Sterling Infrastructure, Inc. (STRL) Q3 2012 Earnings Report, Transcript and Summary

Greetings, and welcome to the Sterling Construction Company, Inc. Third Quarter 2012 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Elizabeth Brumley, Chief Financial Officer for Sterling Construction Company. Ms. Brumley, you may begin.

Thank you. Good morning, ladies and gentlemen, and welcome to Sterling Construction Company's third quarter 2012 conference call. I'm joined by Peter MacKenna, our Chief Executive Officer; and Brian Manning, Executive Vice President and Chief Business Development Officer. I would like to remind you that this call may include certain statements that fall within the definition of forward-looking statements under the Private Securities Litigation Reform Act of 1995. Any such statements are subject to risks and uncertainties, including overall economic and market conditions; competitors; customers and suppliers' actions; weather conditions; and other risks identified in our filings with the Securities and Exchange Commission, which could result in actual results to differ materially from those anticipated. Any such statements should be considered in light of these risks. Predictions that we may make at any time may not continue to reflect management's belief, and we do not undertake to publicly update them. Results for the third quarter were a disappointment to us. While third quarter revenues increased 29% as compared to 2011 third quarter, gross margins declined to 6.9% for the quarter, leaving us at 6.6% for the 2012 year-to-date gross margin. The increase in revenues for the quarter and 9 months ended September 30, 2012, continues to be in line with our expectation of a 25% overall increase for the full year of 2012 over 2011. Our new California and Arizona operations contributed $48.8 million in revenues in the quarter as compared to $1.9 million in 2011 third quarter. While we also saw higher revenues in Utah, where we had higher activity levels and improvements in estimated profitability on certain projects, in addition, revenues in Nevada increased quarter-over-quarter, in part from the $25 million in contracts assumed from a third-party in January 2012. Gross margin at 6.9% in the third quarter of 2012 was below the 9.3% for the third quarter of 2011 and below the 9.0% for the second quarter of 2012. During the quarter, downward revisions in profitability on projects in Texas substantially offset upward revisions on certain projects in Utah. Diluted earnings per share was $0.01 for the quarter as compared to $0.21 for the 2011 third quarter. Basic and diluted EPS included $0.05 related to the increase in the RLW put call liability. In accordance with GAAP, revisions to the estimated liability are reported directly to retained earnings and do not impact net income. But these are taken into consideration in computing EPS. Earnings attributable to the noncontrolling interest owners reduced diluted EPS by $0.12 net of the related tax impact in the 2012 third quarter as compared to $0.10 in the 2011 third quarter. A significant portion of this impact is attributable to the 20% of RLW held by non-controlling interest owners. Higher profits in Utah was a main contributor to the increase. General and administrative expenses for the 2012 third quarter increased $3.2 million as compared to the 2011 third quarter. As a percent of revenues, G&A was 5% versus 4 -- 4% in the prior year quarter. As in the first and second quarters of 2012, some of the increase in G&A is attributable to the expanded California and Arizona operations, in some, as a result of higher professional fees. In addition, we incurred roughly $1 million related to our CEO transition. Capital expenditures were $27.8 million for the year-to-date 2012 period, and we do not expect significant capital expenditures during the fourth quarter 2012. While CapEx will be higher in 2012 than the $24 million incurred in 2011, proceeds from disposals of property and equipment were $11.9 million year-to-date in 2012 versus $1.3 million for the full 2011 year. As mentioned previously, increased sales and purchases of equipment in 2012 are a result of efforts in Texas and other markets to ensure that we have right-sized an efficient fleet. Our overall effective tax rate for the 3 months ended September 30, 2012, was impacted by $3.1 million of earnings allocated to noncontrolling interest owners. After adjusting for this impact, the overall effective tax rate was 46.1% for the third quarter and reflects the impact on interim results of changes in the overall estimated effective tax rate for 2012. I wanted to highlight a change in the timing of including awards and backlog, beginning in this period. Prior to this reporting period, projects were included in backlog and when they became the apparent low bidder rather than when they were officially awarded. Historically, it was rare for a contract to not be awarded to the apparent low bidder. With the expansion into new markets, especially in California, there's a greater risk that the awarding of contracts to the low bidder are challenged. And therefore, we concluded that a change to the timing of reporting was now appropriate. In the third quarter 2012, earnings release and Form 10-Q and going forward, any previously reported backlog and awards have been and will be restated to exclude contracts not yet officially awarded. Backlog at September 2012 remain strong at $704 million, and as just explained, excludes $79 million of potential new contract awards as of September 30. Estimated gross margins in our backlog are comparable to margins on our 2012 year-to-date results of 6.6%. This reflects the impact of projects bid prior to 2012 and on which we have made downward revisions late in 2011 or during 2012. Sterling continues to be in very sound financial condition. Net working capital at quarter end totaled $82.6 million. And since June 30, 2012, net working capital includes the current liability of $23.3 million associated with the RLW put call. As a reminder, this put call is exercisable beginning in the second quarter of 2013. We have $38.2 million in availability under our credit facility at the end of the quarter, with the ability to increase the facility by an additional $50 million. I will now turn the call over to our CEO, Peter MacKenna.

