Description
Granite Construction (GVA) is an engineering and construction company operating in the United States. We believe the company is in a strong position to capitalize on increased highway construction spending and currently trades at 14x P/E, which understates the earnings growth for the following years.
Company Description
Granite Construction Company serves both public and private sector clients and is comprised of many well-coordinated, highly professional teams of builders located across the nation. The company is best known for transportation infrastructure projects including roads, highways, tunnels, bridges mass transit facilities and airports. Granite also produces sand, gravel, ready-mix and asphalt concrete and other construction materials.
Granite West division serves local home markets in the western United States and builds smaller projects of shorter duration. Granite East builds larger, more complex jobs in their home markets of Texas, Florida, New York and surrounding areas.
Some basic numbers on GVA:
US$ 2005 2006
Revenues (M) 2,641 2,969
Net Income (M) 83 81
EPS 2.02 1.94
GVA results in the first half of 2007 have shown stable revenues and improving profitability due to the key drivers of our investment case described below. Current backlog is stable at US$ 2.5 billion.
Investment Case – Key drivers
1. Increased public spending on transportation infrastructure
There is a consensus that after years of under-investment the United States needs to increase funding to improve the transportation infrastructure. The Minnesota bridge collapse was a sad warning of these problems.
And it is already happening: according to US Census Bureau data, the public construction sector saw significant improvement, spending is up 12% yoy in 2007. State and local budgets are stronger, a report by the National Conference of State Legislators stated the national average of growth in surplus for FY07 was 25% yoy.
In California the situation looks even better. Governor Arnold Schwarzenegger passed Proposition 1B, comprising of $20 billion bonds to fund infrastructure renovation of the state. California Department of Transportation (Caltrans) budget increased 30% for this fiscal year and is expected to peak only in 2010.
Remember that California is Granite´s home area and the company has always been one of the major contractors for state and municipalities, so we expect the renovated funding to impact all GVA´s divisions: small projects, large projects and materials sales. It is important to note that E&C companies record earnings at percentage of completion method and projects only contribute to earnings after 25% completion status so the upside effect of the new Caltrans funding will be seen only in 2008 and for larger projects mostly in 2009.
2. Historical results do not correspond to GVA earnings power
Granite 2006 results were impacted by losses from some large projects from the former Heavy Construction Division (HCD) that roughly corresponds to current Granite East division. HCD posted operating losses of US$ 120 M, -12% operating margin.
We believe it is fair to assume a turnaround because:
- “Losing” projects were bid in a tougher environment for E&C, now companies have less capacity available and more pricing discipline;
- Granite reorganized the large projects division, people who were responsible for the bad bids no longer work for there and new standards for bids with appropriate contingencies were developed;
- The losing projects are being completed during the year of 2007 and interim results have not shown further deterioration.
Management now expects the division to break-even in 2007 at a lower revenue base (around -20% yoy) and return to profitability in 2008. They point to four key projects with significant profit potential over the next 12 to 24 months: US-90 in Mississippi, I-64 in Missouri, Inter-County Connector in Maryland and World Trade Center in New York. It is important to note that GVA participates as a subcontractor in the WTC project so the current backlog does not reflect the full revenue potential of the project that tends to be more than US$ 1 billion.
3. Valuable aggregates reserves
Granite is not a typical E&C company since it owns physical assets consisting of aggregate reserves and asphalt / concrete plants located in the Western states. The company produces its own supply of aggregates and asphalt and also sells the remaining materials to third party constructors. This integrated business model allows for guaranteed materials supply and lower project bids since GVA does not pay sales taxes on internally sourced materials.
GVA has nearly 800 million tons of aggregate reserves and in 2006 produced 25 million tons of aggregates, 7.5 million tons of asphalt and 450 cubic yards of concrete.
Aggregate reserves are very valuable due to the scarcity factor, particularly near big cities. The “not in my backyard” issue makes permitting new sources a very hard and time consuming process. The high transportation cost/ton relative to aggregate prices tends to create local monopolies with high pricing power. That has led to repeated price increases, especially in California that tends to have higher prices than the rest of the country.
The pricing upside drove gross margin at the materials division from 17.2% to 23.6% in 2006. 2007 price increases are in double digits even with volumes down due to the housing downturn. Based on current industry trends, we expect prices to grow at a slower rate in 2008 (7-8%) but well above inflation.
