Description

I believe Granite Construction to be one of the better risk-adjusted short opportunities in today's market.  While most publicly traded equities have experienced significant declines in value during the course of 2008 and 2009, Granite Construction is one of the few that has actually appreciated, remaining 8% above ending 2007 levels.  On first look, one would think Granite would have been severely hit by the economic contraction.  Granite Construction is an E&C/Aggregates company tied to public and private construction spending with an emphasis on the California market; all of which have been significantly impaired by the economic downturn.  Despite these headwinds, Granite surprised investors and posted record earnings in 2008.  What the market has failed to appreciate, however, is that the strong earnings can be attributed to a series of one time benefits and ignored accounting adjustments. 

On valuation alone GVA appears expensive, trading at 12.0x trailing earnings and 16.5x headline forward earnings, well above peer multiples of 9.8x and 9.3x respectively.  More importantly, however, is the fact that:

 - 1) over $2.00 of the company's 2008 earnings were derived from one-time accounting related gains,

 - 2) GVA's backlog is down 18% over the prior year,

 - 3) the company's aggregate business is experiencing declining pricing and collapsing volumes,

 - 4) competition has increased substantially on new projects, and

 - 5) several major projects are rolling off in 2009, which are likely to substantially pressure earnings. 

Net net, I believe it is highly likely earnings fall significantly short of estimates this year.  I believe this decline in earnings coupled with a resetting of multiples back in-line with peers should yield a return of close to a 50% over the next 6-12 months. 

Business Overview:

Granite Construction operates two main businesses: construction and materials (excluding real-estate as it is not material) representing roughly 83% and 17% of operating profits respectively.  The construction business consists of a variety of projects including the paving of an individual's driveway all the way to the construction of an interstate highway.  Within the construction segment, Granite breaks the business into two segments, West and East.  The West business, representing 70% of construction profits, is tied to smaller projects (as of 10-K, eight contracts were in excess of $50mm in revenues on revenue base of roughly $2B) where there are no real barriers to entry, pricing is extremely competitive and the business therefore competes against players ranging from small mom & pops to large E&Cs.  While the business is mostly tied to public spending, the supply/demand of residential and commercial construction has a large derivative impact on margins and profitability.  With the current decline in the residential and commercial construction markets, out of work contractors have started to bid on smaller public projects (core GVA market).  For new contract awards, price is usually the key defining factor.  The East business, representing 30% of construction profits, focuses on larger infrastructure based projects including airports, dams, highways, etc.  Scale does matter and price, while not the only defining characteristic, is a key determinant in contract awards.  I view this segment to be a much better business as higher barriers to entry limits competition and allows for adequate returns over time.  For both segments, contracts are generally (69% as of last 10-K) fixed price  with a pass-through for major raw materials.  The company's aggregate business consists of mining rock in the California market and selling to both to its internal construction business and third parties.  

Accounting Adjustments:

As with most E&C companies, there is a tremendous amount of subjectivity when it comes to accounting.  Through percentage of completion accounting, Granite will estimate the margins associated with a given project, but recognize accounting gains or losses for the entirety of the contract when the profitability is running substantially above or below expectations.  If you dig through the 2008 10-K, you will see that Granite recognized $119mm of positive accounting adjustments in the west & east business.  Assuming a 31% tax rate, this accounting adjustment added $2.15 to earnings in 2008, meaning core earnings for the year came in at $1.06/share.  Management noted that roughly 50% of this gain can be attributed to the reversal of charges associated the settlement of claims on older projects. While one should not necessarily back out the entirety of the accounting adjustments, the magnitude of the benefit makes it very unlikely that the company will be able to repeat its 2008 performance.  After having discussions with the company, I believe we will likely see some positive adjustments continued in 2009, but nowhere near the magnitude of 2008.

 GVA also accounts for major projects under the 25% completion rule, meaning the company will recognize revenue but not gross profit for a major project until it hits 25% completion at which point the first 25% of the profits will be recognized at once.  Usually this has little to no impact on the business as Granite does not have many large multi-year contracts.  That said, the company recognized a $17mm operating income gain in Q4 on its ICC contract in Maryland.  According to the company, there are no large projects hitting this accounting threshold for the next few quarters, reducing the likelihood Granite can repeat this performance. 

Backlog/Prop 1B &Other Large Projects:

Granite's backlog is currently down 18% over the prior year due a runoff of temporary demand from Proposition 1B money, as well as the completion last year of a large border fence project.  

Quick overview of Prop 1B: In 2006 after Schwarzenegger came into office, the state of California passed Proposition 1B.  This bill allowed the state to sell $19.9B of bonds to fund a decade of infrastructure spending.  Given GVA's exposure to the CA market (50% of the business), this bill led to a substantial spike in profitability. Like any "Stimulus Bill", prop 1B ramped up quickly over the 2007 & 2008 period (part of the spending was front end loaded) and is now in the process of declining. Specifically, the funding is expected to drop by 28% in FY2010 (July of this year) from $4.1B to $3.0B (See Sheet 2 - http://www.dot.ca.gov/hq/transprog/ibond/070821_approps_and_trailer_bills.xls ).  This has been a source of higher margin business for GVA and should start to weigh on profitability in the back half of the year as spending has dropped off.  Additionally, the current budget crisis in California may result in additional funding delays as the state strives to conserve capital.

