Description

Thesis

Granite has been through two tough years which have left the company trading near a 30-year low P/B multiple of 1.3.   Four large JV contracts in Granite’s Heavy Civil Group have depressed earnings. Three of those contracts end mid-2020 and the fourth ends in 2021.   The end of those contracts should deliver a meaningful cash infusion and return to a more typical P/B multiple of 2.

Company Background

Granite Construction has a long history of operating as an infrastructure contractor and construction materials producer.   Founded in 1922, the company operates through Transportation, Water, Specialty and Materials segments. It builds roads, bridges and tunnels, installs and repairs water and wastewater facilities, installs solar fields and upgrades the power grid, and works on rail and mining infrastructure.

Granite is vertically integrated and faces little risk of obsolescence.    It controls more than 650 million tons of permitted construction materials and asphalt reserves across 54 quarries and 59 asphalt plants. The cost of transporting materials advantages Granite in its local markets, as does its long history with customers and on-the-ground-ready equipment and labor.

Temporary Negatives

Granite’s core operating results have been strong.   However, over the past decade, as public-private construction contracts got bigger, execution risks shifted to contractors.   Granite has experienced cost overruns on four legacy, unconsolidated JV projects. These projects were bid between 2012 and 2014 as design-build and fixed-price, with values ranging from $1 to $4 billion.   Each now involves disputes with project owners. Granite is contractually obligated to continue its work and recognize associated costs regardless of whether it agrees the work it has been instructed to perform is within the scope of the contract.   Compensation has been withheld from Granite despite completion of some projects and project milestones. Unanticipated costs, schedule delays and inability to book revenues have distorted earnings. Heavy Civil represented a 5% drag on revenue growth over the past three quarters, reducing operating profit by $214 million, while its core business grew high single digits.  These headwinds are set to be eliminated over the next two years. Roughly $200 million of work remains on the four legacy projects. Three of the four will be complete mid-2020 at the latest and the other is on track to be completed toward the end of 2021. 

Opportunity

Granite expects large cash collections as it resolves its disputes through negotiations or judgments and as it completes associated projects.   Granite is bearing costs as it progresses through the disputed projects but will not collect cash proceeds until project completion. Granite has referred to the potential for cash collection as being in the “hundreds of millions”.   Should the company receive $200 million, it would equate to 15% of enterprise value. Granite has been buying back modest amounts of stock and $190 million remains on its buyback authorization. A cash influx directed toward buyback of a stock currently trading at book value would seem compelling.

Going Forward

Granite is positioned to be much more consistently profitable going forward.    The contract procurement process has evolved favorably the past few years, with more deals structured under Construction Manager / General Contractor Project Delivery (CMGC).     These contracts are more transparent, incorporate more of Granite’s input on scheduling and pricing, and are more likely to be structured to protect Granite’s profit margin. The company has deemphasized fixed-price projects.  Granite’s project portfolio has become much more diversified and easier to execute. Its backlog consists of more than 4,000 jobs across 44 states, with 97% of contract values being less than $20 million and at an average project size of $2 million.   Backlog is now predominantly jobs where Granite is either solely involved or in the lead position.  

Appreciation Potential

Granite is guiding to 2020 revenue growth of 5% and adjusted EBITDA margins of 6.5% to 8.5%, which includes the impact of Heavy Civil not contributing anything to profits (but stabilizing, with no losses).  This margin midpoint is consistent with Granite’s average and median EBITDA margins over 1988-2018. Granite has often traded at an EV/EBITDA multiple of 6.5, a multiple currently assigned to other construction contractors and which should be justifiable again for Granite as the bad legacy contracts roll off.     These assumptions suggest a return of nearly 50% is possible to 2021. This does not include any cash consideration from the disputed contracts. Revenue growth should accelerate from the guided 5% level as the reduction in Heavy Civil business tails off this year (Heavy Civil is to be limited to 15% of revenue) and the core business continues to grow at high single digits.

Granite’s P/B has historically oscillated around a multiple of 2.0.   Currently it is 1.3. A return to a multiple of 2.0 offers 54% return potential on current book value.

Insider Buying

Six insiders, including the CEO and CFO, purchased stock during August to November 2019.  A total of $736,300 was purchased at an average price of $28, in line with the present stock price.

Tailwinds

Granite has good long-term tailwinds.  Current backlog (referred to as CAP, Committed and Awarded Projects) and alternative procurement work total $4.7 billion, an all-time high, up 44% from a year ago.   The company’s 2018 acquisition of Layne Christensen made it the #2 player in both Sanitary Storm Sewers and Water Transmission Lines while also broadening its geographic footprint.   There is opportunity to win construction contracts in new local markets, although without the benefit of vertical integration.

Granite expects strong revenue growth and improved profitability and cash flow through at least 2023.  Based upon announced public programs, Granite anticipates demand in its markets during 2021 to 2023 will mark “a midcycle point for today’s early stages of infrastructure investment expansion”. 

There is further potential on infrastructure spending.  A Senate Committee last summer unanimously advanced a bill proposing $287 billion in infrastructure spending over five years, including $259 billion to maintain and repair roads and bridges, areas where Granite is the #1 (highways) and #5 player respectively.   Should this bill become law before it expires in September 2020 it will represent a 27% increase from spending under the current FAST Act spending bill.

Multiyear infrastructure projects are underway in Granite markets, including California, where Granite is gaining share (SB1 Program), Washington, Utah and a $45 billion transportation infrastructure program in Illinois.  The American Society of Civil Engineers most recent Infrastructure Report Card calculates $460 billion in annual spending is required to improve the country’s infrastructure. This includes:

o   $271 billion in investment needed for wastewater treatment over the next 20 years.[1]

o   $836 billion in highway and bridge capital expenditure due to underinvestment.[2]

o   47,000 US bridges rated “structurally deficient” and requiring repair.[3]

Risks

-          Granite could be on the losing end of rulings on its four disputed JV contracts.   In July of 2019 Granite received notice of an unfavorable court ruling on one of the project disputes and took a $114 million Q2 charge.

-          Potential for additional unexpected costs beyond the $200 million expected on the four disputed contracts prior to completion.  

-          Potential for cost overruns on other larger Heavy Civil contracts bid during the same period as the disputed projects.  There are a couple of big jobs underway in 2020 which saw small Q3 2019 charges. Total Heavy Civil backlog is $1.7 billion, of which $700 million was bid in 2014-17, in addition to the four disputed contracts.

-          Backlog contains an increased number of smaller, shorter duration projects.  While the company states that it is bidding high margin contracts, the new contract mix may produce lower margins.

-          Short interest is 15.8% of shares outstanding.  Q4 results could deliver yet another quarter of further difficulties in Heavy Civil.

[1] American Society of Engineers, 2017 Infrastructure Report Card

[2] Tripnet.org, October 2018

[3] American Road & Transportation Builders Association, March 2019

Catalyst

Completion of four large, disputed, Heavy Civil JV contracts during 2020 and 2021