Sterling Infrastructure - 10-Q quarterly report FY

Until October 2006, the Company had two operating entities, Texas Sterling Construction, L.P., which operates the Company’s heavy highway construction business and is based in Houston, Texas and Steel City Products, LLC (referred to herein as “Distribution” or “SCPL”).  Substantially all of SCPL’s assets were sold in October 2006, and on May 14, 2007, SCPL was merged into Sterling.  In the periods presented herein, SCPL’s operating results are presented as discontinued operations.  Effective June 29, 2007, Texas Sterling Construction L.P., merged into its general partner, Sterling General, Inc. (a wholly-owned subsidiary of the Company) and changed its name to Texas Sterling Construction Co.

The condensed consolidated financial statements included herein have been prepared by Sterling, without audit, in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.  The condensed consolidated financial statements reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the Company’s financial position at June 30, 2007 and the results of operations and cash flows for the periods presented.  Certain information and footnote disclosures prepared in accordance with generally accepted accounting principles have been either condensed or omitted pursuant to SEC rules and regulations.  Interim results may be subject to significant seasonal variations and the results of operations for the three and six months ended June 30, 2007 are not necessarily indicative of the results to be expected for the full year.

In May 2007, the FASB issued FASB Staff Position FIN 48-1, an amendment to FIN 48, which provides guidance on how an entity is to determine whether a tax position has effectively been settled for purposes of recognizing previously unrecognized tax benefits.  Specifically, this guidance states that an entity would recognize a benefit when a tax position is effectively settled using the following criteria: (1) the taxing authority has completed its examination including all appeals and administrative reviews; (2) the entity does not plan to appeal or litigate any aspect of the tax position; and (3) it is remote that the taxing authority would examine or reexamine any aspect of the tax position, assuming the taxing authority has full knowledge of all relevant information relative to making their assessment on the position.  The Company applied the provisions of this FASB Staff Position in conjunction with the adoption of FIN 48.

On October 27, 2006, the Company sold substantially all of the assets of SCPL to an industry buyer based in Toledo, Ohio.  The Company received proceeds from the sale of $5.4 million, which included a two-year promissory note in the amount of $650,000.  From the proceeds, the Company repaid SCPL’s revolving line of credit in full and retained and settled certain liabilities primarily related to severance and bonus payments.  The Company reported a pre-tax gain on the sale of $249,000 in 2006, equal to $121,000 after taxes.  The Company retained an account receivable, which it believes is fully collectible and recorded liabilities related to the right of the purchaser to request payment for certain inventory not sold within a year and for legal claims which remained unresolved at the sale date.

In the first quarter of 2007, the Company resolved certain of the legal claims and adjusted its liability related to the payment of unsold inventory, which resulted in a $25,000 expense for the quarter.

Summarized financial information for discontinued operations is presented below (in thousands):

We recorded compensation expense of $858,000 and $492,000 for the six-month periods ended June 30, 2007 and 2006, respectively, and $441,000 and $308,000 for the quarters ended June 30, 2007 and 2006, respectively, related to restricted stock grants and stock options outstanding for the periods then ended.  Unrecognized compensation expense at June 30, 2007 for the unvested portion of restricted stock granted was $175,000 and for unvested options was $556,000.

In May 2007, the six independent directors of the Company were each granted 1,598 shares of restricted stock at the market price on the day of grant, or $21.90, which will vest over one year.

Proceeds from the exercise of 50,824 and 112,654 options for the three and six months ended June 30, 2007, respectively, were approximately $106,000 and $175,000, respectively.  At June 30, 2007 there were 432,745 shares of common stock available under the 2001 plan for issuance pursuant to future stock option grants.  No options were granted in the six months ended June 30, 2007 or June 30, 2006, respectively.

This quarterly report on Form 10-Q includes certain statements that are, or may be deemed to be, “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”).  These forward-looking statements may be included throughout this report, including in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in “Risk Factors”, below and relate to matters such as our industry, business strategy, goals and expectations concerning our market position, contract backlog, future operations, margins, profitability, capital expenditures, liquidity and capital resources and other financial and operating information.  We use the words “anticipate,” “assume,” “believe,” “budget,” “continue,” “could,” “estimate,” “expect,” “forecast,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “will,” “future” and similar terms and phrases to identify forward-looking statements in this report.

Forward-looking statements reflect our current expectations regarding future events, results or outcomes.  These expectations may or may not be realized.  Some of these expectations may be based upon assumptions or judgments that prove to be incorrect.  In addition, our business and operations involve numerous risks and uncertainties, many of which are beyond our control, could result in our expectations not being realized or otherwise could materially affect our financial condition, results of operations and cash flows.

Actual events, results and outcomes may differ materially from our expectations due to a variety of factors.  Although it is not possible to identify all of these factors, they include, among others, the following:

Any forward-looking statements included in this report are made only as of the date of this report, and we undertake no obligation to update any information contained in this report or to publicly release the results of any revisions to any forward-looking statements that may be made to reflect events or circumstances that occur, or that we become aware of, after the date of this report, except as may be required by applicable securities laws.

