intend to consider acquiring complementary businesses. We regularly engage in discussions with respect to possible acquisitions. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt and contingent liabilities, which could have a material adverse effect upon our business, financial position and results of operations. Risks we could face with respect to acquisitions include:
•
difficulties in the integration of the operations, technologies, products and personnel of the acquired company;
•
potential loss of employees;
•
diversion of management’s attention away from other business concerns;
•
expenses of any undisclosed or potential legal liabilities of the acquired company; and
•
risks of entering markets in which we have no or limited prior experience.
In addition, it is possible that we will not be successful in consummating future acquisitions on favorable terms or at all.
As we pursue our acquisition strategy, we might experience periods of rapid growth that could strain our management, as well as our operational, financial and other resources. Such a strain might negatively impact our ability to retain our existing employees. In order to maintain and manage our growth effectively, we will need to expand our management information systems capabilities and improve our operational and financial systems and controls. As we grow, our staffing requirements will increase significantly. We will need to attract, train, motivate, retain and manage our senior managers, technical professionals and other employees. We might not be able to find and train qualified personnel, or do so on a timely basis, or expand our operations and systems to the extent, and in the time, required.
We are dependent on our senior management for their depth of industry experience and knowledge.
We are highly dependent on the services of our senior management team. Our senior management team has been in the industry for many years and has substantial industry knowledge and contacts. If a member of our senior management team were to terminate his association with us, we could lose valuable human capital, adversely affecting our business. We currently do not maintain key man insurance on any member of our senior management team.
We generally enter into employment agreements with members of our senior management team, which contain noncompete and other provisions. The laws of each state differ concerning the enforceability of noncompetition agreements. State courts will examine all of the facts and circumstances at the time a party seeks to enforce a noncompete covenant. We cannot predict with certainty whether or not a court will enforce a noncompete covenant in any given situation based on the facts and circumstances at that time. If one of our key executive officers were to leave us and the courts refused to enforce the noncompete covenant, we might be subject to increased competition, which could have a material adverse effect on our business, financial condition and results of operations.
Efforts by labor unions to organize our employees could divert management attention and increase our operating expenses.
Certain groups of our employees have chosen to be represented by unions, and we have negotiated collective bargaining agreements with some of the groups. The negotiation of these agreements could divert management attention away from the operations of the business and result in increased operating expenses and lower net income. If we are unable to negotiate acceptable collective bargaining agreements, we might have to wait through “cooling off” periods, which are often followed by union-initiated work stoppages, including strikes. Depending on the type and duration of such work stoppage, our operating expenses could increase significantly.
We may become subject to CERCLA or other federal or state cleanup laws, which could increase our costs of operations.
The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) generally imposes strict, joint and several liability for cleanup costs upon various parties, including: (1) present owners and operators of facilities at which hazardous substances were disposed; (2) past owners and operators at the time of disposal; (3) generators of hazardous substances that were disposed at such facilities; and (4) parties who arranged for the disposal of hazardous substances at such facilities. The costs of a CERCLA cleanup or a cleanup required by applicable state environmental laws can be very expensive. Given the difficulty of obtaining insurance for environmental impairment liability, CERCLA liability or any liability imposed under state cleanup laws could have a material impact on our business and financial condition.
CERCLA liability extends to cleanup costs necessitated by a release or threat of release of a hazardous substance. The definition of “release” under CERCLA excludes the “normal application of fertilizer.” The EPA regards the land application of biosolids that meet the Part 503 Regulations as a “normal application of fertilizer,” and thus not subject to CERCLA. However, if we were to transport or handle biosolids that contain hazardous substances in violation of the Part 503 Regulations, we could be liable under CERCLA.
From time to time, we manage hazardous substances which we dispose at landfills or we transport soils or other materials which may contain hazardous substances to landfills. We also send residuals and ash from our incinerators
to landfills for use as daily cover over the landfill. Liability under CERCLA, or comparable state statutes, can be founded on the disposal, or arrangement for disposal, of hazardous substances at sites such as landfills and for the transporting of such substances to landfills. Under CERCLA, or comparable state statutes, we may be liable for the remediation of a disposal site that was never owned or operated by us if the site contains hazardous substances that we generated or transported to such site. We could also be responsible for hazardous substances during actual transportation and may be liable for environmental response measures arising out of disposal at a third party site with whom we had contracted.
In addition, under CERCLA, or comparable state statutes, we could be required to clean any of our current or former properties if hazardous substances are released or are otherwise found to be present. We are currently monitoring the remediation of soil and groundwater at one of our properties in cooperation with the applicable state regulatory authority, but do not believe any additional material expenditures will be required. However, there can be no assurance that currently unknown contamination would not be found on this or other properties which would cause us to incur additional material expenditures.
Our intellectual property may be misappropriated or subject to claims of infringement.
We attempt to protect our intellectual property rights through a combination of patent, trademark and trade secret laws, as well as licensing agreements. Our failure to obtain or maintain adequate protection of our intellectual property rights for any reason could have a material adverse effect on our business, results of operations and financial condition.
We also rely on unpatented proprietary technology. It is possible that others will independently develop the same or similar technology or otherwise obtain access to our unpatented technology. To protect our trade secrets and other proprietary information, we require employees, consultants, advisors and collaborators to enter into confidentiality agreements. We cannot be assured that these agreements will provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. If we are unable to maintain the proprietary nature of our technologies, our operations could be materially adversely affected.
If we determine that our goodwill is impaired, we may have to write off all or part of it.
Goodwill represents the aggregate purchase price paid by us in acquisitions accounted for as a purchase over the fair value of the identifiable net assets acquired. Under Statement of Financial Accounting Standards No. 142, we no longer amortize goodwill, but review annually for impairment. In the event that facts and circumstances indicate that goodwill may be impaired, an evaluation of recoverability would be performed. If a write-down to market value of all or part of our goodwill becomes necessary, our accounting results and net worth would be adversely affected. As of December 31, 2006, our total goodwill, net of amortization, was approximately $176.6 million.
We may be unable to meet changing laws, regulations and standards related to corporate governance and public disclosure.
We are spending increasing amount of management time and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules (the “Regulations”). In particular, Section 302 and 404 of the Sarbanes-Oxley Act of 2002 require management’s annual review and evaluation of our internal accounting and disclosure controls and procedures, and beginning in 2005 attestations of the effectiveness of these controls by our independent registered public accounting firm. The process of documenting and testing our controls has required that we hire additional personnel and outside advisory services and has resulted in additional accounting and legal expenses. While we invested significant time and money in our effort to design, evaluate and test our internal control over financial reporting, there are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including cost limitations, the possibility of human error, judgments and assumptions regarding the likelihood of future events, and the circumvention or overriding of the controls and procedures. Accordingly, even effective internal accounting and disclosure controls and procedures can provide only reasonable assurance of achieving their control objectives. If we were unable to comply with the Regulations or
were to report a material weakness in our internal control over financial reporting such disclosure may impact investor perception of our company and may affect our stock price.
There is no assurance that we will continue declaring dividends or have the available cash to make dividend payments.
Although we have a stated policy of paying dividends on our common stock at an annual rate of approximately $0.40 per share, and we paid a cash dividend of $0.10 per share in each quarter since the adoption of our dividend policy in June 2005, there can be no assurance that funds will be available for this purpose in the future. The declaration and payment of dividends is subject to the sole discretion of our Board of Directors, are not cumulative, and will depend upon our profitability, financial condition, capital needs, future prospects, and other factors deemed relevant by our board of directors, and may be restricted by the terms of our Senior Credit Facility.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
Our headquarters are located at 1800 Bering Drive, Suite 1000, Houston, Texas 77057, and our telephone number is (713) 369-1700. We currently lease approximately 18,414 square feet of office space at our corporate office located in Houston, Texas. We also lease regional operational facilities in Houston, Texas; Mt. Arlington, New Jersey; Baltimore, Maryland; Naugatuck, Connecticut; and we have 19 district offices throughout the United States.
We own and operate four drying and pelletization facilities; one located in Sacramento, California, one in New York, New York and two in Baltimore, Maryland. We also own and operate four composting facilities located in Corona, California; Dos Palos, California; Salome, Arizona; and Kern County, California. We own and operate three incineration facilities located in Waterbury, Connecticut; Woonsocket, Rhode Island; and New Haven, Connecticut. Additionally, we own the underlying real estate located in Salome, Arizona and Kern County, California.
We operate three drying and pelletizing facilities located in Hagerstown, Maryland; Honolulu, Hawaii; and Pinellas County, Florida. We operate one composting facility located in Burlington, New Jersey. We also operate a wastewater treatment facility located in the Florida Keys.
We are in the process of building, and will own and operate, a composting facility in Okeechobee, Florida. We will also operate a drying and pelletizing facility located in Stamford, Connecticut once it is built.
We maintain permits, registrations or licensing agreements on more than approximately 960,000 acres of land in 24 states for applications of biosolids.
Item 3.
Item 3.
Legal Proceedings
Our business activities are subject to environmental regulation under federal, state and local laws and regulations. In the ordinary course of conducting our business activities, we become involved in judicial and administrative proceedings involving governmental authorities at the federal, state and local levels. We believe that these matters will not have a material adverse effect on our business, financial condition and results of operations.
However, the outcome of any particular proceeding cannot be predicted with certainty. We are required under various regulations to procure licenses and permits to conduct our operations. These licenses and permits are subject to periodic renewal without which our operations could be adversely affected. There can be no assurance that any change in regulatory requirements will not have a material adverse effect on our financial condition, results of operations or cash flows.
Reliance Insurance
For the 24 months ended October 31, 2000 (the “Reliance Coverage Period”), we insured certain risks, including automobile, general liability, and worker’s compensation, with Reliance National Indemnity Company
(“Reliance”) through policies totaling $26 million in annual coverage. On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order appointing the Pennsylvania Insurance Commissioner as Rehabilitator and directing the Rehabilitator to take immediate possession of Reliance’s assets and business. On June 11, 2001, Reliance’s ultimate parent, Reliance Group Holdings, Inc., filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code of 1978, as amended. On October 3, 2001, the Pennsylvania Insurance Commissioner removed Reliance from rehabilitation and placed it into liquidation.
Claims have been asserted and/or brought against us and our affiliates related to alleged acts or omissions occurring during the Reliance Coverage Period. It is possible, depending on the outcome of possible claims made with various state insurance guaranty funds, that we will have no, or insufficient, insurance funds available to pay any potential losses. There are uncertainties relating to our ultimate liability, if any, for damages arising during the Reliance Coverage Period, the availability of the insurance coverage, and possible recovery for state insurance guaranty funds.
In June 2002, we settled one such claim that was pending in Jackson County, Texas. The full amount of the settlement was paid by insurance proceeds; however, as part of the settlement, we agreed to reimburse the Texas Property and Casualty Insurance Guaranty Association an amount ranging from $0.6 to $2.5 million depending on future circumstances. We estimated our exposure at approximately $1.0 million for the potential reimbursement to the Texas Property and Casualty Insurance Guaranty Association for costs associated with the settlement of this case and for unpaid insurance claims and other costs (including defense costs) for which coverage may not be available due to the liquidation of Reliance. We believe accruals of approximately $1.0 million as of December 31, 2006 are adequate to provide for our exposures. The final resolution of these exposures could be substantially different from the amount recorded.
Design and Build Contract Risk
We participate in design and build construction operations, usually as a general contractor. Virtually all design and construction work is performed by unaffiliated subcontractors. As a consequence, we are dependent upon the continued availability of and satisfactory performance by these subcontractors for the design and construction of our facilities. There is no assurance that there will be sufficient availability of and satisfactory performance by these unaffiliated subcontractors. In addition, inadequate subcontractor resources and unsatisfactory performance by these subcontractors could have a material adverse effect on our business, financial condition and results of operation. Further, as the general contractor, we are legally responsible for the performance of our contracts and, if such contracts are under-performed or not performed by our subcontractors, we could be financially responsible. Although our contracts with our subcontractors provide for indemnification if our subcontractors do not satisfactorily perform their contract, there can be no assurance that such indemnification would cover our financial losses in attempting to fulfill the contractual obligations.
Other
There are various other lawsuits and claims pending against us that have arisen in the normal course of business and relate mainly to matters of environmental, personal injury and property damage. The outcome of these matters is not presently determinable but, in the opinion of management, the ultimate resolution of these matters will not have a material adverse effect on our consolidated financial condition, results of operations or cash flows.
Self-Insurance
We are substantially self-insured for worker’s compensation, employer’s liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses are estimated and accrued based upon known facts, historical trends, industry averages, and actuarial assumptions regarding future claims development and claims incurred but not reported.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Price Range
Our common stock is quoted on the Nasdaq Global Market (“Nasdaq”), and trades under the symbol “SYGR.” The following table presents the high and low sales prices for our common stock for each fiscal quarter of the fiscal years ended 2006 and 2005, as reported by Nasdaq.
As of March 1, 2007, we had 78,403,679 shares of common stock issued and outstanding and 265 holders of record of our common stock.
Dividend Policy
Our board of directors adopted a dividend policy in June 2005, effective upon the closing of the Recapitalization (See Note 1) whereby, we expect to pay quarterly dividends at an annual rate of approximately $0.40 per share, but only if and to the extent dividends are declared by our board of directors and permitted by applicable law and by the terms of our senior secured credit facility (See Note 4). Dividend payments are not guaranteed and our board of directors may decide, in its absolute discretion, not to pay dividends. Dividends on our common stock are not cumulative. For the year ended December 31, 2006, we paid quarterly dividends of $0.10 per share totaling $29.2 million. We paid a quarterly dividend of $0.10 per share in February 2007.
Equity Compensation Plan Information
The following table summarizes as of December 31, 2006, certain information regarding equity compensation to our employees, officers, directors and other persons under our equity compensation plans:
(1)
We have outstanding stock options granted under the 2000 Stock Option Plan (the “2000 Plan”) and the Amended and Restated 1993 Stock Option Plan (the “1993 Plan”) for officers, directors and key employees. There are 7,677,000 options for shares of common stock reserved under the 2000 Plan for future grants. Effective with the approval of the 2000 Plan, no further grants have been made under the 1993 Plan.
(2)
Represents options granted pursuant to individual stock option agreements. An aggregate of 1,181,954 options were granted to executive officers in 1998 and prior. These options had an exercise price equal to the market price, vested over three years, and expire ten years from the date of grant. An aggregate of 850,000 options were granted to executive officers as an inducement essential to the individuals entering into an employment contract with us. These options have an exercise price equal to market value on the date of grant, vest over three years, and expire ten years from the date of grant.
Common Stock Performance Graph
The following graph illustrates the yearly percentage change in the cumulative stockholder return of our Common Stock with the cumulative total return of (i) the NASDAQ (U.S. Companies) Stock Index (the “NASDAQ U.S. Index”) and (ii) the group of peer companies selected by us based on similarity to our line of business and similar market capitalization.
CUMULATIVE TOTAL RETURN
Based upon an initial investment of $100 on December 31,
with dividends reinvested
The Custom Composite Index consists of Allied Waste Industries Inc., American Ecology Corp., Casella Waste Systems, Inc., Clean Harbors Inc., Covanta Holding Corp., Duratek Inc. (ending 1Q06), Republic Services Group, Stericycle Inc. Waste Connections, Inc., Waste Industries USA, Inc., Waste Management, Inc., and WCA Waste Corp. (beginning 3Q04).
Item 6.
Item 6.
Selected Financial Data
The following table summarizes our selected consolidated financial data for each fiscal year of the five-year period ended December 31, 2006. The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements, including the notes thereto, included elsewhere herein.
