Description

Touting the potential for boosts to state and federal infrastructure spending programs while aggressively managing earnings, GVA is distracting investors from a recent deterioration in its earnings power due to 3-4 large ‘problem contracts’

Kicking the can down the road…

After Trump’s election victory, investors’ excitement over the new President’s proposed $1 trillion in infrastructure spending sparked a large rally in Engineering & Construction (E&C) stocks. Naturally, E&C companies that are full U.S. tax-payers with outsized exposure to domestic federal government contracts and/or that cater solely to infrastructure markets did especially well. Also, a wave of local and state infrastructure-spending measures passed on Election Day¹ fueled bullish sentiment further, amid hopes that more would get done at the state and local levels regardless of the climate in Washington.

Few stocks found themselves in the cross-hairs of these positive developments more than Granite Construction (GVA), a pure-play infrastructure E&C company with over 95% of revs geared to public entities with a tax rate in mid-30s.

From November 7th closing price to a peak of ~$62 some 20-days later, GVA appreciated +30%. GVA has now practically given back its entire post-election rally², and trades in-line to peers (~8x NTM EV/EBITDA) and at a ~1x premium to their own historical median (on top of inflated EBITDA estimates).

Why are estimates too high? On the surface, GVA appears to be a company with a fast-growing backlog and top-line well-positioned for a potential boost in U.S. infrastructure spending. But peeling back the onion, the health and quality of GVA’s growth since 2012 is wanting. Specifically, from 2012-16 GVA’s backlog has been concentrated in four large JV-contracts. In each, GVA is the minority partner. These contracts are bigger, longer and more technical in scope than GVA’s typical project. Fixed-price contracts are risky enough. But fixed price $850mm-$3.2bln projects 3-7 years in scope for which you have only 23-40% ownership are even riskier. Given the size, scope and complexity of these projects (and the competitiveness required to win them), these projects come with high risk of significant delays, cost overruns, and ultimately write-downs for GVA. It is this concentration of risky projects in GVA’s backlog, combined with clear evidence of cost overruns on its financials that lead us to believe that forward earnings estimates are far too optimistic.

Despite its problems, GVA’s management has done an effective job diverting investor’s attention to vague, uncertain opportunities on the horizon (i.e. FAST Act, California Bill, Trump’s infrastructure plans, etc.), dissuading investors from scrutinizing what amounts to ambiguous comments about project delays and cost-recovery disputes. This combined with aggressive accounting estimates has kept struggles to-date largely off the income statement. But GVA is merely kicking the can down the road. Once the 3-4 large contracts in question reach their completion date in 1.5-2 years, or possibly before, GVA’s aggressive estimates must square to reality, and investors hoping for uninterrupted profit growth are likely to be severely disappointed.

Key Investment Points

GVA forward estimates are inflated and their shares overvalued because:

• Street has been far too optimistic about the recent passage of the Fixing America’s Surface Transportation “FAST” Highway Bill. Past bill enactments have led to similar bouts of over optimism in GVA’s stock. Hype tends to get ahead of reality concerning the chances of these major transportation bills passing. This time appears no different, because total federal government aid and highway spending is expected to only grow at ~2% under the FAST Act³. Further, EBIT margins have not spiked persistently after the enactment of bills in the past. Nonetheless, consensus is calling for 150bps EBIT margin expansion over NTM, and FY17 EBIT margin of 5.2%, margin levels not sniffed since 2009, when GVA was arguably overearning and right before margins cratered in Q110.

• GVA’s Large Project Construction (LPC) segment is struggling more than investors appreciate due to promotional management plus opaque and aggressive accounting. GVA is likely facing cost overruns and delays in some or all their older, four major large projects (all unconsolidated joint ventures): Tappan Zee, I-35E in Texas (i.e. Dallas Horseshoe), I-4 Project in Orlando, and Penn Rapid Bridge. Management has cited reasons for recent struggles including weather, permits, plus design and scope changes, but has not pointed out the precise contracts at risk of overruns.⁴ GVA believes that a chunk of their delays and cost overruns are compensable items. Their customers disagree. Using aggressive revenue recognition after changing their accounting policy in January 2015, GVA is keeping the impact of these overruns off their income statement (for now).

• Evidence of problem contracts within their financials abounds. Declining LPC gross margins, an increase in dispute resolution claims against customers, and a recent spike in “unbilled receivables” balance all suggest problem contracts. Sharply rising unbilled DSOs for GVA has historically preceded sharp drops in their stock price. This time could prove similar.

• Construction margins have benefited from an increase in internal materials sales. The y/y spike in internal materials sales in 2016 helped Construction margins at the expense of their Materials segment (i.e. robbing Peter to pay Paul). At the same time, consensus expectations are expecting huge gross margin expansion within Construction Materials (after y/y decline in 2016) and continued expansion of gross margins for Construction. We believe this ignores the role internal sales of Construction Materials may have played in the Construction segment’s recent gross margin performance.

• Insider sales. Some insiders have been significant net sellers since 2013, which coincides with when GVA’s problems began.

• Street expectations are for perfect execution and record margins, despite company’s choppy historical track record. The Street is also calling for large incremental gross margins, some SG&A leverage across all GVA’s segments, and a level of operating efficiency, consistency, and execution that GVA has never demonstrated in the past.

