Sterling Construction Co. Write Up

The Inoculated Investor Equity Research http://inoculatedinvestor.blogspot.com/

Sterling Construction Co. (NASDAQ: STRL): 3/26/11Executive SummaryShare Price: $16.02 (52 week low/high: $10.45-$18.15)Market Capitalization: $264M; Enterprise Value (EV): $207M; Free Cash Flow Yield (LTM): 13.3%EV/LTM EBITDA: 4.01x; Market Cap/Net Cash: 3.11x

Company DescriptionSterling Construction Co. (STRL) is a Houston, Texas-based company that focuses on the building, reconstruction, repair and maintenance of transportation and water infrastructure. The company operates mainly in Texas, Nevada and Utah. However, recently STRL has been bidding on and winning contracts in Hawaii, Arizona, Louisiana, and California as well. The company was founded in 1954.

Infrastructure Spending Backdrop Projected FY 2012 budget shortfalls for the states that STRL is most exposed to—Texas, Utah and Nevada—

are 31.5%, 8.2%, and 45.2%, respectively Texas determined it needed to spend $315 billion between 2008 and 2030 on transportation infrastructure Utah determined it needed to spend $18.9 billion between 2007 and 2030 on bridges and roads According to the US Department of Transportation, one in four bridges in America needs significant repairs or

is burdened with more traffic than it was designed to carry According to the Association of State Dam Safety Officials, 1300 dams are "high-hazard," meaning their

collapse would threaten lives The American Society of Civil Engineers estimates that fixing problems with the nation's critical infrastructure

would cost $1.6 trillion

Current Operating Environment Current competition for projects has become quite fierce due to new participants—firms formerly involved in

residential or commercial construction--that have entered the heavy civil construction market Certain competitors have been willing to bid at their cost, just to avoid laying off workers STRL has maintained its pricing discipline and during the early part of 2010, the company was winning only

5% of contracts it bid for New entrants may eventually be forced out of the market but in the meantime their presence will negatively

affect STRL’s margins, revenues and backlog

Margins, Profitability, Backlog In 2010, STRL’s EBIT margin fell to 7.8%--from 10.1% in 2009—but was near the firm’s 5 year average SG&A as a percentage of revenue reached a 5 year high as declining backlogs in certain areas could not be

offset by proportional reductions in SG&A Due to some higher margin projects, 2010 gross margins were higher than the five year average, despite the

competitive bidding environment At the end of 2010, STRL’s backlog reached a record $660M, but organic growth within the backlog has

slowed meaningfully

Valuation Analysis The stock has run up from around $12.50 on March 14th to over $16 now Based on trailing free cash flow (FCF), the stock is trading at a FCF to enterprise value (EV) yield of 13.3% The stock is trading at an EV/Backlog ratio of .31x, far below the five year average of .48x The stock is trading at an EV/EBITDA multiple of 4.01x, versus a 5 year average around 6x The stock is trading at 3.11x the $85M in net cash the company has on its balance sheet

http://inoculatedinvestor.blogspot.com/


An Earnings Power Value (EPV) analysis using an 11% discount rate and a 25% margin of safety produces a target purchase price of $14 and an estimate of intrinsic value around $18.75

The current price above $16 is around 14.4% higher than the target purchase price of $14

Comparative Company Analysis Comps chosen due to similarity were Orion Marine Group (ORN) and Michal Baker Corporation (BKR) Of the three, STRL has consistently had the second highest EBIT margins In 2010, STRL had the highest ROE of the group STRL’s stock is currently trading at the lowest multiples of trailing earnings and EBITDA of the group

Analysis of Major Holders By in large, the institutional holders have been increasing their stakes in STRL The recent run up in the price may have caused some of the top 10 largest holders—who owned about 56% of

shares as of 12/30/2010—to trim their positions Over the past year, there has been 58x more selling than buying among insiders Aside from a recent 1K share purchase by the CEO, the insiders having been selling heavily in recent days

Prominent Risk Factors Uncertain environment for state spending on infrastructure may be prolonged indefinitely Extreme customer concentration: 4 customers in Nevada, Utah and Texas made up 58.5% of total revenue in

2010 Company’s margins may be hit by the rising costs of commodities such as steel, aggregates and diesel fuel STRL is looking for additional acquisition and thus could lever up to make an ill-advised acquisition Bidding on large, multi-year projects is difficult and certain lump sum contracts force STRL to absorb cost

overruns A bankrupt or insolvent state could cut current and future infrastructure spending dramatically or actually try to

get out of existing contracts with STRL

Conclusion The presence of multiple risk factors should cause investors to demand a large margin of safety when

purchasing shares To minimize the potential for permanent capital impairment, look to establish a position at a share price around

$14 If state budgets remain strained, the bidding environment continues to be quite competitive, and trading

multiples stay low, it would not be a surprise to see a larger player such as KBR Inc., The Shaw Group, or Fluor (who is in a JV with STRL) buy a smaller competitor like STRL to boost its growth



Sterling Construction Co. (NASDAQ: STRL): 3/26/11Share Price: $16.02 (52 week low/high: $10.45-$18.15)Market Capitalization: $264MEnterprise Value (EV): $207MFree Cash Flow (LTM): $27.6MFree Cash Flow Yield (LTM): 13.3%

Company Description

Sterling Construction Co. (STRL) is a Houston, Texas-based company that focuses on the building, reconstruction, repair and maintenance of transportation and water infrastructure. The company operates mainly in Texas, Nevada and Utah. However, recently STRL has been bidding on and winning contracts in Hawaii, Arizona, Louisiana, and California as well. At the end of 2009, STRL acquired 80% of Ralph L. Wadsworth Construction Co., LLC (RLW) for about $64M and will have the option to buy the remaining 20% in 2013. The company was founded in 1954.

