ENGINEERING & CONSTRUCTION Richard S. Paget, CFA 212-218-3894 rpaget@morganjoseph.com Christopher Bamman 212-218-3989 cbamman@morganjoseph.com Company Update / Estimates Change May 11, 2006 Key Metrics STRL - NASDAQ $29.97 Pricing Date 05/11/2006 Price Target NA 52-Week Range $31.50-$6.75 Shares Outstanding (mm) 9.3 Market Capitalization ($mm) $278.7 3-Mo Average Daily Volume 100,559 Institutional Ownership 12% Debt/Total Capital 17.5% ROE 16.1% Book Value/Share $7.06 Price/Book 4.2x LTM EBITDA Margin 9.70% EPS($) FY: December Prior Curr. Prior Curr. 2005A 2006E 2006E 2007E 2007E 1Q-Mar 0.06 0.11E 0.27A -- 0.22E 2Q-Jun 0.23 0.25E 0.29E -- 0.33E 3Q-Sep 0.28 0.30E 0.31E -- 0.38E 4Q-Dec 0.52 0.27E 0.26E -- 0.35E FY 1.11 0.93E 1.13E 1.15E 1.28E P/E 27.0x 26.5x 23.4x Revenue($mm) Prior Curr. Prior Curr. 2005A 2006E 2006E 2007E 2007E 1Q-Mar 39.4 47.7E 56.5A -- 63.0E 2Q-Jun 57.2 -- 67.0E -- 75.0E 3Q-Sep 61.2 -- 69.7E -- 78.4E 4Q-Dec 61.6 -- 66.6E -- 74.6E FY 219.4 250.9E 259.7E 280.0E 291.0E 1 Year Price History for STRL Q2 Q3 Q1 2006 Created by BlueMatrix 32 24 16 8 0 Sterling Construction Company, Inc. Rating: Hold Reports Record 1Q, Yet Guidance Unchanged; Raised Estimates; Reiterate Hold Investment Highlights: STRL reported 1Q06 EPS of $0.27 vs. $0.06 last year and our $0.11 estimate. Record 1Q results were driven by very strong revenue growth along with expanding gross margins and favorable SG&A leverage. Virtually all financial metrics exceeded our estimates. Construction revenues grew an impressive 43.3% to $56.5mm from $39.4mm a year ago, driven by healthy infrastructure demand and unusually dry weather. Backlog increased to $346mm, up roughly $100mm Y/Y, implying new orders of approximately $95mm. The operating margin jumped to 7.7% on operating income of nearly $4.4mm, compared to 3.3% and operating income of nearly $1.3mm a year ago. Improved operating efficiencies, better-than-normal weather and greater SG&A leverage all contributed to the increase in operating income and margins. During the 1Q06 conference call, management reiterated its previously stated 2006 guidance for revenues of $230mm -$250mm and net income of $7.5mm-$8.5mm with a bias toward the upper end of the range. We had previously believed this guidance was conservative, and, given the 1Q06 report, we are now even more convinced that management may be overly cautious regarding its expectations for the balance of the year. Based on 1Q06 results and favorable weather trends in 2Q06 to date, we have raised our 2006 EPS estimate to $1.13 from $0.93. We have also increased our 2007 EPS estimate to $1.28 from $1.15. We reiterate our Hold rating, mostly on valuation. While we are positive on the overall fundamentals in Sterling's core markets, STRL stock has doubled from mid-january and is trading at a premium to its peer group. We would become buyers on any pullback near the $20 range. Company Description: Sterling Construction Company, Inc. (www.sterlingconstructionco.com) engages in construction and distribution business in Texas. The company operates primarily through its wholly owned subsidiary, Texas Sterling Construction Company, LP, (TSC), a heavy civil construction company. TSC specializes in the building, reconstruction, and repair of transportation and water infrastructure projects. It primarily works for local and county municipalities and agencies, as well as for the State of Texas. TSC's transportation infrastructure projects include highways, roads, bridges, and light rail; water infrastructure projects comprise water, wastewater, and storm drainage systems. Sterling Construction was founded in 1959. The Disclosure section may be found on pages 5-6 of this report. The Valuation section may be found on page 5 of this report.
