Sterling Infrastructure, Inc. (STRL) Q2 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the Sterling Construction Company Inc. Second Quarter 2013 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brian Manning, Chief Development Officer for Sterling Construction Company. Thank you, sir. You may begin.

Thank you, Christine. Good morning, ladies and gentlemen, and welcome to Sterling Construction's second quarter conference call. I'm joined by Peter MacKenna, our Chief Executive Officer and Kevan Blair, our Acting Chief Financial Officer. I'd 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 cause actual results to differ materially from those anticipated. Any such statements should be considered in light of these risks. Predictions that we make at any time may not continue to reflect management's beliefs and we do not undertake to publicly update them. Our second quarter was characterized by write-downs primarily on 3 projects, but we look -- as we look forward, our book-to-bill ratio continues to trend positively. In an effort to remain transparent, we pre-released an update on the second quarter's earnings and will discuss the negative impact of these projects on earnings within today's call. I will now hand over the call to our acting CFO, Kevan Blair.

Thank you, Brian. As Brian mentioned and as many of you already know from the company's pre-release earnings warning a couple of weeks ago, from a financial standpoint, the past quarter was both difficult and disappointing. Revenues for the quarter were 21% lower than 2012 second quarter, primarily as the result of the completion of several large projects in Utah. Revenues were $133 million compared to $169 million for 2012 second quarter. The company had an operating loss of $26.1 million and a net after-tax loss attributable to Sterling's common shareholders of $17 million. The declines in gross margins were primarily attributable to 3 construction projects, 2 in Texas and 1 in Arizona, which is being constructed by our Utah subsidiary. These 3 projects represented a net pretax charge of $16.3 million due to unanticipated operating issues at quarter end, taking them from breakeven or better to substantial loss positions. General and administrative expenses in Q2 were $9.5 million or 7.1% of revenues. This compares to $8.4 million in the 2012 second quarter. The increase was attributable to additions to the information systems team hired in the fourth quarter of 2012 to upgrade the company's IT infrastructure and certain nonrecurring costs related to the implementation of process enhancements aimed at improving operational control and efficiency. G&A expense also included an increase in certain employee benefit and termination costs. The diluted loss per share for the quarter was $0.93 as compared to a gain of $0.15 for the 2012 second quarter. The revaluation of the liability to non-controlling interest owners for the 3 months ended June 30 reduced the net loss per basic and diluted share attributable to common stockholders by $0.09 as compared to the second quarter of 2012 when there was a $0.05 per share negative impact. For the second quarter of 2013, capital expenditures were $1.8 million compared with $11.9 million in the second quarter of 2012. And we expect the capital expenditures for the balance of the year to remain significantly below the 2012 levels. Total backlog as of June 30, 2013, was $714 million, which is an increase of 8.8% since December and up 3% since last quarter. About 22%, or $154 million, of our backlog is attributable to awards prior to 2012 and is primarily work in Texas. The average margin on these earlier awards continue to be impacted by the Q2 gross profit write-downs and is now estimated currently at around 2%. We expect to complete work on a significant portion of these low-margin contracts in the next 9 to 12 months. In contrast, 78% or $560 million of backlog, all of which is post-2011 project backlog, carried an average gross margin of 6.3%. And projects in backlog that were awarded in 2013 carry an average gross margin of 8%. At June 30, the company was net debt by approximately $7.7 million due to several large customer receivables that weren't received until after quarter end. Historically, some of our largest customer billings, which have a 30- to 45-day pay cycle occur during the summer months as projects are ramped up during good weather. Currently, the company is significantly net cash. Our financial condition remains sound though more challenging due to the large 2013 second quarter gross profit write-downs. Our working capital totaled $65.5 million, including $22 million of cash, cash equivalents and short-term investments. And at June 30, we had tangible net worth of $136 million, which exceeded the amount necessary to support our bonding requirements. I will now turn the call over to our CEO, Peter MacKenna.