Infrastructure Spending Backdrop

Not surprisingly, the poor fiscal condition of many states has caused market participants to be concerned about future levels of infrastructure spending. The fear is that the states are so strapped for cash that they will have to postpone major infrastructure projects for years or even indefinitely. Additionally, raising taxes to fund such spending appears to be a non-starter in most states as many inhabitants are still struggling from the fallout of the financial crisis and subsequent recession. Accordingly, while many stocks have appreciated meaningfully since the Federal Reserve enacted QE2, certain small companies that are reliant on state and government spending on roads, sewers, bridges and waterways have seen their stocks lag behind, or even decline.

Some of the abovementioned concerns may be completely valid, as restrained infrastructure spending may indeed limit revenue growth and depress the margins of companies such as STRL. However, investors also have to consider the secular backdrop regarding the US’s stock of infrastructure. In 2008, when a bridge located in Minnesota collapsed--killing 13 people—the whole nation became acutely aware of the dangerous state of America’s roads, bridges and dams. In fact, a recent report by the Pew Research Center1 illustrated just how dire the situation actually is. Take a look at these statistics:

“More than one in four of America's nearly 600,000 bridges need significant repairs or are burdened with more traffic than they were designed to carry, according to the U.S. Department of Transportation.”

“A third of the country's major roadways are in substandard condition -- a significant factor in a third of the more than 43,000 traffic fatalities each year, according to the Federal Highway Administration.”

“The number of dams that could fail has grown 134% since 1999 to 3,346, and more than 1,300 of those are "high-hazard," meaning their collapse would threaten lives, the Association of State Dam Safety Officials (ASDSO) found. More than a third of dam failures or near failures since 1874 have happened in the last decade.”

“Underground, aging and inadequate sewer systems spill an estimated 1.26 trillion gallons of untreated sewage every year, resulting in an estimated $50.6 billion in cleanup costs, according to the U.S. Environmental Protection Agency.”

1 http://pewresearch.org/pubs/699/look-out-below


http://pewresearch.org/pubs/699/look-out-below


“Fixing these problems and others threatening the nation's critical infrastructure would cost $1.6 trillion -- more than half of the annual federal budget, the American Society of Civil Engineers (ASCE) estimates. And that doesn't include what it will cost for new capacity to serve a growing population.”

The takeaway is that eventually states are going to have to spend money fixing crumbling infrastructure regardless of their financial positions. When human lives are at stake, it is going to be very difficult for politicians to argue that there is no money to be spent on preventing disasters. There is no doubt that the current gap between promised expenditures and incoming revenues at the state level will make it much harder for states to come up with the necessary funding. Additionally, raising taxes when national unemployment rate is still around 9% is going to be politically quite difficult. However, America is dependent on a functioning and ubiquitous transportation and energy network and the negative impact of under-spending on infrastructure could be much more harmful to the economy as whole than higher gas taxes or more expensive toll roads. Therefore, it seems inevitable that through some combination of higher taxes, federal funding or even a national infrastructure bank, the country will figure out a way to maintain and even expand the current network of dams, bridges and roads.

In addition to the above data, STRL provides state- and municipality-specific figures for infrastructure spending in its most recent 10-K that suggest the need for ongoing capital expenditures (emphasis added):

“In February 2009, the American Recovery and Reinvestment Act, or federal economic-stimulus legislation, was enacted by the federal government authorizing $27.5 billion for highway and bridge construction. The highway funds apportioned to Texas, Utah and Nevada approximated $2.7 billion under the federal economic stimulus legislation, and the majority of such amount will be expended in 2009 through 2011.”

“In January 2009, the 2030 Committee, appointed by Texas Department of Transportation (TXDOT) at the request of the Governor of the State of Texas, submitted its draft report of the transportation needs of Texas which at that time had over 193,000 lane-miles and 50,000 bridges in its state highway system. The report further indicated that Texas needs to spend approximately $315.0 billion (in 2008 dollars) for the period 2009 through 2030 to prevent worsening congestion and maintain economic competitiveness on its urban highways and roads, improve congestion/safety and partial connectivity on its rural highways, and to replace bridges.”

“Utah’s Long Range Transportation Plan for 2007-2030 projects spending for highway and bridge construction of $18.9 billion; the Utah Governor’s recommendation for such spending in 2010 was approximately $1.1 billion; and the Utah Office of the Legislative Fiscal Analyst Appropriations Report for fiscal year 2011 indicates appropriations for transportation capital projects total $900 million.”

“Houston’s Capital Improvement Plan includes $664.7 million in the fiscal year ending June 30, 2011 for transportation and water infrastructure projects.”

“The City of San Antonio has adopted a six-year capital improvement plan for its fiscal years 2011 through 2016, which includes $322.5 million for streets and $165.6 million for drainage.”

