UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For the quarterly period ended September 30, 2004
OR
Commission File No. 1-12911
GRANITE CONSTRUCTION INCORPORATED
Corporate Administration:
585 W. Beach StreetWatsonville, California 95076(831) 724-1011
Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes (X) No ( )
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (X) No ( )
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of October 29, 2004.
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Index
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PART I. FINANCIAL INFORMATION
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Item 1. FINANCIAL STATEMENTS (unaudited)
Granite Construction Incorporated
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Granite Construction IncorporatedNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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The components of comprehensive income, net of tax, are as follows:
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Disclosure
This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 regarding future events and the future results of Granite that are based on current expectations, estimates, forecasts, and projections as well as the beliefs and assumptions of Granite’s management. Words such as “outlook”, “believes”, “expects”, “appears”, “may”, “will”, “should”, “anticipates” or the negative thereof or comparable terminology, are intended to identify such forward-looking statements. These forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K under the section entitled “Risk Factors”. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this Report. Granite undertakes no obligation to revise or update publicly any forward-looking statements for any reason.
General
We are one of the largest heavy civil contractors in the United States and are engaged in the construction of highways, dams, airports, mass transit facilities and other infrastructure-related projects. We have offices in Alaska, Arizona, California, Florida, Minnesota, Nevada, New York, Oregon, Texas, Utah and Washington. Our business involves two operating segments: the Branch Division and the Heavy Construction Division (“HCD”).
Our contracts are obtained primarily through competitive bidding in response to advertisements by federal, state and local agencies and private parties and to a lesser extent through negotiation with private parties. Our bidding activity is affected by such factors as backlog, current utilization of equipment and other resources, our ability to obtain necessary surety bonds and competitive considerations. Bidding activity, backlog and revenue resulting from the award of new contracts may vary significantly from period to period.
The two primary economic drivers of our business are (1) federal, state and local public funding levels and (2) the overall health of the economy, both nationally and locally. The level of demand for our services will have a direct correlation to these drivers. For example, a weak economy will generally result in a reduced demand for construction in the private sector. This reduced demand increases competition for fewer private sector projects and will ultimately also increase competition in the public sector as companies migrate from bidding on scarce private sector work to projects in the public sector. Greater competition can reduce revenue growth and/or increase pressure on gross profit margins. A weak economy also tends to produce less tax revenue, thereby decreasing the funds available for spending on public infrastructure improvements. There are funding sources that have been specifically earmarked for infrastructure spending, such as gasoline taxes, which are not necessarily directly impacted by a weak economy. However, even these funds can be temporarily at risk as state and local governments struggle to balance their budgets. Conversely, higher public funding and/or a robust economy will increase demand for our services and provide opportunities for revenue growth and margin improvement.
Our general and administrative costs include salaries and related expenses, incentive compensation, discretionary profit sharing and other variable compensation, as well as other overhead costs to support our overall business. In general, these costs will increase in response to the growth and the related
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increased complexity of our business. These costs may also vary depending on the number of projects in process in a particular area and the corresponding level of estimating activity. For example, as large projects are completed or if the level of work slows down in a particular area, we will often re-assign project employees to estimating and bidding activities until another project gets underway, temporarily moving their salaries and related costs from cost of revenue to general and administrative expense. Additionally, our compensation strategy for selected management personnel is to rely heavily on a variable cash and restricted stock performance-based incentive element. The cash portion of these incentives is expensed when earned while the restricted stock portion is expensed over the vesting period of the stock (generally five years). Depending on the mix of cash and restricted stock, these incentives can have the effect of increasing general and administrative expenses in very profitable years and decreasing expenses in less profitable years.
Results of Operations
Revenue: Revenue from our Branch Division for the three and nine month periods ended September 30, 2004 increased over the corresponding 2003 periods by $65.9 million, or 16.6%, and $119.8 million, or 14.1%, respectively. The growth in revenue reflects increases in both public and private sector revenue and the sale of materials. The increase in private sector revenue and sale of materials reflects the increase in demand created by the continuing strong housing market in California and other Branch Division locations. The increase in Branch Division public sector revenue during the quarter was primarily due to greater revenue from local government agency work, partially offset by the decrease in state government agency work, particularly in California. We continue to experience reduced awards from the California State Department of Transportation due to the continuing budgetary uncertainty in the state (see “Outlook”).