We declared and paid cash dividends on common stock of approximately $29.2 million as of December 31, 2006.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following is a discussion of our results of operations and financial position for the periods described below. This discussion should be read in conjunction with the consolidated financial statements included herein. Our discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. These statements are based on certain assumptions that we consider reasonable. Our actual results may differ materially from these indicated forward-looking statements. For information about these assumptions and other risks and exposures relating to our business and our company, you should refer to the section entitled “Forward-Looking Statements” and “Risk Factors.”
Secondary Equity Offering
On May 16, 2006, we completed a secondary equity offering at $4.15 per share for 19,129,710 shares of common stock, including 15,129,710 shares held by stockholders for which we did not receive any proceeds and 4,000,000 shares issued by us. We received total net proceeds from the sale of the 4,000,000 shares, after underwriting discounts and commissions and offering expenses, of approximately $15.9 million. We used the net proceeds from the offering for working capital and general corporate purposes.
Recapitalization
On June 21, 2005, we executed a $305 million senior credit agreement (See Note 4), repaid $196.9 million of debt under our previously outstanding senior credit agreement and 91/2% senior subordinated notes due 2009, converted all outstanding shares of preferred stock into 41,885,597 shares of common stock, and completed a $160 million offering of 9,302,326 primary and 27,847,674 secondary shares of common stock at an offering price of $4.30 per share. The credit agreement allows us to pay dividends and also resulted in significant cash interest savings when compared to the interest costs of our previously outstanding senior and subordinated debt. The credit agreement, debt repayment, preferred stock conversion, and primary and secondary common stock offering referenced in this paragraph, are collectively referred to herein as the “Recapitalization”.
We incurred certain costs and write-offs relating to the Recapitalization, including $1.5 million of transaction costs and expenses, $5.5 million for stock option redemptions, $1.3 million for transaction bonuses and $19.5 million of debt extinguishment costs. The $5.5 million charge for stock options redeemed relates to 3,043,000 options that were redeemed for $5.5 million of cash. We also recognized as dividends $4.4 million of previously unrecognized accretion on our preferred stock. These costs, write-offs and accretion have been included in our statements of operations for the year ended December 31, 2005.
Background
We generate substantially all of our revenue by providing water and wastewater residuals management services to municipal and industrial customers. We provide our customers with services and capabilities, including, drying and pelletization, composting, product marketing, incineration, alkaline stabilization, land application, transportation, regulatory compliance, dewatering, and facility cleanout services. We currently serve more than 600 customers in 33 states and the District of Columbia. Our contracts typically have inflation price adjustments, renewal clauses and broad force majeure provisions. For the year ended December 31, 2006, we experienced a contract retention rate (both renewals and rebids) of approximately 94 percent.
We categorize our revenues into five types - contract, purchase order, product sales, design\build construction and event work.
Contract revenues are generated primarily from land application, collection and transportation services, dewatering, incineration, composting, drying and pelletization services and facility operations and maintenance, and are typically performed under a contract with terms ranging from 1 to 25 years. Purchase order revenues are primarily from facility operations, maintenance services, and collection and transportation services where services are performed on a recurring basis, but not under a long-term contract. Product sales revenues are primarily generated from sales of composted and pelletized biosolids from internal and external facilities. Design\build
construction revenues are derived from construction projects where we agree to design and build a biosolids facility such as a drying and pelletization facility, composting facility, incineration facility or a dewatering facility that we will subsequently operate once the facility commences commercial operations. Event project revenues are typically generated from digester or lagoon cleanout projects and temporary dewatering projects.
Our percentage of revenue by type is summarized below:
Revenues under our facilities operations and maintenance contracts are recognized either when wastewater residuals enter the facility or when the residuals have been processed, depending on the contract terms. All other revenues under service contracts are recognized when the service is performed. Revenues from design/build construction projects and multi-year cleanout projects are accounted for under the percentage-of-completion method of accounting. We provide for losses in connection with long-term contracts where an obligation exists to perform services and it becomes evident that the projected contract costs will exceed the related revenue.
Our costs relating to service contracts include processing, transportation, spreading and disposal costs, and depreciation of operating assets. Our spreading, transportation and disposal costs can be adversely affected by unusual weather conditions and unseasonably heavy rainfall, which can temporarily reduce the availability of land application. Material must be transported to either a permitted storage facility (if available) or to a local landfill for disposal. In either case, this results in additional costs for transporting, storage and disposal of the biosolid materials versus land application in a period of normal weather conditions. Processing and transportation costs can also be adversely impacted by higher fuel costs. In order to manage this risk at processing facilities, we generally enter into contracts that pass-through fuel cost increases to the customer, or for contracts without pass-through provisions, we from time to time lock in our fuel costs with our fuel suppliers for terms or hedge these costs with financial derivative arrangements. We have hedged 92 percent of our natural gas unit costs for which we do not have a contractual pass-through through December 31, 2011. We have also locked in 47 percent of our electricity costs on contracts that do not have contractual pass-through agreements through December 2010. We continuously review various hedging strategies and plant efficiency opportunities to mitigate this risk going forward, but do expect natural gas costs will remain high through 2007 when compared to historical price levels for natural gas. We subcontract a significant portion of our transportation requirements to numerous contractors which enables us to minimize the impact of changes in fuel costs for over the road equipment. We have also periodically implemented temporary fuel surcharges with selected customers. Our costs relating to construction contracts primarily include subcontractor costs related to design, permit and general construction. Our selling, general and administrative expenses are comprised of accounting, information systems, marketing, legal, human resources, regulatory compliance, and regional and executive management costs.
Our management reviews and analyzes several trends and key performance indicators in order to manage our business. Since approximately 90 percent of our revenues are generated from municipal water and wastewater plants, we monitor trends involving municipal generators, including, among other things, aging infrastructure, technology advances, and regulatory activity in the water and wastewater residuals management industry. We use this information to anticipate upcoming growth opportunities, including new facility growth opportunities similar to the Kern County, California, Woonsocket, Rhode Island, Honolulu, Hawaii, Sacramento, California and Pinellas County, Florida facility projects that we completed over the past three years. We also use this information to manage potential business risks such as increased regulatory pressure or local public opposition to residuals management
programs. On an ongoing basis, our management also considers several variables associated with the ongoing operations of the business, including, among other things:
•
new sales (including the mix of contract and event sales) and existing business retention objectives necessary to maintain our high percentage of contract and other recurring revenues;
•
storage and permitted landbase available to efficiently manage land application of biosolids, especially during inclement weather patterns;
•
regulatory and permit compliance requirements and safety programs and initiatives specific to our business; and
•
reviewing and monitoring utility costs, fuel costs, subcontractor transportation costs, equipment utilization and availability, equipment purchasing activity, headcount, field operating overhead and selling, general and administrative expenses.
Results of Operations
The following table sets forth certain items included in the consolidated financial statements as a percentage of revenue for the periods indicated (in thousands):
Revenue and income from operations are summarized by reporting segment, as follows (in thousands):
Results of Operations for the Years Ended December 31, 2006 and
For the year ended December 31, 2006, revenue was approximately $345.8 million compared to approximately $338.0 million for the year ended December 31, 2005, an increase of approximately $7.8 million, or 2.3 percent. Contract revenues increased $17.0 million due primarily to a $7.0 million increase in revenue from new facilities, including the Central Valley compost, Providence Soils dewatering and Honolulu dryer facilities, a $2.6 million increase related to a disposal contract that started in the third quarter of 2005, a $3.6 million increase related to a long-term cleanout project, and other volume changes. Event revenues increased $15.4 million due primarily to $3.2 million of emergency digester clean-out work, $3.1 million on a soil disposal project, a $1.1 million increase in revenue generated on a large clean water lagoon clean-out project that is being completed over a two year period, $7.5 million on several large lagoon clean-out projects, and other volume changes. Design build construction revenues decreased $23.5 million primarily due to the decrease in construction revenue on the Honolulu dryer facility and other construction projects that have been substantially completed.
Our Residuals Management Operations segment revenues for the year ended December 31, 2006, increased approximately $22.1 million, or 8.2 percent, to $291.7 million compared to $269.6 million for the same period in 2005 due primarily to the increase in revenues from new facility projects described above, the increase in revenue from a long-term cleanout project described above, an increase in other contract revenues, and increases in event work described above. Our Rail Transportation segment revenues for the year ended December 31, 2006, increased approximately $5.2 million, or 13.2 percent, to $44.5 million compared to $39.3 million for the same period in 2005 due primarily to an increase in volume under contracted land application and disposal services contracts, an increase in a disposal contract that started in the third quarter of 2005, and an increase in event work, partially offset by a decrease in purchase order work. Our Engineering, Facilities, and Development segment revenues for the year ended December 31, 2006, decreased approximately $19.8 million to $12.3 million compared to $32.1 million for the same period in 2005 due primarily to the decrease in construction revenue on the Honolulu dryer facility project that has been substantially completed.
Gross profit for the year ended December 31, 2006, was approximately $66.3 million compared to approximately $62.2 million for the year ended December 31, 2005, an increase of $4.1 million. Gross profit as a percentage of revenue increased to 19.2 percent in 2006 from 18.4 percent in 2005. The increase in gross profit margin is a result of revenue mix changes associated with the increase in higher margin contract and event work and the decrease in lower margin design build construction work, partially offset by expected higher fuel costs, an increase in repairs and disposal costs, higher insurance claims, and a $1.4 million increase in depreciation expense.
Transaction costs and expenses and stock option redemptions and transaction bonuses decreased by $8.0 million to $0.3 million for the year ended December 31, 2006, compared to $8.3 million for the year ended December 31, 2005. During 2006, we expensed $0.3 million of transaction costs related to the sale of common stock held by selling shareholders in which we received no proceeds, compared to $8.3 million expended as a result of the Recapitalization in 2005.
Gain on sale of assets decreased by $2.4 million due to $2.4 million of gains from sales of real estate during the year ended December 31, 2005.
Selling, general and administrative expenses for the year ended December 31, 2006 increased $6.7 million to approximately $31.4 million compared to $24.7 million for the same period in 2005. The increase in general and administrative expense is primarily due to $2.7 million of non-cash expense for share based compensation expense related to the issuance of restricted stock and the implementation of SFAS No. 123R in January 2006 (which requires that we expense the fair value of employee stock options over the related service period), $0.9 million of costs related to the completion of the 2005 audit, including the external audit of internal controls required by Section 404 of the Sarbanes-Oxley Act, a $1.4 million positive litigation reserve adjustment that occurred in the second quarter of 2005, and $0.3 million of severance costs related to changes in regional management, and increases in commissions, other incentive compensation, depreciation and other costs.
As a result of the foregoing, income from operations for the year ended December 31, 2006 was approximately $34.7 million compared to approximately $31.6 million for the year ended December 31, 2005. Our Residuals Management Operations segment income from operations for the year ended December 31, 2006, totaled approximately $49.0 million compared to $48.2 million for 2005 due primarily to the positive impact of contract and event revenue mix changes, offset by higher fuel costs, and an increase in repairs and depreciation expense, as well as the $2.4 million decrease in asset sale gains noted above. Our Rail Transportation segment income from operations increased from $4.2 million in 2005 to $6.5 million in 2006 due primarily to higher volumes described above and related improved equipment utilization as well as improved pricing on existing contracts. Our Engineering, Facilities, and Development segment income from operations decreased from $0.6 million in 2005 to a loss of $1.9 million in 2006 due primarily to the decrease in construction revenues described above. The decrease in corporate loss from operations from a loss of $21.4 million in 2005 to a loss of $18.8 million in 2006, primarily relates to the $8.0 million decrease in transaction costs and expenses and stock option expenses and transaction bonuses described above, partially offset by the $1.4 million favorable reserve adjustment in 2005 described above, an increase in insurance claims not recharged to other segments, and the $2.7 million noncash charge in 2006 for share based compensation expense noted above.
Other expense, net, was approximately $21.1 million for the year ended December 31, 2006, compared to approximately $41.6 million for the year ended December 31, 2005, representing a decrease in other expense of approximately $20.5 million. The decrease is primarily due to $19.5 million in debt extinguishment costs and a $1.3 million decrease in interest expense associated with the Recapitalization.
For the year ended December 31, 2006, we recorded a provision for income taxes of approximately $5.6 million compared to a benefit of $0.3 million for the year ended December 31, 2005. Our effective tax rate was approximately 41 percent in 2006 compared to 3 percent in 2005. The increase in the effective tax rate is primarily related to one time provisions in the prior year for deferred taxes related to an increase in the expected statutory rates that will be applied when temporary differences turn in future periods following a legal entity restructuring, and a tax issue identified during a tax audit related to net operating loss carryforwards that has been fully reserved. Additionally, the permanent differences for state taxes, meals and entertainment and similar items that are not deductible for federal purposes reduced the benefit recognized in 2005 because in 2005 we reported a loss. Our tax provision is principally a deferred tax provision that will not significantly impact cash flow since we have significant tax deductions in excess of book deductions and net operating loss carryforwards available to offset future taxable income.
Results of Operations for the Years Ended December 31, 2005 and
For the year ended December 31, 2005, revenue was approximately $338.0 million compared to approximately $325.9 million for the year ended December 31, 2004, an increase of approximately $12.1 million, or 3.7 percent.
We have four significant fixed price, long-term contracts for which we recognized revenues under the percentage of completion method of accounting totaling $31.5 million in 2005 and $17.0 million in 2004 with related gross margin totaling $4.2 million in 2005 and $5.9 million in 2004. The four significant contracts included a $36.5 million project for the design and construction of a biosolids dryer facility, a $14.9 million contract for the removal and disposal of cleanwater residuals from a lagoon over a two year period, a $12.0 million contract for the removal and disposal of biosolids from a lagoon over a five year period and a $3.6 million contract for the installation of a dewatering facility that was substantially completed in 2005. These types of contracts occur infrequently but have a significant impact on reported revenues and earnings. The revenue recognized for construction of the new dryer facility and the dewatering facility is reported as design/build construction revenue, while the revenue recognized for removing and disposing of bio-solids from the lagoon over a multi-year period is reported as contract revenue and the revenue recognized for the removal of clean water residuals over a two year period is being reported as event revenues. Design/build construction revenues increased $14.7 million primarily due to a $11.9 million increase in construction revenue on the Honolulu dryer facility project, which was substantially completed in 2006 and $2.9 million increase for construction of a dewatering facility in Knoxville, Tennessee. Contract revenues increased $1.3 million compared to the prior year due to a $4.1 million increase in revenues from the Sacramento dryer facility that commenced operations in December 2004, a $2.2 million increase related to a new disposal contract and $2.5 million of other contract changes, offset by an expected $7.5 million decrease in revenue on a long-term cleanout job. Event revenues decreased $2.1 million due to an expected year over year decrease in the number of large event projects in 2005 compared to 2004, partially offset by $5.8 million of revenue in 2005 under a $15 million clean water lagoon cleanout project that is expected to take approximately two years to complete. Purchase order and product sales revenues decreased by $1.7 million due primarily to a decrease in purchase order work for soil cleanup projects.