On the reasons for all of this planned spending is population growth in these states. Specifically, according to the company: “From 2005 to 2010, the populations of Texas, Utah and Nevada grew 10.2%, 15.8% and 14.8%, respectively, compared to approximately 4.5% for the national average.” This continuous inflow of people just about guarantees that the states will have to take measures to reduce congestion and assure that the transportation system is adequate. As a result, it is hard to imagine that any state will be able to put off capital expenditures on infrastructure for very long.



Current Bidding Situation

Unfortunately for STRL, while there are a number of ongoing and new projects , the competition for these jobs has become quite fierce. The reason is that a number of new participants have entered the heavy civil construction market. Specifically, companies that were previously involved in residential and commercial construction have begun to bid on infrastructure projects as well. These new players are often not as familiar with the scope of or how to budget for large state and municipal jobs and therefore have been bidding at levels that provide a very small profit margin. Additionally, some firms have been willing to bid at their cost, just to keep their employees occupied and to avoid laying off workers. Accordingly, STRL has been losing out on a number of potentially attractive contracts due to the increased number of bidders. STRL has in some cases accepted a lower margin on certain jobs, but in general the company has stuck to its pricing discipline and has been willing to let its revenues and backlog decline in order to protect its margins.

Further, the company indicated on its Q1 2010 conference call that it was winning an absurdly low 5% of contracts it decided to bid on, partially due to the presence of the irrational players. In general, the team believes that bidding with no margin is unsustainable and that these new entrants will eventually be forced out of the market. In fact, the management team said that by the time of the Q4 2010 conference call, the bidding environment had become more rational and that marginal bidders were having trouble providing the necessary surety and payments bonds. In contrast, the company’s long history and strong working capital position have allowed STRL to obtain surety bonds without difficulty and at reasonable costs. This fact may give STRL an important advantage over competitors who are not as experienced or as well-capitalized.

However, in addition to the difficult bidding environment, there are these negative factors (listed by the company):

“Recent reductions in miles driven in the U.S. and more fuel efficient vehicles are reducing federal and state gasoline taxes, tolls and other highway related taxes collected, which are the primary funding sources for construction of highways and bridges. Also, the federal and Texas highway gasoline tax rates per gallon have not increased since 1994 and 1991, respectively.”

“The federal government has not renewed the five-year SAFETEA-LU bill, which expired September 30, 2009…which has caused uncertainty over subsequent month’s and years’ federal funding to the states for budgeting of future transportation infrastructure lettings.”

“The nationwide decline in home values as a result of the decline in home sales, the increase in foreclosures and a prolonged recession has resulted in decreases in property taxes and some other local taxes, which are among the sources of funding for municipal road, bridge and water infrastructure construction.”

Clearly, STRL’s stock price has been affected by the uncertainty regarding infrastructure spending and the fact that the company has had to choose between foregoing revenue and accepting lower margins. However, the questions investors must ask are: (A) Realistically, how long can states defer spending? (B) How long will STRL’s margins be under pressure? and (C) Does the current stock price reflect far more pessimism than is appropriate?

Customer Concentration

Another real risk that investors must consider when evaluating STRL is customer concentration. The chart below

illustrates just how reliant STRL is on four major customers that represent three states:

% Total Texas DOT Utah DOT Nevada DOT N. Texas Toll Authority Total

Q4 2010 Backlog 16.50% 25.30% N/A 17.40% 59.20%



2010 Revenue 20.70% 26.20% 6.40% 5.20% 58.50%

Obviously, the loss of any one of these customers would have a dramatic impact on the company’s revenues and backlog. While the case can be made that these organizations will be spending pretty consistently in the future, there is no guarantee that STRL will be a beneficiary of any contract awards. But, it should be noted that Sterling Construction was founded in 1954, indicating that the company has been operating in the heavy civil construction space for many years. In addition, based on repeatedly being awarded contracts from the same customers, STRL has clearly proven itself to be a reliable contractor. For example, in FY 2005 the company derived 60% of its revenue from the TXDOT and 75% from its top three customers. Thus, investors should note that STRL has a longstanding relationship with the TXDOT. More importantly, this FY 2005 data suggests that the acquisition of RLW and the addition of the contracts in Utah have actually helped STRL diversify its revenue base and backlog.

In summary, the fact that STRL has been able to maintain its relationships with the most relevant state institutions should be comforting for potential investors. However, there is no question that the customer concentration risk alone should cause investors to use a higher discount rate when determining the intrinsic value of the company.

Backlog

Through organic growth and acquisitions, STRL has been pretty consistent in its ability to increase the size of its backlog. For example, as shown below, partially as a result of the RLW acquisition, the backlog at the end of 2009 was close to 45% higher than it was at the end of 2008. But, the acquisition masks, to some extent, a somewhat troubling trend of tepid organic growth in the backlog. While the company does not break down the backlog by state, the management has indicated on recent calls that backlogs in certain areas have actually been declining. As will be discussed in a little more detail in the following section, reductions in backlog have had a negative impact on STRL’s margins, as the company now has limited ability to reduce SG&A at a proportional rate.