Company Background

GVA operates in three segments: Construction (54% of ’16 revs; 69% of gross profit), LPC (35% revs; 21% gross profit), and Construction Materials (10% of rev; 9% of gross profit) (“CM”):

• Construction comprises construction management of projects focused on improvement of streets, roads, highways, bridges, site work, underground, power-related facilities, water-related facilities, utilities and other infrastructure projects. Typically bid-build projects completed within two years with a contract value of less than $75 million. Given their shorter duration and narrower scope, these contracts are less prone to cost overruns.

• LPC comprises large, complex infrastructure projects with longer duration (i.e. Tappan Zee bridge project). Contract values in this segment typically exceed $75mm are longer than 2 years in duration (some up to 7 years) and include design-build projects with bid-build and construction management/GC ones. LPC Gross margins (green line in Chart 1) have been declining – despite GVA’s efforts to inflate gross margins by delaying the true impact of cost overruns on fixed price contracts via aggressive revenue recognition and estimates. These aggressive estimates have likely flown under the radar of most investors, given they’re buried within the results of unconsolidated JVs.  

Chart 1: Gross Margins by segment

Source: Factset

• CM mines and processes aggregates and operates plants to produce construction materials for internal use and for sale to third parties. GVA both owns and leases aggregate reserves. GVA is vertically-integrated with their Materials segment providing aggregates and raw materials to their Construction segment. They also sell some of their materials externally. The percentage being sold internally was on the higher-end of historical range (39% in 2016 vs. 30-44% over last five years). GVA did not disclose the exact percentage of internal sales in 2015, but we expect towards the high end of that range to the benefit of Construction margins.

Most of GVA’s contracts are fixed price.

Chart 2: Fixed-price contracts as a % of total backlog

Source: Company filings

Those contracts that are not fixed price are “fixed unit price”, under which GVA shifts the risk of miscalculating the number of units for a project to the customer, but still has risk to the actual unit cost realized vs. that in the contract. Only 5% of GVA contracts are “other contracts types” – i.e. not fixed price or fixed unit price.

Looking to history for answers

GVA’s large concentration of fixed price contracts has led to issues in the past. In 2013, GVA’s non-GAAP EPS turned negative as gross margins declined dramatically in its LPC segment, “due to several projects that have completed or are nearing completion as well as projects which have not yet reached the profit recognition threshold, primarily in the Heavy Civil operating group. The decreases during 2013 were also attributable to a net increase of $25.5 million from revisions in estimates in 2013, down from a net increase of $64.6 million in 2012.”

In 2013, GVA suffered a big cost overrun related to one highway project in the State of Washington:

This quarter and throughout 2013, we have dealt with the ongoing negative impact from a large highway project in the State of Washington...During the year and including the third quarter, we incurred significant cost overruns related to unknown conditions at bid time, design issues, schedule delays, re-sequencing, and additional costs related to scope growth. In the last 12 months, we have reported approximately $50 million in negative forecast changes related to this single project.⁵

Gross Income for GVA in 2013 was down $50mm y/y ($185mm vs. $235mm), an amount that mirrors the level of overruns from that year. Adjusted EPS turned negative.

Chart 3: Adj. EPS by year

Source: Factset

In 2013, GVA maintained a more conservative posture towards potential recovery of dispute claims than it does now (i.e. in 2013, it forced cost overruns to hit its income statement right away):

We believe we have rights for a significant cost recovery on this project, which we are pursuing diligently. All of these items are included in an ongoing claim we have in process with the project owner. Now, please remember, we do not accrue for any estimated claim recovery. We only book revenue from a claim once it has been agreed to and executed by all parties.

Here was their revenue recognition policy on this matter from 2013 10-K:

We do not recognize revenue from affirmative contract claims until we have a signed agreement and payment is assured, nor do we recognize revenue from contract change orders until the owner has agreed to the change order in writing. However, we do recognize the costs related to any contract claims or pending change orders when such costs are incurred, and we revise estimated total costs as soon as the obligation to perform is determined. As a result, our gross profit as a percentage of revenue can vary depending on the magnitude and timing of the settlement of claims and change orders.

This policy, though, was troublingly changed to a more aggressive approach effective January 1, 2015:

Effective January 1, 2015, we changed our accounting policy for recognizing revenue associated with affirmative claims with customers and back charges to vendors, designers, and subcontractors. Claim revenue is recognized to the extent of costs incurred when it is probable that a claim settlement with a customer will result in additional revenue and the amount can be reasonably estimated…We believe these changes in accounting policy are preferable as they more accurately reflect the timing and amount of revenue earned on our projects, as well as providing better comparability to our industry peers.

“When it is probable” meaning when GVA estimates there will be revenue and it will be collected.

We will discuss this accounting change in more detail below. The point for now is that the nature of GVA’s contracts make them susceptible to cost overruns. GVA’s historical results have suffered mightily due to cost overruns (i.e. Washington project in 2013). In 2015, presumably as the Tappan Zee Bridge project was showing its first sign of delays, the company changes its accounting policy on “estimate claim recoveries” made against customers, recognizing revenue for the costs incurred as part of these claims. This is ultimately a lot more aggressive of a stance, and an approach that is far more prone to financial shenanigans. This change in policy will allow for the use of aggressive estimates to ultimately delay the day of reckoning associated with cost overruns from problem contracts.