Our Residuals Management Operations revenues for the year ended December 31, 2005, decreased approximately $5.2 million or 1.9 percent to $269.6 million compared to $274.8 million for the same period in 2004 due primarily to the decreases in contract and event revenues. These decreases were anticipated going into the year as in process and pre-sold event work was higher at the beginning of 2004 than 2005 and there was $7.7 million of contract revenue recognized in 2004 on a long-term cleanout contract accounted for using the percentage-of-completion accounting method that did not generate any significant revenue in 2005. Our Rail Transportation revenues for the year ended December 31, 2005, increased approximately $1.3 million or 3.4 percent to $39.3 million compared to $38.0 million for the same period in 2004 due primarily to a $2.2 million increase related to a new disposal contract partially offset by a decrease in event and purchase order revenues from disposal services. Our Engineering, Facilities, and Development revenues for the year ended December 31, 2005, increased approximately $14.8 million to $32.1 million compared to $17.3 million in 2004 due primarily to a $11.9 million increase in construction revenues on a new dryer facility in Honolulu, and a $4.1 million increase in revenues on the Sacramento dryer facility that commenced operations in December 2004, partially offset by the transfer of the Pinellas dryer facility operations to the Residuals Management Operations segment.
Gross profit for the year ended December 31, 2005, was approximately $62.2 million compared to approximately $67.8 million for the year ended December 31, 2004, a decrease of $5.6 million or 8.3 percent. Gross profit as a percentage of revenue decreased to 18.4 percent in 2005 from 20.8 percent in 2004. This decrease in gross profit and gross profit margin is a result of revenue mix changes associated with an increase in low margin construction revenue and the decrease in higher margin contract (including the $7.5 million decrease in revenue on the long-term cleanout contract that had higher than normal margins) and event revenue, along with a $3.6 million increase in the cost of utilities for certain facilities and a $1.6 million increase in depreciation, partially offset by a decrease in facility repair and maintenance costs and a reduction in insurance expense due to lower claims activity.
Selling, general and administrative expenses for the year ended December 31, 2005, were approximately $24.7 million compared to approximately $24.3 million for the year ended December 31, 2004. Selling, general and administrative expenses as a percentage of revenues were 7.3 percent for the year ended December 31, 2005, a slight decrease from the same period of 2004. The decrease relates primarily to favorable net reserve adjustments of $1.0 million, offset by an increase in costs to implement section 404 of the Sarbanes Oxley Act totaling $0.7 million and $0.3 million of compensation expense for grants of restricted stock to certain key employees pursuant to the
terms of a new incentive compensation plan approved in connection with the Recapitalization that results in grants of shares of our common stock at dividend payments dates (See Note 1).
Transaction costs incurred in connection with the Recapitalization consisted of $1.5 million in legal, accounting and underwriting fees.
Stock option redemptions and transaction bonuses included $1.3 million of cash paid for transaction bonuses and $5.5 million for stock options redeemed for certain of our key employees.
Gain on the sale of assets of $2.7 million was $1.8 million higher than in 2004, due primarily to planned sales of certain real estate.
As a result of the foregoing, income from operations for the year ended December 31, 2005 was approximately $31.6 million compared to approximately $43.9 million in the same period in 2004. Our Residuals Management Operations income from operations for the year ended December 31, 2005, totaled approximately $48.2 million compared to $55.9 million for 2004 due primarily to the expected decreases in event and contract revenues (including the decrease in the long-term cleanout contract revenue) described above along with a $1.6 million increase in depreciation expense and the $3.6 million increase in facility utility costs, partially offset by a decrease in facility repair and maintenance costs, a reduction in insurance expense due to lower claims activity and $1.8 million increase in gains on asset sales. Our Rail Transportation income from operations decreased from $5.1 million in 2004 to $4.2 million in 2005 due primarily to an increase in rail transportation costs and excess equipment capacity. Our Engineering, Facilities, and Development income from operations increased from a loss of approximately $1.6 million in 2004 to income of approximately $0.6 million in 2005 due primarily to margin from design/build construction revenue generated on the Honolulu facility and the first year of operations of the Sacramento dryer facility revenue and other revenue changes described above and related margins.
Other expense, net, was approximately $41.6 million for the year ended December 31, 2005, compared to approximately $22.3 million for the year ended December 31, 2004, representing an increase in other expense of approximately $19.3 million, due primarily to the $19.5 million of debt extinguishment costs associated with the Recapitalization.
For the year ended December 31, 2005, we recorded a benefit for income taxes of approximately $0.3 million compared to a provision of $8.6 million for the year ended December 31, 2004. Our effective tax rate was approximately 3 percent in 2005 compared to 40 percent in 2004. The decrease in the effective tax rate is primarily related to a 20 percent decrease associated with the increase in the expected statutory rates that will be applied when temporary differences turn in future periods following a legal entity restructuring in the fourth quarter of 2005, and a 10 percent decrease associated with a tax issue identified during a tax audit related to net operating loss carryforwards that has been fully reserved, along with permanent differences for state taxes, meals and entertainment and similar items that are not deductible for federal tax purposes and therefore reduce the benefit recognized in loss periods. Our tax provision is principally a deferred tax provision that will not significantly impact cash flow because we have significant tax deductions in excess of book deductions and net operating loss carryforwards available to offset future taxable income.
Liquidity and Capital Resources
Overview
During the past three years, our principal sources of funds were cash generated from our operating activities. We use cash mainly for capital expenditures, working capital, debt service and dividends. In the future, we expect that we will use cash principally to fund working capital, our debt service and repayment obligations, capital expenditures and payment of our dividends. In addition, we may use cash to pay potential earn out payments resulting from prior acquisitions. We have historically financed our acquisitions principally through the issuance of equity and debt securities, our credit facility, and funds provided by operating activities.
Historical Cash Flows
Cash Flows from Operating Activities - For the year ended December 31, 2006, cash flows provided by operating activities were approximately $44.6 million compared to cash flow used in operating activities of approximately $3.0 million for the same period in 2005, an increase of approximately $47.6 million. The increase primarily relates to a $27.2 million increase in net income applicable to common stock primarily resulting from improved operating results and the decrease in 2005 charges related to the Recapitalization for transaction costs of $1.5 million, transaction bonuses and stock option redemptions of $6.8 million and debt extinguishment costs of $19.5 million. In addition, we had a decrease in cash required by working capital of $22.5 million, due to $14.7 million of cash generated from increases in accounts payables, $12.6 million of cash generated from changes in cost and estimated earnings in excess of billings due to substantial completion and billing of several projects, $4.9 million of cash generated from changes in accrued interest related to timing of interest payments, partially offset by $8.6 million of cash used related to prepaids and other current assets and a $1.2 million decrease of cash used related to accounts receivable. The improvement in payables primarily relates to a significant use of payables in the prior year following the Recapitalization.
For the year ended December 31, 2005, cash flows used by operating activities was approximately $3.0 million compared to approximately $33.4 million provided by operating activities for the same period in 2004, a decrease of approximately $36.4 million, or 109 percent. The decrease primarily relates to the net loss applicable to common stock of $19.2 million (primarily resulting from $27.8 million of charges related to the Recapitalization including transaction costs of $1.5 million, transaction bonuses and stock option redemptions of $6.8 million and debt extinguishment costs of $19.5 million) compared to net income of $4.1 million in the same period in 2004. In addition, we had an increase in the use of working capital of $11.2 million. The increase in working capital relates primarily to a $5.4 million decrease in trade payables between periods, a $3.1 million decrease in interest payable due to the repayment of debt as part of the Recapitalization, a $2.5 million increase in trade receivables, a $1.6 million increase in costs and estimated earnings in excess of billings, a $2.3 million decrease in benefits accruals relating to the timing of cutoff of payroll between periods and lower bonus accruals, and other decreases in deferred revenues, legal and insurance reserves and other liabilities.
Under the percentage of completion method of accounting, we recognize revenue based on the percentage of costs incurred to date to total estimated costs expected to be incurred on the project multiplied by the contract price. Cost and estimated earnings in excess of billings represents the amount of revenue recognized on these projects in excess of what has been billed to date as provided in the underlying contract. Costs and estimated earnings in excess of billings totaled $8.4 million at December 31, 2006, of which approximately $5.7 million will not be billable in fiscal 2007 and $14.4 million at December 31, 2005, of which approximately $3.8 million was not billable in fiscal 2006 under the terms of the related contract and has therefore been included in non-current assets. Costs incurred on these contracts are expected to be covered by billings and related cash receipts in 2007 and are therefore not expected to significantly impact our liquidity in 2007. There have not been any significant changes to the scope of the work or the payment terms of these contracts and there are no payment related disputes on these contracts. The increase in costs in excess of billings is believed to be fully collectable and thus no additional increase to allowance for doubtful accounts has been deemed necessary.
Cash Flows from Investing Activities - For the year ended December 31, 2006, cash flows used by investing activities were approximately $45.4 million compared to approximately $17.1 million for the same period in 2005. This increase is due primarily to a $27.8 million increase in capital expenditures including new facilities. We expended $40.6 million in 2006 on new facility construction projects, compared to $8.3 million in 2005. Such increases in new facility spending were partially offset by spending decreases on other capital projects.
For the year ended December 31, 2005, cash flows used by investing activities increased to approximately $17.1 million from approximately $13.5 million for the same period in 2004, an increase of approximately $3.6 million. This increase is due primarily to a $5.2 million increase in capital expenditures partially offset by a $3.2 million increase in proceeds from asset sales and a $2.6 million increase in the use of cash restricted for capital projects. The increase in capital expenditures relates to $8.3 million of capital spent (excluding a project funded from restricted cash) on new facility projects compared to $2.7 million spent in the same period last year, and a $1.4 million increase in other capital expenditures.
Cash Flows from Financing Activities - For the year ended December 31, 2006, cash flows used in financing activities were approximately $17.3 million compared to cash flows provided of approximately $38.3 million for the same period in 2005, a decrease of approximately $55.6 million. The decrease primarily relates to a decrease in proceeds from equity offerings from $37.6 million in 2005 to $15.9 million in 2006, an increase in cash dividend payments to $29.2 million in 2006 compared to $14.5 million in 2005, and other changes in debt and debt issuance costs (including the repayment of debt and debt issuance costs and the refinancing of debt related to the Recapitalization in 2005 summarized in Note 1), as well as a $3.6 million decrease in proceeds received from the exercise of options.
For the year ended December 31, 2005, cash flows provided by financing activities were approximately $38.3 million compared to cash flows used of approximately $19.8 million for the same period in 2004, an increase of approximately $58.1 million. The increase primarily relates to proceeds of $37.6 million received from the equity offering (See Note 1), $4.2 million of proceeds received from the exercise of stock options in 2005, proceeds from our new senior secured credit facility net of the repayment of debt and debt issuance costs related to the Recapitalization, less $14.5 million of dividends paid in 2005, compared to $21.3 million of net payments on debt in 2004.
Capital Expenditure Requirements
Capital expenditures for the year ended December 31, 2006 totaled approximately $47.7 million (which included approximately $40.6 million for new facilities) compared to approximately $21.5 million (which included $10.0 million for new facilities) in the same period of 2005. Our ongoing capital expenditure program consists of expenditures for replacement equipment, betterments, and growth.
Debt Service Requirements
Senior Credit Facility
On June 21, 2005, we executed our Senior Credit Facility with a syndicate of financial institutions, including affiliates of Banc of America Securities LLC, Lehman Brothers Inc. and CIBC World Markets Corp. A portion of the proceeds received from the Senior Credit Facility were used to repay our $150 million amended and restated Senior Credit Agreement, entered into on May 8, 2002 by and among us, Bank of America, N.A. and certain other lenders and to tender for all of our $150 million of outstanding 91/2% senior subordinated notes due April 1, 2009 (the “Notes”).
The loan commitments under the Senior Credit Facility are as follows:
(i) Revolving Loan (“Revolver”) up to $95.0 million outstanding at anytime;
(ii) Term B Loans (which, once repaid, may not be reborrowed) of $210.0 million including $30.0 million that was borrowed in December 2005; and
(iii) Letters of Credit up to $50 million as a subset of the Revolver. At December 31, 2006, we had approximately $38.4 million of letters of credit outstanding.
The Revolver has a five-year maturity and the term loan has a seven-year maturity. The Senior Credit Facility is secured by first priority security interests in substantially all of our assets and those of our subsidiaries (other than assets securing nonrecourse debt) and expires on December 31, 2012. There is no amortization of the term loan. The term loan bears interest at LIBOR or prime rate plus a margin (2.25 percent for Eurodollar loans, and 1.25 percent for base rate loans), and the Revolver bears interest at LIBOR or prime rate plus a margin based on a rate schedule (currently 2.75 percent for Eurodollar loans, and 1.75 percent for base rate loans). As of December 31, 2006, these rates total approximately:
As of December 31, 2006, we had $5.2 million borrowed on the Revolver.
The Senior Credit Facility allows us to pay a significant portion of our excess cash flow to shareholders through cash dividends provided we maintain compliance with certain financial covenants and certain other restrictions.
The proceeds of the $30.0 million term loan drawn in December 2005 were used to partially fund new facility construction costs in 2006. The development of these new facilities is consistent with our strategy to pursue new facility opportunities that provide long-term, highly predictable cash flows. These facilities include a composting facility in Kern County, California, and an incineration facility upgrade in Woonsocket, Rhode Island.
The Senior Credit Facility includes mandatory repayment provisions related to excess cash flows, proceeds from certain asset sales, debt issuances and equity issuances, all as defined in the Senior Credit Facility. These mandatory repayment provisions may also reduce the available commitment. The Senior Credit Facility contains standard covenants including compliance with laws, limitations on capital expenditures, restrictions on dividend payments, limitations on mergers and compliance with financial covenants. We were in compliance with those covenants as of December 31, 2006. As of December 31, 2006, we had approximately $51.4 million of unused borrowings under the Senior Credit Facility.
On March 6, 2006, we amended our Senior Credit Facility to, among other things, increase the maximum amount of debt permitted under the leverage ratio and to decrease the minimum amount of interest coverage required under the interest coverage ratio.
Senior Subordinated Notes
In April 2002, we issued the Notes, which were unsecured senior indebtedness and were guaranteed by all of our existing and future domestic subsidiaries, other than subsidiaries treated as unrestricted subsidiaries (“Guarantors”). As of December 31, 2004, all subsidiaries, other than the subsidiaries formed to own and operate the Sacramento dryer project, Synagro Organic Fertilizer Company of Sacramento, Inc. and Sacramento Project Finance, Inc. and South Kern Industrial Center, LLC, were Guarantors of the Notes. On June 21, 2005, the Notes were repurchased with the proceeds of the Senior Credit Facility.
Other Debt
In 1996, the Maryland Energy Financing Administration (the “Administration”) issued nonrecourse tax-exempt project revenue bonds (the “Maryland Project Revenue Bonds”) in the aggregate amount of $58.6 million. The Administration loaned the proceeds of the Maryland Project Revenue Bonds to Wheelabrator Water Technologies Baltimore L.L.C., now our wholly owned subsidiary known as Synagro-Baltimore, L.L.C., pursuant to a June 1996 loan agreement, and the terms of the loan mirror the terms of the Maryland Project Revenue Bonds. The loan financed a portion of the costs of constructing thermal facilities located in Baltimore County, Maryland, at the site of its Back River Wastewater Treatment Plant, and in the City of Baltimore, Maryland, at the site of its Patapsco Wastewater Treatment Plant. We assumed all obligations associated with the Maryland Project Revenue Bonds in connection with our acquisition of the Bio Gro division of Waste Management, Inc. (“Bio Gro”) in 2000. Maryland Project Revenue Bonds in the aggregate amount of approximately $22.8 million have already been repaid. The remaining Maryland Project Revenue Bonds bear interest at annual rates between 6.30 percent and 6.45 percent and mature on dates between December 1, 2007, and December 1, 2016.