Revenue from our Heavy Construction Division for the three and nine month periods ended September 30, 2004 increased over the corresponding 2003 periods by $53.8 million, or 29.3%, and $124.0 million,
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or 24.6%, respectively. Included in HCD revenue during the three and nine month periods ended September 30, 2004 is $30.2 million and $78.9 million, respectively, resulting from the consolidation of our partners’ share of construction joint venture revenue under FIN 46, “Consolidation of Variable Interest Entities” (“FIN 46”) (see Note 7 to the Condensed Consolidated Financial Statements). The remaining increase was due primarily to the increase in volume from a higher backlog at the beginning of the respective periods in the Northeast.
Backlog: Heavy Construction Division backlog of $1.7 billion at September 30, 2004 was $333.1 million, or 24.2%, higher than the HCD backlog at June 30, 2004 and $293.4 million, or 20.7%, higher than the HCD backlog at September 30, 2003. Included in the HCD backlog at September 30, 2004 and June 30, 2004 was $305.1 million and $105.1 million, respectively, resulting from the consolidation of our partners’ share of construction joint venture backlog under FIN 46 (see Note 7 to the Condensed Consolidated Financial Statements). Additions to HCD backlog in the current quarter included a $390.4 million joint venture design-build freeway improvement project in California; a $135.6 million joint venture design-build highway reconstruction project in Minnesota; and a $58.9 million interchange reconstruction project in Florida. As described in Note 7 to the Condensed Consolidated Financial Statements, we began consolidating certain of our joint ventures under the requirements of FIN 46 in 2004. As a result, 100% of the backlog of consolidated joint ventures is included in our backlog, including the two joint venture awards mentioned above.
Branch Division backlog of $606.8 million at September 30, 2004 was $53.3 million, or 8.1%, lower than Branch Division backlog at June 30, 2004 and $124.4 million, or 25.8%, higher than Branch Division backlog at September 30, 2003. The decrease in backlog compared to June 30, 2004 reflects normal seasonal variation in the timing of awards and construction activity. The increase in backlog compared to September 30, 2003 reflects an increase in both private and public sector awards, primarily in western states other than California. The increase in public sector backlog at September 30, 2004 compared with September 30, 2003 reflects an increase in backlog from local government agency projects, partially
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offset by the decrease in backlog from state government agency projects. A sizeable percentage of Branch Division anticipated contract revenue in any year is not reflected in our backlog due to the short duration of smaller Branch Division projects that are initiated and completed during each year.
Gross Profit: We recognize revenue only equal to cost, deferring profit recognition, until a project reaches 25% completion. Because we have a large number of projects at various stages of completion in our Branch Division, this policy generally has little impact on the Branch Division’s gross profit on a quarterly or annual basis. However, HCD has fewer projects in process at any given time and those projects tend to be much larger than Branch Division projects. As a result, HCD gross profit as a percent of revenue can vary significantly in periods where one or several very large projects reach 25% completion and the deferred profit is recognized or conversely, in periods where backlog is growing rapidly and a higher percentage of projects are in their early stages with no associated gross margin recognition.
Additionally, we do not recognize revenue from contract claims until we have a signed settlement agreement and payment is assured and we do not recognize revenue from contract change orders until the contract owner has agreed to the change order. However, we do recognize the costs related to any contract claims or pending change orders when they are incurred. As a result, our gross profit as a percent of revenue can vary during periods when a large volume of change orders or contract claims are pending resolution (reducing gross profit percent) or, conversely, during periods where large change orders or contract claims are agreed to or settled (increasing gross profit percent). Although this variability can occur in both our Branch Division and HCD, it is more pronounced in HCD because of the larger size and complexity of its projects.
Gross profit as a percent of revenue in the Branch Division was negatively impacted by the larger volume of work performed on jobs less than 25% complete which grew from $12.3 million to $27.3 million for the three months ended September 30, 2003 and 2004, respectively, and from $13.0 million to $28.9 million for the nine months ended September 30, 2003 and 2004, respectively. Additionally, the Branch Division incurred costs in the first quarter of 2004 of approximately $1.4 million associated with the closing of certain ready-mix concrete plants in preparation for their subsequent sale during the quarter (see Note 15 to the Condensed Consolidated Financial Statements).