Thanks, Kevan. In these short prepared remarks, I'd like to take a few minutes to address some of the issues and trends we're seeing in the business. Of course, we'll be available to answer your specific questions in a few minutes. Many of the trends highlight the positive impact the steps management has taken over the past few quarters to first stabilize our troubled projects; and second, prepare the organization for growth and sustainable earnings. First, however, I want to report to you the safety performance of Sterling. In the first half of 2013, we worked more than 1.7 million man-hours and did so with best-in-class performance statistics. However, we're deeply saddened to report that our subsidiary, RLW, which has had the best safety history and culture in our organization, had a fatal accident in June. I'm bringing this fact to your attention as it demonstrates how critical it is that we can never have a letup on having a robust and effective safety program. And we must always strive to be ever diligent in the safe execution of our work. With respect to our second quarter reported results, once again, the positive trends in our business were obscured by the margin drag from our remaining pre-2012 contracts. These headwinds were exacerbated by 3 large legacy projects noted earlier that continued to encounter execution issues as they near completion. These issues brought the projects from break-even or marginally profitable to substantial loss positions. While representing only 3 projects out of the 135 projects underway in the second quarter, the impact on our financial results was significant. Problems of this nature, while sometimes unavoidable, are nonetheless unacceptable. And we are making changes in our organization that should enable us to operate more effectively in the coming quarters and years. These changes include improvements to our leadership team, as well as enhancements to our information systems infrastructure, operating processes, procedures, controls and training. The systems and processes we have implemented to date are already helping us identify issues and opportunities as they arise. We're making good headway in burning off work bid during the low-margin recession and the extremely competitive environment that resulted from the recession in the several years that followed. Currently, approximately 23% of our backlog is comprised of these legacy projects. And we are on track to complete a significant portion of this backlog in the next 12 months, which should position the company for material improvement and profitability in 2014. As a matter of fact, the 3 projects that contributed to the lion's share of this quarter's loss are all expected to be substantially complete in the early part of the first quarter 2014. We continue to be very encouraged by our level of bookings and the margins associated with our newer projects. At the end of June, our year-to-date low bid-to-bill ratio was 1.35:1 and that has an average margin of 11.1%. That's $330 million in new orders. And through today, our year-to-date order book exceeds $465 million at even better gross margins than those booked through the end of June. Looking to the second half of 2013, we expect revenues to be flat or slightly down relative to 2012. More importantly, however, we anticipate favorable order booking trends to continue. G&A expense for the balance of the year will remain higher than 2012, as the result of our continued process improvement investments and integration for future growth. As Kevan noted, we expect our CapEx for the year to be significantly lower than prior period, as we continue to believe that our current fleet augmented by leased assets as appropriate, will give us more than adequate capacity to support our growth in 2014 and beyond. Now I would like to hand the call over to Brian Manning, our Chief Development Officer. Brian?

Thank you, Peter. When we look at our markets, we're seeing that construction employment is increasing in most of the states where we work and competition for qualified labor is also increasing. According to the American General Contractors Association, construction unemployment was at 9.1% in July, the lowest level since June of 2008. Residential construction is employing a large portion of construction workers and residential construction represents an increase of more than 15% over 2013 levels. Nonresidential construction is increasing at a slower overall rate and the AGC has reduced its expectations for the second half of 2013 from 8% growth to 7%, and expects to achieve an overall construction spend of $913 billion in 2013. This overall construction number is expected to increase approximately another 8% in 2014 to $989 billion. Uncertainty over public funding of infrastructure projects contributes to the slower rate of growth on nonresidential construction. Sterling recently had a procurement that was in its final stage and was canceled by TEX Rail in Fort Worth over their inability to secure funding. The feds delayed the employer and individual mandates for the 2010 healthcare law, the Affordable Care Act. This 1-year delay gives employers the opportunity to comply with the new requirements. Sterling has been implementing changes in anticipation of the enforcement of the bill over the past 3 years and we'll be ready when actual enforcement begins. We continue to track over $8 billion in construction, with $4.5 billion being in alternative delivery projects. Of which, we have $620 million in active requests for qualifications and requests for proposals. We continue to migrate away from highly competitive, low-margin work and concentrate on the alternative delivery and specialty work. One specialty program that recently was announced in San Antonio is a result of a Federal mandate. The San Antonio Water System has agreed to make significant upgrades to reduce overflows into waterways from sanitary sewer systems. The San Antonio authority has agreed to a $1.1 billion upgrade of their water system to comply with the Clean Water Act by the year 2025. This is certainly a program that Sterling will actively pursue. And now, if there are any questions, we're happy to take them.

[Operator Instructions] Our first question comes from the line of Saagar Parikh with KeyBanc Capital Markets.

So first question, you've been giving some great data on book-to-bill and your net awards and your bookings and the different margins that are in those for 2013. The one thing I want to check on is I think everyone got pretty positive on Sterling back in the 2010, early 2011 timeframe also when your book-to-bill was doing pretty well. I know back in that time, you guys had book-to-bill sometimes of 1.5, 1.8, pretty high numbers. So what's different this time around with this book-to-bill? Specifically, maybe, what was the margin profile of those projects in the 2010-2011 timeframe versus the margin profile now?

