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Integrated Electrical Services 050921 Integrated Electrical Services 050921 Document Transcript

  • HIGH-YIELD/ CONVERTIBLE RESEARCH MILLER TABAK ROBERTS SECURITIES, LLC REPORT__________________________________________________ Integrated Electrical Services, Inc. (IES) Mdys/ Common Current BondCoupon Description Maturity CUSIP S&P Amt O/S CV Price CV Prem. Price Yield YTW Price Opinion 6.500% Ser. A Sr. Conv. Notes 11/01/14 45811EAF0 NA $ 30MM $ 3.25 20.43% $ 2.70 NA NA NA NA 6.500% Ser. B Sr. Conv. Notes 11/01/14 45811EAG8 NA $ 20MM $ 3.25 20.36% $ 2.70 NA NA NA NAMoodys and S&Ps outlook is negative. Coupon Description Maturity CUSIP Mdys/S&P Amt O/S Curr. Yield YTW Bond Price Opinion 9.375% Ser. B Sr. Sub. Notes 02/01/09 45811EAB9 Caa2 / CCC $ 63MM 11.6% 17.3% 80.50 Sell 9.375% Ser. C Sr. Sub. Notes 02/01/09 45811EAE3 Caa2 / CCC $ 110MM 11.5% 16.8% 81.50 SellMoodys and S&Ps outlook is negative. September 21, 2005 Ronald A. Rich (212) 692-5185 rrich@mtrdirect.comOPINIONWe initiate coverage on Integrated Electrical Services with a SELL recommendation on theSenior Subordinated Notes. We believe that IES faces a challenging turnaround and that apurchase of the Senior Subordinated Notes at these levels does not adequately compensate theinvestor for the commensurate risk. With liquidity forecasted to further diminish withoutsuccessful asset sales, we estimate that a bankruptcy filing in the future is more likely thannot. In a workout scenario, we project a full recovery for the Senior Convertible Notes, giventhe small amount outstanding relative to that of the Senior Subordinated Notes. The SeniorSubordinated Notes, on the other hand, would be expected to be substantially impaired. Ourbase case calculations do not incorporate future value drain which would result from anexpanded senior credit facility. Given our assessment of current risks, we might find theSenior Subordinated Notes interesting at 64 ½ . We have not issued an opinion on the SeniorConvertible Notes because they are very thinly traded, but we believe that they would be fairlyvalued at 96 ½.SUMMARY• Headquartered in Houston, TX, Integrated Electrical Services, a $1.1 billion revenue roll-up, is the second largest provider of electrical contracting and maintenance services in the U.S.• IES is in the midst of an operational turnaround, having suffered from inadequate project bidding controls, project mismanagement, weak markets in its commercial business, and diminished surety bonding capacity needed to source new commercial and industrial projects.• IES is highly leveraged, with an LTM adjusted net leverage ratio of 21.6x, and an LTM adjusted net interest coverage of 0.36x for the period ending June 30, 2005 (the calculated ratios are estimates due to the lack of comparability among the LTM quarterly data). Specialty contractor and construction-related companies typically carry very low debt levels. The leverage ratios of IES’s public comparables range between 0.0x and 2.6x. 331 MADISON AVENUE NEW YORK, NEW YORK 10017 (212) 867-7959 FAX (212) 867-6492 (800) 452-4528 (888) HI-YIELD Please refer to the last page of this report for important disclosures
  • • Near-term liquidity appears sufficient, providing management with a window to affect a turnaround. Management has proven that it can raise additional liquidity through the sale of business units, thirteen of which have been completed in the past eleven months. We are concerned that future divestitures may prove more difficult to complete and less financially productive. Management is currently behind on the divestiture schedule it provided on the latest conference call. IES may also have the ability to extend its liquidity by expanding its current senior credit facility, though we project default under the Fixed Charge Coverage covenant in the first quarter ending December 31, 2005.• IES is dealing with reduced surety bonding capacity. Given a shrinking backlog, it is unclear whether the company will be successful in replacing large bonded projects with a sufficient number of smaller ones. As a result, we fear a declining revenue line in its commercial and industrial business units and a further impaired EBITDA margin. We also question whether management-projected improved gross margin will be eroded by increased business development costs associated with a greater number of projects.• There has been substantial turnover within the senior management ranks over the past fiscal year (ending September 30, 2005). While we do not believe that this is necessarily bad, we are concerned with the possible implications. Additionally, conversations with industry sources have pointed to potentially damaging attrition at IES’s subsidiaries.• Our view to risk is colored by the potentially low reorganization value of a troubled construction company, particularly one whose main asset is its workforce. Our recovery analysis assumes that IES’s Residential segment is successfully reorganized, while the Company’s commercial units are sold.• Given our evaluation of the current risks associated with IES’s turnaround, we have based our target pricing on a required return of 9% for the fixed income piece of the Senior Convertible Notes and 15% for the Senior Subordinated Notes.BACKGROUNDIntegrated Electrical Services, Inc. (“IES” or the “Company”) was created in June 1997 to serveas a leading national provider of electrical contracting and maintenance services to thecommercial, industrial and residential markets. Concurrent with the closing of its January 1998initial public offering, IES acquired fifteen electrical contracting and maintenance servicecompanies and a related supply company, making it one of the largest competitors in thedomestic electrical specialty contracting space. Pro forma revenues for the newly formed entitywere $312.7 million, of which 63% was derived from commercial and industrial contracting,25% from residential contracting, and 12% from electrical maintenance work.IES was one of a number of specialty contractor roll-ups which occurred in the late 1990’s. Theroll-ups were driven by market fragmentation, the availability of capital, public versus privatemarket valuation arbitrage, as well as by visions of increased competitive advantage resultingfrom an augmented market footprint, economies of scale, cross-selling and expertisetransference; twelve engineering and construction companies went public between 1997 and2000.Since its founding, IES has grown primarily through acquisitions, making 71 acquisitions fromApril 1998 through December 2000. Presently comprised of 36 active business units withestimated annual revenues of $1.1 billion, much of the Company’s current leverage was incurredto finance this growth. IES fundamentals began to decline in fiscal year 2002 as a result of 2
  • increased competition and project mismanagement. Recently, the Company has been negativelyimpacted by rapidly rising material costs and a difficult surety bonding environment. Lossesexperienced by the surety industry in recent years have caused insurers to limit surety capacityand increase costs to customers. In response, IES has divested thirteen business units, fiscalyear-to-date, that are heavily reliant upon surety bonding. Company management is presentlyfocusing on improving project bidding and execution, sourcing shorter term projects, as well asreducing overhead costs.BUSINESSHeadquartered in Houston, TX, Integrated Electrical Services is the second largest provider ofelectrical contracting and maintenance services in the United States, following Quanta Services.IES’s electrical contracting services include the design of electrical distribution systems, theprocurement and installation of wiring and fixtures within structures, as well as the long-termmaintenance of these systems. These installations support a variety of purposes, includingclimate control, security and communications.Within commercial structures, IES electricians will place piping or tubing, referred to as conduit,inside designated partitions and walls; in residential construction, plastic-covered wire is usuallyused in place of conduit. Insulated wires or cables are then run through the conduit to connectvarious electrical boxes which house switches and outlets. The wiring is then connected tocircuit breakers, transformers, or other components. Upon completion of the installation, thesystem is tested to ensure proper connectivity and safety. IES also installs low voltage wiringsystems, such as voice, data, and video wiring systems typically used for telephones, computers,intercoms, fire alarms and security systems.Success in the electrical contracting business is reliant upon an entrepreneurial spirit which mayprove to be unsustainable in a $1.1 billion roll-up which requires that the more profitablebusiness units financially support the less profitable ones. Illustrating this point, one industryexecutive, in describing the owner of a Houston-based IES competitor, is quoted as saying, “Hehas a following of top people…The way [he] runs his business, he pays his people more thananybody else, he rewards them more than anybody else, but he expects them to move mountainsfor him. So they work hard, but they have fun doing it. There’s a lot of loyalty from the peoplewho work for him” (Source: Dallas Business Journal, April 14, 2003).Operating SegmentsCommercial and Industrial. IES’s commercial work (70% of revenues) consists primarily ofelectrical installations and renovations in office buildings, high-rise apartments andcondominiums, hotels, retail stores and centers, schools, community centers, theaters andstadiums. Within industrial construction, the Company provides services for utilities, includingpower generation and overhead and underground lines, water facilities, manufacturing andprocessing facilities, highway and transportation projects, military installations, and airports.IES’s customer base is comprised of general contractors, developers, building owners andmanagers, engineers, architects and consultants. No customer accounts for more than 10% ofrevenues.New business is typically sourced through long-standing relationships. After reviewing theengineer’s plans and meeting with the client, the IES business unit will construct cost estimates 3