Recent transactions in the construction materials industry highlight the value of these properties, during this year Cemex bought Rinker and Vulcan acquired Florida Rock for prices above 10x EBITDA.
4. Low exposure to housing crisis
The stock has been affected by the housing downturn but housing represents only 7% of GVA´s construction projects. Although there was some reduction in materials volumes, prices were resilient and GVA was able to direct more of their materials to its own public works projects.
There is also some concern that housing contractors are going to compete more intensely in public works with GVA branches. In fact this is happening at the moment and we are modeling some margin decline for 2H/2007, but their capacity is very limited and they cannot match the resource pool, technical expertise, machinery and bonding capabilities of the larger companies. We expect that by 2008 the amount of work generated by the improved Caltrans funding will exhaust their capacity and put margins back on 2006 levels.
Valuation analysis
Granite Construction trades at 14.2x 2008 earnings (near 2004 lows) and 6.5x 2008 EBITDA based on consensus estimates and $ 54 stock price. We see potential upside from consensus eps, which we expect to move from 3.80 to 4.0 (see table below). We assumed for 2008 results:
· return to profitability of the large projects division but still below a “normal” 5% margin with a lower revenue base;
· revenue acceleration of the old branch division due to increased local funding in California.
|
|
2006 |
2007E |
2008E |
|
GVA |
|
growth% |
|
growth% |
|
growth% |
|
Branch/West |
1850 |
|
1980 |
7% |
2118 |
7% |
|
HCD/East |
1114 |
|
891 |
-20% |
891 |
0% |
|
Revenues |
2964 |
|
2871 |
-3% |
3009 |
5% |
|
|
|
margin% |
|
margin% |
|
margin% |
|
Branch/West |
264 |
14% |
238 |
12% |
254 |
12% |
|
HCD/East |
-137 |
-12% |
-18 |
-2% |
22 |
3% |
|
EBIT |
127 |
4% |
220 |
8% |
276 |
9% |
|
Other |
-8 |
|
-12 |
|
-15 |
|
|
Tax |
-38 |
|
-73 |
|
-92 |
|
|
Net Income |
80.5 |
|
135 |
|
170 |
|
|
EPS |
1.94 |
|
3.21 |
|
4.05 |
|
The current multiples are very low when compared to projected earnings growth and also to similar companies. To analyze comparable companies in more detail we need to split GVA in two sectors:
- E&C (70% earnings): E&C companies had excellent performance this year, trading near highs at an average 2008 P/E of 23 (used Fluor, Jacobs, URS, Washington Group and Perini as comparables)
- Materials (30% earnings): average 2008 P/E of 16 from Vulcan and Martin Marietta.
Using the blended average multiple of 20.2 times our earnings estimates we arrive at a potential stock price of $ 82, almost 50% higher than current trading.
Each E&C contract has a different schedule of revenues and costs linked to its execution so it is very difficult to predict future cash flows for the company to assemble a DCF. On the other hand for double-checking purposes we estimated cash-flows for the Materials part of the business for the life of its reserves based on the following assumptions:
- Zero volume growth;
- Aggregate price growth of 5% per year during 5 years of “extra-pricing”;
- Materials margin growing to 25% then stable.
This DCF analysis arrives at a value of US$ 1.5 billion for the materials part of the business or $ 38 per share, which is above the $ 25 implied on the multiples valuation so our confidence increased in the case.
Granite also has a net cash position of US$ 250 million. Management says this money is not available for share buybacks since they need for bonding capabilities and have a strategic plan of acquiring more aggregate reserves and asphalt plants. We are not modeling buybacks at this moment but we believe this is a possibility as the business progresses.
To sum it all up we believe there is a significant opportunity for investors to participate in the growth of Granite Construction both in terms of revenues (rebuilding of US infrastructure) and profits (execution turnaround) at an attractive price.
Risks
- More project write-downs
- Delays in funding or spending in highway projects
Catalyst
GVA stock traded as high as $ 74 this year fueled by good results and LBO speculation. Since the “LBO bubble” burst and a large hedge fund investor reduced his position the stock fell to the current price in the low-to-mid 50´s. Catalysts for the stock are:
Upside surprises in earnings releases as investors see the limited housing exposure and turnaround in large projects,
Company takeover still a possibility.