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POWERSECURE INTERNATIONAL, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Introduction The following discussion and analysis of our consolidated results of operations for the three and six month period ended June 30, 2012, which we refer to as the second quarter 2012 and six month period 2012, respectively, and the three and six month period ended June 30, 2011, which we refer to as the second quarter 2011 and six month period 2011, respectively, and of our consolidated financial condition as of June 30, 2012 should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Cautionary Note Regarding Forward-Looking Statements This Quarterly Report on Form 10-Q and the documents incorporated into this report by reference contain forward-looking statements within the meaning of and made under the safe harbor provisions of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. From time to time in the future, we may make additional forward-looking statements in presentations, at conferences, in press releases, in other reports and filings and otherwise. Forward-looking statements are all statements other than statements of historical fact, including statements that refer to plans, intentions, objectives, goals, strategies, hopes, beliefs, projections, prospects, expectations or other characterizations of future events or performance, and assumptions underlying the foregoing. The words "may," "could," "should," "would," "will," "project," "intend," "continue," "believe," "anticipate," "estimate," "forecast," "expect," "plan," "potential," "opportunity" and "scheduled," variations of such words, and other comparable terminology and similar expressions are often, but not always, used to identify forward-looking statements. Examples of forward-looking statements include, but are not limited to, statements about the following: • our prospects, including our future business, revenues, expenses, net income, earnings per share, margins, profitability, cash flow, cash position, liquidity, financial condition and results of operations, our targeted growth rate and our expectations about realizing the revenues in our backlog and in our sales pipeline; • the effects on our business, financial condition and results of operations of current and future economic, business, market and regulatory conditions, including the current economic and market conditions and their effects on our customers and their capital spending and ability to finance purchases of our products, services, technologies and systems; • the effects of fluctuations in sales on our business, revenues, expenses, net income, earnings per share, margins, profitability, cash flow, liquidity, financial condition and results of operations; • our products, services, technologies and systems, including their quality and performance in absolute terms and as compared to competitive alternatives, their benefits to our customers and their ability to meet our customers' requirements, and our ability to successfully develop and market new products, services, technologies and systems; • our markets, including our market position and our market share; • our ability to successfully develop, operate, grow and diversifyour operations and businesses; • our business plans, strategies, goals and objectives, and our ability to successfully achieve them; • the effects on our financial condition, results of operations and prospects of the sales of our non-core businesses and our ability to effectively and profitably redeploy the proceeds of those sales in our core business; • the sufficiency of our capital resources, including our cash and cash equivalents, funds generated from operations, availability of borrowings under our credit and financing arrangements and other capital resources, to meet our future working capital, capital expenditure, lease and debt service and business growth needs; • the value of our assets and businesses, including the revenues, profits and cash flow they are capable of delivering in the future; 27 -------------------------------------------------------------------------------- Table of Contents • industry trends and customer preferences and the demand for our products, services, technologies and systems; • the nature and intensity of our competition, and our ability to successfully compete in our markets; • fluctuations in our effective tax rates, including the expectation that with the utilization of a significant portion of our tax net operating losses during fiscal 2011 our tax expense in future years will likely approximate prevailing statutory tax rates; • business acquisitions, combinations, sales, alliances, ventures and other similar business transactions and relationships; and • the effects on our business, financial condition and results of operations of litigation, warranty claims and other claims and proceedings that arise from time to time. Any forward-looking statements we make are based on our current plans, intentions, objectives, goals, strategies, hopes, beliefs, projections and expectations, as well as assumptions made by and information currently available to management. Forward-looking statements are not guarantees of future performance or events, but are subject to and qualified by substantial risks, uncertainties and other factors, which are difficult to predict and are often beyond our control. Forward-looking statements will be affected by assumptions and expectations we might make that do not materialize or that prove to be incorrect and by known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those expressed, anticipated or implied by such forward-looking statements. These risks, uncertainties and other factors include, but are not limited to, those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, as amended or supplemented in subsequently filed Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as other risks, uncertainties and factors discussed elsewhere in this report, in documents that we include as exhibits to or incorporate by reference in this report, and in other reports and documents we from time to time file with or furnish to the Securities and Exchange Commission. In light of these risks and uncertainties, you are cautioned not to place undue reliance on any forward-looking statements that we make. Any forward-looking statements contained in this report speak only as of the date of this report, and any other forward-looking statements we make from time to time in the future speak only as of the date they are made. We undertake no duty or obligation to update or revise any forward-looking statement or to publicly disclose any update or revision for any reason, whether as a result of changes in our expectations or the underlying assumptions, the receipt of new information, the occurrence of future or unanticipated events, circumstances or conditions or otherwise. Overview PowerSecure International, Inc., headquartered in Wake Forest, North Carolina, is a leading provider of products and services to electric utilities, and their large commercial, institutional and industrial customers. Our Utility and Energy Technologies segment includes our core business operations, and is the only segment that we have been strategically focused on investing in and growing for the last several years. Conversely, our Energy Services segment contained our non-core business operations. We divested the operations of our Energy Services segment over time, with the final divestitures competed in 2011. Our Utility and Energy Technologies segment includes our three primary product and service areas: our Interactive Distributed Generation products and services, our Utility Infrastructure products and services, and our Energy Efficiency products. These three groups of products and services are commonly focused on serving the needs of utilities and their commercial, institutional and industrial customers to help them generate, deliver, and utilize electricity more efficiently. Our strategy is focused on growing these three product and service areas because they require unique knowledge and skills that utilize our core competencies, and because they address large market opportunities due to their strong customer value propositions. These three product and service areas share common or complementary utility relationships and customer types, common sales and overhead resources, and facilities. However, we discuss and distinguish our Utility and Energy Technologies business among the three product and service areas due to the unique market needs they are addressing, and the distinct technical disciplines and specific capabilities required for us to deliver them, including personnel, technology, engineering, and intellectual capital. Our Utility and Energy Technologies segment operates primarily out of our Wake Forest, North Carolina headquarters office, and its operations also include several satellite offices and manufacturing facilities, the largest of which are in the Raleigh, North Carolina, Randleman, North Carolina, 28-------------------------------------------------------------------------------- Table of Contents McDonough, Georgia, and Anderson, South Carolina areas. The locations of our sales organization and field employees for this segment are generally in close proximity to the utilities and commercial, industrial, and institutional customers they serve. Our Utility and Energy Technologies segment is operated through our largest wholly-owned subsidiary, PowerSecure, Inc. Until the divestitures of our remaining non-core business operations in 2011, our Energy Services segment operated through our two other principal operating subsidiaries, Southern Flow Companies, Inc., which we refer to as "Southern Flow", and WaterSecure Holdings, Inc., which we refer to as "WaterSecure". Interactive Distributed Generation Our Interactive Distributed Generation business involves manufacturing, installing and operating electric generation equipment "on site" at a facility where the power is used, including commercial, institutional and industrial operations, generally on behalf of electric utilities. Our systems provide a dependable backup power supply during power outages, and provide a more efficient and environmentally friendly source of power during high cost periods of peak power demand. These two sources of value benefit both utilities and their large customers. Our Interactive Distributed Generation systems are sold to customers utilizing two basic economic models, each of which can vary depending on the specific customer and application. In our original business model, which is still our primary model, we sell the distributed generation system to the customer. We refer to this as a "project-based" or a "customer-owned" model. For distributed generation systems sold under the project-based model, the customer acquires ownership of the distributed generation assets upon our completion of the project. Our revenues and profits from the sale of systems under this model are recognized over the period during which the system is installed. In the project-based model, we will also usually receive a modest amount of on-going monthly revenues to monitor the system for backup power and peak shaving purposes, as well as to maintain the system. Our second business model is structured to generate long-term recurring revenues, which we refer to as our "recurring revenue model" or "PowerSecure-owned" or "company-owned" model. Our PowerSecure-owned model represents an increasing portion of our distributed generation business. For distributed generation systems completed under this model, we retain ownership of the distributed generation system after it is installed at the customer's site. Because of this, we invest the capital required to design and build the system, and our revenues are derived from regular fees paid over the life of the recurring revenue contract by the utility or the customer, or both, for access to the system for standby power and peak shaving. The life of these recurring revenue contracts is typically from five to fifteen years. The fees that generate our revenues in the recurring revenue model are generally paid to us on a monthly basis and are established at amounts intended to provide us with attractive returns on the capital we invest in installing and maintaining the distributed generation system. Our fees for recurring revenue contracts are generally structured either as a fixed monthly payment, or as a shared savings recurring revenue contract. For our shared savings recurring revenue contracts, a portion or all of our fees are earned out of the pool of peak shaving savings the system creates for the customer. In both economic models, we believe that the customer value proposition is strong. In the customer-owned model, where the customer pays for and obtains ownership of the system, the customer's typical targeted returns on investment range from 15% to 25%, with a payback targeted at three to five years. These paybacks to the customer result from a combination of the benefits of peak shaving, which creates lower total electricity costs, and the value that the backup power provides in avoiding losses from business interruptions due to power outages. Additionally, utilities gain the benefits of smoother electricity demand curves and lower peaks, as the result of having reliable standby power supporting customers in their utility systems, power distribution and transmission efficiencies, and of avoiding major capital outlays that would have been required to build centralized power plants and related infrastructure for peaking needs. In our PowerSecure-owned model, where we pay for, install and maintain ownership of the system in exchange for the customer paying us smaller fees over a period of years, utilities and their customers receive access to our system and the related benefits of distributed generation without making a large up-front investment of capital. Under the PowerSecure-owned model, contracts can be structured between us and the utility, us and the customer, or all three parties. During the six month period 2012, 77.4% of our distributed generation revenues consisted of customer-owned sales, and 22.6% of our distributed generation revenues were derived from recurring revenue sales. Sales of customer-owned systems deliver revenues and profits that are recorded on our financial statements over the course of the project, which is generally over a three to eighteen month timeframe depending on the size of the project, and sales of PowerSecure-owned 29 -------------------------------------------------------------------------------- Table of Contents projects are recorded over a longer time frame of five to fifteen years depending on the life of the underlying contract. Therefore, changes in the sales of customer-owned systems have significant impacts on our near-term revenues and profits and cause them to fluctuate from period-to-period. By contrast, sales under the PowerSecure-owned system model generate revenues and profits that are more consistent from period-to-period and have higher gross margins, and generate revenues and profits over a longer time period, although smaller in dollar amount in any particular period because they are recognized over the life of the contract. Our PowerSecure-owned recurring revenue model also requires us to invest our own capital in the project without any return on capital until after the project is completed, installed and successfully operating. Our recent acquisition of PowerSecure Solar provides us with the ability to provide solar energy systems through our distributed generation business platform. These solar energy systems will be sold