In December 2002, the California Pollution Control Financing Authority (the “Authority”) issued nonrecourse revenue bonds in the aggregate amount of $20.9 million (net of original issue discount of $0.4 million). The nonrecourse revenue bonds consist of $19.7 million (net of original issue discount of $0.4 million) Series 2002-A and $1.2 million (net of original issue discount of $9,000) Series 2002-B (collectively, the “Sacramento Bonds”). The Authority loaned the proceeds of the Sacramento Bonds to Sacramento Project Finance, Inc., one of our wholly owned subsidiaries, pursuant to a loan agreement dated December 1, 2002. The purpose of the loan was to finance the design, permitting, construction of a biosolids dewatering and heat drying/pelletizing facility for the Sacramento Regional County Sanitation District. Sacramento Bonds in the aggregate amount of approximately $1.2 million have already been repaid. The remaining Sacramento Bonds bear interest at annual rates between 4.375 percent and 5.50 percent and mature on dates between December 1, 2007, and December 1, 2024. The Sacramento facility commenced commercial operations in December 2004.
Notes Payable to Sellers of Acquired Businesses
In connection with previous acquisitions, we have $2.5 million in notes payable with certain former owners which includes payments for contingent consideration. The notes payable are due over three remaining years in installments with interest payable at annual rates ranging from five percent to eight percent.
At December 31, 2006, future minimum principal payments of long-term debt, nonrecourse project revenue bonds (See Note 5), capital lease obligations (see Note 6), estimated interest expense on debt, operating lease obligations and purchase commitments are as follows (in thousands):
Interest expense is estimated because certain of our debt has variable interest rates. For purposes of this estimate, variable interest rates as of December 31, 2006 were utilized.
We have entered into various lease transactions to purchase transportation and operating equipment that have been accounted for as capital lease obligations and operating leases. The capital leases have lease terms of three to six years with interest rates ranging from 4.9 percent to 9.34 percent. The net book value of the equipment related to these capital leases totaled approximately $18.3 million as of December 31, 2006. The operating leases have terms of two to eight years. Additionally, we have guaranteed a maximum lease risk amount to the lessor of one of the operating leases. The fair value of this guaranty is approximately $0.2 million as of December 31, 2006 and is included in current liabilities.
We believe we will have sufficient cash generated by our operations and available through our Senior Credit Facility to provide for future working capital and capital expenditure requirements that will be adequate to meet our liquidity needs for the foreseeable future, including payment of interest on our Senior Credit Facility and payments on the Maryland Project Revenue Bonds and the Sacramento Bonds. We cannot assure, however, that our business will generate sufficient cash flow from operations, that any cost savings and any operating improvements will be realized or that future borrowings will be available to us under our Senior Credit Facility in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before maturity. We make no assurance that we will be able to refinance any of our indebtedness, including our Senior Credit Facility, on commercially reasonable terms or at all.
Our board of directors adopted a dividend policy, effective upon the closing of the Recapitalization in 2005, pursuant to which we paid quarterly dividends of $0.10 per share which totaled $29.2 million in 2006. We expect to pay quarterly dividends at an annual rate of approximately $0.40 per share, but only if and to the extent dividends are declared by our board of directors and permitted by applicable law and by the terms of our Senior Credit Facility (See Note 4). Dividend payments are not guaranteed and our board of directors may decide, in its absolute discretion, not to pay dividends. Dividends on our common stock are not cumulative. We declared a quarterly dividend of $0.10 per share in February 2007.
Series D Redeemable Preferred Stock
We have authorized 32,000 shares of Series D Preferred Stock, par value $.002 per share, and previously had outstanding 25,033.601 shares of the Series D Preferred Stock, which was held by GTCR Fund VII, L.P. and its
affiliates, and were convertible by the holders into a number of shares of our common stock computed by dividing (i) the sum of (a) the number of shares to be converted multiplied by the liquidation value and (b) the amount of accrued and unpaid dividends by (ii) the conversion price then in effect. The initial conversion price was $2.50 per share provided that in order to prevent dilution, the conversion price could be adjusted. The Series D Preferred Stock was senior to our common stock or any other of our equity securities. The liquidation value of each share of Series D Preferred Stock was $1,000 per share. Dividends on each share of Series D Preferred Stock accrued daily at the rate of 8 percent per annum on the aggregate liquidation value. Upon conversion of the Series D Preferred Stock by the holders, the holders could have elected to receive the accrued and unpaid dividends in shares of our common stock at the conversion price. The Series D Preferred Stock was entitled to one vote per share. Shares of Series D Preferred Stock were subject to mandatory redemption by us on January 26, 2010, at a price per share equal to the liquidation value plus accrued and unpaid dividends. On June 21, 2005, holders of our preferred stock converted all of their preferred shares into shares of our existing common stock.
Series E Redeemable Preferred Stock
We have authorized 55,000 shares of Series E Preferred Stock, par value $.002 per share, and previously had outstanding 37,497.183 shares of Series E Preferred Stock held by GTCR Fund VII, L.P. and 7,261.504 shares held by certain affiliates of The TCW Group, Inc. The Series E Preferred Stock was convertible by the holders into a number of shares of our common stock computed by dividing (i) the sum of (a) the number of shares to be converted multiplied by the liquidation value and (b) the amount of accrued and unpaid dividends by (ii) the conversion price then in effect. The initial conversion price was $2.50 per share provided that in order to prevent dilution, the conversion price could be adjusted. The Series E Preferred Stock was senior to our common stock and any other of our equity securities. The liquidation value of each share of Series E Preferred Stock was $1,000 per share. Dividends on each share of Series E Preferred Stock accrued daily at the rate of eight percent per annum on the aggregate liquidation value. Upon conversion of the Series E Preferred Stock by the holders, the holders could have elected to receive the accrued and unpaid dividends in shares of our common stock at the conversion price. The Series E Preferred Stock was entitled to one vote per share. Shares of Series E Preferred Stock were subject to mandatory redemption by us on January 26, 2010, at a price per share equal to the liquidation value plus accrued and unpaid dividends. On June 21, 2005, holders of our preferred stock converted all of their preferred shares into shares of our existing common stock.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” This statement establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions of SFAS No. 157 should be applied prospectively as of the beginning of the fiscal year in which SFAS No. 157 is initially applied, except in limited circumstances. We expect to adopt SFAS No. 157 beginning January 1, 2008. We are currently evaluating the impact that this interpretation may have on our consolidated financial statements.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”), which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The provisions of SAB No. 108 are effective for us beginning in the first quarter of 2007. We do not expect any impact to our consolidated financial statements upon adoption of SAB No. 108.
In June 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement 109 Accounting for Income Taxes, was issued (“FIN No. 48”). FIN No. 48 describes accounting for uncertainty in income taxes, and includes a recognition threshold and measurement attribute for recognizing the effect of a tax position taken or expected to be taken in a tax return. FIN No. 48 is effective for fiscal years ending
after December 15, 2006. We adopted FIN No. 48 on January 1, 2007, and will not have a material effect on our financial condition, results of operations, or cash flows.
In December 2004, SFAS No. 123 “Accounting for Stock-Based Compensation” was revised (“SFAS No. 123R”). SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires that companies record compensation expense for employee stock option awards. SFAS No. 123R is effective for annual periods beginning after June 15, 2005. We adopted SFAS No. 123R on January 1, 2006 using the modified prospective method. The impact of adopting SFAS No. 123R resulted in annual expense in 2006 of approximately $2.7 million.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations - An interpretation of FASB Statement No. 143” (“FIN No. 47”). FIN No. 47 clarifies the term conditional asset retirement obligation as used in SFAS No. 143, “Accounting for Asset Retirement Obligations”, and clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN No. 47 was effective for the year ended December 31, 2005, but did not have a material effect on our financial condition, results of operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140”. SFAS No. 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. This Statement also resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133. SFAS No. 140 is amended to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued during fiscal years beginning after September 15, 2006. We do not expect this statement to have a material impact on our consolidated financial statements.
Critical Accounting Estimates and Assumptions
In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following are our significant estimates and assumptions made in preparation of our financial statements that deal with the greatest amount of uncertainty:
Allowance for Doubtful Accounts - We estimate losses for uncollectible accounts receivables based on the aging of the accounts receivable and the evaluation and the likelihood of success in collecting the receivable. Accounts receivables are written off periodically during the year as they are deemed uncollectible when collection efforts have been unsuccessful. The allowance for doubtful accounts at December 31, 2006 and 2005 was approximately $1.0 million and $1.1 million, respectively and is recorded as a reduction of accounts receivables.
Loss Contracts - We evaluate our revenue producing contracts to determine whether the projected revenues of such contracts exceed the direct cost to service such contracts. These evaluations include estimates of the future revenues and expenses. Accruals for loss contracts are adjusted based on these evaluations. An accrual for loss contracts was not required as of December 31, 2006.
Long Term Construction Contracts - Certain long term construction projects are accounted for using the percentage of completion method of accounting and accordingly revenues are recorded based on estimates of total costs to be incurred under the contract. We typically subcontract a portion of the work to subcontractors under fixed price contracts. Costs and estimated earnings in excess of billings included in the accompanying consolidated balance sheets represents revenues recognized in excess of amounts billed under the terms of contracts accounted
for on the percentage of completion method of accounting. These amounts are billable upon completion of contract performance milestones or other specified conditions of the contract.
Property and Equipment/Long-Lived Assets - Property and equipment is reviewed for impairment pursuant to the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The carrying amount of an asset (group) is considered impaired if it exceeds the sum of our estimate of the undiscounted future cash flows expected to result from the use and eventual disposition of the asset (group), excluding interest charges. We did not have any asset impairments under the provisions of SFAS No. 144 as of December 31, 2006.
We regularly incur costs to develop potential projects or facilities and procure contracts for the design, permitting, construction and operations of facilities. We recorded $46.1 million in property and long-term assets related to these activities at December 31, 2006, compared to $12.3 million at December 31, 2005 (approximately $44.2 million and $10.4 million are classified as construction in progress as of December 31, 2006 and 2005, respectively). The increase at December 31, 2006 is primarily a result of the construction on the composting facility in Kern County, California (which began operations in January 2007) and an incinerator facility upgrade in Woonsocket, Rhode Island. As required under current accounting standards, we routinely review the status of each of these projects to determine if these costs are realizable.
Goodwill - Goodwill attributable to our reporting units is tested for impairment by comparing the fair value of each reporting unit with its carrying value. Significant estimates used in the determination of fair value include estimates of future cash flows, future growth rates; costs of capital and estimates of market multiples. As required under current accounting standards, we test for impairment annually at year end unless factors otherwise indicate that impairment may have occurred. We did not have any impairments under the provisions of SFAS No. 142 as of December 31, 2006.
Purchase Accounting - We estimate the fair value of assets, including property, machinery and equipment and its related useful lives and salvage values, and liabilities when allocating the purchase price of an acquisition.
Income Taxes - We assume the deductibility of certain costs in our income tax filings and estimate the recovery of deferred income tax assets. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the activity underlying these assets become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. If actual future taxable income differs from our estimates, we may not realize deferred tax assets to the extent we have estimated.
As of December 31, 2006, we had generated net operating loss (“NOL”) carryforwards of approximately $97.9 million available to reduce future income taxes. These carryforwards begin to expire in 2008. A change in ownership, as defined by federal income tax regulations, could significantly limit our ability to utilize our carryforwards. Accordingly, our ability to utilize our NOLs to reduce future taxable income and tax liabilities may be limited. Additionally, because federal tax laws limit the time during which these carryforwards may be applied against future taxes, we may not be able to take full advantage of these attributes for federal income tax purposes. We estimate that our effective tax rate in 2007 will approximate 42 percent of pre-tax income. Substantially all of our tax provision over the next several years is expected to be deferred in nature due to significant tax deductions in excess of book deductions for goodwill and depreciation.
Legal and Contingency Accruals - We estimate and accrue the amount of probable exposure we may have with respect to litigation, claims and assessments. These estimates are based on management’s assessment of the facts and the probabilities of the ultimate resolution of the litigation.
Derivatives - We have entered into various interest rate and natural gas derivatives to manage our exposure to changes in interest rates and natural gas prices. We estimate the fair value of these derivatives using market data, information provided by the counterparties to these arrangements and other information, as necessary.
Self-Insurance Reserves - We are substantially self-insured for workers’ compensation, employers’ liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses up to deductible amounts are
estimated and accrued based upon known facts, historical trends, industry averages and actuarial assumptions regarding future claims development and claims incurred but not reported.
Actual results could differ materially from the estimates and assumptions that we use in the preparation of our financial statements.
Off-Balance Sheet Arrangements - We do not have any material transactions that meet the definition of an off-balance sheet arrangement, other than operating leases.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We utilize financial instruments, which inherently have some degree of market risk due to interest rate fluctuations. Management is actively involved in monitoring exposure to market risk and continues to develop and utilize appropriate risk management techniques. We are not exposed to any other significant market risks, including commodity price risk, foreign currency exchange risk or interest rate risks from the use of derivative financial instruments. Management does not currently use derivative financial instruments for trading or to speculate on changes in interest rates or commodity prices.
Derivatives and Hedging Activities
Effective October 6, 2006, we entered into a interest rate corridor on a notional amount of $73.5 million whereby we will receive the difference between LIBOR and 5.5 percent if LIBOR is between 5.5 and 6.0 percent. We paid $129,000 to execute this agreement. This agreement expires May 2009. We chose not to designate the arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006, this corridor has a fair market value representing an asset of approximately $0.1 million; accordingly, approximately $23,000 has been recorded in Other Expense (Income), net.
Effective June 26, 2006, we entered into a five year natural gas swap on a monthly settlement volume of 10,416 mmbtu’s, whereby each month beginning January 2007, we receive the NYMEX price for 10,416 mmbtu’s and pay $8.41 for the 10,416 mmbtu’s. This swap is considered to be a cash flow hedge and accordingly the fair value adjustments will be recorded to Accumulated Other Comprehensive Income. The aggregate liability for the fair value of this agreement was approximately $0.5 million at December 31, 2006. Approximately, $0.4 million, net of tax, has been charged to Accumulated Other Comprehensive Income for the year ended December 31, 2006 for this agreement. This swap expires on December 2011.
Also effective June 26, 2006, we entered into a five year three way collar on a monthly settlement volume of 31,250 mmbtu’s, whereby each month beginning January 2007, we will receive the NYMEX price and pay the NYMEX price unless the NYMEX price settles below $6.17 per mmbtu or above $8.00 per mmbtu. If the NYMEX price settles below $6.17 per mmbtu, we will pay the difference between the NYMEX price and $6.17 per mmbtu. If the NYMEX price settles above $8.00 per mmbtu then we will receive the difference between the NYMEX price and $8.00 up to $10.00 per mmbtu. We chose not to designate the arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006, this collar has a fair market value representing a liability of approximately $0.4 million; accordingly, approximately $0.4 million has been recorded in Other Expense (Income), net. This collar expires December 2011.
Effective January 31, 2006, we entered into an interest rate cap agreement on a notional amount of $124.0 million whereby we receive three month LIBOR and pay three month LIBOR unless three month LIBOR settles above 5 percent, in such event we would pay 5 percent. We paid $174,000 to execute this cap. We chose not to designate this arrangement as a hedge. The fair value of the swap was approximately $0.2 million at December 31, 2006; accordingly, the change in the fair value totaling approximately $49,000 has been recorded to Other Expense (Income), net. This agreement expires May 2007.
