Description

Sterling Construction is a diversified construction company trading at similar valuation multiples relative to their history as investors have not recognized the company’s transformation over the past 4-5 years. While the company’s business remains cyclical, they have reduced their risk profile significantly by focusing on businesses with shorter project durations. Sterling has increased margins and is likely to see continued revenue growth from secular growing areas like e-commerce warehousing and data centers, and benefit from general infrastructure spending.

Sterling Construction was founded in 1955 and focused on heavy civil construction in the state of Texas, where it is headquartered. They continued to expand their heavy civil construction business into other mid-western and western states over the past 60 years often through JVs.

In the period from 2011 to 2016, Sterling struggled with operational missteps in their heavy civil business (95% of the business in 2015) and were plagued by projects in Texas that were underbid and created losses. Due to their financial situation, Sterling struggled with liquidity, leading to an equity issuance in 2014 and a continued reduction in their revolver availability.

At the beginning of 2015, Paul Varello, a 72 year old industry veteran, stepped in to get Sterling back on its feet. He achieved this feat by getting the heavy civil business stabilized by improving their bidding criteria and accountability. This opened the door for Joe Cutillo to step in and begin the new phase of Sterling Construction.

Joe Cutillo joined the company in late 2015 as the VP of strategy and business development. He was promoted to CEO in May of 2017 just after the closing of the Tealstone acquisition.

This begins the transformation into what Sterling is today, a diversified construction company that has de-emphasized long duration heavy civil construction projects. 

Sterling Today

Sterling has transformed their company into a diversified construction company through the acquisition of Tealstone Construction (2017) and Plateau Excavation (2019). While the legacy heavy civil business is still the largest by revenue, it is almost irrelevant to the bottom line with more than 80% of their operating income generated outside of the heavy civil business.

Tealstone Construction is a market leader in commercial and residential concrete construction in Dallas-Fort Worth, but has expanded into the Houston and, most recently, Phoenix markets. They essentially pour foundations for commercial contractors, multi-family developers, and national homebuilders.

Plateau Excavation is a leading provider of large scale site infrastructure improvement contracting services and the largest excavating company in the southeastern U.S. They primarily excavate land prior to the building of e-commerce warehousing and data centers.

Sterling now reports their segments as Specialty (Plateau), Residential (Tealstone), and Heavy Civil (legacy business).

Their diversification away from the heavy civil business has allowed them to operate this segment in a much more mindful manner and focus their bidding away from low bid heavy highway projects where they had been burned in the past. Rather they are now more focused on work at airports, rail, and alternative delivery projects. For their most recently reported second quarter, 81% of revenue came from work outside of low-bid heavy highway.

Margins have also improved significantly. Gross margin in their backlog has increased over the past 5 years from mid-single digits when they were only a heavy civil construction company to double digits driven by the addition of these new businesses.  

Why the business trajectory will continue to be interesting

The need for infrastructure spending should aid their heavy civil business. However, I would not expect the P&L to be impacted significantly in the near term even if an infrastructure bill was passed since it takes time for this to flow through to actual projects. It would brighten the outlook though.

They are expanding the number of markets in which Tealstone and Plateau operate. Tealstone was recently pulled into the Phoenix market and Plateau has been pulled into Tennessee by their customers. This has the added benefit of allowing them to pick up new customers in a new market while having a base of business with current customers.

Tealstone has shown the ability to generate solid margins and expand their business. Their business operates in some of the fastest growing new home markets in the U.S. Tealstone entered the Houston market during the first half of 2018. That business has now grown to 13-15% of the totaled completed slabs. Per managements commentary, in Houston they compete against 2 large competitors, whereas in the newly entered Phoenix market, there are no large competitors.

Plateau does excavation work for a variety of customers and projects; however, they have seen growth from industries such as warehousing/distribution centers, and data centers. CBRE estimates that data centers will grow 13.8% during 2021. Jones Lang LaSalle estimates that there is an additional 1.1 million square feet of data centers under construction or planned in the city of Atlanta, which would increase the total inventory in the city by 48%. While growth rates for data centers may to taper off, there still seems to be growth ahead. E-commerce continues to grow and is driving demand for warehousing and distribution centers. This will aid the growth of Plateau as they continue to ride the growth of their customers and at times would create ongoing losses over a number of years while the project is being completed. For example, bridge projects would take up to 4 years to complete. 

Change in Risk Profile

Sterling’s risk profile has changed due to acquisitions. In the past, due to Sterling’s business concentration in heavy civil construction they were more susceptible to large cost overruns on underbid projects. These projects had long durations with significant complexity (creating cost estimation risk) and typically would not show cost overruns for years after they were bid.

Sterling’s new concentration in excavation significantly reduces their average project duration with excavation projects being completed in 6 months to a year. The projects this segment undertakes generally range from $5-10 million which reduces the negative impact from one specific project. The complexity of projects that Plateau undertakes is also much less than the legacy heavy civil business. Plateau takes raw land and turns it into a buildable area. There can be challenges with rock and earth movement, but these issues are more homogeneous and the business’s long operating history allows them to have expertise in these matters.

Tealstone does not report a backlog since projects are so short cycle and can be completed in a day.

These new smaller and shorter duration projects have reduced specific project risk and increased cash flow.  

Balance sheet  

Sterling has levered up to make their acquisitions of Tealstone and Plateau. Both of these businesses have improved their cash flow conversion allowing for more significant debt repayment. Since the Plateau acquisition (~1.5 years ago) Sterling has reduced net debt by 38% over the past year and a half.

Management is likely to continue pursuing acquisitions. I believe the biggest risk for this company is a large acquisition made prior to a cyclical downturn, which could cause financial stress with due elevated debt and lower earnings.

Valuation

As I have discussed above, the NEW Sterling Construction has higher margins, better cash flow conversion, and executes on lower risk projects versus their history. However, their valuation multiples are constant with their historical averages.

During the period from the beginning of 2005 to September 2011, Sterling’s business was on solid footing and earnings were consistent without any major write-offs.

Sterling also trades at a discount to its peer group despite similar profitability. Sterling’s lower market cap may keep them from reaching the average multiples of their peer group. However, even if multiples were to make up half of the ground versus the average, that would lead to over 50% upside.

Catalyst

Investors realize the lower risk of the business, resulting in a higher valuation mutliple, above historical averages.