2023-07-12 02:09:42 ET
Summary
- Sterling Infrastructure provides e-infrastructure, transportation, and building solutions across the US, specializing in infrastructure projects for highways, airports, ports, and rail systems.
- STRL's focus on operating margin is a key driver of its future growth, and it's only getting stronger each year.
- The company's backlog and book-to-burn ratio are expanding, suggesting a strong pipeline of future work and potential revenue growth.
- My base case valuation scenario shows an upside potential for STRL stock of ~26.15% in the mid-range.
- Despite some risks, I am rating the stock as a Buy.
The Company
Sterling Infrastructure, Inc. ( STRL ) is a $1.77-billion market cap company operating in the United States across three segments: E-Infrastructure (51% of total revenue in Q1 FY23 ), Transportation Solutions (28%), and Building Solutions (21%). The E-Infrastructure segment specializes in site development services for projects like data centers, distribution centers, and manufacturing facilities. Transportation Solutions focuses on infrastructure projects for highways, bridges, airports, and rail systems. Building Solutions involves concrete foundations for residential and commercial structures.
In a strategic move, Sterling Infrastructure sold its ownership interest in its partnership with Myers & Sons Construction in December 2022 , aiming to reduce low-bid heavy highway projects and improve margins. The focus on operating margin is a key driver of its future growth, and it is only getting stronger each year:
Sterling Infrastructure's management expects favorable long-term growth opportunities across its segments despite macroeconomic challenges, as outlined in the recent 10-Q filing. In the E-Infrastructure Solutions segment, they anticipate strong demand from data centers and advanced manufacturing projects. Transportation Solutions should benefit from federal and state funding for infrastructure investments. In the Building Solutions segment, residential and commercial markets show promise, with an uptick in housing starts and increased demand in the multi-family sector.
If we look at the actual results of all three segments in Q1 FY2023, we can see that STRL is definitely doing a good job of capitalizing on these market opportunities. First, the 22% organic increase in top-line growth in the E-Infrastructure segment was driven by high-value advanced manufacturing projects and strong demand for data centers, according to the CEO's words during the latest earnings call . The Transportation Solutions segment saw a strategic shift away from low-bid heavy highway work to higher-margin alternative delivery projects - although its revenue declined by 4%, the EBIT improved by 19%, and EBIT margins expanded by ~94 basis points YoY. The Building Solutions segment achieved revenue growth of 7% YoY, primarily driven by increased commercial work. Residential revenue was flat compared to the previous year, with a decline in slab volume offset by price. The segment's EBIT margin declined by ~150 basis points due to a shift towards lower-margin commercial work and rising concrete prices. As a result, Sterling Infrastructure's consolidated revenue increased by 10.28% compared to the prior year while the adjusted EBITDA grew by 13%.
The company's backlog increased to $1.75 billion, up 4% QoQ with a book-to-burn ratio amounting to 1.6x [vs. 1.06x in Q4 FY2022 ]. As we know, the backlog data provides insight into the amount of revenue the company expects to recognize from its contract commitments on projects. The book-to-burn ratio is a metric used by Sterling Infrastructure to measure its business development efforts and track the growth of its backlog and business over time. So the growing book-to-burn ratio indicates that STRL is adding more contracts and projects to its backlog than it's burning through in terms of revenue, suggesting a strong pipeline of future work and potential revenue growth.
In terms of liquidity, it's noteworthy that STRL's cash balance increased to $202.6 million at the end of the quarter (+11.58% QoQ), with a strong operating cash flow of $49.1 million (+84.65% YoY). Cash flow from investing activities was positive, driven by the receipt of $14 million from a divestiture. Cash flow from financing activities included debt repayments of $31 million.
The profitability metrics - ROIC, ROCE, and ROE - are all rising rapidly and appear to be higher than the company's estimated WACC. This means that management has recently begun to create value and that shareholders are making real gains by owning STRL stock.
The company's operating results seem to me to be quite good - both in terms of momentum and in terms of absolute metrics, and there is still room for margin expansion, which means that EPS could continue to outpace revenue growth by quite a bit.
But given the fact that STRL stock has already risen 168% over the past year, the question is how much growth potential is left for new entrants given the stock's valuation
The Valuation
In its latest investor presentation, management provided FY2023 EBITDA guidance of $227.5 million [mid-range], up 6.7% from FY2022 :
Seeking Alpha Premium data shows that STRL stock is pricing in a slight multiple contraction based on next year's EV/EBITDA [compared to TTM value], but in general, the stock is undervalued by 20-22% compared to the whole Industrials sector :
STRL stock looks relatively expensive compared to its historical norm, outperforming its 5-year average EV/EBITDA ratio by 14.6%, even after multiple contraction.
If the company's valuation tends toward the average, then the implied market cap should be $1.419 billion at the guided EBITDA of $227.5 million and an EV/EBITDA of 7.381x (after adjusting the sum for net debt of $260.6 million). This would represent an overvaluation of STRL stock of ~21%.
But here it's important to understand that valuation is a relative thing consisting of many factors. One of the most important points is the margin strength of the analyzed business. STRL is currently posting 5-year highs in EBITDA margin [TTM], suggesting that a return to the average EV/EBITDA is more of a bear-case scenario than a base-case scenario.
We have a group of companies that STRL itself considers to be peers [taken from the company's 10-K filing] that we can use for a little comparative experiment. I have removed the 3 largest and the 2 smallest companies from the group presented so that the range analyzed is relatively uniform in terms of enterprise values.
As you can see from the chart below, STRL is the obvious outperformer in terms of market cap growth over the past year - this is most clearly explained by the margin expansion over the past few years.
However, STR's EV/EBITDA forwarding multiple is ~3% below the peer group average. Given that the company's EBITDA margin exceeds the group average by ~479 basis points, I think this 3% premium for STRL is too low.
I believe that the forwarding EV/EBITDA multiple should be at ~10-12x given the continued margin expansion - this represents an underestimate of ~15-38% of the company's enterprise value today. This is my base case scenario, which yields an undervaluation of STRL stock of ~26.15% in the middle of the range.
The Bottom Line
Sterling Infrastructure is a small-cap company, so it's very important to consider liquidity risks before buying its shares. Also, after such a strong rally as we have seen in the last few months, the most likely scenario is a cooling or consolidation of the share price in the foreseeable future. This could be triggered by a) a slowdown in the firm's margin expansion or b) a cooling of business activity in the end markets. By the way, it's very important to understand that the company operates in very cyclical markets - if we are in for a recession, which I have almost no doubt we are, then STRL stock could most likely fall sharply.
While there are some risks involved, I believe that STRL has the potential to continue rising until it reaches a relatively fair price. My calculations suggest that it could still grow by more than 20%. Therefore, I am rating the stock as a Buy.
Thanks for reading!
For further details see:
Sterling Infrastructure: Another Top-Rated Stock With More To Show