Construction Partners, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This discussion and analysis of our financial condition and results of operations is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition during the period covered by this report. Historical results may not be indicative of future performance. This discussion includes forward-looking statements that reflect our plans, estimates and beliefs. Such statements involve risks and uncertainties. Our actual results may differ materially from those contemplated by these forward-looking statements as a result of various factors, including those set forth under the headings “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” This discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our audited consolidated financial statements and notes thereto included in the 2021 Form 10-K. In this discussion, we use certain non-GAAP financial measures. Explanations of these non-GAAP financial measures and reconciliations to the most directly comparable GAAP financial measures are included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Investors should not consider non-GAAP financial measures in isolation or as substitutes for financial information presented in compliance with GAAP. Overview We are a civil infrastructure company that specializes in the building and maintenance of transportation networks. Our operations leverage a highly skilled workforce, strategically located HMA plants, substantial construction assets and select material deposits. We provide construction products and services to both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites in the southeastern United States. Our public projects are funded by federal, state and local governments and include projects for roads, highways, bridges, airports and other forms of infrastructure. Public transportation infrastructure projects historically have been a relatively stable portion of state and federal budgets and represent a significant share of the United States construction market. Federal funds are allocated on a state-by-state basis, and each state is required to match a portion of the federal funds that it receives. Federal highway spending uses funds predominantly from the Highway Trust Fund, which derives its revenues from fuel taxes and other user fees. In addition to public infrastructure projects, we provide a wide range of large sitework construction and HMA paving services to private construction customers, including commercial and residential developers and local businesses. Recent Developments COVID-19 We did not incur significant disruptions from the COVID-19 pandemic during the three months ended December 31, 2021. However, we continue to closely monitor the impact of the pandemic on all aspects of our business, including its impact on our customers, employees, suppliers and vendors. Among the primary risks to our business from the pandemic are (i) employee absences, which could adversely affect our productivity and our ability to complete projects in accordance with our contractual obligations, and could require us to temporarily close our facilities or project sites, (ii) potential disruptions in our supply chains for raw materials or equipment, whether as a result of facility closures or otherwise, which could increase our labor and materials costs and impair our ability to manufacture HMA or the ability of our subcontractors to complete their required tasks, and (iii) the impact of the COVID-19 pandemic on our customers, which could cause these customers to cancel or delay current or prospective projects or become delinquent in their payments to us for work that we have performed. These risks materialized in varying degrees during the three months ended December 31, 2021, but none of these risks, individually or in the aggregate, have significantly impacted our operations to date. In addition, the extent to which our operations may be impacted by the COVID-19 pandemic going forward will also depend on the duration of the pandemic, the emergence of different COVID-19 variants, the efficacy and adoption rates of vaccines, and actions by government authorities to contain the outbreak or mitigate the impact of the pandemic. Inflationary Trends During the three months ended December 31, 2021, we continued to experience an upward trend in several inflation-sensitive inputs necessary for us to provide our products and services, including upward pressure on wages and increases in the cost of raw materials used to produce HMA and other items that are critical to our business, including fuel, concrete and steel. In addition, we experienced some disruptions from various participants in our supply chain, including subcontractors, materials suppliers and equipment manufacturers, who provide the raw materials, equipment, vehicles, construction supplies and other services we require in order to manufacture HMA and perform our construction projects. To date, we have been able to mitigate some of the effects of inflation, supply chain disruptions and labor constraints on our business by increasing prices for our products and including the anticipated cost increases in the construction projects we bid. However, we are limited in our ability to pass through increased costs for projects already in our backlog and, under those circumstances, may be unable to recoup losses or diminished profit margins by passing these costs through to our customers. 