Sterling Construction is undervalued and can benefit greatly from Biden's Infrastructure Plan!

Valuation: Undervalued Investment Thesis: There is an urgent need to fix America’s roads and bridges, especially in some states (like Hawaii) that between 30-50% of their roads are deemed to be of “poor condition”. Biden has put forth an Infrastructure plan that is currently being negotiated that will help to fix America’s roads and bridges. Biden’s infrastructure plan presents a unique opportunity for civil engineering and construction companies (such as sterling) to win some large Government contracts. This will help Sterling to take their business and revenues to the next level. Based off of the valuation techniques undergone in this report, and by following the plan set out in this report an investment into Sterling could yield a return between 67.32-70.42%. however, there are always risks to investments, which can be found near the end of the report. Company Overview: Sterling construction operates in the United States under three main segments, which are Heavy Civil, Specialty Services, and Residential Projects. Their heavy civil segment consists of infrastructure and rehabilitation projects for highways, roads, bridges, airfields, light rail, water, wastewater, and drainage systems. Their Specialty services include construction site excavation and drainage, drilling, and blasting (for excavation), and foundations for multi-family homes, parking structures and other projects. Their Residential projects consists of pouring concrete foundations for single-family homes Investment Information: Macro Overview: Oil: If you have been reading my past couple analyses you will know about some of the supply chain issues that are currently plaguing businesses globally. However, for this report I will be focusing on the economic outlook of oil. A couple of weeks ago Russian hackers shut down Colonial pipeline and was forced to shut down operations for the time being. Before this took place, there was already a lack of supply of oil in the US, as the demand for oil surpassed the supply by over 1M barrels/day. However, after this hacking, this supply shortage was further threatened in some states, causing oil pries to rise in these states. Furthermore, the IEA (International Energy Agency) announced that they would be suspending oil investments after 2021. This was the latest blow in the beatdown of the oil industry. However, all of these factors hint toward the slowing/decreasing supply of oil. Now, as countries start to open up the demand for oil is expected to surge, this will cause the gap between supply and demand to further increase. Since, there will be less investments into oil, it will be impossible to meet the demand for oil, thus it is likely that we will see an increase in the price of oil. An increase many are starting to feel or have recently felt over the past couple of months. These points can be backed up through an observation of the investment activity of hedge funds. In a recent publication by oilprice.com, hedge funds have been adding bullish bets to already existing positions that will benefit if the price of oil increases. In just one week, hedge funds accumulated over 30M barrels of oil, which is the largest bet on oil since February. Later on in this report, I will highlight how Sterling is not affected by price inflation, unless it is oil, gas, and steel, in which they feel small effects of inflation. By knowing this, and the fact that oil prices are likely to rise, we need to approach this investment with caution and be mindful of the associated risks. Sources: Hedge Funds Bet On Higher Oil Prices | OilPrice.com Colonial Pipeline update: Gasoline shortages developing; diesel issues less clear - FreightWaves Biden’s Infrastructure plan: Earlier this year Joe Biden released his proposed infrastructure bill that is currently being negotiated behind closed doors. This plan is currently being debated, and news sources are indicating that a $1T plan is more likely to be passed in the next couple of weeks, which would be significantly less than his original $2.3T proposed plan. However, $1T will still go a long way, and their original plans will likely be altered but the core premises will remain largely unchanged. One of the big proposals of Biden’s plan is to budget $90B for the improvement of both 20,000 miles of roads, and to improve over 10,000 bridges. Sterling Construction’s Heavy Civil segment of their business is geared to the improvement of both roads and bridges, so they are likely to win some additional government contracts in the coming years for this segment of their business. Furthermore, one of the States that Sterling operates within is Hawaii, and over 30% of the roads in Hawaii are in poor condition and need