| MODTECH HOLDINGS INC ITEM 1A RISK FACTORS Our business is subject to a number of business risks and uncertainties that could impact the accuracy of any future looking statements in this report and cause actual results to differ materially from those projected or anticipated |
| These risk and uncertainties include, but are not limited to, the following: We have recently incurred significant operating losses as well as negative operating cash flow and may continue to do so which could adversely affect our liquidity and our ability to obtain bonding necessary for our construction projects |
| We experienced significant operating losses in 2005 and 2004 as well as negative operating cash flow for both years and may continue to experience future operating losses and negative operating cash flow |
| The operating losses in 2004 were due primarily to losses on a single project and unanticipated price increases for raw materials that were not able to be passed on to the customer |
| Although we had positive gross profit during the year ended December 31, 2005, we experienced a net loss of approximately dlra21dtta1 million for the twelve month period ended December 31, 2005 and a net decrease in cash and cash equivalents of approximately dlra8dtta5 million for the period |
| Cost overruns of dlra11dtta5 million on four projects and the high cost of servicing our debt, totaling dlra9dtta0 million for the twelve-month period ended December 31, 2005 were the primary causes of the losses |
| We may experience future losses that could adversely affect our liquidity and ability to obtain bonding |
| In the past year, we have breached the financial covenants of our credit facility |
| On March 31, 2006, we entered into a new credit facility with Bank of America, as further described below under “Liquidity” in Item 7 |
| This credit facility with Bank of America requires us to maintain certain financial ratios |
| During 2005, we were unable to meet the financial ratios required by our prior lender and had to obtain waivers and amendments |
| We incurred substantial fees to obtain the amendments |
| While we believe we will be able to meet the financial ratios under our new Bank of America credit facility, it is possible that we will fail to do so and have to seek waivers and amendments |
| Borrowings under our new credit facility with Bank of America are secured by liens on substantially all of our assets and the assets of our subsidiaries |
| Should we experience a default under the new credit facility, the lenders could foreclose upon all or substantially all of our assets and the assets of our subsidiaries |
| We cannot assure you that we will generate sufficient cash flow to repay our indebtedness, and we further cannot assure you that, if the need arises, we will be able to obtain additional financing or to refinance our indebtedness on terms acceptable to us, if at all |
| Any such failure to obtain financing could reduce our access to necessary capital to fund our operations which would harm our business, results of operations and financial condition |
| 8 _________________________________________________________________ Our substantial leverage could adversely affect our financial condition |
| We are highly leveraged and expect to continue to be highly leveraged |
| As of December 31, 2005, our aggregate outstanding indebtedness was dlra43dtta6 million |
| As of March 31, 2006, such indebtedness is dlra45 million |
| Our primary source of capital is our credit facility with Bank of America which provides for a revolving line of credit of dlra25 million maturing in March 2009 |
| The amount we are able to borrow under the revolving credit line depends on our borrowing base which in turn depends on our inventory levels, accounts receivable and available cash |
| If these assets decline in value, our borrowing base could decrease, which could reduce our access to capital at a given time and harm our business, results of operations and financial condition |
| For example, it could: • require us to dedicate a substantial portion of our cash flow to the repayment of our indebtedness, reducing the amount of cash flow available to fund manufacturing, distribution and other operating expenses; • limit our flexibility in planning for or reacting to downturns in our business, our industry or the economy in general; • limit our ability to obtain additional financing, if necessary, for operating expenses, or limit our ability to obtain such financing on terms acceptable to us; and • limit our ability to pursue strategic acquisitions and other business opportunities that may be in our best interests |
| The prices of raw materials have significantly increased in recent years and if we are unable to pass these costs onto our customers, our financial results could be significantly harmed |
| The cost of raw materials represents a significant portion of our operating expenses |
| As a result of domestic and international events, the prices of raw materials we use in our operations fluctuate and have significantly increased in recent years |
| Although we did not experience significant fluctuations in the cost of raw materials used in 2005, during 2004, the cost of steel nearly doubled for certain steel used in some of our components and overall our steel costs were up in excess of 30prca |
| We are not always able to obtain the right in our contracts to pass through raw material price increases to our customers |
| Should we again experience significant increases in the price of raw materials as we did in 2004, our financial results could be adversely affected |
| Our credit facility contains certain covenants that limit the way we can conduct business |
| Our credit facility contains various covenants limiting our ability to incur or guarantee additional indebtedness, pay dividends and make other distributions, pre-pay any subordinated indebtedness, make investments and other restricted payments, make capital expenditures, make acquisitions and sell assets |
| These covenants may prevent us from raising additional financing, competing effectively or taking advantage of new business opportunities The loss of any one of our customers or failure to collect a receivable from them could adversely affect our operations and financial position |
| We receive a significant portion of our revenues from the sale of classrooms to California school districts, to leasing companies that lease to such school districts and to a small number of independent dealers |
| Historically, certain California school districts, certain leasing companies and certain independent dealers have individually accounted for 10prca or more of our consolidated revenues in certain quarters or represented 10prca or more of our net accounts receivables on any given date |
| During the year ended December 31, 2005, sales of classrooms, directly or indirectly, for use in California schools accounted for approximately 46prca of our net sales |