under the "project-based", "customer-owned" model, and we also plan to own and operate these systems under a "PowerSecure-owned", "recurring revenue" model. Utility Infrastructure Our Utility Infrastructure business is focused on helping electric utilities design, build, upgrade and maintain infrastructure that enhances the efficiency of their grid systems. Through our UtilityServices business, we provide transmission and distribution system construction and maintenance products and services, install advanced metering and efficient lighting, and provide emergency storm restoration services. Additionally, through our UtilityEngineering and PowerServices consulting engineering firms, we provide utilities with a wide range of engineering and design services, as well as consulting services for regulatory and rate design matters. Revenues for our UtilityServices business are generally earned, billed, and recognized in two primary models. Under the first model, we have regular, on-going assignments with utilities to provide regular maintenance and upgrade services. These services are earned, billed, and recognized either on a fixed fee basis, based on the number of work units we perform, such as the number of transmission poles we upgrade, or on an hourly fee basis, based on the number of hours we invest in a particular project, plus amounts for the materials we utilize and install. Under the second model, we are engaged to design, build and install large infrastructure projects, including substations, transmission lines and similar infrastructure, for utilities and their customers. In these types of projects we are generally paid a fixed price for the project, plus any modifications or scope additions. We recognize revenues from these projects on a percentage-of-completion basis as they are completed. In addition to these two primary models, in some cases, we are engaged by utilities and their customers to build or upgrade transmission and distribution infrastructure that we own and maintain. In those cases, we receive fees over a long-term contract for the customer to have access to the infrastructure to transmit or receive power. Revenues for our UtilityEngineering and PowerServices businesses are earned, billed, and recognized based on the number of hours invested in the particular projects and engagements they are serving. Similar to most traditional consulting businesses, these hours are billed at rates that reflect the general technical skill or experience level of the consultant or supervisor providing the services. In some cases, our engineers and consultants are engaged on an on-going basis with utilities, providing resources to supplement utilities' internal engineering teams over long-term time horizons. In other cases, our engineers and consultants are engaged to provide services for very specific projects and assignments. Energy Efficiency Our Energy Efficiency business is focused on providing energy solutions to utilities, municipalities, and commercial, institutional and industrial customers with strong value propositions that are designed to reduce their energy costs, improve their operations, and benefit the environment. Our Energy Efficiency area includes our EfficientLights, IES and EnergyLite businesses and brands, all of which are focused on bringing light emitting diode, or "LED," lighting solutions to the marketplace. Our EfficientLights business is focused on developing LED-based lighting products for grocery, drug and convenience stores. These LED lighting products include our largest volume product, our EfficientLights fixture for reach-in refrigerated cases, as well as lighting for walk-in storage coolers and open refrigerated shelves. Additionally, our EfficientLights business is in the process of developing and marketing LED-based parking lot lights and security lighting for retail stores. 30 -------------------------------------------------------------------------------- Table of Contents Our IES business designs and manufactures new LED-based lighting products for commercial, industrial and consumer applications. The business of IES includes turn-key product development, engineering and manufacturing of solid state LED-based lights, including street lights, area lights, landscape lights, and other specialty lighting applications. In addition, IES's product portfolio includes component parts, such as power drivers, light engines and thermal management solutions. IES provides its products directly to original equipment manufacturers, or OEMs, and to electronics manufacturers and retailers, either as component solutions or as turn-key products. Additionally, through our EnergyLite business and brand we market our SecureLite and PowerLite family of area lights and street lights, as well as our SuperTube LED light replacement for fluorescent tubes. These products are marketed to utilities and municipalities directly, and through third party distribution arrangements. We generate revenues in our EfficientLights business through the sale of our proprietary LED lights. These lights are primarily sold as retrofits for existing traditional lighting, although they are also sold for initial lighting installations. From time to time we also provide installation services, although that is not a significant portion of our business. We also assist our customers in receiving utility incentives for LED lighting. Our customers are primarily large retail chains, and their installations of EfficientLights have been across various numerous stores within their store base over a diverse geographic scope. We also sell our LED lights to, and through OEMs of refrigerator and freezer cases. We expect our customer base and sales channels to continue to grow and develop as LED technology continues to be more widely adopted. As we bring additional products to market, including our LED-based parking lot light, we expect to employ a similar business model. We also generate LED-based lighting revenues through our IES business through the sale of proprietary LED lights, as well as the sale of LED-lighting components including power drivers, light engines and thermal management solutions. Our IES business designs and manufactures these LED-based lighting products for commercial, industrial and consumer applications. IES provides its products directly to OEMs, electronics manufacturers, and retailers, either as component solutions or as turn-key products. We expect our IES business to bring additional LED lighting products and components to market, and employ a similar business and distribution model. Additionally, through our EnergyLite business and brand we market our SecureLite and PowerLite family of area lights and street lights, as well as our SuperTube light, and we expect to market other produces in the future. We utilize the engineering and manufacturing capabilities of our IES team in the development of these products. These products are marketed to utilities, municipalities and businesses directly and through third party distribution arrangements. Energy Services Business We completed the sales of our two Energy Services businesses in 2011, ceasing our operations in this business segment. We previously conducted our Energy Services operations through our WaterSecure and Southern Flow businesses. Through WaterSecure, we own a significant non-controlling minority portion of the equity interests of MM 1995-2, an unconsolidated business. Equity income at our Energy Services segment consists of our minority ownership interest in the earnings of the WaterSecure operations. In June 2011, MM 1995-2 sold substantially all of its assets and business for cash. Prior to the sale, MM 1995-2 owned and operated water processing, recycling and disposal facilities in northeastern Colorado, and the business served oil and natural gas production companies in that area. Southern Flow, which we sold effective January 1, 2011, provides a variety of oil and natural gas measurement services principally to customers involved in the business of oil and natural gas production, gathering, transportation and processing, with a focus on the natural gas market. As a result of the sale of Southern Flow, its results of operations are now reflected as discontinued operations in our consolidated statements of operations for all periods presented in this report. The sales of our WaterSecure and Southern Flow operations completed our strategy to monetize our non-core assets to focus on the businesses in our Utility and Energy Technologies segment. As a result of these sales, our Energy Services segment ceased business activities in 2011. 31-------------------------------------------------------------------------------- Table of Contents Recent Developments On August 1, 2012, we announced that our PowerSecure subsidiary had received $10 million of new awards for utility infrastructure projects and distributed generation systems. The utility infrastructure awards total $7 million, including transmission and distribution system projects to upgrade existing utility systems, and new infrastructure projects to support expanding oil and gas company production activities. The new distributed generation system awards total $3 million, and include installations for hospital, institutional, and industrial applications. The distributed generation awards include $1 million of traditional turn-key PowerSecure distributed generation projects, a $1 million turn-key distributed solar energy project, and $1 million of recurring revenue projects. The majority of the $9 million of turn-key project-based awards will be completed and recognized in 2012, and the remaining $1 million of recurring revenue will be recognized over a multi-year period. On July 24, 2012, we announced that our PowerSecure subsidiary had received $10 million of new awards for its Interactive Distributed Generation smart grid power systems, utility infrastructure projects, and LED Area Lights. The new Interactive Distributed Generation System awards total $4 million, and include installations for manufacturing, pharmaceutical, hospital, and retail operations. The utility infrastructure awards are approximately $5 million, and include transmission and distribution projects for oil and gas companies and military bases. The new LED Area Light awards are just under $1 million and include an order from a new utility who has adopted the light to roll out across its utility system. On June 27, 2012, we announced that our PowerSecure subsidiary had received $15 million of new awards for its Interactive Distributed Generation smart grid power systems, and utility infrastructure projects. The new Interactive Distributed Generation System awards total $10 million, and include installations for hospital, data center, pharmaceutical, and industrial facilities. The utility infrastructure awards total $5 million, and include transmission system and substation projects for utilities and large industrial customers. All of these awards are for turnkey sales of products and services, with approximately 80% of the revenue expected to be recognized in the second half of 2012, and 20% of the revenue expected to be recognized during the first half of 2013. On June 19, 2012, at our 2012 Annual Meeting of Stockholders, our stockholders adopted and approved an amendment and restatement of our 2008 Stock Incentive Plan, including an amendment to increase the number of shares of our common stock, par value $.01 per share, authorized for issuance thereunder by 1.4 million shares to a total of 2.0 million shares. In addition, on June 19, 2012, at our 2012 Annual Meeting of Stockholders, our stockholders adopted and approved an amendment to our Second Restated Certificate of Incorporation to increase the number of shares of common stock authorized for issuance by us by 25.0 million shares to a total of 50.0 million shares. We effected the increase in the number of authorized shares of our common stock by filing a Certificate of Amendment to our Second Restated Certificate of Incorporation with the Secretary of State of the State of Delaware on June 19, 2012, and the amendment became effective as of such date. On June 5, 2012, we acquired a distributed solar energy business, adding this capability to our Interactive Distributed Generation system platform. Our new capabilities were acquired through the purchase of the utility, commercial and industrial solar energy business of Southern Energy Management, Inc., a North Carolina corporation. Our decision to offer solar solutions resulted from a thorough evaluation of the industry and of the new, significantly improved economics of distributed solar energy systems. The decrease in the cost of solar panels, and corresponding increases in their energy efficiency, in conjunction with our highly efficient distributed generation systems, provides us with a sustainable market opportunity to participate in the downstream segment of the solar business, and bring solar energy projects to our customers and utility partners. We began offering utilities and their large commercial and industrial customers solar energy systems immediately after the acquisition, and took over the installation of several large projects the Seller had in process, including a 4.5 megawatt system. We consummated the acquisition through the formation of Southern Energy Management PowerSecure, LLC, a Delaware limited liability company ("PowerSecure Solar"), which entered into an asset contribution and sale agreement, dated as of June 5, 2012, with the seller. Pursuant to the contribution and sale agreement, PowerSecure Solar completed the acquisition of substantially all of the assets of the seller relating to the business of designing and selling energy 32 -------------------------------------------------------------------------------- Table of Contents efficiency and solar photovoltaic power systems and other solar power technologies for large customers, including utility, commercial and industrial customers. Total consideration paid by PowerSecure Solar to the seller for the acquired business was $3.5 million. After the acquisition, we own 90% of the membership interests in, and control the management of, PowerSecure Solar. The seller owns a 10% non-controlling interest in PowerSecure Solar and retained its business selling solar photovoltaic power systems and solar thermal energy to residential customers and small merchants and professional service providers. Both us and the seller are subject to various buy-sell rights and obligations with respect to their equity interests in PowerSecure Solar. In June 2012, we recorded an additional $1.4 million gain from the 2011 sale of our WaterSecure operations attributable to our receipt of sales proceeds in the same amount that had been placed into escrow pending the outcome of contingencies related to the sale. We do not expect to receive any additional proceeds from this sale. On May 22, 2012, we announced that our PowerSecure subsidiary had received new awards for over 25,000 of its energy efficient LED lights. The new awards include our new EfficientLights®walk-in cooler lights for retailers, and our SecureLite®Area Light for utilities. The lights for these orders are expected to be shipped primarily during the remaining quarters of 2012, and we expect revenue from these orders to be approximately $5 million. Financial Results Highlights Our consolidated revenues during the second quarter 2012 increased by $7.8 million, or 25.9%, compared to our consolidated revenues during the second quarter 2011. The drivers of this revenue increase were the across the board increases in revenues in each of our product and service areas, including a 26.8% increase in revenues from Interactive