FORM 10-K

SECURITIES AND EXCHANGE COMMISSION

Commission file number: 0-19450

STERLING CONSTRUCTION COMPANY, INC.

Securities registered pursuant to Section 12(b) of the Act:
None

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Second 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K þ

     Indicate by check mark whether the registrant is an accelerated filer (as defined by Exchange Act Rule 12b-2). o Yes þ No

Aggregate market value at June 30, 2004 of the voting stock held by non-affiliates of the registrant: $15,557,732.

At March 1, 2005 the registrant had 7,399,681 shares of common stock outstanding

DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates certain information by reference from the Registrant’s definitive proxy statement for the annual
meeting of shareholders to be held on May 19, 2005, which proxy statement will be filed no later than 120 days after
the close of the Registrant’s fiscal year ended December 31, 2004.

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Table of Contents

PART I

Item 1. Business

Cautionary Statement

     This Report on Form 10-K contains certain forward-looking statements that involve risks and uncertainties. The cautionary statements contained in this Report should be read as being applicable to all related forward-looking statements wherever they appear in this Report. The Company’s actual results in the future could differ materially from those discussed here. Important factors that could cause or contribute to such differences include those discussed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Report.

Company Website

     The Company maintains a website at www.sterlingconstructionco.com and makes available free of charge on or through its website, access to its latest Annual Report on Form 10-K, recent Quarterly Reports on Form 10-Q, any amendments to those filings, recent press releases, its Code of Ethics, and Audit Committee Charter together with other filings related to shareholdings. The website content is available for informational purposes only. The website should not be relied upon for investment purposes nor is it incorporated by reference into this Form 10-K.

Business

     Sterling Construction Company, Inc. (“Sterling” or “the Company”) owns two subsidiaries (i) Sterling Houston Holdings, Inc., a heavy civil construction company based in Houston, Texas (the “Construction Segment” or “SHH”) and (ii) Steel City Products, Inc., a distributor of automotive accessories, non-food pet supplies and lawn and garden products based in Pittsburgh, Pennsylvania (the “Distribution Segment” or “SCPI”).

     Further information on the businesses of the Company’s operating segments is discussed below. Financial information for the segments is set forth in Note 13 to the consolidated financial statements of the Company.

Business Strategy

     The Company seeks to increase long-term stockholder value by expanding profit opportunities through winning and executing more contracts and larger ones in its core construction business. This requires the continued investment in a growing staff of professional engineers and construction crews and the addition of capital equipment. Acquisitions are also part of management’s growth strategy and acquisition candidates are regularly evaluated. In general, the Company is seeking acquisitions that would be accretive and have management who will continue to direct the operations of the acquired enterprise. While an acquisition that would expand the scope, either functionally and/or geographically, of the current business would be desirable, management has and will continue to consider other transactions that meet the aforementioned financial and management criteria. The Company’s tax loss carryforwards are an important corporate asset and the protection and utilization of the losses is expected to assist in increasing shareholder values for the next several years. Stockholder value is measured by increases in shareholders’ equity and by the appreciation of the value of the outstanding common stock over a period of years. In addition, the Company measures its success by the ability to attract and maintain experienced and capable employees and to maintain high ethical standards.

The Construction Segment

Operations

     SHH specializes in municipal and state contracts for the construction and paving of highways, building of bridges, installing water and sewer mains, light rail infrastructure projects and similar activities.

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Raw Materials

     The principal raw materials used in SHH’s business include structural steel, concrete and aggregate. These and other raw materials and components which are used and are necessary in the construction business are generally available from numerous sources. Factors such as price and availability of transportation for these raw materials may limit supply at some times. SHH does not foresee shortages in these raw materials in the near term that would have a material adverse effect on the business.

Seasonality

     SHH’s operations can be materially affected by poor weather conditions, so that generally less construction is completed in the winter months. In particular, significant rainfall can cause construction delays adversely affecting revenues and margins on contracts in progress.

Customer Base

     Most of SHH’s revenues are generated in the Houston municipal market, which includes the City of Houston, the Houston Metropolitan Transit Authority and Harris County. (See Note 13)

     In addition to its established operations in Houston, SHH has operations in the Dallas/Fort Worth and San Antonio markets and undertakes contracts for the State of Texas in each of its markets and elsewhere within the State. SHH also occasionally undertakes projects for private developers and corporate customers.

     Most contracts are subject to a competitive public tender process.

     There are no foreign revenues.

     The table set forth in Note 13 to the consolidated financial statements shows contract revenues generated from SHH’s largest customers which accounted for more than 10% of revenues in fiscal 2004, 2003 and 2002.

Contract Backlog

     At December 31, 2004, SHH’s backlog of construction contracts totaled $232 million, the largest year-end backlog in SHH’s history, and an increase of 65% compared with December 31, 2003. Of this amount, approximately $160 million is scheduled to be completed within fiscal 2005, and approximately $72 million in fiscal 2006 and beyond. SHH expects to add further contracts during 2005 for construction during the year and in the future. Through mid-March 2005 ,the Company announced new contract wins individually exceeding $5 million with an aggregate value of $55.5 million.

Competition

     The typical public contract selection process is by sealed bid with the lowest bidder winning in a public selection process. Management undertakes a significant due diligence process in preparing each bid. Participants must post bid bonds for up to 10% of the amount bid, and on successful bids must post performance bonds for 100% of the contract amount. Contracts are priced for labor, sub-contracting, equipment use and materials against detailed specifications provided by the customer.

     SHH’s competitors include large national and regional construction companies as well as smaller contractors. Management is unable to determine the relative size of most competitors, which are privately-owned, but believes that SHH is one of the larger participants in its marketplace, and the largest contractor in Houston that is engaged in municipal civil construction work.

     SHH’s size relative to its many smaller competitors in the municipal construction market gives it several advantages, including greater flexibility to manage its backlog so as to maximize its manpower and equipment

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resources, and the cost effective purchasing of materials, insurance and bonds. Since SHH owns and maintains most of the equipment required for its contracts and has the experienced manpower to handle many types of municipal civil construction, it is able to bid competitively on many categories of contracts, especially complex multi-task projects. In its successful effort to penetrate the state highway market, where most competitors are large, regional contractors, and individual contracts tend to be larger than the Company’s municipal work and involve many specialized skills, SHH acquired the Kinsel heavy highway construction business (“Kinsel”) in September 2002. By fiscal 2004 state highway work had come to represent 33.0% of Construction Segment revenues, compared with 18.6% and 7.7% in fiscal 2003 and 2002, respectively.

Regulation

     Management does not anticipate that existing or known pending environmental legislation or other regulations will require major capital expenditures or will adversely affect its operations. However, in the last two years, environmental issues have adversely impacted the rate at which certain highway contracts have been let in the Houston market.

Employees

     At December 31, 2004, SHH employed approximately 750 persons, of whom 29 were employed in the headquarters in Houston. Most of the others are field personnel. No SHH employees are represented by a labor union. Senior SHH executives, including Patrick T. Manning (also Chief Executive Officer of Sterling) and Joseph P. Harper, Sr. (also President of Sterling) have many years of service with SHH and are employed under long-term contracts, which were renewed during fiscal 2004.

     SHH’s business is dependent upon a readily available workforce of both field and supervisory personnel. SHH does not anticipate any shortage of labor in the near term, but has no assurance that it will be able to continue to attract sufficient numbers of new employees to support its growth in the future.

The Distribution Segment

Operations

     Since its founding in 1947 SCPI has distributed automotive accessories, now including functional and decorative car and truck accessories, car care products, chemicals and car repair and maintenance items. In fiscal 1996, SCPI expanded its merchandise selection to include non-food pet supplies and in fiscal 2000 added lawn and garden products. Sales in fiscal 2004 of pet supplies and lawn and garden products represented approximately 16.5% and 16.6%, respectively, of SCPI’s total sales. SCPI’s automotive and pet distribution operations are conducted from leased facilities in McKeesport, Pennsylvania and its lawn and garden operations are conducted from leased facilities in Glassport, Pennsylvania.