23 Table of Contents South Carolina Acquisition On October 1, 2021, we acquired King Asphalt, Inc. The acquisition established the Company's first platform company in South Carolina and added three HMA plants in the Greenville, South Carolina metro area. For further discussion regarding this transaction, see Note 4 - Business Acquisitions to the unaudited consolidated financial statements included elsewhere in this report. Florida Acquisition On October 18, 2021, we acquired the operations of J. Miller Construction Inc. The acquisition further enhances the Company’s vertical integration of construction services and supplements the Company’s capabilities in the greater Pensacola, Florida market area. For further discussion regarding this transaction, see Note 4 - Business Acquisitions to the unaudited consolidated financial statements included elsewhere in this report. How We Assess Performance of Our Business Revenues We derive our revenues predominantly by providing construction products and services for both public and private infrastructure projects, with an emphasis on highways, roads, bridges, airports and commercial and residential sites. Our projects represent a mix of federal, state, municipal and private customers. We also derive revenues from the sale of HMA, aggregates, and liquid asphalt cement to customers. We recognize revenues derived from projects as we satisfy our performance obligations over time (formerly known as the percentage-of-completion method), measured by the relationship of total cost incurred compared to total estimated contract costs (cost-to-cost input method). Changes in job performance, job conditions and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to estimated costs and income, and are recognized in the period in which the revisions are determined. Revenues derived from the sale of HMA, aggregates, and liquid asphalt cement are recognized when the risks associated with ownership have passed to the customer. Gross Profit Gross profit represents revenues less cost of revenues. Cost of revenues consists of all direct and indirect costs associated with construction contracts, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other expenses at our HMA plants, aggregates mining facilities, and liquid asphalt cement terminal. Our cost of revenues is directly affected by fluctuations in commodity prices, primarily liquid asphalt and diesel fuel. From time to time, when appropriate, we limit our exposure to changes in commodity prices by entering into forward purchase commitments. In addition, our public infrastructure contracts often provide for price adjustments based on fluctuations in certain commodity-related product costs. These price adjustment provisions are in place for most of our public infrastructure contracts, and we seek to include similar provisions in our private contracts. Depreciation, Depletion and Amortization Property, plant and equipment are initially recorded at cost or, if acquired as a business combination, at fair value. Depreciation on property, plant and equipment is computed on a straight-line basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straight-line basis over the estimated useful lives of the assets. Mineral reserves are depleted in accordance with the units-of-production method as aggregates are extracted, using the initial allocation of cost based on proven and probable reserves. General and Administrative Expenses General and administrative expenses include costs related to our operational offices that are not allocated to direct contract costs and expenses related to our corporate offices. These expenses consist primarily of salaries and personnel costs for our administration, finance and accounting, legal, information systems, human resources and certain managerial employees. General and administrative expenses also include acquisition expenses, audit, consulting and professional fees, stock-based compensation expense, travel, insurance, office space rental costs, property taxes and other corporate and overhead expenses. Gain on Sale of Equipment, Net In the normal course of business, we sell construction equipment for various reasons, including when the cost of maintaining the asset exceeds the cost of replacing it. The gain or loss on the sale of equipment reflects the difference between the carrying value at the date of disposal and the net consideration received from the sale of equipment during the period. 