Effective July 1, 2005, we entered into two interest rate agreements. The first is an interest rate collar agreement on a notional amount of $86.5 million, whereby we will receive three month LIBOR and pay three month LIBOR unless three month LIBOR settles below 3.52 percent or above 4.50 percent, in either such event we would pay 3.52 percent or 4.50 percent, as applicable. We chose not to designate this arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. The change in the fair value of approximately
$0.2 million has been recorded in Other Expense (Income), net for the year ended December 31, 2006. This swap expired November 2006.
Also effective July 1, 2005, we entered into an interest rate cap agreement on a notional amount of $73.5 million whereby we will receive three month LIBOR and pay three month LIBOR unless three month LIBOR settles above 6 percent in which case we would pay 6 percent. We paid $220,000 to execute this cap. We chose not to designate this arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006, this cap has a fair market value representing an asset of approximately $0.1 million; accordingly, the change in the fair value of approximately $0.2 million has been recorded in Other Expense (Income), net. This cap expires May 2009.
During the second quarter of 2005, we entered into three forward starting fixed rate swap agreements that were effective November 13, 2006, and mature in May 2010. The notional amount for each fixed rate swap is $28 million, and the fixed rates of interest are 4.69 percent, 4.54 percent, and 4.21 percent. These swaps are considered to be cash flow hedges and accordingly the fair value adjustments will be recorded to Accumulated Other Comprehensive Income and the cash settlements will be recorded to Interest Expense. The aggregate asset for the fair value of these agreements was approximately $1.3 million at December 31, 2006. Approximately $0.4 million, net of tax, has been included in Accumulated Other Comprehensive Income as of December 31, 2006 and approximately $0.1 million has been recorded as a reduction to Interest Expense as of December 31, 2006.
We previously had outstanding 12 percent subordinated debt which was repaid on April 17, 2002, with the proceeds from the sale of the Notes. On June 25, 2002, we entered into a floating-to-fixed interest rate swap agreement that substantially offsets market value changes in our reverse swap agreement (both of which will expire in January 2008). The liability related to this reverse swap agreement and the floating-to-fixed offset agreement totaling approximately $0.9 million is reflected in Other Long-Term Liabilities at December 31, 2006. The loss recognized during the year ended December 31, 2006 related to the floating-to-fixed interest rate swap agreement was approximately $0.3 million, while the gain recognized related to the reverse swap agreement was approximately $0.3 million. The amount of the ineffectiveness of the reverse swap agreement charged to Other Expense (Income), net was approximately $54,000 for the year ended December 31, 2006.
Interest Rate Risk
Total debt at December 31, 2006, included $215.2 million in floating rate debt at a base interest rate plus LIBOR. As a result, our interest cost in 2007 will fluctuate based on short-term interest rates. The impact on annual cash flow of a 10 percent change in the floating rate (i.e. LIBOR) would be approximately $0.6 million.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Board of Directors
Synagro Technologies, Inc.
We have audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Synagro Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Synagro Technologies, Inc. management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Synagro Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Synagro Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Synagro Technologies, Inc. as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year ended December 31, 2006 of Synagro Technologies, Inc. and our report dated March 2, 2007 expressed an unqualified opinion thereon.
/s/ Hein & Associates LLP
Houston, Texas
March 2, 2007
Report of Independent Registered Public Accounting Firm
To the Board of Directors
Synagro Technologies, Inc.
We have audited the consolidated balance sheet of Synagro Technologies, Inc. as of December 31, 2006, and the related consolidated statements of operations, stockholders’equity and cash flows for the year ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Synagro Technologies, Inc. as of December 31, 2006, and the results of its operations and its cash flows for the year ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Synagro Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria) and our report dated March 2, 2007 expressed an unqualified opinion thereon.
As discussed in Note 11 to the consolidated financial statements, the Company adopted Statement of Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” during the year ended December 31, 2006.
/s/ Hein & Associates LLP
Houston, Texas
March 2, 2007
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Synagro Technologies, Inc.:
In our opinion, the consolidated balance sheet as of December 31, 2005 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2005 present fairly, in all material respects, the financial position of Synagro Technologies, Inc. and its subsidiaries at December 31, 2005, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Houston, TX
March 29, 2006
SYNAGRO TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands Except Share Data)
The accompanying notes are an integral part of these consolidated financial statements.
SYNAGRO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
SYNAGRO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
for the years ended December 31, 2006, 2005 and 2004
The accompanying notes are an integral part of these consolidated financial statements.
SYNAGRO TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
NONCASH INVESTING AND FINANCING ACTIVITIES RELATING
TO CONSOLIDATED STATEMENT OF CASH FLOWS
During 2004, dividends totaled approximately $8.8 million, of which approximately $7.8 million represents the eight percent dividend on the Company’s preferred stock that was provided for with additional shares of preferred stock, and approximately $1.0 million represents accretion and amortization of issuance costs.
During 2004, the Company entered into a $4.0 million note to purchase land and entered into capital lease agreements with obligations of approximately $1.7 million to purchase operating and transportation equipment.
During 2005, dividends on preferred shares totaled approximately $9.6 million, of which approximately $3.9 million represents the eight percent dividend on the Company’s preferred stock that was provided for with additional shares of preferred stock, approximately $4.9 million represents accretion and $0.8 million represents amortization and write off of issuance costs.
During 2005, the Company entered into capital lease agreements with obligations of approximately $4.5 million to purchase operating and transportation equipment.
During 2006, the Company entered into capital lease agreements with obligations of approximately $3.4 million to purchase operating and transportation equipment.
The accompanying notes are an integral part of these consolidated financial statements.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Business and Summary of Significant Accounting Policies
Business and Organization
Synagro Technologies, Inc., a Delaware corporation (“Synagro”), and collectively with its subsidiaries (the “Company”) is a national water and wastewater residuals management company serving more than 600 municipal and industrial water and wastewater treatment accounts and has operations in 33 states and the District of Columbia. Synagro offers many services that focus on the beneficial reuse of organic nonhazardous residuals resulting from the wastewater treatment process. Our broad range of services include drying and pelletization, composting, product marketing, incineration, alkaline stabilization, land application, transportation, regulatory compliance, dewatering, and facility cleanout services.
Secondary Equity Offering
On May 16, 2006, the Company completed a secondary equity offering at $4.15 per share for 19,129,710 shares of common stock, including 15,129,710 shares held by stockholders for which the Company did not receive any proceeds and 4,000,000 shares issued by the Company. The Company received total net proceeds from the sale of the 4,000,000 shares, after underwriting discounts and commissions and offering expenses, of approximately $15.9 million. The Company used the net proceeds from the offering for working capital and general corporate purposes.
Recapitalization
On June 21, 2005, the Company executed a $305 million senior credit agreement (See Note 4), repaid $196.9 million of debt under its previously outstanding senior credit agreement and 91/2% senior subordinated notes due 2009, converted all outstanding shares of preferred stock into 41,885,597 shares of common stock, and completed a $160 million offering of 9,302,326 primary and 27,847,674 secondary shares of common stock at an offering price of $4.30 per share. The credit agreement allows the Company to pay dividends and also resulted in significant cash interest savings when compared to the interest costs of the Company’s previously outstanding senior and subordinated debt. The credit agreement, debt repayment, preferred stock conversion, and primary and secondary common stock offering referenced in this paragraph, are collectively referred to herein as the “Recapitalization”.
The Company incurred certain costs and write-offs relating to the Recapitalization, including $1.5 million of transaction costs and expenses, $5.5 million for stock option redemptions, $1.3 million for transaction bonuses and $19.5 million of debt extinguishment costs. The $5.5 million charge for stock options redeemed relates to 3,043,000 options that were redeemed for $5.5 million of cash. The Company also recognized as dividends $4.4 million of previously unrecognized accretion on its preferred stock. These costs, write-offs and accretion have been included in the Company’s statements of operations for the year ended December 31, 2005.
Principles of Consolidation
The consolidated financial statements include the accounts of Synagro and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated.
Cash Equivalents
The Company considers all investments with an original maturity of three months or less when purchased to be cash equivalents.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Costs and Estimated Earnings in Excess of Billings
The asset “Costs and estimated earnings in excess of billings” represents revenues recognized in excess of amounts billed under the terms of contracts accounted for under the percentage of completion method of accounting. These amounts are billable upon completion of contract performance milestones or other specified conditions of the contracts.
Property, Machinery and Equipment, net
Property, machinery and equipment are stated at cost less accumulated depreciation. Depreciation is recorded using the straight-line method over estimated useful lives of three to thirty years, net of estimated salvage values. Leasehold improvements are capitalized and amortized over the lesser of the lease term or the estimated useful life of the asset.
Expenditures for repairs and maintenance are charged to expense when incurred. Expenditures for major renewals and betterments, which extend the useful lives of existing equipment, are capitalized and depreciated. Upon retirement or disposition of property, machinery and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in income from operations in the consolidated statements of operations.
Interest is capitalized on certain assets under construction. Capitalized interest included in construction in process totaled approximately $2.2 million, $0.1 million and $2.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Goodwill
Goodwill represents the excess of aggregate purchase price paid by the Company in acquisitions accounted for as purchases over the fair value of the net identifiable assets acquired. Goodwill attributable to the Company’s reporting units is tested for impairment by comparing the fair value of each reporting unit with its carrying value. Significant estimates used in the determination of fair value include estimates of future cash flows, future growth rates, costs of capital and estimates of market multiples. As required under current accounting standards, the Company tests for impairment annually unless factors otherwise indicate that an impairment may have occurred.
Self-Insurance Liabilities
The Company is substantially self-insured for worker’s compensation, employer’s liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles the Company absorbs under its insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends, industry averages and actuarial assumptions regarding future claims development and claims incurred but not reported.
Deferred Financing Costs
Deferred financing costs, net of accumulated amortization at December 31, 2006 and 2005, totaled approximately $6.1 million and $7.0 million, respectively, and are included in other assets. Deferred financing costs are amortized to interest expense on a straight-line basis over the life of the underlying instruments, which is not materially different from the effective interest method.
Revenue Recognition
Revenues generated from facilities operations and maintenance contracts are recognized either when wastewater residuals enter the facilities or when the residuals have been processed, depending on the contract terms. All other revenues under service contracts are recognized when the service is performed.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Revenues related to long-term fixed price projects are recognized in accordance with percentage-of-completion accounting guidance. Percentage of completion is measured principally by the percentage of costs incurred to date for each contract to the estimated total costs for each contract at completion. Due to uncertainties inherent in the estimation process, it is reasonably possible that the estimated completion costs will be revised in the near term. Such revisions to cost and income are recognized in the periods in which the revisions are determined.
The Company provides for losses in connection with its contracts where an obligation exists to perform services and when it becomes evident the projected contract costs exceed the related revenues.
Use of Estimates
In preparing financial statements in conformity with accounting principles generally accepted in the United States, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following are the Company’s significant estimates and assumptions made in preparation of its financial statements that deal with the greatest amount of uncertainty:
Allowance for Doubtful Accounts - The Company estimates losses for uncollectible accounts based on the aging of the accounts receivable and the evaluation and the likelihood of success in collecting the receivable. Accounts are written off periodically during the year as they are deemed uncollectible when collection efforts have been unsuccessful. The allowance for doubtful accounts at December 31, 2006 and 2005 was approximately $1.0 million and $1.1 million, respectively, and is recorded as a reduction of accounts receivable.
Loss Contracts - The Company evaluates its revenue producing contracts to determine whether the projected revenues of such contracts exceed the direct cost to service such contracts. These evaluations include estimates of the future revenues and expenses. Accruals for loss contracts are adjusted based on these evaluations. An accrual for loss contracts was not required as of December 31, 2006 and 2005.
Long Term Construction Contracts - Certain long term construction projects are accounted for using the percentage of completion method of accounting and accordingly revenues are recorded based on estimates of total costs to be incurred under the contract. The Company typically subcontracts a portion of the work to subcontractors under fixed price contracts. Costs and estimated earnings in excess of billings included in the accompanying consolidated balance sheets represents revenues recognized in excess of amounts billed under the terms of contracts accounted for on the percentage of completion method of accounting. These amounts are billable upon completion of contract performance milestones or other specified conditions of the contract.
Property and Equipment/Long-Lived Assets - Property and equipment is reviewed for impairment pursuant to the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The carrying amount of an asset (group) is considered impaired if it exceeds the sum of the Company’s estimate of the undiscounted future cash flows expected to result from the use and eventual disposition of the asset (group), excluding interest charges. The Company did not have any asset impairments under the provisions of SFAS No. 144 as of December 31, 2006.
The Company regularly incurs costs to develop potential projects or facilities and procure contracts for the design, permitting, construction and operations of facilities. The Company has recorded $46.1 million in property and long-term assets related to these activities at December 31, 2006, compared to $12.3 million at December 31, 2005 (approximately $44.2 million and $10.4 million are classified as construction in progress as of December 31, 2006 and 2005, respectively). The increase at December 31, 2006 is primarily a result of the construction on the composting facility in Kern County, California and an incinerator facility upgrade in Woonsocket, Rhode Island. The Company routinely reviews the status of each of these projects to determine if these costs are realizable.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Goodwill - Goodwill attributable to the Company’s reporting units is tested for impairment by comparing the fair value of each reporting unit with its carrying value. Significant estimates used in the determination of fair value include estimates of future cash flows, future growth rates, costs of capital and estimates of market multiples. As required under current accounting standards, the Company tests for impairment annually unless factors otherwise indicate that an impairment may have occurred. The Company did not have any impairments under the provisions of SFAS No. 142 as of December 31, 2006.
Purchase Accounting - The Company estimates the fair value of assets, including property, machinery and equipment and its related useful lives and salvage values, and liabilities when allocating the purchase price of an acquisition.
Income Taxes - The Company assumes the deductibility of certain costs in its income tax filings and estimates the recovery of deferred income tax assets. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the activity underlying these assets become deductible. The Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. If actual future taxable income differs from its estimates, the Company may not realize deferred tax assets to the extent it was estimated.
As of December 31, 2006, the Company had generated net operating loss (“NOL”) carryforwards of approximately $97.9 million available to reduce future income taxes. These carryforwards begin to expire in 2008. A change in ownership, as defined by federal income tax regulations, could significantly limit the Company’s ability to utilize its carryforwards. Accordingly, the Company’s ability to utilize its NOLs to reduce future taxable income and tax liabilities may be limited. Additionally, because federal tax laws limit the time during which these carryforwards may be applied against future taxes, the Company may not be able to take full advantage of these attributes for federal income tax purposes. The Company estimates that our effective tax rate in 2007 will approximate 42 percent of pre-tax income. Substantially all of the Company’s tax provision over the next several years is expected to be deferred in nature due to significant tax deductions in excess of book deductions for goodwill and depreciation.
Legal and Contingency Accruals - The Company estimates and accrues the amount of probable exposure it may have with respect to litigation, claims and assessments. These estimates are based on management’s facts and the probabilities of the ultimate resolution of the litigation.
Derivatives - The Company has entered into various interest rate and natural gas derivatives to manage its exposure to changes in interest rates and natural gas prices. The Company estimates the fair value of these derivatives using market data, information provided by the counterparties to these arrangements and other information, as necessary.
Self-Insurance Reserves - The Company is substantially self-insured for workers’ compensation, employers’ liability, auto liability, general liability and employee group health claims in view of the relatively high per-incident deductibles the Company absorbs under its insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends, industry averages and actuarial assumptions regarding future claims development and claims incurred but not reported.
Actual results could differ materially from the estimates and assumptions that the Company uses in the preparation of its financial statements.
