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Can we fix it? Yes we can! - Bob the Builder

WARNING: This is a small-cap idea.

This idea is a turnaround. And it is play on increased “infrastructure” spending and “fiscal stimulus.” It will work if Trump is elected president, but it will also work if Clinton is elected president. If Gary Johnson is the next president, it will probably be a loser. 

Sterling Construction is a small-cap publicly-traded construction company. Most of what it builds is heavy highway construction (i.e. paving, road and bridge building and repair) for municipalities and states, partially funded from the federal government. Its business is primarily conducted in Texas, California, and Utah. It has 1,600 employees, most of whom do real work. The CEO of another “construction” company I know said, “no one in our company carries a hammer” - to give you a sense of what they do and don’t do. Well, the employees of Sterling Construction carry hammers, wear hard hats and work gloves, they operate heavy machinery, and bid on road building jobs for a living. Their jobs range from $10 million to $80 million, take typically a year or two complete. Revenues are around $700 million. 

The business is simple and does not appear structurally attractive. You start by being certified to bid on state and municipality work. Unfortunately, there is a phone book of qualified bidders. You also need to be bonded and insured appropriately for the size of the job, which is tougher, but plenty of companies can do it. Next, you receive detailed requirements for the “letting,” or the fixed-price lowest-bid auction. Your estimator crunches a bunch of numbers to guess at the cost of the job, you pad your bid with your gross margin, and you submit your fixed-cost price. If you are the lowest cost qualifying bid, you get the work. Absent some adjustments for “change orders,” your revenues will not be higher than your bid, no matter how much it costs you to complete the job. So how do you make money? You bid the work right, you pass on the mispriced or bad projects, and then you complete the jobs you win fast and cost effectively. 

This setup reminds me of P&C insurance, but without the loss reserves. First, there is the “winner’s curse” dynamic to being the lowest fixed-cost bidder at an auction among undifferentiated competitors. The most aggressive estimator is likely to win - there is a Gresham Law-like dynamic. Second, there are invariably surprises to fixed-price construction contracts - and just like insurance, all surprises are negative and cost you money. For instance, weather can be a major driver of the cost of a job. Winter snow, you pay. Spring flooding, you pay more (feels a little like cat insurance, no?). Third, everyone has some fixed cost in their business, so the bidding can get aggressive and move toward variable cost. There are other similarities, but I will stop there. 

But also like the P&C insurance business, I think the business can be very good in a hard market, which is what I believe we are entering. Early signs are evident. The number of bidders on jobs is declining from 10+ to 4-7. The federal Highway Trust Fund has received a $51B infusion which will guarantee several years of sustained investment, after a period of living hand-to-mouth. Simultaneously, “fed up” states have enacted their own increases in funding to compensate for deferred investment, such as Texas’s constitutional change to appropriate gas tax revenue for highway construction. The NEEST writeup alluded to this changing federal and state dynamic. After being in a depressed state of activity since the Great Recession, funding and letting activity is increasing and absorbing the industry capacity. And when “bellies are full,” the bidding becomes much less aggressive and the gross margins expand.

I think we can be reasonably confident this trend will continue, but I will not be surprised if we see a major increase in fiscal spending on “infrastructure” on top of this following the next election, irrespective of winning political party. It is a widely held view that our “infrastructure” is in poor shape and requires a significant increase in capital investment. Civil employment is barely up during Obama’s presidency (unlike past administrations) and concerns of the federal budget deficit appears to have abated temporarily. Interest rates are abnormally low and “tolling” payment streams for infrastructure projects provides an additional source of funding. And employment levels have returned to normal for most groups, save low-educated men, the exact group that benefits most from increased construction activity. Road building has one further advantage for stimulus - it is “shovel ready.” I think there is a good chance Sterling is about to get “steamrolled” by a big increase in demand for their services. 

While Sterling will benefit from these possible developments, the company is also a turnaround, which is why the stock has so much upside. The company was founded in Michigan but moved its headquarters to the Woodlands in Texas, where it was a state construction company of around $300 million in revenue and gross margins in the low to mid double digits. Following its IPO in 2007, Sterling purchased similar businesses in other states, the most material of which are California and Utah (though also Arizona, Nevada, Hawaii). Following the Great Recession, more competitive bidding, bad luck and bad project management (primarily in Texas) led gross margins to decline to low single digits, leading to operating losses for the company. 

Management was replaced. Then the initial CEO replacement didn’t workout and he was replaced again. Finally, Paul Varello became CEO in February 2015, after a short period on the board. Paul hired the former CFO of CBI and an entrepreneur and former GE executive. It is difficult to judge, but management sounds reasonable to me. Paul receives $1 a year in cash compensation, the rest in stock. That compensation structure seemed to work for AMZN owners, but maybe it is correlation and not causality.  

Paul Varello inherited further embedded losses in the backlog and a stretched financial position with a usury loan of 14%+. In May 2016, the company issued 5.2 million shares for $4, leading to the current sharecount of 25 million (there was also a secondary in 2014). Following the secondary, I estimate PP&E is $70 million, working capital is $40 million (there is a 60-day lag on payments), funded with $15 million in net debt and the rest hard book value. Bonding and insurance relationships sound stable. 

Nothing “hidden” on the balance sheet, but there are two other considerations. First, there is a $56 million valuation allowance against deferred tax assets, so cash flow will be very strong with earnings improvement. There is also an unusual arrangement with two 50%-owned subsidiaries. The net of the arrangement is Sterling must buyout the minority subsidiaries on death of their owners (in their 40s and 50s) at a predetermined price, so they carry the minority interest at the face value of this “put” plus undistributed earnings, which seems too high to me given the recent earnings performance of the subsidiaries. 

Management is very clear about their expected gross margin in their backlog, as well as the run off of “bad contracts” made by previous management. This gives you a clear idea of what they believe the earnings of the business will be. Revenue for 2016 will be around $700 million and net income around $5-8 million. Capex will be around $10-11 million. Gross margin must carry G&A overhead of $40 million per annum. 

What gets me excited is looking forward several years when revenues are nearing $1B without any additional G&A expenses. If gross margins can return to double-digits, as they were from 2006-2010, and as management believes they should, EPS should be near $1 a share. If we get a little help from increased “infrastructure” investment I mentioned above, I wouldn’t be surprised if the stock doubles or triples from today’s trading levels. 

Appendix notes: The accounting is percentage of completion. So there is lots of room for shenanigans. There is also multi-employer pension exposure and some JVs with joint and several liability - I wish this weren’t the case. The nature of this business leads to negative surprises, and the financial position is sufficiently strong only absent a large adverse development. It isn’t clear to me whether this is an "investment” or an “intelligent speculation.” Caveat emptor. 

Catalyst

A Democrat or Republican is elected president and they desire to serve a second term.