Distributed Generation products and services, a 12.2% increase in revenues from Utility Infrastructure products and services, and a 50.7% increase in revenues from Energy Efficiency products. Our second quarter 2012 gross margin as a percentage of revenue was 32.2% compared to 30.9% in the second quarter 2011. On a year-over-year basis, the gross margin increase was driven by a favorable mix of projects completed and a higher percentage of revenues from our higher margin Interactive Distributed Generation and Energy Efficiency products and services. Our operating expenses during the second quarter 2012 increased by $1.6 million, or 16.3%, compared to our operating expenses during the second quarter 2011. The year-over-year increase in operating expenses is due to incremental expenses we have invested in to expand and grow each of our Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency product and service areas. These expenses support new product and customer development, engineering, personnel and equipment, as well as additional sales and marketing activities, and also include increases in depreciation from capital expenditures for our Company-owned distributed generation systems. As a percentage of revenues, operating expenses for the second quarter 2012 decreased 2.5 percentage points compared to the second quarter 2011. Income from our Energy Services segment, which consists of the gain on the sale of our WaterSecure operations along with the management fees and equity income from our WaterSecure operations, decreased $21.0 million during the second quarter 2012 compared to the second quarter 2011, due to the sale of our WaterSecure operations in June 2011 on which we recorded a $21.8 million gain in the second quarter 2011. We recorded an additional $1.4 million gain from the sale of our WaterSecure operations in second quarter 2012 from the receipt of sales proceeds that had been placed into escrow pending the outcome of contingencies related to the sale. We do not expect to receive any additional proceeds from this sale. Our income from continuing operations attributable to PowerSecure International, Inc. shareholders for the second quarter 2012 was $1.6 million, or $0.09 per diluted share, compared to income from continuing operations attributable to PowerSecure International, Inc. shareholders of $18.6 million, or $0.97 per diluted share, for the second quarter 2011, which included the $21.8 million gain from the sale of our WaterSecure operations. Our income from discontinued operations for the second quarter 2012, consisting of the operating results of PowerPackages during the second quarter 2012, was negligible. Our loss from discontinued operations for the second quarter 2011 was ($1.4) million, or ($0.07) per diluted share, which consisted of the loss from discontinued operations of our PowerPackages business. 33-------------------------------------------------------------------------------- Table of Contents In total, our consolidated net income attributable to PowerSecure International, Inc. common stockholders for the second quarter 2012 was $1.6 million, or $0.09 per diluted share, which compared to net income attributable to PowerSecure International, Inc. common stockholders of $17.3 million, or $0.90 per diluted share, for the second quarter 2011, which included the income from the gain on the sale of our WaterSecure operations. Our consolidated revenues during the six month period 2012 increased by $17.3 million, or 32.2%, compared to our consolidated revenues during the six month period 2011. The drivers of this revenue increase were the across the board increases in revenues in each of our product and service areas, including a 20.0% increase in revenues from Interactive Distributed Generation products and services, a 36.4% increase in revenues from Utility Infrastructure products and services, and a 51.8% increase in revenues from Energy Efficiency products. Our six month period 2012 gross margin as a percentage of revenue was 30.6% compared to 31.7% in the six month period 2011. On a year-over-year basis, gross margins were negatively impacted by the mild winter weather in the first quarter of 2012, which caused Utility Infrastructure workloads to be reduced at certain utilities and the redeployment of those crews to other utilities and projects. Therefore, although Utility Infrastructure revenues increased significantly compared to the same period in 2011, inefficiencies in cost of sales related to the demobilization and redeployment of crews negatively impacted six month period 2012 gross margin results. The lower year-over-year gross margins were also due to the overall growth of Utility Infrastructure revenue in 2012, because Utility Infrastructure is generally our lowest gross margin product and service category. In addition, variations in our quarterly gross margins always result from regular on-going differences in the mix of specific projects completed in each quarter. Our operating expenses during the six month period 2012 increased by $2.8 million, or 14.3%, compared to our operating expenses during the six month period 2011. The year-over-year increase in operating expenses is due to incremental expenses we have invested in to expand and grow each of our Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency product and service areas. These expenses support new product and customer development, engineering, personnel and equipment, as well as additional sales and marketing activities, and also include increases in depreciation from capital expenditures for our Company-owned distributed generation systems. In addition, during the six month period 2012, we initiated a cost productivity initiative across business lines to identify opportunities to rationalize general and administrative expenses. This initiative is an on-going focus of ours over the coming quarters with a goal of reducing our costs as a percentage of revenue over time, and improving our operating profit margins. As a percentage of revenues, operating expenses for the six month period 2012 decreased 4.9 percentage points compared to the six month period 2011. Income from our Energy Services segment, which consists of the gain on the sale of our WaterSecure operations along with management fees and equity income from our WaterSecure operations, decreased $22.2 million during the six month period 2012 compared to the six month period 2011, due to the sale of our WaterSecure operations in June 2011 on which we recorded a $21.8 million gain in the six month period 2011. In the six month period 2012, we recorded an additional $1.4 million gain from the sale of our WaterSecure operations attributable to our receipt of sales proceeds that had been placed into escrow pending the outcome of contingencies related to the sale. We do not expect to receive any additional proceeds from this sale. Our income from continuing operations attributable to PowerSecure International, Inc. shareholders for the six month period 2012 was $1.0 million, or $0.05 per diluted share, compared to income from continuing operations attributable to PowerSecure International, Inc. shareholders of $18.0 million, or $0.94 per diluted share, for the six month period 2011, which included the $21.8 million gain from the sale of our WaterSecure operations. Our income from discontinued operations for the six month period 2012, consisting of the operating results of PowerPackages during the six month period 2012, was negligible. Income from discontinued operations for the six month period 2011 was $4.0 million, or $0.21 per diluted share, which consisted of the gain we recorded on the sale of Southern Flow, partially offset by a loss from discontinued operations of our PowerPackages business. In total, our consolidated net income attributable to PowerSecure International, Inc. common stockholders for the six month period 2012 was $1.0 million, or $0.05 per diluted share, which compared to net income attributable to PowerSecure International, Inc. common stockholders of $22.0 million, or $1.15 per diluted share, for the six month period 2011, which included the income from the gain on the sale of both Southern Flow and our WaterSecure operations. 34-------------------------------------------------------------------------------- Table of Contents As discussed below under "-Fluctuations," our financial results will fluctuate from quarter to quarter and year to year. Thus, there is no assurance that our past results, including the results of our year ended December 31, 2011 or our quarter ended June 30, 2012, will be indicative of our future results, especially in light of the current significant downturn in the economy and unfavorable credit and capital markets. Backlog As of the date of this report, our revenue backlog expected to be recognized after June 30, 2012 is $166 million. This includes revenue related to the new business awards described above under "-Recent Developments". It also includes revenue from projects assumed in conjunction with our acquisition of PowerSecure Solar also described above under "-Recent Developments". Our revenue backlog represents revenue expected to be recognized after June 30, 2012, for periods including the third quarter of 2012 onward. This backlog figure compares to the revenue backlog of $151 million we reported in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 filed on May 3, 2012 (the date we last reported our backlog). Our revenue backlog and the estimated timing of revenue recognition is outlined below, including "project-based revenues" expected to be recognized as projects are completed and "recurring revenues" expected to be recognized over the life of the contracts: Revenue Backlog to be recognized after June 30, 2012 Anticipated Estimated Primary Description Revenue Recognition Period Project-based Revenue - Near term $ 78 Million 3Q12 through 1Q13 Project-based Revenue - Long term $ 18 Million 2Q13 through 2014 Recurring Revenue $ 71 Million 3Q12 through 2020 Revenue Backlog to be recognized after June 30, 2012 $ 166 Million Note: Anticipated revenue and estimated primary recognition periods are subject to risks and uncertainties as indicated in "Cautionary Note Regarding Forward-Looking Statements" above. Consistent with past practice, these amounts are not intended to constitute our total revenue over the indicated time periods, as we have additional, regular on-going revenues. Examples of additional, regular recurring revenues include revenues from engineering fees, and service revenue, among others. Numbers may not add due to rounding. Orders in our backlog are subject to delay, deferral, acceleration, resizing, or cancellation from time to time by our customers, subject to contractual rights, and estimates are utilized in the determination of the backlog amounts. Given the irregular sales cycle of customer orders, and especially of large orders, our revenue backlog at any given time is not necessarily an accurate indication of our future revenues. Operating Segments We report our operations as two operating segments. Our Utility and Energy Technologies segment includes our core business operations. It is the only segment that we have been strategically focused on investing in and growing for the last several years. Conversely, our Energy Services segment contains our non-core business operations. We divested the operations of our Energy Services segment over time, with the final divestitures completed in 2011. As a result of these sales, we no longer actively operate in the Energy Services segment. Our reportable segments are strategic business units that offer different products and services and serve different customer bases. They are managed separately because each business requires different technology and marketing strategies. Our operating segments also represent components of our business for which discrete financial information is available and is reviewed regularly by the chief operating decision-maker, or decision-making group, to evaluate performance and make operating decisions. 35-------------------------------------------------------------------------------- Table of Contents Utility and Energy Technologies Our Utility and Energy Technologies segment includes our three primary product and service areas: our Interactive Distributed Generation products and services, our Utility Infrastructure products and services, and our Energy Efficiency products. These three groups of products and services are commonly focused on serving the needs of utilities and their commercial, institutional and industrial customers to help them generate, deliver, and utilize electricity more efficiently. These three product and service areas share common or complementary utility relationships and customer types, common sales and overhead resources, and facilities. However, we discuss and distinguish our Utility and Energy Technologies business among the three product and service areas due to the unique market needs they are addressing, and the distinct technical disciplines and specific capabilities required for us to deliver them, including personnel, technology, engineering, and intellectual capital. Our Utility and Energy Technologies segment is operated through our largest wholly-owned subsidiary, PowerSecure, Inc. Energy Services Until the completion of the sales of our remaining non-core business operations in 2011, our Energy Services segment operated through our two other principal operating subsidiaries, Southern Flow and WaterSecure. WaterSecure holds a significant non-controlling minority portion of the equity interests in an unconsolidated business, Marcum Midstream 1995-2 Business Trust, a Delaware statutory trust, which we refer to as "MM 1995-2" or as our "WaterSecure operations." Our WaterSecure operations provided water processing, recycling, and disposal services for oil and natural gas producers in northeastern Colorado utilizing environmentally responsible technologies and processes. In June 2011, substantially all of the assets and business of MM 1995-2 were sold and the proceeds from the sale and the liquidation of its remaining assets were distributed to MM 1995-2's shareholders, including our WaterSecure subsidiary, in 2011 and 2012. Accordingly, our WaterSecure subsidiary no longer has any on-going operating activity. Our Southern Flow business, which was sold in January 2011, provided oil and natural gas measurement services to customers involved in oil and natural gas production, transportation, and processing, with a focus on the natural gas market. Due to its sale, Southern Flow's operations are reflected as discontinued operations and the results of its operations are excluded from our Energy Services segment for all periods presented in the information below. The sales of our WaterSecure and Southern Flow operations completed our strategy to monetize our non-core assets to focus on the businesses in our Utility and Energy Technologies business segment. As a result of these sales, our Energy Services segment ceased on-going business activities in June 2011 and thus we no longer report ongoing operations in the Energy Services segment in financial periods after June 30, 2011. Results of Operations The following discussion regarding segment revenues, gross profit, costs and expenses, and other income and expenses for the second quarter 2012 compared to the second quarter 2011 excludes revenues, gross profit, and costs and expenses of our PowerPackages business and operations, which were discontinued in 2011, and of our Southern Flow subsidiary, which we sold in January 2011, the financial results of both of which are classified as discontinued operations in our financial statements. 