Off-Balance Sheet Arrangements - The Company does not have any material transactions that meet the definition of an off-balance sheet arrangement, other than operating leases.
Concentration of Credit Risk
The Company provides services to a broad range of geographical regions. The Company’s credit risk primarily consists of receivables from a variety of customers including state and local agencies, municipalities and private industries. The Company had one customer that accounted for approximately 16 percent of total revenue for the years ended December 31, 2006, 2005 and 2004. No other customers accounted for more than ten percent of revenues. Municipal customers accounted for 88 percent of consolidated revenues for the years ended December 31, 2006, 2005 and 2004.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, receivables, accounts payable and accrued liabilities approximate their fair values because of the short-term nature of these instruments. Management believes the carrying amounts of the current and long-term debt approximate their fair value based on interest rates for the same or similar debt offered to the Company having the same or similar terms and maturities.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Taxes
The Company files a consolidated return for federal income tax purposes. The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” This standard provides the method for determining the appropriate asset and liability for deferred income taxes, which are computed by applying applicable tax rates to temporary differences. Therefore, expenses recorded for financial statement purposes before they are deducted for income tax purposes create temporary differences, which give rise to deferred income tax assets. Expenses deductible for income tax purposes before they are recognized in the financial statements create temporary differences which give rise to deferred income tax liabilities.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions of SFAS No. 157 should be applied prospectively as of the beginning of the fiscal year in which SFAS No. 157 is initially applied, except in limited circumstances. The Company expects to adopt SFAS No. 157 beginning January 1, 2008. The Company is currently evaluating the impact that this interpretation may have on its consolidated financial statements.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB No. 108), which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The provisions of SAB No. 108 are effective for the Company beginning in the first quarter of 2007. The Company does not expect any impact to its consolidated financial statements upon adoption of SAB No. 108.
In June 2006, FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement 109 Accounting for Income Taxes, was issued. FIN No. 48 describes accounting for uncertainty in income taxes, and includes a recognition threshold and measurement attribute for recognizing the effect of a tax position taken or expected to be taken in a tax return. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN No. 48 on January 1, 2007, and will not have a material effect on the Company’s financial condition, results of operations, or cash flows.
In December 2004, SFAS No. 123 “Accounting for Stock-Based Compensation” was revised (“SFAS No. 123R”). SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires that companies record compensation expense for employee stock option awards. SFAS No. 123R is effective for annual periods beginning after June 15, 2005. The Company adopted SFAS No. 123R on January 1, 2006 using the modified prospective method. See Note 11.
In March 2005, FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations - An interpretation of FASB Statement No. 143”, was issued. FIN No. 47 clarifies the term conditional asset retirement obligation as used in SFAS No. 143, “Accounting for Asset Retirement Obligations”, and clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN No. 47 was effective for the year ended December 31, 2005, but did not have a material effect on the Company’s financial condition, results of operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140”. SFAS No. 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and SFAS No. 140, “Accounting for Transfers and Servicing of
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Financial Assets and Extinguishments of Liabilities”. This Statement also resolves issues addressed in Statement No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133. SFAS No. 140 is amended to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued during fiscal years beginning after September 15, 2006. The Company does not expect this statement to have a material impact on its consolidated financial statements.
Reclassifications
Certain reclassifications have been made in prior period financial statements to conform to current period presentation. These reclassifications have not resulted in any changes to previously reported net income for any periods. The Company has reclassified prior year book overdrafts totaling $1.7 million for the year ended December 31, 2004 in the Statement of Cash Flows from an operating activity to a financing activity to conform to the current year presentation.
(2) Property, Machinery and Equipment
Property, machinery and equipment consist of the following:
Depreciation expense for the years ended December 31, 2006, 2005 and 2004 was $23.1 million, $21.4 million and $19.8 million, respectively.
(3) Detail of Certain Balance Sheet Accounts
Activity of the Company’s allowance for doubtful accounts consists of the following:
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Activity of the Company’s costs and estimated earnings in excess of billings consists of the following:
Accounts payable includes approximately $1.1 and $9.3 million at December 31, 2006 and December 31, 2005, respectively, for contracts accounted for under the percentage of completion method of accounting, the majority of which is not payable until the Company collects its customer billings on the related contracts.
Prepaid and other current assets consist of the following:
The changes in the carrying amount of goodwill for the years ended December 31, 2006 and 2005 were as follows (in thousands):
The goodwill additions in 2006 and 2005 primarily represent the recording of contingent consideration for previous acquisitions. Such agreements may result in contingent consideration payments through 2008.
Accrued expenses consist of the following:
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(4) Long-Term Debt Obligations
Long-term debt obligations consist of the following:
Senior Credit Facility
On June 21, 2005, the Company closed a $305.0 million senior secured credit facility (the “Senior Credit Facility”) with a syndicate of financial institutions, including affiliates of Banc of America Securities LLC, Lehman Brothers Inc. and CIBC World Markets Corp. A portion of the proceeds received from the Senior Credit Facility were used to repay the Company’s $150 million amended and restated Senior Credit Agreement, entered into on May 8, 2002 by and among the Company, Bank of America, N.A. and certain other lenders (the “Senior Credit Agreement”) and to tender for all of its $150 million of outstanding 91/2 percent senior subordinated notes due April 1, 2009 (the “Notes”).
The loan commitments under the Senior Credit Facility are as follows:
(i) Revolving Loan (“Revolver”) up to $95.0 million outstanding at anytime;
(ii) Term B Loans (which, once repaid, may not be reborrowed) of $210.0 million, including $30.0 million borrowed in December 2005; and
(iii) Letters of Credit up to $50.0 million as a subset of the Revolver. At December 31, 2006, the Company had approximately $38.4 million of letters of credit outstanding.
The Revolver has a five-year maturity and the term loans have a seven-year maturity. The Senior Credit Facility is secured by first priority security interests in substantially all of the Company’s assets and those of its subsidiaries (other than assets securing nonrecourse debt) and expires on December 31, 2012. There is no amortization of the term loan. The term loan bears interest at LIBOR or prime rate plus a margin (2.25 percent for Eurodollar loans, and 1.25 percent for base rate loans), and the Revolver bears interest at LIBOR or prime rate plus a margin based on a rate schedule (currently 2.75 percent for Eurodollar loans, and 1.75 percent for base rate loans). As of December 31, 2006, these rates total approximately:
As of December 31, 2006, the Company had $5.2 million borrowed on its Revolver.
The Senior Credit Facility allows the Company to pay a significant portion of its excess cash flow to shareholders through cash dividends provided the Company maintains compliance with certain financial covenants and certain other restrictions.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The proceeds of the $30.0 million term loan drawn in December 2005 were used to partially fund new facility construction costs in 2006. The development of these new facilities is consistent with the Company’s strategy to pursue new facility opportunities that provide long-term, highly predictable cash flows. These facilities include a composting facility in Kern County, California and an incineration facility upgrade in Woonsocket, Rhode Island.
The Senior Credit Facility includes mandatory repayment provisions related to excess cash flows, proceeds from certain asset sales, debt issuances and equity issuances, all as defined in the Senior Credit Facility. These mandatory repayment provisions may also reduce the available commitment. The Senior Credit Facility contains standard covenants including compliance with laws, limitations on capital expenditures, restrictions on dividend payments, limitations on mergers and compliance with financial covenants. The Company was in compliance with those covenants as of December 31, 2006. As of December 31, 2006, the Company had approximately $51.4 million of unused borrowings under the Senior Credit Facility.
On March 6, 2006, the Company amended its Senior Credit Facility to, among other things, increase the maximum amount of debt permitted under the leverage ratio and to decrease the minimum amount of interest coverage required under the interest coverage ratio.
Senior Subordinated Notes
In April 2002, the Company issued the Notes. The Notes were unsecured senior indebtedness and were guaranteed by all of the Company’s existing and future domestic subsidiaries, other than subsidiaries treated as unrestricted subsidiaries (“Guarantors”). As of December 31, 2004, all subsidiaries, other than the subsidiaries formed to own and operate the Sacramento dryer project, Synagro Organic Fertilizer Company of Sacramento, Inc. and Sacramento Project Finance, Inc. (See Note 5) and South Kern Industrial Center, LLC, were Guarantors of the Notes. On June 21, 2005, the Notes were repurchased with the proceeds of the Senior Credit Facility.
Notes Payable to Sellers of Acquired Businesses
In connection with previous acquisitions, the Company has $2.5 million in notes payable with certain former owners, which includes payments for contingent consideration. The notes payable are due through December 31, 2008 in installments with interest payable at annual rates ranging from five to eight percent.
Future Payments
At December 31, 2006, future minimum principal payments of long-term debt, nonrecourse Project Revenue Bonds (see Note 5) and Capital Lease Obligations (see Note 6) are as follows (in thousands):
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(5) Nonrecourse Project Revenue Bonds
Nonrecourse project revenue bonds consist of the following:
Maryland Project Revenue Bonds
In 1996, the Maryland Energy Financing Administration (the “Administration”) issued nonrecourse tax-exempt project revenue bonds (the “Maryland Project Revenue Bonds”) in the aggregate amount of $58.6 million. The Administration loaned the proceeds of the Maryland Project Revenue Bonds to Wheelabrator Water Technologies Baltimore L.L.C., now the Company’s wholly owned subsidiary known as Synagro-Baltimore, L.L.C., pursuant to a June 1996 loan agreement, and the terms of the loan mirror the terms of the Maryland Project Revenue Bonds. The loan financed a portion of the costs of constructing thermal facilities located in Baltimore County, Maryland, at the site of its Back River Wastewater Treatment Plant, and in the City of Baltimore, Maryland, at the site of its Patapsco Wastewater Treatment Plant. The Company assumed all obligations associated with the Maryland Project Revenue Bonds in connection with its acquisition of the Bio Gro division of Waste Management, Inc. (“Bio Gro”) in 2000. Maryland Project Revenue Bonds in the aggregate amount of approximately $22.8 million have already been repaid. The remaining Maryland Project Revenue Bonds bear interest at annual rates between 6.30 percent and 6.45 percent and mature on dates between December 1, 2007, and December 1, 2016.
The Maryland Project Revenue Bonds are primarily collateralized by the pledge of revenues and assets related to the Company’s Back River and Patapsco thermal facilities. The underlying service contracts between the Company and the City of Baltimore obligated the Company to design, construct and operate the thermal facilities and obligated the City of Baltimore to deliver biosolids for processing at the thermal facilities. The City of Baltimore makes all payments under the service contracts directly with a trustee for the purpose of paying the Maryland Project Revenue Bonds.
At the Company’s option, it may cause the redemption of the Maryland Project Revenue Bonds at any time on or after December 1, 2006, subject to redemption prices specified in the loan agreement. The Maryland Project Revenue Bonds will be redeemed at any time upon the occurrence of certain extraordinary conditions, as defined in the loan agreement.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Synagro-Baltimore, L.L.C. guarantees the performance of services under the underlying service agreements with the City of Baltimore. Under the terms of the Bio Gro acquisition purchase agreement, Waste Management, Inc. also guarantees the performance of services under those service agreements. Synagro has agreed to pay Waste Management $0.5 million per year beginning in 2007 until the Maryland Project Revenue Bonds are paid or its guarantee is removed. Neither Synagro-Baltimore, L.L.C nor Waste Management has guaranteed payment of the Maryland Project Revenue Bonds or the loan funded by the Maryland Project Revenue Bonds.
The loan agreement, based on the terms of the related indenture, requires that Synagro place certain monies in restricted fund accounts and that those funds be used for various designated purposes (e.g., debt service reserve funds, bond funds, etc.). Monies in these funds will remain restricted until the Maryland Project Revenue Bonds are paid.
At December 31, 2006, the Maryland Project Revenue Bonds were collateralized by property, machinery and equipment with a net book value of approximately $50.2 million and restricted cash of approximately $6.1 million, of which approximately $5.3 million is in a debt service fund that is established to partially secure certain payments and can be utilized to make the final payment at the Company’s request.
Sacramento Project Bonds
In December 2002, the California Pollution Control Financing Authority (the “Authority”) issued nonrecourse revenue bonds in the aggregate amount of $20.9 million (net of original issue discount of $0.4 million). The nonrecourse revenue bonds consist of $19.7 million (net of original issue discount of $0.4 million) Series 2002-A and $1.2 million (net of original issue discount of $9,000) Series 2002-B (collectively, the “Sacramento Bonds”). The Authority loaned the proceeds of the Sacramento Bonds to Sacramento Project Finance, Inc., a wholly owned subsidiary of the Company, pursuant to a loan agreement dated December 1, 2002. The purpose of the loan was to finance the design, permitting, construction of a biosolids dewatering and heat drying/pelletizing facility for the Sacramento Regional County Sanitation District (“Sanitation District”). Sacramento Bonds in the aggregate amount of approximately $1.2 million have already been repaid. The remaining Sacramento Bonds bear interest at annual rates between 4.375 percent and 5.50 percent and mature on dates between December 1, 2007, and December 1, 2024. The Sacramento facility has been constructed and commenced commercial operations in December 2004.
The Sacramento Bonds are primarily collateralized by the pledge of certain revenues and all of the property of Sacramento Project Finance, Inc. The facility will be owned by Sacramento Project Finance, Inc. and leased to Synagro Organic Fertilizer Company of Sacramento, Inc., another wholly owned subsidiary of the Company. Synagro Organic Fertilizer Company of Sacramento, Inc. will be obligated under a lease agreement dated December 1, 2002, to pay base rent to Sacramento Project Finance, Inc. in an amount exceeding the debt service of the Sacramento Bonds. The facility will be located on property owned by the Sanitation District. The Sanitation District will provide the principal source of revenues to Synagro Organic Fertilizer Company of Sacramento, Inc. through a service fee under a contract that has been executed.
At the Company’s option, it may cause the early redemption of some Sacramento Bonds at any time on or after December 1, 2007, subject to redemption prices specified in the loan agreement.
The loan agreement requires that Sacramento Project Finance, Inc. place certain monies in restricted accounts and that those funds be used for designated purposes (e.g., operation and maintenance expense account, reserve requirement accounts, etc.). Monies in these funds will remain restricted until the Sacramento Bonds are paid.
At December 31, 2006, the Sacramento Bonds are partially collateralized by restricted cash of approximately $2.3 million, of which approximately $1.7 million is in a debt service fund that was established to secure certain payments and can be utilized to make the final payment at the Company’s request, and the remainder is reserved for construction costs expected to be incurred after notice to proceed is received. The Company is not a guarantor of the Sacramento Bonds or the loan funded by the Sacramento Bonds.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Maryland Project Revenue Bonds and the Sacramento Bonds are excluded from the financial covenant calculations required by the Company’s Senior Credit Facility.
(6) Capital Lease Obligations
The Company has entered into various capital lease transactions to purchase transportation and operating equipment. The capital leases have lease terms of three to six years with interest rates ranging from 4.9 percent to 9.34 percent. The net book value of the equipment related to capital leases totaled approximately $18.3 million and $17.3 million as of December 31, 2006 and 2005, respectively.
Future minimum lease payments, together with the present value of the minimum lease payments, are as follows (in thousands):
(7) Income Taxes
The following summarizes the provision for income taxes included in the Company’s consolidated statement of operations:
Federal and state income tax provisions (benefits) are as follows:
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Actual income tax provision differs from income tax provision computed by applying the U.S. federal statutory corporate rate of 35 percent to income before provision for income taxes as follows:
Deferred taxes for temporary differences are reported at the statutory rates that are expected to be in effect when the temporary differences reverse into taxable income in future periods. The Company completed a legal entity restructuring in the fourth quarter of 2005 which is expected to simplify federal and state tax compliance requirements. As a result of the restructuring, the Company increased its net deferred tax liability for state statutory rates that are expected to be in effect for future taxable income related to temporary differences from 3.4 percent to 5.0 percent. The Company also recorded a reserve for a tax contingency which relates to a tax issue identified during a tax audit related to deductions that are included in the Company’s net operating loss carryforwards.