Backlog Analysis Yearend Backlog % Increase

2010 $660 2.0%

2009 $647 44.7%

2008 $447 -0.7%

2007 $450 13.9%

2006 $395 28.7%

2005 $307 32.3%

Margins and Profitability

As discussed above, a number of external factors have come together to put pressure on STRL’s margins. On top of those, on recent conference calls, the management team has also discussed internal issues that are affecting profitability. First, after eliminating about 25% of its workforce between the fall of 2009 and Q1 2010, SG&A is now relatively fixed and thus will not fall if revenues and backlog decline. Further, STRL’s fixed overhead costs increased as a result of the RLW acquisition. In combination with these two items, the competitive environment that has forced the company to maintain its bidding discipline--and thus lose out on contracts—has caused SG&A as a percentage of revenue to be much higher than it had been during previous years. Also, the company has had to depreciate and pay for the storage of equipment that is not currently being used. Specifically, given that the company has a relatively young fleet, it decided to mothball a handful of machines instead of selling them into a depressed market. The reason is that the management team anticipates having to pay a much higher price if it were to go out and purchase the equipment again in the future. Regardless of the motivation, the subsequent impact was that 2010 EPS was reduced by a few million dollars of unabsorbed equipment overhead. Despite the abovementioned margin pressures, there are a few reasons why STRL has been able to maintain operating margins near the company’s five year average. (The following chart highlights the trend in margins over



the past 5 years, a period that represents both very good and very bad times for state budgets.) The first is the higher gross margin, design-build projects that the company has been awarded recently. Also, while the company does not break out margins by state or by customer, the comments made by the management team hinted that the addition of RLW projects has improved the margin mix. Finally, the management team indicated on the company’s most recent conference call that margins tend to improve as the projects progress and STRL better understands the cost structure and ways to perform more efficiently.

FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 5 Year Average

EBIT Margins 7.1% 6.7% 6.8% 10.1% 7.8% 7.7%

Gross Margins 11.4% 11.0% 10.1% 13.9% 13.6% 12.0%

SG&A% of Revenue 4.3% 4.3% 3.3% 3.8% 5.4% 4.2%

The task of any analyst is to determine what run-rate EBIT margins are going to be for the company and given the fluctuations over the last 3 years, that is not easy to do. But, considering the amount of bidding competition and the uncertainty surrounding state budgets, it is hard to imagine a much worse operating environment for STRL, at least on a margin basis. Therefore, aside from an Armageddon scenario in which states ignore their infrastructure needs for many years, other probable outcomes likely include a more rational competitive environment and more consistent spending by states. However, to establish a sufficient margin of safety, a conservative analyst should be careful not to price in much, if any, margin expansion. In reality, the company has indicated that it expects 2011 EPS to be lower than the $1.13 per share the company earned in 2010. Thus, is makes sense to err on the side of conservatism and then have a free call on any margin expansion in the future (see EPV analysis below).

Capital Expenditures and Free Cash Flow

As a result of concerns over the potential for a decline in the backlog and the uncertain operating environment, during 2008 and 2009 the company put off certain capital expenditures, especially those having to do with new equipment. Specifically, the free cash flow table below shows that CAPEX fell from $19.9M in 2008 to only $5.3M in 2009. Given the levels of spending during the previous years, that 2009 figure likely represented the bare minimum maintenance CAPEX required to keep the construction fleet running. However, the expansion in Utah, the necessary replacement of retiring equipment and the lack of spending in the past will all contribute to higher CAPEX in the future. Some of that was absorbed in 2010, but the company has indicated that it expects 2011 CAPEX to be higher than the $13.4M figure from 2010.

Unfortunately, the company does not break out growth CAPEX (that having to do with an expanded backlog) from maintenance CAPEX (that required to maintain the backlog). Thus, an estimation of maintenance CAPEX for the EPV analysis included below will lack precision. In any case, the following table lays out the free cash flow (FCF) generated by the company over the past 6 years and illustrates why investors might be attracted to STRL—a high FCF yield (calculated by dividing FCF by Enterprise Value):

Free Cash Flow (millions) FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010

EBIT $14.67 $17.72 $20.50 $28.21 $39.41 $35.91

(Minus) Taxes (Based on yearly effective tax rate) 3.07 6.06 7.22 9.75 12.79 10.11

Net Income $11.60 $11.66 $13.28 $18.46 $26.62 $25.80

(Plus) D&A 5.06 7.01 9.54 13.17 13.73 15.80

(Minus) CAPEX 11.40 24.80 26.30 19.90 5.30 13.40

(Minus) Change in Net Working Capital (11.40) 3.70 (8.70) 13.13 (0.40) 0.57

FCF $16.66 -$9.83 $5.22 -$1.40 $35.45 $27.64

FCF/EV (at fiscal yearend) 8.49% N/A 2.02% N/A 13.19% 17.79%

Put/Call Option on the Remaining 20% of RLW



Recall that STRL only bought 80% of RLW in 2009. However, the purchase contract stipulated some additional put and call provisions for the remaining 20%. For example, the owners have a right to put the remainder of RLW to STRL in 2013 and STRL has a call option that allows the company to gain full control in the same year. The put and call price will be determined by multiplying RLW’s average EBITDA from 2010 to 2012 by a minimum of 4x and a maximum of 4.5x. Given the seemingly low multiple for what looks to be a very profitable business, it would be surprising to see STRL not exercise its call option (assuming it has the necessary funds in 2013).

If either the put or call is exercised, the company will no longer have a line item below net income (on the income statement) for “Noncontrolling owners’ interests in earnings of subsidiaries and joint ventures.” Specifically, if STRL had owned 100% of RLW and another small company named RHB (which STRL owns all but 8.33% of), net income for 2010 would have been $26.2M versus $18.6M, a 40.8% increase. However, for now, what is important to note is that STRL has estimated the put liability associated with RLW to be worth $28.7M and thus that amount should be subtracted from the total value of the company in an EPV analysis (presented below).