24 Table of Contents Interest Expense, Net Interest expense, net primarily represents interest incurred on our long-term debt, such as the Term Loan and the Revolving Credit Facility, as well as the changes in fair values of interest swap agreements and amortization of deferred debt issuance costs. These amounts are partially offset by interest income earned on short-term investments of cash balances in excess of our current operating needs. Adjusted EBITDA, Adjusted EBITDA Margin, and Adjusted Net Income Adjusted EBITDA represents net income before, as applicable from time to time, (i) interest expense, net, (ii) provision (benefit) for income taxes, (iii) depreciation, depletion, accretion and amortization, (iv) equity-based compensation expense, (v) loss on the extinguishment of debt, (vi) certain management fees and expenses and (vii) nonrecurring legal settlement costs and associated legal expenses unrelated to the Company’s core operations. Adjusted EBITDA Margin represents Adjusted EBITDA as a percentage of revenues for each period. Adjusted net income represents net income before nonrecurring legal settlement costs and associated legal expenses unrelated to the Company’s core operations. These metrics are supplemental measures of our operating performance that are neither required by, nor presented in accordance with, GAAP. These measures have limitations as analytical tools and should not be considered in isolation or as an alternative to net income or any other performance measure derived in accordance with GAAP as an indicator of our operating performance. We present Adjusted EBITDA, Adjusted EBITDA Margin and Adjusted net income because management uses these measures as key performance indicators, and we believe that securities analysts, investors and others use these measures to evaluate companies in our industry. Our calculation of Adjusted EBITDA, Adjusted EBITDA Margin and Adjusted net income may not be comparable to similarly named measures reported by other companies. Potential differences may include differences in capital structures, tax positions and the age and book depreciation of intangible and tangible assets. The following table presents a reconciliation of net income, the most directly comparable measure calculated in accordance with GAAP, to Adjusted EBITDA and the calculation of Adjusted EBITDA Margin for the periods presented (in thousands, except percentages): For the Three Months Ended December 31, 2021 2020 Net income $ 5,511 $ 7,871 Interest expense, net 1,264 468 Provision for income taxes 1,800 2,680 Depreciation, depletion, accretion and amortization 15,903 11,094 Equity-based compensation expense 1,504 395 Management fees and expenses (1) 375 617 Settlement of legal claim and associated legal expenses (2) — 366 Adjusted EBITDA $ 26,357 $ 23,491 Revenues $ 284,964 $ 190,929 Adjusted EBITDA Margin 9.2 % 12.3 % (1) Reflects fees and reimbursement of certain out-of-pocket expenses under a management services agreement with SunTx Capital Partners, the Company’s controlling stockholder (see Note 12 - Related Parties to the unaudited consolidated financial statements included elsewhere in this report). (2) Reflects legal expenses associated with a settlement agreement entered into in April 2021 unrelated to the Company's core operations. 25 Table of Contents The following table presents a reconciliation of net income, the most directly comparable measure calculated in accordance with GAAP, to adjusted net income for the periods presented (in thousands): For the Three Months Ended December 31, 2021 2020 Net income $ 5,511 $ 7,871 Settlement of legal claim and associated legal expenses (1) — 366 Tax impact due to above reconciling items $ — $ (92) Adjusted net income $ 5,511 $ 8,145 (1) Reflects legal expenses associated with a settlement agreement entered into in April 2021 unrelated to the Company's core operations. Results of Operations Three Months Ended December 31, 2021 Compared to Three Months Ended December 31, 2020 The following table sets forth selected financial data for the three months ended December 31, 2021 and December 31, 2020 (unaudited in thousands, except percentages): Change From the Three Months Ended For the Three Months Ended December 31, December 31, 2020 to the Three Months Ended 2021 2020 December 31, 2021 Dollars % of Revenues Dollars % of Revenues $ Change % Change Revenues $ 284,964 100.0 % $ 190,929 100.0 % $ 94,035 49.3 % Cost of revenues 252,000 88.4 % 160,335 84.0 % 91,665 57.2 % Gross profit 32,964 11.6 % 30,594 16.0 % 2,370 7.7 % General and administrative expenses (24,946) (8.8) % (20,084) (10.5) % (4,862) 24.2 % Gain on sale of equipment, net 441 0.2 % 333 0.2 % 108 32.4 % Operating income 8,459 3.0 % 10,843 5.7 % (2,384) (22.0) % Interest expense, net (1,264) (0.4) % (468) (0.2) % (796) 170.1 % Other income 116 — % 165 — % (49) (29.7) % Income before provision for income taxes and earnings from investment in joint venture 7,311 2.6 % 10,540 5.5 % (3,229) (30.6) % Provision for income taxes 1,800 0.6 % 2,680 1.4 % (880) (32.8) % Earnings from investment in joint venture — — % 11 — % (11) (100.0) % Net income $ 5,511 1.9 % $ 7,871 4.1 % $ (2,360) (30.0) % Adjusted EBITDA $ 26,357 9.2 % $ 23,491 12.3 % $ 2,866 12.2 % Adjusted net income $ 5,511 1.9 % $ 8,145 4.3 % $ (2,634) (32.3) % Revenues. Revenues for the three months ended December 31, 2021 increased $94.1 million, or 49.3%, to $285.0 million from $190.9 million for the three months ended December 31, 2020. The increase included $37.8 million of revenues attributable to acquisitions completed subsequent to December 31, 2020 and an increase of approximately $56.3 million of revenues in our existing markets from contract work and sales of HMA and aggregates to third parties. Gross Profit. Gross profit for the three months ended December 31, 2021 increased $2.4 million, or 7.7%, to $33.0 million from $30.6 million for the three months ended December 31, 2020. The increase in gross profit was primarily the result of the 49.3% 26 Table of Contents increase in revenue in the three months ended December 31, 2021 compared to the three months ended December 31, 2020. The lower gross profit margin was due to (i) lower profit margins on the projects we assumed in connection with acquisitions completed during the three months ended December 31, 2021 and the fiscal year ended September 30, 2021, and (ii) continued lower margins due to increases in the costs of raw materials, fuel, labor and trucking, and supply chain issues. General and Administrative Expenses. General and administrative expenses for the three months ended December 31, 2021 increased $4.8 million, or 24.2%, to $24.9 million from $20.1 million for the three months ended December 31, 2020. The increase was primarily the result of (i) a $1.1 million increase in equity-based compensation expense, (ii) a $2.3 million increase attributable to general and administrative expenses associated with the businesses acquired subsequent to December 31, 2020, and (iii) a $1.2 million increase in other professional fees, primarily driven by expenses incurred in support of acquisition activities, information technology expenses and increased accounting and consulting fees. Interest Expense, Net. Interest expense, net for the three months ended December 31, 2021 increased $0.8 million, or 170.1%, to $1.3 million compared to $0.5 million for the three months ended December 31, 2020. The increase in interest expense was due to an increase in the average principal debt balance outstanding during the three months ended December 31, 2021 compared to the corresponding period in 2020. Provision for Income Taxes. Our effective tax rate decreased to 24.6% for the three months ended December 31, 2021, from 25.4% for the three months ended December 31, 2020. Our lower effective tax rate during the three months ended December 31, 2021 was the result of a benefit of $0.1 million related to an amended state return filed during the period. Net Income. Net income decreased $2.4 million, or 30.0%, to $5.5 million for the three months ended December 31, 2021, compared to $7.9 million for the three months ended December 31, 2020. The decrease in net income was a result of an increase in general and administrative expenses, partially offset by an increase in gross profit, all as described above. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA and Adjusted EBITDA Margin were $26.4 million and 9.2%, respectively, for the three months ended December 31, 2021, compared to $23.5 million and 12.3%, respectively, for the three months ended December 31, 2020. The increase in Adjusted EBITDA was the result of a higher gross profit and depreciation, depletion, accretion and amortization of long-lived assets, partially offset by an increase in general and administrative expenses and interest expense. The lower Adjusted EBITDA Margin was primarily a result of the increase in revenues during the period. See the description of Adjusted EBITDA and Adjusted EBITDA Margin, as well as a reconciliation of Adjusted EBITDA to net income, under the heading “How We Assess Performance of Our Business”. Adjusted Net Income. Adjusted net income decreased $2.6 million, or 32.3%, to adjusted net income of $5.5 million for the three months ended December 31, 2021, compared to adjusted net income of $8.1 million for the three months ended December 31, 2020. The decrease in adjusted net income was primarily a result of lower gross profit and higher general and administrative expenses, all as described above. Inflation and Price Changes As described above under the heading “Inflationary Trends,” during the three months ended December 31, 2021, we continued to experience an upward trend in several inflation-sensitive inputs necessary for us to provide our products and services, including upward pressure on wages and increases in the cost of raw materials used to produce HMA and other items that are critical to our business. Inflation had an immaterial impact on our results of operations for the three months ended December 31, 2020 due to relatively low inflation in the United States during that period and our ability to recover increasing costs by obtaining higher prices for our products, including sale price escalator clauses in most of our public infrastructure sector contracts. 