Significant components of the Company’s deferred tax assets and liabilities for federal income taxes consist of the following (in thousands):
As of December 31, 2006, the Company had net operating loss (“NOL”) carryforwards of approximately $97.9 million available to reduce future income taxes. These carryforwards begin to expire in 2008. A change in ownership, as defined by federal income tax regulations, could significantly limit the Company’s ability to utilize its
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
carryforwards. Accordingly, the Company’s ability to utilize its NOLs to reduce future taxable income and tax liabilities may be limited for both federal and state purposes. Additionally, because federal tax laws limit the time during which these carryforwards may be applied against future taxes, the Company may not be able to take full advantage of these attributes for federal income tax purposes. The net deferred tax liability is recorded in other long-term liabilities in the accompanying consolidated balance sheet. Substantially all of the Company’s tax provision over the next several years is expected to be deferred in nature due to significant tax deductions in excess of book deduction for goodwill and depreciation.
(8) Derivatives and Hedging Activities
Effective October 6, 2006, the Company entered into an interest rate corridor agreement on a notional amount of $73.5 million whereby the Company will receive the difference between LIBOR and 5.5 percent if LIBOR is between 5.5 and 6.0 percent. The Company paid $129,000 to execute this agreement. This agreement expires May, 2009. The Company chose not to designate this agreement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006 this corridor has a fair market value representing an asset of approximately $0.1 million; accordingly, approximately $23,000 has been recorded in Other Expense (Income), net.
Effective June 26, 2006, the Company entered into a five year natural gas swap on a monthly settlement volume of 10,416 mmbtu’s, whereby each month beginning January 2007, the Company receives the NYMEX price for 10,416 mmbtu’s and pays $8.41 for the 10,416 mmbtu’s. This swap is considered to be a cash flow hedge and accordingly the fair value adjustments will be recorded to Accumulated Other Comprehensive Income. The aggregate liability for the fair value of this agreement was approximately $0.5 million at December 31, 2006. Approximately, $0.4 million, net of tax, has been charged to Accumulated Other Comprehensive Income for the year ended December 31, 2006 for this agreement. This swap expires December 2011.
Also effective June 26, 2006, the Company entered into a five year three way collar on a monthly settlement volume of 31,250 mmbtu’s, whereby each month beginning January 2007, the Company will receive the NYMEX price and pay the NYMEX price unless the NYMEX price settles below $6.17 per mmbtu or above $8.00 per mmbtu. If the NYMEX price settles below $6.17 per mmbtu, the Company will pay the difference between the NYMEX price and $6.17 per mmbtu. If the NYMEX price settles above $8.00 per mmbtu then the Company will receive the difference between the NYMEX price and $8.00 up to $10.00 per mmbtu. The Company chose not to designate the arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006 this collar has a fair market value representing a liability of approximately $0.4 million; accordingly, approximately $0.4 million has been recorded in Other Expense (Income), net. This collar expires December 2011.
Effective January 31, 2006, the Company entered into an interest rate cap agreement on a notional amount of $124.0 million whereby it receives three month LIBOR and pays three month LIBOR unless three month LIBOR settles above 5 percent, in such event it would pay 5 percent. The Company paid $174,000 to execute this cap. The Company chose not to designate this arrangement as a hedge. The fair value of the swap representing an asset was approximately $0.2 million at December 31, 2006; accordingly, the change in the fair value totaling approximately $49,000 has been recorded to Other Expense (Income), net. This agreement expires May 2007.
Effective July 1, 2005, the Company entered into two interest rate agreements. The first is an interest rate collar agreement on a notional amount of $86.5 million, whereby the Company will receive three month LIBOR and pay three month LIBOR unless three month LIBOR settles below 3.52 percent or above 4.50 percent, in either such event the Company would pay 3.52 percent or 4.50 percent, as applicable. The Company chose not to designate this arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. The change in the fair value of approximately $0.2 million has been recorded in Other Expense (Income), net for the year ended December 31, 2006. The swap expired November 2006.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Also effective July 1, 2005, the Company entered into an interest rate cap agreement on a notional amount of $73.5 million whereby the Company will receive three month LIBOR and pay three month LIBOR unless three month LIBOR settles above 6 percent, in which case the Company would pay 6 percent. The Company paid $220,000 to execute this cap. The Company chose not to designate this arrangement as a hedge. Accordingly, changes in its fair value are recorded in Other Expense (Income), net. At December 31, 2006, this cap has a fair market value representing an asset of approximately $0.1 million; accordingly, the change in the fair value of approximately $0.2 million has been recorded in Other Expense (Income), net. This cap expires May 2009.
During the second quarter in 2005, the Company entered into three forward starting fixed rate swap agreements that were effective November 13, 2006, and mature in May 2010. The notional amount for each fixed rate swap is $28 million, and the fixed rates of interest are 4.69 percent, 4.54 percent, and 4.21 percent. These swaps are considered to be cash flow hedges and accordingly the fair value adjustments will be recorded to Accumulated Other Comprehensive Income and the cash settlements will be recorded to Interest Expense. The aggregate asset for the fair value of these agreements was approximately $1.3 million at December 31, 2006. Approximately $0.4 million, net of tax, has been included in Accumulated Other Comprehensive Income for the year ended December 31, 2006 and approximately $0.1 million has been recorded as a reduction to Interest Expense as of December 31, 2006.
The Company previously had outstanding 12 percent subordinated debt which was repaid on April 17, 2002, with the proceeds from the sale of the Notes. On June 25, 2002, the Company entered into a floating-to-fixed interest rate swap agreement that substantially offsets market value changes in the Company’s reverse swap agreement (both of which will expire in January 2008). The liability related to this reverse swap agreement and the floating-to-fixed offset agreement totaling approximately $0.9 million is reflected in Other Long-term Liabilities at December 31, 2006. The loss recognized during the year ended December 31, 2006 related to the floating-to-fixed interest rate swap agreement was approximately $0.3 million, while the gain recognized related to the reverse swap agreement was approximately $0.3 million. The amount of the ineffectiveness of the reverse swap agreement charged to Other Expense (Income), net was approximately $54,000 during the year ended December 31, 2006.
(9) Commitments and Contingencies
Leases
The Company leases certain facilities and equipment for its corporate and operations offices under noncancelable long-term operating lease agreements. Rental expense was approximately $14.7 million for 2006 and $12.5 million for 2005 and 2004. Minimum annual rental commitments under these leases are as follows (in thousands):
Customer Contracts
A substantial portion of the Company’s revenue is derived from services provided under contracts and written agreements with the Company’s customers. Some of these contracts, especially those contracts with large
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
municipalities (including its largest contract and at least four of the Company’s top ten contracts), provide for termination of the contract by the customer after giving relatively short notice (in some cases as little as ten days). In addition, these contracts contain liquidated damages clauses which may or may not be enforceable in the case of early termination of the contracts. If one or more of these contracts are terminated prior to the expiration of its term, and the Company is not able to replace revenues from the terminated contracts or receive liquidated damages pursuant to the terms of the contract, the lost revenue could have a material and adverse effect on the Company’s business, financial condition, results of operations and cash flows.
Litigation
The Company’s business activities are subject to environmental regulation under federal, state and local laws and regulations. In the ordinary course of conducting its business activities, the Company becomes involved in judicial and administrative proceedings involving governmental authorities at the federal, state and local levels. The Company believes that these matters will not have a material adverse effect on its business, financial condition, results of operations and cash flows. However, the outcome of any particular proceeding cannot be predicted with certainty. The Company is required under various regulations to procure licenses and permits to conduct its operations. These licenses and permits are subject to periodic renewal without which its operations could be adversely affected. There can be no assurance that regulatory requirements will not change to the extent that it would materially affect the Company’s consolidated financial statements.
Reliance Insurance
For the 24 months ended October 31, 2000 (the “Reliance Coverage Period”), the Company insured certain risks, including automobile, general liability, and worker’s compensation, with Reliance National Indemnity Company (“Reliance”) through policies totaling $26 million in annual coverage. On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order appointing the Pennsylvania Insurance Commissioner as Rehabilitator and directing the Rehabilitator to take immediate possession of Reliance’s assets and business. On June 11, 2001, Reliance’s ultimate parent, Reliance Group Holdings, Inc., filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code of 1978, as amended. On October 3, 2001, the Pennsylvania Insurance Commissioner removed Reliance from rehabilitation and placed it into liquidation.
Claims have been asserted and/or brought against the Company and its affiliates related to alleged acts or omissions occurring during the Reliance Coverage Period. It is possible, depending on the outcome of possible claims made with various state insurance guaranty funds, that the Company will have no, or insufficient, insurance funds available to pay any potential losses. There are uncertainties relating to the Company’s ultimate liability, if any, for damages arising during the Reliance Coverage Period, the availability of the insurance coverage, and possible recovery for state insurance guaranty funds.
In June 2002, the Company settled one such claim that was pending in Jackson County, Texas. The full amount of the settlement was paid by insurance proceeds; however, as part of the settlement, the Company agreed to reimburse the Texas Property and Casualty Insurance Guaranty Association an amount ranging from $0.6 to $2.5 million depending on future circumstances. The Company estimated its exposure at approximately $1.0 million for the potential reimbursement to the Texas Property and Casualty Insurance Guaranty Association for costs associated with the settlement of this case and for unpaid insurance claims and other costs for which coverage may not be available due to the pending liquidation of Reliance. The Company believes accruals of approximately $1.0 million in the aggregate as of December 31, 2006, are adequate to provide for its exposures. The final resolution of these exposures could be substantially different from the amount recorded.
Design and Build Contract Risk
The Company participates in design and build construction operations, usually as a general contractor. Virtually all design and construction work is performed by unaffiliated subcontractors. As a consequence, the
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Company is dependent upon the continued availability of and satisfactory performance by these subcontractors for the design and construction of its facilities. There is no assurance that there will be sufficient availability of and satisfactory performance by these unaffiliated subcontractors. In addition, inadequate subcontractor resources and unsatisfactory performance by these subcontractors could have a material adverse effect on the Company’s business, financial condition and results of operation. Further, as the general contractor, the Company is legally responsible for the performance of its contracts and, if such contracts are under-performed or not performed by its subcontractors, the Company could be financially responsible. Although the Company’s contracts with its subcontractors provide for indemnification if its subcontractors do not satisfactorily perform their contract, there can be no assurance that such indemnification would cover the Company’s financial losses in attempting to fulfill the contractual obligations.
Other
There are various other lawsuits and claims pending against the Company that have arisen in the normal course of business and relate mainly to matters of environmental, personal injury and property damage. The outcome of these matters is not presently determinable but, in the opinion of the Company’s management, the ultimate resolution of these matters will not have a material adverse effect on the consolidated financial condition, results of operations or cash flows of the Company.
Self-Insurance
The Company is self-insured for losses up to deductible amounts for worker’s compensation, employer’s liability, auto liability, general liability and employee group health claims under its insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends, industry averages, and actuarial assumptions regarding future claims development and claims incurred but not reported.
(10) Stockholders’ Equity
Preferred Stock
The Company is authorized to issue up to 10,000,000 shares of Preferred Stock, which may be issued in one or more series or classes by the Board of Directors of the Company. Each such series or class shall have such powers, preferences, rights and restrictions as determined by resolution of the Board of Directors. Series A Junior Participating Preferred Stock will be issued upon exercise of the Stockholder Rights described below.
Series D Redeemable Preferred Stock
The Company has authorized 32,000 shares of Series D Preferred Stock, par value $.002 per share, and previously had outstanding a total of 25,033.601 shares of the Series D Preferred Stock, which were held by GTCR Fund VII, L.P. and its affiliates and were convertible by the holders into a number of shares of the Company’s common stock computed by dividing (i) the sum of (a) the number of shares to be converted multiplied by the liquidation value and (b) the amount of accrued and unpaid dividends by (ii) the conversion price then in effect. The initial conversion price was $2.50 per share provided that in order to prevent dilution, the conversion price could be adjusted. The Series D Preferred Stock was senior to the Company’s common stock or any other of its equity securities. The liquidation value of each share of Series D Preferred Stock was $1,000 per share. Dividends on each share of Series D Preferred Stock accrued daily at the rate of 8 percent per annum on the aggregate liquidation value and could be paid in cash or accrued, at the Company’s option. Upon conversion of the Series D Preferred Stock by the holders, the holders could have elected to receive the accrued and unpaid dividends in shares of the Company’s common stock at the conversion price. The Series D Preferred Stock was entitled to one vote per share. Shares of Series D Preferred Stock were subject to mandatory redemption by the Company on January 26, 2010, at a price per
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
share equal to the liquidation value plus accrued and unpaid dividends. On June 21, 2005, holders of the Company’s preferred stock converted all of their preferred shares into shares of the Company’s existing common stock.
Series E Redeemable Preferred Stock
The Company has authorized 55,000 shares of Series E Preferred Stock, par value $.002 per share. GTCR Fund VII, L.P. and its affiliates owned 37,497.183 shares of Series E Preferred Stock and certain affiliates of The TCW Group, Inc. owned 7,261.504 shares. The Series E Preferred Stock was convertible by the holders into a number of shares of the Company’s common stock computed by dividing (i) the sum of (a) the number of shares to be converted multiplied by the liquidation value and (b) the amount of accrued and unpaid dividends by (ii) the conversion price then in effect. The initial conversion price was $2.50 per share provided that in order to prevent dilution, the conversion price could be adjusted. The Series E Preferred Stock was senior to the Company’s common stock and any other of its equity securities. The liquidation value of each share of Series E Preferred Stock was $1,000 per share. Dividends on each share of Series E Preferred Stock accrued daily at the rate of 8 percent per annum on the aggregate liquidation value and could be paid in cash or accrued, at the Company’s option. Upon conversion of the Series E Preferred Stock by the holders, the holders could have elected to receive the accrued and unpaid dividends in shares of the Company’s common stock at the conversion price. The Series E Preferred Stock was entitled to one vote per share. Shares of Series E Preferred Stock were subject to mandatory redemption by the Company on January 26, 2010, at a price per share equal to the liquidation value plus accrued and unpaid dividends. On June 21, 2005, holders of the Company’s preferred stock converted all of their preferred shares into shares of the Company’s existing common stock.
Earnings Per Share
Basic earnings per share (EPS) is computed by dividing net income applicable to common stock by the weighted average number of common shares outstanding for the period. Diluted EPS is computed by dividing net income before preferred stock dividends by the total of the weighted average number of common shares outstanding for the period, the weighted average number of shares of common stock that would be issued assuming conversion of the Company’s preferred stock, and other common stock equivalents for options outstanding determined using the treasury stock method.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the net income (loss) and weighted average shares to reconcile basic EPS and diluted EPS for the fiscal years 2006, 2005, and 2004 (in thousands except share and per share data):
Basic and diluted EPS are the same for 2005 and 2004 because diluted EPS was less dilutive than basic EPS. Accordingly, 20,766,863 and 38,903,912 shares representing common stock equivalents have been excluded from the diluted earnings per share calculations for 2005 and 2004, respectively.
