10-K 1 form10-k.htm INSITUFORM TECHNOLOGIES, INC. FORM 10-K Insituform Technologies, Inc. Form 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

Commission file number 0-10786

 
Insituform Technologies, Inc.
  
(Exact name of registrant as specified in its charter)

 
Delaware
  
13-3032158
  
 
(State or other jurisdiction of incorporation or organization)
  
(I.R.S. Employer Identification No.)
  
         
 
702 Spirit 40 Park Drive
      
 
Chesterfield, Missouri
  
63005
  
 
(Address of principal executive offices)
  
(Zip Code)
  
 
Registrant’s telephone number, including area code:
  
636-530-8000
     
Securities registered pursuant to Section 12(b) of the Act:
  
None
     
Securities registered pursuant to Section 12(g) of the Act:
    
Title of each class
  
Name of each exchange on which reported
 
Class A Common Shares, $.01 par value
  
The Nasdaq Global Select Market
 
Preferred Stock Purchase Rights
  
The Nasdaq Global Select Market

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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large accelerated o Accelerated filer þ Non-accelerated filer o

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of June 30, 2006: $621,041,614

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date: Class A common shares, $.01 par value, as of February 20, 2007: 27,247,985 shares

DOCUMENTS INCORPORATED BY REFERENCE

As provided herein, portions of the documents below are incorporated by reference:

Document
Part - Form 10-K
   
Registrant’s Proxy Statement
Part III
for the 2007 Annual Meeting of
  
Stockholders
  
 



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Item 1.
Business

Forward-Looking Information

This Annual Report on Form 10-K contains various forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995) that are based on information currently available to the management of Insituform Technologies, Inc. and on management’s beliefs and assumptions. When used in this document, the words “anticipate,” “estimate,” “believe,” “plan,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Such statements are subject to risks and uncertainties and include among others, our belief with respect to estimated and anticipated costs to complete ongoing projects, our belief that our documentation will substantiate contract claim conditions, our expectation with respect to the completion dates of ongoing projects and the amount of backlog we will perform, our belief of the amounts we may recover for pending tunneling claims, our intention to obtain work that is comparable with our tunneling operation’s core competency, our belief with respect to anticipated levels of operating expenses, our belief that we have adequate resources and liquidity to fund future cash requirements and debt repayments, our expectation with respect to the anticipated growth of our businesses and our belief with respect to the strength of our trademark and our degree of market penetration. Our actual results may vary materially from those anticipated, estimated or projected due to a number of factors, such as the competitive environment for our products and services, the availability and pricing of raw materials used in our operations, increased competition upon expiration of our patents or the inadequacy of one or more of our patents to protect our operations, the geographical distribution and mix of our work, our ability to attract business at acceptable margins, the strength of our marketing and sales skills, foreseeable and unforeseeable issues in projects that make it difficult or impossible to meet projected margins, the timely award or cancellation of projects, our ability to maintain adequate insurance coverage for our business activities, political circumstances impeding the progress of work, our ability to remain in compliance with the financial covenants included in our financing documents, the regulatory environment, weather conditions, the outcome of our pending litigation, our ability to enter new markets and other factors set forth in reports and other documents filed by us with the Securities and Exchange Commission from time to time. We do not assume a duty to update forward-looking statements. Please use caution and do not place reliance on forward-looking statements.

General

Insituform Technologies, Inc. is a worldwide company specializing in trenchless technologies to rehabilitate, replace, maintain and install underground pipes. We have three principal operating segments: rehabilitation, tunneling and Tite Liner®. These segments have been determined primarily based on the types of products sold by each segment, and each is regularly reviewed and evaluated separately. While we use a variety of trenchless technologies, the Insituform® cured-in-place pipe (“CIPP”) process contributed 72.3%, 66.7% and 69.2% of our revenues in 2006, 2005 and 2004, respectively.

Revenues are generated by our company and our subsidiaries operating principally in the United States, Canada, Mexico, the United Kingdom, the Netherlands, France, Belgium, Spain, Switzerland, Poland and Chile, and include product sales and royalties from our joint ventures in Europe and Asia, and unaffiliated licensees and sub-licensees throughout the world. The United States remains our single largest market, representing 75.1% of total revenues in 2006. See Note 12 to our Consolidated Financial Statements contained in this report for additional segment information and disclosures.

We were incorporated in Delaware in 1980, under the name Insituform of North America, Inc. We were originally formed to act as the exclusive licensee of the Insituform® CIPP process in most of the United States. When we acquired our licensor in 1992, our name changed to Insituform Technologies, Inc. As a result of our successive licensee acquisitions, our business model has evolved from purely licensing technology and manufacturing materials to performing the entire Insituform® CIPP process and other trenchless technologies, in most geographic locations.


As used in this Annual Report on Form 10-K, the terms “Company” and “Insituform Technologies” refer to Insituform Technologies, Inc. and, unless the context otherwise requires, its direct and indirect wholly-owned subsidiaries. For certain information concerning our industry segments and geographic areas, see Note 12 to our Consolidated Financial Statements contained in this report.

Available Information

Our company’s website is www.insituform.com. We make available on this website under “Investors - SEC,” free of charge, our proxy statements used in conjunction with stockholder meetings, our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K (and amendments to those reports) as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. In addition, our Code of Ethics for our Chief Executive Officer, Chief Financial Officer and senior financial employees, our Business Code of Conduct applicable to our officers, directors and employees, our Corporate Governance Guidelines, and our Board committee charters are available, free of charge, on this website under “Investors - Corporate Governance.” These documents will be made available, free of charge, to any stockholder requesting them.

Technologies

Pipeline System Rehabilitation

The Insituform® CIPP Process for the rehabilitation of sewers, pipelines and other conduits utilizes a custom-manufactured tube, or liner, made of a synthetic fiber. After the tube is saturated (impregnated) with a thermosetting resin mixture, it is installed in the host pipe by various processes and the resin is then hardened, usually by heating it using various means, including steam, forming a new rigid pipe within a pipe.

Pipebursting is a trenchless method for replacing deteriorated or undersized pipelines. A bursting head is propelled through the existing pipeline, fracturing the host pipe and displacing the fragments outward, allowing a new pipe to be pulled in to replace the old line. Pipes can be replaced size-for-size or upsized.

Microtunneling is a trenchless method of drilling a new tunnel from surface operated equipment. Microtunneling is typically used for gravity sewers at depths greater than 15 feet, in congested areas, where unstable ground conditions exist, where construction is below the water table, or where contamination zones are present.

Sliplining is a method used to push or pull a new pipeline into an old one. With segmented sliplining, short segments of pipe are joined to form the new pipe. For gravity sewer rehabilitation, these short segments can often be joined in a manhole or access structure, eliminating the need for a large pulling pit.

Thermopipe® is a polyester-reinforced polyethylene lining system for the rehabilitation of distribution water mains. The factory-folded “C” shape liner is winched into the host pipe from a reel and reverted with air and steam. Once inflated and heated, the liner forms a close-fit within the host pipe, creating a jointless, leak-free lining system.


PolyFlex™ and PolyFold™ are methods of rehabilitating transmission and distribution water mains using polyethylene liners. Inserted into a new or existing pipeline by our proprietary installation processes, the liners are continuous and installed tightly against the inner wall of the host pipe, thereby isolating the flow stream from the host pipe wall and eliminating internal corrosion. 

iTAP™ is a robotic method for reinstating potable water service connections from inside a main. Traditionally, service connections are restored by excavating each service connection when a water distribution main is renewed with a trenchless process. iTAP™ provides a non-disruptive rehabilitation solution for pipes relined with Thermopipe™, Polyflex™ or Polyfold™ lining systems.

See “Patents” below for information concerning these technologies.

Tunneling

Tunneling typically encompasses the construction of man-entry sized pipelines with access through vertical shafts. From the vertical shaft, a tunnel is constructed using a steerable, locally controlled tunnel boring machine. Pipe is typically installed after the tunnel is constructed.

Tite Liner® Process

Our Tite Liner® process is a method of lining new and existing pipe with a corrosion and abrasion resistant polyethylene pipe.