First Quarter 2006 Review Sterling reported F1Q06 EPS of $0.27 on revenues of $56.5mm vs. EPS of $0.06 on revenues of $39.4 million a year ago. The 43.3% increase in revenue was driven largely by contract revenue, which benefited from continued infrastructure spending and favorable weather conditions during the period. Gross margins increased 330bps to 11.8% from 8.5% last year, well above our estimate of 9.0%. Higher volumes and cost leverage, along with greater crew efficiency and productivity, lead to the significant margin improvement. This was even more impressive given that 1Q06 results did not include any incentive awards for the timely completion of contracts. Operating efficiency improved with SG&A falling to 4.1% of sales from 5.2% of sales last year, an improvement of 110bps, reflecting SG&A leverage on strong revenue growth. Income from operations increased to $4.4mm, or 7.7% of sales vs. $1.3mm, or 3.3% of sales last year. The effective tax rate on a GAAP basis was essentially flat with last year at 33.8% compared to 34.0%. However, we note that STRL is able to utilize NOLs to shelter income from Federal taxes. Net income increased significantly to $3.2mm, or 5.4% of sales compared to $827k, or 1.5% of sales last year. Shares outstanding were 21% higher than last year at 11.3mm due to a secondary offering of 2.0mm common shares during the quarter. Backlog increased to $346mm from $246mm a year ago and $307mm at year-end 2005. New orders were approximately $95mm and include two contracts in the Dallas marketplace worth a combined $50mm, which reflect the company expanding its footprint outside the Houston market. Furthermore, the company continues to talk to approximately twenty prospective buyers of its Steele City Products unit, yet there is no time table for a definitive sale agreement in place. Quarterly Operating Summary ($ in thousands, except EPS) 1Q05 2Q05 3Q05 4Q05 1Q06A Revenues $39,413 $57,228 $61,163 $61,634 $56,480 Growth (%) 54.0% 95.0% 52.1% 65.2% 43.3% Gross Profit 3,357 6,005 6,902 7,492 6,686 Gross Profit Margin (%) 8.5% 10.5% 11.3% 12.2% 11.8% SG&A 2,063 2,298 2,410 2,320 2,309 SG&A ratio (%) 5.2% 4.0% 3.9% 3.8% 4.1% Operating Income 1,294 3,707 4,492 5,172 4,377 Operating Margin(%) 3.3% 6.5% 7.3% 8.4% 7.7% Diluted EPS $0.06 $0.23 $0.28 $0.52 $0.27 Source: Company reports. Financial Position Cash and cash equivalents totaled $35.4mm at March 31, 2006, up from $22.3mm at December 31, 2005. STRL continues to improve its balance sheet as evidenced by the fact that long-term debt has declined to 21.2% of equity compared to 30.2% of equity at December 31, 2005, and was as high as 493% at December 31, 2001. However, given the cash position, the company currently has no net debt. Working capital at March 31, 2006, was $46.1mm with a current ratio of 2.0:1 compared to $18.4mm and a current ratio of 1.33:1 at December 31, 2005. Capital expenditures totaled $9.9mm, which included $8.0mm on new equipment and $2.0mm for the assets of Rathole Drilling. 2 MORGAN JOSEPH & CO. INC.
Outlook We remain positive on Sterling's backlog growth potential related to increases in both SAFETY-LU funding and TXDOT budgets for 2006 and 2007. We also expect Y/Y operating margin improvement, as the company works through backlog with higher profitability and a larger proportion of contracts with incentive clauses. Management reiterated its previously stated 2006 guidance for revenues of $230mm -$250mm and net income of $7.5mm-$8.5mm with a bias toward the upper end of the range. We had previously believed this guidance was conservative, and, given the 1Q06 report, we are now even more convinced that management may be overly cautious regarding its expectations for the balance of the year. Based on 1Q06 results and favorable weather trends in 2Q06 to date, we have raised our 2006 EPS estimate to $1.13 from $0.93. We have also increased our 2007 EPS estimate to $1.28 from $1.15. Our estimates do not assume any incremental revenues or earnings from acquisitions, which we think is likely, given the company's growth strategy and balance sheet. 3 MORGAN JOSEPH & CO. INC.