fixing, this presents a good opportunity for Sterling to win a large contract in Hawaii. It is factors like this proposed infrastructure plan that get investors excited for the future of small cap construction and engineering stocks like $STRL. Sources: Biden infrastructure plan seeks fixes for existing roads. Some states are focused on expansion. - The Washington Post Infrastructure: Biden indicated he could support $1 trillion plan, Republicans say, as GOP group prepares new offer - CNNPolitics Financial Information: Sterling has expanded and looks to continue expanding into adjacent markets. In April of 2017, Sterling acquired Tealstone Commercial for $84M, helping Sterling to expand their reach in Texas’ residential markets. Additionally, Sterling has acquired Plateau (in October of 2019) for $427.5M, which helps to expand Sterlings specialty service reach into Georgia (grading, excavation, blasting etc.). The acquisition of Plateau helped Sterling to increase their specialty services revenue by over 100% in 2020. Also, as a result of acquiring Plateau, Sterling had to acquiring financing, and their weighted average interest rate was 6.68% (I used this as the WACC). These acquisitions show Sterling’s willingness (and perhaps need) to grow their business, seeing sterling take on these types of acquisitions can generate excitement among investors and help drive their share prices. Sterling has improved their financial position/health and has plans to continue to improve upon them. Sterling’s margins have increased from 4% (2015) to 9.6% (2020), and they plan to improve them to 12-15% in the future. Sterling’s revenues and gross profit have both increased by 26.7%, and 77.5% respectively (YoY), which are both a result of increased operations from acquiring Plateau. Sterling also has deferred revenues in their “backlog”, which total to $1.2B in revenue. Lastly, Sterling has increased their cash position by over 44% (to $66.2M) and have grown their highest yielding segment (specialty services – yields 13.87%) by over 139%. If they are able to continue this improvement of their financials, and get to their profit margins, their future earnings releases will reflect this and get investors excited about the future of Sterling Construction. There has been a history of company/employee share buybacks. In 2019 Sterling bought back 250,000 of their common shares throughout the year. This buyback is estimated to have costed Sterling between $2.5-4.1M. Furthermore, employees have also been buying shares of Sterling, in 2020, Sterling employees purchased 1,101 shares at an average cost basis of $15.99 (buying a total of $17,605 worth of shares). These purchases show the confidence of both the company itself, and their employees that there is a better future ahead for Sterling and it was perhaps undervalued. Also, future buybacks will help decrease the outstanding shares and be favourable for investors. Company Information: Sterling’s business is seasonal, and are affected by weather conditions, usually during the winter (Q1 and Q4). Creates variability in multiple aspects of the business. Sterling purchases large amounts of resources. The variability in the price of these materials can help/hinder their bottom line. Sterling operates within Southern US, Rocky Mountain states, California, and Hawaii. They have been expanding their reach into new geographies such as Texas and Georgia, which will help to increase their customer base. Valuation information: WACC: I was able to find Sterling’s weighted average interest rate, which I used as an estimate for their WACC. This figure was found in their SEC 10-K filing and totalled 6.68%. CAGR: I found the forward EBIT growth rate on Seeking Alpha, in which they estimated a 45.80% EBIT CAGR. This is similar to the figure I achieved by finding their EBIT growth rate over the past 4 years (which was 54.40%). Interest Expense Growth Rate: I found the interest expense growth rate by finding the CAGR of their interest expense over the past 4 years. By doing this I arrived at a percentage increase of 44.18% YoY. This is very high, however, their history of acquisitions is credited for this growth, and is not necessarily a bad thing, as these acquisitions have helped to drive EBIT. Tax Rate: I found Sterling’s annual effective tax rate to be 34.40% through their 10-K SEC filing. Investment Valuation and Plan: Valuation: In order to value Sterling Construction, I underwent 3 comparable analyses, and a DCF model. In order to verify the accuracy of my DCF model, I compared my results to the results achieved by Tracktak, which is a online DCF calculator. DCF: The DCF model that I created in order to value Sterling Construction, used the inputs listed above in the “valuation information” section of this report. This model