Operations

Most of our installation operations are project-oriented contracts for municipal entities. The contracts are usually obtained through competitive bidding or negotiations and require performance at a fixed price. The profitability of these contracts depends heavily upon the competitive bidding environment, our ability to estimate costs accurately and our ability to effectively manage and execute project performance. Project estimates may prove to be inaccurate due to unforeseen conditions or events. A substantial portion of the work on any given project may be subcontracted to third parties at a significantly lower profitability level to us than work directly performed by us. Also, proper trenchless installation requires expertise that is acquired on the job and through training. Therefore, we provide ongoing training and appropriate equipment to our field installation crews.

The overall profitability of our installation operations is influenced not only by the profitability of specific project contracts, but also by the volume and timing of projects so that the installation operations are able to operate at, or near, capacity.

We are required to carry insurance and provide bonding in connection with certain installation projects and, accordingly, maintain comprehensive insurance policies, including workers’ compensation, general and automobile liability, and property coverage. We believe that we presently maintain adequate insurance coverage for all installation activities. We have also arranged bonding capacity for bid, performance and payment bonds. Typically, the cost of a performance bond is less than 1% of the contract value. We are required to indemnify the surety companies against losses from third-party claims of customers and subcontractors. The indemnification obligations are collateralized by unperfected liens on our assets and the assets of those subsidiaries that are parties to the applicable indemnification agreement.

We generally invoice our customers as work is completed. Under ordinary circumstances, collection from municipalities in the United States is made within 60 to 90 days of billing. In most cases, 5% to 15% of the contract value is withheld by the owner pending satisfactory completion of the project.


Rehabilitation Activities

Our rehabilitation activities are conducted principally through installation and other construction operations performed directly by us or our subsidiaries. In certain geographic regions, we have granted licenses to unaffiliated companies. As described under “Ownership Interests in Operating Licensees and Project Joint Ventures” below, we also have entered into joint ventures from time to time to capitalize on our trenchless rehabilitation processes. Under these contractual joint venture relationships, work is bid by the joint venture entity and subcontracted to the joint venture partners or to third parties. The joint venture partners are primarily responsible for their subcontracted work, but both joint venture partners are liable to the customer for all of the work. Revenue and associated costs are recorded using percentage-of-completion accounting for our subcontracted portion of the total contract only.

Our principal rehabilitation activities are conducted in North America directly by us or through our subsidiaries.

North American rehabilitation operations, including research and development, engineering, training and financial support systems, are headquartered in Chesterfield, Missouri. During 2006, tube manufacturing and processing facilities for North America were maintained in eight locations, geographically dispersed throughout the United States and Canada.

Outside North America, we conduct Insituform® CIPP process rehabilitation operations through our subsidiaries in the United Kingdom, France, the Netherlands, Spain, Switzerland, Belgium and Poland. Through one of our French subsidiaries, Video Injection S.A.S., acquired in 1998, we utilize multifunctional robotic devices, developed by Video Injection, in connection with the inspection and repair of pipelines. We also maintain a manufacturing facility in Wellingborough, England to support European operations.

In addition to sewer rehabilitation, we restore potable water pipes through Insituform Blue™, a division formed in 2006. Currently operating in the United Kingdom and North America, our Insituform Blue™ division restores water pipes using our Thermopipe™, PolyFlex™ and PolyFold™ lining systems. In addition, after restoring water pipes, we reinstate water service connections using iTAP™, a robotic method that avoids digging and disruption.

European operations are headquartered in Paris, France with principal regional facilities located in the United Kingdom, France, The Netherlands, Spain, Switzerland, Belgium and Poland.

Tunneling Activities

We conduct tunneling, microtunneling and a range of pipe system rehabilitation services throughout the United States through our wholly-owned subsidiary, Affholder, Inc. Our principal administrative functions for tunneling are headquartered in Chesterfield, Missouri.

Tite Liner® Activities

Tite Liner® process operations are conducted in the United States through our United Pipeline Systems division. Worldwide Tite Liner® process operations are headquartered in Durango, Colorado. Outside the United States, Tite Liner® process installation activities are conducted through our operating subsidiaries in Chile and Canada and our Mexican subsidiary in which we own a 55% equity interest through our subsidiary INA Acquisition Corp.


Licensees

We have granted licenses for the Insituform® CIPP process, covering exclusive and non-exclusive territories, to licensees who provide pipe repair and rehabilitation services throughout their respective licensed territories. At December 31, 2006, the Insituform® CIPP process was licensed to five unaffiliated licensees, which operate in the following countries: Israel, Japan, Malaysia, New Zealand, Norway and Singapore. There were no unaffiliated domestic licensees. The licenses generally grant to the licensee the right to utilize our know-how and the patent rights (where they exist) relating to the subject process, and to use our copyrights and trademarks.

Our licensees generally are obligated to pay a royalty at a specified rate, which in many cases is subject to a minimum royalty payment. Any improvements or modifications a licensee may make in the subject process during the term of the license agreement generally becomes our property or is licensed to us. Should a licensee fail to meet its royalty obligations or other material obligations, we may terminate the license. Licensees, upon prior notice to us, may generally terminate the license for specific reasons. We may vary the terms of agreement entered into with new licensees according to prevailing conditions.

We act as licensor under arrangements with approved installers relating to the use of our Thermopipe® process in the United Kingdom and elsewhere on a non-exclusive basis.

Ownership Interests in Operating Licensees and Project Joint Ventures

Through our subsidiary, Insituform Holdings (UK) Limited, we hold one-half of the equity interest in Insituform Rohrsanierungstechniken GmbH, our licensee of the Insituform® CIPP process in Germany. Insituform Rohrsanierungstechniken also conducts Insituform® CIPP process operations in Austria, the Czech Republic, Slovakia, Hungary and Slovenia. The remaining interest in Insituform Rohrsanierungstechniken is held by Per Aarsleff A/S, a Danish contractor. The joint venture partners have rights-of-first-refusal in the event either party determines to divest its interest.

Through our subsidiary, Insituform Technologies Limited, we hold one-half of the equity interest in Insituform Environmental Techniques Limited, our licensee of the Insituform® CIPP process in Ireland. The remaining interest is held by Environmental Techniques Limited, an Irish contractor. The joint venture partners have rights-of-first-refusal in the event the other party determines to divest its interest.

During 2006, we acquired through our subsidiary, INA Acquisition Corp., a 50% equity interest in Insituform Asia Limited, our licensee of the Insituform® CIPP process in the Special Administrative Regions of Hong Kong and Macau. The remaining interest is held by VSL International Ltd. The joint venture partners have rights-of-first-refusal in the event the other party determines to divest its interest.

We have entered into several contractual joint ventures in order to develop joint bids on contracts for our pipeline rehabilitation business and for our tunneling operations. Typically, the joint venture entity holds the contract with the owner and subcontracts portions of the work to the joint venture partners. As part of the subcontracts, the partners usually provide bonds to the joint venture. We could be required to complete our joint venture partner’s portion of the contract if the partner were unable to complete its portion and a bond is not available. We continue to investigate opportunities for expanding our business through such arrangements.


Marketing

The marketing of rehabilitation technologies is focused primarily on the municipal wastewater markets worldwide, which we expect to remain the largest part of our business for the foreseeable future. To help shape decision-making at every step, we use a multi-level sales force structured around target markets and key accounts, focusing on engineers, consultants, administrators, technical staff and public officials. We also produce sales literature and presentations, participate in trade shows, conduct national advertising and execute other marketing programs for our own sales force and those of unaffiliated licensees. Our unaffiliated licensees are responsible for marketing and sales activities in their respective territories. See “Licensees” and “Ownership Interests in Operating Licensees and Project Joint Ventures” above for a description of our licensing operations and for a description of investments in licensees.

We offer our Tite Liner® process worldwide to industrial customers to line new and existing pipelines.

We bid on tunneling projects in selected geographical markets in the United States. Our current bidding strategy is designed to obtain profitable work that fits tunneling’s core mining competency. Large, more complex tunneling projects are not part of our current strategy for our tunneling operation.

No customer accounted for more than 10% of our consolidated revenues during the years ended December 31, 2006, 2005 or 2004.

Contract Backlog

Contract backlog is our expectation of revenues to be generated from received, signed and uncompleted contracts whose cancellation is not anticipated at the time of reporting. Contract backlog excludes any term contract amounts for which there is not specific and determinable work released and projects where we have been advised that we are the low bidder, but have not formally been awarded the contract. The following table sets forth our consolidated backlog, by segment, as of December 31, 2006, 2005 and 2004, respectively.

