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The Inoculated Investor Equity Researchhttp://inoculatedinvestor.blogspot.com/
Sterling Construction Co. (NASDAQ: STRL): 3/26/11
Executive Summary
Share Price: $16.02 (52 week low/high: $10.45-$18.15)Market Capitalization: $264M; Enterprise Value (EV): $207M; Free Cash Flow Yield (LTM): 13.3%EV/LTM EBITDA: 4.01x; Market Cap/Net Cash: 3.11x
Company Description
Sterling Construction Co. (STRL) is a Houston, Texas-based company that focuses on the building, reconstruction,repair and maintenance of transportation and water infrastructure. The company operates mainly in Texas, Nevadaand Utah. However, recently STRL has been bidding on and winning contracts in Hawaii, Arizona, Louisiana, andCalifornia as well. The company was founded in 1954.
Infrastructure Spending Backdrop
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Projected FY 2012 budget shortfalls for the states that STRL is most exposed to—Texas, Utah and Nevada— are 31.5%, 8.2%, and 45.2%, respectively
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Texas determined it needed to spend $315 billion between 2008 and 2030 on transportation infrastructure
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Utah determined it needed to spend $18.9 billion between 2007 and 2030 on bridges and roads
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According to the US Department of Transportation, one in four bridges in America needs significant repairs or is burdened with more traffic than it was designed to carry
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According to the Association of State Dam Safety Officials, 1300 dams are "high-hazard," meaning their collapse would threaten lives
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The American Society of Civil Engineers estimates that fixing problems with the nation's critical infrastructurewould cost $1.6 trillion
Current Operating Environment
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Current
competition for projects has become quite fierce due to new participants—firms formerly involved inresidential or commercial construction--that have entered the heavy civil construction market
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Certain competitors have been willing to bid at their cost, just to avoid laying off workers
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STRL has maintained its pricing discipline and during the early part of 2010, the company was winning only5% of contracts it bid for
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New entrants may eventually be forced out of the market but in the meantime their presence will negativelyaffect STRL’s margins, revenues and backlog
Margins, Profitability, Backlog
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In 2010, STRL’s EBIT margin fell to 7.8%--from 10.1% in 2009—but was near the firm’s 5 year average
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SG&A as a percentage of revenue reached a 5 year high as declining backlogs in certain areas could not beoffset by proportional reductions in SG&A
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Due to some higher margin projects, 2010 gross margins were higher than the five year average, despite thecompetitive bidding environment
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At the end of 2010, STRL’s backlog reached a record $660M, but organic growth within the backlog hasslowed meaningfully
Valuation Analysis
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The stock has run up from around $12.50 on March 14
th
to over $16 now
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Based on trailing free cash flow (FCF), the stock is trading at a FCF to enterprise value (EV) yield of 13.3%
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The stock is trading at an EV/Backlog ratio of .31x, far below the five year average of .48x
The Inoculated Investor Equity Researchhttp://inoculatedinvestor.blogspot.com/
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The stock is trading at an EV/EBITDA multiple of 4.01x, versus a 5 year average around 6x
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The stock is trading at 3.11x the $85M in net cash the company has on its balance sheet
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An Earnings Power Value (EPV) analysis using an 11% discount rate and a 25% margin of safety produces atarget purchase price of $14 and an estimate of intrinsic value around $18.75
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The current price above $16 is around 14.4% higher than the target purchase price of $14
Comparative Company Analysis
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Comps chosen due to similarity were Orion Marine Group (ORN) and Michal Baker Corporation (BKR)
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Of the three, STRL has consistently had the second highest EBIT margins
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In 2010, STRL had the highest ROE of the group
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STRL’s stock is currently trading at the lowest multiples of trailing earnings and EBITDA of the group
Analysis of Major Holders
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By in large, the institutional holders have been increasing their stakes in STRL
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The recent run up in the price may have caused some of the top 10 largest holders—who owned about 56% of shares as of 12/30/2010—to trim their positions