Well, that's a good question, I wasn't [indiscernible] we can talk about it a little bit. One of the things that, I think, you should find encouraging and is kind of buried in the numbers a little bit is the size of the projects that we're pursuing now. The projects that were pursued in 2010 in the period you're referring to were much larger projects and of course, had much larger risk profiles associated with them. We picked up -- I don't have the exact number in front of me, it's 82 or 83 projects so far this year. And I think we've only had several of that were above the reporting thresholds that make a press release, which is, I think, $20 million. So the projects are now much smaller. They are shorter in duration, which means our visibility from a cost perspective is much clearer. The margins are better because we're moving away from the more commoditized work, which, I think, there was more of in 2010, more of the commoditized work. So I think the profile of the project is substantially different now than it was then. And you know what? It's the sweet spot of this company really to look at smaller projects, especially in the Texas market. The Utah market is a little bit stronger and that organization is different. But in the Texas market, smaller projects are where we excel and the data we have supports that right now. So we're very happy to continue to pursue these smaller jobs. And it's much better to bring home double-digit margins on smaller jobs than single-digits on big jobs where there's big risk.

Okay. And then moving to your balance sheet. This was the first time that I can remember that you guys went into a net debt position. And I think Kevan did mention that you guys are back into a net cash position now. But what needs to be done that -- for the future where you guys don't fall into the situation where you do kind of come close to that breakeven mark between net cash and net debt? And then with that, now that you've been in for a while, what's your view on net cash, net debt? Where would you like that to fall?

This is Kevan. If you go back historically, in Q1, we were indeed net cash. Even though we had liquidated at that time part of our short-term investments to pay for a put-call buyout during 2013. I think the main difference between then and now is that, of course, our borrowings with our Comerica Bank line are up. So in answer to your question, specifically, one thing that we're doing internally is putting heavy emphasis on managing our cash. We probably have 10 points of cash management, everything from cleaning up retention receivables to our pay schedules, making sure that we're paying our vendors according to term. And of course, part of that strategy is increasing our profits on our projects so that more cash is coming into the business. So you look at the dynamics of -- mostly, the debt is long-term debt related to our lines of credit. We do have the short-term investments, $21 million of long-to-short term, easy liquidatable bond portfolio. And so those dynamics, mainly regarded in cash flow and increased profits, we see that to be the long-term solution as far as net debt versus net cash.

And, Saagar, I just want to add a little more color to that. As the business tends to change a little bit, in particular, our focus on the Hawaiian operation, where we're seeing very robust margins is there is a significant investment in inventory in terms of the materials necessary to support our operations in Hawaii and the slightly longer payment terms that we are experiencing, both at the state and local levels in Hawaii. It's just a slower payment term. That's certainly a part of it. And I think that we're seeing the end result of the acquisition of the Utah subsidiary and in the put-call, which was in the first quarter, which was north of $20 million. So we're seeing sort of the end result of that acquisition, which actually happened, I guess, 4 or 5 years ago. But as Kevan mentioned, part of the process improvement we've made is real focus on cash management and making sure that we pay bills on time, we take discounts when appropriate, we take discounts and focus on cash management. And in terms -- I think, your final point of the question was do I feel about -- how do we feel about net cash, net debt? I'm not afraid to look at a net debt position if it makes sense to support growth in the long term. But I think it's always better to be net cash. I think it's going to shift as we look to grow the business. But right now, I'd like to see more cash on the balance sheet, but I think it's not as bad as it looked at the end of the quarter, for sure.

Okay. And then last question for my part. You mentioned the 3 projects that have impacted you guys in the quarter. And then in the release, you mentioned site-specific issues. Could you go into more detail on what site-specific issues are, especially in those Texas operations? And then what you're doing to make sure that those kind of situations don't happen again.

