Sterling Construction Company, Inc. — Form 10-Q Summary
Reporting period: Three and six months ended June 30, 2017; filed August 2, 2017. The filing identifies the registrant as Sterling Construction Company, Inc. The company provides heavy civil construction and residential and commercial concrete services across several U.S. states. Results are unaudited and may be seasonally variable.
Business Context and Material Developments
- On April 3, 2017, Sterling acquired Tealstone Residential Concrete, Inc. and Tealstone Commercial, Inc. for preliminary consideration of $83.7 million, consisting of $55.0 million cash, $17.1 million of stock, $4.4 million of promissory notes and $7.2 million of deferred payments.
- The acquisition added a residential construction reporting segment and contributed approximately $42.5 million of revenue and $5.5 million of operating income from closing through June 30, 2017.
- Preliminary purchase accounting included $40.0 million of identifiable intangible assets and $36.2 million of goodwill. The allocation remains subject to change.
- Heavy civil backlog was $923 million at June 30, 2017, compared with $823 million at December 31, 2016. Backlog gross margin increased to 8.4% from 8.2% at year-end 2016 and 7.8% at June 30, 2016.
Financial Metrics
| Metric | Three Months Ended June 30 | Six Months Ended June 30 |
|---|---|---|
| Revenue | $246.4 million, up 30.0% | $399.8 million, up 26.5% |
| Gross profit | $25.2 million | $34.5 million |
| Gross margin | 10.2%, versus 8.2% | 8.6%, versus 6.0% |
| Operating income | $8.4 million, versus $3.4 million | $6.6 million, versus $(3.1) million |
| Operating margin | 3.4%, versus 1.8% | 1.6%, versus (1.0)% |
| Net income attributable to common stockholders | $3.7 million, versus $2.0 million | $1.4 million, versus $(5.3) million |
| Diluted earnings per share | $0.13, versus $0.09 | $0.05, versus $(0.25) |
- Segment performance: Heavy civil revenue was $209.2 million for the quarter and $362.6 million for the six-month period. Residential revenue was $37.2 million for both periods. Heavy civil operating income was $3.1 million for the quarter and $1.7 million year to date; residential operating income was $5.2 million and $4.9 million, respectively.
- Cash flow: Six-month operating cash flow was $(12.3) million, compared with $26.7 million provided in the prior-year period. Investing cash flow was $(59.0) million, primarily reflecting the $55.0 million Tealstone cash payment and $5.9 million of capital expenditures. Financing cash flow was $88.6 million, primarily from the new term loan.
- Liquidity: Cash and cash equivalents were $60.1 million at June 30, 2017, versus $42.8 million at December 31, 2016. Working capital was $73.4 million, versus $29.3 million at year-end. Approximately $19.7 million of cash belonged to majority-owned joint ventures and was generally restricted to joint venture activities.
- Debt: Total debt was $89.2 million, including an $85.0 million secured term loan, $11.9 million of Tealstone seller notes and deferred payments, and $2.1 million of equipment-related notes, partially offset by discounts and loan costs. The term loan matures April 4, 2022 and bears interest at LIBOR plus 8.75%.
- Interest and unusual items: Interest expense was $3.0 million for the quarter and $3.1 million year to date, versus $0.8 million and $1.7 million, respectively. The company recorded a $0.8 million loss on extinguishment of prior debt and a $0.9 million write-down on a Texas facility held for sale.
Material Changes Versus Prior Comparable Period
- Revenue increased primarily because of the Tealstone acquisition, which contributed approximately $43 million during the quarter, as well as increased Utah project activity and improved Texas weather.
- Gross margins improved substantially, with Tealstone contributing approximately 2.0 percentage points to the quarterly margin and 1.4 percentage points to the year-to-date margin.
- General and administrative expense increased to $12.8 million for the quarter and $23.4 million year to date, reflecting the acquisition, accelerated vesting costs related to the former CEO, recruiting and increased pre-bid costs.
- Operating cash flow declined despite improved earnings because contract capital reduced liquidity by $18.6 million, including a $40.2 million increase in contracts receivable.
- Debt increased materially following the acquisition financing, while shares outstanding increased through the issuance of 1.9 million shares to Tealstone sellers. Lenders also received warrants for up to 1.0 million shares at an initial exercise price of $10.25 per share.
Guidance, Outlook, Risks and Contingencies
- Management cited favorable transportation infrastructure funding, including federal and state programs, and expects improved market conditions to support activity. The filing does not provide formal revenue or earnings guidance.
- Management stated that available cash, operating cash flow and borrowing resources should be sufficient for the next twelve months, including bonding requirements, but noted that substantial cash constraints, continued losses or inability to obtain financing could materially harm liquidity.
- The term loan requires compliance with restrictive covenants, including secured debt to EBITDA, cash collateral, backlog gross margin, capital expenditure, bonding capacity and Tealstone EBITDA requirements. The company reported compliance at June 30, 2017.
- Outstanding claims and unapproved change orders included $1.4 million of unapproved change orders, $12.0 million of claims and $3.9 million of entitled unpaid project price recorded in contract assets. Resolution remains subject to negotiation and actual results could differ materially.
- Construction contracts are subject to cost overruns, weather, delays, design issues, subcontractor and supplier performance, change-order uncertainty, customer concentration, government funding changes and competitive pricing.
- Unconsolidated joint ventures had approximately $76 million of remaining work, including $39 million attributable to Sterling. Joint venture arrangements create potential joint and several liability if a partner fails to perform.
- The floating-rate term loan creates interest-rate exposure; management estimated that a 1% increase in interest rates would increase annual interest expense by approximately $0.9 million.
- Management reported no pending legal matters expected to have a material adverse effect. Tealstone was excluded from the company’s internal-control effectiveness assessment for the acquisition year.
Investor Verification Items
- Verify the final purchase price allocation for Tealstone, including goodwill, intangible assets and related amortization.
- Monitor Tealstone’s operating performance and compliance with the $12.0 million rolling EBITDA covenant.
- Assess cash conversion, collections of contracts receivable and the effect of contract capital on operating cash flow.
- Review term-loan interest costs, covenant headroom, mandatory excess-cash-flow prepayments and refinancing risk.
- Evaluate the recoverability and timing of the $12.0 million of claims, $1.4 million of unapproved change orders and $3.9 million of entitled unpaid project price.
- Track backlog conversion, backlog gross margin and the $77 million of unsigned low-bid awards excluded from reported backlog.
- Consider dilution from the 1.0 million lender warrants, employee awards and the shares issued in the Tealstone acquisition.