GVA - Granite Construction: Good Long-Term Growth Prospects At Attractive Valuation

2023-08-07 14:35:55 ET

Summary

• Granite Construction's stock price has increased by 18% since my previous article in May, despite a slight correction post-Q2 earnings.
• The company's revenue growth is expected to benefit from a healthy backlog of projects and infrastructure investment initiatives.
• The stock is attractively valued and has good long-term growth prospects, leading to a buy rating.

Investment Thesis

Granite Construction’s (GVA) stock price has increased ~18% following my previous bullish article in May. The stock price saw a slight correction after the Q2 2023 earnings release due to a revenue miss and downward revision of annual guidance caused by a slow start to the year as a result of weather-related disruptions and some charges for its Old-Risk-Portfolio project I-64. However, I remain optimistic about the company's future growth prospects.

Moving forward, GVA’s revenue growth should benefit from a healthy backlog of Committed and Awarded Projects (CAP) worth $5.4 billion, and the completion of the challenging Old-Risk-Portfolio (ORP). In addition, the emerging need to upgrade aging infrastructure in the country, especially in the transportation sector to ensure safety, and the related infrastructure investment initiatives like Infrastructure Investment and Job Act (IIJA) should act as long-term tailwinds for the company’s revenue growth prospects. On the margin front, the completion of ORP losses, and high margins in the CAP should support margin recovery in the coming years. Moreover, the company’s stock is attractively valued and is below its historical averages. Given the good long-term growth prospects and a reasonable valuation, I maintain my buy rating on the stock.

Q2 FY23 Earnings

Recently, Granite Construction reported results for the second quarter of 2023. The company's revenue increased by 5.8% YoY to $898 million, which missed the consensus estimate by $25.54 million. Adjusted EPS was $1.03 and beat the consensus EPS estimate by $0.04. The gross margin remained flat YoY at 11.5% and the adjusted EBITDA margin increased by 140 bps YoY to 8.8%.

The revenue increase was driven by good backlog execution and strength in the company’s California and Mountain regions where demand remained strong. Margins benefited from high margin backlog and price increases in the Material segment, offset by losses incurred on completing the ORPs. Adjusted EPS increased due to improved Y/Y margins and volume leverage.

Revenue Analysis and Outlook

In my previous article, I discussed Granite Constructions' future growth prospects benefiting from a healthy backlog and favorable end-market demand. However, there were some risks as well as the company continues to wind down its old risk portfolio.

In the second quarter of 2023, the company saw some headwinds from inclement weather and some execution delays in one of its ORP projects, I-64. This led to a revenue decline in the Central group region. However, the company was able to more than offset the decline in the Central group through good backlog execution in the California and Mountain region. This led to a 5.8% YoY increase in total revenue to $898 million.

Looking forward, I believe the company should be able to keep growing its top line. GVA should benefit from healthy backlog levels, good end market demand, and completion of the ORP projects.

GVA’s Committed and Awarded Projects (CAP) or backlog continues to remain at healthy levels exiting the second quarter of 2023 thanks to strong bidding activities and healthy end market demand. In the second quarter, the company’s CAP increased 29% YoY to $5.4 billion. The increase in backlog was led by the California region and Mountain region, which grew CAP by ~44% YoY and ~40% YoY respectively. However, the Central group fell behind in growing its CAP and also saw a sequential decrease due to low bidding activities in that region for the majority of the second quarter as the company focused on completing its challenging large projects.

The company expects CAP in the central group to improve in the coming quarters as the bidding pipeline is good going into the third quarter. So, I expect that CAP should continue to grow both year-over-year and sequentially with the help of good demand and bidding momentum in the California and Mountain Region, along with the improvement in the Central region. These healthy CAP levels should continue to support the company’s revenue growth in the coming years.

In addition, the end markets are also favorable. The end markets are benefiting from rising demand for modern, upgraded, and safer infrastructure in the country, particularly in the transportation sector. This demand is focused on improving railroads, bridges, highways, and roads, as the existing infrastructure is aging and becoming overloaded. As a result, there are growing infrastructure investments both in the public and private markets to meet the evolving needs of transportation and ensure safety. The Infrastructure and Job Act (IIJA) a $1.2 trillion federal infrastructure investment program launched in 2022, is such an example of a multi-year tailwind in the transportation sector to support this end market demand. GVA is well-positioned to continue to take advantage of this act.

In its home market of California, the company is winning new orders by taking advantage of the support from IIJA through its partnership with Caltrans (The California Department of Transportation). On the second quarter earnings call, management commented that Year-to-date Caltrans has awarded $3.4 billion of work, including both traditional bid build and construction manager/general contractor procurement type work to GVA. So, I am optimistic about the company’s growth prospects in the years to come.

Margin Analysis and Outlook

In the second quarter of 2023, the gross margin was adversely impacted by the write-down on the I-64 high-rise bridge project in Virginia as the company incurred additional costs due to inclement weather and other factors. The impact of these incremental costs was $21 million on gross profits. However, the company was able to offset it through high-margin projects in its CAP and benefits from the price increases in the Material segment. This resulted in a flat YoY gross margin of 11.5%, while the adjusted EBITDA margin increased 140 bps YoY to 8.8%.

Looking forward, I believe the company should be able to recover its margins. In recent years, the company has strategically shifted its portfolio towards high-value, high-margin projects. These projects have better visibility of costs and risks to be incurred and hence provide better margins as the company is able to quote the best price to the customers according to the associated input costs and risks.

Moreover, in the second quarter earnings call, CEO Kyle Larkin commented regarding GVA’s new contracting method,

A lot of the projects are broken down into smaller contracts on the construction side, so we can take a larger project like we have in Santa Barbara on that 101 corridor that's almost close to about $600 million overall project, but it's broken down into several projects ranging from around $75 million to $150 million.

And so that allows us to really identify and mitigate risk in each specific segment that limits the exposure we have, which allows us to give a better price ultimately to our customer because we don't have to put the risk costs in there necessarily. So we have a lot of confidence also because we've done 60 of these types of projects in our company, and we've done them successfully.

And we believe that it's really a win for us. It's a win for our customers. And ultimately, they don't result in claims. And so we -- that's what gives us the confidence that as we continue to bring in these best value projects, these collaborative contracting type projects that we can execute on them. It's very different than design-build and certainly on these mega projects. I mean, the challenges that we saw in I-64 even in the last quarter, that those would have been managed differently under CMGC, and it would have been something that could have identified, mitigated or even risk would have been shifted back over to the owner.”

The company’s strategic focus over the past few years is working and the higher margin projects in the company’s current CAP and additional projects that the company keeps on winning strategically with higher margins and low-risk profile should help the margin growth in the coming years.

Valuation and Conclusion

GVA's current valuation is at 17.44x FY23 consensus EPS estimate of $2.41 and 10.14x FY24 consensus EPS estimate of $4.15. Over the last five years, the stock has traded at an average forward P/E of 17.65x. I believe, the current challenges from weather-related delays and ORPs are just temporary in nature and these should gradually abate as we progress forward in the second half and into the next year. So, FY24 EPS is a better indicator of the company’s normalized earnings power and the stock is very attractively valued on FY24 P/E.

The company's medium to long-term growth prospects remain positive due to a healthy CAP, completion of loss-making ORPs, strong end-market demand supported by IIJA, and high-margin CAP. I expect the company’s strategic restructuring of its project portfolio and operational execution should start bearing fruit in 2024 and beyond. So, I believe that GVA is a long-term bet and should outperform in the coming years. Considering these growth prospects and the attractive valuation, I maintain a buy rating on the stock.

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