Granite Construction - Q4 2016

Transcript

Operator (participant)

Good morning. My name is Steven, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Granite Construction Investor Relations Fourth Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise, and after the speaker's remarks, there will be a question-and-answer period. To ask a question, please press star one. Please note we will take one question and one follow-up question and one follow-up question from each participant. It is now my pleasure to turn the floor over to your host, Granite Construction Director of Investor Relations, Ron Botoff. Sir, the floor is yours.

Ron Botoff (Head of Investor Relations)

Welcome to the Granite Construction Incorporated Fourth Quarter 2016 Earnings Conference Call. I'm pleased to be here today with President and Chief Executive Officer Jim Roberts, and Executive Vice President and Chief Financial Officer Laurel Krzeminski. We begin today with an overview of the company's safe harbor language. Some of the discussion today may include forward-looking statements. Actual results could differ materially from the statements made today. Please refer to Granite's most recent 10-K and 10-Q filings for a more complete description of risk factors that could affect these projections and assumptions. The company assumes no obligation to update forward-looking statements, whether as a result of new information, future events, or otherwise. Certain non-GAAP measures may be discussed during the call and from time to time by the company's executives. Please note that a reconciliation of certain non-GAAP measures is included as part of our earnings press release.

For more information, visit our Investor Relations website at investor.graniteconstruction.com. Thank you. Now I'd like to turn the call over to Granite Construction Incorporated Chief Executive Officer, Jim Roberts.

James Roberts (CEO)

Thank you, Ron, and good morning, everyone. Thank you for joining us to review our recent results and our outlook. Before we talk about 2016 highlights and future Granite opportunities, let me first thank and congratulate Granite employees and teams for another year of solid safety performance. As we grow and as our opportunities continue to broaden, we are focused on enabling and empowering our employees to get home safely each and every single day. Our team's emphasis on improving safety in and around our work zones is a constant, a key component to operational and financial performance. On a personal note, I offer my regards and my support to all Granite employees and their families who, as part of an evacuation order for nearly 200,000 people, were told to relocate to higher ground due to the weakening of the Oroville Dam in Northern California this past week.

With winter storms and erratic weather conditions continuing to pound our country, our society's decades-long underinvestment in infrastructure is creating a wake. The resulting damage, though thankfully not yet catastrophic, highlights the potential devastation. It highlights and puts a human face on our very real need to rebuild America's infrastructure. Now is the time to act before all of the work and investment of previous generations begins to crumble right in front of our eyes. Before I hand the call over to Laurel today, I want to spend a few minutes on our overall performance, including some segment trends. Then I will finish with some thoughts on what we believe is an improving macro environment for our company, for our sector, and for our investors. Another particularly strong construction segment performance was countered by challenges at certain large projects during the quarter and throughout the year.

While we needed the precipitation, particularly here in California and across much of the West, wet weather late in the year slowed activity in December, both in the construction and construction materials segments. As a result, after benefiting from a particularly mild weather fourth quarter last year, net income decreased to $57.1 million in 2016, our second-best bottom-line performance since 2009. Construction activity must pause at times when Mother Nature speaks. It's part of the work that we do. But even with weather conditions that put production into a pause mode, notably and pleasantly, demand continues to increase. While business conditions vary significantly by geography, they are stable in some markets and steady to strong in many others. Granite enters 2017 in our best position in many, many years. Consistent capital investment in our business provides us with a strong base and capacity for growth.

Our ongoing investment and continuous improvement has prepared us well to help internal business gears turn more efficiently, positioning us to create increased leverage. Our teams are ready to respond to the outside drivers of a positive, improving macro environment. Taking a deeper dive, the construction segment extended its consistently strong performance through 2016. We are particularly pleased with margins remaining historically strong at north of 17% in the quarter. The result? Gross margin above 15% in 2016, up almost 50 basis points from a strong 2015 performance. We remain very encouraged by the consistently strong mid-teens margin performance in this segment of our business. Construction segment backlog finished at a year-end record level above $1 billion. And this occurred without a pickup in public spending. This foundation provides confidence for increasing long-term demand as we move into 2017 construction season and well beyond.

Public transportation and infrastructure spending, which we will touch on in some more detail in a few moments, remains steady and stable. Diverse geographic and end market opportunities are expected to provide each of our local businesses with opportunities for organic growth, with diversification and private market activity producing a positive counterbalance to public demand. Now onto the construction materials segment, which continues to perform well. Wet fourth quarter weather in the West impacted our steady-performing construction materials segment for almost all of December, though demand and committed volumes remained solid. Committed volumes or materials backlog continue to grow, giving us confidence as we plan for improved demand and increased leverage in 2017 and beyond. While overall 2016 materials consumption was nearly identical to 2015, we experienced a volume shift from external to internal consumption.

As a result, it created an internal volume benefit to the construction segment and a reduction in construction materials segment revenue. Notably, we maintained our margins at nearly 11%. Continuous improvement efforts have had a big impact on our plant efficiency, and we continue to look to leverage opportunities in this area. We are poised to benefit significantly with increased demand and continued emphasis on identifying, delivering, and sustaining plant efficiency improvements. This highlights the overall balance of our business portfolio, as well as the benefits of vertical integration in this part of our business. Now on to large projects segment, which provided both fourth quarter and 2016 results well below our expectations, emanating from performance, design, and owner-related issues at a small number of our projects nearing completion in late 2017 and 2018.