estimated an upside of 117.82% or a share price of $47.81. This price estimate is high, although it is not absurd, and in order to get more context, and perhaps a better valuation I decided to also undergo 3 comparable. Comparable Analyses: The 3 comparable analyses that I chose to do were EV/EBITDA, EV/Revenue, and P/E. EV/EBITDA: This comparable is commonly used to value all types of companies, and by comparing $STRL’s EV/EBITDA to that of some industry competitors, I arrived at an implied upside of 26.7%, or a share price of $27.81. This is significantly lower than the result of the DCF model, however they are both signaling that Sterling Construction is undervalued. EV/Revenue: This multiple is used when acquisitions are common, and in this case, we know that Sterling has had a history of acquiring companies like Plateau and Teal stone. These comparable signals that the share price should be $2160n in order to be valued fairly, which would imply a downside of 1.6%. This just signals that Sterling has not overpaid tremendously during their acquisitions and that they are currently at fair value factoring in their acquisitions. P/E: The P/E multiple is also commonly used in the analysis space. By undergoing this analysis, I found that Sterling is undervalued and that the fair value per share is $28.01, which implies an upside of 27.61%. This is similar to that of the EV/EBITDA multiple and signals that Sterling is undervalued. Average Comparable Valuation: The average valuation from all of the comparable analyses that I underwent is $25.81 and implies an upside of 17.59%. I think that the comparable analysis is understating the fair value because Sterling is yet to observe the full potential of their earnings increases through their acquisitions yet, and because they are doing the necessary things in order to maximize growth in the future. Plan: In order to minimize the risk of this investment and ensure enough upside to make this investment worthwhile, entering a position under $22 is crucial (preferably under $21.60). I would sell 50% of my investment when the price reaches the average comparable estimate of $25.81. I would hold my remaining 50% of the investment until the price reaches $47.81 (the DCF valuation). Catalysts: Earnings releases: If Sterling can meet their target profit margins in future earnings releases, they will be noticeably more profitable, which might attract investors.   Future acquisitions: If Sterling continues to acquire companies it is likely that their stock price will increase (as long as they are not overpaying).   Future Share Repurchases: If Sterling continues to buy back their shares it will send a bullish signal to investors, as it essentially means that Sterling believes they are undervalued.   Future employee share purchasing: This also sends a bullish signal to investors because the people who are closest to the company are showing their belief in the future operations of Sterling. Risks: Reliance on Raw Materials: If the price of gas, oil, and/or steel goes up, then Sterling will incur more costs which will have a negative effect on their margins. US Trade Policies: If the US bans their trading with Canada (as an example), they will be importing less fuel, and as a consequence, their fuel prices are likely to rise, decreasing Sterling’s profit margins. Dependency on Large Customers: Due to the size of their contracts, a couple of Sterling’s customers represent a large portion of their revenues. This is bad because if one or two of these customers leaves then Sterling’s revenues will be greatly affected, causing investors to be scared away or to exit their positions. However, Sterling has a backlog of contracts and revenues that can help to combat this issue. Contract Cancellation: Many of Sterling’s contracts are cancellable on short-notice, and when this occurs the customer pays for what is already completed, however Sterling’s work crew and equipment will remain idle until other work becomes available. This will have an effect on the expected revenues from their backlog. Indebtedness: Sterling is carrying a lot of debt through their acquisitions of Plateau and Tealstone. However, Sterling believes that they can meet their debt obligations in full and on time, but if they cannot manage these payments it will be a very bad scenario. Portfolio Reasoning: It is a perfect fit for the portfolio I am building out Small Cap Undervalued Helps to diversify I am yet to own a stock in construction/engineering industry. I have $MHO in the portfolio, which is residential construction, this is somewhat similar, but their operations are vastly different. Hedges against inflation Sterling does not feel the effects of inflation (except oil, gas, and steel) so it can help decrease the volatility of my portfolio.

