Business Context and Reporting Period
Sterling Construction Company, Inc. filed its Form 10-K for the fiscal year ended December 31, 2017. The company operates in heavy civil construction and residential concrete construction across several U.S. states, with infrastructure projects including highways, bridges, airports, ports, transit, water systems and drainage. The filing includes unaudited fourth-quarter information. The company subsequently became known as Sterling Infrastructure, Inc.
Operations were reported in two segments: heavy civil construction and residential construction. The residential segment was added through the April 3, 2017 acquisition of Tealstone Residential Concrete, Inc. and Tealstone Commercial, Inc.; 2017 results include approximately nine months of Tealstone operations.
Financial Highlights
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Revenue | $958.0 million | $690.1 million | Up 38.8% |
| Gross profit | $89.1 million | $42.1 million | Up 111.8% |
| Gross margin | 9.3% | 6.1% | Up 320 basis points |
| Operating income (loss) | $26.2 million | $(4.7) million | Returned to profitability |
| Operating margin | 2.7% | (0.7)% | Improved |
| Net income (loss) | $15.8 million | $(7.4) million | Returned to profitability |
| Net income attributable to common stockholders | $11.6 million | $(9.2) million | Returned to profitability |
| Diluted earnings per share | $0.43 | $(0.40) | Improved |
| Net cash provided by operating activities | $23.0 million | $43.9 million | Down $20.9 million |
Heavy civil construction generated $850.0 million of revenue and $11.3 million of operating income. Residential construction generated $108.0 million of revenue and $14.9 million of operating income. Tealstone contributed approximately $136.9 million of revenue and $16.5 million of operating income from the acquisition date through year-end.
Cash and cash equivalents increased to $84.0 million from $42.8 million. Working capital increased to $96.2 million from $29.3 million. Operating cash flow was reduced by a $23.8 million investment in contract capital, including higher receivables and joint venture balances.
Balance Sheet, Debt and Liquidity
- Total assets were $463.3 million, compared with $301.8 million at December 31, 2016.
- Total debt was $90.1 million, compared with $5.4 million at year-end 2016. Long-term debt, net of current maturities, was $86.2 million.
- The new Oaktree Facility provides an $85.0 million secured term loan maturing April 4, 2022. Interest is generally LIBOR plus 8.75%, payable monthly, and the facility is secured by substantially all company and subsidiary assets.
- The company had no revolving credit facility at year-end. Management stated that available cash, operating cash flow and expected resources were sufficient to fund the next twelve months of operations and bonding requirements, subject to operational performance and market conditions.
- The Oaktree Facility requires quarterly offers to prepay 75% of excess cash flow and restricts additional debt, liens, acquisitions, capital expenditures, investments and dividends.
- The company was in compliance with the Oaktree Facility covenants at December 31, 2017. Key requirements include secured debt to EBITDA limits, minimum cash collateral, minimum backlog gross margin, capital expenditure limits, bonding capacity of at least $1.0 billion and minimum Tealstone Residential Concrete EBITDA.
- Capital expenditures were $9.5 million in 2017; management expected 2018 capital expenditures to be similar, although project awards could increase that amount.
Material Changes Versus the Prior Comparable Period
- Revenue growth reflected approximately nine months of Tealstone operations, higher heavy civil activity, large joint venture projects and increased Rocky Mountain-region activity.
- Gross margin improved due to better bid discipline, project management, project execution, higher-margin work and improved fixed-cost absorption.
- General and administrative expense increased to $48.4 million from $36.8 million, primarily due to Tealstone, higher stock-based and incentive compensation, and higher recruiting and pre-bid costs. As a percentage of revenue, G&A declined to 5.0% from 5.3%.
- Interest expense increased to $9.8 million from $2.6 million because of the higher debt balance under the Oaktree Facility. The company also recorded a $0.8 million loss on extinguishment of debt.
- Heavy civil backlog declined to $744.4 million from $823.0 million, while unsigned low-bid awards increased to $250.0 million from $226.0 million. Combined backlog declined to approximately $995 million from $1.04 billion.
- Backlog gross margin increased to 8.4% from 8.2%. Management expected approximately 80% of year-end backlog to be recognized as 2018 revenue.
- The company paid $54.9 million of cash for the Tealstone acquisition, issued 1.9 million shares valued at $17.1 million and recorded promissory notes and deferred payments. It also issued warrants for up to 1.0 million shares at an initial exercise price of $10.25 per share.
Guidance, Outlook, Risks and Unusual Items
Management expected continued improvement in heavy civil markets, supported by federal transportation funding and infrastructure initiatives in Texas, Utah and California. Management also expected growth in the Dallas-Fort Worth residential construction market and planned to expand Tealstone into Houston and surrounding areas.
- Approximately 80% of heavy civil backlog was expected to convert to revenue in 2018. Backlog is subject to customer termination rights, execution risk, cost changes and potential changes in estimated quantities, claims and change orders.
- Heavy civil revenue is concentrated among government customers. The Utah Department of Transportation represented 14.7% of 2017 revenue and the Texas Department of Transportation represented 10.8%.
- Residential construction revenue was concentrated among D.R. Horton, Pulte Homes and HISTORYMAKER Homes, which collectively represented more than 61% of residential construction revenue.
- Fixed unit-price and lump-sum contracts expose the company to cost overruns from labor, fuel, materials, subcontractors, equipment, weather, site conditions, design issues and delays.
- Revenue and profit estimates for heavy civil contracts use percentage-of-completion accounting. Changes in estimates produced a $0.9 million net gain in operating income in 2017, compared with a $6.3 million net charge in 2016.
- At December 31, 2017, the company included $5.0 million of unapproved change orders and $5.0 million of claims in costs and estimated earnings in excess of billings. Negotiations remained ongoing, and recorded amounts could change.
- Construction joint ventures generally impose joint and several liability. Approximately $113 million of work remained on unconsolidated joint venture contracts, including a $55 million proportionate share attributable to Sterling.
- The company had $85.2 million of goodwill and $44.8 million of intangible assets at year-end. No goodwill or long-lived asset impairment was recorded in 2017.
- The Tax Cuts and Jobs Act reduced the value of deferred tax assets, but the reduction was offset by a reduction in the valuation allowance. The company maintained a full valuation allowance on net deferred tax assets and reported only $118,000 of income tax expense.
- The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting. The control assessment excluded Tealstone, which represented approximately 8% of total assets and 14% of consolidated revenue; Tealstone was expected to be included beginning in 2018.
Most Important Facts for Investors to Verify
- Whether the company can sustain the 2017 margin improvement and integrate Tealstone without weakening operating performance.
- Conversion and profitability of the $744.4 million heavy civil backlog and the $250.0 million of unsigned low-bid awards.
- Compliance with the Oaktree Facility’s tightening financial covenants, cash collateral requirements and mandatory excess-cash-flow prepayments.
- Interest-rate exposure from the LIBOR plus 8.75% floating-rate term loan and the company’s ability to refinance or repay the 2022 maturity.
- Collection and resolution of retainage, unapproved change orders and claims, including the $43.5 million of retainage outstanding at year-end.
- Customer concentration, particularly dependence on UDOT, TXDOT and major residential homebuilders.
- Potential liabilities from joint and several joint venture obligations, surety bonds, environmental matters, insurance claims and multi-employer pension plans.
- Whether operating cash flow remains sufficient given working-capital volatility, restricted cash, debt service and the absence of a revolving credit facility.