In the fourth quarter, 3 projects accounted for the lion's share of the sequential and year-over-year segment profit decline. Granite teams and our partners are sharpening our focus on opportunities to mitigate risk and improve project performance. Importantly, the newer projects in our portfolio are performing well, and they are beginning to provide improved returns. But this will not be an overnight or a quick fix. While resolution of protracted issues should benefit some existing projects as they get closer to completion, it will take some time. Clearly, increased project productivity and efficiency remain critical focus areas for improvement. While it will take some time to create significant improvement, these areas of focus guide our prioritization of risk and appropriate project returns on future project selection, teaming, and bidding. Now on to my favorite subjects, politics and public policy.

With our country's investment priorities focused more and more every day on rebuilding American infrastructure, today Granite is poised to provide infrastructure solutions to meet our country's needs. Let's start with the very good news. In November, voters approved more than $200 billion of incremental infrastructure investment in the form of local measures, with the majority of this in California and Washington State. These long-term voter commitments reflect strong underpinning of support to rebuild, modernize, and improve America's infrastructure. Next, the good news on the legislative front in California, where state officials continue to make progress towards legislation that will more appropriately address infrastructure funding. Governor Jerry Brown, the Speaker, and the Senate Pro Tem all have agreed to an April 6 deadline to pass a transportation funding bill, targeting significant hikes in investment to address long-term shortfalls.

We are maintaining our focus on the governor and California legislators to deliver much-overdue incremental investment beginning in 2017. Last week, U.S. governors sent the new administration a list of 428 shovel-ready projects they regard as high priority. The full list of projects covers 49 U.S. states and territories, with California's list alone representing nearly $100 billion worth of projects. Unifying project criteria includes focusing on readiness for construction, innovation, and national benefits. Though the rhetoric from the Trump administration remains extremely constructive, it remains too soon to estimate the timing or magnitude of incremental investment without more detail. Promises to rebuild America's infrastructure are great, but we remain cautiously aware of how slowly Congress acts. 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. The FAST Act was and is critical for planning at state and local levels. Today, public market demand remains stable in anticipation of the now-overdue infusion of investment from Congress. Granite teams are well prepared to deliver both on the president's commitment to rebuilding our country's infrastructure as well as solid growth in all of our markets across the country. Positive private non-residential demand continues to fuel construction segment growth, the same part of our business that we expect will benefit the most from increased public spending over time. We expect 2017 will provide Granite teams an opportunity to grow at a rate faster than we have seen in recent years. Solid execution should create gross profit growth, operating income expansion, and improved overall bottom-line performance across our business portfolio.

Now I hand it over to Laurel with some more detail on our results and an update of our 2016 outlook.

Laurel Krzeminski (CFO)

Thank you, Jim. Good morning, everyone. For the year, a 6.1% revenue increase met our mid-single-digit growth expectations, and it helped us to eclipse $2.5 billion in revenue for the first time since 2008. Notably, our fourth quarter 2016 revenue of $666.7 million was our best fourth quarter revenue performance since 2006 and our third best ever. During the quarter and throughout 2016, consistently strong construction segment results were countered by underperformance in our large project segment. Company gross profit increased slightly in 2016 to more than $301 million, with consolidated gross profit margin of 12%, down from 12.6% last year. In the fourth quarter, profitability and earnings, impacted negatively by certain large projects and some tough winter weather, took a step back from particularly strong results last year. As a result, 2016 earnings per share finished at $1.42, down 6.4% from $1.52 last year.

However, our business continues to operate overall at a very high level, and we expect to build significantly from the healthy, foundational level of profitability we have achieved the past two years. The investments we continue to make in our business and in our people are paying dividends. We finished 2016 with record year-end backlog of nearly $3.5 billion, up 19.8%. Large project construction backlog also increased 19.8% year-over-year to nearly $2.5 billion, and construction segment backlog grew 19.7% from 2015 to finish above $1 billion, another year-end record. As we've seen each quarter this year, fourth quarter bookings were broad-based across end markets and geographies, continuing to highlight the benefits of diversification and the broadening of opportunities for our business. Looking at the segment detail, fourth quarter construction segment revenue increased more than 5% to $359.7 million, with 2016 construction revenue improving 8.1% to nearly $1.4 billion.

In the fourth quarter, segment gross profit margin of 17.2% remained strong, though down from a particularly strong nearly 20% last year. Construction margin improved nearly 50 basis points in 2016 to 15.3%. We're excited and encouraged to be able to build upon a strong 2015 and to maintain margins at this very healthy level of performance. Moving now to large project construction, where segment revenues increased nearly 11% in the quarter to $246.1 million, and 2016 revenues increased 9.3% to $888.2 million. Fourth quarter segment margin declined to 5.5% from 11.6%, with 2016 segment margin finishing down more than 250 basis points at 7.2%. As Jim mentioned, the underperformance and challenges are limited to a small number of projects nearing completion in late 2017 and 2018. As our project portfolio matures and the influence of newer, better-performing projects grows, we expect it will provide improved returns.

Finally, let's talk about solid-performing construction materials segment. Overall, 2016 materials consumption was nearly identical to 2015, even with a wet weather impact to the business in the fourth quarter. In the fourth quarter, materials revenue was $60.9 million, down 8% from last year. Demand shifted to increased internal construction segment use in 2016. As a result, the external sales that comprise construction materials revenue decreased 11.6% to $261.2 million. Materials gross profit margin in the quarter was 10%, down from about 11% last year. For 2016, construction materials segment gross margin was 10.7%, down about 40 basis points from 2015. Although weather slowed production in the fourth quarter, bidding activity and pricing remained steady through the end of 2016, which resulted in growing committed volumes for 2017.