  • and submit its bid for the project. If the project is awarded, it is scheduled in phases andincrementally billed as it is completed, net of a 5% to 10% retainage based on total project cost.The Commercial and Industrial (“C&I”) segment is characterized by long, complex projectswhich are executed under fixed-priced or guaranteed maximum price contracts. This contractstructure has exposed IES to compromised margins resulting from under-bidding and costoverruns and recently led management to shorten project duration and to shift revenue mixtoward its residential operating segment. IES’s average contract is currently between $500,000and $600,000 and requires between six and nine months to complete. As of the third quarter of2005, commercial and industrial revenue accounted for 70% of total revenue, down from 77% inthe prior year’s quarter. Much of the shift has been accomplished through the divestiture ofbusiness units which focus on commercial and industrial contracting. This change in service mixhas also been motivated by an increasingly difficult surety bonding environment, a dynamicwhich will be addressed in detail below in the Recent Trends section.Residential. Anchored by subsidiary Houston-Stafford of Stafford, TX, IES is the largestresidential electrical contractor in the country. The Residential segment provides electricalinstallations for developers of new single family homes and multi-family low-rise apartments,condominiums and town homes. IES’s residential operating segment is considerably moreprofitable than its commercial and industrial segment, typically executing projects which areshorter in project duration and less complex. Also, the surety bonding requirement for thissegment is considerably lower. Demand for residential work is seasonal in nature, with higherrevenues generated during the spring and summer quarters (Q3 and Q4). Single-familyinstallations are not entered into the Company’s backlog.Project Financial StructureRevenues. Electrical contracting typically comprises 10% of the total construction costs of agiven project. IES recognizes revenue from construction contracts on a percentage-of-completion method, whereby costs incurred and accrued to-date are compared with the estimatedtotal cost for each contract. While this methodology is common, its accuracy is vulnerable torevisions in project costs produced by inaccurate bidding, and poor project management, jobperformance and job conditions. The Company recently encountered errors at three of itssubsidiaries relating to improperly recording revenues associated with change orders, costscharged to certain contracts and the estimates of costs to complete on certain contracts. As aresult, reported results for the six months ended March 31, 2004 and the years ended September30, 2002 and 2003 have been revised, reflecting a decrease in operating profit in the amount of$4.5 million, $1.0 million and $0.8 million, respectively.Costs. IES’s operating costs are comprised mainly of materials, labor and insurance. Materialsare ordered for a particular project and are typically utilized within 30 days. They consist ofcommodity-based products such as conduit, wire, fuses, fixtures and control panels. At thecommodity level, IES makes use of steel, copper and gasoline. While the Company does hedgeits materials exposure on fixed-priced contracts to a reasonable extent, the contracts do notcontain material escalation clauses, leaving IES vulnerable to rapidly rising commodity pricing.Material cost savings are one of the touted benefits of roll-ups such as IES, but such savingsare often absorbed by increased overhead and compliance costs. For the years endingSeptember 30, 2002, 2003 and 2004, materials expense as a percentage of cost of services was42%, 43% and 51%, respectively. 4
  • As a non-union shop, IES benefits from lower employee benefit costs, as well as more flexiblework rules. In a tight labor market, though, labor costs can effectively become less variable. Inwhat is considered an ongoing and ever increasing labor shortage of electricians, we believe thatIES is currently faced with supporting an underutilized labor force in some of its markets,due to Company anticipation of an up-tick in commercial electrical contracting demandand the commensurate difficulty with staffing up. For the years ending September 30, 2002,2003 and 2004, labor and related expenses as a percentage of cost of services was 43%, 42% and48%, respectively.Geographic MarketsAs of August 6, 2005, IES had 36 active business units and over 100 Figure 1locations serving the continental U.S. During the formation of IES, Business Unitmanagement touted the competitive advantage that a national footprint Headquarter Locations As of September 9, 2005would provide in competing for projects with national or regionalcustomers. Outside of service work, this does not appear to have been Region Southeast State No. Units AL 1the case, given the local nature of construction and contracting. Figure FL 2 GA 11 delineates our estimate of IES’s current business unit headquarter KY 1locations. While it has a national presence, the Company has NC 1 SC 2derived the majority of its revenue from the Sunbelt states. As TN 2 VA 3shown in Figure 2, nearly 70% of revenue has historically come from 13the South, with the Mid-Atlantic and Northeast a distant second. It is West AZ 3 CA 2evident in the following charts (see Figures 3a-3c) that private CO 1nonresidential construction put-in-place spending is down from its OR 3 NV 22000 to 2001 highs and is essentially running flat in IES’s main WA 1 12markets. On a national basis, year-over-year monthly growth of Southwest TX 9private nonresidential construction put-in-place spending has leveled Midwest IA 1 NE 1off at approximately 5%, as compared with what had been a trend of OH 1increases over the second half of 2004 (see Figure 3a). Spending in 3 Mid-Atlantic MD 2the Southeast region has grown by approximately 4% in years 2003 Northeast MA 1and 2004 (see Figure 3b), while in the Southwest region, spending has SUBTOTAL 40declined (see Figures 3c). Construction spending forecasts are Less adjustments 4 TOTAL 36 Figure 2 addressed below in Source: Company and MTR estimates. the Outlook Percentage of Revenue by Region section. According to our market feedback, As of June 2004 demand within IES’s commercial markets varies considerably. Florida, for example, is Southwest, 10% one market in which customers seem Northeast, 6% desperate for electrical contracting services, South, 34% Mid-Atlantic, while in Texas demand is considered anemic 14% throughout the industry. It is anticipated, Midwest, 5% though, that a number of Texas markets will Northwest, 6% rebound on the heels of rising oil and gas Southeast, 25% prices. As for Hurricane Katrina, management has stated that, though IESSource: Company. does not have a presence in the affected areas, the tragedy may result in additionalwork for regionally located business units and/or increased project margins due to reducedcontractor capacity in its markets. 5
  • Figure 3a Private Nonresidential Construction Put-In-Place National - Seasonally Adjusted Annual Rate 250,000 10.0% Percentage Change Dollars in Millions 245,000 8.0% 240,000 6.0% 235,000 4.0% 230,000 2.0% 225,000 0.0% Se 4 05 04 M 5 M 5 05 A 4 N 4 D 4 04 A 5 Fe 5 0 0 0 0 0 0 0 0 l ug ay n ct p ov b ar pr ec n Ju Ju Ja O Spending Year-Over-Year ChangeSource: Department of Commerce.Figure 3b Private Nonresidential Construction Put-In-Place Southeast Region 70,000 30.0% Percentage Change Dollars in Millions 60,000 20.0% 50,000 40,000 10.0% 30,000 0.0% 20,000 -10.0% 10,000 0 -20.0% 94 95 96 97 98 99 00 01 02 03 04 19 19 19 19 19 19 20 20 20 20 20 Spending Annual ChangeSource: Department of Commerce.Figure 3c Private Nonresidential Construction Put-In-Place Southwest Region 30,000 30.0% Percentage Change Dollars in Millions 25,000 20.0% 20,000 10.0% 15,000 0.0% 10,000 5,000 -10.0% 0 -20.0% 94 95 96 97 98 99 00 01 02 03 04 19 19 19 19 19 19 20 20 20 20 20 Spending Annual ChangeSource: Department of Commerce. 6
  • RECENT TRENDSSurety BondingSurety bonding has historically been an important component of new business development forIES. Large projects and government funded projects typically always require the Company topost bid, payment and performance bonds. A surety bond is a three-party instrument among asurety, the contractor and the project owner. The agreement requires the contractor to complywith the terms and conditions of a contract. If the contractor is unable to successfully performthe contract, the surety assumes the contractor’s responsibilities and ensures that the project iscompleted.Financial losses experienced by surety providers in recent years have led providers to tightenunderwriting standards and caused many to leave the business entirely. IES’s falteringfundamentals in its Commercial and Industrial segment have led IES’s surety provider, Chubb,to limit bonding capacity and to secure most of its exposure. As of June 30, 2005, IES had $110million of cost-to-complete on bonded projects, as compared with $151 million as of March 31,2005. Of this amount, collateral was comprised of $18.0 million in cash, $11.4 million in lettersof credit and $60 million in receivables, summing to 81% of total exposure.These limitations on securing bonding have altered IES’s strategic direction. Through a changein projects bid and a recent divestiture program, the Company has refocused its sourcing effortson smaller projects, which do not require surety bonding. The Company purports that thesesmaller projects will carry higher margins, though this is contrary to the feedback we havereceived from the marketplace, which indicated that there is a greater degree ofcompetition for smaller assignments. Additionally, selling expense should increase givensmaller project size and constant selling expense per project. On the other hand, an increasein gross margin may be achieved because IES can more accurately bid on and properly executesmaller scale projects.The Company has also mentioned its intention to obtain a secondary surety provider. Weconsider success with this endeavor unlikely and believe that Chubb will continue to securethe balance of its unsecured exposure and reduce its outstanding bonds. We also believethat Chubb will continue to work with IES management in a fiscally prudent manner.Abandoning IES’s surety bonding program would limit the Company’s ability to win futurebusiness and potentially harm Chubb’s current bonding exposure to IES if deteriorating salesimperiled its ability to complete current projects.DivestituresIn October 2004, IES announced a strategic realignment of all its business units. Therealignment is aimed at divesting underperforming commercial units and is expected to becompleted within fiscal 2005. Management has classified each of IES’s business units as eitherCore, Under Review or Planned Divestiture. The Core category is comprised of the Company’sresidential units and well-performing commercial units. While subject to change, remainingPlanned Divestiture units accounted for an estimated $106 million of fiscal 2004 revenues andapproximately $55 million of LTM revenues through July 2005, a percentage decrease of 48%.To-date, divested units are comprised of thirteen business units responsible for an estimated $244million of fiscal 2004 revenues (see Figure 4). The vast majority of these units areheadquartered in the Southeast and Southwest regions. As of this writing, only two divestitures 7
