UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark one)
For the Quarter ended June 30, 2003
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 12 b-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 August 7, 2003.
TABLE OF CONTENTS
Index
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PART I. FINANCIAL INFORMATION
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Item 1. FINANCIAL STATEMENTS (unaudited)
Granite Construction IncorporatedCONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except share and per share data)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Granite Construction IncorporatedCONDENSED CONSOLIDATED STATEMENTS OF INCOME(Unaudited - in thousands, except per share data)
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Granite Construction IncorporatedCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited - in thousands)
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Granite Construction IncorporatedNOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Disclosure:
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 California, Nevada, Arizona, Utah, Washington, Oregon, Alaska, Texas, Georgia, Florida and New York. Our business involves two operating segments: the Branch Division and the Heavy Construction Division.
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, 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.
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 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 employees from those projects to estimating and bidding activities until another project assignment becomes available, 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 a very profitable year and decreasing expenses in less profitable years.
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Results of Operations
Revenue: Total revenue for the three and six month periods ended June 30, 2003 increased over the corresponding 2002 periods by $10.4 million and $43.4 million, respectively. Branch Division revenue for the three and six month periods in 2003 includes $55.8 million and $73.5 million, respectively, from our majority owned Wilder Construction Company (“Wilder”) subsidiary, which was consolidated in our financial statements beginning in May of 2002, versus $35.9 million in the three and six month periods in 2002. Excluding the Wilder revenue, Branch Division revenue for the three and six month periods ended June 30, 2003 decreased over the corresponding 2002 periods by $48.1 million and $44.7 million, respectively, due primarily to higher than normal rainfall during the first part of the second quarter in many of the areas the Branch Division works and the effects of a weaker general economy and uncertainty surrounding public funding, particularly in California (see “Outlook”). Revenue from our Heavy Construction Division increased 25.5% and 18.8% in the three and six months ended June 30, 2003 over the corresponding periods in 2002 due primarily to larger volume from a higher backlog at the beginning of 2003.
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Backlog: Our backlog at June 30, 2003 of $1,931.4 million was $343.4 million, or 21.6%, higher than the backlog at June 30, 2002. Branch Division backlog decreased by $34.7 million, or 6.1%, from June 30, 2002 to June 30, 2003, reflecting decreases in most of the areas the Branch Division works. The decreased Branch Division backlog reflects decreases in both public sector and private sector backlog which we believe is the result of a continued weak economy in most of the Branch Division locations and uncertainty surrounding public funding, particularly in California (see “Outlook”).
Heavy Construction Division backlog at June 30, 2003 of $1,395.2 million represents an increase of $378.1 million, or 37.2%, from its backlog at June 30, 2002 and $51.5 million, or 3.8%, from its backlog at March 31, 2003. HCD’s awards for the second quarter of 2003 included a $66.6 million highway contract in North Carolina, a $53.4 million dam project in Arkansas and a $91.2 million share of a highway bridge joint venture contract in Virginia.
Gross Profit: Gross profit as a percent of revenue decreased to 11.3% in the second quarter of 2003 from 13.9% in the second quarter of 2002 and to 11.2% in the six months ended June 30, 2003 from 12.5% in the corresponding 2002 period. Gross profit in the quarter and six months ended June 30, 2003 was negatively impacted by a higher volume of revenue from projects less than 25% complete. We recognize revenue only to the extent of cost, deferring profit recognition, until a project reaches 25% complete. The amount of revenue generated from projects below the 25% completion threshold was approximately $53.0
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million and $35.0 million for the three months ended June 30, 2003 and 2002, respectively, and $63.0 million and $48.0 million for the six months ended June 30, 2003 and 2002, respectively. Gross margins in the Branch Division were also negatively impacted by reductions in various state and local transportation funding programs, resulting in fewer projects being bid with increasing pressure on margins. Additionally, HCD gross margins were lower than expected during the 2003 quarter due to revised profit forecasts on several projects.
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). Although the composition of costs varies with each contract, our gross profit margins were not significantly impacted by changes in any one of these costs during the first six months of 2003.
