ROAD - Construction Partners: Interesting Road Ahead

2023-11-07 01:28:09 ET

Summary

• Construction Partners operates as a consolidator in road construction, focusing on acquisitions of small operators in the industry.
• The company has been able to grow its revenues significantly with the company's strategy, making the stock intriguing.
• ROAD stock is quite difficult to value due to the constant acquisitions, but with my current DCF model estimates, I believe the stock is fairly valued.

Construction Partners ( ROAD ) operates as a consolidator in road construction. The company's strategy revolves around constant acquisitions of small operators in the industry. Construction Partners has been able to grow revenues very well after the company's IPO as the company has been able to execute its strategy very well. The stock is quite challenging to value as its fair value largely depends on future acquisitions and margin trajectory; I tried to demonstrate the valuation with a discounted cash flow model.

The Company & Stock

Construction Partners focuses on the construction and maintenance of asphalt roads. The company focuses on small projects with the majority of revenues coming from the public sector. I believe that the public sector is currently a highly valuable revenue avenue for Construction Partners' shareholders - public spending isn't as dependent on the economy as a whole when compared to the private sector. Private investments in industrial and commercial development could rely very highly on the economy's state, which represents a good part of Construction Partners' revenues. The company has a large footprint in states such as Alabama, Florida, Georgia, North Carolina, and South Carolina:

Being the reason behind the large number of operational points, Construction Partners' strategy revolves around acquisitions of local operators in the area. From FY2018 to FY2022, the company has completed a total of 19 acquisitions. The strategy focuses on a regional focus with short projects, consolidating a fragmented industry:

The company's strategy seems to have worked well so far. The stock has returned an impressive return of 227% since the company had an IPO in the first half of 2018:

Financials

Construction Partners' strategy that revolves around acquisitions has resulted in a good amount of growth for the company. From FY2016 to LTM figures as of Q3/FY2023, the company's compounded annual growth rate in revenues has been 16.1% :

From FY2016 to FY2022, Construction Partners' cash acquisitions add up to a sum of $456 million. Compared to the company's current market capitalization of almost $2.1 billion, the acquisitions seem to have added a good amount of value. Furthermore, Construction Partners is expecting revenues of $1.75 billion to $1.825 billion, representing a growth of 20.6% from the current trailing figure.

The company's margins have been thin and have gone lower in the past years. From FY2016 to FY2022, Construction Partners' average EBIT margin has been 5.9%:

The EBIT margin can be quite misleading - Construction Partners' EBITDA margin is a more stable figure as it isn't disturbed by acquisition-related accounting. The company is aiming for some operating leverage with a target adjusted EBITDA margin of 13% to 14% for FY2027:

Valuation

As Construction Partners has a very frequent acquisition history, the company's EBIT includes a large amount of amortization that skews the view into Construction Partners' ability to generate free cash flow. Because of this, I believe that an EBITDA-based figure is more accurate. Currently, Construction Partners trades at a forward EV/EBITDA ratio of 12.7, above the company's all-time mean of 10.8:

As the EBITDA figure can be very misrepresenting, I constructed a discounted cash flow model to better estimate a rough fair value for the stock. Unlike my usual method, I try to model further acquisitions into the model from Construction Partners. I believe that this approach is constituted, as acquisitions are a core part of Construction Partners' operations; excluding acquisitions would result in a too low estimate.

For Construction Partners' revenues, I estimate a figure of around $1.8 billion for FY2024, in line with the company's guidance. After the year, I estimate the pace of acquisitions and overall growth to slow down in small steps as the geographical area should start to have a smaller number of potential companies to acquire - for FY2025, I estimate the growth to slow down to 16%. The growth eventually stops into a perpetual growth rate of 2% from FY2033 forward as I estimate the company's acquisition-based strategy to stop into constant operations with a better cash flow conversion. The DCF model's revenues represent a CAGR of 9.7% from FY2022 to FY2032.

Construction Partners targets for an adjusted EBITDA margin of 13% to 14%. In the model, I estimate the company's EBITDA to rise to the target eventually with an estimated adjusted EBITDA margin of 13.2% achieved in FY2032 with incremental increases in the margin. The margin is expected to expand by 2.2 percentage points from the FY2023 estimate of 11.0%. As Construction Partners' acquisition pace slows down, I estimate the company's cash flow conversion to become better - in FY2024, I estimate the company's cash flows to remain slightly negative, but to improve slowly into a good cash flow conversion in FY2032 and forward. Construction Partners guides the company's maintenance CapEx to be around 3.25% of its revenues, which is modelled into the cash flow model.

The mentioned estimates along with a cost of capital of 8.44% craft the following DCF model with a fair value estimate of $40.27, very near the stock price at the time of writing:

The used weighted average cost of capital is derived from a capital asset pricing model:

In Q2, Construction Partners had $5 million in interest expenses. With the company's current amount of interest-bearing debt, the company's annualized interest rate comes up to a figure of 4.81%. Construction Partners uses a relatively safe amount of debt in its financing - I estimate Construction Partners' long-term debt-to-equity ratio to be 20%. In the case that Construction Partners' acquisitions significantly exceed my DCF model estimates, I believe that the company could finance further acquisitions with debt, but at the moment I see the estimate as reasonable.

On the cost of equity side, I use the United States 10-year bond yield of 4.64% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran's latest estimate for the United States, made in July. Yahoo Finance estimates Construction Partners' beta at a figure of 0.78 . Finally, I add a liquidity premium of 0.4%, crafting a cost of equity of 9.65% and a WACC of 8.44%, used in the DCF model.

Takeaway

Construction Partners is an intriguing company. The company's management has been able to execute the acquisition strategy well, adding to the company's growing operations. I believe that a good number of acquisitions are already priced into the stock price, though - my DCF model estimates the stock to be fairly valued with estimates that I see as reasonable. For the time being, I have a hold rating for the stock.

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