     Many of SCPI’s largest customers transmit their own orders directly to SCPI’s warehouse; nevertheless, SCPI continues to provide personal service to many customers, which involves visits by its sales personnel to customers’ stores to count and re-order merchandise. Since most orders are generated electronically and are shipped within a few days of receipt, the size of SCPI’s order backlog is not relevant to an understanding of the business. Shipments are either made directly to each of the customers’ stores or are packed for onward shipment to stores via the retailers’ distribution centers. SCPI also provides price ticketing and associated services to those of its customers that request such services.

Sources of Supply

     SCPI acquires its merchandise from a large number of suppliers, the largest of which accounted for 13.5% of its purchases for fiscal 2004. Many of the products sold by SCPI carry nationally advertised brand names, but because of the diversity and number of suppliers and products carried, the business is not generally dependent on the continued availability of individual products or continued dealings with existing supply sources. From time to time,

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market or seasonal conditions may affect the availability of certain merchandise, but not to the extent that the Company believes would materially impact its business.

     Steel City Products generally carries in inventory only those products that its customers have identified as necessary for their own merchandising needs and does not acquire significant quantities of other merchandise.

Seasonality

     SCPI’s automotive and lawn and garden businesses are seasonal, being slowest in the early winter months than at other times of the year. In anticipation of higher sales volume in the spring and summer, SCPI carries higher inventories of these products beginning in the winter months. As is customary in the automotive aftermarket and in the lawn and garden products business, some suppliers allow extended payment terms to SCPI for such inventory build-ups.

     SCPI’s pet supply business is less subject to seasonality, but usually experiences increased sales in the fourth quarter of the year.

     SCPI’s needs for working capital are affected by these seasonal fluctuations and other factors (see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - - Liquidity and Capital Resources”).

Customer Base

     SCPI’s customers include supermarket chains, drug stores, general merchandise retail chains, automotive specialty stores, hardware stores, variety stores, some smaller garden centers and other automotive accessory distributors. Most customers are based in the northeastern United States, although stores operated by some customers are located outside of that area, and since 2000 SCPI has been selling to the West Coast distribution facility of one of its major customers (See Note 13). There are no foreign sales.

     SCPI’s customers are continually affected by changes in the retail environment, including the competitive pressures facing regional mass merchandisers and the growing influence of national automotive and pet specialty chains. These have led to fluctuations in the level of business that SCPI enjoys with individual customers. Some customers have changed their buying practices to acquire certain merchandise direct from manufacturers rather than through distributors such as SCPI.

     In its efforts to offset these trends, SCPI has in recent years added new customers, especially in the supermarket and drug store sectors, has expanded its product offerings to certain customers, has enlarged the territory that it serves and has introduced new categories of products. Management believes that these efforts have resulted in a more diverse and financially secure customer base.

     None of SCPI’s business is based on government contracts and there are no long-term sales contracts with any customers.

Competition

     The distribution business for automotive parts and accessories, non-food pet supplies and lawn and garden products is highly competitive, with several similar companies operating in SCPI’s market place, and many of SCPI’s suppliers also offering their products directly to retailers. Management is unable to quantify SCPI’s relative size in relation to its competitors, but believes it is one of the largest independent distributors of automotive accessories in the Northeastern United States. In recent years, a number of significant competitors of SCPI have gone out of business and some of SCPI’s customers have chosen to purchase some products directly from manufacturers. SCPI competes on the basis of its management’s merchandise expertise, the breadth of merchandise offered, price, levels of service, order fill rates and order turnaround times. Management believes that SCPI’s long history, good reputation, experienced management, product selection, pricing, and traditionally high service levels and order fill rates, enable it to compete favorably with other distributors and direct sales by manufacturers.

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Regulation

     SCPI’s management does not anticipate that existing or known pending environmental legislation or other regulations will require major capital expenditures or will adversely affect its operations.

Employees

     SCPI employs approximately 50 persons, of which about 40 are employed in the headquarters office and distribution facility in McKeesport and the Glassport distribution facility. The others are field personnel. Senior executives, including the Chairman of the Board of Directors, Bernard H. Frank (a founder of Steel City Products), the President and Chief Executive Officer, Terrance W. Allan and the Vice President of Sales, Patrick Nicholson, have many years of service with SCPI. Mr. Allan is employed under a long-term contract.

     Warehouse and certain office employees of SCPI are represented by Local 636 of the International Brotherhood of Teamsters. SCPI has experienced generally good labor relations and no significant labor disputes have affected its business for many years. The union contract was extended in 2003 to December 1, 2005.

Item 2. Properties

     SHH owns a 15,000 sq. ft. headquarters building in Houston located on a seven-acre parcel on which its equipment repair center is also located. It also leases small offices in Grand Prairie and San Antonio, Texas.

     SCPI operates its automotive and pet supply businesses from a leased, 67,000 square-foot building located in an industrial park in McKeesport, Pennsylvania. With the addition of the lawn and garden distribution business in 2000, SCPI leased an additional 43,000 sq. ft. of warehouse space located in an industrial park in nearby Glassport, Pennsylvania.

Item 3. Legal Proceedings

     The Company is involved in certain claims and lawsuits occurring in the normal course of business. Management, after consultation with outside legal counsel, does not believe that the outcome of these actions would have a material impact on the financial statements of the Company. (See Note 15)

Item 4. Submission of Matters to a Vote of Security Holders

     No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2004.

Item 4A. Executive Officers of the Company

     Executive officers of the Company are as follows:

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Patrick T. Manning. Mr. Manning joined SHH in 1971 and led its move from Detroit, Michigan into the Houston market in 1978. He is currently SHH’s President and Chief Executive Officer. Mr. Manning has served on a variety of construction industry committees, including the Gulf Coast Trenchless Association and the Houston Contractors’ Association, where he served as a member of the Board of Directors and as President from 1987 to 1993. He attended Michigan State University from 1969 to 1972. Mr. Manning has served as Chairman of the Board and Chief Executive Officer of Sterling since July 2001, when the Company increased its equity investment in SHH to 80.1% (the “Sterling Transaction”).

Joseph P. Harper, Sr. Mr. Harper has been employed by SHH since 1972 and has performed both estimating and project management functions as well as his primary role as SHH’s Treasurer. Mr. Harper has served as President and Chief Operating Officer of the Company since the completion of the Sterling Transaction in July 2001. Mr. Harper also serves as a director of SCPI.

Maarten D. Hemsley. Mr. Hemsley has been an employee and/or director of the Company or SCPI in various capacities since 1988. Mr. Hemsley served as President, Chief Operating Officer and Chief Financial Officer of the Company until July 2001, and currently serves as Chief Financial Officer of both Sterling and SCPI. Since January 2001, Mr. Hemsley has also been a consultant to (and since May 2002 an employee of) JO Hambro Capital Management Limited, an investment management company based in the United Kingdom as Fund Manager of Leisure & Media Venture Capital Trust, plc, and recently as a principal of its Trident Private Equity II investment fund.. Mr. Hemsley is a director of Tech/Ops Sevcon, Inc., a public company that manufactures electronic controls, of XN Checkout Holdings plc, a United Kingdom public company that provides electronic sales solutions to the restaurant, pub and hotel markets, and of a number of privately-held companies in the United Kingdom.

Roger M. Barzun. Mr. Barzun has been Vice President, Secretary and General Counsel of the Company since August 1991 and was a Senior Vice President from May 1994 until July 2001. Mr. Barzun has been a lawyer since 1968 and is a member of the New York and Massachusetts bars.