ValuationEV/BacklogBacklog is kind of a crude measure of future revenue. However, while compiling the data regarding STRL’s current backlog, an interesting ratio emerged. Specifically, as the chart below indicates, even though STRL’s backlog has more than doubled over the last 6 years, the stock is trading at the lowest enterprise value to backlog ratio during that six year period. In fact, even though the stock has run up substantially since the end of 2010, the current EV/backlog is still a fraction of what it has been in the past. Now, it may be true that market cap and EV do not rise proportionately with backlog, suggesting that the ratio should fall as backlog increases. But, the currently depressed ratio may be indicative of just how much pessimism is baked into the stock price.

Backlog Analysis Yearend Backlog Yearend EV/Backlog Current EV/Backlog

2010 $660 0.24x 0.31x

2009 $647 0.42x

2008 $447 0.48x

2007 $450 0.57x

2006 $395 0.51x

2005 $307 0.64x

Multiples AnalysisThe following chart tracks the year end trading multiples for STRL’s stock over the past six years. The stock would look even cheaper if it had not had such a miraculous run over the last few weeks. On March 14th, 2011, the stock closed at $12.48, implying a free cash flow yield of about 18.5%. Since that day, ostensibly as a result of the release of the company’s 10-K, the stock price has risen above $16. At a price near $12.50, there was likely a very large margin of safety available for anyone who considering a purchase of the stock. Now, even though the FCF yield is still above 13% and the stock is trading at 3.11x net cash, the buying opportunity is not quite as clear cut.

Valuation FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 Current

Stock Price (FY End) $18.62 $20.52 $20.51 $17.92 $19.02 $12.86 $16.02

EV/EBITDA 9.95x 8.11x 8.59x 5.21x 5.06x 3.01x 4.01x

FCF/EV 8.49% N/A* 2.02% N/A* 13.19% 17.79% 13.33%

P/E Ratio 16.85x 19.30x 17.24x 13.55x 10.52x 11.12x 13.86x

EV/Sales 0.89x 0.80x 0.84x 0.52x 0.69x 0.34x 0.45x

Market Cap/Net Cash 25.38x 9.36x 15.86x 8.78x 5.00x 2.50x 3.11x

Price/BV 4.02x 2.47x 1.85x 1.43x 1.20x 0.76x 0.94x*N/A denotes a year with negative FCF

EPV Analysis



In order to determine if there is a sufficient margin of safety still present in the stock price, an Earnings Power Value (EPV) analysis was conducted with the goal of ascertaining intrinsic value. Given the company-specific risks, the analysis was based on the following conservative assumptions:

A fair estimate of run-rate revenue is 2010 revenue minus a 5% haircut. This is a very conservative estimate as it assumes that revenue does not grow at all—in fact, it declines and stays depressed--despite the secular tailwinds having to do with infrastructure spending.

A conservative estimate of run-rate EBIT margins is 7.7% or the five year average for the firm. A fair estimate of the tax rate going forward is the 32.92% five year average for STRL. Run-rate D&A is equal to 2010 D&A, despite the fact that the company will be spending more on

equipment in 2011 and thus will incur more depreciation expense in the future. Run-rate maintenance CAPEX equals $10.6M. As mentioned above, this is a very hard number to

determine with accuracy. However, given that the company was still able to operate with $5.3M in CAPEX in 2009 but spend $13.4M in 2010, it seems sufficiently conservative to double the former amount to calculate run-rate maintenance CAPEX.

The value of the put liability regarding the remaining 20% of RLW ($28.7M) should be subtracted from EPV

Given the customer concentration, the uncertain outlook for state finances, and the current bidding environment, an 11% cost of capital seemed appropriate to compensate for those risks.

A 25% margin of safety in necessary to compensate for the difficulty inherent in ascertaining EPV with precision. This high margin of safety is required despite the fact that the company has a conservative balance sheet with virtually no debt (only $400K) and $85M in net cash.

EPV AnalysisRun Rate Revenue (2010 Revenue minus a 5% haircut) $436.90Conservative Run Rate EBIT Margin (5 Year Average) 7.70%

Implied EBIT $33.63

Estimated Tax Rate (5 Year Average) 32.92%

After Tax EBIT $22.56(Plus) Run Rate D&A Estimate (2010 Figure) 15.80(Minus) Maintenance CAPEX Estimate (2x 2009 Figure) 10.60

Adjusted After Tax EBIT $27.76

EPV Based on Adjusted EBITNet Cash- PV of Non-controlling

Cost of Capital EPVInterest

(2013 Put Option)Adjusted

EPVCurrent

Market CapMargin Of

SafetyPercentage

MOS

8% $347.02 $56.38 $403.39 $263.77 $139.62 34.61%

9% $308.46 $56.38 $364.84 $263.77 $101.06 27.70%

10% $277.61 $56.38 $333.99 $263.77 $70.22 21.02%

11% $252.38 $56.38 $308.75 $263.77 $44.98 14.57%

12% $231.34 $56.38 $287.72 $263.77 $23.95 8.32%

13% $213.55 $56.38 $269.92 $263.77 $6.15 2.28%

14% $198.30 $56.38 $254.67 $263.77 -$9.10 -3.57%

15% $185.08 $56.38 $241.45 $263.77 -$22.32 -9.24%

Purchase Target

EPV with an 11% cost of capital $308.75

(Minus) 20% margin of safety $77.19



Implied market cap $231.56

# Shares outstanding 16.47

Implied share price $14.06

Target purchase price $14.00

Current price $16.02

% Difference in prices 14.4%

Using the above assumptions, the estimated intrinsic value of the company is about $18.75 and a purchase price that includes the requisite 25% margin of safety is $14.00. Parenthetically, using the price on March 14th ($12.48) implies a margin of safety of around 33%. Unfortunately, this analysis was conducted a bit too late, and at the current price, the stock does not offer a sufficient margin of safety.