Passage of federal and state funding bills unlikely to change the outlook materially

GVA management has used first the promise of the FAST Act, and more recently a possible California State Infrastructure bill and less so Trump’s infrastructure plan to highlight the potential for future contract bid opportunities in 2018 and beyond. The impact of these “promising” opportunities has been to distract investors from problem contracts, and to create the canvas on which to paint an unrealistically rosy outlook.

A historical analysis of backlog and sales suggest GVA performance depends less on the whims of government bills and more on general economic activity. Historically, GVA’s backlog has moved up and down in ~5-7 year cycles (with the current upcycle getting long in the tooth) with no discernible pattern of persistent backlog upticks after the government passes new, major federal spending bills.

EV/Backlog has swung from 0.4x (at cycle peaks) to 0.8x (at cycle troughs) with a median of 0.6x. EV/Backlog ended 2016 at ~0.6x,despite approaching a likely cyclical peak, and now stands at 0.5x:

Chart 4: EV/Backlog and Backlog with annotations marking key additions to backlog since 2012  

Source: Company filings

Despite these realities, management has been keen to turn investors’ attention to the potential for higher highway and water infrastructure spending thanks to the passage of new bills at the federal, state, and local levels. Regarding the state and local levels, GVA cites $200 billion worth of spending measures that passed on Election Day.⁶

But these promises with GVA follow a familiar pattern of hype followed by subsequent backtracking. Take the FAST Act.

In Feb. 2016, GVA management claimed the bill could “rapidly could change the capacity and pricing landscape” starting in the second half of 2016.⁷

Fast forward to Feb. 2017 earnings call:

Today at the federal level, the FAST Act, the long-term highway bill passed by Congress in December of 2015 has not yet provided a single incremental dollar of infrastructure investment. Congress continues to fund government spending by continuing resolution.

A “continuing resolution” puts the planned $2.4bln increase in FAST Act spending on-hold, while maintaining 2016 spending levels through at least April of this year.⁸ This stoppage of planned increases in federal spending has caused states to put more of their own projects on hold out of concern they will not receive enough federal funding to support them. Yet again, hype got ahead of reality.

Regarding a possible California Transportation bill, GVA management has not been very measured in their statements either, “We are maintaining our focus on the Governor and California legislators to deliver much overdue incremental investment beginning in [April] 2017.” But even if the bill were passed in April (not a done deal at all) they cautioned, “you would probably see stuff on the street, bidding by the end of the year and you would see it in our 2018 financials.” Further, it remains very uncertain whether Governor Brown can get the needed votes to pass anything.⁹

So outside of a few Election Day ballot measures¹⁰, GVA’s talk of a sustainable pipeline of opportunities on the horizon has been more than anything else, talk.

Regarding Trump, GVA has prudently been more cautious, “Although rhetoric from the Trump administration remains extremely constructive…we remain cautiously aware of how slowly Congress acts.”¹¹

Further, a read of recent American Road & Transportation Builders Association (“ARBTA”) data on U.S. Highway Awards suggests challenges for GVA.¹² In February, while monthly orders were up +16% y/y, this was due to outsized growth in Florida, North Carolina and Georgia. GVA’s core market, California, experienced declines (-36% y/y in Feb. primarily due to wet weather; -3% TTM y/y).¹³ Also, TTM y/y Highway orders overall have been declining since March 2016.  

It is undeniable our country needs more infrastructure spending and there are tons of “shovel-ready” projects in need of funding. What remains unclear, however, is the political viability of any changes to the current funding regime. A shovel-ready project that doesn’t get funding doesn’t do GVA or their peers any good.

Measuring the hype versus reality

Infrastructure spending needs ultimately must confront the cold, hard reality of political will. For GVA, this means that hype surrounding new spending bills are likely never to square with trends in its backlog, sales, and EBIT growth.

The below chart looks at GVA’s backlog and marks the passage of new major, federal spending bills:

Chart 5: y/y backlog growth with annotations for passage of major, Federal infrastructure bills   

Source: Company filings

A more helpful algorithm for understanding GVA’s backlog is: 5-7 year cycles of growth followed by cyclical downdrafts. Specifically, their historical backlog and sales experienced:

• Growth from 1999-2004

• Decline from 2004-2009

• Growth 2009-2016. But note, regarding this most recent cycle, hiccups in 2012-3 timeframe were followed by a period:

• From 2012-16 where GVA added $2.4bln in backlog growth entirely from four, chunky (and low/negative margin) LPC contracts plus acquired backlog from Kenny.

• Total backlog over this same time is up only by $1.8bln.

• This posits another interpretation of their historical backlog: since the Great Recession, GVA has failed to consistently and organically garner a steady flow of medium-sized, more profitable contracts. In exchange, it made an acquisition and aggressively bid on minority slots in large, complex, 3-7-year design-build JV contracts. It has deferred the consequences of this risky path to growth through aggressive accounting assumptions, but the day is reckoning is nigh.