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UndervaluedSmallCaps

May 27, 2021

2.70%

Change % Since Posting

22.19

Price When Posted

0.60

Change Since Posting

STRL

Sterling Construction Company, Inc.

22.79

0.22
0.97%
Current Price

Sterling Construction is undervalued and can benefit greatly from Biden's Infrastructure Plan!

bullish

Valuation: Undervalued

Investment Thesis:

  • There is an urgent need to fix America’s roads and bridges, especially in some states (like Hawaii) that between 30-50% of their roads are deemed to be of “poor condition”.
    • Biden has put forth an Infrastructure plan that is currently being negotiated that will help to fix America’s roads and bridges.
  • Biden’s infrastructure plan presents a unique opportunity for civil engineering and construction companies (such as sterling) to win some large Government contracts.
    • This will help Sterling to take their business and revenues to the next level.
  • Based off of the valuation techniques undergone in this report, and by following the plan set out in this report an investment into Sterling could yield a return between 67.32-70.42%.
    • however, there are always risks to investments, which can be found near the end of the report.

Company Overview:

Sterling construction operates in the United States under three main segments, which are Heavy Civil, Specialty Services, and Residential Projects.

Their heavy civil segment consists of infrastructure and rehabilitation projects for highways, roads, bridges, airfields, light rail, water, wastewater, and drainage systems.

Their Specialty services include construction site excavation and drainage, drilling, and blasting (for excavation), and foundations for multi-family homes, parking structures and other projects.

Their Residential projects consists of pouring concrete foundations for single-family homes

Investment Information:

Macro Overview:

Oil:

If you have been reading my past couple analyses you will know about some of the supply chain issues that are currently plaguing businesses globally. However, for this report I will be focusing on the economic outlook of oil.

A couple of weeks ago Russian hackers shut down Colonial pipeline and was forced to shut down operations for the time being. Before this took place, there was already a lack of supply of oil in the US, as the demand for oil surpassed the supply by over 1M barrels/day. However, after this hacking, this supply shortage was further threatened in some states, causing oil pries to rise in these states.

Furthermore, the IEA (International Energy Agency) announced that they would be suspending oil investments after 2021. This was the latest blow in the beatdown of the oil industry. However, all of these factors hint toward the slowing/decreasing supply of oil.

Now, as countries start to open up the demand for oil is expected to surge, this will cause the gap between supply and demand to further increase. Since, there will be less investments into oil, it will be impossible to meet the demand for oil, thus it is likely that we will see an increase in the price of oil. An increase many are starting to feel or have recently felt over the past couple of months.

These points can be backed up through an observation of the investment activity of hedge funds. In a recent publication by oilprice.com, hedge funds have been adding bullish bets to already existing positions that will benefit if the price of oil increases. In just one week, hedge funds accumulated over 30M barrels of oil, which is the largest bet on oil since February.

Later on in this report, I will highlight how Sterling is not affected by price inflation, unless it is oil, gas, and steel, in which they feel small effects of inflation. By knowing this, and the fact that oil prices are likely to rise, we need to approach this investment with caution and be mindful of the associated risks.

Sources:

Hedge Funds Bet On Higher Oil Prices | OilPrice.com

Colonial Pipeline update: Gasoline shortages developing; diesel issues less clear - FreightWaves

Biden’s Infrastructure plan:

Earlier this year Joe Biden released his proposed infrastructure bill that is currently being negotiated behind closed doors. This plan is currently being debated, and news sources are indicating that a $1T plan is more likely to be passed in the next couple of weeks, which would be significantly less than his original $2.3T proposed plan. However, $1T will still go a long way, and their original plans will likely be altered but the core premises will remain largely unchanged.

One of the big proposals of Biden’s plan is to budget $90B for the improvement of both 20,000 miles of roads, and to improve over 10,000 bridges.

Sterling Construction’s Heavy Civil segment of their business is geared to the improvement of both roads and bridges, so they are likely to win some additional government contracts in the coming years for this segment of their business. Furthermore, one of the States that Sterling operates within is Hawaii, and over 30% of the roads in Hawaii are in poor condition and need fixing, this presents a good opportunity for Sterling to win a large contract in Hawaii.

It is factors like this proposed infrastructure plan that get investors excited for the future of small cap construction and engineering stocks like $STRL.