(11) Stock Based Compensation
As of January 1, 2006, the Company adopted SFAS No. 123R to account for stock based employee compensation. SFAS No. 123R requires the Company to record the cost of stock options and other equity-based compensation in its income statement based upon the estimated fair value of those awards. The Company elected to use the modified prospective method for adoption, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. Accordingly, prior periods have not been restated to reflect stock based compensation. For all unvested options outstanding as of December 31, 2005, the previously measured but unrecognized compensation expense, based on the fair value at the original grant date, will be recognized in the statement of operations over the remaining requisite service period. For equity-based compensation granted subsequent to January 1, 2006, compensation expense, based on the fair value on the date of grant, will be recognized in the statement of operations over the requisite service period.
Information related to stock based compensation is as follows:
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock Option Plans
At December 31, 2006, the Company had outstanding stock options granted under the 2000 Stock Option Plan (the “2000 Plan”) and the Amended and Restated 1993 Stock Option Plan (the “1993 Plan”) for officers, directors and key employees of the Company (collectively, the “Option Plans”).
At December 31, 2006 there were 7.7 million options for shares of common stock reserved under the 2000 Plan for future grants. Effective with the approval of the 2000 Plan, no further grants have been made under the 1993 Plan. The exercise price of options granted shall be at least 100 percent (110 percent for 10 percent or greater stockholders) of the fair value of the Company’s common stock on the date of grant. Options must be granted within ten years from the date of the Option Plan and become exercisable at such times as determined by the Option Plan committee. Options are exercisable for no longer than five years for certain ten percent or greater stockholders and for no longer than ten years for others.
SFAS No. 123R requires tax benefits relating to excess stock based compensation deductions over that recognized in expense to be prospectively presented in the Company’s statement of cash flows as financing cash inflows. However, in cases where the Company has a NOL carryforward, SFAS No. 123R states that no amount shall be recorded until the deduction reduces income taxes payable on the basis that cash tax savings have not occurred. Accordingly, for the year ended December 31, 2006, the Company has not reported any excess tax benefits from the settlement (i.e. exercise of options) of stock based compensation as cash provided by financing activities on its statement of cash flows.
The Company’s policy of meeting the requirements upon exercise of stock options is to issue new shares.
Plan
The fair value of each option award granted after December 31, 2005, is estimated on the date of grant using a Black-Scholes option valuation model. Expected volatilities are based on the historical volatility of the Company’s stock. The expected term of options granted is derived from the simplified method referred to in SEC’s Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB No. 107”) which represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve at the time of grant. For the year ended December 31, 2006, the Company used the following information related to new option grants.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table provides additional information related to the 2000 Plan:
The weighted average grant date fair value for the 553,750 options granted in 2006 was $1.11 per share. Options outstanding at December 31, 2006, had a weighted average remaining contractual life of 6.2 years and an intrinsic value of $4.8 million. Options exercisable at December 31, 2006, had a weighted average remaining contractual life of 4.8 years and an intrinsic value of $4.0 million.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Plan
The following table provides additional information related to the 1993 Plan:
Options outstanding at December 31, 2006, had a weighted average remaining contractual life of 3.0 years and an intrinsic value of $860. Options exercisable at December 31, 2006, had a weighted average remaining contractual life of 3.0 years and an intrinsic value of $860.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other Options
In addition to options available for issuance under the above plans, the Company has other options outstanding to employees and directors of the Company which were issued at exercise prices equal to the fair market value at the grant date of the options. The following table provides additional information related to the other stock options:
Options outstanding at December 31, 2006, had a weighted average remaining contractual life of 3.5 years and an intrinsic value of $2.0 million. Options exercisable at December 31, 2006, had a weighted average remaining contractual life of 3.0 years and an intrinsic value of $1.5 million.
The following table summarizes information about total stock options outstanding as of December 31, 2006:
The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was approximately $0.4 million, $3.1 million and $28,000, respectively. Cash received from option exercises under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was approximately $0.6 million, $4.2 million and $0.1 million, respectively. There was no tax benefit realized for the tax deductions resulting from option exercises of share-based payment arrangements for the year ended December 31, 2006.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2006, there was approximately $2.2 million of total unrecognized compensation cost related to nonvested options. That cost is expected to be recognized on a straight line basis over the weighted average vesting period of 2.9 years.
Prior to January 1, 2006
Prior to January 1, 2006, the Company accounted for stock based compensation using the intrinsic method prescribed in Accounting Principles Board Opinion No. 25 (“Opinion No. 25”). As required by SFAS No. 123R, the Company has disclosed below the effect on net loss and loss per share on equity-based employee compensation, including stock options, which would have been recorded using the fair value based method for the years ended December 31, 2005 and 2004, respectively.
The weighted average fair values of options granted were $4.31 and $2.51 for the years ended December 31, 2005 and 2004, respectively. The weighted average fair values were determined using the Black-Scholes option valuation method assuming no expected dividends. The expected term was calculated using the simplified method referred to in SAB No. 107. Other assumptions used are as follows:
Restricted Stock Plan
During June 2005, the Company executed the Synagro Technologies, Inc. 2005 Restricted Stock Plan (the “Restricted Plan”) for the benefit of certain named employees. Under the Restricted Plan up to 3.5 million shares of the Company’s common stock were authorized for issuance. Shares, which are granted by the Company’s Compensation Committee, are subject to a vesting schedule. As the vesting dates pass, the restrictions on a proportionate number of shares will lapse, and such shares will be considered to be compensation to the recipient, and may be held or sold at the option of the recipient. Currently, the number of shares granted is based on the outstanding stock options held by the employee under the Company’s stock option plans multiplied by the Company’s dividend rate on its common stock.
Upon adoption of SFAS No. 123R on January 1, 2006, amounts previously recorded in equity under Opinion No. 25 at December 31, 2005, related to unearned compensation for restricted stock awards have been reversed against paid in capital and will be expensed over the requisite service period in accordance with SFAS No. 123R.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Expense related to shares of restricted stock is recorded straight line over the longest vesting tranche in accordance with the provisions of SFAS No. 123R. The following table provides additional information related to the Company’s Restricted Plan:
Fair value for shares granted is determined using the closing price on the day prior to the date of grant. The total fair value of shares vested was approximately $1.2 million for the year ended December 31, 2006.
As of December 31, 2006, there was approximately $1.1 million of total unrecognized compensation cost related to nonvested restricted shares. That cost is expected to be recognized on a straight line basis over the weighted average vesting period of 3.7 years.
(12) Special Charges
The Company incurred a special charge of $0.3 million for costs associated with the re-audit of its 2001 financial statements during 2004.
(13) Employee Benefit Plans
The Company sponsors a defined contribution retirement plan for full-time and some part-time employees. The plan covers employees at all of the Company’s operating locations. The defined contribution plan provides for contributions ranging from 1 percent to 15 percent of covered employees’ salaries or wages. The Company may make a matching contribution as a percentage of the employee contribution. The matching contributions totaled approximately $1.1 million for each of 2006, 2005 and 2004.
(14) Quarterly Results of Operations (Unaudited)
Quarterly financial information for the years ended December 31, 2006 and 2005, is summarized as follows (in thousands, except per share data):
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In the second quarter of 2005, the Company incurred certain costs and write-offs relating to the Recapitalization (See Note 1).
The sum of the individual quarterly earnings per share amounts do not agree with year-to-date earnings per share as each quarter’s computation is based on the weighted average number of shares outstanding during the quarter, the weighted average stock price during the quarter, and the dilutive effects of the redeemable preferred stock and stock options, if applicable, in each quarter.
(15) Condensed Consolidating Financial Statements
As discussed in Note 4, all of the Company’s 100% owned domestic subsidiaries, except the subsidiaries formed to own and operate the Sacramento biosolids processing facility, Synagro Organic Fertilizer Company of Sacramento, Inc. and Sacramento Project Finance, Inc., (See Note 4) and Philadelphia Biosolids Services, L.L.C. (collectively the “Non-Guarantor Subsidiaries”), are Guarantors of the Senior Credit Facility. Each of the Guarantors is 100% owned by the Company and the guarantees are full, unconditional and joint and several. Additionally, the Company is not a Guarantor for the debt of the Non-Guarantor Subsidiaries. Accordingly, the following condensed consolidating balance sheets have been presented as of December 31, 2006 and December 31, 2005. In October 2006, South Kern Industrial Center, L.L.C. which had no operations prior to December 2006, and was formed to own and operate a compost facility, became a Guarantor of the Senior Credit Facility. Accordingly, it has been classified as a Guarantor subsidiary in the accompanying December 31, 2006 condensed consolidating balance sheets. The condensed consolidating statements of operations has also been presented for the year ended December 31, 2006 and December 31, 2005 and the condensed consolidating statement of cash flows has been presented for the year ended December 31, 2006 and December 31, 2005.
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED CONSOLIDATING BALANCE SHEETS
AS OF DECEMBER 31, 2006
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED CONSOLIDATING BALANCE SHEETS
AS OF DECEMBER 31, 2005
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONSOLIDATING STATEMENTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 2006
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONSOLIDATING STATEMENTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 2005
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2006
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2005
(Dollars in thousands)
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(16) Segment Information
The Company’s Chief Operating Decision Maker regularly evaluates operating results, assesses performance and allocates resources on a geographic basis, with the exception of its rail operations and its engineering, facilities, and development (“EFD”) group which are separately managed. Accordingly, the Company reports the results of its activities in three reporting segments, which include: Residuals Management Operations, Rail Transportation, and EFD.
Residuals Management Operations include the Company’s business activities that are managed on a geographic basis in the Northeast, Central, Southwest regions of the United States. These geographic areas have been aggregated and reported as a segment because they meet the aggregation criteria of SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information.” Rail Transportation includes the transfer and rail haul of materials across several states where the material is typically either land applied or landfill disposed. Rail Transportation is a separate segment because it is monitored separately and because it only offers long-distance land application and disposal services to its customers. EFD includes construction management activities and start up operations for certain new processing facilities as well as the marketing and sale of certain pellets and compost fertilizers.
The Company’s operations by reportable segment are summarized below (in thousands):
Corporate assets primarily include prepaid expenses, investments in subsidiaries and intercompany loans. Corporate expenses primarily include general and administrative expenses and adjustments for insurance and other benefit allocations.
The accounting policies of the Company’s segments are the same as those described for the Company in Note 1. Revenues from transactions with other segments are based on terms substantially similar to transactions with
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
unrelated third party customers. The following reconciles segment income from operations to the Company’s consolidated income before provision for income taxes:
For the year ended December 31, 2005, included in total other expense are certain costs and write-offs relating to the Recapitalization discussed in Note 1, including $1.5 million of transaction costs and expenses, $5.5 million for stock option redemptions, $1.3 million for transaction bonuses and $19.5 million of debt extinguishment costs.
Revenues generated from the services that the Company provides are summarized below:
Land application and disposal includes revenues generated from providing land application, dewatering and disposal services. Facilities operations include revenues generated from providing drying and pelletization, composting and incineration operations services. Cleanout services include revenues generated from lagoon and digester cleanout projects. Product marketing includes revenues generated from selling pellets and compost as organic fertilizers. Design and build services include revenues generated from contracts where we agree to design, build and operate certain processing facilities under a long-term operating contract.
The Company had one customer that accounted for approximately 16 percent of total revenue for the years ended December 31, 2006, 2005, and 2004, and whose revenue are included in the Residuals Management Operations and Rail Transportation reporting segments.
(17) Subsequent Events
On January 28, 2007, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with Synatech Holdings, Inc., a Delaware corporation (“Parent”) owned by The Carlyle Group, and Synatech, Inc., a Delaware corporation and wholly-owned subsidiary of Parent (“Merger Sub”) pursuant to which Merger Sub will merge with and into the Company (the “Merger”), with the Company continuing as the surviving corporation and as a wholly-owned subsidiary of Parent. The Merger Agreement provides that Merger Sub’s Certificate of Incorporation and bylaws will be the Certificate of Incorporation and bylaws of the surviving corporation except that the Certificate of Incorporation shall be amended to provide for the name of the corporation to be Synagro Technologies, Inc.
The Merger Agreement provides that at the effective time of the Merger, each issued and outstanding share of common stock, par value $.002 per share, of the Company, other than any such shares owned by the Company,
SYNAGRO TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Parent or any of their respective subsidiaries, shall be cancelled and shall be converted automatically into the right to receive $5.76 in cash, without interest. Also, pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding option to acquire shares of Company common stock under any stock option, restricted stock, or incentive plan will be cancelled in exchange for the right to receive, for each share of common stock issuable upon exercise of such option, cash in the amount of the excess, if any, of $5.76 over the exercise price per share of any such option.
The Merger Agreement contains termination rights for both the Company and Parent, and further provides that, upon termination of the Merger Agreement under specified circumstances, including (i) by the Company approving or recommending an acquisition proposal, and (ii) the Company board of director’s withdrawal or modification of its approval of the Merger, the Company may be required to pay Parent a break-up fee equal to $13.9 million. The Company may be required to pay Parent its expenses not in excess of $1.5 million if the Merger Agreement is terminated due to a breach of the Company’s representations, warranties, or covenants. Parent may be required to pay the Company liquidated damages of $13.9 million and its expenses not in excess of $1.5 million if the Merger Agreement is terminated due to a breach of Parent’s or Merger Sub’s representations, warranties, or covenants.
The consummation of the Merger is subject to the satisfaction or waiver of certain closing conditions, including, without limitation, the approval of a majority of the votes by the Company’s stockholders entitled to vote thereon (other than those held by Parent and their respective affiliates), and the termination or expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. The Merger Agreement also contains customary representations, warranties, and covenants of Parent, Merger Sub, and the Company. The Merger is not subject to a financing condition. A special meeting of the Company’s stockholders has been scheduled for March 29, 2007 to vote on the approval of the merger.
ITEM 9.
ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended, have concluded that, as of the end of the fiscal year covered by this Annual Report on Form 10-K, the Company’s disclosure controls and procedures were effective to provide reasonable assurances that information required to be disclosed in the reports filed or submitted under such Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and such information is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Management of Synagro Technologies, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting has been designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Company; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorization of management and directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on that assessment using the criteria in Internal Control - Integrated Framework, management determined that, as of December 31, 2006, the Company’s internal control over financial reporting was effective.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by Hein & Associates LLP, an independent registered public accounting firm, as stated in their report which appears herein.
ITEM 9B.
ITEM 9B.
Other Information
None.
PART III
In accordance with paragraph (3) of General Instruction G to Form 10-K, Part III of this Report is omitted because the Company has filed with the Securities and Exchange Commission, not later than 120 days after December 31, 2006, a definitive proxy statement pursuant to Regulation 14A involving the election of directors. Reference is made to the sections of such proxy statement entitled “Other Information - Principal Stockholders,” “Other Information - Executive Compensation,” “Election of Directors - Management Stockholdings,” “Principal Accounting Fees,” and “Other Information - Certain Relationships and Related Transactions, and Director Independence,” which sections and subsections of such proxy statement are incorporated herein.
PART IV
ITEM 15.
ITEM 15.
Exhibits and Financial Statement Schedules
1. Financial Statements:
2. Financial Schedules:
All financial statement schedules are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or the notes thereto.
3. Exhibits:
*
Filed with this Form 10-K.
(1)
Management contract or compensatory plan or agreement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SYNAGRO TECHNOLOGIES, INC.
(Registrant)
By:
/s/ ROBERT C. BOUCHER, JR.
Robert C. Boucher, Jr.
Chief Executive Officer
Date: March 2, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
*
Filed with this Form 10-K
(1)
Management contract or compensatory plan or agreement