Sterling Infrastructure (STRL) reported Q2 2023 results on Aug. 7 after the close. The quarter was so good the company increased its full-year guidance for 2023.
Investors liked what they heard. Early in Aug. 8 trading, STRL shares were up more than 16% on the news. Year-to-date, Sterling’s shares are up more than 125%. The Texas-based construction company’s shares have been on fire for five years, generating a 376% return, 7x better than the S&P 500.
While it’s tempting to jump on the bandwagon in true “meme” fashion, it helps if investors objectively consider the company’s pros and cons before buying its shares.
Its Shares Are Up for a Reason
In the second quarter, the company's revenues were $522.3 million, 13.1% higher than in Q2 2022. It finished the quarter with a $2.39 billion combined backlog -- defined as contracts in place and unsigned contracts already awarded -- 42% higher than as of June 30, 2022.
Its EBITDA (earnings before interest, taxes, depreciation and amortization) in the quarter was $73.5 million, 29% higher than a year earlier.
“Our strong second quarter results, record backlog and favorable opportunities across our markets give us confidence in our ability to deliver revenue and profitability growth for the year,” stated CEO Joe Cutillo in its Q2 2023 press release.
“In light of our results to date, we are increasing our full year guidance. The mid-point of our guidance ranges would offer an improvement in revenue by 13% and net income by 32% over 2022.”
Specifically, the company expects $2.0 billion in revenue at the midpoint of its guidance, with $255 million in EBITDA and $4.10 a share in earnings. Based on this earnings guidance, its shares are trading at a reasonable 18.2x its 2023 earnings.
Sterling has three operating segments: E-Infrastructure Solutions (50% of revenue), Transportation Solutions (29%), and Building Solutions (21%).
While its Building Solutions business is the smallest of the three segments -- the unit lays commercial and residential concrete foundations for customers in the Dallas, Houston, and Phoenix markets -- many of its customers are large homebuilders such as Lennar (LEN) and PulteGroup (PHM), providing significant backlog for the company.
Its E-Infrastructure segment, the company’s largest by revenues and operating profits continues to win awards to build large manufacturing facilities in the U.S. In addition to manufacturing facilities, it also builds data centers, e-commerce distribution facilities, and warehouses. Since 2021, the units backlog has grown by 69%, from $433 million to $731 million in Q1 2023.
Since 2016, it’s continued transforming its business from a low-margin heavy-civil business to one with three diversified revenue streams. As a result, its operating margin has improved from -2% in 2016 to 9.0% in 2022.
If you look at any income statement from the construction industry, you will see that margins aren’t high. In the second quarter, its operating margin was 11.5%, 200 basis points higher than Q2 2022.
That is just one of the reasons why its shares have done well in 2023.
The Downside of Sterling
There is no question that the business is far more profitable today than it was five years ago. By virtually every financial metric or ratio, Sterling is arguably in the best financial position it’s been in since it was founded in 1955.
Having said that, it’s hard to imagine its margins getting much more robust in the quarters to come. And should there be a recession in 2024, that would hurt its ability to win new business.
In 2018, STLR stock traded at 0.29x sales. Currently, it’s 1.08x, a five-fold increase over 4.5 years. The company benefited from higher-margin business, and that’s translated into the multiple expansion over this period.
One has to ask themselves how long it can keep this up. It’s one thing to keep growing sales and operating profits. It’s another to keep the multiple growing at the same time.
The Bottom Line
As of Dec. 31, 2018, Sterling had a free cash flow of $26.3 million, according to Barchart.com data. As of Dec. 31, 2022, it was $158.2 million, a compound annual growth rate of 56.6%. At the end of 2018, it had an enterprise value of $282 million. It is $2.05 billion as of Aug. 8.
So, at the end of 2018, it had a free cash flow yield (free cash flow divided by enterprise value) of 9.3%. Today, it’s 7.7%. I consider anything over 8% to be value territory. At 7.7%, it’s pretty darn close.
Despite the significant gains post-earnings, investors ought to at least look at Sterling as an excellent long-term hold to play the ongoing need for infrastructure investment by federal and state governments.
You might get a better entry point for the stock by selling the March 15/2024 $70 put options. As I write this, the bid is $6.40. Should the shares be put to you in 31 weeks, your net price would be $63.60, 13.3% lower than where it’s currently trading. If it remains above $70, you pocket the premium income, an annualized yield of 14.4%.
However, it's essential to understand that if the shares fall to $50 by next March, your loss is $13.60 a share ($63.60 net price less $50).
The other possibility is to buy a call that gives you the right to purchase the shares at expiry. In this scenario, your maximum risk is the premium paid for this right. The March 15/2024 $90 call option has a current ask price of $5.40. That’s a 7.3% premium paid for the right to buy its shares at $90. At most, you’d be out of pocket $540.
On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