Comparative Company Analysis

There are a number of small construction companies that operate in the same space as STRL. However, Orion Marine Group (ORN) and Michael Baker Corporation (BKR) were chosen as valuable comps because they had similar businesses, market caps and yearly revenues.

Margins and Returns

EBIT Margins FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 5 Year Average

STRL 7.1% 6.7% 6.8% 10.1% 7.8% 7.7%

ORN 11.5% 13.1% 8.7% 10.9% 9.2% 10.7%

BKR 2.5% 6.6% 7.3% 6.6% 4.9% 5.6%

Gross Margins

STRL 11.4% 11.0% 10.1% 13.9% 13.6% 12.0%

ORN 21.0% 24.0% 19.3% 21.4% 18.5% 20.8%

BKR 13.3% 19.8% 18.5% 19.8% 19.8% 18.3%

ROE

STRL 18.1% 12.3% 12.2% 12.2% 9.8% 12.9%

ORN 26.4% 24.3% 14.8% 12.2% 9.3% 17.4%

BKR 11.9% 16.6% 17.5% 15.6% 8.3% 14.0%

As shown above, ORN has consistently had the highest operating margins of the group, likely because the company engages in a substantial amount of difficult work—dredging, for example. However, of the two more similar companies, STRL has enjoyed higher operating margins than has BKR, despite having lower gross margins. In addition, even though the five year average return on equity (ROE) for STRL is lower than that of its competitors, during a very rough year in 2010, STRL achieved the highest ROE of the group. In summary, based on the above data, one would expect ORN to trade at the highest multiples as a result of the historically higher margins and ROE. From there, the questions that arise are how large should the premium be and is STRL trading at an unwarranted discount?

Multiple Analysis

Average P/E Ratio** FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 5 Year Average Current/LTM

STRL 18.76x 19.71x 15.00x 10.64x 11.40x 15.10x 13.20x



ORN* N/A 18.66x 14.78x 22.68x 18.63x 18.69x 13.85x

BKR 28.62x 28.07x 9.30x 10.85x 13.19x 18.01x 14.98x

Average EV/EBITDA

STRL 10.86x 8.69x 7.02x 4.15x 3.79x 6.90x 4.01x

ORN* N/A 8.54x 6.52x 8.33x 7.00x 7.60x 5.07x

BKR 8.47x 9.08x 4.30x 4.88x 5.28x 6.40x 4.95x

Average TEV/Sales

STRL 1.00x 0.84x 0.70x 0.47x 0.46x 0.69x 0.45x

ORN* N/A 1.55x 1.16x 1.41x 1.17x 1.32x 0.77x

BKR 0.34x 0.44x 0.31x 0.38x 0.46x 0.39x 0.34x*ORN was not publicly traded until 2007**Capital IQ calculates the average trailing multiple over each (entire) year and this is the number presented for each company above

The first thing to notice is that all of the companies are trading below their five year averages for each category, in some cases meaningfully so. However, this is to be expected given the turmoil in the firms’ markets. Next, aside from BKR’s current EV/Sales multiple (which has been low historically as well), STRL is currently trading at the lowest multiples of the three firms. In fact, at about 4x trailing EBITDA, STRL trades at a substantial discount to its peers and its five year average EBITDA multiple. Clearly, all of these companies’ stock prices are being weighed down by the operating environment. But, STRL seems to be performing admirably and it has only been in the last two weeks that investors have noticed and have driven the company’s multiples up closer to those of its peers.

Management Compensation and Insider Holding Analysis

First, a brief glance at the total management compensation chart highlights that this is a family-oriented business. There are two Mannings and two Harpers who have prominent positions. With small, family-run companies, there is always the risk that certain members will pay themselves exorbitant salaries at the expense of shareholders. However, given that the company generates over $450M in revenue, none of the below salaries seem excessive. In fact, the base salaries for the executives are much lower than the total compensation amount and the higher amounts were only received because EBITDA and EPS targets were reached by the company. Although, it should be mentioned that the targets--$24.3M in EBITDA and $.52 in EPS—were set at very low levels and thus were easily achievable.