Problem contracts in LPC likely foreshadow disappointing results

Before we dive into some aspects of GVA’s accounting that suggests the company has been overearning and deferring the day of reckoning related to some problem contracts, we scrub GVA’s large contracts to understand where they may be facing delays and recognizing revenue aggressively.

GVA’s disclosures are helpful in this task, given it defines what constitutes a large contract (>$75mm and longer than 2 years), and tells us when each large contract entered backlog, and the scheduled completion date of each project. With this information in hand, we can create a scorecard against which to measure their performance and possible project delays.

Assuming the LPC projects progressed in a straight-line fashion, here is such a scorecard:

Table 6: Large contracts from 2013 to present

Source: Company filings and press releases. Analyst Estimates.

With this method, we can arrive close to current backlog for LPC ($2,454mm). This would suggest that GVA is pulling backlog into revs on a schedule consistent with their projects progressing on-time towards the initially disclosed completion dates (in a linear fashion).

Their accounting (unbilled receivables, dispute claims, declining JV net income), however, suggests GVA could face delays/overruns in these same projects.

More on the accounting later. But first, it only takes a cursory read of media coverage around some of their biggest revenue-contributing JV projects to notice glaring discrepancies between how GVA depicts their progress (i.e. on-time) and reality. Shorting GVA consequently is partially an “over” bet on the over/under they finish the above contracts on-time and on-budget (and that their customers agree with who should incur cost overruns, if any). We like the over.

Further, 2017 consensus revenues - absent any new contract wins entering revs by year end - look elevated at present ($970mm vs. the $922mm our analysis suggests). Note, there have been no new announced LPC contract wins YTD. Management has guided to low double-digit revenue guidance. We can arrive at this by applying a 2016 “burn-rate” (i.e. Sales / Backlog from 12-months prior) to current backlog. This approach would mean $982mm in LPC sales, consistent with consensus. But given analysis above, this would likely require the addition of new LPC contracts into backlog in the coming months, or some revenue pull-forward. In our base case, we give management the benefit of the doubt on the topline for FY17, which could prove generous on our part.

Also, under-appreciated by investors: for at least three projects above, GVA is the “consolidating partner”. And included within GVA’s backlog (and future revs) are minority interests: Ohio Interceptor, South Hartford, and Colorado DOT. The first one of these appeared in Q315.

For these projects GVA is 65%, 65%, and 51% ‘consolidating partner’ respectively, but includes 100% of the contract size in their backlog. Taking out minority interests would reduce backlog by $200mm. Perhaps not coincidentally, making this adjustment would also result in flat sequential LPC backlog growth from the time they began this practice (Q315). This stagnant backlog growth could be taken as an additional sign of problems with existing LPC contracts, and that GVA is reorienting it entire approach to bidding on contracts: perhaps tightening bidding standards, passing on giant LPC JV contracts, being more conservative on price, etc.

Further, the delays we will highlight below address the chief problem with GVA’s heavy reliance on large contracts for sales and backlog growth. These delays raise questions about the quality of their backlog, and raise questions about the likely profitability to be realized as these backlog projects progress.  

From June 2009 to present, 77% of GVA’s backlog growth comes from acquisition (i.e. Kenny) or LPC-related growth. Paramount to the preservation of GVA’s growth narrative, and providing ample motive for their earnings management, is the premise GVA can execute these LPC contracts on-time and profitably. Evidence suggests it has struggled to do this since 2012.

One more thing to highlight before taking a closer look at the larger contracts. A news article concerning the Ohio project (one they won with Obayashi in a JV) suggests that GVA has won LPC bids due to aggressive price discounts. Obayashi/GVA’s winning bid of $184mm was 22% below the next lowest bid. The city of Akron had estimated the project would cost them $252mm.¹⁴

The large bid-to-cover spread from the Ohio project suggests that GVA could still be entering LPC contracts at unfavorable fixed-prices, setting them up for more, future cost overruns.

Evidence of delays

Now to the problem contracts. Below we highlight the four biggest revenue contributors and oldest LPC projects, for all of which there is evidence in the press of delays and cost overruns (note: management has said their issues pertain to “three individual contracts” – so likely 3/4 of the below):

• I-35E in Texas (i.e. Dallas Horseshoe): GVA has noted how this project had been affected by rainfall – so could behind schedule:¹⁵

…we are doing some big work in Dallas and it has affected – that's the IH-35 job. [The rainfall in mid-November in Texas] has absolutely affected that job. We've had a big – we had a big wet year at the beginning of last year as well that had a significant negative effect in Texas. Then it dried out. We made huge progress, but I would say that that job – one job there in Dallas itself has been affected by rain over the last 12 months.¹⁶

Partners on this project include FLR and BBY.GB. The project still has a completion date target of this summer, but there is risk this could get pushed back.