Sterling Construction Company, Inc. Income Statement FY02-FY07E ($ in thousands) FYE December FY2002 FY2003 1Q04 2Q04 3Q04 4Q04 FY2004 1Q05 2Q05 3Q05 4Q05 FY2005 1Q06A 2Q06E 3Q06E 4Q06E FY2006E 1Q07E 2Q07E 3Q07E 4Q07E FY2007E Revenues 111,747 149,006 25,586 29,354 40,221 37,317 132,478 39,413 57,228 61,163 61,634 219,439 56,480 66,957 69,726 66,565 259,727 62,975 74,992 78,442 74,552 290,961 Cost of Revenues 98,935 131,181 22,908 24,739 36,323 35,248 119,217 36,056 51,223 54,261 54,142 195,683 49,794 59,458 61,707 59,575 230,534 56,678 66,518 69,107 65,830 258,132 Gross Profit 12,812 17,825 2,678 4,615 3,898 2,069 13,261 3,357 6,005 6,902 7,492 23,756 6,686 7,499 8,018 6,989 29,193 6,298 8,474 9,335 8,723 32,829 General and Administrative 6,862 7,400 2,468 1,789 1,639 1,800 7,696 2,063 2,298 2,410 2,320 9,091 2,309 2,611 2,650 2,463 10,033 2,449 2,700 2,667 2,460 10,276 Operating Income 5,950 10,425 210 2,826 2,259 269 5,565 1,294 3,707 4,492 5,172 14,665 4,377 4,888 5,369 4,526 19,160 3,849 5,774 6,668 6,262 22,553 Net Interest Expense (2,427) (1,842) (519) (219) (425) (293) (1,456) (391) (441) (366) (138) (1,336) 186 125 50 50 411 50 50 50 50 200 Net Income Before MI and Taxes 3,523 8,583 (309) 2,607 1,834 (24) 4,109 903 3,266 4,126 5,033 13,329 4,563 5,013 5,419 4,576 19,571 3,899 5,824 6,718 6,312 22,753 Minority Interest (873) (1,627) (167) (442) (253) (100) (962) - - - - - - - - - - - - - - - Income from Continuing Operations 2,650 6,956 (476) 2,165 1,581 (124) 3,147 903 3,266 4,126 5,033 13,329 4,563 5,013 5,419 4,576 19,571 3,899 5,824 6,718 6,312 22,753 Income Tax Expense (Benefit) (174) 1,752 (563) 34 333 (1,939) (2,134) 307 1,110 1,403 (32) 2,788 1,541 1,704 1,842 1,556 6,644 1,326 1,980 2,284 2,146 7,736 Net Income from Continuing Operations 2,824 5,204 87 1,531 1,248 3,015 5,281 596 2,156 2,723 5,065 10,541 3,022 3,308 3,576 3,020 12,927 2,573 3,844 4,434 4,166 15,017 Net Income from Discontinued Operations 528 215 181 93 68 30 372 231 245 57 27 559 171 - - - 171 - - - - - Net Income 3,352 5,419 268 1,624 1,316 3,045 5,653 827 2,401 2,780 5,092 11,100 3,193 3,308 3,576 3,020 13,098 2,573 3,844 4,434 4,166 15,017 Diluted EPS from Continuing Operations $0.46 $0.80 $0.02 $0.22 $0.18 $0.42 $0.75 $0.06 $0.23 $0.28 $0.52 $1.11 $0.27 $0.29 $0.31 $0.26 $1.13 $0.22 $0.33 $0.38 $0.35 $1.28 Diluted Shares Outstanding 6,102 6,488 6,800 7,082 7,128 7,102 7,028 9,283 9,414 9,705 9,728 9,538 11,266 11,351 11,436 11,522 11,394 11,608 11,695 11,783 11,871 11,739 Margins Gross Margin 11.5% 12.0% 10.5% 15.7% 9.7% 5.5% 10.0% 8.5% 10.5% 11.3% 12.2% 10.8% 11.8% 11.2% 11.5% 10.5% 11.2% 10.0% 11.3% 11.9% 11.7% 11.3% G&A as % Revenues 6.1% 5.0% 9.6% 6.1% 4.1% 4.8% 5.8% 5.2% 4.0% 3.9% 3.8% 4.1% 4.1% 3.9% 3.8% 3.7% 3.9% 3.9% 3.6% 3.4% 3.3% 3.5% Operating Margin 5.3% 7.0% 0.8% 9.6% 5.6% 0.7% 4.2% 3.3% 6.5% 7.3% 8.4% 6.7% 7.7% 7.3% 7.7% 6.8% 7.4% 6.1% 7.7% 8.5% 8.4% 7.8% Tax Rate -6.6% 25.2% 118.3% 1.6% 21.1% 1563.7% -67.8% 34.0% 34.0% 34.0% -0.6% 20.9% 33.8% 34.0% 34.0% 34.0% 33.9% 34.0% 34.0% 34.0% 34.0% 34.0% Net Margin 2.5% 3.5% 0.3% 5.2% 3.1% 8.1% 4.0% 1.5% 3.8% 4.5% 8.2% 4.8% 5.4% 4.9% 5.1% 4.5% 5.0% 4.1% 5.1% 5.7% 5.6% 5.2% Growth Revenue 33.3% -28.3% -33.1% 9.8% 13.6% -11.1% 54.0% 95.0% 52.1% 65.2% 65.6% 43.3% 17.0% 14.0% 8.0% 18.4% 11.5% 12.0% 12.5% 12.0% 12.0% Operating Income 75.2% -88.7% 5.5% -15.0% -72.4% -46.6% 516.2% 31.2% 98.8% 1822.7% 163.5% 238.3% 31.9% 19.5% -12.5% 30.7% -12.1% 18.1% 24.2% 38.4% 17.7% EPS 73.3% -6.3% 221.0% 5.9% 60.3% 22.6% 47.1% 317.8% 27.3% 11.5% -49.6% 2.7% -17.4% 12.8% 20.3% 33.9% 12.7% Source: Company reports and Morgan Joseph & Co. Inc. estimates 4 MORGAN JOSEPH & CO. INC.