Thanks, Liz. I want to mention at the outset that my predecessor as CEO and Chairman, Pat Manning, is in the hospital. I know all of you on the call join me in wishing Pat a speedy recovery. This is my first quarterly call as CEO of Sterling, and it really is a privilege to be here with you today. While these are prepared remarks, I hope to be able to address any unanswered questions you may have in the Q&A session. It's been just 2 months since I've joined the company, and I've spent a great deal of that time analyzing and evaluating the various aspects of the business. Notwithstanding the quarterly results that Liz just outlined, I've generally been pleased with a lot of what I've seen. We have nearly 1,800 hardworking and dedicated employees working on 111 projects in 10 states, executing more than $205 million worth of work in this quarter alone. I was also pleased to see that the effort to obtain new work was quite strong, and we have an impressive capture rate. In fact, we've secured 79 projects so far this year, giving us a book to bill in excess of 1, and that certainly is an accomplishment in the extremely competitive heavy highway market sector. Overall gross margin of our 2012 year-to-date order book compares favorably to what is currently in the backlog. And we believe we're seeing evidence of mounting upward pressure on the bidding results, especially on some of the recent TXDOT lettings. We've also seen impressive bid results from our subsidiary, Ralph L. Wadsworth, and our affiliated companies, Myers & Sons and RHB, all of them being successful on some exciting new work. I think it's appropriate that we provide an update on our ongoing efforts to implement policies, processes and procedures that will ensure that the estimating function, job cost accounting and forecasting are performed in such a way that provides the most timely and accurate information to all the stakeholders. Significant changes to the way Sterling runs its business have been made during the year. Changes in not only the frequency of job cost reviews, but also the rigor of cost to complete calculations, have surfaced many of the issues that resulted in the write-downs this year. A deep review has been conducted on nearly all the projects in Texas Sterling's portfolio, and we are now managing all our work with a sharper focus. Many of the changes were well underway before my arrival, and since September, we've taken additional steps to develop a strong and mature project management process. To help facilitate many of these changes, we've just assembled a team of industry-experienced IT professionals. We're very pleased to welcome our new CIO, Scott DeMasse, and his team to Sterling. I know they'll be making a huge contribution to the company. Scott will be joining the executive leadership team at Sterling, which includes its subsidiaries and affiliates. That team has been meaning to develop a platform-wide initiatives identifying and implementing best management practices both from within our company and from our peers. Over the next several months, we'll be developing our new strategic plan and preparing our company for that journey. As a matter of fact, we're meeting again on Monday in Utah to continue the work of taking Sterling to the next level. I'm looking forward to sharing our strategic plan with you in the quarters to come. I've been asked by a lot of people, both from within Sterling and from without, what my first impressions of the company are. I've told them all that it's a company with good bones. The fundamentals of the company are strong. We have good, hardworking and dedicated employees that are motivated to do what it takes to make the company successful. We have a strong balance sheet and the resources necessary to return us to appropriate levels of profitability and the ability to grow and diversify our business. Brian Manning, our Executive Vice President and Chief Development Officer, is here in Houston with us today. One of Brian's many responsibilities is to look at the marketplace and the opportunities that exist for Sterling. Here's Brian to provide some color on how we see the marketplace. I'll now turn the call over to him. Brian?