General and Administrative Expenses: General and administrative expenses increased by $7.0 million in the six months ended June 30, 2003 from the comparable 2002 period and by $0.9 million in the quarter ended June 30, 2003 compared with the June 2002 quarter. Included in these increases were costs of approximately $6.3 million and $1.2 million for the six months and three months ended June 30, 2003, respectively, associated with our Wilder subsidiary and our expansion into Northern California, both of which were first reflected in our costs in May, 2002. Variable compensation decreased in the second quarter 2003 due to lower income than in the comparable 2002 quarter and increased in the six-month period ended June 30, 2003 due primarily to higher variable compensation associated with the CPTC investment income recognition (see “Other Income/Expense”). 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 expense.
Operating Income: Our Heavy Construction Division’s contribution to operating income decreased in the second quarter of 2003 compared with the second quarter of 2002 primarily due to the effects of lowered profit forecasts on several projects that were partially offset by the positive contribution from higher revenue during the 2003 period. For the six months ended June 30, 2003, HCD’s contribution to operating income increased due to the margin generated from higher 2003 revenue. Our Branch Division’s contribution to operating income decreased in both the quarter and six months ended June 30, 2003 compared with the same periods in 2002 due to the factors described in “Revenue”, “Gross Profit”,
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and “General and Administrative Expenses”, above. Unallocated other corporate expenses principally comprise corporate general and administrative expenses.
Other Income (Expense): Included in other income (expense) in the six months ended June 30, 2003 is $18.4 million recognized in the first quarter of 2003 related to the sale of the State Route 91 Tollroad Franchise by the California Private Transportation Corporation, of which we are a 22.2% limited partner. Additionally, included in other, net in the three and six months ended June 30, 2003 is approximately $1.9 million in gain recognized on the sale of a portion of our investment in T.I.C. Holdings, Inc. (“TIC”) back to TIC for a cash payment of approximately $6.0 million.
Provision for Income Taxes: Our effective tax rate decreased to 36.2% in the three and six month periods ended June 30, 2003 from 37.5% in the comparable periods in 2002 due to the combined factors of higher percentage depletion deductions related to quarry properties and higher tax credits.
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Outlook
Our outlook for the remainder of 2003 and into 2004 includes both challenges and opportunities. The short-term challenges are primarily caused by reduced transportation budgets and economic conditions we are experiencing in the West – particularly in California. On the positive side, we have a strong Heavy Construction Division (HCD) backlog and see continued demand for our services.
California Budget Overview
On the political front in California, after a 43-day stalemate, Governor Gray Davis signed the much anticipated fiscal year 2003-2004 budget. The California budget includes significant reductions to the state’s transportation budget using transportation funds to aid the General Fund. With California being the largest market for the Branch Division, this is a concern for us going forward and has created uncertainty in our Branch business, which will likely persist through 2004.
To date in 2003, the California Transportation Commission (“CTC”) has allocated $1.0 billion to new projects and suggested that an additional $800 million will be allocated over the fiscal year ended June 2004. This works out to $1.8 billion over an 18-month period, which annualizes to $1.2 billion. With new contracting from the California Department of Transportation (“Caltrans”) averaging around $2.4 billion annually over the past several years, the current construction contracting level amounts equate to a 50% reduction from the historic contracting level. It also remains questionable how much the program can, or will be, ramped up during the next fiscal year. In addition to the state budget, the amount that the CTC is able to allocate depends on the level of federal funding, state fuel tax revenues and truck weight fees. The State Highway Account has lost more than $150.0 million annually as a result of a 2000 state law restructuring the fees. Corrective legislation to prospectively restore these lost fees is pending in Sacramento.
Under Proposition 42, approved by voters in March 2002, revenue from the sales tax on gasoline that previously went to the General Fund was to be transferred into the Transportation Investment Fund (“TIF”) for transportation purposes, beginning in 2003-2004. However, the current budget requires that the Proposition 42 transfer be partially suspended with a total of $289.0 million being transferred to the TIF with the balance of $856.0 million remaining in the General Fund, which is to be repaid with interest by 2009. Of the $289.0 million portion transferred to the TIF, $189.0 million will be available for projects and the remaining $100.0 million allocated to the State Highway Account to repay prior loans to the Transportation Highway Congestion Relief Program.
