Sterling Infrastructure: Still Cheap, Still Growing Strong (NASDAQ:STRL)

Introduction

The last time I wrote about Sterling Infrastructure, Inc. (NASDAQ:STRL) was in mid-July 2023 when the stock was trading at $59.11. At the time I initiated a “Buy” rating, so I’m glad to see that since then STRL stock is up almost 20% while the S&P 500 Index (SPY) (SP500) (SPX) is down 7.85%:

A few months have passed since then. Sterling managed to report for Q2 FY2023, and many interesting things have happened in the industry since July. In addition, according to Seeking Alpha, the company is set to report Q3 FY2023 on November 6 – so I think it’s time to update my thesis and see how it has changed.

The Latest Financials

Sterling Infrastructure is now a $2.18-billion market cap company operating in the United States across three segments: E-Infrastructure (49.8% of total revenue in Q2 FY23), Transportation Solutions (28.9%), and Building Solutions (21.2%). At the same time, almost 65% of the total operating profit comes from the most important segment – E-Infrastructure. This segment specializes in providing site development services for projects such as data centers, distribution centers, and manufacturing facilities. Meanwhile, Transportation Solutions focuses on infrastructure projects related to highways, bridges, airports, and rail systems, and Building Solutions involves the construction of concrete foundations for residential and commercial structures.

In a strategic move aimed at reducing low-bid heavy highway projects and improving profit margins, Sterling Infrastructure divested its ownership interest in its partnership with Myers & Sons Construction in December 2022. As I wrote in the last article, we have seen from the company’s financial results that this corporate action is already bearing fruit. The company’s Q2 FY2023 results have once again confirmed this: Sterling’s gross profit margins improved to an all-time high of 17.7% while EBIT margins reached 11.5%, also a historical high for the company. STRL continued to expand its revenue growth, and even more actively if we compare the new figures with the data for the first half of FY2023:

As the management elaborated during the earnings call, the E-Infrastructure segment achieved over 11% revenue growth and a 32% increase in operating income, benefiting from advanced manufacturing projects, data centers, and improved supply chains; Transportation Solutions saw a 5.9% revenue growth and a 33% increase in operating income due to margin expansion and increased infrastructure project activity, notably in aviation; Building Solutions achieved nearly 30% revenue growth, driven by residential and commercial activities.

Sterling also generated exceptionally strong cash flow this quarter, with STRL’s operating cash flow increasing more than fourfold, according to first-half data:

The “Changes in operating assets and liabilities” were positively influenced by “Contracts in progress”:

To me, this is an indirect sign that STRL is significantly increasing the volume of contracts. Be that as it may, the company’s combined backlog reached a new record level in Q2, up 42% from the end of FY2022. This growth was driven by high-value advanced manufacturing projects, data centers, and infrastructure investments. A book-to-burn ratio greater than 1 indicates that the company is recognizing revenue faster than it is adding new contracts to its backlog, which could be seen as a positive sign of strong performance and efficient operations. In Q2, Sterling had a book-to-burn ratio of 1.9x, which is very good, in my view – at least it’s better than last year:

Due to the strong first-half results and a record backlog, Sterling increased its full-year guidance, anticipating a 13% increase in revenue and a 32% increase in net income relative to 2022 levels. I believe that this goal is quite achievable, because judging from current backlog numbers and management comments, STRL has already secured projects related to electric vehicles and solar products and expects strong demand from the technology sectors, supported by government initiatives and incentives. We are talking about the E-Infrastructure segment here. In addition, there is also the Transportation Solutions segment, which should benefit from the Infrastructure Investments and Jobs Act (IIJA) and strong support for transportation initiatives at the state and local levels; and the Building Solutions segment, which is driven by new home starts, with a focus on the Dallas-Fort Worth, Houston and Phoenix markets.

The company’s business model appears to be well diversified to weather potential difficulties in the two segments with the lowest EBIT contribution, so I believe the decline STRL stock suffered a week ago is an overreaction and not fundamentally supported.

And what about Sterling’s valuation today?

The Valuation

The Wall Street consensus sees STRL’s FY2023 revenue growth in line with management’s +13% year-over-year forecast. But EPS growth of 28% in Q3 FY2023 is slightly below STRL’s 32% net income growth forecast. Most likely, analysts are factoring in growth in the number of shares outstanding.

In my opinion, management should consider initiating a share buyback from the market. At least a small program so that the number of shares stops growing so actively. But in general, I don’t see any problem in increasing the number of shares if the business is growing and at the same time this growth is very high quality, considering the margin expansion.

In recent quarters, analysts have been wrong about STRL’s earnings per share performance. Most recently, the company surprised with earnings per share of $1.27, beating estimates of $0.34.

Last time, I pointed out that STRL’s EV/EBITDA ratio was roughly in line with the stock’s historical norm and that this ratio should only increase with continued margin expansion. In recent months, the stock’s EV/EBITDA multiple hasn’t grown much – just 5%.

At the same time, margins have continued to expand. This tells me that the stock is still undervalued, even though it has risen nearly 20% since my last bullish call.

Even comparing multiples across peers, STRL is currently undervalued by the market by 10.5% based on the FWD EV/EBITDA multiple, while next year’s EBITDA growth is 1,454 basis points higher than the median in the selected sample of companies (i.e., 25.9% vs. 11.4%):

The Verdict

For sure, investing in Sterling Infrastructure entails various risks every potential buyer should be aware of. First off, the construction industry’s cyclicality may affect STRL’s revenue and earnings during economic slowdowns. Secondly, fierce competition from other construction companies, including smaller specialized contractors, poses a challenge. Complex projects that face delays or budget overruns can impact profitability. High debt levels make STRL vulnerable to economic downturns. To be fair, though, I don’t think debt is the biggest risk to STRL, in my opinion, because the debt-to-equity ratio is well below 1 and falling:

Third, the company’s performance relies on its management team, and any mistakes could affect its financial health. Moreover, STRL’s expansion into new markets may bring success but could also result in increased costs and reduced short-term profits, adding to the investment risks.

But despite the risks, I believe STRL is stronger today than ever before, and the tailwinds and growth drivers surrounding the company could allow it to continue to expand its margins, which would put a premium on its still-low valuation.

I don’t know how the company will report for Q3 FY2023, but I definitely expect strong results. Therefore, I reiterate my “Buy” recommendation and wait for November 6.

Thanks for reading!