Sterling Construction Company, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2019. The filing identifies the registrant as Sterling Construction Company, Inc. (NASDAQ: STRL), a heavy civil infrastructure, infrastructure rehabilitation, and residential concrete construction company operating primarily in the western and southern United States. The financial statements are unaudited and prepared under U.S. GAAP.
Financial Results and Key Metrics
| ($ in thousands, except per-share data) | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Revenue | $291,699 | $291,266 | $779,734 | $782,492 |
| Gross profit | $29,216 | $31,279 | $74,215 | $82,159 |
| Gross margin | 10.0% | 10.7% | 9.5% | 10.5% |
| Operating income | $12,115 | $14,373 | $28,019 | $33,201 |
| Net income attributable to Sterling | $7,957 | $8,917 | $17,600 | $19,580 |
| Diluted EPS | $0.30 | $0.33 | $0.66 | $0.72 |
- Revenue: Essentially flat year over year in the third quarter and down 0.4% for the nine-month period.
- Profitability: Q3 gross profit declined $2.1 million and nine-month gross profit declined $8.0 million. Lower margins reflected heavy civil project mix, lower heavy civil volume, weather impacts, and lower margins during the Houston residential expansion.
- Expenses: General and administrative expense declined to $10.8 million in Q3 and $34.1 million year to date. Acquisition-related costs were $1.9 million in Q3 and $2.2 million year to date, primarily related to the Plateau acquisition.
- Segments: Q3 heavy civil revenue was $251.8 million, down 1.1%, with operating income of $8.7 million. Residential revenue was $39.9 million, up 8.8%, with operating income of $5.3 million. Nine-month residential revenue increased 1.1%, while heavy civil revenue declined 0.6%.
- Cash flow: Nine-month cash provided by operating activities was $8.5 million versus $26.2 million in 2018. Capital expenditures were $7.9 million, and net cash used in investing activities was $6.6 million.
- Liquidity: Cash and cash equivalents were $76.5 million at September 30, 2019, versus $94.1 million at December 31, 2018. Working capital was $119.1 million versus $123.4 million at year-end.
- Debt: Total debt was $79.9 million, including $67.1 million outstanding under the Oaktree Facility. Net long-term debt was $62.5 million after current maturities and deferred debt costs. The company was in compliance with Oaktree covenants at September 30, 2019.
- Leases: Adoption of ASC 842 resulted in $14.6 million of operating lease right-of-use assets and $14.7 million of operating lease liabilities at September 30, 2019.
Material Changes Versus Prior Comparable Period
- Revenue was broadly stable, but gross margin fell 70 basis points in Q3 and 100 basis points for the nine-month period.
- Operating income decreased 15.7% in Q3 and 15.6% for the nine-month period, while diluted EPS declined from $0.33 to $0.30 in Q3 and from $0.72 to $0.66 year to date.
- Heavy civil results were affected by the substantial completion of two large design-build joint venture projects in 2018, partially offset by increased fully controlled heavy highway and aviation work. Management expects joint venture revenue to increase in 2020 as new projects ramp up.
- Residential construction benefited from higher completed slab volume, particularly from the Houston expansion, but Houston work carried lower margins while the business builds scale.
- Operating cash flow was substantially lower because of seasonal working-capital use, including a $34.4 million unfavorable change in contract capital.
- Backlog increased to $881.4 million from $850.7 million at December 31, 2018. Approximately 70% was expected to be recognized as revenue within the following twelve months. Backlog margin increased to 9.3% from 8.5%.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- Management expects full-year cash flow from operations to approximate operating income and expects operating cash flow to improve as seasonal cash inflows occur in the second half of the year.
- Management reported sufficient liquid financial resources to fund the next twelve months of operations, including bonding requirements.
- Infrastructure demand remains supported by state, local, federal, aviation, and transportation funding programs. A potential federal infrastructure bill could provide an additional growth catalyst, although management did not expect a significant impact before late 2020 or 2021.
- On October 2, 2019, after the reporting date, the company completed the $411.6 million Plateau acquisition, consisting principally of $375.0 million in cash, stock, a $10.0 million subordinated note, and a preliminary working-capital adjustment. Preliminary purchase accounting included $162.7 million of identifiable intangible assets and $150.2 million of goodwill; final accounting was not complete.
- The Plateau acquisition was financed in part through new senior secured facilities comprising a $75.0 million revolving facility and a $400.0 million term loan, with an aggregate maturity date of October 2, 2024. The facilities refinanced and extinguished the Oaktree Facility and materially increased leverage after quarter-end.
- Unapproved change orders and claims included in contract prices totaled approximately $15.4 million at September 30, 2019, primarily related to delays on a Texas bridge project caused by design errors in the owner-provided plans. Resolution remains subject to customer negotiations, and unfavorable outcomes could reduce or reverse previously recognized revenue.
- Construction accounting depends on estimates of costs, productivity, claims, incentives, penalties, and project completion. Changes in estimates can materially affect revenue and profit.
- The company has joint and several liability on certain construction joint ventures. Unconsolidated joint venture work remaining was approximately $46.2 million, including $23.0 million representing Sterling’s proportionate share. Management was not aware of any partner failure requiring Sterling to fund another partner’s obligations.
- Management stated that ordinary-course legal proceedings were not expected to have a material adverse effect. The company maintained a $28.9 million valuation allowance against net deferred tax assets and believed continued positive results could support removing the allowance in the fourth quarter of 2019.
- Principal risks include project cost overruns, design errors, weather, labor and material cost inflation, subcontractor or joint venture partner failures, public infrastructure funding changes, bonding and liquidity requirements, customer concentration, acquisition integration, and restrictive debt covenants.
Important Facts for Investors to Verify
- Confirm final purchase accounting, post-acquisition operating results, integration costs, and synergies from the Plateau acquisition.
- Assess the increase in leverage and covenant compliance under the new credit facilities following the October 2, 2019 refinancing.
- Monitor the resolution and collectability of the $15.4 million of unapproved change orders and claims, particularly the Texas bridge project claim.
- Evaluate whether backlog growth and the 9.3% backlog margin translate into improved gross margins and cash flow.
- Track contract capital, receivables, costs in excess of billings, and seasonal working-capital recovery.
- Determine whether the deferred tax valuation allowance is removed and quantify the resulting earnings benefit, if any.
- Review exposure to joint and several liabilities, bonding requirements, and potential performance failures by joint venture partners or subcontractors.