• Tappan Zee: An August 2016 NY Times article suggested the project is behind schedule, “The bridge is not progressing as fast as the first optimistic schedule had it (the Thruway Authority once said the first span would be ready early next year)…”¹⁷¹⁸ Now it is “towards the end of next year.” One reason cited for delays on the Tappan Zee project is the technical nature of the project and difficulty with land access, as the center of the bridge requires a 1.5-mile journey from shore.¹⁹

Partner on this is FLR. Per a recent update from office of Governor Cuomo, the bridge is expected to still open in 2018, which is on-time and on-budget (for New York State),²⁰ which may be wishful thinking given the first key project milestone was pushed back about 6 months. Also, regarding cost overrun disputes on this contract, NYDOT was GVA’s largest-volume customer in 2014-15. Potentially angering the NYDOT over who should pay for weather-related or other compensable items on the Tappan Zee may not be a good business strategy, even if viable, given NYDOT’s importance as a customer.  

• Penn Rapid Bridge: Per a presentation on the project, it is subject to Mobilization (upfront) payment, Milestone payments, and Availability Payment (which is not available until full completion of all 580 projects). This project should address roughly 4,500 structurally deficient bridges across the state of Pennsylvania.

Walsh/GVA JV is leading construction on the project. Some of the bridge construction within this project has been delayed due to permitting issues.²¹ The project ^{22 23} was originally supposed to be complete in 2017,²⁴ but is now slated for 2018 completion date.²⁵

• I-4 Project in Orlando: GVA partner noted on a recent call that the, “I-4 Ultimate road project - while construction is currently running a few months behind schedule, the expected completion date in 2021 has not changed.”²⁶

Partner JLG.GB with expected completion date being held steady at this point for 2021.

Management’s vague references to struggles has left much unanswered…

With this background, management’s ambiguous statements around delays become more troubling.

Management has refused to tie dispute recovery claims to specific contracts, making it more difficult for investors to assess the risk that these claims may turn out unfavorably for GVA. On the most recent earnings call James Roberts refused to name individual contracts when pressed in the Q&A, “…on some of the issues that are out there and I'm thinking about these three jobs that we discussed in preferably not giving any individual names, but let me give you some issues that are going on out there.” He then cited permits, weather, design, and scope issues without naming which projects they pertain to:

• “One of major projects we struggled mightily trying to get permit so that we can build the work out in front of us. And therefore, we have a significant impact on the schedule. We believe it's a compensable item with the owner. And the owner is working with us through a dispute resolution process.”

• “…we have significant weather that we believe contractually allows us to be compensated for whether or not just relative to an extension of time, but also compensable for additional cost to accelerate the job to get back into the original schedule if needed. Again, the owner in this case thinks that it's not a compensable item we do.”

• “Design issues. We've got design issues that have cropped up during the jobs, where the design changes, and we believe again those are compensable issues versus what we bid around.”

Weather, permit delays, and design changes all slow down projects and increase the costs. GVA feels these items were not accounted for in original contract. Their clients do. Further, in what seemed like an implicit admission that some of the design-related cost overruns were their fault, the CEO mentioned:

And we've stepped up our game internally at Granite. We've got a design management team now in place. We're working much closer with our owners on the newer projects. We're doing a much deeper review of contractual obligations relative to those issues I talked about. We believe we've got a really good handle on the work that we have recently bid, I'll call that in the last 12 months.

Why would a “deeper review of contractual obligations” be needed if the items on old contracts that GVA thinks are compensable were compensable?

Earnings Quality Poor

Against this backdrop of LPC project struggles, we became concerned with signs of problem contracts within GVA’s financial statements. Specifically:

• Rising Day Sales Outstanding (DSOs) - particularly “unbilled” receivables, which could suggest possible aggressive revenue recognition under percentage-of-completion (POC) accounting on GVA’s consolidated projects.

• Increase in “estimated cost of recovery of customer affiliate claims” – costs that GVA thinks their customers must compensate them for, for which their customers disagree (these pertaining to their unconsolidated LPC Construction JVs).

• Declining Gross Margins at Unconsolidated Construction JVs – since this is where the problem contracts reside. In FY16, gross margins on these projects declined to levels that make them negative earners after allocating overhead.

• Cash flow generation trailing earnings – 2016 marked a sizable gap in GVA’s cash flow from ops versus the sum of its net income and D&A.

We estimate the increase in recovery claims alone inflated EPS by as much as ~81% in 2016 (i.e. $26mm contribution to adjusted net income of $57mm for the year, or $1.42 vs. $0.78).

Further, in 2016 GVA inflated cash flow from ops by including excess distributions from Unconsolidated JVs (a ‘financing’ cash flow) within the operating section. Excess distributions contributed $8mm to CFFO in 2016.

Despite this, cash generation in 2016 significantly trailed net income, a classic earnings quality flag. Specifically, CFFO-to-Net Income plus D&A and stock compensation was 50% ($73mm vs. $144mm). This gap is entirely explained by the soaring receivables balanced (and helped somewhat by the inclusion of what’s effectively a financing cash flow in the operating section).

Days Sales Outstanding (Receivables/Sales) “DSOs”

The recent uptrend in DSOs begun back in the summer of 2012. This is right before their Kenny acquisition and the Tappan Zee bridge contract win – arguably two moves the company made to “scramble the egg” and obscure challenges elsewhere in their business.

Chart 7: Historical Day Sales Outstanding (“DSO)

Source: Factset, Company Filings.