Management Member Total Calculated Compensation ($ thousands) FY 2007 FY 2008 FY 2009 FY 2010

Harper, Joseph P. President, Chief Operating Officer, Treasurer and Director $621.9 $599.8 $697.3 $703.0

Harper, Joseph P. Executive Vice President of Finance N/A N/A N/A $408.0

Colombo, Anthony Executive Vice President of Operations N/A N/A N/A $492.7

Manning, Brian Chief Business Development Officer and EVP N/A N/A N/A $415.6

Manning, Patrick T. Chairman and Chief Executive Officer $652.8 $599.4 $700.0 $690.0

Allen, James Chief Financial Officer $389.1 $362.5 $407.5 $410.2Source: Capital IQ

Next, as shown below, as the stock has run up over the last few weeks, the insider selling has really picked up. Both the CFO and the COO sold 10K shares above $15 and the CFO’s sale left him with no share ownership at all. Over the last year, there has been around 58x more selling than buying on a nominal basis. However, it is important to note that the only buy occurred just last Friday as the CEO bought 1,000 more shares. Now, clearly this was a small purchase. But, amidst the rapid selling by other executives, it is very curious to see that the CEO bought shares at a higher price than any of the most recent sales occurred at. In general, the management team only owns a fraction of total shares outstanding and therefore potential investors cannot conclude that management’s interests are completely aligned with those of shareholders.



Insider Ownership

Person Position # of shares % of total shares Recent Activity Price Date

Brian Manning EVP 0.22 1.34% None N/A N/A

Joseph Harper COO 0.205 1.25% Sell 10K $15-$15.11 3/22/2011

Maarten Hemsley Director (former CFO) 0.181 1.10% Sell 2K $15.41 3/25/2011

Patrick Manning CEO 0.042 0.26% Buy 1K $15.44 3/25/2011

James Allen CFO 0.000 0.00% Sell 10K $15.26 3/25/2011

Insider Trades Last 3 Months Last Year

Buys $0.015 $0.015

Sells ($0.634) ($0.874)Sources: Capital IQ and Form 4 Oracle

Major Holder Analysis

In contrast to the insider buying, the institutions that own STRL’s stock have been adding to their positions recently. For the most part, the data below is as of 12/31/2010 and the recent activity column indicates whether each firm added to or reduced its position between 9/30/2010 and 12/31/2010. The data shows that on a net basis the largest stakeholders added about 539K shares during that period. Now, as the price has run up, it would not be surprising to see that some of these firms had trimmed their positions. Unless the firms file a 13G, the markets will not know exactly what these investors decided to do until the middle of May (45 days after the end of Q1 2011). But, since the stock has continued to go up each day over the last week, there does not appear to be much selling pressure or a block of shares for sale at a discounted price.

In any case, what is important to note is just how concentrated the ownership of STRL’s stock is. Specifically, the top ten holders own over 56% of total shares outstanding. Thus, given the fact that the average daily volume for STRL's stock is only around 50K shares2, substantial selling by any of these shareholders could really move the price. Therefore, investors have to consider this limited liquidity when assessing whether to purchase shares of STRL.

Major Holders (millions of shares) Recent Activity

Firm # of Shares % of total Shares Add or Reduce? Amount

Columbia Management 2.206 13.40% Add 0.010

Perkins Investment Mgmt (Janus) 1.431 8.69% Add 0.018

Royce & Associates 1.230 7.47% Add 0.044

Blackrock 0.898 5.45% Add 0.064

Wellington Mgmt 0.696 4.23% Reduce 0.003

Vanguard 0.673 4.09% Add 0.021

T. Rowe Price 0.672 4.08% Add (0.016)

BNY Mellon 0.578 3.51% Reduce 0.035

Keybank 0.512 3.11% Add 0.512

Ramsey Asset Mgmt 0.422 2.56% Reduce (0.152)

Top 10 Total 9.318 56.59% 0.539Source: Capital IQ and 13G filings

Brief Five Forces Analysis

It would be difficult to argue that STRL has a substantial moat or durable competitive advantage. For the most part, the company is at the mercy of market conditions and has very little pricing power. Thus, investors should make sure to use a high discount rate and require a sufficiently large margin of safety when calculating a potential

2 http://finance.yahoo.com/q?s=STRL&ql=1


http://finance.yahoo.com/q?s=STRL&ql=1


purchase price. However, given STRL’s long history and apparently strong relationships with customers, it is important to at analyze the competitive position of the company:

Competitors: In this case there are many competent competitors with experience in the heavy civil infrastructure space. However, some of the new entrants do not appear to be as savvy or have enough pricing discipline to succeed in the space. Unfortunately for STRL, the fact that the states are so budget constrained may lead them to pick the lowest bidder as opposed to the highest quality company offering a reasonable price. Therefore, the current competitive situation can be described as fierce, with price being the most important factor.

Suppliers: Since STRL has to purchase aggregates, steel, and fuel from third parties, the company is at the mercy of the prevailing market price. Thus, while the suppliers of these commodities are not able to charge above-market prices, STRL likely has little power to negotiate discounts from the suppliers.

Customers: The states and municipalities currently have the power in the relationship with STRL. There are so many bidders and players who are willing to bid with little to no margin, STRL has no pricing power whatsoever. In other words, STRL is unlikely to be able to increase its customers’ willingness to pay, regardless of the quality of the service offering. The company is then forced to bid an amount that provides a margin that the management team is comfortable with and hope that the bid is low enough to be accepted.

New Entrants: There are very minimal barriers to entry in this space. Apparently, many companies that had been focused on residential and commercial construction have begun to bid for infrastructure jobs. It is true that these new entrants are often at a disadvantage due to lack of experience, few prior relationships with customers, and difficulty securing surety bonds. Accordingly, over time, some of these firms will likely be forced to drop out of the market. But, in the meantime, there is little that can stop them from entering the competitive process and submitting bids that are far below those that STRL is willing to tender.