   
December 31,
  
Backlog
  
2006
  
2005
  
2004
  
   
(In millions)
  
               
Rehabilitation
  
$
201.7
  
$
213.3
  
$
190.4
  
Tunneling
    
75.7
    
66.3
    
129.3
  
Tite Liner®
    
12.8
    
20.2
    
8.6
  
Total
  
$
290.2
  
$
299.8
  
$
328.3
  

The dollar amount of the backlog is not necessarily indicative of our future earnings relative to our performance of such work. Although backlog represents only those contracts that are considered to be firm, there can be no assurance that cancellation or scope adjustments will not occur with respect to such contracts. We expect to perform all of the backlog in the rehabilitation and Tite Liner® segments, and nearly all of the backlog in the tunneling segment, during 2007. See “Risk Factors” in Item 1A of this report for further discussion regarding backlog.

Product Development

By using our own laboratories and test facilities, as well as outside consulting organizations and academic institutions, we continue to develop improvements to our proprietary processes, including the materials used and the methods of manufacturing and installing pipe. During the years ended December 31, 2006, 2005 and 2004, we spent $3.6 million, $2.9 million and $2.9 million, respectively, on research and development related activities, including engineering.


Manufacturing and Suppliers

We maintain our North American Insituform® CIPP process liner manufacturing facility in Batesville, Mississippi. In Europe, Insituform Linings Plc. (“Insituform Linings”), a majority-owned subsidiary, manufactures and sells Insituform® CIPP process liners from its plant located in Wellingborough, United Kingdom. We hold a 75% interest in Insituform Linings, and Per Aarsleff A/S holds the remainder. These interests are subject to rights-of-first-refusal that we and Per Aarsleff A/S hold in the event of proposed divestiture.

Although raw materials used in Insituform® CIPP Process products are typically available from multiple sources, our historical practice has been to purchase materials from a limited number of suppliers. We maintain our own felt manufacturing facility at our Insitutube® manufacturing facility in Batesville. Substantially all of our fiber requirements are purchased from one source, but there are alternate vendors readily available.
 
We believe that the sources of supply for our Insituform® CIPP process operations in both North America and Europe are adequate for our needs. Our pricing of raw materials is subject to fluctuations in the underlying commodity prices.

We have a third party contractual commitment for the manufacture and supply of Thermopipe® process products through 2007. Thermopipe® is used for potable water pipe rehabilitation and other rehabilitation applications.

We sell Insituform® CIPP process liners and related products to certain licensees pursuant to fixed-term supply contracts. Under the arrangements assumed in connection with the acquisition of the Thermopipe® process and under subsequent arrangements, we also sell Thermopipe® process products to approved installers.

We also manufacture certain equipment used in our Insituform® CIPP and Tite Liner® businesses.

Patents

As of December 31, 2006, we held 61 United States patents relating to the Insituform® CIPP process, the last of which will expire in 2023. As of December 31, 2006, we had 15 pending United States patent applications relating to the Insituform® CIPP process.

We have obtained and are pursuing patent protection in our principal overseas markets covering various aspects of the Insituform® CIPP process. The specifications and/or rights granted in relation to each patent will vary from jurisdiction to jurisdiction. In addition, as a result of differences in the nature of the work performed and in the climate of the countries in which the work is carried out, not every licensee uses each patent, and we do not necessarily seek patent protection for all of our inventions in every jurisdiction in which we do business.

There can be no assurance that the validity of our patents will not be successfully challenged. Our business could be adversely affected by increased competition upon expiration of the patents or if one or more of our Insituform® CIPP process patents were adjudicated to be invalid or inadequate in scope to protect our operations. We believe in either case that our long experience with the Insituform® CIPP process, our continued commitment to support and develop the Insituform® CIPP process, the strength of our trademark, and our degree of market penetration should enable us to continue to compete effectively in the pipeline rehabilitation market.


We hold one basic issued patent and three pending patent applications in the United States relating to the Thermopipe® process for rehabilitating pressurized potable water and other aqueous fluid pipes.

We hold a small number of patents relating to our corrosion and abrasion protection business. We believe that the success of our Tite Liner® process business, operated through our United Pipeline Systems division, depends primarily upon our proprietary know-how and our marketing and sales skills.

See “Risk Factors” in Item 1A of this report for further discussion.

Competition

The markets in which we operate are highly competitive, primarily on the basis of price, quality of service and capacity to perform. Most of our products, including the Insituform® CIPP process, face direct competition from competitors offering similar or essentially equivalent products or services. In addition, customers can select a variety of methods to meet their pipe installation and rehabilitation needs, including a number of methods that we do not offer.

Most of our competitors are local or regional companies, and may be either specialty trenchless contractors or general contractors. There can be no assurance as to the success of our trenchless processes in competition with these companies and alternative technologies for pipeline rehabilitation.

Seasonality

Our operations can be affected by seasonal variations. Seasonal variations over the past five years have been minimal; however, our results tend to be stronger in the second and third quarters of each year due to milder weather. We are more likely to be impacted by weather extremes, such as excessive rain or hurricanes, which may cause temporary, short-term anomalies in our operational performance in certain localized geographic regions. However, these impacts are usually not material to our operations as a whole. See “Risk Factors” in Item 1A of this report for further discussion.

Employees

As of December 31, 2006, we had approximately 2,000 employees. Certain of our subsidiaries and divisions are parties to collective bargaining agreements covering an aggregate of approximately 200 employees. We generally consider our relations with our employees and unions to be good.

Government Regulation

We are required to comply with all applicable United States federal, state and local, and all applicable foreign statutes, regulations and ordinances. In addition, our installation and other operations have to comply with various relevant occupational safety and health regulations, transportation regulations, code specifications, permit requirements, and bonding and insurance requirements, as well as with fire regulations relating to the storage, handling and transporting of flammable materials. Our manufacturing facilities, as well as our installation operations, are subject to federal and state environmental protection regulations, none of which presently have any material effect on our capital expenditures, earnings or competitive position in connection with our present business. However, although our installation operations have established monitoring programs and safety procedures, further restrictions could be imposed on the manner in which installation activities are conducted, on equipment used in installation activities and on the use of solvents or the thermosetting resins used in the Insituform® CIPP process.

The use of both thermoplastics and thermosetting resin materials in contact with drinking water is strictly regulated in most countries. In the United States, a consortium led by NSF International, under arrangements with the United States Environmental Protection Agency, establishes minimum requirements for the control of potential human health effects from substances added indirectly to water via contact with treatment, storage, transmission and distribution system components, by defining the maximum permissible concentration of materials that may be leached from such components into drinking water, and methods for testing them. In April 1997, the Insituform PPL® liner was certified by NSF for use in drinking water systems, followed in April 1999 by NSF certification of the Insituform RPP® liner for such use. Our drinking water lining products also are NSF certified. NSF assumes no liability for use of any products, and NSF’s arrangements with the EPA do not constitute the EPA’s endorsement of NSF, NSF’s policies or its standards. Dedicated equipment is needed in connection with use of these products in drinking water applications. We do not expect material revenues from our proprietary products for drinking water pipe rehabilitation at least through 2007.


Item 1A.

The following are some of the risks that we face in our business. The list of risk factors is not exhaustive. There can be no assurance that we have correctly identified and appropriately assessed all factors affecting our business or that publicly available and other information with respect to these matters is complete and correct. Additional risks not presently known to us or that we currently believe to be immaterial also may adversely impact us. Should any risks or uncertainties develop into actual events, these developments could have material adverse effects on our business, financial condition, cash flows and results of operations.

Continued under-performance by our tunneling business segment may result in goodwill and fixed asset impairment.

Late in 2004 and 2005, our tunneling business experienced a number of margin write-downs on its larger projects. In addition, underutilized equipment was a significant adverse factor in the results of our tunneling business in 2005 and 2006. There were significant losses in our tunneling business in 2004, 2005 and 2006. During 2006, it was determined, based on forecasted results for the next five years, that there was no impairment of our tunneling goodwill or fixed assets. However, if our tunneling business fails to improve performance, we may have exposure to the impairment of our goodwill and certain of our fixed assets in the tunneling segment.

Our business is dependent on obtaining work through a competitive bidding process.

The markets in which we operate are highly competitive. Most of our products and services, including the Insituform® CIPP process, face direct competition from companies offering similar or essentially equivalent products or services. In addition, customers can select a variety of methods to meet their pipe installation and rehabilitation needs, including a number of methods that we do not offer. Competition also places downward pressure on our contract prices and profit margins. Intense competition is expected to continue in these markets, and we face challenges in our ability to maintain strong growth rates. If we are unable to meet these competitive challenges, we could lose market share to our competitors and experience an overall reduction in our profits.