Before I discuss our guidance, let me make a couple of comments and cover a few modeling assumptions on SG&A tax rate and CapEx. SG&A growth last year was attributable primarily to personnel-related costs, including increased business development and selling expenses. We expect the investments we've made and our growth opportunities will drive SG&A as a percentage of revenue lower than last year. With the ramp-up of our new consolidated tunnel jobs, non-controlling interest has increased, especially compared to the past few years. This increase has moved our tax rate lower, and as a result, we currently expect our 2017 tax rate in line with last year, exclusively of any potential federal tax reform impact. Both project and market demand drove increased CapEx investment in 2016 to nearly $91 million, more than double our 2015 investment. We currently anticipate 2017 capital expenditures in line with 2016.

With that, I finish with our outlook. We're excited about the improving long-term trends, and we're quite optimistic about our opportunity to accelerate growth in 2017. We currently expect low double-digit consolidated revenue growth and consolidated EBITDA margin of 6.5%-7.5%. Now, before we take your questions, let me turn the call back to Jim.

James Roberts (CEO)

Thank you very much, Laurel. Yes, we are very optimistic, and our teams are ready. Granite employees are poised to accelerate growth this year, even without the benefit of a step-up at the federal level or state level in California. These remain incremental growth drivers and opportunities. With the backdrop of improving public funding trends across the country, our growth outlook is encouraging. We continue to invest in our people and our businesses. We are primed for growth. So, with a positive outlook across our business, we continue to challenge our leaders to take their teams to even higher levels of expectation and success. With record company year-end backlog of $3.5 billion, we are confident that our teams can achieve our expectations for much-improved results beginning in 2017. And with that, we will be happy to take your questions.

Operator (participant)

Thank you. To ask a question, please press star one. Please limit yourself to one question and one follow-up, and jump back in the queue if you have additional questions. Our first question comes from Jerry Revich with Goldman Sachs. Please go ahead.

Jerry Revich (Analyst)

Hi. Good morning, everyone.

James Roberts (CEO)

Morning, Jerry.

Jerry Revich (Analyst)

I'm wondering if you folks can talk about the large construction projects that you highlighted that were a headwind in the quarter. Where are we in the process? When do they roll off? And are any of them at the point where they're gross profit negative, or are the margins just lower than what was anticipated?

James Roberts (CEO)

Okay. So let me, first of all, suggest that none of them are negative, and we expect them to roll off late this year and next year. And let me give a little color, Jerry, on some of the issues that are out there. And I'm thinking about these three jobs that we discussed and preferably not giving any individual names, but let me give you some issues that are going on out there. Permits. Some of these larger projects require the owner to provide permits for us to be able to build our work, and they need to get out ahead of us with permits. On one of our major projects, we struggled mightily trying to get permits 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. But what happens is that these are prolonged discussions, and in the interim, we end up not booking any profit on that kind of work. Another issue on one of our jobs, we had significant weather that we believe contractually allows us to be compensated for weather, 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. So once again, we have an issue. It goes through the dispute resolution process, and towards the end of the job, we intend and hope to come to resolution.

We've got some scope changes on some jobs where some owners are asking to change the internal design of the job and still allowing us or requiring us to meet schedules and pricing. We believe, again, those are compensable items. 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. So there's a host of items there that are really focused on those three individual projects, 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. We also believe that the issues that we have outstanding on these three projects, that we'll bring them to resolution over the next year or two, but we will still have another, probably, I would say, two years, a year and a half to two years to get these projects behind us.

Jerry Revich (Analyst)

Okay. Thank you for the color. And separately, can you talk about the cadence of project awards over the course of 2017? How big is your pipeline compared to the same point a year ago, and when do you expect the major decisions to come up on some of the bigger projects you're focused on?

James Roberts (CEO)

Okay. You bet, Jerry. So as always, we try to look about a two-year outlook out in front of us in large projects, and it takes quite a bit of time in order to engage with the owners, potential joint venture partners, design teams. We're looking close to about $20 billion over the next two years. We are taking the position that we like to lead projects, if at all possible. We're looking at projects that might be a tad smaller than they were historically, but at the same time, we have a larger role in them. We're looking specifically at projects where we know the owners and they're good to deal with, and we are looking heavily at projects diving deep into the contractual requirements to make sure that the issues that we've seen in the past are not repeated in the future.

But the pipeline is full. It's healthy, and we're going to be demanding higher margins and expectations going forward in this business.

Jerry Revich (Analyst)

Okay. Thank you, Jim.

James Roberts (CEO)

Thank you very much, Jerry.

Operator (participant)

The next question comes from Nick Coppola with Thompson Research. Please go ahead.

Nicholas Coppola (Senior Equity Analyst)

Hey, good morning.

James Roberts (CEO)

Morning, Nick.

Nicholas Coppola (Senior Equity Analyst)

I want to make sure I understand your commentary about the FAST Act. It sounds like there hasn't been any benefit to date. What are the key drivers to start seeing some of those dollars flow through, and what are your expectations throughout the year?

James Roberts (CEO)

Okay. So let's remember what the FAST Act did first. So back in December 2015, we got the FAST Act passed as a real benefit to the industry. It's a 5-year-long bill, $305 billion. And what it did was provide really some stability in the DOT's funding, and that has happened. So the DOTs know that they have a certain amount of money set aside for their businesses going forward. So there has been that benefit, but it hasn't been a monetary benefit because the incremental dollars that were supposed to be added to the program starting in this year were held back because we are now funding the FAST Act and the federal spending environment through a continuing resolution, which basically means they're going to continue to fund the Federal Highway, Federal Transportation Program at the same level as last fiscal year.