DSO are now back at 2007 levels, and above a threshold (DSO of 60) that preceded large prior declines in GVA’s stock price:

More troublingly, “Unbilled DSOs” were up 17-58% y/y in each of the last 5 Q’s, which might suggest aggressive revenue recognition on consolidated results under percentage-of-completion accounting:

Chart 8: Historical Day Sales Outstanding (“DSO) vs. key threshold

Source: Factset, Company Filings.

Chart 9: Unbilled DSO quarterly year-over-year % change  

Source: Factset, Company Filings.

Recovery claims

Even more potentially damning to GVA’s growth narrative than the rising DSOs is the increase in “estimated cost recovery of claims” it has experienced over the last two years after a change in accounting policy at the start of 2015.

In 2016, GVA had $65.4mm of such claims (vs. $39.7mm in 2015 and $0 in 2014)²⁷ against its customers that arose from cost increases due to scope, design, weather, and permit issues. This amounts to over half the adjusted net income GVA generated over these two years combined ($117mm). GVA thinks these costs are compensable items. Its customers disagree. There is risk that GVA is making aggressive assumptions via this account to manage earnings.

What does this balance represent? Let’s say hypothetically the Tappan Zee project scope changes. GVA claims the costs attached to this changing scope were not covered in the original contract; and therefore, the contract must be amended to pay GVA for the new scope. The NYDOT says ‘the scope’ in question is encompassed within the language from the original contract.

Assume there were $20mm in costs under dispute in this hypothetical example. GVA would recognize revenue in association with these $20mm in unplanned costs incurred under POC accounting, all under the belief that the NYDOT will ultimately agree to the scope ‘change’ and pay GVA for the $20mm in costs under a new agreement. If NYDOT does not agree the scope has changed and persists the cost was included in the original scope, and the claim is settled for NYDOT, then the $20mm of GVA’s previously recognized revenue associated with this $20mm in costs under POC accounting becomes essentially a pull-forward of revenue, because it is now just a cost overrun on the original contract. At project completion, or possibly before if a dispute resolution occurs first or GVA makes a change to its estimate, GVA’s gross profit will be $20mm lower.  

These ‘estimated recovery claims’ are made within GVA’s unconsolidated JVs and have 100% flow-through to EPS, if you believe the claim amounts represent pure cost overruns on a fixed-price contract that will prove to have no attached revenue.

Here is the important disclosure:

Revenue related to affirmative claims with customers is recognized to the extent of costs incurred when it is probable that a claim settlement with a customer will result in additional revenue and the amount can be reasonably estimated.

“When it is probable” is simply an accounting estimate made by GVA management.

LPC Gross Profit is affected if estimated recovery claims ultimately are written-off and transferred to “estimated costs to complete” projects. Such a shift was the chief reason GVA cited for the 2016 y/y LPC Gross Margin decline:

The decreases were primarily due to net changes from revisions in estimates (see Note 2 of ‘Notes to the Consolidated Financial Statements’), including an increase to estimated costs to complete from outstanding affirmative claims, change orders and back charges.

Also, the $26mm rise in the claim balance in 2016 happened despite some apparent write-offs of claims into “expected costs to complete” given the above gross margin explanation.

The rising claim balance poses risks for future gross margin headwinds, if the resolutions don’t go in GVA’s favor.  

Four specific reasons make this rising claim balance at best a likely aggressive estimate, or at worst a blatant attempt to manage earnings:

1. Relative power of GVA’s customers (like NYDOT), and the contractual scrutiny that goes into a project like the Tappan Zee bridge render it hard to believe that NYDOT would come out on losing end of any dispute resolution;  

2. GVA’s minority ownership in the projects in question makes any negotiation more complex;

3. The history of overruns at GVA, and evidence of current projects facing delays, and;

4. Actions GVA has taken to better understand contractual obligations upfront suggests that maybe it did not do this in the past.  

Unconsolidated Construction Joint Ventures

How GVA is inflating EPS using aggressive dispute resolution claim estimates is not immediately obvious, because it is happening in their accounting for unconsolidated JVS. It is only through piecing together various footnotes and disclosures that it becomes clear. Here we provide more background on their Unconsolidated JVs to aid the reader in this process.

The value of GVA’s stake in their unconsolidated joint ventures will change every year from taking GVA’s equity share of the Unconsolidated JV times:

• The increase (decrease) in net income (net loss) from the JV

• Plus any contributions made to JV

• Less any distributions out of the JV

• Plus or minus any change due to accounting estimate adjustments

In 2016, GVA’s share of the net income of these unconsolidated JV’s was $15.6mm. GVA received $19.3mm in distributions and made $11.8mm in contributions to these same JVs. This would suggest a change in interest in the JVs of ~$8mm. The equity interest in JV’s increased, however, by ~$15mm, helped by the $26mm increase in claims offset partially by some other change in estimates (not clear based on the quality of disclosures what those might be).  

Chart 10: GVA Equity Interest in Unconsolidated Construction Joint Ventures

Source: Company 2016 10-K.  

From disclosures, included in Granite’s interest in these unconsolidated JVs are estimates for claim disputes.²⁸ This balance increased by $16mm in 2016 (to $65mm from $39mm in 2015. Note: this balance did not exist prior to a change in accounting policy from Jan. 2015).