HCD gross profit as a percent of revenue for the three months ended September 30, 2004 and 2003 reflect increased cost forecasts for several HCD projects, including approximately $4.0 million recognized in connection with two projects in the third quarter 2004 primarily due to delays and estimated rework
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resulting from the unusually wet third quarter weather in Florida and New Mexico (see Note 3 to the Condensed Consolidated Financial Statements). Additionally, the HCD gross profit margin in the third quarter 2004 was slightly negatively impacted by the increase in volume of work performed on jobs less than 25% complete, which grew from $32.8 million to $44.1 million for the three months ended September 30, 2003 and 2004, respectively. On a year to date basis, HCD gross profit as a percent of revenue fell to 5.3% in 2004 from 8.5% in 2003 due largely to the recognition of higher costs related to changes in estimated cost to complete eight large projects (see Note 3 to the Condensed Consolidated Financial Statements).
Cost of revenue consists of direct costs on contracts, including labor and materials, subcontractor costs, direct overhead costs and equipment expense (primarily depreciation, maintenance and repairs and fuel).
General and Administrative Expenses: Salaries and related expenses in the three months and nine months ended September 30, 2004 increased $0.8 million, or 4.0%, and $2.8 million, or 4.6%, respectively over the comparable periods in 2003 due primarily to a combination of higher payroll related benefits and normal salary increases. Incentive compensation, discretionary profit sharing and other variable compensation decreased in the nine months ended September 30, 2004 compared with the corresponding period in 2003 due primarily to lower Heavy Construction Division profitability in the 2004 period. Other general and administrative costs include information technology, occupancy, office equipment and supplies, depreciation, travel and entertainment, outside services, advertising and marketing, training and other miscellaneous expenses, none of which individually exceeded 10% of total general and administrative expenses.
Gain on Sales of Property and Equipment: The increase in gain on sales of property and equipment in the nine months ended September 30, 2004 as compared with the same period in 2003 was primarily due to a gain of approximately $10.0 million recognized on the sale of certain assets related to our ready-mix concrete business in Utah in the first quarter of 2004.
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Other Income (Expense): The decrease in equity in income of affiliates in the nine months ended September 30, 2004, compared with the corresponding period in 2003 was due to $18.4 million in income recorded in the first quarter of 2003 related to the sale of the State Route 91 Toll Road Franchise by the California Private Transportation Corporation, of which we are a 22.2% limited partner.
Provision for Income Taxes: Our effective tax rate decreased to 31.5% and 32.0% for the three and nine month periods ended September 30, 2004, respectively, from 36.2% for the corresponding periods in 2003 due primarily to the effect of consolidating our partners’ share of construction joint venture income under FIN 46 (see Note 7 to the Condensed Consolidated Financial Statements). Generally, our construction joint ventures are not subject to income taxes on a stand-alone basis. On October 22, 2004, Congress passed the American Jobs Creation Act of 2004 (the “Act”). The Act includes a deduction based on income from qualified domestic production activities which will be phased in from 2005 through 2010. We are currently evaluating the provisions of the Act and are investigating the impact of this new deduction on our future effective tax rate.
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Outlook
The economy in the western United States, where 70.7% of our third quarter 2004 revenues were generated, is steady. The Branch Division continues to experience continuing demand for private sector work in the residential, commercial and industrial markets. Our business is also benefiting from a strong public sector bidding environment in Arizona, Utah and Nevada. The state of California, however, continues to struggle, spending more than it is collecting in tax revenues. While Governor Schwarzenegger has pledged his support to increase transportation funding, the California Department of Transportation (“Caltrans”) has yet to increase the amount of traditional road construction work being bid. We remain hopeful, however, that funds budgeted for California transportation improvements will be converted into transportation projects in 2005. In 2004, local governments, such as cities and counties, provided unexpectedly strong funding, which drove much of our Branch business, and we expect that strength to continue next year.
Going forward, the strength of the private sector, as well as the local agency work and construction materials business will all play a key role in the Branch Division’s ability to maintain its current performance. In particular, there continues to be a healthy demand for its services and construction materials related to the residential, commercial and industrial markets in the West. The amount of Caltrans work available will depend in large part on several state and federal transportation funding issues that may or may not be resolved in 2005.
Many states continue to invest in large transportation projects (typically valued at over $100.0 million), which our Heavy Construction Division is well positioned to pursue. HCD recently opened an estimating office in Minneapolis where it is currently completing work on the $329.6 million Hiawatha Light Rail Design-Build project. In addition, the division is pursuing two projects in Canada. Although the division’s margin performance has, in part, been impacted by its rapid growth, we are taking steps to build the infrastructure to support our growth and return to traditional margins. All of our HCD regions: National, Texas, Southeast, Granite Halmar and Western are focused on improving project execution and performance. The Company’s outlook for an improved performance from HCD is contingent on an increase in gross margins on its projects going forward.