So what we're already understanding is that between now and April, the end of April, there could be an opportunity to see this be fully funded again, which would throw another $1 billion back into the program, which would be obviously incrementally added monies that we haven't seen yet. So there has been a benefit because of the stability, but there has not been any financial benefit from increased spending.

Nicholas Coppola (Senior Equity Analyst)

Okay. That's helpful. Then another policy-type question. Could you just talk a bit about Measure M and how you plan to benefit from that?

James Roberts (CEO)

Okay. You bet. So last November, there were a host of very positive ballot measures that were passed, and I mentioned the number of $200 billion in November through the ballot initiatives. And I'll run them through real quickly, then I'll talk a little bit about the benefits in each of them. So LA County Measure M, which is the one that Nick is referring to here, was basically a $120 billion program over 40 years. So it's a $3 billion a year program, and it's an LA County measure. Interestingly enough, we historically have not been a major player in the downtown proper LA market, but recently, timing is everything, right, have moved in and have some significant work there at LAX and some other work in the area.

So we will be a player in receiving, certainly, our portion of the $3 billion per year over the next 40 years. The other thing that happens when you start having that type of inflection relative to funding in a marketplace, it starts taking the competitive team's involvement in those projects, which opens up the overall market in the surrounding areas for being less competitive. So we love the idea that there's more money in the system. If we don't get the work, our competitors will, and that will change the pricing mechanism and create opportunities for us, even if we don't get Measure M work, but I do think we will get our share of that. Nick, a couple of other items that are really important to us: Santa Clara, past Measure B, Santa Clara County, which is in the South Bay Area of California. That's $5.5 billion.

We're a major player in the Bay Area. BART, the subway system, had a $1.5 billion play there. Stanislaus County, which is out in the Central Valley of California, had almost a billion-dollar measure there, which is a very large addition to the program out in the valley. Monterey County, right down here in our backyard, Measure X was $565 million. Merced, again, out in the valley of California, $450 million. Santa Cruz County, $400 million. It's just a great list. Now, the other thing that happened was those were all California-induced programs, but we saw a great pass of a great bill or a measure up in the state of Washington, the Sound Transit, which is a $54 billion addition over 25 years. And we are a player with Sound Transit. They're a very good owner.

They have a very good program, and that will really help our Washington state business as well.

Nicholas Coppola (Senior Equity Analyst)

All right. That's some great color. Thanks for taking my questions.

James Roberts (CEO)

Thanks, Nick.

Operator (participant)

The next question comes from Alex Ragle with FBR. Please go ahead.

Alex Ragle (Analyst)

Thank you. Good morning, Jim.

James Roberts (CEO)

Morning, Alex. How are you doing?

Alex Ragle (Analyst)

Not too bad. You referenced the California Transportation Bill with a sort of a drop-dead passage date, deadline date of April 6th. Let's just jump forward and cross our fingers and hope that they meet that deadline. When might you start to see bidding opportunities, and when might you start to see revenue coming through the P&L?

James Roberts (CEO)

Okay. So, Alex, I'm with you. I always keep anything legislatively, I keep my fingers crossed. So we're both in the same game there. And I wouldn't call it a drop-dead date, but I would say that it is the most encouraging time goal that we've seen in the last 12 months when we've really been working hard to get a transportation bill in California. So let's assume for a moment that April 6th comes along and the bill is passed, which certainly we have significant momentum today for that to occur. Several things need to occur. First of all, the governor put in his budget for 2017 fiscal year $4.3 billion of additional spending. We have two bills on the floor today. One, actually, SB 1, has recently been passed by the Senate Transportation Committee with a 7-2 vote.

So that was a very good vote for us to get that one passed. And that's a $6.3 billion additional funding mechanism per year. And AB 1 over on the Assembly side is virtually identical to SB 1 at $6.3 billion. So first of all, let's talk about the size of what we could see in April when we get a bill, assuming that it is April and assuming we get a bill. Let's just say for the moment that it's somewhere in the neighborhood of $5 billion additional funding per year. In the state, different than the feds, they can get this enacted much faster and get it put into the system, I would say within two quarters, probably into the system, allowing work to start bidding.

I would say that you would probably see stuff on the street bidding by the end of the year, and you would see it in our 2018 financials.

Alex Ragle (Analyst)

That is great news. Then, Laurel, maybe a little bit more color on the three projects. There's been a couple of quarters in a row now where we've had some sort of headwinds on certain large projects. Is there any way you could quantify the to-date headwinds that have passed through the P&L in 2016?

Laurel Krzeminski (CFO)

In our footnotes and our financial statements, we have a section that's called revisions and estimates, and our 10-K will be coming out later today. It shows you the number of projects and how much was written up or down and gives you a range there. I'll tell you what you're going to see in that is somewhere around a year-over-year difference in large projects of about $20 million to the negative.

Alex Ragle (Analyst)

That is helpful. Thank you. I'll get back in queue. Appreciate it.

James Roberts (CEO)

Thanks, Alex.

Operator (participant)

The next question comes from Michael Dudas with Vertical Research. Please go ahead.

Michael Dudas (Equity Research Analyst)

Good morning, Jim. Ron, Laurel.

Laurel Krzeminski (CFO)

Morning.

James Roberts (CEO)

Morning, Mike.

Michael Dudas (Equity Research Analyst)

Morning, Mike. First question, you mentioned in your prepared remarks about the construction materials business. As you look into the 2017, will we see continued shifts to using more of your aggregate internally, and are you seeing any additional positive signs from some of the opportunities selling externally to some of your competitors out in the market?