Required Disclosures Rating and Price Target History for: Sterling Construction Company, Inc. (STRL) as of 05-10-2006 04/07/06 I:Hold:NA 32 24 16 8 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 2004 2005 2006 0 Created by BlueMatrix Valuation Methodology While we are very positive on the underlying fundamentals in Sterling's core markets, STRL stock is up over 50% from the offering in mid-january. A Buy rating that assumes at least a 20% increase would suggest a 28x multiple on 2007 EPS, which is a premium to its peer group average. We would become buyers on any pullback near the $20 range. I, Richard Paget, CFA, the author of this research report, certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers, and no part of my compensation was, is, or will be directly or indirectly tied to the specific recommendations or views contained in this research report. I, Christopher Bamman, the author of this research report, certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers, and no part of my compensation was, is, or will be directly or indirectly tied to the specific recommendations or views contained in this research report. Research analyst compensation is dependent, in part, upon investment banking revenues received by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. intends to seek or expects to receive compensation for investment banking services from the subject company within the next three months. Morgan Joseph & Co. Inc. makes a market in the shares of STRL. Morgan Joseph & Co. Inc. has managed or co-managed a public offering of securities or received compensation for investment banking services from Sterling Construction Company, Inc. within the past 12 months. Investment Banking Services/Past 12 Mos. Rating Percent Percent BUY [B] HOLD [H] SELL [S] 58.46 41.54 0.00 18.42 7.41 0.00 5 MORGAN JOSEPH & CO. INC.
Meaning of Ratings A) Buy means reasonable outperformance relative to the market over 12-18 months. B) Hold means market-type risk adjusted performance; potential source of funds. C) Sell means expected to underperform the market. Other Disclosures The information contained herein is based upon sources believed to be reliable but is not guaranteed by us and is not considered to be all inclusive. It is not to be construed as an offer or the solicitation of an offer to sell or buy the securities mentioned herein. Morgan Joseph & Co. Inc., its affiliates, shareholders, officers, staff, and/or members of their families, may have a position in the securities mentioned herein, and, before or after your receipt of this report, may make or recommend purchases and/or sales for their own accounts or for the accounts of other customers of the Firm from time to time in the open market or otherwise. Opinions expressed are our present opinions only and are subject to change without notice. Morgan Joseph & Co. Inc. is under no obligation to provide updates to the opinions or information provided herein. Additional information is available upon request. Copyright 2006 by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. 600 Fifth Avenue, 19th Fl New York, NY 10020 Tel. 212.218.3700 Fax. 212.218.3789 Sales and Trading New York Tel. 212.218.3767 Fax. 212.218.3705 Pittsford Tel. 877.237.6542 Fax. 585.899.6029 6 MORGAN JOSEPH & CO. INC.