In an unusual twist of good news, the defeat of two gambling initiatives, Proposition 68 and 70, on the November 2nd ballot in California will help reinvigorate the state’s transportation accounts by as much as $1.2 billion. As part of the agreements made in June of this year between Governor Schwarzenegger and five Indian gaming tribes, the tribes will finance a $1.2 billion bond that will be used to accelerate repayment of Proposition 42 revenues previously borrowed from transportation accounts to close the budget deficit. The defeat of these propositions protects these gaming compacts and paves the way for this one-time early repayment to transportation. These funds could be available during the first half of 2005, provided litigation is resolved and the bonds are let.
From a federal perspective, the House and Senate approved legislation on September 30, 2004 to extend the federal highway, transit and safety programs through May 31, 2005. The sixth extension passed the House and was approved unanimously by the Senate and signed into law by the President. While the extension provides for another eight months of spending, the annual appropriations process is ongoing. Although many are interpreting the eight-month extension as the end of the Transportation Act for the 21st Century (“TEA-21”) reauthorization efforts for the year, that may not be the case. There also remains the possibility that other legislation, including TEA-21 reauthorization, could be brought up during the “lame duck” session after the November election.
After a lengthy debate, a permanent “fix” for the ethanol tax treatment problem as it relates to highway funding was adopted as part of the recent corporate tax bill. In the future, the 2.5 cents excise tax on ethanol will go to the Highway Trust Fund and the cost of the 5.2 cents per gallon differential treatment of
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ethanol will no longer negatively impact the Highway Trust Fund. The Associated General Contractors of America estimates that these changes will generate an additional $3.0 billion a year for transportation.
Looking at guidance for the current year, we expect the Branch Division operating income to be in line with its 2003 performance. In addition, we are no longer forecasting a large HCD project to reach 25% complete this year and now expect to recognize the associated profit for that project when it reaches 25% complete in 2005. Our fiscal year 2004 earnings guidance is in the range of $1.15 to $1.20 per diluted share. It is important to note that the amount of work we are able to complete in the fourth quarter can vary significantly due to weather.
In summary, although the outcome of the state and federal funding issues remain uncertain, we are confident that the on-going need to maintain and expand the capacity of our nation’s infrastructure will provide us with ample opportunity to continue to grow our business.
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Liquidity and Capital Resources
Our primary sources of liquidity are cash flows from operations and borrowings under our credit facilities. We expect the principal use of funds for the foreseeable future will be for capital expenditures, working capital, debt service, acquisitions and other investments. We have budgeted $58.0 million for capital expenditures in 2004, which includes amounts for construction equipment, aggregate and asphalt plants, buildings, leasehold improvements and the purchase of land and aggregate reserves.
Our cash and cash equivalents and short-term and long-term marketable securities totaled $259.5 million at September 30, 2004, and includes $68.3 million of cash from our newly consolidated joint ventures (see Note 7 to the Condensed Consolidated Financial Statements). This joint venture cash is for the working capital needs of each joint venture’s project. The decision to distribute cash must generally be made jointly by all of the partners. We believe that our current cash and cash equivalents, short-term investments, cash generated from operations and amounts available under our existing credit facilities will be sufficient to meet our expected working capital needs, capital expenditures, financial commitments and other liquidity requirements associated with our existing operations through the next twelve months and beyond. If we experience a significant change in our business such as the execution of a significant acquisition, we would likely need to acquire additional sources of financing.
Cash provided by operating activities of $45.4 million for the nine months ended September 30, 2004 represents a $36.6 million decrease from the amount provided by operating activities during the same period in 2003. The decrease was primarily due to lower net income in the first nine months of 2004 compared to the same period in 2003, cash of approximately $10.0 million used to purchase and develop properties held for sale, a decrease in cash flow from billings in excess of cost, net in the first nine months of 2004 and higher accounts receivable balances. Our costs and estimated earnings in excess of billings have increased from $42.2 million at September 30, 2003 to $61.0 million at September 30, 2004, due primarily to the growth in revenue from the 2003 to the 2004 period as well as an increase in the number of projects with billing provisions that require completion of discrete components of work rather than the more typical monthly unit price billing terms. Such billing provisions result in delays in our ability to bill and receive payment from the project owner. Our accounts receivable have increased from $326.8 million at September 30, 2003 to $434.4 million at September 30, 2004 due to the combined factors of the inclusion of approximately $41.0 million of accounts receivable from our newly consolidated joint ventures under FIN 46, higher revenue in the 2004 quarter and higher accounts receivable from retention provisions in our contracts, which are generally due upon completion of the projects and acceptance by the contract owner. The growth in retention receivables is largely due to an increase in the number of large HCD projects that are nearing completion at September 30, 2004 compared with September 30, 2003.