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Over the past year, there has been 58x more selling than buying among insiders
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Aside from a recent 1K share purchase by the CEO, the insiders having been selling heavily in recent days
Prominent Risk Factors
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Uncertain environment for state spending on infrastructure may be prolonged indefinitely
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Extreme customer concentration: 4 customers in Nevada, Utah and Texas made up 58.5% of total revenue in2010
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Company’s margins may be hit by the rising costs of commodities such as steel, aggregates and diesel fuel
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STRL is looking for additional acquisition and thus could lever up to make an ill-advised acquisition
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Bidding on large, multi-year projects is difficult and certain lump sum contracts force STRL to absorb costoverruns
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A bankrupt or insolvent state could cut current and future infrastructure spending dramatically or actually try toget out of existing contracts with STRL
Conclusion
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The presence of multiple risk factors should cause investors to demand a large margin of safety whenpurchasing shares
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To minimize the potential for permanent capital impairment, look to establish a position at a share price around$14
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If state budgets remain strained, the bidding environment continues to be quite competitive, and tradingmultiples stay low, it would not be a surprise to see a larger player such as KBR Inc., The Shaw Group, or Fluor (who is in a JV with STRL) buy a smaller competitor like STRL to boost its growth
The Inoculated Investor Equity Researchhttp://inoculatedinvestor.blogspot.com/
Sterling Construction Co. (NASDAQ: STRL): 3/26/11
Share Price: $16.02 (52 week low/high: $10.45-$18.15)Market Capitalization: $264MEnterprise Value (EV): $207MFree Cash Flow (LTM): $27.6MFree Cash Flow Yield (LTM): 13.3%
Company Description
Sterling Construction Co. (STRL) is a Houston, Texas-based company that focuses on the building, reconstruction,repair and maintenance of transportation and water infrastructure. The company operates mainly in Texas, Nevadaand Utah. However, recently STRL has been bidding on and winning contracts in Hawaii, Arizona, Louisiana, andCalifornia as well. At the end of 2009, STRL acquired 80% of Ralph L. Wadsworth Construction Co., LLC (RLW)for about $64M and will have the option to buy the remaining 20% in 2013. The company was founded in 1954.
Infrastructure Spending Backdrop
Not surprisingly, the poor fiscal condition of many states has caused market participants to be concerned aboutfuture levels of infrastructure spending. The fear is that the states are so strapped for cash that they will have topostpone major infrastructure projects for years or even indefinitely. Additionally, raising taxes to fund suchspending appears to be a non-starter in most states as many inhabitants are still struggling from the fallout of thefinancial crisis and subsequent recession. Accordingly, while many stocks have appreciated meaningfully since theFederal Reserve enacted QE2, certain small companies that are reliant on state and government spending on roads,sewers, bridges and waterways have seen their stocks lag behind, or even decline.Some of the abovementioned concerns may be completely valid, as restrained infrastructure spending may indeedlimit revenue growth and depress the margins of companies such as STRL. However, investors also have to consider the secular backdrop regarding the US’s stock of infrastructure. In 2008, when a bridge located in Minnesotacollapsed--killing 13 people—the whole nation became acutely aware of the dangerous state of America’s roads,bridges and dams. In fact, a recent report by the Pew Research Center
illustrated just how dire the situation actuallyis. Take a look at these statistics:
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“More than one in four of America's nearly 600,000 bridges need significant repairs or are burdened withmore traffic than they were designed to carry, according to the U.S. Department of Transportation.”
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“A third of the country's major roadways are in substandard condition -- a significant factor in a third of themore than 43,000 traffic fatalities each year, according to the Federal Highway Administration.”
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“The number of dams that could fail has grown 134% since 1999 to 3,346, and more than 1,300 of thoseare "high-hazard," meaning their collapse would threaten lives, the Association of State Dam SafetyOfficials (ASDSO) found. More than a third of dam failures or near failures since 1874 have happened inthe last decade.”
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“Underground, aging and inadequate sewer systems spill an estimated 1.26 trillion gallons of untreatedsewage every year, resulting in an estimated $50.6 billion in cleanup costs, according to the U.S.Environmental Protection Agency.”
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