James Roberts (CEO)

Okay. So let's talk about it because that's a portion of our business that's near and dear to my heart. The materials business has really stabilized over the last couple of years, and I'm not sure I can give you an exact direction relative to internal versus external. What happened in 2015 was we bid some very large projects in California, and Granite was not the low bidder on them, but one of our materials utilizers and customers was. So you saw a couple of huge projects move into our customers' realm, which created external material sales for us. Just the opposite happened in 2016. We had some very large material-driven projects that Granite was the low bidder on, and so the materials went over to Granite versus our third-party customers. We see the committed volumes, Mike, for 2017 already greater than 2016.

So we're already, and we can call it backlog, although we don't analyze backlog from an external discussion standpoint, our committed volumes for 2017, and I'll say across the west, are very healthy going into the year. That's both internal and external. You can kind of think about it over the last couple of years, it's been about a 50/50 split. Historically, and I'll say this from a historical standpoint, historically, the driver, as the markets get stronger, which I believe they will, and that's if we get a transportation bill in California and some federal infusion, I think you're going to see our external customer base outpace our internal customer base. The stronger the marketplace, the faster the external market increases. So I think what you'll probably see in 2017, assuming all things are equal, Mike, a stronger shift towards external than internal.

Michael Dudas (Equity Research Analyst)

Better pricing, I would think.

James Roberts (CEO)

Yes, definitely better pricing. We've had a couple of price increases. Our last price increase was at the end of last year. We've been able to see, I'll call it mid-single-digit range increases, we'll say 5% across the west on an annualized basis. I think we're working on getting another single-digit increase this year. That, I think, is going to happen up until the point where the demand changes. If the demand begins to change due to a California Transportation Bill and due to some federal funding, then I think that creates an inflection point for pricing. But I don't see pricing dramatically changing until we get significant additional funding in place. And I do believe that if we get that in place, the materials business always is the first location where we see a material change in the marketplace.

So we'll keep our eye on that, Mike, but if we get some infusion both in California and the feds, I think what you start seeing is the materials business will move up faster than the other two businesses.

Michael Dudas (Equity Research Analyst)

Excellent. Jim, my follow-up is, assuming the three drivers of California transportation, FAST Act, SB 1 monies, and if there's something that comes out of the Trump administration, let's all hit it and say 2018 and 2019, as investors in Granite stock, how should we look? Should Granite be seeing great volume opportunities, or is it more towards margin opportunities to the bottom line in an environment where demand could exceed supply pretty nicely?

James Roberts (CEO)

Okay. So typically what happens every time, and I've been through several of these, Mike, relative to big market adjustments, and we'll talk about this one as a nice upward market adjustment. First thing you're going to see is pricing changes. You're going to see some margin, the margin change first. Because what happens is, and you're going to see it in the materials business first and then the construction business. What will happen is that our competitors, as the demand changes, they will fill up fairly fast. And once they fill up, they will basically slow down or just basically stop bidding work. So in the interim, in the very short term, pricing will come up, and it will come up quite quickly. The second thing that will happen is that as they slow down in their bidding opportunities, we have tremendous elasticity inside Granite.

We can scale up, and we can do a lot more work. I think secondarily, you're going to start seeing our volume go up. The nice part about it is if you get the volume increase tied with the price increases, that's where you start seeing the real leverage in terms of the overall returns of the company.

Michael Dudas (Equity Research Analyst)

Jim, thank you very much for your help.

James Roberts (CEO)

All right, Mike. Thank you.

Operator (participant)

The next question comes from Bobby Burleson with Canaccord. Please go ahead.

Robert Burleson (Managing Director)

Hi, good morning. Thanks for taking my questions.

Ron Botoff (Head of Investor Relations)

Hey, Bobby.

James Roberts (CEO)

Sure, Bobby.

Robert Burleson (Managing Director)

Hi. So the first one would be just kind of big picture. Let's say we didn't get a Trump infrastructure plan at all, but the FAST Act is working in terms of better visibility for kind of longer duration projects, and there's some incremental funding also from the state and local level. Do we still enter one of your best kind of upturns in the market that you guys have seen versus kind of historical upturns?

James Roberts (CEO)

Okay. So I think that what you're asking, Bobby, is that let's leave the Trump infrastructure uplift aside for the moment, and let's assume that we get a California bill. I do think that's probably one of the biggest drivers of our West Coast business is going to be the California Transportation Bill. That will hit much faster than anything coming from the feds. But even if we don't have anything from the Trump administration and we do not get a California bill, we're pretty comfortable with the guidance that we gave you. We believe that's where the company is going without the infusion of those additional funding mechanisms. So I still think it's very healthy without it. The BART initiatives are exactly - you nailed it.

The local measures, simultaneously coupled with the private market, the industrial, commercial, renewable energy markets, are going to continue to drive growth in our construction segment. But what will happen with a California bill and the Trump infrastructure program, it will start changing pricing, and it will change price quite quickly. So we're right where we are. We have very strong organic growth, but we will not get to an inflection point without both of those happening.

Robert Burleson (Managing Director)

How does the FAST Act factor into this?

James Roberts (CEO)

It's already part of the program today. It is, I'd say, just a stability mechanism more than anything, Bobby. I don't see it as creating significant demand except that as you start seeing additional measures—and let's talk about the local measures—as long as there's a healthy state budget, which there is in a lot of states today, and the feds are doing their part with the FAST Act, and the local measures are there, then we don't see general funds out of the states start robbing these pools. And we see that money actually going to transportation, which I think is where it is today. So from that perspective, I just put the FAST Act down as part of our foundation for where we are today.

Robert Burleson (Managing Director)

Okay. And then I guess just in terms of timing of awards, should we expect any kind of air pocket with backlog sometime in the first half? You have to space for the timing of awards you're waiting to hear back on. And in terms of.