36 -------------------------------------------------------------------------------- Table of Contents Second Quarter 2012 Compared to Second Quarter 2011 Revenues Our consolidated revenues are generated entirely by sales and services provided by our Utility and Energy Technologies segment. We currently provide a variety of Utility and Energy Technologies products and services, including Interactive Distributed Generation products and services, Utility Infrastructure products and services, and Energy Efficiency products. The following table summarizes our Utility and Energy Technologies segment revenues for the periods indicated (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Utility and Energy Technologies: Interactive Distributed Generation $ 16,139 $ 12,725 $ 3,414 26.8 % Utility Infrastructure 12,912 11,510 1,402 12.2 % Energy Efficiency 8,816 5,851 2,965 50.7 % Total $ 37,867 $ 30,086 $ 7,781 25.9 % Our consolidated revenues for the second quarter 2012 increased $7.8 million, or 25.9%, compared to the second quarter 2011 due to an increase in sales in each of our Utility and Energy Technologies segment products and services, including increases in Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency revenues. Our Utility and Energy Technologies segment distributed generation revenues are significantly affected by the number, size and timing of our Interactive Distributed Generation and Utility Infrastructure projects as well as the percentage of completion of in-process projects, and the percentage of customer-owned as opposed to PowerSecure-owned distributed generation recurring revenue projects. Our Interactive Distributed Generation sales have fluctuated significantly in the past and are expected to continue to fluctuate significantly in the future. The increase in our Utility and Energy Technologies segment revenues in the second quarter 2012 over the second quarter 2011 consisted of a $3.4 million, or 26.8%, increase in revenues from Interactive Distributed Generation products and services, a $3.0 million, or 50.7%, increase in revenues from Energy Efficiency products, and a $1.4 million, or 12.2%, increase in revenues from Utility Infrastructure products and services. The increase in our Interactive Distributed Generation product sales and services reflects an increase in both our PowerSecure-owned recurring revenue systems and customer-owned project sales. During the second quarter 2012, 20.9% of our distributed generation revenues were derived from recurring revenue sales, an increase over the second quarter 2011 when 19.7% of our distributed generation revenues were derived from recurring revenue sales. The increase in our Energy Efficiency sales and services in the second quarter 2012 compared to the second quarter 2011 primarily reflects an increase in revenues from our portfolio of LED lighting products including existing and new products that were introduced in 2010 and 2011 as well as an increase in the number of customers. The increase in our Utility Infrastructure product sales and services was due to an increase in the number of utilities that we service, and an increase in those utilities' spending levels on transmission and distribution system maintenance and construction. The future level of our revenues will depend on the timing and degree of the recovery of the domestic economy, the health of the credit markets and the return to pre-recession levels of customer spending for capital improvements and energy efficiency projects, as well as our ability to secure new significant purchase orders. The level and timing of our future revenues will also be affected by the amount and proportion of revenues coming from recurring revenue projects in the future, which results in revenue being recognized over a longer period. We are particularly susceptible to changes in economic conditions due to the fact that our product offerings are largely discretionary investment items for our customers, and this factor can therefore subject new sales orders to delay or deferment especially when economic conditions are not positive. 37-------------------------------------------------------------------------------- Table of Contents Gross Profit and Gross Profit Margin Our segment gross profit represents our revenues less our cost of sales. Our segment gross profit margin represents our gross profit divided by our revenues. The following tables summarizes our Utility and Energy Technologies segment cost of sales along with our segment gross profit and gross profit margin for the periods indicated (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Utility and Energy Technologies: Cost of Sales $ 25,663 $ 20,780 $ 4,883 23.5 % Gross Profit $ 12,204 $ 9,306 $ 2,898 31.1 % Gross Profit Margin 32.2 % 30.9 % Cost of sales and services include materials, personnel and related overhead costs incurred to manufacture products and provide services. The 23.5% increase in our consolidated cost of sales and services for the second quarter 2012 compared to the second quarter 2011, was driven by the increase in costs associated with the 25.9% increase in sales, together with the factors discussed below leading to the improvement in our gross profit margin. Our Utility and Energy Technologies segment gross profit increased $2.9 million, or 31.1%, in the second quarter 2012 compared to the second quarter 2011. As a percentage of revenue, our Utility and Energy Technologies segment gross profit margin in the second quarter 2012 was 32.2%, an increase of 1.3 percentage points compared to the second quarter 2011. An important driver in the period-over-period change in our gross profit margin is the relative gross margins we generally earn in each of our Distributed Generation, Utility Infrastructure and Energy Efficiency product and service categories. Our Distributed Generation products and services generally yield gross profit margins in the 25-45% range, our Utility Infrastructure products and services generally yield gross profit margins in the 5-30% range, and our Energy Efficiency products generally yield gross margins in the 20-40% range. The gross profit margin we realize within these ranges largely correlates to the amount of value-added product and services we deliver, with highly engineered, turn-key projects realizing higher gross profit margins due to the benefits they deliver our customers and the value we deliver because we are vertically integrated. Because of these gross profit margin differences, changes in the mix of our product lines affect our consolidated gross profit margin results. Our gross profit margin improvement in the second quarter 2012 compared to the second quarter 2011 was driven by a higher percentage of revenues from our higher margin Distributed Generation and Energy Efficiency products and services. As is always the case, variability in our quarterly gross margins is also caused by regular on-going differences in the mix of specific projects completed in each quarter. In the long-term, we expect that gross profit margins for this segment will increase because of anticipated greater productivity, operations and manufacturing efficiencies, improvements in technology, and growth in our higher-margin recurring revenue projects. Our gross profit and gross profit margin have been, and we expect will continue to be, affected by many factors, including the following: • the absolute level of revenue achieved in any particular period, given that portions of our cost of sales are relatively fixed over the near-term, the most significant of which is personnel and equipment costs; • the amount of revenue achieved in each of our Distributed Generation, Utility Infrastructure and Energy Efficiency product and service categories, which have different gross profit margins; • our ability to improve our operating efficiency and benefit from economies of scale; • our level of investments in our businesses, particularly for anticipated or new business awards; • improvements in technology and manufacturing methods and processes; • the mix of higher and lower margin projects, products and services, and the impact of new products and technologies on our pricing and volumes; • our ability to manage our materials and labor costs, including any future inflationary pressures; • the costs to maintain and operate distributed generation systems we own in conjunction with recurring revenue contracts, including the price of fuel, run hours, weather, and the amount of fuel utilized in their operation, as well as their operating performance; • the geographic density of our projects; 38 -------------------------------------------------------------------------------- Table of Contents • the selling price of products and services sold to customers, and the revenues we expect to generate from recurring revenue projects; • the rate of growth of our new businesses, which tend to incur costs in excess of revenues in their earlier phases and then become profitable and more efficient over time if they are successful; • costs and expenses of business shutdowns, when they occur; and • other factors described below under "-Fluctuations." Some of these factors are not within our control, and we cannot provide any assurance that we can continue to improve upon those factors that are within our control, especially given the current economic climate as well as our movement to an expected higher percentage of recurring revenue projects. Moreover, our gross revenues are likely are likely to fluctuate from quarter to quarter and from year to year, as discussed in "-Fluctuations" below. Accordingly, there is no assurance that our future gross profit margins will improve or even remain at historic levels in the future, and will likely decrease if revenues decrease. Operating Expenses Our operating expenses include general and administrative expense, selling, marketing and service expense, and depreciation and amortization. The following table sets forth our consolidated operating expenses for the periods indicated (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Consolidated Operating Expenses: General and administrative $ 9,093 $ 7,952 $ 1,141 14.3 % Selling, marketing and service 1,366 1,214 152 12.5 % Depreciation and amortization 1,136 802 334 41.6 % Total $ 11,595 $ 9,968 $ 1,627 16.3 % Costs related to personnel, including wages, benefits, stock compensation, bonuses and commissions, are the most significant component of our operating expenses. During the second quarter 2012, the year-over-year increase in operating expenses is due to incremental expenses we have invested in to expand and grow each of our Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency product and service areas. These expenses support new product and customer development, engineering, personnel and equipment, as well as additional sales and marketing activities, and also include increases in depreciation from capital expenditures for our Company-owned distributed generation systems. In the near term, we expect our operating costs, particularly our general and administrative expenses, to increase as we develop and integrate our PowerSecure Solar operations into our Interactive Distributed Generation operations. In the mid-term future, we expect the growth in our operating expenses to moderate as we implement cost reduction efforts to support our expected growth in more cost effective ways, and leverage our existing cost structure. In the longer term future, we expect our operating costs to grow to support the growth of our business, although at a lower growth rate than revenues over time, and that growth will be dependent in large part upon future economic and market conditions. Accordingly, the timing and the amount of future increases in operating expenses will depend on the timing and level of future improvements in economic and business conditions and the effects of such economic recovery on our revenues. We cannot provide any assurance as to if, when, how much or for how long economic conditions will improve, or the effects of future economic conditions on our revenues, expenses or net income. 39-------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses. General and administrative expenses include personnel wages, benefits, stock compensation, and bonuses and related overhead costs for the support and administrative functions incurred in our Utility and Energy Technologies segment together with unallocated corporate general and administrative costs. The 14.3% increase in our consolidated general and administrative expenses in the second quarter 2012, as compared to the second quarter 2011, was due to investments in personnel, vehicles and other expenses to support our increasing levels of revenue and investments in new business opportunities. The following table provides further detail of our general and administrative expenses by segment (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Segment G&A Expenses: Utility and Energy Technologies: Personnel costs $ 5,106 $ 4,609 $ 497 10.8 % Vehicle lease and rental 654 577 77 13.3 % Insurance 266 156 110 70.5 % Rent-office and equipment 256 210 46 21.9 % Professional fees and consulting 133 157 (24 ) (15.3 )% Travel 307 240 67 27.9 % Development costs 166 141 25 17.7 % Other 806 592 214 36.1 % Energy Services - - - n/m Unallocated Corporate Costs 1,399 1,270 129 10.2 % Total $ 9,093 $ 7,952 $ 1,141 14.3 % The increase in our personnel costs, vehicle lease and rental, insurance, travel and rental costs during the second quarter 2012 compared to the second quarter 2011 was due to staffing increases to support our recent and expected growth and investments in new and expanded business opportunities across each of our product and service areas of Distributed Generation, Energy Efficiency, and Utility Infrastructure. In the near-term, we expect our general and administrative expense levels to increase compared to our general and administrative expenses in the second quarter 2012 as we develop and integrate our PowerSecure Solar operations into our Interactive Distributed Generation operations. Over the long-term, we expect our expenses in these areas to increase, although at lower growth rates than our revenues, as we strive to leverage our cost structure and deliver higher operating profit margins. Unallocated corporate general and administrative expenses include similar personnel costs as described above as well as costs incurred for the benefit of all of our business operations, such as acquisition costs, legal, Sarbanes-Oxley, public company reporting, director expenses, accounting costs, and stock compensation expense on our stock options and restricted stock grants which we do not allocate to our operating segments. These costs increased year-over-year due primarily to costs incurred in connection with the recent acquisition of our PowerSecure Solar operations. We expect our unallocated corporate costs for the remainder of 2012 to remain at approximately the same or lower levels as we incurred during the second quarter 2012. 