As the footnote describes, this recovery claim amount is included in the value of GVA’s equity interest with no offsetting liability. To the extent this claim is never recovered, that entire $67mm could become a gross margin headwind. The increase in this asset balance contributed $16mm in earnings in 2016.

GVA’s “Risk Factors” spell out clearly the problems that could arise from these dispute claims not getting resolved favorably:

Our failure to adequately recover on affirmative claims brought by us against project owners or other project participants (e.g., back charges against subcontractors) for additional contract costs could have a negative impact on our liquidity and future operations… The potential gross profit impact of recoveries for affirmative claims may be material in future periods when they, or a portion of them, become probable and estimable or are settled. When these types of events occur, we use working capital to cover cost overruns pending the resolution of the relevant affirmative claims and may incur additional costs when pursuing such potential recoveries.

Further, GVA “Risk Factors” also note it could face penalty payments if some of its projects are not completed on time. And since it is a minority partner in big JVs like the one working on the Tappan Zee, this also subjects them to the poor performance of some of their JV partners. This is further motive for GVA to deny the realities of these key projects being behind schedule. GVA does not seem to take any reserves for possible penalty payments, which introduces further off-balance sheet risk.

Also, we get further evidence the JVs are struggling by the rapid decline from 2014-16 in GVA’s unconsolidated JV gross profit margins (from 11% in 2014 to 3% in 2016).

Chart 11: Unconsolidated Construction Joint Venture Gross Margins  

Source: Company 2016 10-K.  

After considering overhead allocation, these unconsolidated JVs are negative contributors to earnings. Only by looking at a buried footnote in the 10-K is this clear.

Note, just as the net income or profitability of these unconsolidated JVs are declining, the equity value of GVA’s interest in these JVs are increasing to the benefit of earnings, which fails a basic sniff test.

A final sign of stress at the JVs is evident in “deficit in construction joint ventures” for which GVA notes:

As of December 31, 2016, and 2015, [Equity in unconsolidated construction joint ventures] included $16.6 million and $8.6 million, respectively, of deficit in construction joint ventures that is included in accrued expenses and other current liabilities in the consolidated balance sheets.

This amount is a reserve or accrued liability that represents obligations in certain JVs which exceed the equity interest in that JV.  

Insider Sales

Management insider behavior does not instill confidence over the potential for problem contracts to get settled favorably.

CEO James Roberts from ~209k shares in 2013 down to ~168k:

Source: Bloomberg.  

Senior VP Michael Donnino position ~84k in 2013 to 57k:

Source: Bloomberg.  

Construction Materials Gross Profit

In 2016, gross margins in Construction Materials declined y/y, due to “to declines in external sales volumes and sales prices partially offset by a decrease in variable costs from improved efficiency at certain asphalt plants.”

When internal use of construction materials increases, this benefits Construction gross margins at the expense of Construction Materials gross margins. Investor expectations are ignoring this basic relationship by both extrapolating recent gross margin expansion in Construction AND calling for margin expansion in Construction Materials.

Street is positioning for 200-300bps of Construction Material Gross Margin expansion per annum, and no contraction in Construction margins. Note, if Construction margins reverted to its sub-10% average from 2010-14 vs. the ~16% 2019E embedded in consensus estimates, this alone would have a $100mm negative impact to EBIT 2019E consensus estimate of ~$260mm.

Chart 12: Gross Margin consensus expectations

Source: Factset. Analyst Estimates.

Also, improving Materials margins would likely require more external sales, which would mean less Construction unit volume y/y.

VALUATION

Consensus expectations are for 10%+ organic growth (with over $1bln in LPC revs in 2018) plus continued gross margin improvement in the Construction segment, and a rebound in gross margins for the LPC and Construction Materials segments after y/y declines in 2016.

Note, you must go back to 2004-06 for a period where GVA achieved multiple years of double-digit y/y revenue growth, something Consensus is calling for in 2017-18. GVA, however, with its growing dependence on unprofitable, large contracts is not the same business now as it was before the Great Recession.

In our base case, we give GVA credit for 11% FY17 y/y rev growth, but followed by 3% in FY18 and FY19, as key LPC projects reach completion, and promised bid activity/backlog replenishment fails to materialize.

Consensus considers no potential adverse impact from unfavorable resolution of estimated recovery claims (the balance of which has ballooned to ~$67mm, since GVA changed its revenue recognition policy in Jan. 2015). To model 2017-19 LPC Gross Margins in our base case, we assume average segment gross margins from 2010-16 of 11.7%, less $22mm of headwinds per annum in 2017-19 (essentially smoothing out an adverse resolution of claim recovery estimate over three years), which amounts to ~9.6% segment GM%. We assume 12.7% LPC gross margins in risk case.

We give them credit for continued margin expansion in Construction Materials, as they continue to grow external sales amid a broader pick-up in demand for aggregates. We plateau Construction margins, given the record gross margins in this segment over the last two years (~15.2% avg.) is some 600bps higher than where it averaged from 2010-14. This segment’s margins have benefitted from more Construction Materials being sold internally, but such a gain is not sustainable. There could be further upside to the short if Construction margins mean revert. Consensus is calling for improvement in Construction margins off inflated levels with a concurrent, vast improvement in Construction Materials margins, which together we do not think is achievable.