Sure. And this is a result of a little bit of your earliest -- earlier question about the jobs, the larger projects that were bid in 2010 that had a longer horizon. For example, in the job in North Texas, we had anticipated labor costs in the bid back in 2010, we're now seeing those costs almost 30% higher and the quality of the labor is actually a lot lower. So we're projecting losses on the cost to complete. The losses on the project are not losses that were experienced before and we're just recognizing. This is recognition of our inability to complete the job for the budgeted cost to complete because the labor costs are now 30% more. And the quality of labor is actually significantly less. That is, I mentioned, one of those unavoidable situations; I'm not sure what we could do about that other than make sure that we take every precaution at bid time, anticipating labor cost 2 or 3 years out. And as you can imagine, that's a tough thing to do so -- hence our focus on smaller projects right now. The same is essentially true in Arizona. We talked about a loss in Arizona and it's a cost-to-complete issue for us. That is a project where we had the fatality as well. So a really hard focus on calculating cost-to-complete for that job resulted in the write down. As I said though, the good news is that these projects will all be substantially complete over the next 2 quarters. First quarter of 2014, they'll be no longer dragging our margins down.

Okay. And the reason I bring it up is that I think on the last quarter call, you guys had mentioned -- you gave a breakdown of your backlog that was booked prior to 2012 and then you gave a number of the amount of backlog and the margin from the pre-2012 time period that was at a certain percentage. Then you mentioned that approximately $185 million in Texas-related backlog was still susceptible to cost volatility? So were these 2 projects that had the issues part of that $185 million?

They were, yes.

Our next question comes from the line of Nick Coppola with Thompson Research Group.

I wanted to get a little bit more color on the drag from challenged projects we should expect in '14. Certainly, there was helpful color in the release about this $154 million of legacy backlog that's expected to burn off over the next 12 months. But what does the cadence look like there? I mean, even as we get into '14, should we expect kind of a significant drag from this low-margin work?

I think that the biggest drag are these 3 legacy projects and they're all in loss positions. And as I said to Saagar, they'll be burned off in the first quarter of '14. And of course, as we continue to burn them off as a percentage of the backlog, the overall gross margin of the backlog should continue to improve. And that's certainly a trend we've been seeing. I'm looking at a schedule of percentage of completion and they are all in the high percentage of the completion and while they may still be susceptible to some cost volatility, I think we've taken a relatively conservative posture on these projects. So will there be a major impact? I don't believe so. But there's always the risk of some impact.

Okay, that's helpful. And then kind of looking forward now at your opportunity set, I heard you mention the $620 million of projects you're actively pursuing. Were there any specific larger projects in there? And I heard you talk about Texas being more of a smaller project mix now, but is there anything -- any specific large projects maybe outside or inside Texas that we should be paying attention to?

Well, those were the large projects, $620 million that Brian talk about, he'll give you color on that in a second. We're looking at several billion dollars worth of bidding through the end of the year. And what Brian mentioned were the specific large projects that we look at in a slightly different lens, and I'll let Brian talk to that quick.

Sure. Thanks, Peter. The projects that I spoke about, they're spread across primarily Denver and Texas and the overall project size is large. But we entered into some JV arrangements. So one, in particular, we're in Texas a tri-venture on a $500 million project. And so part of that joint venture or arrangement [ph] is to spread some of that risk and make ourselves more attractive to an owner by the qualifications. So there's quite a number of projects that we are pursuing and looking at. The dollar volume is high overall, as Peter mentioned, on the alternative delivery. But then, we have also our bread-and-butter, low-bid type of work that we pursue everyday. I think in this year, we'll have pursued over 500 bids on work of that type of work.

Okay, that's helpful. And last question here. We know Kevan is here with us on an interim basis. Is there any update in terms of finding a permanent CFO?

Yes. I would hope that we're within 2 to 3 weeks of making an announcement on the final disposition of the CFO role here. We're in the last strokes of the decision. So you should hear it in the next couple of weeks.

Our next question comes from the line of John Rogers with D. A. Davidson. John B. Rogers - D.A. Davidson & Co., Research Division: A couple of things. I just want to make sure I'm thinking about this right and I appreciate the backlog in margin profile information. But given that you've got $154 million of essentially low-margin work to be completed into the first part of 2014, if you build to budget, does that imply that we're essentially looking at 4% gross margins over the next couple of quarters?