  • had been announced in the fourth quarter of 2005, as compared with five that had been scheduledto be completed by quarter-end. Figure 4 Divestitures Fiscal Year-to-Date (In Millions of Dollars) Cash 2004 2004 Proceeds/ Business Unit State Proceeds Revenue Op. Margin Revenue Date Goss Electrical AL $ 4.0 $ 19.0 -2.2% 0.21x 11/30/04 Delco Electric OK 7.5 38.7 3.9% 0.19x 12/10/04 B. Rice Electric TX Ace/Putzel GA 3.5 17.3 -2.8% 0.20x 01/07/05 DKD Electric NM 4.4 27.3 2.2% 0.16x 02/01/05 Howard Brothers Electric NC T&H Electric NC 4.5 16.5 9.1% 0.27x 03/02/05 Canova Electrical PA 1.7 8.0 11.3% 0.21x 04/18/05 Anderson & Wood ID 3.2 13.3 4.5% 0.24x 05/04/05 Tech Electric NC Ernest P. Breaux Electrical LA 5.6 49.3 4.3% 0.11x 06/30/05 Brink Electric Construction SD 4.7 19.3 10.3% 0.24x 08/05/05 Florida Industrial Electric * FL 6.0 35.5 -0.8% 0.17x 09/05/05 Subtotal 44.9 Adjustment to Subtotal 1.9 Cash True-Up 3.1 TOTAL $ 49.9 $ 244.2 0.20x Source: Company Reports and MTR. * Revenue figure reflected is for LTM ending August 2005.Cash proceeds for the Company’s current divestiture Figure 5program total $50 million, and given average cash proceeds Divestiture Summary As of September 5, 2005of $0.20 per fiscal 2004 revenue dollar (as compared with an (In Millions of Dollars)estimated $0.75 per revenue dollar paid for IES’s founding No. Cash Est LTMcompanies), the balance of Planned Divestitures could Status Units Proceeds Revenuegenerate an incremental $28 million, assuming that those Sold 13 $ 48.0 $ 244.2 Closed 2 - 9.3already divested units were not low-hanging fruit. An Planned 4 28.1 140.7additional three units are classified as Under Review ($196 Under Review 3 39.2 195.8 Source: Company Reports and MTR.million of 2004 revenues) and could produce estimated cash * Cash proceeds for Planned and Under Review are estimated.proceeds of $39 million, though based on comments made onthe fiscal third quarter 2005 conference call, we assume that these units will be retained in themedium-term. In what we believe to be every case, each divested unit has been sold to itsprevious owner/current manager. This implies that 1) the previous owner believes that shecan create value once disassociated from IES; 2) the unit’s projects can get bonded whenseparated from IES (possibly via owner personal guarantees); 3) the buyer of the divested unitperceives that she is buying at a level at which she can make an acceptable return; and 4) theredoes not exist another buyer for the unit. This also clearly demonstrates that IES has theability to readily divest its structurally disparate units and to generate incrementalliquidity.As for what IES will do with the cash proceeds of its divestiture program, we believe that itwill not readily use recent proceeds to repurchase debt, as it is not required under itsindentures given the size of asset sales. With backlog declining, uncertainty surrounding future 8
  • commercial project awards and declining operating margins, we suspect that the Company willlikely wait and see if it requires the cash proceeds to support operations.MACRO DRIVERSDemand for commercial and industrial electrical contracting services is driven by constructionand renovation activity, which is highly correlated to growth in real gross domestic product andto the rate of unemployment. Electrical contracting will lag a construction trend, as it is put-in-place during the latter part of the project. As shown in the Figure 6, our correlation analysisproduced an R2 (statistical measure, 100% signifies perfect correlation) of 99.5%, showing anextremely high correlation among real GDP, the rate of unemployment and fixed investment innonresidential construction spending. Figure 6 Figure 7 Nonresidential Correlation Analysis Residential Correlation Analysis (In Billions of Dollars) (In Billions of Dollars) Nonresidential Home New Unemploy. Fixed Mortgage Housing Year Real GDP Rate Investment Year Real GDP Yields Investment 1995 $ 8,031.7 5.59% $ 762.5 1995 $ 8,031.7 7.87% $ 171.4 1996 8,328.9 5.41% 833.6 1996 8,328.9 7.80% 191.1 1997 8,703.5 4.94% 934.2 1997 8,703.5 7.71% 198.1 1998 9,066.9 4.51% 1,037.8 1998 9,066.9 7.07% 224.0 1999 9,470.3 4.23% 1,133.3 1999 9,470.3 7.04% 251.3 2000 9,817.0 4.02% 1,232.1 2000 9,817.0 7.52% 265.0 2001 9,890.7 4.79% 1,180.5 2001 9,890.7 7.00% 279.4 2002 10,074.8 5.80% 1,075.6 2002 10,074.8 6.43% 298.8 2003 10,381.3 6.00% 1,110.8 2003 10,381.3 5.80% 345.7 2004 10,841.9 5.50% 1,228.6 2004 10,841.9 5.77% 416.1 Variables Variables Y Real Nonresidential Fixed Investment Y Real New Housing Investment X1 Real GDP X1 Real GDP X2 Unemployment Rate X2 Home Mortgage Yields Output Output 2 2 R = 99.5% R = 95.0% Y= 0.1668 * X1 - 10610.8 * X2 + 13.46175 Y= 0.05077 * X1 - 3756.68 * X2 + 46.7746 Source: Department of Commerce and MTR analysis. Source: Department of Commerce and MTR analysis.Demand for residential electrical contracting services is correlated to housing starts and is, inlarge part, driven by the health of the economy and the level of interest rates. With new housinginvestment as the dependent variable and an R2 of 95.0%, the regression analysis in Figure 7clearly shows a very strong relationship among the three.CORPORATE STRUCTURE Figure 8 INTEGRATED ELECTRICAL SERVICES, INC. (Holding Company) Revolving Credit Facility 6.5% Senior Convertible Notes 9.375% Senior Subordinated Notes Operating Subsidiaries Revolving Credit Facility Guarantors of: 6.5% Senior Convertible Notes 9.375% Senior Subordinated Notes Source: Company reports. 9
  • CAPITAL STRUCTUREIES is structured as a holding company with substantially all of its assets and operations held byits subsidiaries. Each of the Company’s notes has been issued by the holding company entity,while both the parent and its operating subsidiaries are co-borrowers on the bank facility.Revolving Credit FacilityOn August 1, 2005, IES obtained a new three-year $80 million revolving credit facility withBank of America, N.A., replacing its old facility which was scheduled to mature on August 31,2005. As of August 9, 2005, there were no cash borrowings under the facility. Net of $15million of reserves and $47 million of outstanding LC’s, revolver availability was $18 million.A Back-Up Letter of Credit in the amount of $42.1 million has been issued to secure the lettersof credit that had been issued under the previous facility; in addition, a $5.0 million letter ofcredit has been issued to Chubb as additional security for its surety obligations. The letters ofcredit issued collateralize $36 million in casualty insurance and $11.4 million in surety bonding.The Company and each of its operating subsidiaries are co-borrowers of the facility; all othersubsidiaries are guarantors of the facility. The obligations of the borrowers and the guarantorsare secured by a pledge of substantially all of the assets of the Company and its subsidiaries,excluding any assets pledged to secure surety bonds procured by the Company and itssubsidiaries in connection with their operations. The facility also carries a $70 million Letter ofCredit sub-facility.Outstanding borrowings are charged an interest rate equal to 1) LIBOR plus an applicable marginranging from 2.5% to 3.5%, based upon the Fixed Charge Coverage ratio, or 2) a domestic bankrate plus an applicable margin ranging from 0.5% to 1.5%, based upon the Fixed ChargeCoverage ratio, at the election of the borrower. Fixed Charges are defined as interest expense,capital expenditures, principal payments of debt, depreciation associated with equipment, andincome taxes.The facility’s Borrowing Base is calculated as a percentage of Eligible Accounts Receivable,Inventory and Equipment, less a reserve of $15 million. Borrowings against accounts receivableare determined as an amount equal to the lesser of 85% Eligible Accounts Receivable and 80%of cash collections; against inventory, as an amount equal to the lesser of $10 million and thelesser of (a) 65% of Eligible Inventory and (b) 85% of Eligible Inventory Liquidation Value; andagainst equipment, as an amount equal to the lower of cost or market.The loan agreement contains a covenant that specifies a Fixed Charge Coverage ratio for eachcumulative monthly period (starting at one month and increasing up to a trailing twelve months),commencing in July 2005 at 0.59, scaling in a non-linear fashion to 1.00 in May 2007. Weproject covenant default during the first quarter of fiscal 2006, ending December 31, 2005,and believe that the bank will issue a waiver; our calculation of this ratio is not certaingiven current guidance. In addition to customary events of default, the facility is cross-defaulted to the Senior Convertible Notes, the Senior Subordinated Notes and the Company’sagreement with Chubb.6.5% Senior Convertible NotesOn November 24, 2004, IES sold Series A and B Senior Convertible Notes due November 1,2014 in the amount of $30 million and $6 million, respectively, followed by a $14 million SeriesB issue on February 24, 2005. The capital raise was conducted in two parts to comply with the$30 million basket provision under the Limitation on Indebtedness covenant in the Subordinated 10