We may experience cost overruns on our projects.

We typically conduct our business under guaranteed maximum price or fixed price contracts, where we bear a significant portion of the risk for cost overruns. Under such contracts, prices are established in part on cost and scheduling estimates, which are based on a number of assumptions, including assumptions about future economic conditions, prices and availability of materials and other exigencies. Our profitability depends heavily on our ability to make accurate estimates. Inaccurate estimates, or changes in other circumstances, such as unanticipated technical problems, difficulties obtaining permits or approvals, changes in local laws or labor conditions, weather delays, cost of raw materials, or our suppliers or subcontractors’ inability to perform could result in substantial losses, as such changes adversely affect the revenue and gross profit recognized on each project.


Our use of the percentage-of-completion method of accounting could result in a reduction or reversal of previously recorded results.

We employ the percentage-of-completion method of accounting for our construction projects. This methodology recognizes revenues and profits over the life of a project based on costs incurred to date compared to total estimated project costs. Revisions to revenues and profits are made once amounts are known and/or can be reasonably estimated. On a historical basis, we believe that we have made reasonably reliable estimates of the progress towards completion in our long-term contracts. However, given the uncertainties associated with some of our contracts, it is possible for actual costs to vary from estimated amounts previously made. The effect of revisions to estimates could result in the reversal of revenue and gross profit previously recognized.

Our success depends on attracting and retaining qualified personnel.

We use a multi-level sales force structured around target markets and key accounts, focusing on engineers, consultants, administrators, technical staff and elected officials to market our products and services. We are also dependent on our personnel to continue to develop improvements to our proprietary processes, including materials used and the methods of manufacturing and installation. Our ability to attract, develop and retain qualified personnel has a significant effect on our ability to profitably execute our work. Our success in attracting qualified personnel is dependent on the resources available in individual geographic areas and the impact on the labor supply of general economic conditions, as well as our ability to provide a competitive compensation package and work environment.
 
Our recognition of revenues from insurance claims and from change orders, extra work or variations in the scope of work could result in a reduction or reversal of previously recorded revenues.

We recognize revenues from insurance claims and from change orders, extra work or variations in the scope of work as set forth in our written contracts with our client when management believes that realization of these revenues are reasonably assured and the recoverable amounts can be reasonably estimated. Prior to our decision to recognize these revenues, we consult with outside legal counsel to determine the likelihood of recovery and the amount of the recovery that can be estimated. We also factor in all other information that we possess with respect to the claim to determine whether the claim should be recognized at all and, if recognition is appropriate, what dollar amount of the claim should be recognized. On this basis, we believe that we have historically made reasonably reliable estimates of amounts of revenue to be recognized. Due to factors that we did not anticipate at the time of recognition, however, revenues ultimately received on these claims could be less than revenues recognized by us in a prior reporting period or periods, resulting in the need to reduce or reverse revenues and gross profit previously recognized in subsequent reporting periods.

Extreme weather conditions may adversely affect our operations.

We are likely to be impacted by weather extremes, such as excessive rain or hurricanes, which may cause temporary, short-term anomalies in our operational performance in certain localized geographic regions. Historically, these impacts have not been material to our operations as a whole. However, delays and other weather impacts can adversely affect our ability to meet project deadlines and may increase a project’s cost and decrease its profitability.


We may be liable to complete work under our joint venture arrangements.

We enter into contractual joint ventures in order to develop joint bids on contracts for our pipeline rehabilitation business and for our tunneling operations. The success of these joint ventures depends largely on the satisfactory performance of our joint venture partners of their obligations under the joint venture. Under these joint venture arrangements, we may be required to complete our joint venture partner’s portion of the contract if the partner is unable to complete its portion and a bond is not available. In such case, the additional obligations could result in reduced profits or, in some cases, significant losses for us with respect to the joint venture.

A substantial portion of our raw materials is from a limited number of vendors and we are subject to market fluctuations of certain commodities.

The majority of our fiber requirements for tube manufacturing are from one source. However, we continue to negotiate with other supply sources. The manufacture of the tubes used in our rehabilitation business is dependent upon the availability of resin, a petroleum-based product. In certain markets, such as North America and Europe, we currently obtain a majority of our resin requirements from single suppliers, although we believe that other sources of supply are available. We have a supply agreement with a supplier of resin that requires the supplier to provide a majority of our resin requirements but the agreement does not set a fixed purchase price for the product. Resin prices have fluctuated on the basis of the prevailing prices of oil and we anticipate that prices will continue to be heavily influenced by the events affecting the oil market. In addition, we purchase a significant volume of fuel to operate our trucks and equipment. At present, we do not engage in any type of hedging activities to mitigate the risks of fluctuating market prices for oil or fuel and increases in the price of oil may cause an adverse effect on our cost structure which we may not be able to recover from our customers.

Our intellectual property may be successfully challenged.

Our business could be adversely affected by increased competition upon expiration of our patents or if one or more of our Insituform® CIPP process patents were adjudicated to be invalid or inadequate in scope to protect our operations. We believe in either case that our long experience with the Insituform® CIPP process, our continued commitment to support and develop the Insituform® CIPP process, the strength of our trademark and our degree of market penetration should enable us to continue to compete effectively in the pipeline rehabilitation market.

We are subject to a number of restrictive debt covenants.

Our Senior Notes and our line of credit facility contain certain restrictive debt covenants. Our ability to meet these restrictive covenants may be affected by factors described above and others outside our control. Failure to meet one or more of these restrictive covenants may result in an event of default and may hinder our ability to take advantage of attractive business opportunities. Upon an event of default, our lender(s) may declare all amounts outstanding as due and payable and we may not have sufficient capital available at that time to pay the amounts due to our lenders.

Our revenues are substantially dependent on municipal government spending.

Many of our customers are municipal governmental agencies, and as such, we are dependent on municipal spending. Spending by our municipal customers can be affected by local political circumstances, budgetary constraints and other factors.


We have international operations that are subject to foreign economic and political uncertainties and foreign currency fluctuation.

Through our subsidiaries and joint ventures, our business is subject to fluctuations in demand and changing international economic and political conditions that are beyond our control. For the year ended December 31, 2006, 24.9% of our revenues were derived from international operations. We expect a significant portion of our revenues and profits to come from international operations and joint ventures for the foreseeable future. Operating in the international marketplace exposes us to a number of risks, including abrupt changes in foreign government policies and regulations and, in some cases, international hostilities. To the extent that our international operations are affected by unexpected and adverse foreign economic and political conditions, we may experience project disruptions and losses which could significantly reduce our revenues and profits.

From time to time, our contracts may be denominated in foreign currencies, which will result in additional risk of fluctuating currency values and exchange rates, hard currency shortages and controls on currency exchange. Changes in the value of foreign currencies could increase our U.S. dollar costs for, or reduce our U.S. dollar revenues from, our foreign operations. Any increased costs or reduced revenues as a result of foreign currency fluctuations could affect our profits.
 
Our backlog is an uncertain indicator of our future earnings.

Our backlog, which at December 31, 2006 was approximately $290 million, is subject to unexpected adjustments and cancellation. The revenues projected in this backlog may not be realized or, if realized, may not result in profits. We may be unable to complete some projects included in our backlog in the estimated time and, as a result, such projects could remain in the backlog for extended periods of time. To the extent that we experience project cancellation or scope adjustments, we could face a reduction in the dollar amount of our backlog and the revenues that we actually receive from such backlog.

Our bonding capacity may be limited in certain circumstances.

A significant portion of our projects requires us to procure a bond to secure performance. From time to time, it may be difficult to find sureties who will provide the contract-required bonding at acceptable rates for reasons beyond our control (for example, as a result of changing political or economic conditions in a foreign country). With respect to our joint ventures, our ability to obtain a bond also may depend on the credit and performance risks of our joint venture partners, some of whom may not be as financially strong as we are. Our inability to obtain bonding on favorable terms would have a material adverse effect on our business. 


None.

Item 2.

Our executive offices are located in Chesterfield, Missouri, a suburb of St. Louis, at 702 Spirit 40 Park Drive. The executive offices are leased from an unaffiliated party through May 31, 2007. We will relocate our executive offices to a facility at another location we own in Chesterfield during 2007. We also own our research and development and training facilities in Chesterfield.