Terrance W. Allan. Mr. Allan has been an officer of SCPI for more than the last five years. He was appointed President of SCPI in May 2000 and its Chief Executive Officer in May 2002.

PART II

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     Prior to February 12, 2004, the Company’s Common Stock traded on the OTC Bulletin Board, under the symbol STCS.OB. On February 12, 2004, the Company’s stock commenced trading on the American Stock Exchange under the symbol STV.

     The following table sets forth the high and low bid prices by fiscal quarter for the Company’s common stock for fiscal years 2004 and 2003.

     In its first quarter through March 15, 2005, the Company’s stock has ranged from a low of $5.13 to a high of $7.28.

     Such quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

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     There were approximately 3,600 holders of record of the Company’s common stock on March 1, 2005.

     No cash dividends were declared or paid in fiscal years 2004, 2003 or 2002. The Company does not anticipate the declaration of cash dividends in the foreseeable future. The ability of the Company’s operating subsidiaries, SHH and SCPI, to upstream funds to Sterling for payment of dividends is limited by their respective bank credit agreements.

     On December 22, 2004, 1,794,627 shares were issued in connection with the exercise of the Put in which the Company purchased the remaining 19.9% of SHH. (See Note 4).

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Item 6. Selected Financial Data

     The following table sets forth selected financial and other data of Sterling Construction Company, Inc. and subsidiaries and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, which follows, and the Consolidated Financial Statements and related Notes (amounts in thousands, except per share data).

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

     As discussed in “ITEM 1. BUSINESS” above, the Company operates primarily as a heavy civil construction company based in Houston, Texas under the trade name “Texas Sterling Construction”. The Company’s distribution business is conducted in Pittsburgh, Pennsylvania under the name “Steel City Products”.

Critical Accounting Policies

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management’s estimates, judgments and assumptions are continually evaluated based on available information and experience, however, actual amounts could differ from those estimates. The Company’s significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements.

     Certain of the Company’s accounting policies require higher degrees of judgment than others in their application. These include the recognition of revenue and earnings from construction contracts and the valuation of long-term assets. Management evaluates all of its estimates and judgments on an on-going basis.

     Revenue Recognition: The Company uses the percentage of completion accounting method for construction contracts in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Revenue and earnings on construction contracts are recognized on the percentage of completion method in the ratio of costs incurred to estimated final costs. Provisions are recognized in the statement of income for the full amount of estimated losses on uncompleted contracts whenever evidence indicates that the estimated total cost of a contract exceeds its estimated total revenue.

     Factors that can contribute to changes in estimates of contract profitability include, without limitation, site conditions that differ from those assumed in the original bid to the extent that contract remedies are unavailable, the availability and skill level of workers in the geographic location of the project, the availability and proximity of materials, the accuracy of the original bid, inclement weather and timing and coordination issues inherent in all projects, including design/build. Contract cost consists of direct costs on contracts, including labor and materials, subcontractor costs, direct overhead and equipment expense (primarily depreciation, fuel, maintenance and repairs). Depreciation is provided using straight-line methods for construction equipment. Contract cost is recorded as incurred and revisions in contract revenue and cost estimates are reflected in the accounting period when known. If the Company projects a loss on a project the estimated loss is immediately recognized. Claims for additional contract revenue are recognized if it is probable that the claim will result in additional revenue and the amount can be reliably estimated. The foregoing as well as weather, stage of completion and mix of contracts at different margins may cause fluctuations in gross profit achieved in different accounting periods and these fluctuations may be significant.

     A significant portion of the Construction Segment’s revenues is derived from contracts that are “fixed unit price” under which the Company is committed to provide materials or services required by a project at fixed unit prices (for example, dollars per cubic yard of concrete or per cubic yards of earth excavated). All government contracts and many of the Company’s other contracts provide for termination of the contract for the convenience of the party contracting with the Company, with provisions to pay the Company for work performed through the date of termination.

     The construction industry is highly competitive and lacks firms with dominant market power. The majority of the Company’s business involves construction contracts obtained through competitive bidding. The volume and profitability of the Company’s construction work depends to a significant extent upon the general state of the economy of Texas, especially in the Houston area, the volume of work available to contractors and competitors’

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levels of backlog. The Company’s construction operations could be adversely affected by labor stoppages or shortages, adverse weather conditions, economic downturns, shortages of supplies or government actions.

     Valuation of Long-Term Assets: Long-lived assets, which include property, equipment and acquired identifiable intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment evaluations involve management estimates of useful asset lives and future cash flows. Actual useful lives and cash flows could be different from those estimated by management and this could have a material effect on operating results and financial position. Additionally, the Company had goodwill with a value of approximately $13 million at December 31, 2004, which must be reviewed for impairment at least annually in accordance with Statement of Financial Accounting Standards No. 142 (“SFAS 142”). The impairment testing required by SFAS 142 requires considerable judgment and there can be no assurance that an impairment charge will not be required in the future. The Company completed its annual impairment review for goodwill effective October 1, 2004 and it did not reveal impairment of goodwill.

     Deferred Taxes: Deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts and tax bases of assets and liabilities. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based upon projected future taxable income and the expected timing of the reversals of existing temporary differences. As a result of this review and the related SHH acquisition, in fiscal 2001 the Company reduced the valuation allowance against the deferred tax asset related to the estimated utilization of the net operating loss carryforwards. Due to the operating profitability of the Company and the expiration of loss carryforwards, in fiscal 2004, 2003 and 2002, the valuation allowance was reduced by $18.9 million, $4.9 million and $1.5 million, respectively.

Liquidity and Capital Resources

     At SHH, the level of working capital varies principally as a result of changes in the levels of cost and estimated earnings in excess of billings, of billings in excess of cost and estimated earnings and levels of retention and the timeliness of payment of receivables by its customers. SHH’s cash requirements are also impacted by its needs for capital equipment, which have generally been financed from cash flow or from borrowings under its line of credit.

     At SCPI, the level of working capital varies primarily with the amounts of inventory carried, which can change seasonally, the size and timeliness of payment of receivables due from customers and the amount of credit extended by suppliers. SCPI’s working capital needs not financed by suppliers have been financed from cash flow and borrowings, principally under its line of credit.

Contractual Obligations

     Fixed, noncancelable obligations of the Company at December 31, 2004 are as follows (in thousands):

     In connection with construction contracts in backlog and in progress, the Construction Segment generally has back-to-back agreements to assure the supply of required materials, services and sub-contracting. In the majority of instances pricing under these supply and sub-contract agreements is fixed at levels that were agreed when the related contract was bid and secured.

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Exercise of the Put

     As part of the Sterling Transaction, the Company granted certain selling shareholders a “Put” option for the 19.9% of SHH stock owned by them, pursuant to which they had the right to sell the remaining SHH shares to the Company at a date of their choosing between July 2004 and July 2005 at a minimum price of $105 per SHH share. The price of the Put was to be based on a multiple of Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) for the 12 months immediately preceding the Put exercise date. The Company recorded the fair value of the Put as a $4.1 million liability on the effective date of the Sterling Transaction, July 18, 2001. From the date of the transaction through the date of exercise the Put liability increased by $1.5 million to $5.6 million.