  • Note indenture. The proceeds from the sale were used to repay a portion of the Company’s oldcredit facility and for corporate purposes. The Convertible Notes bear interest at an annual rateof 6.5%, payable semiannually on May 1 and November 1, and are convertible into commonshares at an initial conversion price of $3.25 per share.The Convertible Notes are senior unsecured obligations and are guaranteed on a seniorunsecured basis by the Company’s significant domestic subsidiaries. Prior to March 1, 2006, theSeries B Convertible Notes are not convertible as long as any Series A Convertible Notes areissued and outstanding. On or after November 1, 2008, the Company has the option to redeemthe Convertible Notes if the last reported trading price of the Common Stock is greater than150% of the then current conversion price for at least 20 trading days in the 30 consecutivetrading days ending on the day prior to the date on which the Company delivers notice ofredemption. Upon a Change of Control, defined, in part, as the purchase of more than 50% ofthe Voting Stock, the Company is required to repurchase the Convertible Notes at par plusaccrued interest. The holder of Notes who converts her securities during the FundamentalChange Conversion Period is entitled to the Make-Whole Premium upon conversion. As of June30, 2005, $50 million of Senior Convertible Notes were outstanding.9.375% Senior Subordinated NotesOn January 25, 1999 and May 29, 2001, IES issued $150.0 million and $125.0 million of SeriesB and C Senior Subordinated Notes due February 1, 2009. Proceeds from the Series B issuancewere used to finance acquisitions, while those of the Series C issuance were used to repayamounts outstanding under the credit facility. The notes bear interest at 9.375%, payablesemiannually on February 1 and August 1.The Subordinated Notes are unsecured and subordinated to all existing and future seniorindebtedness, including the Senior Convertible Notes. They are guaranteed on a seniorsubordinated basis by all of IES’s subsidiaries. Post-default distributions, including those madeat exit from bankruptcy, are to be paid to holders of senior indebtedness until they are madewhole (including pre- and post-petition interest). However, the indenture contains a so-called “XClause.” This X Clause, in theory, entitles holders of the Subordinated Notes to retaindistributions consisting of “Permitted Junior Securities,” even if senior creditors haven’t beenmade whole. Permitted Junior Securities are defined as “capital stock of the Company or debtsecurities that are subordinated to all Senior Indebtedness to at least the same extent as the Notesare subordinated to all Senior Indebtedness.” X Clauses are not particularly powerful protectionsfor holders of subordinated debt. First, they don’t require debtors to structure bankruptcydistributions to include Permitted Junior Securities, and, second, courts have been very reluctantto actually enforce them, when to do so would permit a substantial recovery to juniorbondholders before senior bondholders are made whole. While we are aware of recent efforts todraft X Clauses to compel a more favorable judicial interpretation, the X Clause in questiondoesn’t have such strengthened language. The Subordinated Notes are callable on or afterFebruary 1, 2005 at $103.125, February 1, 2006 at $101.563 and February 1, 2007 at $100. Thenotes carry a change of control put at 101%.Under the definition of Permitted Indebtedness, the Subordinated Note indenture allows theCompany to borrow up to $250 million under a credit facility, as compared with its currentfacility of $80 million. We calculate that, given its estimated eligible trade accountsreceivable balance alone, IES working capital accounts should support at least anadditional $50 million in senior credit. This, of course, assumes lender willingness, which 11
  • should not be taken for granted given the potential speed with which receivables becomeuncollectible on non-performing construction projects and/or the property of the suretyprovider via its subrogation rights. Otherwise, the Company’s ability to incur indebtedness islimited through a Consolidated Fixed Charge Coverage ratio of at least 2.0, pro forma for theacquired indebtedness, with which it is clearly not in compliance. Fixed Charges are defined asinterest expense and dividends paid or accrued on Redeemable Capital Stock or Preferred Stock.Pursuant to the indenture, net cash proceeds from asset sales that are not used to reduce seniorindebtedness or to reinvest in assets that are useful in the business within 360 days of the assetsale, and which are equal to or exceed $10 million, are to be used to purchase the SubordinatedNotes for cash at 100% of the principal amount plus accrued and unpaid interest to the purchasedate. Noncompliance with this provision of the indenture is not an Event of Default. Given thesale price (averaging $3.4 million) of the divestitures completed year-to-date and of thosecurrently planned, it would appear that this provision is not applicable to IES’s currentstrategic realignment.The Company redeemed two tranches of Subordinated Notes in the amount of $27.1 million and$75.0 million on September 30, 2002 and September 30, 2004, respectively. As of June 30,2005, $62.9 million of the Series B Notes and $110 million of the Series C Notes wereoutstanding.Leverage / Liquidity Figure 9IES had total net debt of $192.4 million as of June 30, 2005. LeverageGiven an LTM adjusted EBITDA (defined as operating As of June 30, 2005 (In Millions of Dollars)income before depreciation and amortization, net of MTR- Leveragedetermined non-recurring items) of $8.9 million, the Amt. O/S Thru Revolving Credit Facility $ - 0.0xCompany had a net leverage ratio of 21.6x. LTM adjusted Senior Convertible Notes 50.0 5.6xnet interest coverage is calculated at 0.36x for the period. Senior Subordinated Notes Total 172.9 222.9 25.1x 25.1xAs of August 9, 2005, IES had liquidity in the amount of $53 LTM Adjusted EBITDA $ 8.9million, comprised of $35 million in cash and $18 million of Source: MTR analysis.revolver availability.MANAGEMENT / OWNERSHIPC. Byron Snyder, Founder of IES and Chairman of the Board Figure 10 Beneficial Ownershipsince the Company’s inception in 1997, replaced H. Roddy of IES Common StockAllen as president and CEO effective June 30, 2005. On June As of May 13, 2005 (Shares In Millions)2, 2005, Mr. Allen announced that he had retired as president, Owner No. Shares % ClassCEO and a director of IES. Mr. Allen had been a director since Marathon Asset 7.7 17.9%2001, and CEO and president since October 2002. Throughout Amulet Limited Fidelity 7.7 4.7 16.4% 12.1%his career, Mr. Snyder has held leadership roles at both private Directors and Off., other 3.9 10.1% Jeffrey Gendell 3.7 9.4%equity firms and operating companies. As reported in the Barclays Global Investors 3.5 9.0% Dimensional Fund 3.2 8.1%Company’s latest proxy statement, Mr. Snyder beneficially State Street Research 2.8 7.0%owns 6.4% of IES common stock (see Figure 10). Our C.ByronPartners Artisan Snyder 2.6 2.2 6.7% 5.6%feedback from the marketplace has been positive regarding Mr. Ardsley Advisory Source: Company reports. 2.0 5.1%Snyder. Those who purport to know him well consider him anaccomplished dealmaker and an astute business person. We view his assumption of the CEOrole as positive for IES, but telling of its current state of affairs. 12
  • Richard Humphrey was named COO of IES on March 31, 2005, replacing Richard China, wholeft the Company in November 2004. Mr. Humphrey has 35 years of experience in the industry,beginning in 1970 when he founded ARC Electric, Inc., currently a subsidiary of IES. Mr.Humphrey remained as president of ARC until 2001, when he assumed the role of regionaloperating officer.David Miller was appointed CFO of IES in January 2005. Mr. Miller has been with theCompany since January 1998 and was previously chief accounting officer. He replaced WilliamReynolds, who had been CFO since June 2000.Bob Callahan was promoted to senior vice president of human resources in February 2005,replacing Margery Harris, who had been with IES since October 2000. Mr. Callahan has beenwith the Company since 2001.COMPETITIONBased on data from F.W. Dodge and EC&M Magazine, IES management estimates that theelectrical contracting industry generated $90 billion in annual revenues for 2004. The industry ishighly fragmented and is comprised of over 70,000 companies, most of which are owner-operated. Within the top 10 companies, as ranked by size, electrical contracting revenues rangefrom approximately $1.5 billion down to $300 million; of these, four companies are public (seeFigure 11).Figure 11 Specialty Contractors - Public Comparables As of August 31, 2005 (In Millions of Dollars) LTM LTM EBITDA Enterprise EV / EV / Net Debt /Company Ticker Specialty Sales EBITDA Margin Net Debt Value EBITDA Sales EBITDAIntegrated Electrical Services IES Electrical $ 1,169.4 $ 8.9 0.8% $ 192.4 $ 299.7 33.8x 0.26x 21.7xEMCOR Group EME Elec. / Mechanical 4,719.1 83.7 1.8% 1.5 857.8 10.3x 0.18x 0.0xEMCOR Group, US Electrical Division* Electrical 1,233.2 74.9 6.1%Quanta Services PWR Electrical / Utilities 1,694.1 83.3 4.9% 220.2 1,623.8 19.5x 0.96x 2.6xInfraSource Services IFS Utilities / Electrical 775.0 54.5 7.0% 99.3 690.3 12.7x 0.89x 1.8xComfort Systems USA FIX Mechanical / HVAC 869.6 28.4 3.3% (26.2) 299.9 10.5x 0.34x 0.0xDycom Industries DY Utilities / Comm. 996.1 130.6 13.1% (67.6) 797.9 6.1x 0.80x 0.0xSource: Company Reports and MTR analysis.* Estimated.EMCOR Group (EME). Headquartered in Norwalk, CT, EMCOR Group has an interestinghistory with predecessor entities that have focused on supplying water for municipalities and oncomputer systems reselling. Formerly known as JWP, EMCOR emerged from bankruptcy in1994 to concentrate on its core mechanical and electrical contracting businesses. Since then, ithas grown successfully through acquisition. Its installed systems are used for power generationand distribution, lighting, communications, plumbing and HVAC. LTM electrical contractingrevenues are $1.2 billion with estimated EBITDA margins of 6.1%. The company had net debtof $1.5 million as of June 30, 2005.Quanta Services (PWR). Quanta Services, which is headquartered out of Houston, TX, is aleading national provider of network infrastructure solutions to the electric power, gas,telecommunications and cable television industries. Quanta recently posted total LTM sales of$1.7 billion with an EBITDA margin of 4.9%. Its net leverage ratio, as of June 30, 2005, was2.6x. 13