40-------------------------------------------------------------------------------- Table of Contents Selling, Marketing and Service Expenses. Selling, marketing and service expenses consist of personnel and related overhead costs, including commissions for sales and marketing activities, together with travel, advertising and promotion costs incurred in our Utility and Energy Technologies segment. The 12.5% increase in selling, marketing and service expenses in the second quarter 2012, as compared to the second quarter 2011, was due to increases in compensation, travel, and advertising and promotion expenses. The following table provides further detail of our segment selling, marketing and service expenses (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Segment Selling, Marketing and Service: Utility and Energy Technologies: Salaries $ 742 $ 588 $ 154 26.2 % Commission 312 413 (101 ) (24.5 )% Travel 186 121 65 53.7 % Advertising and promotion 144 46 98 213.0 % Bad debt expense (recovery) (18 ) 46 (64 ) (139.1 )% Energy Services - - - n/m Total $ 1,366 $ 1,214 $ 152 12.5 % In the future, we expect our near-term and long-term Utility and Energy Technologies segment selling, marketing and services expenses to grow in order to reflect, drive and support future growth. Depreciation and Amortization Expenses. Depreciation and amortization expenses include the depreciation of property, plant and equipment and the amortization of certain intangible assets including capitalized software development costs and other intangible assets. The 41.6% increase in depreciation and amortization expenses in the second quarter 2012, as compared to the second quarter 2011, primarily reflects increased depreciation and amortization resulting from capital investments at our Utility and Energy Technologies segment during 2011. These capital investments are primarily investments in PowerSecure-owned distributed generation systems for projects deployed under our recurring revenue model. 41 -------------------------------------------------------------------------------- Table of Contents Other Income and Expenses Our other income and expenses include the gain on the sale of our WaterSecure operations, management fees and equity income earned by our Energy Services segment as managing trustee of MM 1995-2 relating to the WaterSecure operations, interest income, interest expense and income taxes. The following table sets forth our other income and expenses for the periods indicated, by segment (dollars in thousands): Quarter Ended Period-over-Period June 30, Difference 2012 2011 $ % Other Segment Income and (Expenses): Utility and Energy Technologies: Interest income and other income $ - $ - $ - n/m Interest expense (68 ) (98 ) 30 (30.6 )% Segment total (68 ) (98 ) 30 Energy Services: Gain on sale of unconsolidated affiliate 1,439 21,786 (20,347 ) (93.4 )% Equity income - 548 (548 ) (100.0 )% Management fees - 114 (114 ) (100.0 )% Segment total 1,439 22,448 (21,009 ) Unallocated Corporate: Interest income and other income 23 22 1 4.5 % Interest expense (48 ) (46 ) (2 ) 4.3 % Income tax benefit (provision) (621 ) (3,183 ) 2,562 (80.5 )% Segment total (646 ) (3,207 ) 2,561 Total $ 725 $ 19,143 $ (18,418 ) Gain on Sale of Unconsolidated Affiliate. Gain on sale of unconsolidated affiliate at our Energy Services segment consists of our minority ownership share of the gain recognized by our WaterSecure operations related to the sale of substantially all of the assets and business of MM 1995-2 in June 2011. At the time of the sale, MM 1995-2 deferred $4.0 million of the gain until such time as certain contingencies associated with the sale were eliminated and the associated escrowed sales proceeds were received. These contingencies expired and were resolved in the second quarter 2012 and $3.9 million of the funds that were placed into escrow were released. In June 2012, we received our share of the escrowed sales proceeds and recorded a corresponding gain in the amount of $1.4 million during the second quarter 2012. Equity Income. Equity income at our Energy Services segment consists of our minority ownership interest in the earnings of the WaterSecure operations. Our equity income is a direct function of the net income of the WaterSecure operations. We recorded no equity income during the second quarter 2012 due to the sale of the WaterSecure operations on June 1, 2011, and due to that sale we will not record any equity income from this source in the future. Management Fees. Management fees at our Energy Services segment consist entirely of fees we earn as the managing trustee of the WaterSecure operations. These fees, to a large extent, are based on a percentage of the revenues of the WaterSecure operations. We recorded no management fees during the second quarter 2012 due to the sale of the WaterSecure operations on June 1, 2011, we will not record any management fees from this source in the future. Interest Income and Other Income. Interest income and other income for each segment consists primarily of interest we earn on the interest-bearing portion of our cash and cash equivalent balances. In total, interest income and other income increased slightly during the second quarter 2012, as compared to the second quarter 2011. This slight increase was attributable to an increase in interest-bearing cash and cash equivalent balances in the second quarter 2012 compared to the second quarter 2011. Our future interest income will depend on our cash and cash equivalent balances, which will increase and decrease depending upon our profit, capital expenditures, and our working capital needs, and future interest rates. Interest Expense. Interest expense for each segment consists of interest and finance charges on our credit facilities, term loan and capital leases. In total, interest expense decreased during the second quarter 2012, as compared to the second quarter 2011. The decrease in our interest expense reflects the reduction in balances outstanding on our capital lease obligation due to regular payments made on our capital leases over the year together with a reduction in interest 42 -------------------------------------------------------------------------------- Table of Contents associated with decreased borrowings under the revolving portion of our credit facility during the second quarter 2012, partially offset by the interest associated with our term loan we completed on February 7, 2012. We expect our future interest and finance charges to increase over time as a result of anticipated borrowings under our credit facility to fund future working capital needs and recurring revenue projects at our Utility and Energy Technologies segment. Income Taxes. The income tax provision or benefit we record is the result of applying our annual effective tax rate by our net income or loss. Our effective tax rate and our income tax provision or benefit includes the effects of permanent differences between our book and taxable income, changes in our deferred tax assets and liabilities, changes in the valuation allowance for our net deferred tax asset, state income taxes in various state jurisdictions in which we have taxable activities, and expenses associated with uncertain tax positions that we have taken or expense reductions from uncertain tax positions as a result of a lapse of the applicable statute of limitations. Our overall effective tax rate in the second quarter 2012 increased, as compared to the second quarter 2011, as we expect our effective tax rate in 2012 will more closely approximate statutory rates. Non-controlling Interest. We acquired a 67% controlling ownership interest in IES on April 1, 2010 and we acquired a 90% controlling ownership interest in PowerSecure Solar effective June 2, 2012. We record the full amount of income or loss from IES and PowerSecure Solar in our consolidated statements of operations. The non-controlling ownership interests in the income or loss of IES and PowerSecure Solar is reflected as a reduction or addition to net income or losses to derive income attributable to PowerSecure International stockholders. The increase in the addition for the non-controlling interest in the loss of our majority-owned subsidiaries in the second quarter 2012, as compared to the second quarter 2011, is a result of increased development activities at IES to bring a broader complement of new lighting products to market as well as transitional expenses at our newly acquired PowerSecure Solar operations. Six Month Period 2012 Compared to Six Month Period 2011 Revenues The following table summarizes our Utility and Energy Technologies segment revenues for the periods indicated (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Utility and Energy Technologies: Interactive Distributed Generation $ 28,644 $ 23,870 $ 4,774 20.0 % Utility Infrastructure 26,040 19,087 6,953 36.4 % Energy Efficiency 16,368 10,784 5,584 51.8 % Total $ 71,052 $ 53,741 $ 17,311 32.2 % Our consolidated revenues for the six month period 2012 increased $17.3 million, or 32.2%, compared to the six month period 2011 due to an increase in sales in each of our Utility and Energy Technologies segment products and services, including increases in Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency revenues. Our Utility and Energy Technologies segment distributed generation revenues are significantly affected by the number, size and timing of our Interactive Distributed Generation and Utility Infrastructure projects as well as the percentage of completion of in-process projects, and the percentage of customer-owned as opposed to PowerSecure-owned distributed generation recurring revenue projects. Our Interactive Distributed Generation sales have fluctuated significantly in the past and are expected to continue to fluctuate significantly in the future. The increase in our Utility and Energy Technologies segment revenues in the six month period 2012 over the six month period 2011 consisted of a $7.0 million, or 36.4%, increase in revenues from Utility Infrastructure products and services, a $5.6 million, or 51.8%, increase in revenues from Energy Efficiency products, and a $4.8 million, or 20.0%, increase in revenues from Interactive Distributed Generation products and services. The increase in our Interactive Distributed Generation product sales and services reflects an increase in both our PowerSecure-owned recurring revenue systems and customer-owned project sales. During the six month period 2012, 22.6% of our distributed generation revenues were derived from recurring revenue sales, an increase over the six month period 2011 when 18.3% of our distributed generation revenues were 43 -------------------------------------------------------------------------------- Table of Contents derived from recurring revenue sales. The increase in our Utility Infrastructure product sales and services was due to an increase in the number of utilities that we service, and an increase in those utilities' spending levels on transmission and distribution system maintenance and construction. The increase in our Energy Efficiency sales and services in the six month period 2012 compared to the six month period 2011 primarily reflects an increase in revenues from our portfolio of LED lighting products including existing and new products that were introduced in 2010 and 2011 as well as an increase in the number of customers. The increase in our Energy Efficiency sales and services in the six month period 2012 compared to the six month period 2011 reflects both an increase in the number of customers as well as an increase in revenues from our portfolio of LED lighting products including existing and new products that were introduced in 2010 and 2011. Gross Profit and Gross Profit Margin The following tables summarizes our Utility and Energy Technologies segment cost of sales along with our segment gross profit and gross profit margin for the periods indicated (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Utility and Energy Technologies: Cost of Sales $ 49,293 $ 36,706 $ 12,587 34.3 % Gross Profit $ 21,759 $ 17,035 $ 4,724 27.7 % Gross Profit Margin 30.6 % 31.7 % The 34.3% increase in our consolidated cost of sales and services for the six month period 2012 compared to the six month period 2011, was driven by the increase in costs associated with the 32.2% increase in sales, together with the factors discussed below leading to the decrease in our gross profit margin. Our Utility and Energy Technologies segment gross profit increased $4.7 million, or 27.7%, in the six month period 2012 compared to the six month period 2011. As a percentage of revenue, our Utility and Energy Technologies segment gross profit margin in the six month period 2012 was 30.6%, a decrease of 1.1 percentage points compared to the six month period 2011. An important driver in the period-over-period change in our gross profit margin is the relative gross margins we generally earn in each of our Distributed Generation, Utility Infrastructure and Energy Efficiency product and service categories. Our Distributed Generation products and services generally yield gross profit margins in the 25-45% range, our Utility Infrastructure products and services generally yield gross profit margins in the 5-30% range, and our Energy Efficiency products generally yield gross margins in the 20-40% range. The gross profit margin we realize within these ranges largely correlates to the amount of value-added product and services we deliver, with highly engineered, turn-key projects realizing higher gross profit margins due to the benefits they deliver our customers and the value we deliver because we are vertically integrated. Because of these gross profit margin differences, changes in the mix of our product lines affect our consolidated gross profit margin results. Our lower gross profit margins in the six month period 2012 compared to the six month period 2011 were due to an increase in the growth and amount of Utility Infrastructure revenue in the six month period 2012, which is generally our lowest gross margin product and service category. In addition, gross margins were negatively impacted by the mild winter weather early in the six month period of 2012, which caused Utility Infrastructure workloads to be reduced at certain utilities and the redeployment of those crews to other utilities and projects. Therefore, although Utility Infrastructure revenues increased significantly compared to the same period in 2011, inefficiencies in cost of sales related to the demobilization and redeployment of crews negatively impacted six month period 2012 gross margin results. As is always the case, variability in our quarterly gross margins is also caused by regular on-going differences in the mix of specific projects completed in each quarter. In the long-term, we expect that gross profit margins for this segment will increase because of anticipated greater productivity, operations and manufacturing efficiencies, improvements in technology, and growth in our higher-margin recurring revenue projects. 