Substitutes: In this case there are minimal substitutes available to the states and municipalities. Functioning roads and sewers are necessary to keep the local economies running and thus they must be maintained and upgraded on a regular basis, especially in states like Texas that have seen above-average population growth. Thus, for the foreseeable future, local governments are going to have to rely on quality companies like STRL to provide infrastructure construction services.

Risk Factors

In addition to the risk factors discussed throughout the analysis, the following is a list of a few more for investors to consider:

Rising commodity costs impact margins: STRL is forced to buy aggregates, steel and diesel fuel based on market prices. As such, as market prices increase, gross margins can be negatively impacted. The company has, on occasion, bought some ETFs whose price movements were highly correlated with the fluctuations in the price of the underlying commodities. However, the company has never been effectively fully hedged. In an attempt to alleviate investor’s fears, the management team commented on the Q4 2010 conference call that the cost of diesel fuel, for example, as percentage of the entire contract, is not anywhere near as high as most people think it is. But, if prices were to spike and STRL had entered into fixed price or lump sum contracts that did not allow for any way to pass along price increases, the company’s margins would be hurt.

The company levers up to make an ill-advised acquisition: STRL has a $75M credit facility available that it could tap in order to make another acquisition. While the company has been paying down its debt and has been disciplined regarding the price it is willing to pay for acquisitions, there is always the risk that STRL uses debt to make an ill-advised purchase. In that case the company’s strong net cash position could be reduced without an offsetting positive impact on cash flows.



One of the major customer states effectively becomes bankrupt: If Utah, Texas, or Nevada were to get into such dire fiscal straits that the state was effectively bankrupt, infrastructure spending could be reduced meaningfully and the state could even try to get out of existing contracts. Given STRL’s dependence on these states for revenues and to maintain the backlog, such an outcome would be very harmful to STRL.

Inaccurate bidding or cost overruns impact project profitability: The management team has indicated on recent conference calls that it takes a substantial amount of expertise to make accurate assessments of the total costs of certain projects. With that in mind, STRL typically enters into three types of contracts: fixed price, lump sum and cost-plus. In fixed price contracts—which make up the majority of the company’s contracts--STRL often has the ability to submit change orders when conditions change and thus can pass often pass along increased costs. Similarly, in cost-plus contracts, the customer bears the risk of rising costs. However, in the case of lump sum contracts, STRL is typically forced to absorb any cost overruns. Accordingly, to the extent STRL enters into lump sum contracts, there is the risk that the associated projects generate low margins or even outright losses.

Conclusion

There are two very distinct realities regarding infrastructure spending in the US. The first is that many bridges, dams, sewers and waterways are either already in poor shape or are deteriorating. When this fact is combined with continuing population growth, the obvious conclusion is that states are going to have to allocate more and more funds to infrastructure maintenance and construction. Unfortunately, the other truth is that the states’ distressed fiscal situations require them to make very difficult spending tradeoffs. Specifically, states’ revenues have fallen as a result of the housing bust and the recession and expenses have increased due to high unemployment and poverty rates. As such, some states are facing large budget deficits that may have to be closed before they can consider spending on large infrastructure projects.

Take Texas for example. According to an article in the Texas Tribune, Texas lawmakers are considering a budget that is $23 billion smaller than the current one.3 Apparently, raising taxes is not an option, so Texas is going to have to make dramatic cuts to its spending. Similarly, Nevada’s situation is so precarious that it is proposing to cut 17% of the state’s higher education budget.4 Of course, Utah is no better shape. According to the Center on Budget and Policy Priorities, 44 states are anticipating budget shortfalls for FY 2012 (versus the level of the FY 2011 budget). On that list includes Utah with an 8.2% shortfall, Texas with a 31.5% shortfall, and Nevada with an astonishing 45.2% shortfall.5 Recall that these states are STRL’s three largest customers in terms of revenue and backlog. Given the shortfalls in these states, it is not hard to imagine that spending on new infrastructure projects is going be restrained for a while.

The question for investors (and everyone who lives in these states) is how to reconcile these two realities. In the case of STRL, the only way to evaluate the company is to prepare the worst—in terms of a cost of capital, margin of safety, revenue, and EBIT margin assumptions—and hope that the states’ fiscal conditions improve over time. Operating under that premise, a conservative EPV analysis produces an estimate of intrinsic value of $18.75 and a target purchase price—that includes a higher than normal 25% margin of safety—of $14. Therefore, investors should be patient and wait for the pessimism surrounding state spending to bring the stock down to a level in which there is less risk of permanent loss of capital. But, in the meantime, investors should be cognizant that larger players, such as Fluor—which is currently involved in a JV with STRL—might be interested in acquiring the company at the right price.

3 http://www.texastribune.org/texas-taxes/budget/texas-senate-facing-tight-budget-hunts-for-revenue/4 http://www.lasvegassun.com/news/2011/mar/21/students-rally-against-budget-cuts-call-business-t/5 http://www.cbpp.org/cms/?fa=view&id=711


http://www.cbpp.org/cms/?fa=view&id=711

http://www.lasvegassun.com/news/2011/mar/21/students-rally-against-budget-cuts-call-business-t/

http://www.texastribune.org/texas-taxes/budget/texas-senate-facing-tight-budget-hunts-for-revenue/

Sterling Construction Co. Write Up

Documents

Transcript of Sterling Construction Co. Write Up