     The Put was exercised on July 19, 2004 and a compilation of the results for the 12 months preceding the exercise date was performed, with the result that the purchase price was determined to be approximately $15.0 million. The Put transaction was finalized in November 2004 and settled in December reflecting the terms of a Put Restructuring Agreement entered into in September 2003, The Put price was satisfied by cash of approximately $2.4 million (derived from borrowings on available long-term bank facilities), five-year notes of approximately $6.4 million, and the balance through the issuance of approximately 1,569,000 shares of the Company’s common stock at an agreed value of $4.00 per share, representing a premium to the market at the time of exercise. At the date the terms of the agreement were settled, the stock was recorded at the fair value of $5.14. (See Note 4)

Financing

     At December 31, 2004 and 2003, the Company’s debt consisted of (in thousands):

Related Party Debt

Subordinated Debt

     As part of the Sterling Transaction, certain shareholders of SHH were issued subordinated promissory notes by SHH in the aggregate amount of $6 million in payment for certain of their SHH shares. These notes were repaid over three years through September 30, 2004 in equal quarterly installments and carried interest at 12% per annum.

Subordinated Zero Coupon Notes/NASCIT Loan

     The Sterling Transaction was funded in part through the sale of zero coupon notes combined with the issuance of zero coupon notes to certain selling shareholders of SHH. Warrants for Sterling common stock were

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issued in connection with the zero coupon notes and are exercisable for ten years from closing at $1.50 per share. The zero coupon notes were discounted at a rate of 12%, maturing four years from the date of closing of the Sterling Transaction, subject to earlier payment in the event the SHH Put was exercised before such date. Employee selling shareholders of SHH received an aggregate face value of $3.8 million in zero coupon notes, in which Mr. Manning and Mr. Harper received zero coupon notes in the face amount of $799,000 and $1.0 million, respectively and warrants for 63,498 shares and 81,301 shares, respectively. North Atlantic Smaller Companies Investment Trust (“NASCIT”), an investor in SHH, received a note in the face amount of $4 million. In December 2003, a prepayment of $1.3 million was made on the zero coupon note issued to NASCIT in consideration of the forgiveness of six months’ interest on such notes.

     The Put was exercised in July 2004, which triggered payment of the zero coupon notes. Upon settlement of the Put in December 2004, the employee selling shareholders received a cash payment of $783,000 utilizing funding from long term borrowings under SHH’s line of credit. Of the balance, $901,000 was converted into 225,326 shares of common stock at an agreed value of $4.00 per share, which represented a premium to the market price on the date of exercise. The stock was recorded on the date the terms were settled at a fair value of $5.14. The remaining $1.9 million was converted into new five-year notes at 12%, with principal and interest payable quarterly beginning March 31, 2005. NASCIT received a cash payment of $834,000, with the balance of $1.4 million converted into a new five-year note at 12% interest, with principal and interest payable quarterly beginning March 31, 2005 (See Note 14).

Management/Director Notes

     Notes with an aggregate face amount of $1.3 million issued in connection with the October 1999 purchase of the second equity tranche of shares of SHH were restructured as part of the Sterling Transaction. Of the total, notes for $800,000 were issued to several members of Sterling’s management, including Joseph P. Harper, since elected the Company’s President. Notes totaling approximately $559,000 were due to Robert Davies, the Company’s former Chairman and Chief Executive Officer, and, through a participation agreement, Maarten Hemsley, formerly the Company’s President and now its Chief Financial Officer. In consideration for the extension of the maturity dates of these notes, the face amounts were increased in July 2001 by an aggregate of approximately $342,000. Furthermore, certain amounts owed by the Company to Messrs. Davies and Hemsley aggregating approximately $355,000 were converted into notes. All such notes were to mature over four years, unless maturity was triggered by the exercise of the Put, and carried interest at 12% per year. Principal and interest may be paid only from defined cash flow of Sterling and SCPI, or from proceeds of any sale of SCPI’s business. In December 2003, prepayments of accrued interest and principal were made to certain of these noteholders. Mr. Harper received prepayment totaling $86,000 and Mr. Davies received prepayment totaling $411,000. Mr. Hemsley declined any prepayment of his notes.

     Pursuant to a Restructuring Agreement entered into in September 2003, when the Put was exercised in July 2004, triggering payment of the Management/Director notes, one half of the balance of the notes was paid in cash utilizing funding from long term borrowings under the SHH line of credit, with the remainder converted into new five-year notes at 12% interest, amortized quarterly beginning March 31, 2005. Mr. Davies, Mr. Harper, Mr. Hemsley and Mr. Manning received cash payments of $166,876, $1,045,764, $208,397 and $460,458, respectively.

Convertible Subordinated Notes

     In December 2001, in conjunction with an amendment to the SCPI Revolver and in order to strengthen SCPI’s working capital position through the purchase of additional inventory, Sterling obtained funding of $500,000 principally from members of management and directors (including Messrs. Frickel (a director of the Company), Harper and Hemsley, who loaned $155,000, $100,000 and $25,000, respectively) (the “Convertible Subordinated Notes”). In January 2002, two other members of management, including Bernard Frank funded a further $60,000, which was used for general corporate purposes. The notes evidencing these advances were convertible at any time prior to the maturity date into the Company’s common stock at a price of $2.50 per share and otherwise matured and were payable in full in December 2004. Interest at an annual rate of 12% was payable monthly. The notes were senior to debt issued in connection with the Sterling Transaction. All notes were converted at the election of their holders into common stock on December 31, 2004.

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Other Related-Party Debt

     In January 2003, members of management of the Company and of SHH (including Messrs. Harper and Hemsley) further funded SCPI with a $250,000 short-term loan to reduce SCPI’s vendor payables. Interest on the notes was payable monthly at the annual rate of 10%. The notes, which are subordinated to the SCPI Revolver, matured in July 2003, but were extended beyond that date with the granting of a guarantee by SHH, and an increase in the interest rate to 12% per annum, effective January 2004. The notes were repaid in three installments in January and February 2005.

SHH Revolver and SCPI Revolver

     In conjunction with the Sterling Transaction, SHH entered into a three-year agreement providing for a bank revolving line of credit with a maximum line of $13.0 million, subject to a borrowing base (the “SHH Revolver”). The line of credit carries interest at prime, subject to achievement of certain financial targets and is secured by the equipment of SHH and guarantees by the parent company. In December 2004, SHH entered into an amendment of the agreement providing for a maximum line of $17 million with a maturity date of May 1, 2007, under substantially the same terms as the original loan. The agreement was finalized in February 2005. SHH paid a fee of $15,000 in connection with the increase in the line and the renewal. At December 31, 2004, the balance on the SHH Revolver was $13.3 million, with an effective rate of interest of 5.25% and availability under the line of credit was $671,000. The balance at the end of the year included borrowing of approximately $5.0 million in late December to fund the settlement of the Put and related payments. SHH is required to maintain financial covenants of debt, current and cash flow coverage ratios, and at December 31, 2004 SHH was in compliance with these covenant requirements.

     Management believes that the SHH Revolver will provide adequate funding for SHH’s working capital, debt service and capital expenditure requirements, including seasonal fluctuations for at least the next twelve months through March 31, 2006.

     In July 2001 SCPI entered into an agreement for a bank revolving line of credit in the amount of $5.0 million, subject to a borrowing base (the “SCPI Revolver”). In fiscal 2002, the line of credit was further amended to extend the term to May 2004 and to remove certain limitations on borrowing and in fiscal 2003, the interest rate was reduced to prime plus 1% and the maturity date extended to December 2004. In March 2004, the line was extended until May 31, 2006. The credit agreement continues to mandate that SCPI utilize a lockbox arrangement with the lender and the agreement further provides that the lender may accelerate the maturity date of the SCPI Revolver if a material adverse change occurs in SCPI’s business. Because of these arrangements, the Company reports the SCPI Revolver as a current liability. At December 31, 2004, the outstanding balance on the Revolver was $3.6 million and the effective rate of interest was 6.25%. SCPI had no excess availability on its line of credit at December 31, 2004. The SCPI Revolver is secured by the assets of SCPI and is subject to the maintenance of a fixed charge coverage ratio covenant. At December 31, 2004, SCPI was in compliance with its financial covenant.