  • InfraSource Services (IFS). InfraSource Services, located in Media, PA, provides transmissionand distribution services to electric and gas utilities throughout the U.S. In 2003, the companywas sold off by its parent, Exelon (a subsidiary of the utility PECO), to GFI Energy Ventures andOaktree Capital Management, and it was subsequently taken public in 2004. LTM sales for theperiod ending June 30, 2005 were $775 million, with an EBITDA margin of 7.0%. Thecompany’s net leverage ratio was 1.8x.Other large, private competitors include Rosendin Electric, Fisk Corp., Xcelecom Inc., Morrow-Meadows Corp., Red Simpson Inc., ANECO Electrical Construction and Miller Electric.The following paragraph recounts the cautionary tale of Encompass Services, a now defunct roll-up, which not too long ago, was the largest electrical contracting business in the United States.Encompass Services. Encompass Services began with Figure 12the formation of Group Maintenance America Corp. Encompass Services(GroupMAC). Established to consolidate the electrical Financial Comparison (In Millions of Dollars)contracting industry, GroupMAC went public in 1997.Following a number of add-on acquisitions, GroupMAC Encompass IES 3Q02 3Q05merged with Building One to create the country’s largest Revenues 838.6 284.0facilities services conglomerate. Crushed by its heavy Adjusted EBITDA 15.7 3.4 Adjusted EBITDA Margin 1.9% 1.2%debt load and the economic recession of the early 2000’s, Interest Expense, net 19.6 7.6Encompass filed for bankruptcy protection in 2002. The Net Debt 1,088.6 192.5 LTM Net Interest Coverage 1.1x 0.36xfirm’s decline is recounted well in its Disclosure Net Leverage Ratio 12.7x 21.7xStatement dated April 11, 2003: following a disappointing Backlog 1,300.0 383.0 Months Backlog 4.7 5.8second quarter of 2002, “Encompass’s customers Liquidity 76.8 44.1increasingly began to demand bid and performance Source: Company reports and MTR estimates.bonds for new and existing construction contracts. In early October, Encompass beganexperiencing increased difficulty securing new construction contracts and bid andperformance bonds for its commercial activity. In addition, Encompasss sureties begannotifying Encompass of new and increased collateral requirements, based upon their concernfor Encompasss creditworthiness, demanding that Encompass and its Subsidiaries post letters ofcredit in order to obtain the necessary bonding, which further exacerbated Encompasssliquidity problems…In light of Encompasss announced financial difficulties, customers forexisting projects increasingly requested bonds, or requested increased coverage amounts ofbonds, on continuing projects, and threatened to terminate Encompass from such projects ifsuch requests were not satisfied. Bonding requirements for new projects significantly increasedin frequency, and Encompass was entirely excluded from bidding on a number of projects.Encompasss sureties imposed increasingly stringent requirements to the issuance of bonds,including requiring full cash collateral for the face amount of new bonds issued.” Subsequently,in October 2002, Encompass submitted a prepackaged plan of reorganization, which was laterrejected. Ultimately, the company’s business units were sold.One of the more notable sales was Encompass’s Residential Services Group (“RSG”). Withannual revenues of approximately $300 million, RSG provided HVAC, plumbing and othercontracting services in residential and small commercial buildings. Acquired by WellspringCapital Management, RSG was purchased for approximately $50 million, or 2.25x estimatedEBITDA. Wellspring Capital sold RSG fifteen months later to Direct Energy for $150 million,or 6.25x EBITDA. 14
  • RECENT FINANCIAL RESULTSCommercial and Industrial Segment Figure 13Commercial and industrial revenues Commercial and Industrial Segmentdecreased 13.6% to $197.7 million in Cost Structurethe third quarter of fiscal 2005 ending 105.0% Percentage of RevenuesJune 30, 2005, down from $228.9 100.0%million in the prior year’s quarter. The 95.0%decrease is a result of decreased awards 90.0%of bonded projects, the closure of plant 85.0%and utility work at one subsidiary, and 80.0% Q4 03 Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05more selective bidding. Adjusted grossmargins for the third quarter of 2005 Adjusted Cost of Services as % Revenue Adjusted SG&A as % Revenueremained relatively flat at 9.9% on a Source: Company and MTR estimates.year-over-year basis, improving from 8.3% in the prior quarter; unadjusted gross margindeclined due to decreased awards of bonded projects and reduced job profitability at certainsubsidiaries. SG&A expense in the third quarter of 2005 continued to rise despite business unitdivestitures, increasing to $19.1 million, or 9.6% of segment revenue. As a result, adjustedEBITDA margin for the commercial and industrial segment decreased to 1.1% for the thirdquarter of 2005 from 3.1% in the prior year’s quarter (see Figure 16).Residential Segment Figure 14Residential revenues increased4.8% in the third quarter of Residential Segment Cost Structure2005 to $86.3 million from 100.0%$82.3 million in the prior year’s Percentage of Revenues 95.0%quarter due primarily to the 90.0%increased demand for new 85.0%single-family and multi-family 80.0%housing. Gross margins 75.0%increased to 22.1% in the 70.0%quarter versus 21.4% and Q4 03 Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 0517.5% for the second quarter of Adjusted Cost of Services as % Revenue Adjusted SG&A as % Revenue2005 and the third quarter of2004, respectively. SG&A Source: Company and MTR estimatesexpense in the third quarter of 2005 rose 11.8% year-over-year to $9.8 million, or 11.3% as apercentage of revenues, versus 10.6% in the prior year’s quarter. Adjusted EBITDA marginincreased to 11.1% in the third quarter of 2005, as compared with 9.1% in the second quarter of2005 and 7.2% in the third quarter of 2004. Excluding corporate overhead, IES’s residentialsegment accounted for 81.4% of total operating segment adjusted EBITDA whilecomprising just 30.4% of total revenues.CorporateAdjusted SG&A increased 57% in the third quarter of 2005 to $8.8 million, or 3.1% of totalrevenue, from $5.6 million in the prior quarter. The increase was due to costs associated with anincentive program, consulting fees associated with Sarbanes-Oxley compliance, and increasedaudit fees. Total adjusted EBITDA was basically flat, sequentially, in the third quarter of 2005at $3.4 million, but down 53% from $7.2 million in the third quarter of 2004. 15
  • Backlog Figure 15Backlog for the third quarter of 2005 Backlogdecreased 32% to $383 million from $566 (In Millions of Dollars)million in the prior year’s quarter, 3Q05 2Q05 ** Q/Q 3Q04 Y/Yrepresenting 5.8 months of backlog versus Backlog 383 435 -12% 566 -32% Months Backlog * 5.8 6.0 -0.2 7.4 -1.67.4 months in the prior year (calculated on Backlog as % Ann. C&I Rev.* 48.4% 50.3% -190bps 61.8% -1,340bps Source: Company Reportsannualized quarterly commercial and * Figures calculated using annualized quarterly C&I revenue. ** Revenue figures for 2Q05 used in calculations have not been adjusted for subsequent divestitures.industrial segment revenues).Cash FlowCash flow from operations before working capital in Q3 2005 was $0.3 million, as comparedwith -$5.9 million in the prior quarter, due to semiannual cash interest payments. Since the thirdquarter of 2004, average quarterly trailing twelve-month cash flow from operations has averaged-$1.6 million. Over the past three quarters, asset sales have supplemented cash from operationswith $36.2 million of cash flow, some of which was used to reduce debt levels (see Figure 16). 16
  • Figure 16 INTEGRATED ELECTRICAL SERVICES, INC. Adjusted Historical Quarterly Segment Operating Statement * (In Millions of Dollars) COMMERCIAL AND INDUSTRIAL SEGMENT Q4 Q1 Q2 Q3 Q4 ** Q1 Q2 Q3 9/30/03 12/31/03 3/31/04 6/30/04 9/30/04 12/31/04 3/31/05 6/30/05Revenue Before Divestitures, estimated $ 309.6 $ 289.0 $ 266.8 $ 284.7 $ 275.4 $ 253.9 $ 240.6 $ 218.2Revenue from Recently Divested Units - 49.2 49.7 55.8 - 38.0 24.5 20.5Revenues 309.6 239.7 217.1 228.9 275.4 215.9 216.1 197.7Cost of Services 271.0 209.9 196.0 206.0 253.6 196.1 198.2 178.0 Gross Margin percentage 12.5% 12.4% 9.7% 10.0% 7.9% 9.2% 8.3% 9.9%SG&A Expense 25.8 18.5 17.7 17.9 24.4 19.5 18.4 19.1 % of Revenues 8.3% 7.7% 8.1% 7.8% 8.9% 9.0% 8.5% 9.6%Income from Operations 12.8 11.3 3.4 5.1 (2.6) 0.3 (0.4) 0.5Depreciation and Amortization 2.9 2.1 2.1 2.0 2.4 2.0 2.3 1.6Adjusted EBITDA $ 15.6 $ 13.4 $ 5.5 $ 7.1 $ (0.2) $ 2.3 $ 1.9 $ 2.2 Adjusted EBITDA Margin 5.0% 5.6% 2.5% 3.1% -0.1% 1.1% 0.9% 1.1% RESIDENTIAL SEGMENT Q4 03 Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05Revenues $ 71.1 $ 71.2 $ 73.2 $ 82.3 $ 81.5 $ 69.7 $ 71.4 $ 86.3Cost of Services 57.1 56.2 58.4 67.9 66.2 55.8 56.1 67.2 Gross Margin percentage 19.7% 21.1% 20.2% 17.5% 18.8% 19.8% 21.4% 22.1%SG&A Expense 8.2 8.3 8.5 8.8 8.3 8.5 9.0 9.8 % of Revenues 11.5% 11.7% 11.6% 10.6% 10.2% 12.2% 12.6% 11.3%Income from Operations 5.9 6.7 6.3 5.6 7.0 5.3 6.3 9.3Depreciation and Amortization 0.2 0.3 0.3 0.3 0.3 0.2 0.2 0.3Adjusted EBITDA $ 6.1 $ 7.0 $ 6.7 $ 5.9 $ 7.3 $ 5.5 $ 6.5 $ 9.5 Adjusted EBITDA Margin 8.5% 9.8% 9.1% 7.2% 9.0% 7.9% 9.1% 11.1% CONSOLIDATED Q4 03 Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05SG&A Expense, corporate 5.4 5.2 5.2 6.4 8.3 5.9 5.6 8.8 % of Total Revenues 1.4% 1.7% 1.8% 2.1% 2.3% 2.1% 1.9% 3.1%Total Income from Operations 13.2 12.8 4.5 4.3 (3.8) (0.3) 0.3 1.0Total Depreciation and Amortization 5.4 2.9 2.9 2.9 3.3 2.7 3.3 2.4Total Adjusted EBITDA $ 18.6 $ 15.7 $ 7.5 $ 7.2 $ (0.5) $ 2.4 $ 3.5 $ 3.4 Adjusted EBITDA Margin 4.9% 5.0% 2.6% 2.3% -0.1% 0.9% 1.2% 1.2%Source: Company and MTR estimates.* Quarterly figures exclude non-recurring items.* Quarterly figures are not necessarily comparable due to divestitures and financial restatements.** Q4 2004 figures do not incorporate adjustments for divestitures. 17
  • Figure 17 INTEGRATED ELECTRICAL SERVICES, INC. Historical Quarterly Cash Flow Summary * (In Millions of Dollars) Q4 Q1 Q2 Q3 Q4 ** Q1 Q2 Q3 SOURCES 9/30/03 12/31/03 3/31/04 6/30/04 9/30/04 12/31/04 3/31/05 6/30/05 Adjusted EBITDA $ 18.6 $ 15.7 $ 7.5 $ 7.2 $ (0.5) $ 2.4 $ 3.5 $ 3.4 Non-Cash Comp. Expense - 0.1 0.2 0.2 0.2 0.2 0.4 0.4 Total Sources 18.6 15.8 7.7 7.4 (0.3) 2.6 4.0 3.8 USES Cash Interest Expense (11.7) (0.2) (13.3) (0.7) (9.2) (1.1) (8.7) (1.4) Cash Income Taxes - (0.4) (0.3) (0.3) 0.1 (0.3) (0.4) (0.1) Capital Expenditures (1.4) (1.6) (1.3) (1.4) (2.3) (1.2) (1.0) (1.3) Working Capital Changes (16.8) 0.4 (1.5) (0.8) 3.9 (5.1) 9.0 4.1 Change in Noncurrents (2.9) 0.3 2.9 (1.3) (1.1) (0.4) 0.2 (0.6) Total Uses (32.9) (1.4) (13.4) (4.6) (8.6) (8.1) (0.9) 0.6 Adjusted Free Cash Flow $ (14.3) $ 14.3 $ (5.7) $ 2.8 $ (8.9) $ (5.4) $ 3.1 $ 4.4 Asset Sales - - - - - 11.7 12.4 12.1 Net Changes in Debt (0.1) (0.1) (25.1) (7.1) 15.0 10.3 (15.9) (2.4) Net Change in Cash $ (14.3) $ 14.2 $ (30.8) $ (4.3) $ 6.1 $ 16.6 $ (0.5) $ 14.1 Cash Balance 40.2 44.2 19.0 13.3 22.2 31.7 32.4 31.5 Revolver Availability 97.6 95.0 91.3 99.2 41.3 38.7 33.4 12.6 Total 137.8 139.2 110.3 112.5 63.5 70.4 65.8 44.1 Source: Company and MTR estimates * Quarterly figures exclude non-recurring items. * Quarterly figures are not necessarily comparable due to divestitures and financial restatements. ** Q4 2004 figures do not incorporate adjustments for divestitures.OUTLOOKWe are not bullish on IES’s prospects, but we do not consider its future to be determined atthis time. The loss of quality people at many of the Company’s business units and thedependency of future growth on the state of the Company’s current financial health posesignificant challenges. Aside from unforeseen factors, it appears that management may havetime to affect a turnaround, given the Company’s limited capital requirements and its ability tosell units to generate liquidity.MarketsThe U.S. commercial construction market has experienced a significant decline since its peak in2000. Having been revised downward, forecasted commercial construction spending is projectedto grow 3% in 2005 by F.W. Dodge, which is a far cry from initial projections upwards of 10%.While this forecast is certainly better than a market contraction, marketplace demandmust accelerate to utilize unabsorbed capacity so that incremental utilization drives IEStop-line growth and improved project margins. Industry sources have commented that theoverall construction industry has improved over the past few months. 18
