Thursday, August 26, 2010

When All The Problems Are Short-Term

Sterling Construction (STRL) builds and repairs roads, highways and water infrastructure for governments in Texas, Nevada and Utah. Sometimes, a stock will be down for reasons that are unknown. This is not the case here. Government budgets for infrastructure projects are weak, as states struggle with the lower tax receipts that the recession has brought. Competitors used to working on commercial and residential projects have entered the government market as a way to fill their excess capacity. Companies have been bidding for projects at extremely low, and sometimes negative margins!

Amidst all this bad news, why would anyone in their right mind be interested in a company like Sterling Construction? Well, a look at the company's problems reveals that they are all of a short-term nature. This industry, along with many others, has more capacity than it has demand. When that happens, prices fall and margins get squeezed. But this doesn't last forever. As some competitors fail (due to high debt levels or money-losing operations) and industry capacity shrinks (as depreciation far outweighs capex), conditions will eventually return to normal.

But margins and revenues will not return to normal overnight. Therefore, it is not enough for investors to find beaten down companies; they must ensure that these companies can last until such time as conditions are better. Sterling is such a company, with cash and short-term investments of $96 million against debt of $25 million.

Furthermore, the company appears to trade at a discount to its earnings. Subtracting its net cash position, the company trades for just over $100 million, yet it earned $25 million in 2009! Earnings this year will be substantially lower than they were last year, however, due to the reasons discussed above. However, this company has the ability to maintain its capacity for when industry conditions return to normal.

The market will beat down companies with poor near-term outlooks. Sterling Construction has proven to be no exception. However, as the company's problems are short-term, and as the company has the ability to outlast this downturn, investors with a long-term outlook may have here an opportunity for stellar returns with low risk.

Disclosure: None

3 comments:

Franck said...

Hi SAJ,

115 M USD of Goodwill. It is too much for me.

What do you think ?

++
Franck

editor said...

Not a big fan of all the acquisitions and share issuances, but interesting, thanks.

Saj Karsan said...

Hi Franck,

It's a lot of Goodwill, yes, so it's not an asset play. To buy this company, you have to believe in their ability to earn a better-than-normal return on their hard assets.

Hi tscott,

I agree. They are not intent on returning money to shareholders, but rather in growing the business, which could be very successful but it does add more risk.