James Roberts (CEO)

Did you say?

Robert Burleson (Managing Director)

Your year-over-year growth?

James Roberts (CEO)

Did you say an air pocket? Is that what you said?

Robert Burleson (Managing Director)

Yeah. Is there going to be a pause in the ability to grow at that pause in the year-over-year basis?

James Roberts (CEO)

No, I don't think so. I think we've got a very consistent bidding environment right now. There's work being bid both at the construction and the large projects level. Again, large projects is very lumpy, and historically has always been very lumpy. We have quite a few projects that have been bid and we're waiting for results on right now. And if one of those lands in the first quarter, it could be a big uptick in the first quarter. I do think what you'll see also in the first quarter is the construction activity is typically quite strong in the first part of the year from a bidding perspective. So in the first and second quarter, construction should be active, but large projects are always lumpy.

Robert Burleson (Managing Director)

Okay. Great. Thank you.

James Roberts (CEO)

You bet. You bet, Bobby.

Operator (participant)

The next question comes from Joe Giordano with Cowen and Company. Please go ahead.

Joseph Giordano (Managing Director)

Hey, guys. Good morning. This is Tristan in for Joe today. I just had a quick one on M&A. You've talked about doing a deal in the past. How is your pipeline looking right now? And then is the primary reason for not having done something already more based on pricing or the quality of assets available?

James Roberts (CEO)

Okay. I want you to repeat that a little bit. If you're focusing on M&A only? But is that basically the question? How come we haven't done anything yet?

Joseph Giordano (Managing Director)

Yes.

James Roberts (CEO)

Okay. So remember what we've talked about with M&A, and maybe I'll just rephrase where we stand. We are in the acquisitive mode. We do believe that acquisitions are part of our strategic plan to get us to where we want to be in the next five years. We publicly stated that there are two environments that we're focused on. One is expanding our vertically integrated business model that we currently have in California and the West, taking that to the East. We believe that's a very strong model. We believe we're very good players in that model and that we are looking for building that model throughout the country. So that's certainly an opportunity, and that we do have opportunities in that pipeline. We also have opportunities in the water pipeline, and we've mentioned that before.

The other significant area of diversification that is our primary area would be water. I personally believe that's going to be a huge infusion of funding into that program over the next 5-10 years. Again, we have some opportunities in that pipeline as well. Both the vertical integration, geographic diversification, and the water diversification plays are in the pipeline, and we are working through the system. As you know, they take time. Sometimes you get to the dance, and really the music stops, and sometimes the music plays, and you complete the dance. We have a team of people that are dedicated to that process in Granite, and they're working on deals constantly.

Joseph Giordano (Managing Director)

Okay. Thanks for the call. When you talk about water, a water opportunity, is it more on the transportation side or the treatment side?

James Roberts (CEO)

Both. I think when we talk about water, what we're really looking at is trying to be a countrywide vertically integrated player in the water industry. We're a large player in the heavy construction player today. We're in the pipelining business today. We would see it in the treatment, the pipelines, the lining, the entire infrastructure model of water.

Joseph Giordano (Managing Director)

Thank you.

Operator (participant)

The next question comes from Brent Thielman with D.A. Davidson. Please go ahead.

Brent Thielmann (Equity Research Analyst)

Hi. Good morning.

James Roberts (CEO)

Morning, Brent.

Brent Thielmann (Equity Research Analyst)

I guess most questions have been answered here, but maybe one for the construction segment. Margins, 17%, really good despite some problems I think you had with weather. Is it fair to say you would have seen something north of that level of profitability if you had kind of a milder December? And does this give you any comfort around maybe a level above mid-teens longer term?

James Roberts (CEO)

Well, let me suggest this. The biggest issue for weather, and let's say December, because December was, there was 8 or 9 days of rain, and that really did hamper the work in the west. What happens in the construction business is most of that business is local work. And when rain occurs, even though there may not be rain afterwards, it takes time for the job to dry out, and sometimes the owners flat say, "We're done." They know the holidays are coming, and they just shut the jobs down. And that happened on a major job in Southern California this year. And so I would say the biggest issue in construction was more revenue-driven than margin-driven because we take a percentage of completion recognition on our job.

So unless the weather caused a physical write-down on the job, it really didn't change the margin, but it did change the actual gross profit and revenue that we could have performed in the month of December. That's another reason why this December was a little slower than last year was because a lot of projects were just flash shut down in the west due to the weather. The same thing on the construction materials segment in the quarter. Once that weather hits and all of our customers take a look outside and say, "Well, I don't expect it to dry out for three or four days," they basically say, "It's time to go home for the winter, and we'll come back in the spring." Just another note, Brent, on that same topic, it has been significantly wet in the month of January.

It's still raining today. In fact, on the way in this morning, it was raining and the wind's blowing. I'm one of those guys that probably is one of the few people in the state of California that cringes every day it rains because it certainly impacts our business, but we need it. The reservoirs are filled up, and this is going to be a really good long-term program for the state of California and the western U.S., but it certainly did hurt December, and it hurt January.

Brent Thielmann (Equity Research Analyst)

Okay. Okay. Well, that's good color. Maybe more of a housekeeping question, Laurel, in terms of D&A and thinking about that margin target for 2017. Should that D&A hold relatively flat? Is there anything that's rolling off there?

Laurel Krzeminski (CFO)

We expect our DD&A to go up actually due to the CapEx, so somewhere around $75 million, up a little bit from this year.

Brent Thielmann (Equity Research Analyst)

Okay. Great. Thank you. Best of luck.

Laurel Krzeminski (CFO)

Thanks.