  • According to the National Association of Home Builders, the U.S residential constructionmarket, as measured by new housing starts, grew by 5.8% in 2004. As of August 10, 2005, theNAHB forecasts the market to peak in 2005 with 2.0 million starts (a record year), or 3.3%annual growth, declining to 1.9 million starts in 2006. These forecasts bode well for IES’sresidential operating segment, which should continue to show a strong top line andoperating margin.Financial ProjectionsOur projections reflect our concern with the difficulties facing IES management in turningaround its Commercial and Industrial operating segment. Specifically, we are concerned aboutIES’s declining backlog, high leverage, a difficult surety bonding environment, marketswhich have yet to rebound and the loss of quality people within the organization. Themodel’s drivers are intended to portray a degrading fundamental picture at the Company’sCommercial and Industrial segment, and a resulting decrease in liquidity.Commercial and Industrial. We project C&I segment revenue will decrease 2.5% sequentiallyfor the quarters ending September 30, 2005 and December 31, 2005, accelerating to 4.0%,thereafter, through the end of fiscal 2007. We have accelerated the decline in revenue to reflectanticipated backlog shrinkage; projected revenues are net of projected divestitures. Grossmargin for the segment is forecast at 9.5%, as compared with an adjusted gross margin of 9.9%in Q3 2005 and an LTM adjusted gross margin of 8.8%. Based on some of the positive feedbackwe have received from the marketplace concerning recent cost-cutting activity, we have assumedthat management successfully reduces annual SG&A by $500k each quarter, and thus haveprojected SG&A to improve $125k quarterly. From a historical perspective, it is surprising thatgiven the recent divestiture of business units that had high SG&A expense relative to theirrevenue base, segment SG&A as a percentage of segment revenues has only increased on a year-over-year basis in each of the last four quarters. Our resulting projected C&I adjusted EBITDAmargin declines sequentially, averaging -0.5% over the next four quarters, or -$850k.Figure 18 INTEGRATED ELECTRICAL SERVICES, INC. Commercial and Industrial Segment Projected Quarterly Operating Statement (In Millions of Dollars) 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07Revenues $ 186.4 $ 172.3 $ 162.3 $ 155.8 $ 149.5 $ 143.6 $ 137.8 $ 132.3 $ 127.0Cost of Services 168.7 155.9 146.8 141.0 135.3 129.9 124.7 119.7 114.9SG&A Expense 18.9 18.8 18.6 18.5 18.4 18.3 18.1 18.0 17.9Depreciation and Amortization (1.9) (1.8) (1.7) (1.7) (1.6) (1.6) (1.5) (1.5) (1.4)Adjusted EBITDA 0.7 (0.6) (1.5) (2.0) (2.6) (3.1) (3.5) (4.0) (4.4)Revenues, Q/Q % Change * -5.7% -7.6% -5.8% -4.0% -4.0% -4.0% -4.0% -4.0% -4.0%As a % Revenues:Cost of Services 90.5% 90.5% 90.5% 90.5% 90.5% 90.5% 90.5% 90.5% 90.5%SG&A Expense 10.1% 10.9% 11.5% 11.9% 12.3% 12.7% 13.2% 13.6% 14.1%Depreciation and Amortization -1.0% -1.0% -1.1% -1.1% -1.1% -1.1% -1.1% -1.1% -1.1%Adjusted EBITDA 0.4% -0.3% -0.9% -1.3% -1.7% -2.1% -2.6% -3.0% -3.5%Source: MTR projections.* Percentage change in 4Q05, 1Q06 and 2Q06 reflects divestitures. 19
  • Residential. Residential segment revenue, on a year-over-year basis, is projected to increase4.5% in the fourth quarter of 2005, remain flat through fiscal 2006 and decline by 2.5% in fiscal2007, in-line with a slowing housing market. Gross margins are expected to remain strong,ranging between 21% and 22% through fiscal 2007. Segment SG&A is projected to be flat at$9.6 million, given our limited visibility. Resulting projected Residential adjusted EBITDAmargin varies between 7.2% and 11.5% through fiscal 2007, primarily due to seasonality.Figure 19 INTEGRATED ELECTRICAL SERVICES, INC. Residential Segment Projected Quarterly Operating Statement (In Millions of Dollars) 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07Revenues $ 85.2 $ 69.7 $ 71.4 $ 86.3 $ 85.2 $ 67.9 $ 69.6 $ 84.1 $ 83.1Cost of Services 66.0 55.0 56.4 67.3 66.4 53.7 55.0 65.6 64.8SG&A Expense 9.6 9.6 9.6 9.6 9.6 9.6 9.6 9.6 9.6Depreciation and Amortization (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2)Adjusted EBITDA 9.8 5.3 5.6 9.6 9.3 4.9 5.2 9.1 8.9Revenues, Y/Y % Change 4.5% 0.0% 0.0% 0.0% 0.0% -2.5% -2.5% -2.5% -2.5%As a % Revenues:Cost of Services 77.5% 79.0% 79.0% 78.0% 78.0% 79.0% 79.0% 78.0% 78.0%SG&A Expense 11.3% 13.8% 13.4% 11.1% 11.3% 14.1% 13.8% 11.4% 11.6%Depreciation and Amortization -0.3% -0.3% -0.3% -0.2% -0.2% -0.3% -0.3% -0.2% -0.2%Adjusted EBITDA 11.5% 7.5% 7.9% 11.1% 11.0% 7.2% 7.5% 10.8% 10.7%Source: MTR projections.Projected Cash Flow / LiquidityGiven our view of cash burn in the foreseeable future, sufficient medium-term liquidity isreliant upon successful asset sales. To-date, the Company has sold two business units in thefourth quarter of 2005, generating $10.7 million in cash proceeds and a $2.0 million three-yearpromissory note. Based upon information provided in the Company’s second quarter 10-Q, ourprojections assume that three additional units are sold in the first quarter of 2006, producing$21.1 million in proceeds (0.2x fiscal 2004 revenues) and one unit is sold in the second quarterof 2006, producing $7.0 million in proceeds. On the last Company conference call, managementhad guided that all asset sales should be completed in the current quarter.Assuming no working capital contributions/requirements or cash income taxes, IES isprojected to maintain liquidity through the third quarter of fiscal 2007; without successfulasset sales, management is projected to have through fiscal 2006 to affect a turnaround.We have assumed that the remaining revolver availability will be used to issue letters of credit tocollateralize additional surety bonding. 20
  • Figure 20 INTEGRATED ELECTRICAL SERVICES, INC. Projected Quarterly Cash Flow Summary (In Millions of Dollars) Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4SOURCES 9/30/05 12/31/05 3/31/06 6/30/06 9/30/06 12/31/06 3/31/07 6/30/07 9/30/07Adjusted EBITDA Commerical and Industrial $ 0.7 $ (0.6) $ (1.5) $ (2.0) $ (2.6) $ (3.1) $ (3.5) $ (4.0) $ (4.4) Residential 9.8 5.3 5.6 9.6 9.3 4.9 5.2 9.1 8.9 Corporate SG&A (7.3) (7.3) (7.3) (7.3) (7.3) (7.3) (7.3) (7.3) (7.3) Corporate Depreciation 0.5 0.5 0.5 0.5 0.5 0.4 0.4 0.4 0.4Total Adjusted EBITDA 3.8 (2.1) (2.6) 0.8 (0.0) (5.0) (5.2) (1.7) (2.4)Non-Cash Comp. Expense 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4Total Sources 4.1 (1.7) (2.3) 1.1 0.3 (4.7) (4.8) (1.4) (2.0)USESCash Interest Expense (2.4) (8.8) (2.8) (9.3) (2.9) (9.3) (2.9) (9.3) (2.9)Cash Income Taxes - - - - - - - - -Capital Expenditures (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3)Working Capital Changes - - - - - - - - -Change in Noncurrents - - - - - - - - -Total Uses (3.7) (10.1) (4.0) (10.6) (4.2) (10.6) (4.2) (10.6) (4.2)Adjusted Free Cash Flow $ 0.5 $ (11.8) $ (6.3) $ (9.4) $ (3.9) $ (15.2) $ (9.0) $ (11.9) $ (6.2)Asset Sales, Completed 10.7 - - - 0.7 - - - 0.7Asset Sales, Projected - 21.1 7.0 - - - - - -Net Changes in Debt - - - - - - - - -Net Change in Cash $ 11.1 $ 9.3 $ 0.7 $ (9.4) $ (3.2) $ (15.2) $ (9.0) $ (11.9) $ (5.6)Beginning Cash Balance 31.5 42.6 52.0 52.7 43.3 40.0 24.8 15.8 3.9Ending Cash Balance 42.6 52.0 52.7 43.3 40.0 24.8 15.8 3.9 (1.7)Without Additional Asset SalesBeginning Cash Balance 31.5 42.6 30.8 24.5 15.1 11.9 (3.4) (12.3) (24.3)Ending Cash Balance 42.6 30.8 24.5 15.1 11.9 (3.4) (12.3) (24.3) (29.9)Source: MTR projections.RATING AGENCIESOn May 17, 2005, Moody’s downgraded IES’s Senior Implied rating to B3 from B2 and itssenior unsecured issuer rating to Caa2 from Caa1, changing its rating outlook to negative fromstable. The downgrade reflects the Company’s current negative cash flow generation, the lower-than-expected reduction in debt balances via asset sales, its weak liquidity, and the difficulty theCompany is expected to encounter as it attempts to grow its core operations.Standard and Poor’s, on May 19, 2005, announced that it placed IES’s corporate credit andsubordinated debt rating on CreditWatch with negative implications. S&P stated that theCreditWatch placement reflects the Company’s weakened liquidity position following a creditfacility covenant violation. 21
  • VALUATION Figure 21Valuation multiples in thespecialty contracting industry Historical Construction Industry EV/EBITDA Multipleare cyclical, paralleling those ofthe industries serviced, and they 9.5xare presently at record high 8.5xlevels. As can be clearly seen 7.5xin Figure 21, between 6.5xDecember 1997 and December 5.5x2002, the Enterprise Value to 4.5xLTM EBITDA multiple for 7 8 9 0 1 2 98 99 00 01 02 -9 -9 -9 -0 -0 -0 n- n- n- n- n- ec ec ec ec ec eccompanies in the construction Ju Ju Ju Ju Ju D D D D D Dindustry varied greatly, ranging EV / EBITDA Multiplefrom 4.6x in June 2000 to 9.2x Source: Houlihan Lokey Howard & December 2001, averaging6.6x. Among IES’s public Figure 22comparables delineated inFigure 11 above, EBITDA IES Historical EBITDA Multiple vs. EBITDA Marginmultiples currently range from 16.0x 14.0%6.1x to 19.5x; excluding 14.0x 12.0% EBITDA Multiple EBITDA Margin 12.0xoutliers, a tighter valuation 10.0x 10.0% 8.0%band is reflected with a range 8.0x 6.0%of 10.0x to 13.0x. While we 6.0x 4.0x 4.0%assume that these valuation 2.0% 2.0xlevels reflect the market’s view 0.0x 0.0%of forward earnings, they are 1999 2000 2001 2002 2003 2004difficult to reconcile. EBITDA Multiple EBITDA MarginHighlighting the difference Source: Company Reports and MTR analysis. * Valuation calculated at two weeks following SEC filing date.Figure 23 IES Valuation between current and historical levels, Figure 22 charts IES’s (In Millions of Dollars) historical EBITDA multiple against its EBITDA margin. Aside Residential Segment Current Historical from the fact that they are trending in opposite directions, IES’sLTM Revenue $ 308.9 $ 308.9LTM EBITDA 28.9 28.9 EBITDA multiple has averaged 5.7x (excluding the high andSG&A, corporate allocation 8.7 8.7 low of the range). In valuing IES within today’s marketAdjusted LTM EBITDA 20.2 20.2EBITDA Multiple 10.0x 7.0x context, we have parsed the Company into its two reportingValuation $ 202.0 $ 141.4 segments and have assumed that the Commercial and Industrial C&I Segment segment units are sold. As shown in Figure 23, current marketLTM Revenue, estimated 837.7 837.7 multiples, when applied to the Residential segment, result in anRevenue MultipleValuation, Sold-off 0.175x 0.175x $ 146.6 $ 146.6 IES value of $349 million. Industry sources believe that an EBITDA multiple ranging between 6.0x and 8.0x is moreTotal ValueSource: MTR analysis. $ 348.6 $ 288.0 consistent with historical metrics. Applying a valuation multiple of 7.0x to IES’s Residential segment, we arrive at anenterprise value of $288 million. A $288 million enterprise value, net of IES’s current net debtload, implies an equity value of $95 million, or $2.61 per share. 22