That's pretty close. As we look at backlog burn off, we have a forecast where we identify how much gross margins we're going to get from these various segments of projects, those bid before 2011. Those bid after, specifically what we're doing in 2013. And while there isn't a lot of gross profit to be recognized on this $154 million, average 2% for all of the projects in the legacy segment of projects; our chief goal, of course, is to stay on budget, especially with the new projects, the ones that aren't in that legacy and accelerate the production and completion as much as we can on these legacy projects, especially the big ones. As we do that, the gross margins will be lower, of course, on the ones that are in the legacy segment. But the real strategic goal is to work with those -- make those numbers better than we have actually estimated if we can wherever possible to keep the production and the profits, manage the change orders, et cetera, on the non-legacy projects and maximize the projects there. So we're using that strategy, trying and get through the tough ones. And as we improve our processes and stick to some of those core principles on project management that we already know what we need to do and where the improvements need to be, I think it will average out and we should be pretty close to forecast. John B. Rogers - D.A. Davidson & Co., Research Division: Okay. And I guess -- I mean, at those sorts of margin levels then -- I mean, you're probably unprofitable or close to breakeven, I mean, are there any -- there's no pressure from bonding companies or anything on that if you finish the year and then just based on the outlook for 2014 is there? Any concerns or anything to be aware of?

Not at all. And we have a very close relationship with our surety and they're almost like the family priest, they have to make sure they have complete visibility into the organization. And I did want to say, the $330-odd million that we had at the end of the quarter and the $460-something million that we have year-to-date that has highly accretive margins in it -- we had 11% at the end of the quarter and the stuff we're seeing, since the end of the quarter, is north of 15%. These are relatively short-duration projects. They should burn rapidly. So I think you'll see an accretive effect on that gross margin as the year pans out and completes. So like -- what you said was absolutely true, if we can accelerate this new work and use some of that better gross margin then we can ameliorate to some degree the drag of these legacy jobs. The big thing is we burn these things off and be done with them as rapidly as possible. John B. Rogers - D.A. Davidson & Co., Research Division: Okay. So some of this new work could be completed in 2013?

Absolutely. John B. Rogers - D.A. Davidson & Co., Research Division: Okay. And then the improvement in margins here that you've seen recently in terms of your bookings, is it the similar type of work or is it a different mix of jobs or anything there, water projects, overpasses or something that's given you opportunity to substantially improve margins, bid margins?

Well, yes, actually. The -- entering the Hawaiian market has given us much better margins in our core sort of work. Here, in Texas, we've done a lot more water transmission work, the operations in the intermountain states are doing more private work in terms of parking structures and assorted work along that line. So we have mixed up our portfolio of work and really focusing on shorter duration, higher margin, better risk profile work, that's what we're well-suited to do and that's what we need to focus on right now.

John, we're seeing more opportunities at municipalities and as we have population shifts as well or these federally mandated programs as the one in San Antonio that I mentioned. Certainly, in the early '90s through our subsidiary, Texas Sterling, did quite well during that time period on the sewer overflow program that was federally mandated there as well. So there's a -- there tend to be a large concentration of work. And it's not from traditional funding sources and is essentially a mandated program that needs to be completed within a defined time period. We're also seeing that in California where the Caltrans has less work but the municipalities are certainly picking up some of the pace. John B. Rogers - D.A. Davidson & Co., Research Division: Okay. And just lastly, if I could. Any significant large projects, megaprojects that you might be JV-ing on that we should be keeping an eye on?

The most recent one that I mentioned to Saagar was a project here in Texas. It's a 288 in Texas, which will be procured as a public-private partnership. We expect some results from our RFQ pursuits within the next 3 weeks. And that will be the most significant one that we have going currently.

[Operator Instructions] Our next question comes from the line of Paul Betz with BB&T.

I have some clarification questions. In the pre-release, you only mentioned 2 products, but in today's release, you mentioned 3. Did you know about this third one or -- before or did it pop up over the last 10 days?

The third project, Paul, was one we made reference to in the first quarter, which is a JV where we're in a minority position. And yes, it wasn't a surprise.

Okay. And then in today's release, you said the net charges were $18 million with about $13.9 million for the 3 projects. But I think you mentioned and the Q talks about $16.3 million, is that a year-to-date number, or is there something else that I'm missing?

Yes, the number in the Q was a year-to-date number. Whereas in the press release, we were trying to specify how much of that was in the second quarter.

Mr. MacKenna, we have no further questions at this time. I would now look to turn the floor back over to you for closing comments.

Thank you. This has been a challenging quarter for us. And in our effort to remain transparent to you all, we did come out with a pre-release and try to give you as much insight into the organization as is reasonable and prudent for us. And I hope you did get that from us. We remain cautiously optimistic about the future. Our order book is strong, and that is ultimately the way that we get out of this by growing the company with much better backlog, with much better margins in it, focus on our strengths and improve the company to take advantage of our ambition for the future. In the next few weeks, we will be announcing the final CFO search results and introducing the new CFO to you all and look forward to our third quarter call. Thank you very much.

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