27 Table of Contents Liquidity and Capital Resources Cash Flows Analysis The following table sets forth our cash flows for the periods indicated (in thousands): For the Three Months Ended December 31, 2021 2020 Net cash provided by (used in) operating activities, net of acquisitions $ (577) $ 709 Net cash used in investing activities (80,274) (94,056) Net cash provided by (used in) financing activities 67,461 (3,250) Net change in cash and cash equivalents $ (13,390) $ (96,597) Operating Activities During the three months ended December 31, 2021, cash used in operating activities, net of acquisitions, was $0.6 million, primarily as a result of: • net income of $5.5 million, including $15.9 million of depreciation, depletion, accretion and amortization of long-lived assets and equity-based compensation expense of $1.5 million; • an increase in inventories of $2.5 million due to acquisitions and normal fluctuations in our inventory cycle; • an increase in prepaid expenses and other current assets of $3.5 million due to the timing of payments for various insurance policies and expenses; • a decrease in accounts payable and accrued expenses and other current liabilities of $24.2 million due to the timing of processing transactions in our accounts payable cycle; and • a net increase in the difference between costs and estimated earnings in excess of billings on uncompleted contracts and billings in excess of costs and estimated earnings on uncompleted contracts of $5.8 million due to the timing of performing and closing projects. During the three months ended December 31, 2020, cash provided by operating activities, net of acquisitions, was $0.7 million, primarily as a result of: • net income of $7.9 million, including $11.1 million of depreciation, depletion, accretion and amortization of long-lived assets and equity-based compensation expense of $0.4 million; • a decrease in contracts receivable including retainage, net, of $18.5 million due to the timing of processing transactions in our accounts receivable cycle; • a decrease in accounts payable and accrued expenses and other current liabilities of $24.7 million due to the timing of processing transactions in our accounts payable cycle; and • a net decrease in the difference between costs and estimated earnings in excess of billings on uncompleted contracts and billings in excess of costs and estimated earnings on uncompleted contracts of $7.0 million due to the timing of performing and closing projects. Investing Activities During the three months ended December 31, 2021, cash used in investing activities was $80.3 million, of which $65.9 million related to acquisitions completed in the period and $15.1 million was invested in property, plant and equipment, partially offset by $0.7 million of proceeds from the sale of equipment. During the three months ended December 31, 2020, cash used in investing activities was $94.1 million, of which $84.1 million related to acquisitions completed in the period and $10.5 million was invested in property, plant and equipment, partially offset by $0.5 million of proceeds from the sale of equipment. 28 Table of Contents Financing Activities During the three months ended December 31, 2021, cash provided by financing activities was $67.5 million. We received $70.0 million of proceeds from our Revolving Credit Facility, primarily used for acquisitions completed in the period. This cash flow was offset by $2.5 million of principal payments on long-term debt. During the three months ended December 31, 2020, cash used in financing activities was $3.3 million, representing the repayment of principal on long-term debt during the period. Credit Agreement We and each of our subsidiaries are parties to the Credit Agreement, which provides for the Term Loan and the Revolving Credit Facility. At December 31, 2021 and September 30, 2021, we had $195.0 million and $197.5 million, respectively, of principal outstanding under the Term Loan, $90.0 million and $20.0 million, respectively, of principal outstanding under the Revolving Credit Facility, and availability of $123.7 million and $193.7 million, respectively, under the Revolving Credit Facility, including reduction for outstanding letters of credit. The obligations of our subsidiaries under the Term Loan and the Revolving Credit Facility are secured by a first priority security interest in substantially all of our assets. The Credit Agreement requires the Company to satisfy certain financial covenants, including a minimum fixed charge coverage ratio of 1.20-to-1.00 and a maximum consolidated leverage ratio of 3.00-to-1.00, subject to certain adjustments. At December 31, 2021 and September 30, 2021, our fixed charge coverage ratio was 3.14-to-1.00 and 3.29-to-1.00, respectively, and our consolidated leverage ratio was 2.49-to-1.00 and 1.99-to-1.00, respectively. From time to time, the Company has entered into interest rate swap agreements to hedge against the risk of changes in