  • RECOVERY ANALYSISDistributable ValueThe value that would be distributed in a workout scenario among IES’s creditors will come fromthree sources: 1) interest in the reorganized entity, which we have assumed is IES’s Residentialsegment, 2) proceeds from the sale of the C&I business units, and 3) the cash build that occurswhile in bankruptcy.In determining the value of the Residential segment in a reorganization, we based our valuationon a normalized EBITDA figure, as opposed to the figure reflected in the Company’s currentrun-rate. Current revenue and EBITDA are at record levels, the direct result of an overheatedhousing market. Implicit in our assumption is that a value determined in bankruptcy will reflecta more sustainable level. Our calculation of enterprise value for the Residential segmentuses a normalized revenue figure of $280 million, an EBITDA margin of 8.9% and anEBITDA multiple of 4.0x. This compares with current LTM revenue of $313 million, anEBITDA margin of 10.5% and a current average specialty contractor EBITDA multiple of 11.8x(see Figure 11). Using the bankruptcy sale of Encompass’s RSG as a point of reference (2.25xestimated EBITDA), we applied an EV/EBITDA multiple of 4.0x to reflect the uncertaintyassociated with reorganizing the Residential segment. The two quoted EBITDA margins are notcomparable because our estimate includes an allocation for corporate SG&A, which the latterdoes not. The resulting enterprise value for the Residential segment is $99.6 million (seeFigure 25).The calculation for the amount of proceeds from the sale of the commercial business units isbased upon recent IES divestiture values (see Figure 4). We have assumed that the revenueline has further declined to $600 million (current adjusted LTM revenues are estimated at$838 million) and that unit sales are not as productive in bankruptcy, applying a 0.125xmultiple to revenues. Sale proceeds for the commercial business units are projected to be$75.0 million. This recovery value is intended to reflect the difficulty associated with sellinga negative EBITDA construction business that is heavily reliant on its workforce.Lastly, we project a slight cash build of $2.2 million. This is a result of the payables rebuildbeing offset by an annual cash burn of $23.8 million in bankruptcy. Thus, total distributablevalue sums to $176.8 million. Figure 24 Projected Surety Claims in BankruptcyTreatment of Surety Bonding (In Millions of Dollars)In the event of default on a bonded project by a contractor, Outstanding Surety Bondingthe surety provider is required to either arrange for the C&I Segment Revenue $ 600.0 Margins Backlog in Months 4.0completion of the contract or make payment to the project Backlog 200.0 Backlog, cost-to-complete 181.0 90.5%owner in the amount of the bond. Having exercised its right Percentage of Backlog Bonded 50.0%of subrogation, the surety becomes entitled to all Surety Bonding, cost-to-complete $ 90.5receivables associated with the project, even to the possible Surety Provider Claimdetriment of a receivables-secured credit facility provider. Percentage of Projects in Default 25.0%The performing surety is not only required to complete the Surety Loss on Defaulted Projects:project as specified in the bonded contract, but also to cure Revenues 25.0 Cost of Services, initial 22.6 90.5%all defaults and bear all expenses associated with Cost Overruns 11.3 50.0%completing the project. In addition, the surety is often Loss (8.9)required to satisfy liquidated damages associated with Surety Provider Claim $ (8.9)completion delays. Source: MTR analysis. 23
  • In our analysis, we have assumed that 25% of IES’s commercial projects fall into default,resulting in liquidated damages and the like estimated at 50% of project costs (see Figure 24).This produces an $8.9 million loss for the surety, which is claimed in bankruptcy on a securedbasis via the letter of credit collateral.The Other unsecured claim line item of $10.0 million addresses possible damages claims filed bythe owners of non-bonded projects.Figure 25 Recovery Analysis (In Millions of Dollars)DISTRIBUTABLE VALUE SUMMARY Enterprise Value of Residential Segment MarginEnterprise Value of Residential segment $ 99.6 Normalized Revenue $ 280.0 100.0%Sale Proceeds of Commercial Units 75.0 Cost of Services 218.4 78.0%Cash Build / (DIP Financing) 2.2 SG&A, segment 30.8 11.0%Total Distributable Value $ 176.8 SG&A, allocated corporate 8.7 3.1% Operating Income 22.1 7.9%VALUE ALLOCATION Depreciation and Amortization 2.8 1.0%Senior Credit Facility $ -Letters of Credit, Surety claim 8.9 Normalized EBITDA 24.9 8.9%Value to Unsecureds 167.8 EBITDA Multiple 4.0x Enterprise Value - Residential Segment $ 99.6Trade Payables 10.5 Sale Proceeds of Commercial Units6.5% Senior Convert. Notes plus Accrued 50.8 Degraded Revenue Base $ 600.09.375% Senior Sub. Notes plus Accrued 176.9 Revenue Multiple 0.125xOther 10.0 Sale Proceeds $ 75.0Total Unsecured Claims 248.2 Cost of Services 546.0 91.0%Recovery to Unsecured Claims as % Face 67.6% Cash Build / (DIP Financing) Beginning Cash Balance $ 5.0Senior Convertible Notes Recovery Working Capital - Upfront 20.9Initial Value Allocation $ 34.4 Ongoing Cash Build / (Burn) (23.8)Value Allocation from Subordinated Notes 19.7 Subtotal 2.1Total Recovery 54.1 Interest Income / (DIP Interest Expense) 0.0 Total Cash Build / (Burn) $ 2.2FV Recovery to Sr. Conv. Notes as % Face 108.1% Annual Cash Build / (Burn) Near-Term EBITDA $ (8.0)Senior Subordinated Notes Recovery Post-Petition Interest -Net Value Allocation $ 99.9 Professional Fees (10.0) Capital Expenditures (5.8)FV Recovery to Sr. Sub. Notes as % Face 57.8% Working Capital - Annual Cash Build / (Burn) $ (23.8) Working Capital - Upfront Breakdown DaysOther Assumptions Beginning Payables $ 52.4 25Length of Bankruptcy (months) 12 Payables after Paydown (20 days) 10.5 5Secured Debt at Filing - Payables Rebuild 62.8 30 Change in Cash $ 20.9Source: MTR analysis.Value AllocationNet of secured claims of $8.9 million, distributable value of $167.8 million is available for theunsecured claims, which are comprised of payables, the Senior Convertible Notes plus accruedinterest, the Senior Subordinated Notes plus accrued interest and other unsecured claims. As awhole, the unsecured claimants recover 67.6% of claims in our base case scenario. Value is thentransferred from the Senior Subordinated Notes to the Senior Convertible Notes, until theConvertible Note holders recover par plus pre- and post-petition interest. 24
  • In our base case scenario, the Senior Convertible Notes recover 108.1% of face value, while theSenior Subordinated Notes recover 57.8% of face value.Sensitivity AnalysisThe following sensitivity analyses examine the future value recovery to the Convertible andSubordinated Notes under varying valuation assumptions. With regard to the Senior ConvertibleNotes, our sensitivity matrix clearly demonstrates the varying degree to which the notes maintaina strong recovery (see Figure 26). This is due to the amount of the issue outstanding relative tothat of the Subordinated Notes. Impairment to the Convertible Notes begins at an enterprisevalue of $68 million, a level which is easily supported by the Residential segment alone ($100million).Figure 26 Sensitivity Analysis FV Recovery of Senior Convertible Notes Residential Segment EBITDA Multiple 6.0x 5.5x 5.0x 4.5x 4.0x 3.5x 3.0x 2.5x 2.0x 0.250x 108% 108% 108% 108% 108% 108% 108% 108% 108% Commercial 0.200x 108% 108% 108% 108% 108% 108% 108% 108% 108% Segment 0.150x 108% 108% 108% 108% 108% 108% 108% 108% 108% Revenue 0.125x 108% 108% 108% 108% 108% 108% 108% 108% 108% Multiple 0.100x 108% 108% 108% 108% 108% 108% 108% 108% 108% 0.075x 108% 108% 108% 108% 108% 108% 108% 108% 108% 0.050x 108% 108% 108% 108% 108% 108% 108% 108% 108%Source: MTR analysis.The future value recovery to the Senior Subordinated Notes, on the other hand, is furtherimpaired with each decrement in valuation multiple (see Figure 27).Figure 27 Sensitivity Analysis FV Recovery of Senior Subordinated Notes Residential Segment EBITDA Multiple 6.0x 5.5x 5.0x 4.5x 4.0x 3.5x 3.0x 2.5x 2.0x 0.250x 102% 102% 102% 102% 98% 91% 84% 78% 71% Commercial 0.200x 102% 101% 95% 88% 82% 75% 68% 62% 55% Segment 0.150x 92% 86% 79% 72% 66% 59% 53% 46% 39% Revenue 0.125x 84% 78% 71% 64% 58% 51% 45% 38% 31% Multiple 0.100x 76% 70% 63% 56% 50% 43% 37% 30% 23% 0.075x 68% 62% 55% 48% 42% 35% 29% 22% 15% 0.050x 60% 54% 47% 41% 34% 27% 21% 14% 7%Source: MTR analysis.RECOMMENDATIONGiven the limited downside protection an investor is afforded in IES, our returns analysis isfocused on incorporating the probability associated with a bankruptcy filing. We have appliedthis probability to arrive at expected cash flows to note holders via coupon payments, recovery inbankruptcy and principal repayment at maturity. As shown in Figure 28, our base case scenarioincorporates an estimate of the likelihood of a bankruptcy filing at 60% at the time of the SeniorSubordinated Notes maturity. Our choice of this probability is only meant to convey our 25