     Management believes that the SCPI Revolver will continue to provide adequate funding for SCPI’s working capital, debt service and capital expenditure requirements, including seasonal fluctuations for at least the next twelve months through March 31, 2006, assuming no material deterioration in current sales or profit margins.

SHH Mortgage

     In June 2001, SHH completed the construction of a new headquarters building on land adjacent to its existing equipment repair facility in Houston. The building was financed principally through an additional mortgage of $1.1 million on the land and facilities, at an interest rate of 7.75% per annum, repayable over 15 years. The new mortgage is cross-collateralized with an existing mortgage on the land and facilities which was obtained in 1998 in the amount of $500,000, repayable over 15 years with an interest rate of 9.3% per annum.

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Insituform Note

     In September 2002, a wholly owned subsidiary of SHH acquired the Kinsel Heavy Highway construction business from a subsidiary of Insituform Technologies. The transaction was financed through the issuance of two unsecured two-year notes aggregating $1.5 million to Insituform, with the balance funded through additional borrowings under the SHH Revolver. The Insituform Notes bore interest at 9% and were payable in quarterly installments plus accrued interest through September 2004.

Capital Expenditures

     Capital expenditures made by Sterling and its subsidiaries during fiscal 2004 totaled $3.6 million, consisting almost exclusively of heavy construction equipment at SHH.

Tax Loss Carry-forwards

     At December 31, 2004, Sterling had the benefit of net operating tax loss carry-forwards (the “Tax Benefits”) of approximately $38.9 million, which expire in the years 2005 through 2020 and, in the event of no change of control as discussed below, which are expected to shelter most income of Sterling and its subsidiaries from federal income taxes for several years. A change in control of Sterling exceeding 50% in any three-year period may lead to the loss of the majority of the Tax Benefits. In order to reduce the likelihood of such a change of control occurring, Sterling’s Certificate of Incorporation includes restrictions on the registration of transfers of stock resulting in, or increasing, individual holdings exceeding 4.5% of Sterling’s common stock. Shareholdings over 5% resulting from the Sterling Transaction, and changes thereto resulting from the shares issued pursuant to the exercise of the Put, were approved by the Company’s Board following receipt of required opinions that these did not adversely affect the availability of the Tax Benefits.

     Since the regulations governing the Tax Benefits are highly complex and may be changed from time to time, and since Sterling’s attempts to reduce the likelihood of a change of control occurring may not be successful, management is unable to determine the likelihood of the continued availability of the Tax Benefits. However, management believes that the Tax Benefits are currently available in full and intends to take all appropriate steps to help ensure that they remain available. Should the Tax Benefits become unavailable to Sterling, most of its future income and that of any consolidated affiliate would not be shielded from federal taxation, thus reducing funds otherwise available for corporate purposes (see Note 8 to the Consolidated Financial Statements). In fiscal 2004, approximately $42 million of tax losses expired unused.

Cash Flows

     Cash flows for the past three years are summarized as follows (in thousands):

     In fiscal 2004, cash provided by operations decreased by $14.9 million compared with fiscal 2003. The decrease was due to lower income from operations, combined with increases in costs and estimated earnings and decreases in billing in excess of cost. These decreases were offset in part by a higher level of trade payables in the current year.

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     Net cash provided by operations for fiscal 2003 was $17.8 million, an increase of $12.7 million compared with prior year. The increase was due to improved operating results, combined with increases in billings in excess of costs and estimated earnings, and to increases in other accrued expenses, offset by decreases in vendor payables and increases in contracts receivable and inventories.

     Cash used in investing activities increased in fiscal 2004 by approximately $1.6 million compared with the prior year. The increase was due to the purchase of the remaining 19.9% of SHH by the Company in December 2004. Capital expenditures in fiscal 2004 were lower than fiscal 2003 by approximately $761,000. Capital expenditures by the Company consist primarily of purchases of construction equipment.

     In fiscal 2003, cash used in investing activities decreased by approximately $2.6 million, due principally to the acquisition of the Kinsel business in fiscal 2002.

     Cash provided by financing activities increased substantially in 2004 compared with 2003. The increase was due to higher borrowings on the SHH Revolver, which funded $5 million in December to settle the Put transaction. Certain loans to shareholders of $1.5 million and the loans to Insituform of $563,000 for the funding of the Kinsel transaction in fiscal 2002 were repaid.

     Financing activities used approximately $13.2 million of cash in fiscal 2003, due in part to the reduction of the SHH revolver from $14 million at the end of fiscal 2002 to $6.6 million at the end of fiscal 2003. Also in fiscal 2003, the KTI Loan was repaid in the amount of $1.2 million, and prepayments of $2 million were made on debt maturing in 2005.

     Management does not believe that inflation has had a material negative impact on the Company’s operations or financial results during recent years. However, in fiscal 2004 increases in oil prices adversely affected the costs of operating the construction fleet and certain abnormal increases in steel prices have had an adverse effect on the Construction Segment’s profitability.

     The Company did not have any off-balance sheet arrangements at December 31, 2004 or December 31, 2003.

Results of Operations

     Operations include SHH (the “Construction Segment”) and SCPI, (the “Distribution Segment”). SHH is a heavy civil construction company based in Houston, Texas that specializes in municipal and state contracts for highway paving, bridge, water and sewer and light rail. SCPI, through its operating division, Steel City Products, is headquartered in McKeesport, Pennsylvania, and distributes automotive accessories, non-food pet supplies and lawn and garden products.

     Consolidated revenues and operating profit for fiscal 2004 decreased 9% and 40% respectively, from the exceptional levels that were achieved in fiscal 2003.

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Fiscal Year Ended December 31, 2004 (Fiscal 2004) Compared with Fiscal Year Ended December 31, 2003 (Fiscal 2003)

Construction

     As expected, contract revenues in fiscal 2004 decreased from the record levels in fiscal 2003. State highway business generated $39 million in revenues in 2004, an increase of 50% compared with the prior year. SHH has begun to successfully compete for and work on much larger multi-year jobs. Business with the City of Houston and Harris County decreased in fiscal 2004, due to the completion of several large projects in 2003. Poor weather, especially in the second and fourth quarters of 2004, significantly reduced the number of available workdays on many of the Construction Segment’s contracts.

     Gross profit was $13.3 million, or 10.0% of contract revenues, compared with gross profit in the prior year of $17.8 million, or 12.0% of contract revenues. The decrease was due to the lower revenues and resulting higher fixed cost absorption rates, and to the mix of contracts in process, as many with higher margins were completed in fiscal 2003.

     SHH reported operating income of $7.1 million compared with operating profit of $12.2 million in the prior year, principally due to the lower revenues and to the hiring of additional project managers and additional personnel in 2004.

     A combination of lower gross margins due to bad weather and some construction problems encountered on contracts in the Dallas market, together with higher expenses, adversely affected the Construction Segment in the fourth quarter of fiscal 2004.

     Contract backlog at December 31, 2004 was $232 million, of which $160 million is expected to be completed within fiscal 2005 and approximately $72 million in fiscal 2006 and beyond.

Distribution

     Sales in fiscal 2004 for the Distribution segment totaled $21.7 million, an increase of $1.1 million, or 5.7% from fiscal 2003. Additional sales of new products and product lines to existing customers increased automotive accessories sales by approximately $800,000. Sales of pet supplies increased by approximately $400,000 due to increased promotional orders to existing customers. Sales of lawn and garden products decreased by approximately $100,000.

     Gross profit was $3.2 million, an increase of approximately $200,000, or 6% from the prior year. Margins on pet supplies increased due to the higher sales volumes. Although sales of lawn and garden products decreased, margins on these items increased due to the mix of products. Margins on automotive accessories remained comparable with the prior year.

