Sterling Infrastructure: The Undervalued FCF Star (NASDAQ:STRL)

Investment thesis

Sterling Infrastructure (NASDAQ:STRL) grabbed my attention because it ranks highly among the Seeking Alpha Quant top-rated stocks. After diving deep into the company’s fundamentals, I can totally agree with its high Quant rating because the company demonstrates strong financial performance, and the management is focusing on delivering long-term value to shareholders. Best-in-class FCF profitability and a wide variety of services offered to customers make STRL well-positioned to succeed in one of America’s major industries. Last but not least, the valuation is very attractive, with the upside potential for the stock possibly more than double its current value. All in all, I assign the stock a “Strong Buy” rating.

Company information

Sterling Infrastructure is a diversified company operating across various niches within the infrastructure and construction industry. STRL conducts its activities within three segments specializing in E-Infrastructure, Transportation, and Building solutions. The company’s operations are present in the U.S., primarily across the Southern, Northeastern, and Mid-Atlantic U.S., the Rocky Mountain States, and Hawaii.

The company’s fiscal year ends on December 31. According to the latest 10-K report, the E-Infrastructure segment’s sales comprised approximately half of the company’s total revenue.

Financials

The company’s financial performance over the last decade has been solid. Revenue compounded annually at 13.7%, which is impressive considering the ten-year horizon I am looking at. As the business scaled up, the company’s profitability metrics also widened substantially. The operating margin turned from -13% ten years ago to 9% in FY 2022. While the FY 2022 operating margin might still look relatively narrow at high single digits, I like the trend of consistently improving profitability ratios across the board.

Having consistently positive free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] in the last three years enabled the company to sustain a healthy balance sheet with a moderate level of leverage. It is also important to underline that the major part of the debt is long-term, and the covered ratio looks sufficient. Near-term liquidity metrics are in excellent shape as well. STRL does not pay dividends to shareholders, and stock buybacks are insignificant. I consider this capital allocation approach sound since the top line is compounding at double-digits and profitability metrics are expanding.

The latest quarterly earnings were released on August 7, when the company topped consensus estimates by a wide margin. Revenue demonstrated a slight YoY growth amid the current uncertain environment, compared to a subtle YoY decline in the previous quarter. Despite slow revenue growth, the adjusted EPS expanded substantially from $0.86 to $1.27.

The upcoming quarter’s earnings release is estimated for November 7. Consensus estimates forecast quarterly revenue at $566 million, which indicates a slight 1.7% YoY growth. The adjusted EPS is expected to outpace revenue growth by expanding YoY from $0.97 to $1.25.

The strength in profitability despite revenue stagnating due to the current harsh environment is achieved by the revenue mix improvement. It is a big quality sign indicating that the management’s execution is at a very high level. The focus on the project mix looks like the best option to improve profitability amid the current environment of massive headwinds to increase revenue. While tightening the belt and implementing cost-cutting amid the demand softness seems to be an apparent “quick and dirty” option, the project mix improvement looks like a more sustainable step requiring more creativity from the management but which can build long-term value for shareholders. Overall, the company operates in a broad construction industry, which is the major locomotive of the U.S. economy, especially considering the massive shortage of homes after underinvestment in the industry since the Great Recession. According to Seeking Alpha Quant, STRL’s profitability is robust compared to the sector median. The levered FCF margin is the metric that matters the most to me as a long-term investor, and Sterling is a rockstar here, outnumbering the sector median by more than twice. I also like the company’s diverse set of offerings to the market, which provides solid ground for cross-selling and upselling.

Valuation

The stock has significantly outperformed the broader U.S. market this year with a massive 120% year-to-date rally. Seeking Alpha Quant assigns the stock a decent “B-” valuation grade. Current multiples are mostly lower than the sector median, which is likely to indicate undervaluation. On the other hand, a comparison with historical averages says that the current multiples are substantially higher. Multiple expansions might have happened due to a solid profitability improvement in recent quarters.

Multiples analysis outcomes are mixed and insufficient to give me a high level of conviction. Therefore, I want to run a discounted cash flow [DCF] simulation. I use a 10% WACC for discounting. I have consensus estimates for revenue for the next three fiscal years, and I incorporate a very conservative 5% CAGR for the years beyond. I use the last full fiscal year’s 6.4% FCF margin ex-SBC for my base year and expect a 50 basis points expansion per year.

According to my DCF simulation, the business’s fair value is slightly above $5 billion, which indicates a more than a hundred percent undervaluation. The upside potential is around 130%, meaning the stock’s fair price could be approximately $170 in my view.

Risks to consider

After a massive rally in previous months, there is a high risk of a pullback in the stock price before the rally continues toward the stock’s fair value. Over the past twelve months, the stock price more than tripled, and this rally is not infinite. Amid the current uncertain environment, there is a substantial risk of quarterly earnings misses or guidance downgrades, which can lead to a massive market overreaction, and investors might start selling off the stock. Moreover, most of the investors already have massive unrealized gains, and they might be tempted to record a profit by selling the stock.

The current uncertain macro environment with tight credit conditions and Federal funds rates at their highest since the beginning of the century also does not add tactical optimism. Expensive debt financing might force significant construction and infrastructure projects to be postponed, downscaled, or canceled. Given that Sterling relies on a limited number of large customers, even if one of the projects is downsized, this can be a solid disruption to the company’s financial performance in the short term.

Bottom line

To conclude, STLR is a “Strong Buy”. I think the company’s robust fundamentals suggest that the massive recent rally has been fair. The company demonstrates solid revenue growth over the long term, but it does not prioritize revenue growth at all costs. I like the management’s focus on the project mix improvement, which is likely to add a lot of value for shareholders over the long term. However, potential investors should keep in mind that there might be a solid pullback in the stock price after it has tripled over the last twelve months. Dollar cost averaging would be the best option to mitigate the risk in my opinion.