We own a liner manufacturing facility and a contiguous felt manufacturing facility in Batesville, Mississippi.  Our manufacturing facility in Memphis, Tennessee, which was closed in January 2004, but reopened in 2006, is located on land sub-leased from an unaffiliated entity for an initial term of 40 years expiring on December 31, 2020. Insituform Linings, a majority-owned subsidiary, owns certain premises in Wellingborough, United Kingdom, where its liner manufacturing facility is located.


We own or lease various operational facilities in the United States, Canada, Europe and Latin America.

The foregoing facilities are regarded by management as adequate for the current requirements of our business.

Item 3.

In the third quarter of 2002, an accident on an Insituform® CIPP process project in Des Moines, Iowa resulted in the death of two workers and the injury of five workers. We fully cooperated with Iowa’s state OSHA in the investigation of the accident. Iowa OSHA issued a Citation and Notification of Penalty in connection with the accident, including several willful citations. Iowa OSHA proposed penalties of $808,250. We challenged Iowa OSHA’s findings, and in the fourth quarter of 2003, an administrative law judge reduced the penalties to $158,000. In the second quarter of 2004, the Iowa Employment Appeal Board reinstated many of the original penalties, ordering total penalties in the amount of $733,750. We appealed the decision of the Employment Appeal Board to the Iowa District Court for Polk County, which, in the first quarter of 2005, reduced the penalties back to $158,000. We appealed the decision of the Iowa District Court and, on February 8, 2006, our appeal was heard by the Iowa Court of Appeals. On March 17, 2006, the Court of Appeals issued its opinion, vacating all citations issued under the general industry standards (all citations except two serious citations) and reducing total penalties to $4,500. Thereafter, the Employment Appeal Board filed a petition for further review with the Iowa Supreme Court, and we filed a resistance to the petition. On September 29, 2006, the Iowa Supreme Court granted the Employment Appeal Board’s petition for further review, and set the case for consideration during the week of December 4, 2006. On February 16, 2007, the Iowa Supreme Court issued its opinion, reinstating all citations issued under the general industry standards, including several willful citations, and reinstating penalties in the amount of $733,750. The Iowa Supreme Court remanded the case back to the Iowa District Court to enter an order consistent with its opinion. We currently are reviewing the Court’s opinion and our options regarding further judicial review of the Court’s opinion.
 
We are involved in certain other actions incidental to the conduct of our business and affairs. Management, after consultation with legal counsel, does not believe that the outcome of any such other litigation will have a material adverse effect on our consolidated financial condition, results of operations or cash flows.

Item 4.
Submission of Matters to a Vote of Security Holders

There were no matters submitted during the quarter ended December 31, 2006 to a vote of our stockholders, through the solicitation of proxies or otherwise.

Item 4A.
Executive Officers of the Registrant

Our executive officers, and their respective ages and positions with us, are as follows:

Name
  
Age at
February 1, 2007
  
Position with the Company
Thomas S. Rooney, Jr.
  
47
  
President and Chief Executive Officer
Thomas E. Vossman
  
44
  
Senior Vice President and Chief Operating Officer
David F. Morris
  
45
  
Vice President, General Counsel and Secretary
David A. Martin
  
39
  
Vice President and Controller
 

Thomas S. Rooney, Jr. has been our President since April 2003, and our Chief Executive Officer since July 2003. From April 2003 to July 2003, Mr. Rooney was our Chief Operating Officer. From 2000 until he joined our company, Mr. Rooney was Senior Vice President and Regional Manager for Gilbane Building Company.

Thomas E. Vossman joined our company in January 2005 as Vice President for the Southwest region of our sewer pipeline rehabilitation business and assumed the role of Senior Vice President and Chief Operating Officer in May 2005. From March 2004 to December 2004, Mr. Vossman served as a consultant to the contracting industry. Prior thereto, Mr. Vossman served as Senior Vice President of American Residential Services, managing 19 contracting operations, and in various positions of increasing authority at Encompass Services Corporation, a consolidator of commercial/industrial/residential mechanical contracting companies, most recently as Regional President, residential division, managing 12 operating locations across the Eastern United States.

David F. Morris has been our Vice President, General Counsel and Secretary since January 2005. From March 1993 until January 2005, Mr. Morris was with the law firm of Thompson Coburn LLP, St. Louis, Missouri, most recently as a partner in its corporate and securities practice areas. Mr. Morris also served as Senior Vice President, Associate General Counsel and Secretary of Unified Financial Services, Inc., a diversified financial services company, from December 1999 to March 2004.

David A. Martin has served as our Vice President and Controller since January 2006. Prior thereto, Mr. Martin served as our Corporate Controller for two years, following two and one-half years as controller of our European operations. Mr. Martin joined our company in 1993 from BDO Seidman, LLP, where he was a senior accountant.


PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

(a)   The company’s common shares, $.01 par value, are traded on The Nasdaq Global Select Market (previously known as The Nasdaq Stock Market) under the symbol “INSU.” The following table sets forth the range of quarterly high and low sales prices for the years ended December 31, 2006 and 2005, as reported on The Nasdaq Global Select Market. Quotations represent prices between dealers and do not include retail mark-ups, mark-downs or commissions.

Period
  
High
  
Low
  
           
2006
          
First Quarter
  
$
27.87
  
$
18.51
  
Second Quarter
    
29.67
    
20.89
  
Third Quarter
    
25.53
    
18.56
  
Fourth Quarter
    
27.70
    
22.04
  
               
2005
              
First Quarter
  
$
22.98
  
$
13.24
  
Second Quarter
    
17.50
    
13.86
  
Third Quarter
    
21.17
    
15.86
  
Fourth Quarter
    
20.99
    
14.90
  

During the quarter ended December 31, 2006, we did not make any repurchases of our common stock, nor offer any equity securities that were not registered under the Securities Act of 1933, as amended. As of February 1, 2007, the number of holders of record of our common stock was 701.

Holders of common stock are entitled to receive dividends as and when they may be declared by our board of directors. We have never paid a cash dividend on the common stock. Our present policy is to retain earnings to provide for the operation and expansion of our business. However, our board of directors will review our dividend policy from time to time and will consider our earnings, financial condition, cash flows, financing agreements and other relevant factors in making determinations regarding future dividends, if any. Under the terms of certain debt arrangements to which we are a party, we are subject to certain limitations on paying dividends. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Financings.”


The following table provides information as of December 31, 2006 with respect to the shares of common stock that may be issued under our existing equity compensation plans:

Equity Compensation Plan Information
Plan Category
  
Number of securities to be issued upon exercise of outstanding options, warrants and rights(1)
(a)
  
Weighted-average exercise price of outstanding options, warrants and rights
(b)
  
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
(c)
  
               
Equity compensation plans approved by security holders
    
1,392,199
  
$
19.85
    
2,193,500
  
                     
Equity compensation plans not approved by security holders
    
-
    
n/a
    
-
  
                     
Total
    
1,392,199
  
$
19.85
    
2,193,500
  

(1)
The number of securities to be issued upon exercise of outstanding options, warrants and rights includes 1,298,392 stock options and 93,807 deferred stock units outstanding at December 31, 2006.

Performance Graph

The following performance graph compares the total stockholder return on our common stock to the S&P 500 Index and a composite group index for the past five years. Our peer group index is comprised of the following six companies:

 
·
INEI Corporation, f/k/a Insituform East, Incorporated
 
·
Michael Baker Corporation
 
·
Granite Construction, Inc.
 
·
Fluor Corporation
 
·
Jacobs Engineering Group, Inc.
 
·
Foster Wheeler Corporation

As of September 5, 2003, we acquired the business of Insituform East, Incorporated, including selected assets.


The graph assumes that $100 was invested in our common stock and each index on December 31, 2001 and that all dividends were reinvested.

Comparison of Five-Year Cumulative Return


   
2001
  
2002
  
2003
  
2004
  
2005
  
2006
  
Insituform Technologies, Inc.
  
$
100.00
  
$
66.65
  
$
64.50
  
$
88.62
  
$
75.72
  
$
101.09
  
S&P 500 Index
  
$
100.00
  
$
77.90
  
$
100.25
  
$
111.15
  
$
116.61
  
$
135.03
  
Composite Peer Group Index
  
$
100.00
  
$
81.86
  
$
115.21
  
$
139.89
  
$
198.70
  
$
229.03
  

Notwithstanding anything set forth in any of our previous filings under the Securities Act of 1933 or the Securities Exchange Act of 1934 which might incorporate future filings, including this Annual Report on Form 10-K, in whole or in part, the preceding performance graph shall not be deemed incorporated by reference into any such filings.