     Operating profit in the current year was $827,000, compared with $576,000 in the prior year. The increase was due to the increased gross profit and to reductions in bad debt expense in the current year.

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Corporate

     Corporate expenses decreased by $313,000 in fiscal 2004 compared with the prior year. In 2003, the Company had increased its liability for the Put in anticipation of its exercise in 2004, resulting in a charge of $1.0 million. Offsetting this in fiscal 2004 were expense increases due to the listing of the Company’s stock on the American Stock Exchange and subsequent hiring of a public relations firm ($100,000); increased legal expenses related to the Put ($80,000) and to non-cash items such as deferred compensation expense related to options issued ($80,000) and to the conversion of certain of the zero coupon notes into stock at the settlement of the Put ($257,000).

     In the fourth quarter of fiscal 2004, the reduced profitability of the Construction Segment resulted in a pre-tax consolidated loss of $140,000.

Fiscal Year Ended December 31, 2003 (Fiscal 2003) Compared with Fiscal Year Ended December 31, 2002 (Fiscal 2002)

     Consolidated revenues and net income increased by 26.2% and 14.8%, respectively, from fiscal 2002. The increase in earnings resulted in a 7.7% increase in diluted earnings per share over fiscal 2002 results.

Construction

     Contract revenues in fiscal 2003 totaled $149 million, an increase of $37 million, or 33% compared with fiscal 2002. The increase was due to higher revenues on municipal contracts and the effect of the full year revenues generated by the addition of contracts acquired with the Kinsel business, enhanced by generally favorable weather conditions, which permitted faster average completion of contracts.

     Gross profit was $17.8 million, or 12% of contract revenues, compared with gross profit in the prior year of $12.8 million, or 11.5% of contract revenues. The increase of $5 million was due primarily to the revenue increase and favorable market conditions.

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     As a result of the increased gross profit, SHH reported operating profit of $12.2 million, compared with $7.1 million in fiscal 2002.

     Contract backlog at December 31, 2003 was approximately $141 million, an increase of approximately $3 million from the prior year. Of the $141 million, $107 million was scheduled to be completed in fiscal 2004, and $34 million was scheduled to be completed in fiscal 2005 and beyond.

Distribution

     Sales in fiscal 2003 for the Distribution segment totaled $20.5 million, a decrease of $2 million, or 9% from fiscal 2002. The decrease was due primarily to the loss of Ames business in the prior year, which totaled approximately $3.0 million in fiscal 2002. Although sales of automotive products and pet supplies decreased by $3 million, sales of lawn and garden products increased by $1.2 million, due to sales to a new customer and to increased sales to existing customers.

     Gross profit was $3.0 million, a decrease of approximately $600,000, or 16% from the prior year. The decrease was principally the result of the lower sales volumes, however margins on pet supplies increased in fiscal 2003, as such sales to Ames in the prior year were at lower gross margin.

     Operating profit in fiscal 2003 was $576,000, compared with $1,039,000 in the prior year. The decrease was due to the lower sales volumes and reduced gross profit.

Corporate

     Corporate expenses increased by $700,000 due to an increase of $480,000 in the expense related to the Put, which was exercised during fiscal 2004. The increased Put liability reflected the strong operating results at SHH. In addition, the Company recorded expense of $287,000 related to variable option expense for option grants after June 2000 and before adoption of SFAS 123 in January 2003.

Risk Factors

     SHH measures its performance within the construction industry through the bidding process and the number, size and expected profitability of contracts obtained throughout the year. The Company is subject to various risks and uncertainties. Many factors affect the bidding climate, such as economic downturns, the amount of local, state and federal government funds available for infrastructure upgrade and new construction, as well as the number of bidders in the market and the prices at which they are prepared to bid, which are in turn affected by such bidders’ profitability and contract backlogs. Factors outside the bidding climate include: (a) weather conditions such as precipitation and temperature, which can result in significant variability in quarterly revenues and earnings, particularly in the first and fourth fiscal quarters; (b) the availability of bonding, the absence of which would adversely affect the Company’s ability to obtain new contracts; (c) the price of oil, (d) the price and availability of steel and other construction materials, which can significantly fluctuate and impact operating expense and (e) the availability of qualified field and supervisory personnel. While in recent years the Company has reported significant growth in revenues and profitability, there can be no assurance that it will be able to continue to achieve revenue and profit growth.

     The distribution industry has been adversely affected by suppliers that offer products directly to retailers, precluding the need for a distributor. SCPI has been able to maintain its presence in the distribution industry by offering new product lines and by competing through product selection, distribution services, order fill rates, short turnaround times and breadth of merchandise offered but there can be no assurance that it will be able to continue to do so.

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Certification

     This Annual Report on Form 10-K has been certified by Patrick T. Manning, Chief Executive Officer of the Company, and by Maarten D. Hemsley, Chief Financial Officer of the Company, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code) and the certification is attached as Exhibit 32.0.

Item 7(A). Quantitative and Qualitative Disclosure about Market Risk

     The Company and its subsidiaries are exposed to certain market risks from transactions that are entered into during the normal course of business. Sterling’s primary market risk exposure is related to interest rate risk. The Company manages its interest rate risk by attempting to balance its exposure between fixed and variable rates while attempting to minimize its interest costs. An increase of 1% in the market rate of interest would have increased the Company’s interest expense in fiscal 2004 by approximately $30,000.

     Financial derivatives are used as part of the overall risk management strategy. These instruments are used to manage risk related to changes in interest rates. The portfolio of derivative financial instruments consists of interest rate swap agreements. Interest rate swap agreements are used to modify variable rate obligations to fixed rate obligations, thereby reducing the exposure to higher interest rates. Amounts paid or received under interest rate swap agreements are accrued as interest rates change with the offset recorded in interest expense.

     The Company applies Statement of Financial Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. Under SFAS No. 133, the Company’s interest rate swaps have not been designated as hedging instruments; therefore changes in fair value are recognized in current earnings.

     Because the Company derives no revenues from foreign countries or otherwise has no obligations in foreign currency, the Company experiences no foreign currency exchange rate risk.

Item 8. Financial Statements and Supplementary Data

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
Sterling Construction Company, Inc.

We have audited the accompanying consolidated balance sheets of Sterling Construction Company, Inc. and its subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the three years in the period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sterling Construction Company, Inc. and its subsidiaries as of December 31, 2004 and December 31, 2003 and the results of their operations and their cash flows for the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America.

Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule II is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.

As discussed in Note 2 to the Consolidated Financial Statements, the Company restated its financial statements for the years ended December 31, 2003 and 2002 due to a misclassification of its release of an income tax valuation allowance between deferred income tax benefit and accumulated paid-in capital.

/s/ Grant Thornton LLP

Houston, Texas
March 11, 2005

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STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003
(Dollar amounts in thousands, except per share data)

The accompanying notes are an integral part of these consolidated financial statements

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STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
December 31, 2004, 2003 and 2002
(Dollar amounts in thousands, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

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STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For the years ended December 31, 2004, 2003 and 2002
(Dollars in thousands)

The accompanying notes are an integral part of this consolidated financial statement

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STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2004, 2003 and 2002
(Dollar amounts in thousands)

25

STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2004, 2003 and 2002
(Dollar amounts in thousands) (Continued)

     Additional common stock was issued upon the conversion of $560 of convertible debt in 2004

     Additional common stock was issued upon the conversion of $901 of zero coupon notes in 2004

The accompanying notes are an integral part of these consolidated financial statements.

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STERLING CONSTRUCTION COMPANY, INC. & SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Business and Significant Accounting Policies

Basis of Presentation:

     Sterling Construction Company, Inc. (“Sterling” or “the Company”) owns two subsidiaries; Sterling Houston Holdings, Inc., (“Construction” or “SHH”) and Steel City Products, Inc. (“Distribution” or “SCPI”).