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Cash provided by investing activities of $28.0 million for the nine months ended September 30, 2004 represents a $68.1 million increase from the amount used by investing activities during the same period in 2003. The increase was primarily due to an increase in net maturities of marketable securities in the 2004 period which were reinvested in shorter-term cash equivalent investments to take advantage of recent changes in interest rates.
Cash used by financing activities was $27.8 million for the nine months ended September 30, 2004, an increase of $7.2 million from the same period in 2003. The increase was mainly due to $4.0 million used to purchase our common stock for contribution to the ESOP in 2004, and net distributions to minority partners in our consolidated construction joint ventures in 2004.
We had standby letters of credit totaling approximately $1.4 million outstanding at September 30, 2004, which will expire between February and April 2005.
In addition to our working capital and cash generated from operations, we currently have access to funds under a $100.0 million bank revolving line of credit, which allows for unsecured borrowings through June 2006. Outstanding borrowings under the revolving line of credit are at our choice of selected LIBOR rates plus a margin that is recalculated quarterly. The margin was 1.25% at September 30, 2004. The unused and available portion of this line of credit was $98.8 million at September 30, 2004. Additionally, our Wilder subsidiary has a bank revolving line of credit of $10.0 million that expires in June 2006. There were no amounts outstanding under the Wilder line of credit at September 30, 2004.
Restrictive covenants under the terms of our debt agreements require the maintenance of certain financial ratios and the maintenance of tangible net worth (as defined) of approximately $411.5 million. We were in compliance with these covenants at September 30, 2004. Additionally, our Wilder subsidiary has restrictive covenants (on a Wilder stand-alone basis) under the terms of its debt agreements that include the maintenance of certain ratios of working capital, liabilities to net worth and tangible net worth and restrict Wilder capital expenditures in excess of specified limits. Wilder was in compliance with these covenants at September 30, 2004. Failure to comply with these covenants could cause the amounts due under the debt agreements to become currently payable.
Website Access
Our website address is www.graniteconstruction.com. On our website we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. The information on our website is not incorporated into, and is not part of, this report.
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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There was no significant change in our exposure to market risk during the nine months ended September 30, 2004.
Item 4. CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision of and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended as of September 30, 2004. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
There was no change in our internal control over financial reporting during the quarter ended September 30, 2004 that materially affected, or is reasonably likely to materially affect our internal control over financial reporting.
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PART II. OTHER INFORMATION
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Item 1. LEGAL PROCEEDINGS
As disclosed in the Company’ Annual Report on Form 10-K for the years ended December 31, 2002 and 2003, our wholly-owned subsidiary, Granite Construction Company (“GCCO”), as a member of a joint venture, Wasatch Constructors, is among a number of construction companies and the Utah Department of Transportation that were named in a lawsuit filed in the United States District Court for the District of Utah. The plaintiffs are two independent contractor truckers who filed the lawsuit on behalf of the United States under the federal False Claims Act seeking to recover damages and civil penalties in excess of $46.4 million.
As disclosed in the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, plaintiffs’ Fourth Amended Complaint was filed on July 12, 2004. The Company and GCCO believe that the allegations in the lawsuit are without merit and intend to defend them vigorously.
We are a party to a number of other legal proceedings and believe that the nature and number of these proceedings are typical for a construction firm of our size and scope. Our litigation typically involves claims regarding public liability or contract related issues. While management currently believes, after consultation with counsel, that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse effect on our financial position or overall trends in results of operations, litigation is subject to inherent uncertainties. Were an unanticipated unfavorable ruling to occur, there exists the possibility of a material adverse impact on the results of operations, cash flows and/or financial position for the period in which the ruling occurs.
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Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the three months ended September 30, 2004, we did not sell any of our equity securities that were not registered under the Securities Act of 1933, as amended. The following table sets forth information regarding the repurchase of shares of our common stock during the three months ended September 30, 2004:
Issuer Purchases of Equity Securities
Item 3. DEFAULTS UPON SENIOR SECURITIES
None
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Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Item 5. OTHER INFORMATION
Item 6. EXHIBITS
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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