Sources:

Biden infrastructure plan seeks fixes for existing roads. Some states are focused on expansion. - The Washington Post

Infrastructure: Biden indicated he could support $1 trillion plan, Republicans say, as GOP group prepares new offer - CNNPolitics

Financial Information:

Sterling has expanded and looks to continue expanding into adjacent markets. In April of 2017, Sterling acquired Tealstone Commercial for $84M, helping Sterling to expand their reach in Texas’ residential markets. Additionally, Sterling has acquired Plateau (in October of 2019) for $427.5M, which helps to expand Sterlings specialty service reach into Georgia (grading, excavation, blasting etc.). The acquisition of Plateau helped Sterling to increase their specialty services revenue by over 100% in 2020. Also, as a result of acquiring Plateau, Sterling had to acquiring financing, and their weighted average interest rate was 6.68% (I used this as the WACC). These acquisitions show Sterling’s willingness (and perhaps need) to grow their business, seeing sterling take on these types of acquisitions can generate excitement among investors and help drive their share prices.

Sterling has improved their financial position/health and has plans to continue to improve upon them. Sterling’s margins have increased from 4% (2015) to 9.6% (2020), and they plan to improve them to 12-15% in the future. Sterling’s revenues and gross profit have both increased by 26.7%, and 77.5% respectively (YoY), which are both a result of increased operations from acquiring Plateau. Sterling also has deferred revenues in their “backlog”, which total to $1.2B in revenue. Lastly, Sterling has increased their cash position by over 44% (to $66.2M) and have grown their highest yielding segment (specialty services – yields 13.87%) by over 139%. If they are able to continue this improvement of their financials, and get to their profit margins, their future earnings releases will reflect this and get investors excited about the future of Sterling Construction.

There has been a history of company/employee share buybacks. In 2019 Sterling bought back 250,000 of their common shares throughout the year. This buyback is estimated to have costed Sterling between $2.5-4.1M. Furthermore, employees have also been buying shares of Sterling, in 2020, Sterling employees purchased 1,101 shares at an average cost basis of $15.99 (buying a total of $17,605 worth of shares). These purchases show the confidence of both the company itself, and their employees that there is a better future ahead for Sterling and it was perhaps undervalued. Also, future buybacks will help decrease the outstanding shares and be favourable for investors.

Company Information:

  • Sterling’s business is seasonal, and are affected by weather conditions, usually during the winter (Q1 and Q4).
    • Creates variability in multiple aspects of the business.
  • Sterling purchases large amounts of resources.
    • The variability in the price of these materials can help/hinder their bottom line.
  • Sterling operates within Southern US, Rocky Mountain states, California, and Hawaii.
    • They have been expanding their reach into new geographies such as Texas and Georgia, which will help to increase their customer base.

Valuation information:

WACC:

I was able to find Sterling’s weighted average interest rate, which I used as an estimate for their WACC. This figure was found in their SEC 10-K filing and totalled 6.68%.

CAGR:

I found the forward EBIT growth rate on Seeking Alpha, in which they estimated a 45.80% EBIT CAGR. This is similar to the figure I achieved by finding their EBIT growth rate over the past 4 years (which was 54.40%).

Interest Expense Growth Rate:

I found the interest expense growth rate by finding the CAGR of their interest expense over the past 4 years. By doing this I arrived at a percentage increase of 44.18% YoY. This is very high, however, their history of acquisitions is credited for this growth, and is not necessarily a bad thing, as these acquisitions have helped to drive EBIT.

Tax Rate:

I found Sterling’s annual effective tax rate to be 34.40% through their 10-K SEC filing.

Investment Valuation and Plan:

Valuation:

In order to value Sterling Construction, I underwent 3 comparable analyses, and a DCF model. In order to verify the accuracy of my DCF model, I compared my results to the results achieved by Tracktak, which is a online DCF calculator.

DCF:

The DCF model that I created in order to value Sterling Construction, used the inputs listed above in the “valuation information” section of this report. This model estimated an upside of 117.82% or a share price of $47.81. This price estimate is high, although it is not absurd, and in order to get more context, and perhaps a better valuation I decided to also undergo 3 comparable.