James Roberts (CEO)

Thank you very much, Brent.

Operator (participant)

The next question comes from Ryan Cassil with Seaport Global Securities. Please go ahead.

Ryan Cassil (Analyst)

Good morning. This is Jacob.

James Roberts (CEO)

Good morning, Ryan.

Ryan Cassil (Analyst)

This is Jacob.

James Roberts (CEO)

Oh, Jacob. Okay.

Ryan Cassil (Analyst)

As markets begin to ramp over the next couple of years, could you give us an update maybe on how you see your cost structure playing out versus competitors in reference to the owning versus renting equipment dynamic?

James Roberts (CEO)

Okay. So let me give you a—I think it's a great discussion point about our cost structure in general. And let me talk about it in general, then I'll talk about the equipment on rent to own. So certainly, we have some very large—and I'm going to talk on the materials facilities first, Jacob. We have some very large materials facilities that have been underutilized now for years and years and years. And so as the market ramps up and potential volumes increase, we have a very, very scalable product in terms of our materials facilities. And that's going to be a really nice opportunity for us for incremental margin just relative to production. We've been underutilized our capacity significantly in our materials business, so we could easily ramp up 40%-50%, even greater % in our materials business without having to make major investments in our plants.

On our rolling stock, we analyze that heavily every single year, and we certainly look at lease, rent versus own. We do believe that the ability for us to have a very low cost of capital allows our ownership cost to be much lower than a rental environment, and we'll continue to do that. Certainly, as we ramp up, we need to keep CapEx in line with our operating cash flow. We'll balance the two out, and if we need to rent, we will rent. And we typically rent during the peak months in the summer when we don't believe on the long term that we're going to need those pieces of equipment in a - I'll call it through the winter and through several more years. So rent to own is on a year-by-year decision, but certainly, as you can see, our CapEx is increasing.

We're buying more rolling stock, more plant equipment, and we believe, we've always believed that owning equipment is much more beneficial to the company than renting. Now, I will say this: relative to the overall size of our fleet, we do see it increasing, and that's why you're going to see the depreciation go up. And again, I think that's really healthy. And the value of that fleet will come into play, the real value, as we increase the utilization of all the individual pieces. And as that utilization increases, so does our efficiency. So again, we'll go back to the ownership side as we consider it to be more beneficial.

Ryan Cassil (Analyst)

All right. Thank you for the color.

James Roberts (CEO)

Thanks, Jacob.

Operator (participant)

The next question is a follow-up from Alex Rygiel with FBR. Please go ahead.

Alex Ragle (Analyst)

Thank you. Either Jim or Laurel. The construction backlog is up about 20% year-over-year. It's been up 20%-30% year-over-year now for 5 quarters in a row. But the construction revenue has been only increasing maybe 5%-10% a year in the last 4 or 5 quarters. What's the disconnect there? Is the project size getting longer and getting stretched, or are you expecting a very significant near-term ramp sort of as a catch-up?

James Roberts (CEO)

Okay. Two things. First of all, the observation was correct, Alex. The average size of the projects is getting a little bigger, so the burn time is getting longer. And so that's why as that ramps up, it doesn't burn off as fast, so you don't see the same equivalent 20% increase on a volume basis. With that said, I do believe that there is a point here where you're going to see the construction business grow faster than what we've had in the past, and that was one of the things that we talked about earlier. That's going to be one of the first drivers of our volume increase. Right after materials will be the construction business. The other thing that's happened in the construction business is we've actually, over the last 3-4 years, developed some very strong relationships with private partners.

Those private customers have some very large projects, and those are turning over a longer period of time than our standard smaller DOT work. So although the margins are great and the burn's a little slower, but I do think that you'll see our overall growth rate pick up a little bit as we discussed in our guidance.

Alex Ragle (Analyst)

Very helpful. Thank you.

James Roberts (CEO)

Thank you, Alex.

Operator (participant)

The next question comes from Rohit Seth with SunTrust. Please go ahead.

Rohit Seth (Analyst)

Hey, thanks for taking my question. Just on the California highway bill, you had mentioned potentially a $5 billion per year spend. What's the spend been like over the last few years in California?

James Roberts (CEO)

Well, it's not very good. Let me suggest that. It's actually reduced itself over the last several years from about $2.5 billion to about $1.7 billion. So if you think about it, this is not the size of a new bill. This is additive to the current level. So at the low end, the additional amount that has been discussed from the governor is $4.3 billion. At the high end, both Senator Beall and Assemblyman Frazier's bills are at the $6 billion level, so those are additive to the $1.7 billion.

Rohit Seth (Analyst)

Gotcha. Okay. Yeah. That's all I had to ask. Thank you.

James Roberts (CEO)

Okay, Rohit. Thank you.

Rohit Seth (Analyst)

Thank you. Bye.

Operator (participant)

The next question comes from Brian Rafn with Morgan Dempsey Capital Management. Please go ahead.

Brian Rafn (Director of Research and Portfolio Manager)

Morning, Jim.

James Roberts (CEO)

Morning, Brian. I would have been disappointed if you hadn't been on the line.

Brian Rafn (Director of Research and Portfolio Manager)

Pushing that star button, you must put buy-side guys at the bottom of the list.

James Roberts (CEO)

Well, I don't have anything to do with that, Brian, so don't hold that against me, okay?

Brian Rafn (Director of Research and Portfolio Manager)

All right. Let me ask you on something that Bill Dorey used to talk about, bid-day discipline, selection of type of projects, knowing the owner's profile. Is there any deviation? Because you guys have focused on that for a decade. Is there a greater stringency? Is there more leakage with what you think owners are trying to push onto you and shift risk? How do you see that? Because you guys have always kind of focused on that for at least the last 7, 8, 10 years. So I can't believe that's a new problem with some of these major projects, on the heavy civil side.