Branch Division Outlook
As the volume of public sector work being put out to bid in California decreases, and areas of the private sector economy remain weak, we are seeing an increase in the number of bidders for the available work, which is creating pressure on project margins. We do not expect this pressure to let up in the foreseeable future. On the positive side, our Branch Division aggregate sales are holding up well compared to last year’s record levels. Although we are experiencing some softening of material prices, we continue to have success in selling our materials, in some cases, to those construction jobs on which we were the unsuccessful bidder. We feel that our quality control program and the ability to understand the issues from the contractor’s viewpoint gives us a unique advantage over some of the pure-materials suppliers. However, there is no reason to believe that the aggregate business will escape the same pricing pressure that we are experiencing in our Branch Division construction business.
While it is still too early to precisely predict what the specific impact of state and local funding reductions will have on our Branch business, we anticipate 2003 operating income for the Branch Division to be down approximately 20% from its 2002 level. However, some of the indicators discussed above suggest that even that level of performance will be a challenge.
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Federal Highway Bill Reauthorization
At the federal level, the House and Senate Committees are still working toward a six-year reauthorization bill to replace the current legislation, the Transportation Equity Act of the 21st Century (“TEA-21”), which expires September 30, 2003. Industry analysts are indicating that the reality of a six-year bill is increasingly unlikely. Expedient alternatives would be either a two-year or six-month extension, with the former being favored by the industry. There appears to be considerable sentiment in both houses and on both sides of the aisle to bring funding levels for transportation significantly higher than the levels being proposed by the Bush Administration. According to the American Road and Transportation Builders Association, the likely annual average funding levels could be in the range of $39.0 billion to $50.0 billion. The average annual funding level under TEA-21 was $28.8 billion.
Heavy Construction Division Outlook
HCD continues to participate in a very strong bidding environment across the country and has seen a significant increase in awards of large projects, including transit and rail projects over the past few years. HCD is taking aim at these new opportunities and pursuing new markets in Minnesota, Oregon, Washington and Virginia, while also actively bidding in its core geographic marketplaces, such as Texas, Florida and New York. As these projects are quite large and have been in the development pipeline for a longer period, they are not as influenced by current states’ budget problems.
In addition, HCD is targeting bidding opportunities from coast to coast, totaling more than $12.0 billion over the next twelve to eighteen months – excluding the approximately $2.0 billion in projects that our Granite Halmar office in New York is targeting throughout their area. The division is currently pursuing approximately 18 design-build projects, to which we feel our experience in the design-build area provides us with a competitive advantage. Through June 30, 2003, design-build projects made up approximately 28.0% of HCD’s backlog.
Going forward, we are focused on the relentless execution of our work in order to capture the operating income that our stakeholders deserve. We believe that our employees, diverse structure and financial strength will enable us to successfully navigate through these uncertain times and position our business to take advantage of the upturn when it does occur. We remain very encouraged about the short and long-term prospects for HCD and our Branches, despite the current difficult environment in California. We remain confident that the on-going need to maintain and replace our nation’s infrastructure will provide us with the opportunities to grow our business.
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Liquidity and Capital Resources
Cash provided by operating activities of $29.0 million for the six months ended June 30, 2003 represents a $17.6 million increase from the amount provided by operating activities in the same period in 2002. This increase was primarily attributable to a larger growth in accounts payable in the first six months of 2003 due to costs associated with higher revenue, partially offset by a lower increase in accounts receivable in the same period due primarily to a change in the mix between billed receivables and unbilled revenue (costs and estimated earnings in excess of billings). Changes in cash from operating activities primarily reflect seasonal variations based on the amount and progress of work being performed.
Cash provided by investing activities of $8.7 million for the six months ended June 30, 2003 represents a $32.3 million increase from the amount used in investing activities in the same period in 2002. The increase was largely due to cash received from the sale of the State Route 91 Tollroad Franchise by the California Private Transportation Corporation, of which we are a 22.2% limited partner and higher net maturities of marketable securities. We have budgeted approximately $59.0 million for capital expenditures in 2003, which includes amounts for construction equipment, aggregate and asphalt plants, buildings, leasehold improvements and the purchase of aggregate reserves.