44 -------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table sets forth our consolidated operating expenses for the periods indicated (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Consolidated Operating Expenses: General and administrative $ 17,738 $ 15,633 $ 2,105 13.5 % Selling, marketing and service 2,424 2,368 56 2.4 % Depreciation and amortization 2,221 1,575 646 41.0 % Total $ 22,383 $ 19,576 $ 2,807 14.3 % During the six month period 2012, the year-over-year increase in operating expenses is due to incremental expenses to expand and grow each of our Interactive Distributed Generation, Utility Infrastructure, and Energy Efficiency product and service areas. These expenses support new product and customer development, engineering, personnel and equipment, as well as additional sales and marketing activities, and also include increases in depreciation from capital expenditures for our Company-owned distributed generation systems. In the near term, we expect our operating costs, particularly our general and administrative expenses, to increase as we develop and integrate our PowerSecure Solar operations into our Interactive Distributed Generation operations. In the mid-term future, we expect the growth in our operating expenses to moderate as we implement cost reduction efforts to support our expected growth in more cost effective ways, and leverage our existing cost structure. In the longer term future, we expect our operating costs to grow to support the growth of our business, although at a lower growth rate than revenues over time, and that growth will be dependent in large part upon future economic and market conditions. Accordingly, the timing and the amount of future increases in operating expenses will depend on the timing and level of future improvements in economic and business conditions and the effects of such economic recovery on our revenues. We cannot provide any assurance as to if, when, how much or for how long economic conditions will improve, or the effects of future economic conditions on our revenues, expenses or net income. General and Administrative Expenses. The 13.5% increase in our consolidated general and administrative expenses in the six month period 2012, as compared to the six month period 2011, was due to investments in personnel, vehicles and other expenses to support our increasing levels of revenue and investments in new business opportunities. The following table provides further detail of our general and administrative expenses by segment (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Segment G&A Expenses: Utility and Energy Technologies: Personnel costs $ 9,917 $ 8,938 $ 979 11.0 % Vehicle lease and rental 1,322 1,080 242 22.4 % Insurance 563 304 259 85.2 % Rent-office and equipment 499 419 80 19.1 % Professional fees and consulting 315 373 (58 ) (15.5 )% Travel 615 512 103 20.1 % Development costs 299 302 (3 ) (1.0 )% Other 1,613 1,238 375 30.3 % Energy Services - - - n/m Unallocated Corporate Costs 2,595 2,467 128 5.2 % Total $ 17,738 $ 15,633 $ 2,105 13.5 % The increase in our personnel costs, vehicle lease and rental, insurance, travel and rental costs during the six month period 2012 compared to the six month period 2011 was due to staffing increases to support our recent and expected growth and investments in new and expanded business opportunities across each of our product and service areas of 45-------------------------------------------------------------------------------- Table of Contents Distributed Generation, Energy Efficiency, and Utility Infrastructure. Other general and administrative expenses including professional and consulting fees and development costs decreased as a result of cost control efforts undertaken earlier in the first quarter of 2012. In the near term, we expect our general and administrative expenses, to increase as we develop and integrate our recently acquired PowerSecure Solar operations into our distributed generation operations. In the longer term future, we expect our general and administrative expenses to grow to support the growth of our business, although at a lower growth rate than revenues over time as we strive to leverage our cost structure and deliver higher operating profit margins. The increase in our unallocated corporate general and administrative expenses during the six month period 2012 as compared to the six month period 2011 was due primarily to costs incurred in connection with the recent acquisition of our PowerSecure Solar operations. We expect our unallocated corporate costs for the remainder of 2012 to remain at approximately the same or slightly lower levels as we incurred during the six month period 2012. Selling, Marketing and Service Expenses. The 2.4% increase in selling, marketing and service expenses in the six month period 2012, as compared to the six month period 2011, was due to an increase in travel and advertising and promotion expense, partially offset by recovery of bad debt and compensation costs. The following table provides further detail of our segment selling, marketing and service expenses (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Segment Selling, Marketing and Service: Utility and Energy Technologies: Salaries $ 1,402 $ 1,246 $ 156 12.5 % Commission 406 644 (238 ) (37.0 )% Travel 377 292 85 29.1 % Advertising and promotion 291 144 147 102.1 % Bad debt expense (recovery) (52 ) 42 (94 ) (223.8 )% Energy Services - - - n/m Total $ 2,424 $ 2,368 $ 56 2.4 % In the future, we expect our near-term and long-term Utility and Energy Technologies segment selling, marketing and services expenses to grow in order to reflect, drive and support future growth. Depreciation and Amortization Expenses. The 41.0% increase in depreciation and amortization expenses in the six month period 2012, as compared to the six month period 2011, primarily reflects increased depreciation and amortization resulting from capital investments at our Utility and Energy Technologies segment during 2011. These capital investments are primarily investments in PowerSecure-owned distributed generation systems for projects deployed under our recurring revenue model. 46 -------------------------------------------------------------------------------- Table of Contents Other Income and Expenses Our other income and expenses include the gain on the sale of our WaterSecure operations, management fees and equity income earned by our Energy Services segment as managing trustee of MM 1995-2 relating to the WaterSecure operations, interest income, interest expense and income taxes. The following table sets forth our other income and expenses for the periods indicated, by segment (dollars in thousands): Six Months Ended Period-over-Period June 30, Difference 2012 2011 $ % Other Segment Income and (Expenses): Utility and Energy Technologies: Interest income and other income $ - $ - $ - n/m Interest expense (130 ) (187 ) 57 (30.5 )% Segment total (130 ) (187 ) 57 Energy Services: Gain on sale of unconsolidated affiliate 1,439 21,786 (20,347 ) (93.4 )% Equity income - 1,559 (1,559 ) (100.0 )% Management fees - 282 (282 ) (100.0 )% Segment total 1,439 23,627 (22,188 ) Unallocated Corporate: Interest income and other income 45 42 3 7.1 % Interest expense (94 ) (99 ) 5 (5.1 )% Income tax benefit (provision) (228 ) (3,230 ) 3,002 (92.9 )% Segment total (277 ) (3,287 ) 3,010 Total $ 1,032 $ 20,153 $ (19,121 ) Gain on Sale of Unconsolidated Affiliate. Gain on sale of unconsolidated affiliate at our Energy Services segment consists of our minority ownership share of the gain recognized by our WaterSecure operations related to the sale of substantially all of the assets and business of MM 1995-2 in June 2011. At the time of the sale, MM 1995-2 deferred $4.0 million of the gain until such time as certain contingencies associated with the sale were eliminated and associated escrowed sales proceeds were received. These contingencies expired and were resolved in the second quarter 2012 and $3.9 million of the funds that were placed into escrow were released. In June 2012, we received our share of the escrowed sales proceeds and recorded a corresponding gain in the amount of $1.4 million during the six month period 2012. Equity Income. We recorded no equity income during the six month period 2012 due to the sale of the WaterSecure operations on June 1, 2011, and due to that sale we will not record any equity income from this source in the future. Management Fees. We recorded no management fees during the six month period 2012 due to the sale of the WaterSecure operations on June 1, 2011, and due to that sale we will not record any management fees from this source in the future. Interest Income and Other Income. In total, interest income and other income increased slightly during the six month period 2012, as compared to the six month period 2011. This slight increase was attributable to an increase in interest-bearing cash and cash equivalent balances in the six month period 2012 compared to the six month period 2011. Our future interest income will depend on our cash and cash equivalent balances, which will increase and decrease depending upon our profit, capital expenditures, and our working capital needs, and future interest rates. Interest Expense. In total, interest expense decreased during the six month period 2012, as compared to the six month period 2011. The decrease in our interest expense reflects the reduction in balances outstanding on our capital lease obligation due to regular payments made on our capital leases over the year together with a reduction in interest associated with decreased borrowings under the revolving portion of our credit facility during the six month period 2012, partially offset by the interest associated with our term loan we completed on February 7, 2012. We expect our future interest and finance charges to increase over time as a result of anticipated borrowings under our credit facility to fund future working capital needs and recurring revenue projects at our Utility and Energy Technologies segment. Income Taxes. Our overall effective tax rate in the six month period 2012 increased, as compared to the six month period 2011, as we expect our effective tax rate in 2012 will more closely approximate statutory rates. 47-------------------------------------------------------------------------------- Table of Contents Non-controlling Interest. The increase in the addition for the non-controlling interest in the loss of our majority-owned subsidiaries in the six month period 2012, as compared to the six month period 2011, is a result of increased development activities at IES to bring a broader complement of new lighting products to market as well as transitional expenses at our newly acquired PowerSecure Solar operations. Fluctuations Our revenues, expenses, margins, net income, cash flow, cash, working capital, debt balance sheet positions, and other operating results have fluctuated significantly from quarter-to-quarter, period-to-period and year-to-year during our operating history and are likely to continue to fluctuate in the future due to a variety of factors, many of which are outside of our control. Factors that affect our operating results include the following: • the effects of general economic and financial conditions, including the ongoing challenges in the economy and the difficult capital and credit markets, and the potential for such economic and market challenges to continue or recur in the future, negatively impacting our business operations and our revenues and net income, including the negative impact these conditions could have on the timing of and amounts of orders from our customers, and the potential these factors have to negatively impact our access to capital to finance our business; • the size, timing and terms of sales and orders, including large customer orders, as well as the effects of the timing of phases of completion of projects for customers, and customers delaying, deferring or canceling purchase orders or making smaller purchases than expected; • our strategy to increase our revenues through long-term recurring revenue projects, recognizing that increasing our revenues from recurring revenue projects will require significant up-front capital expenditures and will protract our revenue and profit recognition from those projects over a longer period compared to turn-key sales, while at the same time increasing our gross margins over the long-term; • our ability to sell, complete and recognize satisfactory levels of near-term quarterly revenues and net income related to our project-based sales and product and service revenues, which are recognized and billed as they are completed, in order to maintain our current profits and cash flow and to satisfy our financial covenants in our credit facilities and to successfully finance the recurring revenue portion of our business model; • our ability to maintain and grow our Utility Infrastructure revenues, and maintain and increase pricing, utilization rates and productivity rates, given the significant levels of vehicles, tools and labor in which we have invested and which is required to serve utilities in this business area, and the risk that our utility customers will change work volumes or pricing, or will displace us from providing services; • the sale of our non-core Southern Flow and WaterSecure businesses, including the associated loss of revenues, cash flow and income from those businesses and our ability to redeploy the sales proceeds productively and profitably into our core business; • our ability to obtain adequate supplies of key components and materials of suitable quality for our products on a timely and cost-effective basis, including the impact of potential supply line constraints, substandard parts, changes in environmental requirements, and fluctuations in the cost of raw materials and commodity prices, including without limitation with respect to our Energy Efficiency business unit in relation to third party manufacturing arrangements we have with vendors in China and other component parts that originate in Japan; • the performance of our products, services and technologies, and the ability of our systems to meet the performance standards they are designed and built to deliver to our customers, including but not limited to our recurring revenue projects for which we retain the on-going risks associated with the performance and ownership of the systems; • our ability to access significant capital resources on a timely basis in order to fund working capital requirements, fulfill large customer orders, finance capital required for recurring revenue projects, and finance working capital and equipment; • our ability to develop new products, services and technologies with competitive advantages and positive customer value propositions; 48 -------------------------------------------------------------------------------- Table of Contents • our ability to implement our business plans and strategies and the timing of such implementation; • the pace of revenue and profit realization from our new businesses and the development and growth of their markets, including the timing, pricing and market acceptance of our new products and services; • changes in our pricing policies and those of our competitors, including the introduction of lower cost competing technologies and the potential for them to impact our pricing and our profit margins; • variations in the length of our sales cycle and in the product and service delivery and construction process; • changes in the mix of our products and services having differing margins; • changes in our expenses, including prices for materials including but not limited to copper, aluminum and other raw materials, labor costs and other components of our products and services, fuel prices including diesel, natural gas, oil and gasoline, and our ability to hedge or otherwise manage these prices to protect our costs and revenues, minimize the impact of volatile exchange rates and mitigate unforeseen or unanticipated expenses; • changes in our valuation allowance for our net deferred tax asset, and the resulting impact on our current tax expenses, future tax expenses and balance sheet account balances; • the effects of severe weather conditions, such as hurricanes, on the business operations of our customers, and the potential effect of such conditions on our results of operations; • the life cycles of our products and services, and competitive alternatives in the marketplace; • budgeting cycles of utilities and other industrial, commercial and institutional customers, including impacts of the current downturn in the economy and difficult capital markets conditions on capital projects and other spending items; • changes and uncertainties in the lead times required to obtain the necessary permits and other governmental and regulatory approvals for projects; • the development and maintenance of business relationships with strategic partners such as utilities and large customers; • economic conditions and regulations in the energy industry, especially in the electric utility industry, including the effects of changes in energy prices, electricity pricing and utility tariffs; • changes in the prices charged by our suppliers; • the effects of governmental regulations and regulatory changes in our markets, including emissions regulations; • the effects of litigation, warranty claims and other claims and proceedings; • our ability to make and obtain the expected benefits from the development or acquisition of technology or businesses, and the costs related to such development or acquisitions; and • our ability to achieve and maintain a positive safety record, due to the importance of safety on attracting and retaining quality employees, maintaining positive financial performance, and attracting and retaining utility and customer contracts. Because we have little or no control over most of these factors, our operating results are difficult to predict. Any adverse change in any of these factors could negatively affect our business and results of operations. Our revenues and other operating results are heavily dependent upon the size and timing of customer orders and payments, and the timing of the completion of those projects. The timing of large individual orders, and of project completion, is difficult for us to predict. Because our operating expenses are based on anticipated revenues over the long-term and because a high percentage of these are relatively fixed, a shortfall or delay in recognizing revenues can cause our operating results to vary significantly from quarter-to-quarter and can result in significant operating losses or declines in profit margins in any particular quarter. If our revenues fall below our expectations in any particular quarter, we may not be able to or it may not be prudent to reduce our expenses rapidly in response to the shortfall, which can result in us suffering significant operating losses or declines in profit margins in that quarter. 