Sterling Construction Company, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2017. The filing identifies the registrant as Sterling Construction Company, Inc. (the metadata refers to Sterling Infrastructure, Inc.). Results are unaudited and may be seasonally variable.
Business Context
Sterling is a heavy civil construction company operating primarily in transportation infrastructure, water infrastructure, and residential and commercial concrete construction across multiple U.S. states. Following the April 3, 2017 acquisition of Tealstone, the Company reports two segments: Heavy Civil Construction and Residential Construction.
Financial Performance and Position
| Metric | Three Months Ended September 30 | Nine Months Ended September 30 |
|---|---|---|
| Revenue | $304.2 million, up 47.9% | $704.0 million, up 34.9% |
| Gross profit | $30.6 million, up 84.3% | $65.1 million, up 82.4% |
| Gross margin | 10.1%, versus 8.1% | 9.2%, versus 6.8% |
| Operating income | $12.6 million, versus $3.7 million | $19.2 million, versus $0.6 million |
| Operating margin | 4.2%, versus 1.8% | 2.7%, versus 0.1% |
| Net income attributable to Sterling stockholders | $7.1 million, versus $2.4 million | $8.5 million, versus a $2.9 million loss |
| Diluted earnings per share | $0.26, versus $0.10 | $0.33, versus a $0.12 loss |
- Cash and cash equivalents were $66.5 million at September 30, 2017, compared with $42.8 million at December 31, 2016.
- Working capital was $84.8 million, compared with $29.3 million at year-end 2016.
- Net cash used in operating activities was $7.0 million, compared with $35.7 million of operating cash flow in the prior-year period. The principal drag was a $36.2 million use of contract capital, including higher receivables and costs in excess of billings.
- Net cash used in investing activities was $57.3 million, primarily reflecting the $55.0 million cash payment for the Tealstone acquisition and $8.3 million of capital expenditures.
- Net cash provided by financing activities was $88.0 million, including proceeds from the new $85.0 million term loan.
- Total debt was $89.6 million, including the $85.0 million term loan, $12.1 million of Tealstone seller notes and deferred payments, and $1.8 million of equipment-related debt. Debt was $5.4 million at December 31, 2016.
- The term loan matures April 4, 2022 and bears interest at applicable LIBOR plus 8.75%. The Company reported compliance with all loan covenants at September 30, 2017.
Material Changes Versus the Prior Comparable Period
- The Tealstone acquisition added approximately $92.9 million of revenue and $13.2 million of operating income from the acquisition date through September 30, 2017. Tealstone contributed approximately $50.4 million of third-quarter revenue.
- Residential Construction generated $40.9 million of third-quarter revenue and $78.2 million for the nine-month period, with operating income of $5.7 million and $10.6 million, respectively. This segment did not exist in the comparable 2016 periods.
- Heavy Civil Construction revenue increased 28% in the quarter and 20% year to date, driven primarily by Utah projects, a new Rocky Mountain joint venture project, and improved Texas project productivity.
- Gross margin benefited from Tealstone, which management estimated contributed approximately 1.6 percentage points in the quarter and 1.4 percentage points year to date.
- General and administrative expense increased to $13.1 million for the quarter and $36.5 million year to date, primarily due to the acquisition, accelerated stock compensation related to the former CEO’s departure, and Utah pre-bid and recruiting costs.
- Interest expense increased to $3.6 million for the quarter and $6.7 million year to date because of the higher debt balance. The Company also recorded a $0.8 million loss on extinguishment of prior debt year to date.
- Backlog was $804 million at September 30, 2017, compared with $823 million at December 31, 2016 and $820 million at September 30, 2016. Backlog gross margin increased to 8.4% from 8.0% at September 30, 2016.
Outlook, Commentary, Risks, and Unusual Items
- Management cited favorable infrastructure funding trends, including federal transportation funding and increased transportation spending or authorization in Texas, Utah, and California.
- Management stated that more rigorous bid evaluation and approval processes are intended to improve project selection, margins, and risk control.
- The Company expects sufficient liquidity to fund the next twelve months of operations and bonding requirements, but cautioned that substantial cash constraints, losses, or inability to obtain financing could materially impair working capital.
- Outstanding debt carries floating-rate exposure; management estimated that a 1% increase in interest rates would increase annual interest expense by approximately $0.9 million.
- At September 30, 2017, the Company recorded $0.3 million of unapproved change orders, $10.5 million of claims, and $3.9 million of entitled unpaid project prices in costs and estimated earnings in excess of billings. Negotiations remain ongoing, and actual recoveries could differ materially from recorded amounts.
- The Tealstone purchase-price allocation remains preliminary. Identifiable intangible assets were recorded at approximately $46.6 million, with $1.4 million of amortization recognized year to date. Earn-out payments of up to $15.0 million may be payable subject to performance and employment conditions.
- Joint ventures had approximately $51 million of work remaining at September 30, 2017, including $27 million representing Sterling’s proportionate share. Joint venture agreements generally create joint and several liability if a partner cannot perform or fund its obligations.
- Management reported no material pending legal matters and no material changes to previously disclosed risk factors. Hurricane Harvey did not have a significant net impact because lost project time was offset by emergency work.
- The Company adopted simplified goodwill impairment guidance early without a material impact. It planned to adopt the new revenue standard on January 1, 2018 using the modified retrospective method and had not identified a material expected financial statement impact, although implementation and disclosures were still being finalized.
- Disclosure controls were considered effective; however, Tealstone was excluded from the internal-control assessment for the acquisition year.
Investor Verification Points
- Verify the sustainability of Tealstone’s revenue and margins, including the preliminary purchase accounting, intangible-asset amortization, and potential earn-out obligations.
- Monitor operating cash conversion, receivables, contract assets, claims, change orders, and the continued use of working capital as project activity expands.
- Review compliance with the term-loan covenants, including the secured debt-to-EBITDA, cash collateral, backlog gross-margin, capital-expenditure, bonding, and Tealstone EBITDA requirements.
- Assess refinancing and interest-rate risk associated with the $85.0 million LIBOR-based term loan and the requirement to offer quarterly prepayments based on excess cash flow.
- Evaluate backlog conversion and margin assumptions, particularly the decline in reported backlog from year-end and the reduction in unsigned low-bid awards.
- Review the collectibility and ultimate resolution of recorded claims and unapproved change orders.
- Consider liquidity restrictions on cash held by joint ventures and subsidiaries, as well as potential joint and several obligations under construction joint ventures.