Thank you, Peter. I will now address 3 issues: the election, the state of construction and the -- our opportunity pipeline. Now that the election has concluded, it eliminates some of the uncertainty, and the construction industry now prepares for a future where the political players are now known. With President Obama being elected to a second term, Democrats increasing their Senate majority and strong Republican control of Congress, we look to our leadership for bipartisan deals to advance infrastructure. Voters in this election approved with an 80% success rate more than 380 ballot initiatives, totaling more than $30 billion in state, local and school bond measures. Most notably, Proposition 30 in California, allowing for new income tax and sales tax for the state that should keep California construction spending on track. Last 4 years produced 2 construction bills, a 4-year aviation reauthorization and a 27-month surface transportation bill. Key issues in the next 4 years include the financial cliff. Billions of dollars in tax breaks will expire on December 31, and mandatory spending cuts will be considered so that the government does not bump up against the federal debt ceiling. Industry experts expect a short-term extension to these tax breaks. Industry would like to see Congress pass a new Water Resource Development Act or WRDA to authorize new Army Corps of Engineers locks and dams dredging in environmental restoration projects. We will also look for action from Congress to shore up the Highway Trust Fund beyond 2014. President Obama stressed that we have a $2.2 trillion deficit for old infrastructure that needs improvement so that we can compete around the world. The state of construction is improving in an economy that is growing slowly and unemployment is declining. In fact, Sterling is experiencing construction unemployment improvement in all of our states where we have operating units with the exception of Nevada. The housing market is getting stronger, especially multi-family. As more people move to urban areas, they will need upgrades to aging infrastructure, another good sign for Sterling. As we look at the pipeline of opportunity for work, we are making changes to position ourselves for the next upcycle. As Peter mentioned, we are -- with the hiring of our new CIO, we are upgrading our systems for communication and efficiency among all operating units. This also includes the way that we track potential projects. We are investing more time and effort in research before making strategic moves. Our balance sheet is strong, and it will provide us with opportunities, both organically and through acquisition in the coming year. The Panama Canal expansion will also offer opportunities for Sterling, not only for dock site improvements to the ports but also for transportation infrastructure to support those ports. EPA is in the process of improving numerous drinking water standards for various impurities that will require upgrades to existing systems. Water and wastewater drivers are still strong in our south and southwestern markets, where population continues to grow. There is a need for replacement and upgrades to the 16,000 wastewater systems nationwide that discharge more than 850 billion gallons of untreated sewage into surface waters each year. In fact, there are still combined sewer systems, storm and sewage, that serve approximately 950 communities. Although Sterling felt that we had the right price for the associated risks on the Grand Parkway proposal with Kiewit and Granite, we were not selected for the project. There was a significantly lower price, approximately $0.5 billion, from one of our competitors. There is still opportunity for Sterling on this billion-dollar project -- construction program being built just 6 miles from our Houston office. Technical proposal goes in on a project of similar size, I-35E in Dallas on Monday, and we look forward to the opportunities that this program presents. In total, we are currently pursuing $3.3 billion in alternative delivery projects. And the pipeline for this specialized work continues to grow. There's more effort and expense required on these pursuits, but the reward is also certainly greater. And now, if there are any questions, we are happy to entertain them.

[Operator Instructions] Our first question is from Rich Wesolowski of Sidoti & Company.

If you take the difference in the value of your Wadsworth put call liability in September versus June, it translates to about a $4 million pretax favorable profit revision for Wadsworth. And the company as whole didn't report any net profit revisions for the quarter, so from that can we infer that $4 million was about the size of the write-down in Texas?