| During the same year, two independent dealers accounted for 9dtta9prca and 5dtta5prca, respectively, of our net sales |
| The loss of any significant customer, the failure to collect a significant receivable from a significant customer, any material reduction in orders by a significant customer or the cancellation of a significant customer order could significantly reduce our revenues and consequently harm our financial condition and our ability to fund our operations and service our debt |
| Sales of our classroom products are dependent upon the legislative and educational policies and the financial condition of the states in which we do business |
| The demand for our modular relocatable classrooms is affected by various state statutes which, among other things, prescribe: • The way in which all school classrooms to be constructed on public lands must be designed and engineered; • The methods by which customers for our classroom product, primarily individual school districts, obtain funding for the construction of new facilities; and • The manner in which available funding is spent |
| 9 _________________________________________________________________ As a result, our business depends upon the legislative and educational policies and financial condition of the states in which we do business |
| For example, in California, funding for new school construction and rehabilitation of existing schools by school districts currently is provided primarily at the state level, through annual allocations of funds derived from general revenue sources and statewide bond issues |
| In addition, school districts obtain funding for the purchase or lease of school facilities through the imposition of developers’ fees and local bond issuances |
| The availability of this funding is subject to financial and political considerations which vary from district to district and is not tied to demand |
| In California there is a requirement that, in order for school districts to increase the amount of funds to be received from developers in excess of the statutory level, school districts must show that 20prca of all classroom space, not just space to be added, consists of relocatable classrooms |
| Although our classroom units qualify as relocatable structures, there are alternative structures that are less relocatable in nature than our classrooms that may also satisfy this legislative requirement |
| Changes in the legislative and educational policies or shortages of financial resources at either state or local levels in the states in which we do business could make our products less attractive to our principal customers or reduce the financial ability of our principal customers to purchase our products, any of which could reduce our revenue and harm our business, results of operations and financial condition |
| Despite the existence of some barriers to entry into our markets, our markets are competitive and our market share may be reduced if competitors enter the market or we are unable to respond to our competitors effectively |
| Barriers to entry into the modular classroom and commercial and light industrial modular building markets consist primarily of access to capital, the availability of a qualified labor pool, the nature of the bidding process, the level of performance bonding required, and the industry’s regulated environment |
| In the California market, for example, the state approves the designs and plans for classrooms sold to California schools and the time required to complete the approval process also creates a barrier to entry |
| However, manufacturers of other modular buildings, including housing and classrooms, who possess a skilled work force and manufacturing facilities, could easily adapt their manufacturing facilities to produce modular structures, and might choose to do so, during an economic downturn in their industry |
| We expect continued competition from existing competitors as well as competition from new entrants into the modular building market |
| In 2005, two of our former executive officers opened separate and unrelated modular building manufacturing business, one in Texas and the other across the street from our plant in Perris, California |
| Our ability to compete successfully depends on several factors, including: • maintaining high product quality; • ability to deliver products on a timely basis; • pricing policies of our competitors; • success in designing and manufacturing new products; • performance of competitors’ products; • marketing, manufacturing and distribution capability; and • financial strength |
| To the extent our products achieve market success, competitors typically seek to offer competitive products or lower prices, which, if successful, could reduce our market share, harm our ability to compete successfully and reduce our revenue and margins which could harm our business, results of operations and financial condition |
| Fluctuations, seasonality and economic downturns in any of our end-markets may have adverse consequences for our business |
| Our quarterly revenue typically has been highest in the second and third quarters of the year when school districts generally place a large number of orders for modular classrooms to be delivered in time for the upcoming school year |
| Additionally, first and fourth quarter revenues are typically lower due to a greater number of holidays, days of inclement weather, and customer budget and fiscal constraints during such periods |
| In the past, the level of funding available from the states in which we do business to the school districts which are the end customers of our classrooms have caused such districts to experience budget shortfalls and to reduce their demand for our products despite growing student populations |
| If restrictions or limitations on funding available to school districts from the states in which we do business increases, it could result in a lower number of orders for our products which could reduce our revenues and consequently harm our financial condition and our ability to fund our operations and service our debt |
| If we are unable to successfully contain costs and effectively transition operations in connection with our recent plant closures, our revenues and profitability could decline |
| We closed our plant in Lathrop, California on April 30, 2005 |
| The effect of this closure will increase our transportation costs for jobs in Northern California |
| This increase in costs could reduce our ability to obtain future work in Northern California or our profit margins could be negatively impacted |
| If we are unable to effectively integrate our former operations at Lathrop into our remaining plants, it could harm our overall operations |
| We also closed a small facility in Perris, California on December 31, 2005 |
| If we are unable to effectively integrate our former operations at this facility into our remaining plants, it could harm our overall operations |
| 10 _________________________________________________________________ If liabilities related to inspection and certification tests exceed our estimates, our profitability could be harmed |
