GVA

Business Context and Reporting Period

Company: Granite Construction Inc.
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Three months ended March 31, 2007
Business Overview: One of the largest heavy civil contractors in the U.S., operating through two primary segments: the Branch Division (local markets, materials sales) and the Heavy Construction Division (HCD) (large infrastructure projects). The company also operates a real estate subsidiary, Granite Land Company. In February 2007, the company announced an organizational realignment into "Granite West" and "Granite East."

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Total revenue decreased 1.7% year-over-year. The Branch Division revenue increased 12.1% driven by higher public sector activity and material sales in California. Conversely, HCD revenue declined 17.8% due to lower backlog at the start of the year and the completion of large projects in the West and Northeast.
• Profitability: Gross profit increased 19.4% to $48.0 million, improving the gross margin to 9.9%. This was driven by the Branch Division's margin expansion (18.0%) and real estate sales. However, HCD reported a gross loss of $6.4 million (negative 3.2% margin) due to significant downward estimate changes on four projects totaling $15.5 million in reduced gross profit.
• Operating Expenses: General and administrative expenses rose 12.6% to $54.3 million, primarily due to increased personnel costs and higher reserves for doubtful accounts ($1.5 million increase).
• Cash Flow: Net cash provided by operating activities dropped significantly to $3.9 million from $40.0 million in the prior year, largely due to a decrease in net billings in excess of costs.
• Backlog: Total backlog increased to $2.50 billion (up 10.7% from Dec 2006), driven by a 20% increase in HCD backlog, including a $463.9 million Maryland highway project. Branch Division backlog declined 5.9% due to slowing residential development.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects the Branch Division to have an excellent year, particularly in the West, supported by healthy public funding. For HCD, management anticipates operating income could be breakeven in 2007 as underperforming projects are completed, with expectations of increasingly positive returns in 2008 and beyond.
• Unusual Items & Contingencies:
  • Project Estimate Changes: HCD recorded a net $15.5 million reduction in gross profit due to estimate changes on four projects. Additionally, a specific highway project in Oregon involving massive landslides is forecast at a loss of approximately $20.0 million; the company is negotiating a contract termination with the Oregon Department of Transportation.
  • Joint Venture Losses: Three joint venture projects are forecast at a loss. One partner is believed unable to contribute required capital, resulting in a $2.6 million expense for potentially uncollectible balances in Q1 2007.
  • Real Estate Sales: Granite Land Company contributed $4.9 million in revenue and $2.9 million in operating income from asset sales, which is not comparable to the prior year.
• Risks:
  • Legal Proceedings: The company is a defendant in ten active silica litigation lawsuits (believes liability is remote) and is under investigation regarding Disadvantaged Business Enterprise (DBE) compliance on the Hiawatha Light Rail project.
  • Market Risks: Exposure to energy price volatility (diesel, asphalt) and labor shortages. Increased competition for public sector work as private residential markets slow.
• Subsequent Event: In April 2007, the company acquired assets of the Superior Group of Companies for approximately $56.8 million, funded by a borrowing under its revolving credit line.

Investor Verification Checklist

• HCD Project Forecasts: Verify the status and potential cost implications of the four HCD projects with significant downward estimate changes and the Oregon highway project termination negotiations.
• Joint Venture Solvency: Assess the financial stability of minority partners in the three loss-forecast joint ventures and the adequacy of reserves for uncollectible partner balances.
• Legal Exposure: Monitor the outcome of the Hiawatha DBE investigation and the silica litigation, despite management's current assessment of remote liability.
• Backlog Quality: Review the composition of the $2.5 billion backlog, noting that approximately 18.4% of HCD backlog is related to projects forecast at a loss.
• Organizational Realignment: Track the progress of the "Granite West" and "Granite East" restructuring and its impact on future cost structures and segment reporting.