Cash used by financing activities was $12.1 million for the six months ended June 30, 2003, a decrease of $9.7 million from the same period in 2002. The decrease was mainly due to lower net repayments of long-term debt by our Wilder subsidiary.
On June 27, 2003, we entered into an agreement for a $100.0 million bank revolving line of credit, which allows for unsecured borrowings for up to three years through June 27, 2006, with interest rate options. Outstanding borrowings under the revolving line of credit are at LIBOR plus margin (1.20% and 1.38% at June 30, 2003). This line of credit replaces a $60.0 million line of credit we entered into in June of 2001. Additionally, we have standby letters of credit totaling $1.5 million, of which $1.3 million reduces the amount available under the line of credit. The unused and available portion of the line of credit at June 30, 2003 was $98.7 million. Restrictive covenants under the terms of this line of credit include the maintenance of certain financial ratios and tangible net worth (as defined) of approximately $377.0 million. We are in compliance with these covenants and the covenants of our other debt agreements at June 30, 2003.
Additionally, our Wilder subsidiary has a bank revolving line of credit of $10.0 million that expires in June 2005, of which $6.5 million was available at June 30, 2003.
On July 28, 2003 we announced a quarterly cash dividend of $0.10 per common share. The dividend is payable October 15, 2003 to stockholders of record on September 30, 2003.
Our cash and cash equivalents and short-term and long-term marketable securities totaled $178.1 million at June 30, 2003. We believe that our current cash and cash equivalents, short-term marketable securities,
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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 at least the next twelve months.
Recent Accounting Pronouncements: In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities - an Interpretation of ARB No. 51.” FIN 46 addresses consolidation accounting for certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. As more fully described in our Annual Report of Form 10-K under the section entitled “Critical Accounting Policies,” we participate in various construction joint ventures in order to share expertise, risk and resources for certain highly complex projects. We are currently evaluating whether certain of these jointly controlled entities meet the definition of a variable interest entity in FIN 46. If all of the entities being evaluated met the definition and we were required to consolidate them, the result to our financial position would be an increase in assets (primarily current assets) of approximately $108.0 million and an increase in current liabilities of approximately $100.0 million. Additionally, consolidation of these entities would increase our revenue and cost of revenue, but there would be no impact on operating profit or net income.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. Our majority owned subsidiary, Wilder, has certain redemption features covering substantially all of its non-Granite common shareholders and we are currently assessing the applicability of SFAS 150 to these instruments. If it is determined that all of these instruments meet the requirements described in SFAS 150 we could record a long-term liability of approximately $22.0 million and a cumulative effect of a change in an accounting principle of approximately $10.0 million in our financial statements for the third quarter ended September 30, 2003.
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
In February 2003, we entered into two interest rate swap agreements in order to gain access to the lower borrowing rates normally available on floating-rate debt, while avoiding the prepayment and other costs that would be associated with refinancing our long-term fixed-rate debt. The swaps purchased have a combined notional amount of $50.0 million, a thirty-month term with six-month settlement periods and provide for us to pay variable interest at LIBOR plus a set rate spread and receive fixed interest of between 6.54% and 6.96%. The notional amount does not quantify risk or represent assets or liabilities, but rather, is used in the determination of cash settlement under the swap agreement. As a result of purchasing these swaps, we will be exposed to credit losses from counter-party non-performance; however, we do not anticipate any such losses from these agreements, which are with a major financial institution. The agreements will also expose us to interest rate risk should LIBOR rise during the term of the agreements. These swap agreements are accounted for under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Under the provisions of SFAS 133, we initially recorded the interest rate swaps at fair value, and subsequently recorded any changes in fair value in other income, net. Fair value is determined based on quoted market prices, which reflect the difference between estimated future variable-rate payments and future fixed-rate receipts.
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 (the “Exchange Act”)). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2003, our disclosure controls and procedures are effective for gathering, analyzing and disclosing the information we are required to disclose in the reports we file under the Exchange Act, within the time periods specified in the SEC’s rules and forms.
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PART II. OTHER INFORMATION
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Item 1. LEGAL PROCEEDINGS
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Item 3. DEFAULTS UPON SENIOR SECURITIES
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Item 5. OTHER INFORMATION
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Item 6. EXHIBITS AND REPORTS ON FORM 8-K
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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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