| Most of our contracts require us to build classrooms which meet certain established state mandated function and manufacturing specifications |
| Under such contracts, we assume the liability for correcting, without additional compensation, any deficiencies which cause the classrooms to fail inspection and certification tests |
| We rely upon our experience and expertise to evaluate the potential for such liability and to price our bids accordingly and we follow strict quality control standards and subject our units under construction to extensive testing under the supervision of inspectors hired by our customers |
| In the past, we have incurred liability for corrections significantly in excess of our estimates, and this has adversely affected our profitability |
| We could incur such liability again in the future |
| We are subject to government regulations and other standards that impose operational and reporting requirements |
| We are subject to a variety of Untied States federal, state and local government laws, rules and regulations, including those related to the use, storage, handling, discharge or disposal of certain toxic, volatile or otherwise hazardous chemicals used in the manufacturing process |
| We believe we are currently in material compliance with such laws, rules and regulations and price our bids in accordance with our experience and expertise to include the costs of such compliance |
| If there are changes in such laws, rules or regulations or we are found not to be in compliance with such laws, rules or regulations, we could be required to incur substantial additional expenses to acquire equipment necessary to make our manufacturing process compliant and could incur fines or penalties associated with any non-compliance, which we are unable to quantify at this time but which could be material |
| Any such event could cause our product costs to significantly increase, thus reducing our margins and harming our ability to compete effectively which would harm our business, results of operations and financial condition |
| The Sarbanes-Oxley Act of 2002 required us to change or supplement some of our corporate governance and securities disclosure and compliance practices |
| The Securities and Exchange Commission and NASDAQ have revised, and continue to revise, their regulations and listing standards |
| These developments have increased, and may continue to increase, our legal compliance and financial reporting costs |
| For example, direct costs relating to Sarbanes-Oxley compliance during 2005 are estimated to exceed dlra500cmam000 and in 2004 were approximately dlra750cmam000 |
| These developments may also make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage |
| This, in turn, could make it more difficult for us to attract and retain qualified member of our board of directors, or qualified executive officers |
| Failure to comply with present or future laws, rules and regulations of any kind that govern our business could result in suspension of all or a portion of production, cessation of all or a portion of our operations, or the imposition of significant administrative, civil, or criminal penalties, any of which could harm our business |
| We may underutilize our manufacturing facilities or we may have inadequate facilities to meet the demand for our products |
| We may underutilize our manufacturing facilities from time to time as a result of reduced demand for our products |
| If demand for our products does not increase consistent with our plans and expectations, we will continue to incur fixed expenses and if our facilities are underutilized our revenues and margins will decrease which could harm our ability to fund operations and service our debt |
| Conversely, there may be situations in the future in which our manufacturing facilities will be inadequate to meet the demand for our products |
| Our inability to generate sufficient manufacturing capacities to meet demand, either through our own facilities or through outsourcing to third parties, could result in our inability to fulfill orders or require us to turn down orders which could have an adverse effect on our business, results of operations and financial condition |
| Our assembly line process requires a significant number of manufacturing employees, many of whom are employed at relatively low wages |
| In periods of low unemployment, we have experienced difficulty in finding suitable replacements for our workforce when turnover occurs |
| Additionally, the remote location of our manufacturing facility in Glen Rose, Texas, may make it difficult to hire qualified employees at that facility |
| Our inability to hire and retain sufficient numbers of manufacturing employees at any of our operating facilities could result in our inability to fulfill orders or require us to turn down orders which could have an adverse effect on our business, results of operations and financial condition |
| 11 _________________________________________________________________ We have acquired and may continue to acquire other companies and may be unable to successfully integrate these companies into our operations |
| In the past, we have expanded our operations through strategic acquisitions, and we may continue to expand and diversify our operations with additional acquisitions |
| We may not realize the anticipated benefit from any of the transactions we pursue |
| Regardless of whether we consummate any such transaction, the negotiation of a potential transaction as well as the integration of the acquired business could require us to incur significant costs and cause diversion of management’s time and resources |
| Any such transaction could also result in impairment of goodwill and other intangibles, write-offs and other related expenses |
| If we are unsuccessful in integrating these companies into our operations or if integration is more difficult than anticipated our business, results of operations and financial condition could be harmed |
| Some of the risks that may affect our ability to integrate acquired companies include those associated with: • Unexpected losses of key employees or customers of the acquired company; • Conforming the acquired company’s standards, processes, procedures and controls with our operations; • Coordinating new product and process development; • Hiring additional management and other critical personnel; and • Increasing the scope, geographic diversity and complexity of our operations |
| Earthquakes or other natural disasters may cause us significant losses |
| Our corporate headquarters, certain of our manufacturing facilities and certain other critical business operations are located near major earthquake fault lines |
| We do not maintain earthquake insurance and could be harmed in the event of a major earthquake |
| We maintain some business interruption insurance to help reduce the effect of such business interruptions, but we are not fully insured against such risks |