     The accompanying consolidated financial statements include the accounts of subsidiaries in which the Company has a greater than 50% ownership interest and all significant intercompany accounts and transactions have been eliminated in consolidation. For all years presented, the Company had no subsidiaries with ownership interests less than 50%.

Organization and business:

     The Company’s operations at December 31, 2004 consisted of two businesses, Construction and Distribution. Construction comprises SHH, a heavy civil construction company based in Houston that specializes in municipal and state contracts for highway paving, bridge, water and sewer, and light rail, and its subsidiaries. Distribution comprises SCPI, a wholesale distributor operating under the trade name Steel City Products which principally sells automotive accessories, primarily to drug and supermarket retailers, discount retail chains, hardware and automotive stores, based mainly in the Northeastern United States. SCPI also distributes non-food pet supplies and lawn and garden products.

Use of Estimates:

     The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Certain of the Company’s accounting policies require higher degrees of judgment than others in their application. These include the recognition of revenue and earnings from construction contracts under the percentage of completion method, the valuation of long-term assets, estimates for the use of the Company’s net operating loss carryforwards and the allowance for doubtful accounts. Management evaluates all of its estimates and judgments on an on-going basis.

Revenue Recognition:

     Construction

     The Company’s primary business since July 2001 has been as a general contractor in the State of Texas where it engages in various types of heavy civil construction projects for both public and private owners. Credit risk is minimal with public (government) owners since the Company ascertains that funds have been appropriated by the governmental project owner prior to commencing work on public projects. However, most public contracts are subject to termination at the election of the government although, in the event of termination, the Company is entitled to receive the contract price on completed work and reimbursement of termination-related costs. Credit risk with private owners is minimized because of statutory mechanics liens, which give the Company high priority in the event of lien foreclosures following financial difficulties of private owners.

     Revenues are recognized on the percentage-of-completion method, measured by the percentage of costs incurred to date to estimated total costs for each contract.

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     Contract costs include all direct material, labor, subcontract and other costs and those indirect costs related to contract performance, such as indirect salaries and wages, equipment repairs and depreciation, insurance and payroll taxes. Administrative and general expenses are charged to expense as incurred. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. 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 costs and income and are recognized in the period in which the revisions are determined. An amount equal to costs attributable to contract claims is included in revenues when realization is probable and the amount can be reliably estimated.

     The asset, “Costs and estimated earnings in excess of billings on uncompleted contracts” represents revenues recognized in excess of amounts billed. The liability “Billings in excess of costs and estimated earnings on uncompleted contracts” represents billings in excess of revenues recognized.

     Distribution

     Revenue is recognized when all of the following criteria are met:

Cash and Cash Equivalents:

     The Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. Included in cash and cash equivalents at December 31, 2004 and 2003 are uninsured temporary cash investments of $6.0 million and $9,000 in a money market fund stated at fair value. Additionally, the Company had at December 31, 2004 and 2003 $54,000 and $7.5 million, respectively, of cash balances in excess of the Federal Deposit Insurance Corporation insured limits. For the years ended December 31, 2004, 2003 and 2002, the Company recorded interest income of $9,000, $17,000 and $6,000, respectively, which is netted in interest expense in the financial statements.

Contracts Receivable:

     Contracts receivable are based on contracted prices. Based upon a review of outstanding contracts receivable, historical collection information and existing economic conditions, management has determined that all contracts receivable at December 31, 2004 and 2003 are fully collectible, and accordingly, no allowance for doubtful accounts against contracts receivable is required. Contracts receivable are written off based on individual credit evaluation and specific circumstances of the customer, when such treatment is warranted.

Accounts Receivable:

     The Company maintains an allowance for doubtful accounts of its Distribution Segment, which is reviewed periodically based on customer credit history reports. The Company believes it conservatively estimates its doubtful accounts. Due to the bankruptcy filings of certain customers, the allowance for doubtful accounts increased by $172,000 in fiscal 2003. The allowance increased in 2004 by $2,000. Credit for returns is not deemed to be significant.

Retainage:

     Many of the contracts under which the Company performs work contain retainage provisions. Retainage refers to that portion of revenue earned by the Company but held for payment by the customer pending satisfactory completion of the project. Unless reserved, the Company assumes that all amounts retained by customers under such provisions are fully collectible. Retainage on active contracts is classified as a current asset regardless of the term of the contract. Retainage is generally collected within one year of the completion of a contract. Retainage was approximately $9.5 million and $12.4 million at December 31, 2004 and December 31, 2003, respectively, of which

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$1.3 million is expected to be collected beyond 2005. At December 31, 2003, retainage expected to be collected beyond 2004 was $3.8 million.

Inventories:

     The Company’s inventories are stated at the lower of cost as determined by the first-in first-out (FIFO) method, or market.

Property and Equipment:

     Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method. The estimated useful lives used for computing depreciation and amortization are as follows:

     Depreciation expense was approximately $4.5 million, $4.8 million and $3.8 million in fiscal years 2004, 2003 and 2002.

Deferred Loan Costs:

     Deferred loan costs represent loan origination fees paid to the lender and related professional fees. These fees are amortized over the term of the loan. Amortization expense for fiscal years 2004, 2003 and 2002 was $82,000, $102,000 and $151,000, respectively.

Goodwill:

     Goodwill represents the excess of the cost of companies acquired over the fair value of their net assets at the dates of acquisition.

     The Company accounts for goodwill in accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 142 requires that: (1) goodwill and indefinite lived intangible assets are no longer amortized, (2) goodwill is tested for impairment at least annually at the reporting unit level, (3) the amortization period of intangible assets with finite lives is no longer be limited to forty years, and (4) intangible assets deemed to have an indefinite life are tested for impairment at least annually using a one step process.

     The first step in the impairment test of goodwill is to identify a potential impairment by comparing the fair value to the reported value of each reporting unit. The second step of the goodwill impairment test measures the amount of the impairment loss, if any, and is recorded in the consolidated statements of operations during the period in which the test is performed.

     Intangible assets that have finite lives continue to be subject to amortization. In addition, the Company must evaluate the remaining useful life each reporting period to determine whether events and circumstances warrant a revision of the remaining period of amortization. If the estimate of an intangible assets remaining life is changed, the remaining carrying amount of the intangible asset is amortized prospectively over that revised remaining useful life.

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     The amounts recorded by the Company for goodwill are as follows (dollars in thousands):

     The Company performed impairment testing on both reporting segments as of October 1, 2004. The analysis indicated no impairment of the Company’s recorded goodwill for either reporting segment.

Equipment Under Capital Leases:

     The Company accounts for capital leases, which transfer substantially all the benefits and risks incident to the ownership of the property to the Company, as the acquisition of an asset and the incurrence of an obligation. Under this method of accounting, the recorded value of the leased asset is amortized principally using the straight-line method over its estimated useful life and the obligation, including interest thereon, is amortized over the life of the lease. Depreciation expense on leased equipment and the related accumulated depreciation is included with that of owned equipment.

Shipping and Handling Costs:

     Shipping costs are recorded in cost of goods sold. Expenses incurred for handling goods in preparation for shipment to customers totaled $772,000, $753,000 and $875,000 during fiscal years 2004, 2003 and 2002, respectively. These expenses are primarily related to warehouse personnel.

Federal and State Income Taxes:

     Sterling accounts for income taxes using an asset and liability approach. Deferred tax liabilities and assets are recognized for the future tax consequences of events that have already been recognized in the financial statements or tax returns. Net deferred tax assets are recognized to the extent that management believes that realization of such benefits is considered more likely than not. Changes in enacted tax rates or laws may result in adjustments to the recorded deferred tax assets or liabilities in the period that the tax law is enacted (see Note 8).