We did have -- we did obviously -- it was about breakeven. So the write-downs in Texas pretty much offset some other upward revisions that we saw in Utah.

But the absolute size of the bulk is $4 million close to the right numbers in the ballpark?

It's in the ballpark. There are some disclosures of about what the year-to-date write-downs are, and net-net for the quarter, it was not significant. So as you're inferring, the write-downs in Utah -- I mean, in Texas were offsetting what was in Utah.

Right. Okay. The gross is what I'm trying to figure out. But can you confirm whether or not any of the work written down in the September quarter was added to backlog after management had reportedly reset the big parameters in December?

It was not.

Well, that's good. So last one and looking out to 2013 and your comment on the backlog margin. A back-of-the-envelope calculation would suggest that about 60%-plus of your current backlog was won in 2012, but you're saying is being carried at the bid margin, which I imagine is high single-digits. So that would suggest your backlog from 2011 and prior, the minority of the pie has been written down to a level that would dilute the total backlog margin to 6%? Is that interpreted correctly?

I think that's a fair interpretation. We've got a [indiscernible] jobs that are either at 0 margin because they're in a loss position or very low margins.

Our next question is from Nick Coppola of Thompson Research.

I mean, obviously, something that we're all trying to figure out is if the worst of revisions are over. And now that you've kind of, I heard, spent some time analyzing your portfolio, how long is it going to take for some of the lower margin work to burn off? And what kind of confidence do you have that maybe there won't be further revisions going forward?

Well, I think we've gotten a substantial portion of the revisions at this point. There's a few projects where we may see some more revisions downward, but not any -- I'm not expecting anything to the degree of what we saw this quarter.

Okay, fair enough. And then I guess just going back to a prior comment about half of backlog -- I think last quarter was about half of backlog is expected to be constructed in the back half of '12. So I mean that would imply about $390 million in revenue. Is that kind of still the right way to think about it? Or do we need to kind of revise those expectations?

In terms of the revenues, we're still expecting to be about 25% ahead of where we were last year.

Right. Okay, that makes sense. And then I guess one last question that's kind of more thematic. In terms of -- I mean, what -- how are you thinking about the impact of alternative funding mechanisms in Texas? I mean, Texas has been a leader in promoting those types of projects. How much do you really expect to benefit? And I heard you made some comments in your opening remarks on that, but any color there would be appreciated.

We continue to pursue those types of projects, Nick. We've been in discussions with TXDOT on a couple more of smaller magnitude, where alternative funding sources will come into play, specifically public-private partnerships. So as these programs roll out and they see some success, we will continue to pursue them.

Our next question is from Saagar Parikh of Keybanc Capital Markets.

Quickly, again on the margin front. Looking inside of the gross margin, looking at SG&A, it increased in the quarter, and I know, Liz, you mentioned that around $1 million of it was due to compensation for Peter and for Pat, but you end up taking that out. It seemed like the absolute number increased in the quarter, both year-over-year and sequentially. Year-over-year, due to Myers and JBC most likely, but even sequentially, I just want to get more color on that trend and where we can really see it go in 2013.

I think if you take out the $1 million, you're well below a 5% rate, so something like 4.8% versus 4.4% of last year's. So I think that's well below what we see some of our competitors spending in the industry at a reasonable trend. That said, there are some further cost, professional fees this quarter that bumped it up. So overall, I mean, I think our G&A is well in line with what's needed at this point and it's pretty frugal.

That's for sure. I just wanted to get some -- why there was an uptick, but.

Yes, I mean, overall -- I mean, a large degree, the uptick, if you take out the $1 million related to the CEO transition, some of it is going to be -- a decent amount will be related to the California and the Arizona operations and just the higher level of revenues, to be candid. And we are -- I mean, even in Texas, revenues were up.

So it's safe to assume then taking out some of these onetime items in G&A that we saw this year, your 2013 G&A as a percentage of revenue most likely will be trending downwards or closer to that 5% number?