Item 6.

The selected financial data set forth below has been derived from our consolidated financial statements contained in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K, and previously published historical financial statements not included in this Annual Report on Form 10-K. The selected financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements, including the footnotes, contained in this report.

   
Year Ended December 31,
  
   
2006(1)
  
2005
  
2004
  
2003(2)
  
2002(2,3,4)
  
   
(In thousands, except per share amounts)(Unaudited)
  
                       
INCOME STATEMENT DATA:
                      
Revenues
  
$
596,715
  
$
595,282
  
$
542,598
  
$
487,272
  
$
480,358
  
Operating income
    
31,459
    
23,743
    
8,178
    
21,591
    
50,183
  
                                 
Income from continuing operations
    
24,678
    
13,160
    
597
    
4,628
    
28,560
  
Loss from discontinued operations
    
-
    
-
    
-
    
(1,103
)
  
(5,869
)
Net income
    
24,678
    
13,160
    
597
    
3,525
    
22,691
  
Basic earnings per share:
                               
Income from continuing operations
    
0.91
    
0.49
    
0.02
    
0.17
    
1.08
  
Loss from discontinued operations
    
-
    
-
    
-
    
(0.04
)
  
(0.22
)
Net income
    
0.91
    
0.49
    
0.02
    
0.13
    
0.86
  
Dilutive earnings per share:
                             
Income from continuing operations
    
0.90
    
0.49
    
0.02
    
0.17
    
1.07
  
Loss from discontinued operations
    
-
    
-
    
-
    
(0.04
)
  
(0.22
)
Net income
    
0.90
    
0.49
    
0.02
    
0.13
    
0.85
  
                                 
BALANCE SHEET DATA:
                               
Unrestricted cash and cash equivalents
  
$
96,393
  
$
77,069
  
$
93,246
  
$
93,865
  
$
71,401
  
Working capital, net of unrestricted cash
    
77,466
    
70,114
    
61,637
    
73,535
    
52,829
  
Current assets
    
310,364
    
274,024
    
273,201
    
277,273
    
252,651
  
Property, plant and equipment
    
90,453
    
95,657
    
90,846
    
75,667
    
71,579
  
Total assets
    
550,069
    
518,328
    
513,154
    
508,360
    
473,013
  
Current maturities of long-term debt and line of credit
    
16,814
    
18,264
    
15,778
    
16,938
    
49,360
  
Long-term debt, less current maturities
    
65,046
    
80,768
    
96,505
    
114,323
    
67,014
  
Total liabilities
    
209,277
    
213,106
    
221,671
    
227,726
    
198,965
  
Total stockholders’ equity
   
338,611
    
303,496
    
289,836
    
279,169
    
272,618
  
 __________________________

(1)
Effective January 1, 2006, we adopted SFAS 123(R), “Share Based Payment” which requires recording expense for stock option and other equity compensation awards. We recorded $2.9 million in incremental expense for stock options in 2006.

(2)
We have completed various acquisitions that have been accounted for under the purchase method of accounting, including Elmore Pipe Jacking, Inc. in 2002, Sewer Services, Ltd. in 2003, Video Injection (remaining interest) in 2003, Insituform East in 2003, and Ka-Te Insituform (remaining interest) in 2003.

(3)
Results include a pre-tax intangible asset impairment and restructuring charges of $3.5 million and $2.5 million, respectively.

(4)
Effective January 1, 2002, we adopted SFAS 142, “Goodwill and Other Intangible Assets,” and ceased amortizing goodwill.


Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

Consolidated

   
Years Ended December 31,
  
   
2006
  
2005
 
2004
  
   
(Dollars in thousands)
  
               
Revenues
  
$
596,715
  
$
595,282
  
$
542,598
  
Gross profit
    
127,954
    
116,841
    
99,499
  
Gross profit margin
    
21.4
%
  
19.6
%
  
18.3
%
Operating expenses
    
96,495
    
93,098
    
91,321
  
Operating income
   
31,459
    
23,743
    
8,178
  
Operating income percentage
    
5.3
%
  
4.0
%
  
1.5
%

Fourth Quarter 2006 Results

Consolidated net income in the fourth quarter of 2006 was $10.4 million, contributing significantly to our $24.7 million in net income for the year ended December 31, 2006. Operationally, the fourth quarter of 2006 was strong, with the highest revenues of any quarter in 2006. Revenue in the fourth quarter of 2006 was $154.9 million, with $33.6 million in gross profit, which is a gross profit margin of 21.7%. Operating expenses were $23.4 million, resulting in operating income of $10.1 million. Operating margin, which is operating income as a percentage of revenue, was 6.2% in the fourth quarter of 2006, the strongest of any quarter this year.

In addition to operations, a number of items below the operating income line also benefited our consolidated net earnings in the fourth quarter of 2006, including:

 
·
Interest income of $1.3 million in the quarter due to improved treasury practices, higher interest rates and higher cash balances.
 
·
Other income of $4.3 million, primarily from gains on sales of property and equipment, of which,
­- $0.8 million was from tunneling property and equipment,
-­ $1.8 million was from the sale-leaseback of one of our European properties, and
-­ $1.7 million was from the disposal of other property and equipment in North America.
 
·
A tax rate of 30.1% for the quarter to bring the 2006 effective tax rate to 31.8%.

See Note 14 to our consolidated financial statements, “Selected Quarterly Financial Data” for summarized financial data by quarter for the year ended December 31, 2006.

2006 Compared to 2005

Consolidated net earnings nearly doubled in 2006 to $24.7 million, or $0.90 per diluted share, from $13.2 million, or $0.49 per diluted share, in 2005. Operationally, the rehabilitation business generated higher revenue due primarily to stronger performance in the second half of 2006 compared to the same period in 2005. Cost reductions have been a major initiative over the last several years, with a primary focus on productivity through the implementation of steam and continued material enhancements. As a result of these cost reductions, we have been able to be more competitive in the marketplace, while market pricing has declined. The first half of 2006 was especially slow for our domestic rehabilitation business due to a market softening that began in late 2005 and continued into the first quarter of 2006. Our Tite Liner® operations were very strong in 2006 compared to 2005, with higher revenues, gross profit and operating income. In addition, gross and operating margins were also higher in the Tite Liner® business in 2006 compared to last year. Our tunneling business posted an operating loss this year, but the operating loss in 2006 decreased by $7.5 million to $9.4 million compared to an operating loss of $16.9 million in 2005. All of the large jobs that generated losses in the tunneling business have been completed, and the primary cause of operating losses in that segment of our business during 2006 was the effect of underutilized equipment, as a result of much lower revenue compared to 2005 and 2004.


Consolidated operating expenses were $3.4 million higher in 2006 compared to 2005, primarily due to the following (in thousands):

   
Year Ended
December 31, 2006 vs. 2005
  
   
Increase
(Decrease)
  
Legal & accounting professional fees
  
$
3,125
  
Stock option expense
    
2,870
  
Other equity compensation expense
    
547
  
Incentive compensation expense
    
247
 
Other, including business unit operating expenses
    
(3,392
)
Total
  
$
3,397
  

Legal and accounting fees increased significantly, as we have focused on protecting our intellectual property (discussed in more detail, below) and as we have engaged professional resources to assist us in strategies to minimize our income tax exposure, particularly in foreign tax jurisdictions. Stock option expense was recorded, for the first time, in 2006 as required by SFAS 123(R), Share Based Payment, which was effective for our company on January 1, 2006. Other equity compensation expense relates to awards of restricted stock and deferred stock units and is calculated based on our closing stock price on the grant date. As our stock price was generally higher in 2006 than in 2005, restricted stock and deferred stock units granted in 2006 resulted in higher expense than awards granted in 2005.

Operating income was $7.7 million higher in 2006, at $31.5 million compared to $23.7 million in 2005 due to higher revenues in our rehabilitation and Tite Liner® businesses along with stronger gross profit margins in the Tite Liner® business.