  • sentiment and not intended to imply any Figure 28quantitative foundation. This Probability of Chapter 11 Filingprobability is an increasing function 0.7which accelerates in the second half of2007. 0.6 0.5Senior Convertible Notes 0.4Assuming a required yield of 9.0%, we 0.3value the fixed income piece of theConvertible Notes at 90 ¾ (see Figure 0.229). Using an option-adjusted spread of 0.1500bps, a stock price of $2.61, a stock 0 9/6/05 2/1/06 8/1/06 2/1/07 8/1/07 2/1/08 8/1/08 2/1/09volatility of 40% and a recovery inbankruptcy of 100, we calculate an Prob. of Filingequity option premium of 5 ¾ and Source: MTR estimate.thus, a Senior Convertible Note value of 96 ½. The equity option premium was calculatedusing Bloomberg’s bankruptcy model on its convertible bond valuation function.Figure 29 Sensitivity Analysis Internal Rate of Return - Senior Convertible Notes Purchase Price of Sr. Convertible Notes 100.00 95.00 90.00 85.00 80.00 75.00 70.00 65.00 Probability 0% 6.6% 7.4% 8.2% 9.1% 10.1% 11.2% 12.3% 13.6% of 20% 6.6% 7.5% 8.5% 9.5% 10.6% 11.9% 13.3% 14.8% Chapter 11 40% 6.6% 7.6% 8.8% 10.0% 11.4% 12.9% 14.6% 16.5% Filing 60% 6.6% 7.8% 9.2% 10.7% 12.4% 14.2% 16.3% 18.7% 80% 6.5% 8.1% 9.8% 11.7% 13.8% 16.1% 18.7% 21.7% 100% 6.5% 8.6% 10.8% 13.2% 15.9% 18.8% 22.0% 25.6%Source: MTR analysis.* Calculated using XIRR Excel function.Senior Subordinated NotesOur returns analysis on the Senior Subordinated Notes, currently priced at 81.50, produces aninternal rate of return of 5.6% in our base case scenario (see Figure 30). Given our perceivedrisk associated with IES and the Senior Subordinated Notes subordination provision, we wouldtarget a return of 15%, or a purchase price of 64 ½. We have not incorporated a scenarioanalysis for the X Clause stated in the indenture due to our view that it will likely not alter thedistribution of value between the Senior Convertible Notes and the Senior Subordinated Notes. 26
  • Figure 30 Sensitivity Analysis Internal Rate of Return - Senior Subordinated Notes Purchase Price of Sr. Subordinated Notes 85.00 80.00 75.00 70.00 65.00 60.00 55.00 50.00 Probability 0% 15.8% 18.2% 20.8% 23.7% 26.9% 30.6% 34.6% 39.3% of 20% 12.3% 14.6% 17.2% 20.1% 23.3% 26.9% 30.9% 35.5% Chapter 11 40% 8.4% 10.7% 13.3% 16.1% 19.3% 22.8% 26.8% 31.3% Filing 60% 4.0% 6.3% 8.8% 11.6% 14.7% 18.2% 22.1% 26.6% 80% -1.1% 1.2% 3.7% 6.4% 9.4% 12.9% 16.8% 21.2% 100% -7.2% -4.9% -2.5% 0.2% 3.2% 6.5% 10.4% 14.8%Source: MTR analysis.* Calculated using XIRR Excel function.RISKSRisks to our sell recommendation are rooted in the successful execution of a turnaround plan.IES has certainly been adept at executing the sale of business units albeit to the units’ formerowner, and generating liquidity. The distinct nature of its operational structure, while likely acentral part of IES’s core problem, is clearly a benefit to an asset sale program. IES does nothave large capital requirements and could operate for some time given no impending debtmaturities. Additionally, while Mr. Snyder is known as an astute dealmaker and entrepreneur, hemay also prove to be a strong crisis manager. While not necessarily a practical solution, onecould envision a scenario in which Mr. Snyder decides to redefine IES as strictly a residentialelectrical contractor and proceeds to sell all of its commercial subsidiaries to reduce debt,emerging as a much smaller, healthy company. Management has in no way alluded to suchmeasures and we believe that this would be counterintuitive for the man whose vision was thegenesis for IES.Looking beyond management, we do not foresee exogenous factors playing a meaningful role inthe Company’s turnaround. Ultimately, our opinion is based on a generally bearish view of thedifficulties facing IES at this point, and our belief that its current downhill momentum will bechallenging, at best, to curtail. 27
  • Figure 31 INTEGRATED ELECTRICAL SERVICES, INC. Historical Quarterly Balance Sheet * (In Millions of Dollars) Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 9/30/03 12/31/03 3/31/04 6/30/04 9/30/04 12/31/04 3/31/05 6/30/05Cash $ 40.2 $ 44.2 $ 19.0 $ 13.3 $ 22.2 $ 31.7 $ 32.4 $ 31.5Restricted Cash - - - - - - - 10.0Accounts Receivable, Trade 245.6 278.3 248.5 242.4 201.4 209.2 195.4 192.4Accounts Receivable, Retainage ** 68.8 NA NA 71.2 61.7 65.4 55.6 56.4Costs and Est. Earnings in Excess of Billings 47.0 44.0 39.1 50.9 31.8 37.1 35.0 25.7Inventories 20.5 17.4 19.9 26.3 19.6 18.1 19.5 24.3Prepaid Expenses and Other Current Assets 14.4 14.5 8.1 27.8 12.9 21.6 22.1 22.0Assets Held for Sale Assoc. with Disc. Ops. - 69.5 97.8 - 90.3 29.1 28.4 13.0Other Current Assets 0.1 - 18.1 0.0 - 0.0 - -Total Current Assets 436.6 467.7 450.4 432.1 439.9 412.3 388.3 375.4PP&E, net 52.7 48.3 44.5 46.9 41.1 41.1 37.4 35.1Goodwill, net 197.9 169.1 167.0 197.9 82.9 90.3 87.2 82.3Other Non-Current Assets 27.3 25.7 31.2 32.2 17.1 19.4 19.6 16.2TOTAL ASSETS $ 714.5 $ 710.9 $ 693.1 $ 709.0 $ 580.9 $ 563.2 $ 532.5 $ 509.0Current Maturities of Long-Term Debt 0.3 0.2 7.3 35.1 43.0 26.4 2.4 0.0Accounts Payable and Accrued Expenses 138.1 115.7 109.6 139.8 132.7 119.0 129.8 127.0Billings in Excess of Costs and Est. Earnings 42.4 39.9 33.4 42.1 31.3 43.2 36.0 35.0Liabilities Related to Assets Held for Sale - 13.5 18.2 - 24.1 11.9 7.0 4.7Other Current Liabilities - - 0.6 - - - - -Total Current Liabilities 180.8 169.3 169.1 217.0 231.0 200.5 175.3 166.8Long-Term Debt, net of current maturities 0.2 0.2 43.0 8.0 15.0 6.0 0.1 0.0Senior Convertible Notes, net - - - - - 38.7 50.7 50.7Senior Subordinated Notes, net 247.9 247.9 173.2 173.2 173.2 173.2 173.2 173.2Other Non-Current Liabilities 20.6 22.6 32.4 34.1 18.5 18.8 19.3 17.9Stockholders Equity 264.9 270.8 275.4 276.7 143.2 126.0 113.9 100.3TOTAL LIABS. AND STOCKHOLDERS EQUITY $ 714.5 $ 710.9 $ 693.1 $ 709.0 $ 580.9 $ 563.2 $ 532.5 $ 509.0* Some figures have been restated. Figures as of 9/30/04 12/31/04 3/31/05 6/30/04 6/30/05 12/31/04 3/31/05 6/30/05** Figures not available for Accounts Receivable, Retainge are included in Accounts Receivable, Trade. 28
  • Miller Tabak Roberts Fixed Income/Convertible Important DisclosuresGeneral DisclosureMiller Tabak Roberts Securities, LLC observes the fixed-income securities research rules of the NASD, SEC, Ontario Securities Commission, and Investment Dealers Association ofCanada.The firm does no investment banking or investment management business with any person; however, the firm may from time to time act as broker or dealer on the account ofcompanies covered in its research reports. Neither the firm nor the author of this report is aware of any factors or relationships with respect to any personnel of the firm or its affiliateswhich would reasonably be expected to indicate a potential conflict of interest, including, without limitation to matters of compensation, ownership and service as an officer, director oradviser, except as set forth in detail below. Miller Tabak Roberts Securities, LLC research reports and other research materials are made available to institutional customers of ouraffiliated firm Miller Tabak Roberts Securities (UK) LLP only upon such a customers request. Miller Tabak Roberts Securities, LLCs research activities are regulated by the UnitedStates Securities and Exchange Commission and National Association of Securities Delears and do not necessarily comply with all research rules of the United Kingdom FinancialServices Authority.SRO DisclosuresCompensation DisclosureThe firm and its affiliates have not received compensation from the subject of this report, or persons known by this firm to be affiliates of the subject, in the prior twelve months for theperformance of services. Neither the authoring analyst, nor any supervisory or executive person with the ability to influence the content of this report, nor any member or principalofficer of the firm, nor any of their respective households or immediate families, has received compensation from the subject of this report in the prior twelve months.Ownership DisclosureNeither the author of this report, nor any member of the authors household or immediate family, has any financial interest in any of the securities of the subject(s) of this report.Neither the firm nor its affiliates beneficially owns in excess of 1% of any class of the common equity securities of the subject(s) of this report.Officer/Director DisclosureNeither the author of this report nor any member of the authors household or immediate family, has served or serves as an officer, director or advisory board member of thesubject(s) of this report.Valuation MethodsPlease see page 22 of this report for an explanation of the methods of valuation utilized by the analyst.Risk FactorsPlease see page 27 of this report for an explanation of the risks utilized by the analyst.Dissemination of ResearchThe firm distributes research by electronic mail and U.S. mail, and at meetings with customers. Our research distribution lists include only employees and our customers, and aresegregated by market segment (convertible, high yield and distressed, and emerging market). From time to time we provide research to prospective customers and employees. Wedo not provide, or authorize the redistribution, of our research to the general public. We do not seek retail investors as customers.Market MakingAs of the date of this report, firm makes a market in some or all the fixed income and convertible securities (if any) of the subject(s) of this report. The firm reserves the right to stop,or start, making markets in any securities (including, without limitation, securities subject of this report), at any time, without notice.Suitability and ReliabilityAlthough the information contained herein has been obtained from sources Miller Tabak Roberts Securities, LLC believes to be reliable, its accuracy and completeness cannot beguaranteed. This report is for information purposes only and under no circumstances is it to be construed as an offer to sell, or a solicitation to buy, any security. Anyrecommendation contained in this report may not be appropriate for all investors. Additional information is available upon request.Research Ratings and DistributionBUY describes a security that we expect to provide a total return (price appreciation plus yield and any distributions) in excess of securities with a similar risk profile.HOLD describes a security that we expect to provide a total return (price appreciation plus yield and any distributions) comparable to securities with a similar risk profile.SELL describes a security that we expect to provide a total return (price appreciation plus yield and an distributions) below that of securities with a similar risk profile.NO RECOMMENDATION describes a security in which we believe there is insufficient information to support a specific opinion or we have expedited publication to address near-term customer needs for factual information. Absence of an opinion should not be inferred to mean a HOLD.Percentage of Securities Covered by the Firm Receiving this Recommendation since 1/1/04:(MTR undertakes no investment banking operations.)BUY 47.8%HOLD (6.3%)/No Recommendation (29.5%) 35.8%SELL 16.4%Other DisclosureVisitsThe author of this report has not visited material operations of the subject of this report.Analyst CertificationI, Ronald A. Rich, hereby certify that the views expressed in this report accurately reflect my personal views about thesubject company(ies) and its securities. I also certify that I have not been, am not, and will not be receiving director indirect compensation for expressing the specific recommendation(s) in this report.