I think that we are going to step back and examine what the appropriate levels are for G&A. So for example, Peter's brought on for the new CIO, and that's obviously going to be an incremental add to the G&A expense but we expect to get a significant amount of return for our money on that.

This is Peter. I mean, this is obviously an area for us to focus on as well, especially in terms of looking towards integrating all the operating units within Sterling. Looking towards removing redundancies and really getting the full value proposition out of these acquisitions is something that we'll be looking at as we go through the budgeting process, which we're doing right now and as we develop our strategic plan for the future. So this is certainly an area of opportunities.

Okay, great. And then one follow-up on gross margins. Instead of 2013, which was what has already been touched on -- or touched on. Looking into 2014, because as you guys know, we all have to put out 2014 forecasts soon. And they're not even out yet for that matter, but looking in 2014, I know in the past you guys have said that your gross margin goal was 10% to 12%. Is that still the longer-term goal for 2014? Is that something that you think is achievable based on the business outlook that Brian gave?

That's a tough question. There are definitely elements in our business that are returning double-digit gross margins. And I think as we develop our strategic plan, it's a matter of redeploying our resources to exploit those areas of higher margin. We kind of alluded to it in our prepared remarks that there's a whole lot of commodity work that goes on in this company in this sector, I should say, especially in the highway piece. And while that's an important part of our business, we need to diversify this platform. One, to take some of the revenue and funding risk out of it, but also to try to exploit higher margins elsewhere, sort of adjacent sectors. Brian talked a little bit about some areas that are of interest to us. And you've seen some previous comments about working out in Hawaii and some of the work in Nevada and Wyoming, and the Dakotas, and certainly something we'll be focusing on. So I think we're trying to move away from the heavy commodity work and try to diversify that platform.

And with that -- a follow-up with that comment then, Brian, in his outlook comments, mentioned a lot of water-related work. And I know as in the downturn maybe water funding wasn't there as much. And because of that, maybe the percentage of your water business that declined a bit. Is that -- when you mean getting away from the commoditized businesses to a degree, are you talking about getting into the water business or increasing the water component a little bit more again because I would assume it's higher margin?

When we're looking at that, water is certainly something that we do well. And with population shifts, the water is a necessity. They can have -- allow for more traffic congestion but certainly, water is in high demand and a need. You can't turn off those supplies. So we have seen some trends of what municipalities increasing their water rates to be able to pay for the systems that they have in place and then provide for some additional growth. Because those are user fees, it will follow the population and there'll be opportunities there as well. Surface water programs, we've mentioned in previous calls about the subsidence in Houston especially, and there's programs in place, one that we're pursuing very heavily on the -- taking -- converting from groundwater to surface water, which has a lot of plant work and associated line work, so certainly taking what we do well in Texas as far as utilities and then looking at our other markets and expanding those capabilities in other markets is an area that we're looking at.

[Operator Instructions] Next question is from Jack Kasprzak of BB&T.

Brian, could you -- there was some background noise in your comments. What was the name of the project you said you guys missed or underbid on? I just didn't hear it.

It was the Grand Parkway project here in Houston. There's 3 segments of the Grand Parkway that recently bid. And it's a fairly big program here, and it's one that will require a number of local resources. So we still view it as an opportunity.

Was it the first or second segment that was bid?

It's the -- there's several segments. It's the 290 to 59 portion of it. So the northern portion of it. But there's several other segments that will come after that, specifically sections H and I will be on the radar for TXDOT to develop in the near future.

Okay. And then I guess, Peter, in your comments, you referenced the Texas market and bidding and seem to suggest that maybe you guys were seeing a little improvement in competitive pressure. Is that -- did I hear that right? Do you think the market's starting to tick up a bit just in terms of perhaps pricing?

Yes, you did hear it right. Just last week, we had 5 bids, 1 win and 4 seconds, which was a little disappointing. But we're right there. Some of the jobs we only missed by fractions of a percent. But the interesting pieces if you look at the overall spread of pricing, the number of bidders is down a little bit. But even the low bids were above the engineer's estimate. So it's certainly implying that the numbers are recovering. And if you look at the third, fourth and fifth bidders, the numbers are significantly higher. So there's definitely upward pressure. There's still some bottom feeders, but all of us here think that the numbers are trending up now at least in latest TXDOT lettings.