James Roberts (CEO)

Okay, Brian. I'm going to tell Mr. Dorey that you mentioned him, by the way. And you are right on, and you know us well, Brian, that bid-day discipline is imperative. I do believe, though, with that said, that as we got into these very complicated P3 design-build projects, that the contractual requirements have changed. And literally speaking, and I'll give you an example on one job. On one job we're doing that is a very large P3, there was only a couple of words that changed from the standard DOT language to the language in this contract. And those couple of words, and I'm talking a word here and there, changed the whole complexity of the job relative to the quality requirements of a project in the field.

It's almost like going through these very onerous contracts with a fine-toothed comb now to make sure that you don't miss something and you don't make an assumption that the contractual language is the same as it was before. They have become very onerous, and that is exactly why, Brian, that we have gone out and really determined, even more so than before, who we want to work with and who we don't want to work with. I believe that as we see this macro uptick, it's going to really allow us to be much more conservative as to who we deal with. We're going to be able to pick and choose, and if we just look at language and it's ambiguous, we don't need to bid to work. I would say that during the downturn, unfortunately, we probably knew some of this language was ambiguous.

We looked at it and figured we'd be able to work with the owners, and the relationships obviously have struggled on some of those jobs. But bid-day discipline is right up our alley. Our teams are focused on it, and the other part of it is obviously contractual understanding.

Brian Rafn (Director of Research and Portfolio Manager)

Yeah. Okay. No, I appreciate that. When you talk about the FAST Act, that kind of an overall federal umbrella, you've got some very aggressive state DOTs. We've seen that here in Wisconsin. You've got the local referendums. If you layer in the Trump infrastructure, you've heard that bantering with the $1 trillion, and it could be transit, pipelines, defense. It could be all over the place. If you have that type of really robust demand, for you guys, does it make you more selective from a margin standpoint in looking selectively at deals, or do you open the spending and really ramp up your rolling stock and asphalt hot mix plants? And is it really about expanding bench strength and really going after the volume?

James Roberts (CEO)

Okay. So first of all, I would suggest that, having gone through this several times now, that the first thing to do is to be selective. The first thing to do is to make sure that you understand, from a business intelligence standpoint, how every individual market is acting and reacting to the changes. So you don't go out and just ramp up and get a bunch of backlog. The first thing that does is it ruins the marketplace, and we consider ourselves to be a market leader. So we'll sit back and we'll watch, and we'll be selective. And then what we'll look at is pricing. And certainly, it is going to be an advantageous position to go into the marketplace to increase our rolling stock and our plant equipment. So we've already, in advance of what we see as a ramp-up, we've been out increasing our CapEx.

The problem's going to happen if you're in a reactive mode. You're not going to have access to the equipment and the plant facilities in a timely manner to be able to facilitate the upside from those projects. That's why we've ramped up our CapEx significantly over the last couple of years because we see this happening. But we're going to be very selective first, and then we'll slowly open up the volume mechanism. But again, you don't want to open up the volume mechanism where it starts diluting the pricing opportunities. So it's a real fine line, Brian.

Brian Rafn (Director of Research and Portfolio Manager)

Yeah. Okay. And then on. You talk a little bit more about some of the private, some of the subdivision real estate, home building, power, wind, solar. If we see a defense build-up, like you guys did some defense work, I think, in Guam, what are some of the non-transit stuff that you're seeing maybe as a counterbalance?

James Roberts (CEO)

You bet. So first of all, on the private sector side, we've seen a real ramp-up in the commercial industrial side. Big boxes are coming back. And big boxes that are, for us, even $30-$40 million box work for grading and underground and site work, that was stagnant for the last six years. And we're seeing industrial parks popping up again. And the local smaller players, those are a little bit above their capabilities, especially when you get to a big dirt-moving job and real big underground job. So I would say industrial commercial has come back nicely. The renewable energy is still strong with us. I don't see that changing. We've got a very nice backlog of renewable energy work, mostly in the solar sector, a little bit in the wind sector. I also see the transmission distribution business very strong.

We're getting, as you know, Brian, we do a lot of construction management work in that sector, and we're actually in the hiring mode there with a lot of new contracts with the utility companies. So that's very nice. Overall, I think you see the federal and defense market starting to get more robust. We're starting to see more activity at the U.S. bases. We're starting to see Guam come up again. And I think we have a whole separate federal division that handles that work, so that's very nice. And probably where the big money is on the private side is the high-tech side. That's where we're seeing them make major investments in their campuses and in their distribution centers. And so we're following them very closely. But it's a combination of all the above, Brian.

Brian Rafn (Director of Research and Portfolio Manager)

All right. Thanks, guys.

James Roberts (CEO)

Okay, Brian. Take care.

Operator (participant)

This is the end of Q&A, and I would now like to turn the call back over to our hosts.

James Roberts (CEO)

All right. Well, thank you, everybody, for your questions. A lot of great questions. A quick note for our shareholders and our analysts. Laurel, Ron, and I will be on the road in Connecticut. We'll be in New York twice. We'll be in Las Vegas for ConExpo, and we'll be in Florida over the next six weeks. So please do not hesitate to reach out so that we can catch up with all of you very soon. And thank you to all of our employees for keeping your fellow workers safe every day and performing at an exemplary level. We greatly appreciate it. As always, Laurel, Ron, and I are available for follow-up if you have any further questions. Thank you, everyone.

Operator (participant)

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.