2023-12-01 12:52:35 ET
Summary
- Sterling Infrastructure, Inc. has corrected ~20% since my last article, making the valuation reasonable.
- STRL's revenue growth is supported by a healthy backlog level of $2.4 billion and increasing demand for data centers, manufacturing operations, and federal infrastructure funding.
- The company's margin growth is driven by high-margin projects in the backlog and improving execution.
Investment Thesis
I started coverage of Sterling Infrastructure, Inc. ( STRL ) in August 2022 with a buy rating. After the stock almost tripled in a year, I moved to the sideline in August 2023 and downgraded the stock to neutral. The stock has corrected ~20% since then and I believe the valuation is back to a reasonable range and growth prospects remain attractive. STRL’s revenue growth should benefit from a healthy combined backlog level of $2.4 billion exiting Q3 2023. The company is seeing increasing demand as a result of rising requirements for data centers, the reshoring of manufacturing operations in the U.S., aging infrastructure, and federal infrastructure funding, which should continue to support the company's end markets. Furthermore, the residential market is also near the bottom and any recovery in demand within the residential market is expected to contribute to revenue growth.
On the margin front, the company should benefit from high-margin projects in the backlog, improving execution, and abating supply chain challenges. The valuation also seems reasonable due to the stock price correction since my previous article in August. Given the multi-year growth prospects ahead and reasonable valuations, I am upgrading my rating to a buy.
Revenue Analysis and Outlook
In my previous article on Sterling Infrastructure, I discussed the company’s good growth prospects. The company has reported its earnings for the third quarter of 2023 since then. In the third quarter of 2023, STRL’s revenue growth saw continued momentum from healthy backlog execution and strong end-market demand, supported by various government infrastructure investments. This resulted in a 13.7% YoY increase in revenue to $560 million. On a segment basis, revenue in the E-infrastructure segment declined slightly due to softness in the e-commerce and small warehouse centers. This was offset by good demand for data centers and manufacturing. In the Transportation segment, revenue growth enjoyed healthy demand trends for highways, roads, and aviation, along with easy comps. Lastly, the Building Solutions segment saw growth recovery as residential markets began to improve.
STRL’s Historical Revenue (Company Data, GS Analytics Research)
Looking forward, I believe the company should be able to continue delivering revenue growth benefiting from a healthy and growing backlog level, and long-term secular demand trends across the segments.
In the second half of 2022 and the beginning of the current year, the company faced challenges from supply chain issues which affected revenue growth in the transportation segment. Moreover, the slowdown in the residential segment affected the revenue growth in the building solutions segment in the back half of last year. So, the growth in these segments should benefit from easier comparisons.
Furthermore, the company’s awarded backlog stands at a very healthy level of $2.01 billion exiting the third quarter of 2023. This awarded backlog level reflects growth of 20.4% YoY with a book-to-burn ratio of 1.5x. The year-to-date backlog increased by 42.1% despite good backlog execution (i.e., conversion of backlog to revenues.) In addition, the unsigned low-bid award increased by 59.5% YoY to $375 million as bidding activity remained strong in the transportation sector. This led to a combined backlog (awarded + low-bid) of $2.4 billion, which reflects year-over-year growth of 25.8% and year-to-date growth of 41.4%. I expect this healthy level of backlog growth to continue supporting the company’s revenue growth.
STRL’s Order Backlog (Company Data, GS Analytics Research)
The demand drivers for all three segments remain solid. In the E-infrastructure segment, the company is witnessing increasing demand from data centers and manufacturing. The rapidly changing technology and adoption of digitization and artificial intelligence are fueling the need to build data centers in order to store the increasing amounts of data. STRL is also witnessing strong demand in the construction of electric vehicle (EV) battery manufacturing facilities. The CHIPS and Science Act and Inflation Reduction Act are driving this end-market demand, and management expects the rate of flow of funds from the Chips and Science Act to increase in the coming year, supporting the growth outlook for the segment. Moreover, the recent trend towards reshoring manufacturing in the U.S. to establish supply chain self-resilience in the country should also help the company’s revenue growth moving forward.
Moving on to the Transportation segment, infrastructure in the United States is aging, driving the need for new, modern, and reliable infrastructure in the country. This has increased the demand in the transportation sector to develop new highways, bridges, and roads. This secular demand trend is further supported by the federal government’s Infrastructure Investment and Jobs Act (IIJA) and Inflation Reduction Act (IRA), which should act as a multi-year tailwind for the company. In addition, the company is also seeing more and more activity picking up in the aviation sector as air travel continues to rise which may result in good orders in the upcoming year. So, revenue growth prospects look good in the Transportation segment as well.
In the Building Solutions segment, the company has seen some headwinds from the weak single-family residential market over the last year which affected its revenue growth, but it was more than offset by strength in the multifamily and commercial market in the recent quarters. Further, the residential market has started showing some signs of bottoming and potential recovery, as is evident from an Y/Y increase in starts in the recent months. The company is doing a good job in terms of gaining share and capitalizing on these opportunities and, in the third quarter, STRL’s revenue from the residential construction work increased by 52% YoY as compared to the average increase of 7% for single-family home starts nationally. In addition, the company also acquired Professional Plumbers Group, Inc ((PPG)) in November 2023. PPG serves a range of residential home builders in the greater Dallas area and is expected to contribute annualized revenue of $50 to $55 million in the Building segment. This should support the Building segment’s revenue growth inorganically. Management continues to remain active in pursuing M&A, and with a comfortable leverage ratio of 1.3x, I expect good inorganic growth ahead.
Overall, I remain optimistic about the company’s revenue growth prospects ahead, as the company enjoys multi-year demand tailwinds and has a healthy backlog level.
Margin Analysis and Outlook
In the third quarter of 2023, the company’s margin growth saw benefits from high margin backlog, improved execution, and volume leverage from sales growth. This resulted in a 30 bps YoY increase in gross margin to 16.4%. The operating margin increased by 20 bps YoY to 10.2%. The benefits for operating margin were partially offset by an increase in G&A expenses driven by inflationary headwinds.
STRL’s Historical Gross Margin and Operating Margin (Company data, GS Analytics Research)
Looking forward, I expect Sterling to keep posting margin improvement. The company’s margin growth should benefit from increasing margins in the backlog. Over the past year, the company has focused on being highly selective in its bidding process and only selecting projects with high margins. This led to a 200 bps YoY increase in the combined backlog margin to 14.9%. The company is continuing its focus on high-margin projects, which should help margins. Moreover, as stated in the revenue analysis, management expects the aviation sector to pick up and further accelerate in FY24. This should also improve the margin profile of the backlog, as aviation infrastructure activities have a high margin profile.
STRL’s Historical Margin in Combined Backlog (Company data, GS Analytics Research)
Valuation and Conclusion
Sterling is currently trading at a ~13.41x FY24 consensus EPS estimate of $4.74 and a ~12.11x FY25 consensus EPS estimate of $5.25. This is higher than its 5-year historical average FWD P/E of 11.29x. I believe the stock deserves to trade at a premium over the last 5-year multiple given the improved end-market outlook driven by government stimulus as well as improved execution with the company focusing on high-margin projects. I am comfortable with a low to mid-teen P/E for the company given the company’s double-digit expected EPS growth. At the time of my last article, the stock was trading at a high teens P/E multiple, which I found pricey. With the P/E valuation back to the low teen range, I believe the stock provides a good entry point. Hence, I am changing my rating to a buy.
For further details see:
Sterling Infrastructure: Moving To A Buy Again After The Recent Correction (Rating Upgrade)