Stock-Based Compensation:

     Effective January 1, 2003, the Company adopted SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” which amends SFAS Statement No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Company transitioned utilizing the prospective method for options granted after January 1, 2003. Stock option expense for options granted in fiscal 2004 was $36,000 and for options granted in fiscal 2003 was $13,000.

     Prior to adoption of SFAS 148, the Company accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.

     The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS Statement No. 123, “Accounting for Stock-Based Compensation”, to stock-based employee compensation (dollars in thousands, except per share data).

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     The Company recorded compensation expense of approximately $315,000 and $288,000 in the fiscal 2004 and 2003, respectively related to options granted between June 2000 and January 2003 under option plans that were subject to variable option accounting. The Board of Directors amended these plans in March 2004 with the result that the market price at which these options are measured as compensation expense throughout their vesting periods was fixed at the date of such amendment.

Earnings Per Share:

     Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is the same as basic but assumes the exercise of convertible subordinated debt securities and includes dilutive stock options and warrants using the treasury stock method. The following table reconciles the numerators and denominators of the basic and diluted per common share computations for net income for the fiscal years 2004, 2003 and 2002 (in thousands, except per share data):

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     At December 31, 2002 there were 410,601 options not included in the shares for the dilutive stock options and warrants as they would have been antidilutive. No options were considered antidilutive at December 31, 2004 and 2003.

Derivatives:

     Financial derivatives, consisting of interest rate swap agreements, are used as part of the overall risk management strategy to manage the risk related to changes in interest rates. Interest rate swap agreements are used to modify variable rate obligations to fixed rate obligations, thereby reducing the exposure to higher interest rates. Amounts paid or received under interest rate swap agreements are accrued as interest rates change with the offset recorded in interest expense.

     The Company applies Statement of Financial Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. Under SFAS No. 133, the Company’s interest rate swaps have not been designated as hedging instruments; therefore changes in fair value are recognized in current earnings.

Put Liability and Exercise of the Put

     As part of the Sterling Transaction (see Note 4), the Company granted certain selling shareholders (the “Selling Shareholders”) a “Put” option for the remaining 19.9% of SHH stock owned by them, pursuant to which they had the right to sell the remaining SHH shares to the Company at a date of their choosing between July 2004 and July 2005 at a minimum price of $105 per SHH share. The price of the Put was based on a multiple of Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) for the twelve months immediately preceding the Put exercise date. The Company recorded the fair value of the Put as a $4.1 million liability on the effective date of the Sterling Transaction, July 18, 2001. The fair value of the Put was reviewed quarterly and changes were reflected as components of pre-tax earnings. In fiscal 2002, the Company recorded approximately $520,000 as expense related to the change in the fair value of the Put and the liability increased to approximately $4.6 million. In the fourth quarter of fiscal 2003, exceptionally strong earnings during 2003 increased the likelihood that the Put would be exercised in 2004. Accordingly, based on an independent valuation of SHH, an updated estimate of the Put price was established in December 2003 and the Put liability was increased by $1.0 million.

Recent Accounting Pronouncements:

     On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure, as was allowed under APB 25, will no longer be an alternative.

     SFAS 123(R) must be adopted in interim periods beginning after June 15, 2005. The Company accounts for its stock-based compensation under the fair value method, and does not believe adoption of SFAS No. 123(R) will have a material effect on its financial position or results of operations.

Reclassifications:

Certain prior years’ balances have been reclassified to conform to current year classifications.

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2.	Restatement of 2002 Results

     Management’s review of the valuation of the deferred tax asset in 2004 led to the discovery of misclassification in the 2002 deferred tax valuation allowance between deferred income tax benefit and accumulated paid-in capital. The following have been restated to reflect this misclassification, (dollar amounts in thousands, except per share data):

3.	Property and Equipment

     Property and equipment are summarized as follows (in thousands):

     Warehouse equipment financed under capital leases amounted to $132,647 and $106,402 at December 31, 2004 and December 31, 2003, respectively and accumulated depreciation related to such leased assets was $81,835 and $57,930.

4.	Investment in Affiliated Company (“Sterling Transaction”)

     In July 2001, the Company completed the Sterling Transaction, in which it increased its equity ownership in SHH from 12% to 80.1%. SHH is a heavy civil construction company based in Houston that specializes in municipal and state contracts for highway paving, bridge, water and sewer, and light rail.

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     Total consideration for the increase in equity was $24.6 million, including the Company’s previous investment in SHH of $3.5 million, and consisted of (a) cash payment of $9.9 million, (b) conversion of a $1.3 million SHH subordinated note receivable into Sterling equity, (c) issuance of subordinated notes and warrants, and (d) the sale and issuance of the Company’s common stock. For accounting purposes, the value of the 1,124,536 shares of common stock sold was determined based on the average price of the Company’s common shares over the 5-day period before and after the closing date.

     As part of the Sterling Transaction, the Company granted the Selling Shareholders a “Put” option for the remaining 19.9% of SHH stock owned by them, pursuant to which they had the right to sell the remaining SHH shares to the Company at a date of their choosing between July 2004 and July 2005 at a minimum price of $105 per SHH share. The Company recorded the fair value of the Put as a $4.1 million liability at July 18, 2001. The fair value of the Put was reviewed quarterly and changes were reflected as components of pre-tax earnings. In fiscal 2002, the Company recorded approximately $520,000 as expense related to the change in the fair value of the Put and the liability increased to approximately $4.6 million. Strong earnings in fiscal 2003 increased the likelihood that the Put would be exercised in 2004. Accordingly, based on an independent valuation of SHH in the fourth quarter of fiscal 2003, the Company recorded an additional $1.0 million expense related to the change in the fair value of the Put. At December 31, 2003, the Put liability was approximately $5.6 million.

     Effective July 19, 2004, the Selling Shareholders exercised the Put.

     The purchase price of the SHH shares was to be computed as a multiple of SHH’s EBITDA for the twelve months preceding the exercise, with a minimum price of $12 million. Accordingly, a compilation of the financial statements of SHH for the period from July 2003 through June 2004 was completed in November 2004 as a result of which the purchase price was fixed at $15.0 million. Settlement of the Put transaction occurred on December 22, 2004, following which the Company owned 100% of SHH.

     The Put price was satisfied by cash of approximately $2.4 million (derived from borrowings on available long-term bank facilities), five-year notes of approximately $6.4 million, and the balance through the issuance of approximately 1,569,000 shares of the Company’s common stock at an agreed value of $4.00 per share, representing a premium to the market price on the date of exercise. At the date the terms were settled, the common stock was recorded at a fair value of $5.14 per share The cash owed the selling shareholders and the notes issued in connection with the Put accrued interest from November 13, 2004 until the date of closing, December 22, 2004.

     The final settlement of the Put transaction resulted in an increase of approximately $5.1 million to the Company’s reported amount of goodwill related to SHH.

     The settlement of the Put triggered the repayment of approximately $7.9 million of the Company’s debt owed to management and others who funded the Sterling Transaction in 2001. The Company paid this amount as well through a combination of cash of approximately $2.4 million (from borrowings on available long-term bank facilities), issuance of five-year notes of approximately $4.7 million and the balance through the issuance of approximately 225,000 shares of the Company’s common stock, at a fair value of $5.14 per share.

     The following table reflects the settlement of the Put as if it had been completed at the beginning of each respective period of fiscal 2004, 2003 and 2002, even though, by its terms, the Put was not exercisable before July 19, 2004 (dollar amounts in thousands, except per share data):

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STERLING CONSTRUCTION COMPANY, INC.
CONSOLIDATED PROFORMA RESULTS OF OPERATIONS
FISCAL YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002