49-------------------------------------------------------------------------------- Table of Contents As we develop new lines of business, our revenues and costs will fluctuate because generally new businesses require start-up expenses and it takes time for revenues to develop, which can result in losses in early periods. Another factor that could cause material fluctuations in our quarterly results is the amount of recurring, as opposed to project-based, sources of revenue we generate for our distributed generation and utility infrastructure projects. To date, the majority of our Utility and Energy Technologies segment revenues have consisted of project-based distributed generation revenues, project-based utility infrastructure revenues and sales of LED lighting fixtures, which are recognized as the sales occur or the projects are completed. However, we have marketing efforts focused on developing more sales under our recurring revenue model, for which the costs and capital is invested initially and the related revenue and profit is recognized over the life of the contract, generally five to fifteen years. Recurring revenue projects, compared to project-based sales, are generally more profitable over time, but result in delayed recognition of revenue and net income, especially in the short-term, as we implement an increased number of these recurring revenue projects. Due to all of these factors and the other risks, uncertainties and other factors discussed in this report and in our Annual Report on Form 10-K for the year ended December 31, 2011, quarter-to-quarter, period-to-period or year-to-year comparisons of our results of operations should not be relied on as an indication of our future performance. Quarterly, period or annual comparisons of our operating results are not necessarily meaningful or indicative of future performance. Liquidity and Capital Resources Overview We have historically financed our operations and growth primarily through a combination of cash on hand, cash generated from operations, borrowings under credit facilities, leasing, and proceeds from private and public sales of equity. On a going forward basis, we expect to require capital primarily to finance our: • operations; • inventory; • accounts receivable; • property and equipment expenditures, including capital expenditures related to distributed generation PowerSecure-owned recurring revenue projects; • software purchases or development; • debt service requirements; • lease obligations; • deferred compensation obligations; • business and technology acquisitions and other growth transactions; and • stock repurchases. Working Capital At June 30, 2012, we had working capital of $65.0 million, including $23.7 million in cash and cash equivalents, compared to working capital of $69.4 million, including $24.6 million in cash and cash equivalents at December 31, 2011. Changes in the components of our working capital from December 31, 2011 to June 30, 2012 and from December 31, 2010 to June 30, 2011 are explained in greater detail below. At both June 30, 2012 and December 31, 2011, we had $20.0 million of available and unused borrowing capacity from our credit facility. However, the availability of this capacity under our credit facility includes restrictions on the use of proceeds, and is dependent upon our ability to satisfy certain financial and operating covenants including financial ratios, as discussed below. 50 -------------------------------------------------------------------------------- Table of Contents Cash Flows The following table summarizes our cash flows for the periods indicated (dollars in thousands): Six Months Ended June 30, 2012 2011Net cash provided by (used in) operating activities $ 3,800 $ (11,723 ) Net cash provided by (used in) investing activities (5,609 ) 32,817 Net cash provided by financing activities 910 6,852 Net increase (decrease) in cash and cash equivalents $ (899 ) $ 27,946 Cash Provided by (Used in) Operating Activities Cash provided by (used in) operating activities consists primarily of net income adjusted for certain non-cash items including depreciation and amortization, stock-based compensation expenses and equity income. Cash used in operating activities also include operating cash distributions from our unconsolidated affiliate, the effect of changes in working capital and other activities, and cash provided by or used by our discontinued operations. Cash provided by operating activities of $3.8 million for the six month period 2012 included the effects of the following: • our income from continuing operations of $0.4 million; • gain on sale of unconsolidated affiliate of $1.4 million; • non-cash charges of $2.2 million in depreciation and amortization; • stock-based compensation expense of $0.6 million; • a decrease of $4.4 million in accounts receivable; • a decrease of $0.9 million in inventories; • a decrease of $0.4 million of accounts payable; • a decrease of $3.0 million of accrued expenses; and • cash provided by discontinued operations of $0.1 million. Cash used in operating activities of $11.7 million for the six month period 2011 included the effects of the following: • our income from continuing operations of $17.6 million; • gain on sale of unconsolidated affiliate of $21.8 million; • non-cash charges of $1.6 million in depreciation and amortization; • stock-based compensation expense of $0.9 million; • non-cash equity income from our WaterSecure operations of $1.6 million partially offset by cash distributions from those operations of $0.6 million; • an increase of $12.6 million in accounts receivable; • an increase of $1.0 million in inventories; • a decrease of $1.2 million in deferred income taxes; • a net decrease of $2.0 million in other assets and liabilities; • a decrease of $1.1 million of accounts payable; • an increase of $3.5 million of accrued expenses; and • cash used in discontinued operations of $1.1 million. Cash Provided by (Used in) Investing Activities Cash used in investing activities was $5.6 million in the six month period 2012 and cash provided by investing activities was $32.8 million in the six month period 2011. Historically, our principal cash investments have related to the purchase of equipment used in our production facilities, the acquisitions of certain contract rights, the acquisition and installation of equipment related to our recurring revenue sales, and the acquisition of businesses or technologies. During 51 -------------------------------------------------------------------------------- Table of Contents the six month period 2012, we used $3.5 to million to acquire a 90% ownership interest in PowerSecure Solar, we used $2.3 million to purchase and install equipment at our recurring revenue distributed generation sites, we used $1.2 million principally to acquire operational assets, and we received $1.4 million from the sale of our WaterSecure operations. During the six month period 2011, we received $25.6 million from the sale of our WaterSecure operations, we received $16.5 million from the sale of our Southern Flow business, we used $7.6 million to purchase and install equipment at our recurring revenue distributed generation sites, and we used $1.7 million principally to acquire operational assets. Cash Provided by Financing Activities Cash provided by financing activities was $0.9 million in the six month period 2012 and cash provided by financing activities was $6.9 million in the six month period 2011. During the six month period 2012, we received $2.4 million proceeds from a term loan, we used $1.0 million to repurchase shares of our common stock and we used $0.5 million to repay our capital lease and term loan obligations. During the six month period 2011, we received $5.0 million from borrowings on our credit facility, we received $2.1 million from sale leaseback transactions, we received $0.3 million from the exercise of stock options, we used $0.2 million to repurchase our common stock, and we used $0.4 million to repay our capital lease obligations. Capital Spending Our capital expenditures during the six month period 2012 were approximately $3.5 million, of which we used $2.3 million to purchase and install equipment for our PowerSecure-owned recurring revenue distributed generation systems, and we used $1.2 million to purchase equipment and other capital items. Our capital expenditures during the six month period 2011 were approximately $9.3 million, of which we used $7.6 million to purchase and install equipment at our recurring revenue distributed generation sites, and we used $1.7 million to purchase equipment and other capital items. We anticipate making capital expenditures of approximately $7-10 million for fiscal year 2012, although customer demand for our Interactive Distributed Generation systems under recurring revenue contract arrangements, and economic and financial conditions could cause us to reduce or increase those capital expenditures. The vast majority of our capital spending has to date been and will continue to be used for investments in assets related to our recurring revenue projects as well as equipment to support our growth. Indebtedness Line of Credit. We have had a credit facility with Citibank, N.A. ("Citibank"), as administrative agent and lender, and other lenders since entering into a credit agreement in August 2007. At June 30, 2012 and December 31, 2011, our credit agreement with Citibank along with Branch Banking and Trust Company ("BB&T") as additional lender, consists of a $20.0 million senior, first-priority secured revolving and term credit facility. The credit facility is guaranteed by all of our active subsidiaries and secured by all of our assets and the assets of our active subsidiaries. In addition, the credit facility provides for a five year term loan of up to $2.6 million, and we completed the financing of a $2.4 million term loan under this provision on February 7, 2012. We have used, and intend to continue to use, the proceeds available under the credit facility to finance PowerSecure's recurring revenue projects as well as to finance capital expenditures, working capital, and for general corporate purposes. The credit facility, as a revolving credit facility, will mature and terminate on November 12, 2014. However, we have the option prior to that maturity date to convert a portion of outstanding principal balance thereunder, in an amount not to exceed the present value of estimated annual contract revenues receivable under recurring revenue distributed generation projects, into a non-revolving term loan for a two year period expiring November 12, 2016, making quarterly payments based upon a four year fully amortized basis. Outstanding balances under the credit facility (including under the term loan described below) bear interest, at our discretion, at either the London Interbank Offered Rate ("LIBOR") for the corresponding deposits of U. S. Dollars plus an applicable margin, which is on a sliding scale ranging from 2.00% to 3.25% based upon our leverage ratio, or at Citibank's alternate base rate plus an applicable margin, on a sliding scale ranging from 0.25% to 1.50% based upon our leverage ratio. Our leverage ratio is the ratio of our funded indebtedness as of a given date, net of our cash on hand in excess of $5.0 million, to our consolidated EBITDA, as defined in the credit agreement, for the four consecutive fiscal quarters ending on such date. Citibank's alternate base rate is equal to the higher of the Federal Funds Rate as published by the Federal Reserve of New York plus 0.50%, Citibank's prime commercial lending rate and 30 day LIBOR plus 1.00%. 