GVA - Granite Construction's Outperformance Can Continue

Summary

• The Old Risk Portfolio (ORP) is nearing completion in 2023, and the company’s efforts to strengthen CAP (backlog) should help revenue and margin growth.
• GVA’s initiative of developing a second home market in Texas to expand its market share in the central group should also be positive for its future growth.
• GVA is de-risking its project portfolio by shifting from complex design-built projects to smaller bid-build or best-value projects which should raise longer-term margin prospects.

Investment Thesis

Granite Construction’s ( GVA ) stock price has increased over 27% since my bullish last article , significantly outperforming the S&P 500’s ( SPY ) flattish performance in the same time period. The company should be able to deliver good revenue growth as it has a healthy level of Committed and Awarded Projects (CAP) and the demand in the majority of the company’s end markets is strong. Furthermore, the U.S Infrastructure investment and jobs act (IIJA) funding of approximately $1.2 trillion should provide GVA with a good order pipeline for future backlog and revenue growth. Turning to margins, the retention of higher-margin water and mineral businesses should benefit GVA’s margin. In addition, the completion of the ORP projects and a line-up of higher-margin projects in its CAP should also help with margin growth. The company is expected to see strong EPS growth in the coming years, helped by good revenue growth and margin expansion. The valuation also looks reasonable at 12.27x FY23 consensus EPS estimates. Hence, I believe the stock can continue to outperform and I have a buy rating on it.

GVA: Revenue Outlook

GVA has had a tough last few years as some of its large contracts incurred significant losses. As the company is winding down these problem projects (which are now classified under the Old Risk Portfolio or ORP), its revenue and Committed and Awarded Projects (CAP or backlog) have been negatively impacted in recent years. The good news is that most of its Old Risk Portfolio projects are almost complete.

The company stands with $150 million of CAP left on the ORP projects at the end of Q3 2022 and expects $55 million of CAP relating to challenging ORP, to be carried into 2023. The company has one small profitable project of $35 million included in the ORP projects as it’s a non-sponsored joint venture. Including this small profitable project, CAP remaining in the ORP projects to be carried into 2023 stands at approximately $90 million.

Looking forward, I believe GVA has good revenue growth potential. The funding from the IIJA of approximately $1.2 trillion is expected to flow in early 2023, which should support CAP growth. In addition to the IIJA, the company is focused on growing its market share through shifting towards a more client-centric approach, investing in its vertically integrated business model, and expanding home markets. One such initiative taken by the company is to establish Texas as its second home market (in addition to California). The end market in Texas’s Houston Metro area is rapidly growing. The company has had a presence in Texas for 15 years and has developed good relations with Texas DOT, labor subcontractors, and vendors. However, while chasing work across the country, the company missed out on opportunities to strengthen those relations and convert them into significant project wins. The company is now focused on winning more high-quality projects in Texas and turning it into GVA’s second home market. These initiatives are bearing fruits and in the last quarter, the company has won 3 highway projects in southwest Houston for $145 million in total. I believe the healthy funding levels in Texas should benefit GVA’s revenues in the coming years.

The company should also benefit from better project execution in the near term as it has improved its CAP or backlog conversion rate. In Q2 2022, GVA saw project delays affecting its revenue outlook. However, management improved the situation in Q3 2022 through better project execution and limiting the number of project delays. We should expect it to continue to do so moving forward. Moreover, the healthy CAP exiting Q3 2022, should help the company deliver revenue growth moving forward. In the Material segment, the strength of new asphalt orders is strong as the market remains healthy in its home markets.

In a nutshell, Healthy CAP, strong demand in the majority of the end markets, along with the support from IIJA funding, its emerging second home market in the Central group, and improved project execution should help generate higher revenue in moving forward. So I believe the company can see good growth in the coming years and meet its target of reaching annual organic growth of 6-8% in the coming years.

GVA: Margin Outlook

GVA’s margins have improved since major write-offs in 2019. However, more recently there were execution issues in the second quarter of 2022. In the third quarter, project execution improved resulting in a 60 bps Y/Y gross margin expansion. The increase in the gross margin was partially offset by the losses of the ORP projects. The gross margin excluding the ORP project was 14.8% in the last quarter.

Looking forward, I believe the company should be able to deliver gross margin growth in the coming years. GVA has increased its focus on better project execution with the organization in order to reduce costs. In the Construction segment, the company is focusing on an appropriate selection of projects, accurate estimates on bid day, and improved project execution. GVA has established a construction leadership council ((CLC)) to identify best ideas and practices on the bidding day and project execution practices. In addition, GVA’s challenged ORP which are the lower-margin projects are nearing completion. The challenged ORP was 8% of total CAP at the beginning of 2022, which the company expects to be reduced to 1-2% of total CAP as it enters into 2023. Moreover, the retention of higher-margin water resources and mineral service businesses should act as an additional tailwind for margin growth as the end markets for these businesses continues to remain strong. In the Material segment, the company is improving overall execution through plant automation to increase production capacity and decrease per-unit costs. The company opened two new aggregate and asphalt locations in California at the beginning of 2021, having advanced technologies. These facilities have helped the company to replace aging plants, thereby increasing production capacity and lowering overall production costs. These initiatives should help the company deliver margin expansion.

GVA’s target is to achieve a 14-15% gross margin and a 9-11% adjusted EBITDA margin by 2024 as it focuses on completing ORP projects, improving its selection process, bidding day performance, and overall execution of projects. Given the company’s gross margin excluding ORP was already in this range last quarter, it doesn’t look like a difficult-to-achieve target.

Valuation and Conclusion

GVA is currently trading at a P/E of 12.62x 2023 consensus EPS estimates of $2.79. The stock is trading at a discount vs. its historic 5-year average forward P/E of 19.35x. The company’s revenue growth prospects look good due to strong end-market demand, healthy CAP, and the funding environment in the U.S. The margins should benefit from the overall improved execution of its operations under its new strategic plan, higher margin CAP, and declining projects related to ORP. The stock is expected to post meaningful earnings growth helped by revenue growth and margin expansion.

Hence, I believe the stock is undervalued and hence a good buy at the current level.

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