Putting this all together, we model GM% expansion company-wide (from 12% in FY16 to 13.6% in FY19), but far less than consensus expectations.

Consensus is calling significant operating leverage, with SG&A as a % of sales going down to 7.5% from 8.7% in 2016. We assume 8% of FY19 sales.

In our base case, we apply a 17x NTM P/E, 8x EV/NTM EBITDA and 20x P/NTM FCF which is in-line with both GVA’s 10-year median average and current peer median averages. We are not relying on multiple contraction – and have focused on getting “E” right.

We apply our NTM multiples to YE 2019 results to get to a 2019 price target that we expect to be realized by 12/31/18. In our base case, we get a target price of $29 versus current price of ~$49, for a ~26% IRR in our base case versus about 10% negative IRR, or $59 target, in our risk case.

A risk case where GVA’s tax rate falls to 20% would amount to $72 target price, or negative 24% IRR. This amounts to ~3:1 base-to-risk case with positive expected value by our estimates even if corporate tax reform came to fruition. There is additional upside to our base case if Construction margins mean-revert.

RISKS

• Further mega contract wins delay the day of reckoning.

• M&A risk amid consolidation of the E&C industry.  

This report (this “Report”) on Granite Construction (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold short positions tied to the securities of the Company described herein and stand to benefit from a decline in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their short exposure to the Company’s securities or establish long positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

[1] Measure M in L.A. County ($3 billion per year); Measure B in Santa Clara County; Measure X in Monterrey County, a measure in Stanislaus County (i.e. Central Valley of California). Sound Transit bill in State of Washington. C.f. Feb. 17, 2017 earnings call in Q&A for more commentary.

[2] $48,72 current price as of 3/17/2017

[3] https://www.transportation.gov/sites/dot.gov/files/docs/fhwa_fy2017_budget.pdf

[4] See Q416 Earnings call transcript from Feb. 17, 2017.

[5] Earnings call from Nov. 4, 2013

[6] See “Outlook” discussion from Feb. 17, 2017

[7] Earnings call from Feb. 25, 2016

[8] http://thehill.com/policy/transportation/309218-transportation-funding-boost-on-hold-due-to-stopgap-spending-bill

[9] http://www.latimes.com/politics/essential/la-pol-ca-essential-politics-updates-gov-jerry-brown-offers-a-bigger-plan-1484090897-htmlstory.html

[10] Measure M in L.A. County ($3 billion per year); Measure B in Santa Clara County; Measure X in Monterrey County, a measure in Stanislaus County (i.e. Central Valley of California). Sound Transit bill in State of Washington.

[11] Feb. 17, 2017 Q416 Earnings Call Transcript.

[12] Bloomberg Ticker “RTBAHWVD Index”

[13] Longbow Research report. “ARTBA: Oh Say Can You See…” March 20, 2017

[14] http://www.ohio.com/news/break-news/akron-to-save-68-million-on-winning-184-1-million-bid-for-ohio-canal-interceptor-tunnel-1.619131

[15] http://ftp.dot.state.tx.us/pub/txdot-info/dal/i35e/35e_project_tracker.pdf

[16] Feb. 25, 2016 Earnings Call Transcript

[17] http://www.nytimes.com/2016/08/04/nyregion/tappan-zee-bridge-project-reaches-halfway-point.html?_r=0

[18] http://www.lohud.com/story/news/local/tappan-zee-bridge/2015/11/09/delayed-first-tappan-zee-bridge-span/75454894/

[19] http://www.newnybridge.com/about/

[20] ww.newnybridge.com/governor-cuomo-announces-milestone-topping-off-and-completion-of-eight-main-span-towers-on-new-ny-bridge/

[21] http://triblive.com/local/plum/11228995-74/project-bridge-road

[22] DOT state of Ohio

[23] https://www.dot.state.pa.us/public/Bureaus/Press/P3/PennDOT_DBE_Presentation_RBR.pdf

[24] GVA press release from March 19, 2015

[25] http://triblive.com/local/valleynewsdispatch/11602775-74/road-bridge-bridges

[26] August 25, 2016 transcript

[27] From footnote, “Included in this balance as of December 31, 2016 and 2015 was $65.4 million and $39.7 million, respectively, related to Granite’s share of estimated cost recovery of customer affirmative claims. In addition, this balance included $5.6 million related to Granite’s share of estimated recovery of back charge claims as of December 31, 2016. There was no estimated recovery of back charge claims as of December 31, 2015.”

[28]  Included in this balance as of December 31, 2016 and 2015 was $65.4 million and $39.7 million, respectively, related to Granite’s share of estimated cost recovery of customer affirmative claims. In addition, this balance included $5.6 million related to Granite’s share of estimated recovery of back charge claims as of December 31, 2016. There was no estimated recovery of back charge claims as of December 31, 2015.

Catalyst

• Completion of the 3-4 problem contracts in the next 1.5-2 years – and unfavorable resolution of outstanding dispute claims.

• Economic downturn that crimps government spending (particularly at state and local levels) for infrastructure projects.

• Further delays and overruns at key LPC projects.

• Lack of new LPC contract wins to replenish LPC backlog “burn”.