 To reinforce the magnitude of the current slowdown it is worth noting that new awards from CalTrans (great indicator of the West business) are down roughly 80% over Q1 last year.  In addition to Proposition 1B spending, Granite has benefited from a border fence project that contributed $350mm in revenues in 2008.  According to the company, revenues from this project will decline to $50mm in 2009 as the contract rolls off. Assuming a normal margin on the business, I would expect this shortfall will pressure EPS by roughly $.65 this year. 

Competitive Dynamics:

With backlog down across the industry, it is not surprising to see the competitive dynamics heat up.  If you look at Granite's construction business, margins have ranged from a low of 9.5% to a high last year of 18.5%.  While the business is mostly tied to public spending, the supply/demand of the residential and commercial construction markets have a large derivative impact on margins and profitability.  With the decline in the construction market, many out of work contractors have started to bid on smaller public projects simply because there is no business to be found in the residential or commercial market.  Further, the large increase in prop 1B money served to delay a dramatic increase in competition.  Now that many of these contracts are rolling off and the residential market continues to decline, the number of bidders per contract is spiking, and is likely to show up in Granite's margins over the next six months.  The California Dept of Transportation actually tracks this data on a monthly basis.  If you open the below link and click on the "Contract Progress Report" at the bottom of the page, you will see that the average bidders/contract have increased dramatically.  You will also see on the same chart that the average bid is now coming in well below the engineer's estimates.  I believe this to be a unique data point for margins and one that most of the street does not follow closely.  To revisit the margin sensitivity of the business, earnings would completely disappear in the event construction margins went back down to the 9.5% range. 

http://www.dot.ca.gov/hq/esc/oe/bidsopened.html

Aggregate Business:

Granite operates an aggregate business in California representing roughly 17% of operating profits.  The company uses 49% of the rock mined internally, with the remainder sold to third parties.  While I have a favorable view on US aggregate assets due to a long term pricing story, Granite is facing certain headwinds that are not prevalent in the rest of the country.  Granite operates quarries that are 1) heavily hit by the declining residential & commercial volumes in CA, and 2) in significantly more competitive markets v other players.  This can be attributed to a greater exposure to small mom & pop aggregate operators (highly focused on current cash flow and willing to cut price) as well as competition from water based players (much cheaper to ship over water v truck).  In many of Granite's markets, volumes are down 20-30% with pricing down double digits.  If you look at public commentary from competitors, Vulcan Materials has recently noted (last conference call) that the only region where pricing is under pressure is in the California market.  I will note that Vulcan's quarries are located in Southern California which are not experiencing the pricing compression as in Granite's markets.  Assuming a 20% decline in volumes & 2.5% decline in pricing, I estimate the aggregate business will likely experience a $.48 headwind in 2009.

Earnings Bridge:

While one can attempt to nail down earnings for 2009 it is difficult to develop a strong view on the exact margins embedded in the backlog or what the accounting adjustments are likely to be.  That said, I believe the table below provides a decent sense of the moving parts going into 2009.  I have assumed the company is able to offset some of the earnings declines via cost savings (assuming G&A declines at roughly 10% YoY - quite aggressive given recent results & discussions with the company) and some additional positive accounting adjustments.  While the earnings bridge is well below consensus, I will highlight that I have not factored in the decline in Prop 1B spending, margin contraction from greater competition in the smaller project E&C business, or any budgetary shortfalls in CA.

 At a multiple of 10-15x this would yield a price of $14.00-$21.00 per share or 48%-65% below current levels. 

Risks:

There are a couple risks to highlight, both of which are associated with public policy.  While I believe these events to be more a function of sentiment than true economic risk, it is worth addressing what can impact the equity in the short-term.   

 The Obama stimulus plan - Most are likely aware of the $787B stimulus plan signed into law earlier this year, which includes $27B of highway infrastructure spending.  Of the $27B, California has been allocated $2.6B of which 50% will put out within 120 to 180 days.  While this may sound like a large sum of funding, Granite's management does not intend to get much of this business.  They believe that heavy competition for these projects will result in unattractive margins.  Instead, Granite has decided not to bid on the majority of projects, waiting to see if market condition improves.  I believe this highlights the current competitive market in California and the difficult times ahead.

Expiration of SAFETEA-LU - The federal highway bill known as SAFETEA-LU will expire on September 30, 2009.  This bill serves as the backbone of highway infrastructure spending on a national basis and is a key driver of Granite's business.  Many industry sources are pushing for a large increase in annual spending in the next version of the bill, but there are a number of very large hurdles in the way.  The funding for this bill comes from the Highway Trust Fund, which generates its deposits from the federal gas tax.  Because this tax has remained the same for years its purchasing power has diminished over time.  When combined with a reduction in miles driven & greater fuel efficiency, the tax is no longer enough to sustain current SAFETEA-LU spending.  If Congress wants to increase federal highway spending for the next bill, it will need to increase the gasoline tax.  While not impossible, this is a politically sensitive issue as no congressman wants to be responsible for raising fuel based taxes in an economic downturn.  It is highly unlikely Congress will able to make any real progress putting together a new bill before the current one expires (last bill was extended roughly 18 months beyond original expiration). 

Catalyst

Earnings miss