Sterling Infrastructure: Still A Buy, Despite The Strong Rally In 2023

The strategic shift of Sterling Infrastructure (NASDAQ:STRL) over the past years toward an infrastructure service provider has dramatically changed the company. Now with increasing exposure to higher-margin markets in the e-infrastructure and transportation segments, Sterling has delivered consistent top-line growth and margin expansion.

Unsurprisingly, shares of the company have rallied over past years, rising more than 100% only in 2023. In spite of this, the company's valuation is still reasonable at current levels and while the price action may be a little noisy in the short term, as the market digests such a strong surge in the stock price, I believe a buy rating is still warranted for the company, as earnings growth should continue to move prices higher over time.

The Strategic Transformation Of The Company Has Paid Off

Back in 2016, Sterling had its core business concentrated on low-bid heavy highway projects, which accounted for nearly 79% of total revenue, typically with a gross margin in the range of 7-8%. Since then, the company has implemented a program to improve bid discipline, reduce risk, and minimize project losses, which led to an improvement in gross margin to nearly 10.9% in the segment backlog in 2022.

Given the limited margin improvement potential in that competitive market, Sterling has progressively scaled-down heavy highway projects to focus on alternative delivery heavy highway projects and other scopes, such as airports.

Meanwhile, the company has expanded into new markets, driven by acquisitions. As a result, Sterling now has a significant portion of total revenue stemming from site infrastructure development projects, including next-generation manufacturing, data centers, and warehousing, which are under the e-infrastructure business unit and represents now roughly 51% of total revenue.

Sterling has also developed a business line in the building segment, focused on concrete construction to attend both residential and commercial markets, including multi-family foundations and parking structures, among other applications, mostly in Texas. This segment contributes to just 6% of total revenue so far, but it has been growing, driven by acquisitions like CCS in Dec 2022, which expanded Sterling's footprint in the residential market to Arizona.

The figure below shows how this transition from low-margin heavy highway projects to become a more diversified infrastructure service provider has improved the operational performance of the company. Gross profit margin has increased from mid-single digits in 2016 to as high as 17% and EBITDA from roughly zero to 13%, while SG&A has remained at mid-single digits over the past years.

Margin Improvements Across All Three Business Segments

Sterling's financial results have continued to surprise estimates, as has been the case for the past nine quarters. In the second quarter of 2023, total revenue increased 13% over a year ago to $522.3 million, with 11% organic growth and 2% due to acquisitions, exceeding the consensus by 5.5%, while in the bottom line operating income surged 37% and EPS grew 47%, handily surpassing forecasts by 37%.

The e-infrastructure segment was the largest contributor for these results, with revenue climbing 13% and operating margin expanding 250 bps to 16.6%, thanks to strong activity in advanced manufacturing projects and data centers. Meanwhile, easing supply chain issues and more favorable margins in large projects boosted profitability in the quarter.

In the other two segments, the transportation business saw top-line growth of 5.9% and operating margin expansion of 130 bps to a record 6.5%, as a result of margin improvement efforts. And in the building segment, revenue increased by 30%, with organic growth of more than 16%, and double-digit growth both in the residential and commercial markets, while higher residential volume and better margins led to operating margin expansion of 70 bps to 12.1%.

Strong Backlog Underscores Increased Guidance

Consistent with the top-line growth seen over past quarters, Sterling reported backlog at record levels in Q2 at $1.7 billion, up 18% compared to the beginning of the year. Importantly, gross margin of the backlog expanded 120 bps to 15.5% on record, primarily driven by higher margins in the transportation backlog and higher participation of e-infrastructure segment in the total backlog.

Taking into account this growing backlog and first-half results, the company has raised full-year 2023 guidance and now expects revenue growth of 13% and a net income increase of 32% compared to 2022.

Looking ahead, we can expect a favorable outlook across Sterling's end markets. In the e-infrastructure segment, for example, demand for onshoring and renewable solutions should continue to support new manufacturing projects, while growing data demand is expected to drive investments in infrastructure for call centers. In addition, the Infrastructure Bill is expected to support projects in the transportation sector.

On the flip side, the demand in the building segment may be more subject to fluctuations, reflecting the trajectory of interest rates that can affect housing affordability, especially in the single-family market. Additionally, a rebound in inflation may affect the cost of concrete, pressuring project profitability.

All in all, despite potential challenges, the overall environment is generally constructive, and we are likely to see top-line organic growth at nearly high-single digits over the coming years, with some upside coming from potential new M&A activity.

Reasonable Valuation, Despite The Rally

The historical surge in the shares of Sterling was not enough to leave the stock in the overvalued territory, as Sterling's P/E forward of nearly 17.2 is still slightly below the median of construction and engineering stocks of 18.4.

More broadly, when comparing with the whole industrial sector though, the situation seems more mixed, as multiples of S&P 500 and Russel 2000 industrial sectors are roughly at 16.1 and 18.8, respectively.

We can also use a quality financial metric, such as ROE, to give us further information to gauge Sterling's valuation relative to the peer group.

Sterling's ROE of 23%, for example, is well above the construction and engineering peer group's estimated ROE of 9% and the Russel 2000 industrial sector of 9%. In fact, Sterling's ROE is closer to the S&P 500 industrial sector of nearly 22%.

In my view, it suggests that while Sterling is a Russell 2000 constituent, the company exhibits a quality metric closer to the S&P 500 average. Therefore, a comparison with the S&P 500 would be more appropriate rather than using the Russell 2000 index.

In conclusion, Sterling's P/E forward multiple of 17.2 is still at reasonable levels and offers a high-single-digit upside relative to the peer group of construction and engineering companies or the S&P 500 industrial sector.

While the current valuation is not a negative for Sterling, the overall market environment is not ideal either, as the restrictive monetary policy in U.S. in place and uncertainties regarding the path of inflation and economic growth are likely to keep investors sentiment more risk-averse for a while.

That said, despite short-term challenges, underlying fundamentals are overall constructive in Sterling's end markets, notably in e-infrastructure segment. This is expected to drive top-line and earnings growth for the foreseeable future and remains a major catalyst for share price appreciation.