Comparable Analyses:

The 3 comparable analyses that I chose to do were EV/EBITDA, EV/Revenue, and P/E.

EV/EBITDA:

This comparable is commonly used to value all types of companies, and by comparing $STRL’s EV/EBITDA to that of some industry competitors, I arrived at an implied upside of 26.7%, or a share price of $27.81. This is significantly lower than the result of the DCF model, however they are both signaling that Sterling Construction is undervalued.

EV/Revenue:

This multiple is used when acquisitions are common, and in this case, we know that Sterling has had a history of acquiring companies like Plateau and Teal stone. These comparable signals that the share price should be $2160n in order to be valued fairly, which would imply a downside of 1.6%. This just signals that Sterling has not overpaid tremendously during their acquisitions and that they are currently at fair value factoring in their acquisitions.

P/E:

The P/E multiple is also commonly used in the analysis space. By undergoing this analysis, I found that Sterling is undervalued and that the fair value per share is $28.01, which implies an upside of 27.61%. This is similar to that of the EV/EBITDA multiple and signals that Sterling is undervalued.

Average Comparable Valuation:

The average valuation from all of the comparable analyses that I underwent is $25.81 and implies an upside of 17.59%. I think that the comparable analysis is understating the fair value because Sterling is yet to observe the full potential of their earnings increases through their acquisitions yet, and because they are doing the necessary things in order to maximize growth in the future.

Plan:

In order to minimize the risk of this investment and ensure enough upside to make this investment worthwhile, entering a position under $22 is crucial (preferably under $21.60).

I would sell 50% of my investment when the price reaches the average comparable estimate of $25.81.

I would hold my remaining 50% of the investment until the price reaches $47.81 (the DCF valuation).

Catalysts:

  • Earnings releases: If Sterling can meet their target profit margins in future earnings releases, they will be noticeably more profitable, which might attract investors.

 

  • Future acquisitions: If Sterling continues to acquire companies it is likely that their stock price will increase (as long as they are not overpaying).

 

  • Future Share Repurchases: If Sterling continues to buy back their shares it will send a bullish signal to investors, as it essentially means that Sterling believes they are undervalued.

 

  • Future employee share purchasing: This also sends a bullish signal to investors because the people who are closest to the company are showing their belief in the future operations of Sterling.

Risks:

  • Reliance on Raw Materials: If the price of gas, oil, and/or steel goes up, then Sterling will incur more costs which will have a negative effect on their margins.
  • US Trade Policies: If the US bans their trading with Canada (as an example), they will be importing less fuel, and as a consequence, their fuel prices are likely to rise, decreasing Sterling’s profit margins.
  • Dependency on Large Customers: Due to the size of their contracts, a couple of Sterling’s customers represent a large portion of their revenues. This is bad because if one or two of these customers leaves then Sterling’s revenues will be greatly affected, causing investors to be scared away or to exit their positions. However, Sterling has a backlog of contracts and revenues that can help to combat this issue.
  • Contract Cancellation: Many of Sterling’s contracts are cancellable on short-notice, and when this occurs the customer pays for what is already completed, however Sterling’s work crew and equipment will remain idle until other work becomes available. This will have an effect on the expected revenues from their backlog.
  • Indebtedness: Sterling is carrying a lot of debt through their acquisitions of Plateau and Tealstone. However, Sterling believes that they can meet their debt obligations in full and on time, but if they cannot manage these payments it will be a very bad scenario.

Portfolio Reasoning:

  • It is a perfect fit for the portfolio I am building out
    • Small Cap
    • Undervalued
  • Helps to diversify
    • I am yet to own a stock in construction/engineering industry.
      • I have $MHO in the portfolio, which is residential construction, this is somewhat similar, but their operations are vastly different.
    • Hedges against inflation
      • Sterling does not feel the effects of inflation (except oil, gas, and steel) so it can help decrease the volatility of my portfolio.
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Target Price

8/ 10

Confidence

1-3 Years

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