Gross profits increased by $0.7 million, reflecting the increase in revenues, offset by a decline in gross margins to 11.3% for the three months ended June 30, 2007 from 12.2% in the prior year period.  The decrease in gross margins was due to a lower average margin in backlog this year compared to the prior year, and the rainfall that affected this year’s second quarter, which adversely affected productivity.  These negative factors were offset, in part, by improved gross margins earned on several projects nearing completion in the period, and a reduction in costs associated with the re-design of certain contracts.

General and administrative expenses, net of other income decreased slightly compared with the prior period, despite the increase in revenues, as these expenses do not vary directly with the volume of work performed on contracts in progress, leading to a reduction in the percentage of these overheads to revenues.

The increase in operating income resulted from the increased gross profit combined with the reduction in overheads.

In the second quarter of 2007, interest income increased by $91,000 compared with the second quarter of the prior year.  The increase was due to interest earned on higher cash balances and short-term auction rate securities throughout the period, which resulted principally from proceeds received in the mobilization phase of certain contracts, to the unutilized portion of the proceeds of our 2006 equity offering, and to higher interest rates.  Interest expense in the second quarter of 2007 was approximately $42,000 compared with interest expense of $20,000 in the prior year.

Our effective income tax rate was 33.5% and 34.7% for the three months ended June 30, 2007 and 2006, respectively.  The decrease in the effective tax rate is a result of an increase of non-taxable income from investments in municipalities.  Approximately $0.9 million of net operating loss carry forwards remain at June 30, 2007 to offset future taxable income.  As described in Note 10, we adopted the provisions of FIN 48 in the first quarter of 2007.  Such adoption did not result in an adjustment to retained earnings.

Gross profits decreased by $0.3 million, despite the higher revenues this year, due to a decrease in gross margins to 9.8% for the six months ended June 30, 2007 from 12.0% in the prior year period.  The decrease in gross margins was due principally to the lower average margin in backlog this year, compared with the prior year, and to the wetter weather in the period, which adversely affected productivity.  These factors were partly offset by certain positive contract results in the second quarter of fiscal 2007, as described above.

General and administrative expenses, net of other income decreased slightly compared with the prior period, despite the increase in revenues, as these expenses do not vary directly with the volume of work performed on contracts in progress, leading to a reduction in the percentage of these overheads to revenues.

There was a slight decrease in operating income due to the decreased gross profit, offset by the decrease in overheads.

In the first half of 2007, net interest income increased by $277,000 compared with the prior year period.  The increase was due to interest earned on higher cash balances and short-term auction rate securities throughout the period, which resulted principally from proceeds received in the mobilization phase of certain contracts, and to the unutilized proceeds of our 2006 equity offering, and to higher interest rates.  Interest expense in the first half of 2007 was approximately $67,000, of which $15,000 was capitalized as part of our construction in progress, compared with interest expense of $114,000 in the prior year period.

Our effective income tax rate was 33.6% and 34.3% for the six months ended June 30, 2007 and 2006, respectively. The decrease in the effective tax rate is a result of an increase of non-taxable income from investments in municipalities.  Through the periods reported, the Company’s federal income taxes were largely offset by net operating loss carryforwards.

Significant non-cash items included in operating activities are:

●           depreciation and amortization, which for the first six months of the current year totaled $4.7 million, an increase of $1.1 million from last year, as a result of the continued increase in the size of our construction fleet in recent years;

●           stock-based compensation expense increased by $0.4 million as a result of stock option grants in 2006 that were issued at significantly higher grant prices due to increases in our stock price.

The significant components of the changes in working capital are as follows:

●           contracts receivable increased $8.0 million in the current year, compared with an increase of $9.5 million last year, which are attributable to revenue increases and to higher levels of customer retentions;

●           cost and estimated earnings in excess of billings on uncompleted contracts increased by $3.4 million this year compared to last year’s decrease of $0.9 million, principally due to the higher volume of work in progress at June 30, 2007;

●            billings in excess of costs on uncompleted contracts increased by $3.3 million this year, compared with last year’s decrease of $1.7 million.  These changes principally reflect fluctuations in the timing and amount of mobilization payments received for the start-up of certain contracts;

●           trade payables, which increased by $6.7 million in the first six months of this year, compared with a decrease of $2.1 million in the first six months of 2006; these variations resulted from changes in the volume of materials and sub-contractors in the respective periods due to the change in the mix of contracts in progress.

Expenditures for the replacement of certain equipment, to expand our construction fleet and acquire real estate for materials handling, totaled $16.6 million in the first six months of 2007, compared with a total of $15.6 million of equipment purchases in the same period last year, which included the acquisition of certain drill shaft equipment of RDI.  In 2006, we began investing surplus funds generated by our equity offering into short-term auction rate securities as described in Note 4.

Financing activities in the first six months of 2007 primarily reflected the reduction of $5.0 million in the outstanding revolving line of credit balance.  In the prior year period, funds generated by the offering of common stock in January 2006 totaled approximately $27.0 million, net of expenses, and funds generated from the exercise of options and warrants in that period totaled $663,000.  In addition, in the first six months of 2006, $8.5 million was used to prepay all of the Company’s outstanding 12% five-year promissory notes held by members of management.

In addition to our cash balances and cash provided from operations, we use our revolving line of credit facility with Comerica Bank (the Revolver) to finance our capital expenditures and working capital needs.