52 -------------------------------------------------------------------------------- Table of Contents The credit facility is not subject to any borrowing base computations or limitations, but does contain certain financial covenants made by us. Under the credit agreement, if cash on hand does not exceed funded indebtedness by at least $5.0 million, then our minimum fixed charge coverage ratio must be in excess of 1.25, where the fixed charge coverage ratio is defined as the ratio of the aggregate of our trailing 12 month consolidated EBITDA plus our lease expense minus our taxes based on income and payable in cash, divided by the sum of our consolidated interest charges plus our lease expenses plus our scheduled principal payments and dividends, computed over the previous period. In addition, we are required to maintain a minimum consolidated tangible net worth, computed on a quarterly basis, of not less than the sum of $80.0 million, plus an amount equal to 50% of our net income each fiscal year commencing January 1, 2012, with no reduction for any net loss in any fiscal year, plus 100% of any equity we raise through the sale of equity interests, less the amount of any non-cash charges or losses. Also, the ratio of our funded indebtedness to our capitalization, computed as funded indebtedness divided by the sum of funded indebtedness plus stockholders equity, cannot exceed 25%. As of June 30, 2012, we were in compliance with these financial covenants. Under the credit agreement, upon the sale of any of our assets or the assets of our subsidiaries other than in the ordinary course of business or the public or private sale or issuance of any of our equity or our debt or the issuance or any equity or debt of our subsidiaries other than equity issuances where the aggregate net equity proceeds do not exceed $15.0 million, we are required to use the net proceeds thereof to repay any indebtedness then outstanding under the credit facility. The credit facility contains customary terms and conditions for credit facilities of this type, including restrictions on our ability to incur additional indebtedness, create liens, enter into transactions with affiliates, make acquisitions or sales, pay dividends on or repurchase our capital stock or consolidate or merge with other entities. In addition, the credit agreement contains customary events of default which were not modified in connection with the amendment and restatement, including payment defaults, breach of representations and warranties, covenant defaults, cross-defaults, certain bankruptcy or insolvency events, judgment defaults and certain ERISA-related events, which were not modified by the amendment and restatement. Our obligations under the credit facility are secured by guarantees ("Guarantees") and security agreements (the "Security Agreements") by each of our active subsidiaries, including PowerSecure, Inc. and its subsidiaries. The Guarantees guaranty all of our obligations under the credit facility, and the Security Agreements grant to the Lenders a first priority security interest in virtually all of the assets of each of the parties to the credit agreement. There were no balances outstanding on the revolving portion of the credit facility at, or during the six months ended, June 30, 2012 or at December 31, 2011 or at August 6, 2012. We currently have $20.0 million available to borrow under the credit facility. However, the availability of this capital under our credit facility includes restrictions on the use of proceeds, and is dependent upon our ability to satisfy certain financial and operating covenants, as described above. Term Loan. The credit agreement also provides for a five year term loan of up to $2.6 million, and we completed the financing of a $2.4 million term loan under this provision on February 7, 2012. The term loan is secured by deeds of trust we granted for the benefit of the lenders on the real estate and offices of our headquarters in Wake Forest, North Carolina and on the real estate and offices of our PowerFab facility in Randleman, North Carolina. The term loan was made under the credit agreement, and upon the same terms and conditions including covenants and interest rates, except that we are required to make quarterly principal repayments of $40 thousand, plus interest, on the term of the term loan based on a 15 year amortization schedule with the remaining outstanding principal balance due and payable on November 12, 2016. The outstanding balance on our term loan was $2.3 million at June 30, 2012. Capital Lease Obligations. We have a capital lease with SunTrust Equipment Finance and Leasing, an affiliate of SunTrust Bank, from the sale and leaseback of distributed generation equipment placed in service at customer locations. We received $5.9 million from the sale of the equipment in December 2008 which we are repaying under the terms of the lease with monthly principal and interest payments of $85 thousand over a period of 84 months. At the expiration of the term of the lease in December 2015, we have the option to purchase the equipment for $1 dollar, assuming no default under the lease by us has occurred and is then continuing. The lease is guaranteed by us under an equipment lease guaranty. The lease and the lease guaranty constitute permitted indebtedness under our current credit agreement. 53-------------------------------------------------------------------------------- Table of Contents Proceeds of the lease financing were used to finance capital investments in equipment for our recurring revenue distributed generation projects. We account for the lease financing as a capital lease in our consolidated financial statements. The lease provides us with limited rights, subject to the lessor's approval which will not be unreasonably withheld, to relocate and substitute equipment during its term. The lease contains representations and warranties and covenants relating to the use and maintenance of the equipment, indemnification and events of default customary for leases of this nature. The lease also grants to the lessor certain remedies upon a default, including the right to cancel the lease, to accelerate all rent payments for the remainder of the term of the lease, to recover liquidated damages, or to repossess and re-lease, sell or otherwise dispose of the equipment. Under the lease guaranty, we have unconditionally guaranteed the obligation of our PowerSecure subsidiary under the lease for the benefit of the lessor. Our capital lease obligation at June 30, 2012 and December 31, 2011 was $3.2 million and $3.6 million, respectively. Preferred Stock Redemption. The terms of our Series B preferred stock required us to redeem all shares of our Series B preferred stock that remained outstanding on December 9, 2004 at a redemption price equal to the liquidation preference of $1 thousand per share plus accumulated and unpaid dividends. Our remaining redemption obligation at June 30, 2012, to holders of outstanding shares of Series B preferred stock that have not been redeemed, is $0.1 million. Contractual Obligations and Commercial Commitments We incur various contractual obligations and commercial commitments in our normal course of business. We lease certain office space, operating facilities and equipment under long-term lease agreements; in February 2012, we completed a $2.4 million term loan under our credit facility; to the extent we borrow under the revolving portion of our credit facility, we are obligated to make future payments under that facility; we have a deferred compensation obligation; and we have a non-compete agreement providing for on-going payments. At June 30, 2012, we also had a liability for unrecognized tax benefits and related interest and penalties totaling $1.0 million. We do not expect a significant payment related to these obligations within the next year and we are unable to make a reasonably reliable estimate if and when cash settlement with a taxing authority would occur. Accordingly, the information in the table below, which is as of June 30, 2012, does not include the liability for unrecognized tax benefits (dollars in thousands): Payments Due by Period Remainder More than Contractual Obligations Total of 2012 1-3 Years 4-5 Years 5 Years Revolving portion of credit facility (1) $ - $ - $ - $ - $ - Term loan (2) 2,632 120 467 2,045 - Capital lease obligations (2) 3,553 508 2,030 1,015 - Operating leases 10,791 1,362 4,805 3,320 1,304 Deferred compensation (3) 2,661 - - 2,661 - Non-compete agreement 300 - 200 100 - Series B preferred stock 104 104 - - - Total $ 20,041 $ 2,094 $ 7,502 $ 9,141 $ 1,304 (1) Total repayments are based upon borrowings outstanding as of June 30, 2012, not actual or projected borrowings after such date. Repayments do not included interest that may become due and payable in any future period. (2) Repayments amounts include interest on the term loan at the interest rate in effect as of June 30, 2012 and on the capital lease obligation at the interest rate per the agreement. (3) Total amount represents our expected obligation on the deferred compensation arrangement and does not include the value of the restricted annuity contract, or interest earnings thereon, that we purchased to fund our obligation. 54 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements During the second quarter 2012, we did not engage in any material off-balance sheet activities or have any relationships or arrangements with unconsolidated entities established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide additional funding to any such entities. Liquidity Based upon our plans and assumptions as of the date of this report, we believe that our capital resources, including our cash and cash equivalents, amounts available under our credit facility, along with funds expected to be generated from our operations, will be sufficient to meet our anticipated cash needs, including for working capital, capital spending and debt service commitments, for at least the next 12 months. However, any projections of future cash needs and cash flows are subject to substantial risks and uncertainties. See "Cautionary Note Regarding Forward-Looking Statements" above in this report and Part II "Item 1A. Risk Factors." Although we believe that we have sufficient capital to fund our activities and commitments for at least the next 12 months, our future cash resources and capital requirements may vary materially from those now planned. Our ability to meet our capital needs in the future will depend on many factors, including the effects of the current economic and financial crisis, the timing of sales, the mix of products, the amount of recurring revenue projects, our ability to meet our financial covenants under our credit facility, unanticipated events over which we have no control increasing our operating costs or reducing our revenues beyond our current expectations, and other factors listed above under "-Fluctuations" above. For these reasons, we cannot provide any assurance that our actual cash requirements will not be greater than we currently expect or that these sources of liquidity will be available when needed. We also continually evaluate opportunities to expand our current, or to develop new, products, services, technology and businesses that could increase our capital needs. In addition, from time to time we consider the acquisition of, or the investment in, complementary businesses, products, services and technology that might affect our liquidity requirements. We may seek to raise any needed or desired additional capital from the proceeds of public or private equity or debt offerings at the parent level or at the subsidiary level or both, from asset or business sales, from traditional credit financings or from other financing sources. In addition, we continually evaluate opportunities to improve our credit facilities, through increased credit availability, lower debt costs or other more favorable terms. However, our ability to obtain additional capital or replace or improve our credit facilities when needed or desired will depend on many factors, including general economic and market conditions, our operating performance and investor and lender sentiment, and thus cannot be assured. In addition, depending on how it is structured, a financing could require the consent of our current lending group. Even if we are able to raise additional capital, the terms of any financings could be adverse to the interests of our stockholders. For example, the terms of a debt financing could restrict our ability to operate our business or to expand our operations, while the terms of an equity financing, involving the issuance of capital stock or of securities convertible into capital stock, could dilute the percentage ownership interests of our stockholders, and the new capital stock or other new securities could have rights, preferences or privileges senior to those of our current stockholders. Accordingly, we cannot provide any assurance that sufficient additional funds will be available to us when needed or desired or that, if available, such funds can be obtained on terms favorable to us and our stockholders and acceptable to those parties who must consent to the financing. Our inability to obtain sufficient additional capital on a timely basis on favorable terms when needed or desired could have a material adverse effect on our business, financial condition and results of operations. Critical Accounting Policies Management's discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates, including those related to revenue recognition and percentage of completion, fixed price contracts, product returns, warranty obligations, bad debt, inventories, cancellations costs associated with long term commitments, incentive compensation, investments, intangible assets, assets subject to disposal, income taxes, restructuring, service contracts, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which 55-------------------------------------------------------------------------------- Table of Contents form the basis for making estimates and judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ from those estimates and could have a material impact on our consolidated financial statements. We have identified the accounting principles which we believe are most critical to understanding our reported financial results by considering accounting policies that involve the most complex or subjective decisions or assessments. These accounting policies described below include: • revenue recognition; • allowance for doubtful accounts; • inventory valuation reserve; • warranty reserve; • impairment of goodwill and long-lived assets; • deferred tax valuation allowance; • uncertain tax positions; • costs of exit or disposal activities and similar nonrecurring charges; and • stock-based compensation. These accounting policies are described in our Annual Report on Form 10-K for the year ended December 31, 2011 in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Recent Accounting Pronouncements Fair Value Measurements - In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2011-04, which amended Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This amendment is intended to result in convergence between U.S. GAAP and International Financial Reporting Standards ("IFRS") requirements for measurement of and disclosures about fair value. This amended guidance clarifies the concepts applicable for fair value measurement of non-financial assets and also expands the disclosures for fair value measurements that are estimated using significant unobservable inputs used in a fair value measurement. This amended guidance became effective for us on a prospective basis commencing January 1, 2012. The adoption of this standard had no effect on our financial position or results of operations. Testing Goodwill for Impairment - In September 2011, the FASB issued ASU No. 2011-08, Intangibles-Goodwill and Other (Topic 350)-Testing Goodwill for Impairment. This standard, which amends and updates guidance on the periodic testing of goodwill for impairment, provides companies with the option to first assess qualitative factors to determine whether it is more likely than not that that the fair value of a reporting unit is less than its carrying amount. If so, then it is necessary to perform the two-step quantitative goodwill impairment test. This standard becomes effective for fiscal years beginning after December 15, 2011, with early adoption allowed. We adopted this standard effective October 1, 2011. The adoption of this standard had no effect on our financial position or results of operations. Testing Indefinite-Lived Intangible Assets for Impairment - In July 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This standard, which amends the guidance on testing indefinite-lived intangible assets, other than goodwill, for impairment, provides companies with the option to first perform a qualitative assessment before performing the two-step quantitative impairment test. If the company determines, on the basis of qualitative factors, that the fair value of the indefinite-lived intangible asset is more likely than not to exceed its carrying amount, then the company would not need to perform the 56-------------------------------------------------------------------------------- Table of Contents two-step quantitative impairment test. This standard does not revise the requirement to test indefinite-lived intangible assets annually for impairment. This standard becomes effective for annual and interim impairment tests performance for fiscal years beginning after September 15, 2012, with early adoption allowed. We do not expect the adoption of this standard will have a material effect on our financial position or results of operations. |