Okay. And you guys have about $50 million of cash investments on your balance sheet, how much do you need to keep on the balance sheet for bonding purposes.

Well, I think the question is really, can we take that cash and redeploy it into something more efficient. And with some of the opportunities that were mentioned on the call, I'm looking to the future of using that maybe in a little bit different way.

Okay. So you could fund the acquisitions with it? Is that what you're implying or other...

Yes.

Yes, okay. Better be clear. And real quick too, after recent expansions, how much of your business right now is Texas on a run rate or pro forma basis, would you say? I know it can move around based on bids and size of projects, but you've expanded to other states too.

Well, it's definitely less than half. And we did give you an indicator as to what the California and the Arizona piece is, so that's $48.8 million, which is about 25%, so you can kind of get a feel for their -- for that.

Our next question is from Rich Wesolowski of Sidoti.

What would you imagine the average bid margin is on, for example, the $80 million in low bid work not yet included in backlog? In the past, I think it was alluded to somewhere in the high single-digits, maybe 8%.

I don't know that we've ever gotten that specific.

I'm a little reluctant to go there.

Okay. Liz, you had seemed to allude to additional write-downs potentially ahead for the projects that have already slipped, but as I understand the process, the write-downs that you've taken are by definition the estimates of what cost would need to be incurred to finish the work. So I'm curious why management would not conservatively forecast these jobs in the current quarter and take a bath big enough to have real confidence that the problem has been defined, put a more worse case in there.

Rich, I may have been a little too strong in my remarks. I think Peter discussed the fact that we've gone through and scrubbed a significant portion of the jobs and so -- and I think that's a very fair assessment. There are a few jobs where we're making even more exact estimates as to where we're going to end up on those. But I think what the overall takeaway from that is that if we do have downward revisions in the fourth quarter or in future quarters, they're going to be much more in line with what we would view as a normal state, not what you see this quarter our like what we saw in the first quarter.

Okay. And back to the kind of the gross write-down and write-up conversation. Based on what you see from Wadsworth's backlog, which I assume a big part of is the I-15 that you saw profitability improved, how long will you continue to enjoy that favorable offset to what's happening in Texas with those projects coming to an end fairly soon?

Well, the 1-15 job is going to be completed, and it will be opening in the next segment or so. So there's still -- we're still going to be examining what we need to hold in terms of contingencies, et cetera, on that job. And then I think that you've always got new ongoing projects there in Utah, and I think in addition as we get better methodologies for forecasting our business and estimating those, you're going to see a trend more towards upward revisions towards the end of the projects, which you would expect because you would expect to hold back some profits based on unforeseen contingencies, et cetera, rather than what we're seeing now, which is write-downs that occur throughout the projects.

And keep in mind, our book to bill is over 1. We are replacing backlog faster than we burn it. And the margin in the order book is favorable to where we stand now. So the I-15 is a very important project and has performed wonderfully for us, but there are other projects coming in.

Right. I just want to make sure. For Utah, it seems we defined the group of projects in Texas as outsiders that are giving you trouble, but in Utah, it seems to be a little more opaque. I just want to make sure this wasn't 1 or 2 tremendous jobs that were now being completed that was giving you this profit upside.

We do see some upsides that are going to be attributed to maybe 1 or 2 projects in Utah for from time to time because they've done some larger projects that have overall had an impact, but they aren't necessarily the same projects quarter-after-quarter. The second quarter was attributable to different projects in Utah.

Great. Okay. Lastly, I'm sure Pat Manning is either listening or will be circling back. We'd like to wish him the best in his recovery.

We have no further questions in the queue at this time. I would like to turn the floor back over to management for any closing remarks.

Well, thank you very much for participating in the call. This has been an exciting experience for me, my first time doing this. And I look forward to speaking to you all next quarter. Thank you very much.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.