There were a number of factors not directly related to operations that also contributed to the increase in net earnings in 2006, most notably (pre-tax):

 
·
sales of tunneling property and equipment resulted in gains of $2.5 million;
 
·
sales of other property resulted in gains of $3.7 million;
 
·
interest income increased by $1.8 million due to improved cash management practices, higher interest rates and a $0.4 million increase in pre-judgment interest on a claim receivable; and
 
·
interest expense was $1.6 million lower due to our annual debt amortization payment.


2005 Compared to 2004

Consolidated revenues from operations increased 9.7% in 2005 compared to 2004. We experienced significant revenue growth in our rehabilitation and Tite Liner® segments, while tunneling revenues increased only slightly. Greater revenues were achieved through successful sales efforts, greater crew capacity and higher backlog in the rehabilitation and Tite Liner® segments, while a more selective bidding strategy, and the continuation of a few larger low-margin/loss projects led to the small increase in our tunneling revenue.

Consolidated gross profit margins increased from 18.3% to 19.6% due to margin gains in the rehabilitation business. In our rehabilitation business, we achieved certain manufacturing and logistical efficiencies and we experienced improved productivity in the second half of 2005. However, these favorable developments were tempered by the effect of increased fuel and commodity prices, particularly resin. In the rehabilitation segment, a claim receivable (as discussed below under “Rehabilitation Segment - Gross Profit and Margin”) was recorded in 2005 which provided a net $3.4 million benefit to gross profit. Excluding the effect of the claim receivable, margins increased by three-quarters of a percent in the rehabilitation business despite significantly higher commodity and fuel prices. Tite Liner® margins were somewhat lower in 2005 compared to 2004 due to higher volume of work performed in South America, which includes installing steel pipe (a commodity) and our Tite Liner® product at a lower gross profit margin. Tunneling gross margins continued to suffer in 2005 from the continuation of large projects that experienced downward gross margin revisions.


Operating expenses increased by only 1.9% in 2005 compared to 2004 due principally to controlled expenses in rehabilitation. There were increases in compensation and benefits for additional staffing required to support our business growth, as well as increased legal expenses relating to various matters described more fully in Note 11 to the consolidated financial statements contained in this report. These costs were offset by a decrease in incentive compensation, as our results were below expectations for the year. As a percentage of revenue, operating expenses were 15.6% of revenue in 2005 compared to 16.8% in 2004.

As a result, operating income increased by $15.6 million, or over 190%, to $23.7 million in 2005 compared to $8.2 million in 2004.

Intellectual Property and Other Legal Matters

In the past few years, we have increased our emphasis on protecting the intellectual property that is at the core of our business. As part of this effort, we have actively prosecuted a number of legal proceedings seeking to collect damages and to enforce other remedies against third parties based upon patent infringement, breach of license and implied license agreements and unauthorized use of trade secrets involving our proprietary intellectual property.

In one such case filed against Cat Contracting, Inc., Michigan Sewer Company and FirstLiner USA, Inc. in the United States District Court in Houston, Texas, we had received a judgment of $9.5 million in 1999 based upon the infringement of certain in-liner patents we owned. Upon subsequent appeal, the finding of infringement was upheld, but the award of damages, including the finding of willfulness, was subject to rehearing. We believed that we had a strong position in upholding the original damage award and, after investigation, we also concluded that the defendants had a viable source to collect all or a portion of the award, if confirmed. On the basis of these determinations, we decided to aggressively pursue the rehearing on damages. The damages rehearing was completed in the third quarter of 2006, and we currently are awaiting the court’s decision. No receivable related to this matter has been recorded in the consolidated financial statements as of December 31, 2006.

In June 2005, after investigation, we commenced a lawsuit in the United States District Court in Memphis, Tennessee against our long-time international partner, Per Aarsleff A/S, a Danish public company, and certain of its subsidiaries and affiliates. The suit alleges breach by these entities of license agreements and implied license agreements with us involving our proprietary intellectual property relating to the Insituform® CIPP process. We seek monetary damages for breach of our license agreements and implied license agreements between the Per Aarsleff entities and our company and for royalties owed by the Per Aarsleff entities to us under these agreements. In 2006, we amended our complaint against the Per Aarsleff entities to include additional damage claims based upon Per Aarsleff’s continued use of our patented technology in Denmark, Sweden and Finland following the termination of the license agreements and Per Aarsleff’s use of our trade secrets in its Danish tube manufacturing facility. Our amended complaint also seeks an injunction against Per Aarsleff’s continued operation of the tube manufacturing facility. In April 2006, we filed a separate patent infringement action in Denmark against Per Aarsleff seeking to enjoin its continued use of an inversion device covered by one of our European patents. We also have filed separate legal actions in Germany against Per Aarsleff relating to its conduct involving our joint venture company in Germany and with respect to transactions between Per Aarsleff and our German joint venture company, which we believe were at prices other than arms’-length. We estimate the aggregate claims in these matters to be in excess of $10.0 million; however, no claims receivable has been recorded in the consolidated financial statements. Due to the uncertainties of litigation, as well as issues regarding the collectibility of damage awards, there can be no assurance regarding these litigations at this time or as to the amount of money, if any, that we may ultimately recover against Per Aarsleff. This case currently is set for trial in the second quarter of 2008.


In June 2005, we filed a petition in State Court in St. Louis County, Missouri against Reynolds, Inc., certain of its subsidiaries and affiliates and an officer of Reynolds, Inc. This suit has been moved to the United States District Court in St. Louis. The suit alleges that Reynolds, among other things, (i) tortiously interfered with a non-competition and confidentiality agreement we had with a former employee and (ii) misappropriated our trade secrets. In April 2005, the St. Louis County Court had entered a temporary injunction against our former employee, finding that he had violated the terms of his non-competition and confidentiality agreement with us and had retained, misappropriated and disseminated to Reynolds, Inc. property of our company for the benefit of Reynolds. In light of the court’s April 2005 findings, we amended our petition to add Reynolds as a defendant in the action. This case currently is set for trial in the second quarter of 2007.

As discussed in previous reports, we also are vigorously pursuing a number of tunneling claims, and continue to incur significant legal costs and expenses in prosecuting such actions. As of December 31, 2006, we had approximately $18.7 million in tunneling claims, of which approximately $7.2 million has been recognized.

We have recorded significant expenses, including attorneys’ fees and other litigation costs, in connection with the prosecution of these intellectual property lawsuits, tunneling claims and other legal matters. For the years ended December 31, 2006, 2005 and 2004, we incurred attorneys’ fees and litigation costs of approximately $6.6 million, $4.3 million and $3.5 million, respectively, with respect to these lawsuits and other legal matters. Other than $7.2 million and $7.6 million in receivables at December 31, 2006 related to tunneling claims and our claim against our excess insurance carrier (see Note 11 “Boston Installation”), respectively, we have not recorded any receivable related to these lawsuits. We have vigorously pursued these lawsuits based upon our business judgment that the possibility of recovery of substantial damages, the granting of the requested injunctive relief and other ancillary benefits arising from our proactive protection of our intellectual property, justifies the expenses previously incurred and currently projected. Because of the substantial uncertainty at this time with respect to the liability and/or damages outcomes, including the collectibility of any damages awarded, we cannot estimate a dollar amount or range of recovery from these lawsuits at this time.


Contract Backlog

Contract backlog is management’s expectation of revenues to be generated from received, signed, uncompleted contracts whose cancellation is not anticipated at the time of reporting. Contract backlog excludes any term contract amounts for which there is not specific and determinable work released and projects where we have been advised that we are the low bidder, but have not formally been awarded the contract.

Backlog
  
December 31,
2006
  
September 30,
2006
  
June 30,
2006
  
March 31,
2006
  
December 31,
2005
  
(in millions)
  
Rehabilitation
  
$
201.7
  
$
201.2
  
$
186.8
  
$
216.2
  
$
213.3
  
Tunneling
    
75.7
    
80.7
    
70.1
    
50.2
    
66.3
  
Tite Liner®
    
12.8
    
13.2
    
15.6
    
20.1
    
20.2
  
Total
  
$
290.2
  
$
295.1
  
$
272.5
  
$
286.5
  
$
299.8
  

The dollar amount of backlog is not necessarily indicative of future earnings relative to the performance of such work. Although backlog represents only those contracts that are considered to be firm, there can be no assurance that cancellation or scope adjustments will not occur with respect to such contracts.
 