interest rates. At December 31, 2021 and September 30, 2021, the aggregate notional value of these interest rate swap agreements was $196.3 million and $198.3 million, respectively, and the fair value was $1.5 million and $(0.8) million, respectively, which is included within other assets, other current liabilities or other long-term liabilities on the Company’s Consolidated Balance Sheets. For more information about the Credit Amendment, see Note 8 - Debt to the unaudited consolidated financial statements included elsewhere in this report. Capital Requirements and Sources of Liquidity During the three months ended December 31, 2021 and 2020, our capital expenditures were approximately $15.1 million and $10.5 million, respectively. Our capital expenditures are typically made during the same fiscal year in which they are approved. At December 31, 2021, our commitments for capital expenditures were not material to our financial condition or results of operations on a consolidated basis. For fiscal 2022, we expect total capital expenditures to be $60.0 million to $65.0 million. Our capital expenditure budget is an estimate and is subject to change. Historically, we have required significant amounts of cash in order to make capital expenditures, purchase materials and fund our organic expansion into new markets. Our working capital needs are driven by the seasonality and growth of our business, with our cash requirements increasing in periods of growth. Additional cash requirements resulting from our growth include the costs of additional personnel, production and distribution facilities, enhancements to our information systems, integration costs related to any acquisitions and our compliance with laws and rules applicable to public companies. We have historically relied on cash available through credit facilities, in addition to cash from operations, to finance our working capital requirements and to support our growth. We regularly monitor potential capital sources, including equity and debt markets, in an effort to meet our planned capital expenditures and liquidity requirements. Our future success will depend on our ability to access outside sources of capital. We believe that our operating cash flow and available borrowings under the Credit Agreement will be sufficient to fund our operations and planned capital expenditures for at least the next 12 months. However, future cash flows are subject to a number of variables, including the potential impacts of COVID-19, and significant additional capital expenditures will be required to conduct our operations. There can be no assurance that operations and other capital resources will provide sufficient cash to maintain planned or future levels of capital expenditures. In the event that we make one or more acquisitions and the amount of capital required is greater than the amount of cash on hand we have available for acquisitions at that time, we could be required to reduce the expected level of capital expenditures and/or seek additional capital. If we seek additional capital, we may do so through borrowings under the Credit Agreement, joint ventures, asset sales, offerings of debt or equity securities or other means. However, the unprecedented public health and governmental efforts to contain the spread of COVID-19 have created significant uncertainty as to general economic conditions for fiscal 2022 and beyond, and our ability to engage in any such transactions may be constrained by economic conditions and other factors outside of our control. We cannot guarantee that additional capital will be available on acceptable terms or at all. If we are 29 Table of Contents unable to obtain the funds we need, we may not be able to complete acquisitions that may be favorable to us or finance the capital expenditures necessary to conduct our operations. Contractual Obligations The following table summarizes our significant obligations outstanding as of December 31, 2021: Payments Due by Fiscal Year Total 2022 2023 2024 2025 2026 2027 and Thereafter Debt obligations $ 285,000 $ 7,500 $ 10,000 $ 11,250 $ 15,000 $ 241,250 $ — Operating leases 13,034 1,669 2,078 1,715 1,388 1,381 4,803 Purchase commitments 3,422 1,969 1,453 — — — — Royalty payments 2,340 234 196 189 137 124 1,460 Asset retirement obligations 2,805 — — — — — 2,805 Total $ 306,601 $ 11,372 $ 13,727 $ 13,154 $ 16,525 $ 242,755 $ 9,068 Off-Balance Sheet Arrangements As of December 31, 2021, the Company had aggregate letters of credit outstanding in the amount of $11.3 million, future purchase commitments of $3.4 million for diesel fuel and $2.3 million of minimum royalty payments related to aggregates facilities. Other than the letters of credit, future purchase commitments and minimum royalty payments, we do not currently have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, changes in our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. See Note 17 - Commitments to our unaudited consolidated financial statements included elsewhere in this report for additional information.