Rehabilitation Segment

   
Years Ended December 31,
  
 
  
2006
  
2005
  
2004
  
   
(Dollars in thousands)
  
               
Revenues
  
$
481,220
  
$
445,072
  
$
409,408
  
Gross profit
    
113,623
    
109,585
    
94,305
  
Gross profit margin
    
23.6
%
  
24.6
%
  
23.0
%
Operating expenses
    
81,874
    
75,275
    
77,173
  
Operating income
   
31,749
    
34,310
    
17,132
  
Operating income percentage
    
6.6
%
  
7.7
%
  
4.2
%

Revenues

Rehabilitation revenues were 8.1% higher in 2006 compared to 2005. However, backlog in the rehabilitation segment decreased by 5.4% in 2006 compared to 2005. The first half of 2006 was affected by a significant market softening in the United States, which occurred late in 2005 and lasted into the first quarter of 2006. During this slow period, there was heightened competition for fewer projects, resulting in low-margin pricing, and a decrease in our workable backlog during the first half of 2006. Rather than obtain work at low margins, we were able to take advantage of better margins when the slow period was followed by modest growth in the second quarter of 2006, and even stronger growth in the second half of 2006. As a result, backlog grew in the second half of 2006 after declining during the first half of the year. Due to the improvement in the market, during the second half of 2006, revenue was substantially higher than the same periods in 2005, as demonstrated in the table below, which presents rehabilitation revenues, by quarter, compared to the prior year:

   
Rehabilitation Revenues by Quarter
  
   
2006
  
2005
  
$ Increase
  
% Increase
  
   
(dollars in thousands)
  
1st quarter
  
$
111,658
  
$
105,228
  
$
6,430
    
6.1
%
2nd quarter
    
125,218
    
123,231
    
1,987
    
1.6
%
3rd quarter
    
118,269
    
107,821
    
10,448
    
9.7
%
4th quarter
    
126,075
    
108,792
    
17,283
    
15.9
%
Total
  
$
481,220
  
$
445,072
  
$
36,148
    
8.1
%
 

As stated earlier, revenue was somewhat tempered by market price reductions during the year as a result of competitiveness we have gained over the last few years through cost efficiencies gained from the implementation of steam and other technological improvements.

Revenue from our European rehabilitation business was slightly higher in 2006 compared to 2005 due primarily to higher royalty revenue, which was $0.9 million higher in 2006 as compared to 2005. Revenue from European CIPP installations were lower primarily due to results in the United Kingdom and France, while operations in other European countries achieved higher revenue, particularly in the Netherlands.

We expect growth in our rehabilitation business in 2007, both in North America and Europe. Rehabilitation backlog decreased by 5.4% compared to December 31, 2005, but grew by approximately 8.0% in the second half of 2006, to $201.7 million at December 31, 2006. In addition, due to improved crew productivity and technological advances, particularly in our steam inversion process, we expect to achieve growth with minimal crew expansion.

Rehabilitation revenues increased $35.7 million, or 8.7%, in 2005 as compared to 2004 due to a number of factors, including successful sales efforts through an expanded sales force, higher backlog and expanded crew capacity. Backlog at the beginning of 2005 was $78.6 million higher than at the beginning of 2004. During 2005, we experienced a full year of larger CIPP process crew capacity to accommodate our growing backlog. Revenues were higher in 2005 compared to 2004 across nearly all geographic regions in both North America and Europe. Revenue from our European contracting operations increased by 11.5% during 2005 as compared to 2004 and revenue from our North American contracting operations increased by 7.7% during 2005 as compared to 2004. European revenues were principally impacted by growth and improved markets in the United Kingdom, the Netherlands and France.

Gross Profit and Margin

Rehabilitation gross profit increased by $4.0 million, or 3.7%, to $113.6 million in 2006 compared to $109.6 million in 2005, due primarily to higher revenues and increased crew efficiencies, partially offset by higher material costs. However, gross profit margins slid by one percentage point, to 23.6% in 2006 compared to 24.6% in 2005. One factor impacting the gross profit margin in 2006 related to the price reductions which were driven in the marketplace. Another factor in the percentage-point decline in gross profit margin is the effect of an insurance claim recognized in 2005, which provided a $3.4 million benefit to gross profit. In 2006, an additional $0.5 million related to the same claim was recorded. See Note 11 to the consolidated financial statements for a more detailed description of this insurance claim receivable. Excluding the effect of insurance claim recognition, gross profit margin would have been 23.5% in 2006 compared to 23.8% in 2005. A table reconciling gross profit, excluding the effect of insurance claims, to gross profit, as reported, is provided in the table below for the years ended December 31, 2006 and 2005 (dollars in thousands):

   
Years Ended
December 31,
  
   
2006
  
2005
  
Gross profit, excluding insurance claims
  
$
113,097
  
$
106,138
  
Gross profit margin, excluding insurance claims
    
23.5
%
  
23.8
%
Effect of insurance claims recognition
    
526
    
3,447
  
Gross profit, as reported
  
$
113,623
  
$
109,585
  
Gross profit margin, as reported
    
23.6
%
  
24.6
%

Our material costs were driven slightly higher in 2006 primarily by resin costs. Resin, a petroleum-based product, is subject to pricing volatility, and is a significant raw material in our CIPP process. In many cases, we have the ability to pass through such price increases to our customers. However, to the extent we may have longer-term contracts with fixed pricing, our ability to pass through such price increases may be limited. During 2006, our ability to pass through a substantial portion of our raw material price increases to our customers enabled us to maintain a gross profit margin that was only slightly lower than the gross profit margin achieved in 2005, excluding the effect of insurance claims recognition.


Rehabilitation gross profit increased by $15.3 million, or 16.2%, in 2005 as compared to 2004. Gross profit margins in the rehabilitation segment were 24.6% in 2005 compared to 23.0% in 2004. During 2005, a claim receivable (as discussed in Note 11 to the consolidated financial statements) was recorded which provided a net $3.4 million benefit to rehabilitation gross profit. Excluding the effect of this claim receivable, rehabilitation gross margins would have increased by just over three-quarters of a percentage point due to a decrease in low-margin pipebursting work, advances in crew productivity and efficiencies in manufacturing and logistics. These results were achieved despite significant increases in raw material costs, particularly resin, during late 2004 and into 2005. In addition, fuel costs increased significantly during the same period.

Operating Expenses

Operating expenses were $6.6 million, or 8.8%, higher in 2006 compared to 2005 due to higher corporate expenses, including equity compensation and legal expenses. These increases were offset slightly by lower field expenses, primarily due to reorganization efforts. Operating expenses, as a percentage of revenue, were 17.0% in 2006 compared to 16.9% in 2005.

Operating expenses decreased $1.9 million, or 2.5%, in 2005 as compared to 2004, due primarily to lower incentive compensation expense and lower amortization expense. Incentive compensation expense was lower as our overall results were below expectations. Amortization expense was lower due to the full amortization during 2004 of certain intangibles acquired with Insituform East, Inc. These reductions in operating expenses were partially offset by increased compensation and legal costs necessary to support growth and our strategic initiatives. As a percentage of revenues, operating expenses were 16.9% in 2005 compared to 18.8% in 2004.

Operating Income and Margin

Higher revenues in 2006 were offset by higher subcontract and material costs, higher operating expenses and the effect of the aforementioned claim recognized in 2005. Consequently, operating income fell $2.6 million, or 7.5%, to $31.7 million in 2006 compared to $34.3 million in 2005. Operating margin, which is operating income as a percentage of revenue, similarly fell to 6.6% in 2006 compared to 7.7% in 2005.

In 2005, higher revenues along with lower operating expenses resulted in significantly higher operating income in the rehabilitation segment as compared to 2004. Rehabilitation operating income increased by $17.2 million, or over 100%, in 2005 as compared to 2004, and operating margin, increased to 7.7% in 2005 compared to 4.2% in 2004.

Insituform Blue™

During 2006, we launched a new potable water infrastructure division under the name Insituform Blue™. Under Insituform Blue™, we operate with a variety of technologies geared to the global drinking water market. Insituform Blue™ did not have a material effect on our consolidated results of operations, and is expected to generate modest operating losses, perhaps for the next few years, as we establish this business for the future.


Tunneling Segment

   
Years Ended December 31,
  
   
2006
  
2005
  
2004  
  
   
(Dollars in thousands)
  
               
Revenues
  
$
69,296
  
$
111,687
  
$
108,729
  
Gross loss
    
(1,048
)
  
(4,184
)