Shares of small-cap stock Sterling Infrastructure (STRL -0.41%) are on a tear as investors gobble up anything that could seemingly have something to do with artificial intelligence (AI). That apparently includes this specialty infrastructure contractor. Sterling stock is up some 180% in the last year (as of this writing on April 24, 2024).
Sterling certainly is a unique way to play AI. Its largest and most profitable segment is called "E-Infrastructure Solutions," which handles construction services for large companies (think big tech) in need of data centers, e-commerce warehouses, power generation facilities, and the like. In fact, Sterling seems to be leaning into this important segment, as data centers are high priority these days. Is the stock still a good buy?
A secret bet on data center development?
Since 2017 (when current CEO Joseph Cutillo took the reins of the business), Sterling has embarked on a growth mission. It started with strengthening its traditional heavy highway and civil business (the "Transportation Solutions" segment) by being more disciplined in bidding on jobs. The goal was to boost profit margins, which has been a successful strategy (more on that in a moment).
Since then, Sterling has made multiple acquisitions to get into large residential projects in Texas and Arizona (now the segment called "Building Solutions"), and multiple acquisitions to form its "E-Infrastructure" segment.
It's this last segment that may have Wall Street interested. E-Infrastructure revenue was $937 million in 2023, 48% of Sterling's total last year. However, E-Infrastructure operating income was $141 million, 62% of the total. This fast-growing segment thus also happens to be far and away the most profitable part of this construction business. Growth and higher profit margins over time can equate to big stock gains.
E-Infrastructure from data centers isn't all Sterling has going for it, though. The company did notch a big 66% increase in RPO (remaining performance obligation, current and future amounts to be invoiced to customers) in the Transportation segment last year. Big civil projects like highways and freeways can take years to complete, so any new project entering the pipeline can take years to turn into revenue, and accumulate on balance as RPO.
However, the shorter-to-fill RPO of E-Infrastructure also notched a healthy 35% increase in 2023 to reach $814 million. That could be an indicator that data center and related project construction is heating up for Sterling.
A cheap small-cap stock, or cyclical AI-fueled peak?
Sterling Infrastructure was a great story in 2023. However, construction -- even specialty construction -- is a highly competitive industry. That's reflected in Sterling's historical single-digit-percentage operating margin profile. Thanks to its bidding discipline in the Transportation segment and the big additions to E-Infrastructure, margins have improved dramatically in the last couple of years, over 11% for the business overall exiting 2023.
Data by YCharts.
Clearly, this contractor is riding a strong growth trend, with further growth in the works as data center and AI buildout heat up. Shares trade for about 20 times Wall Street analysts' expectations for 2024. It isn't exactly a bargain, but compared to the AI and data center hype brewing elsewhere in the stock market, Sterling looks like a relative value.
My personal hesitation at buying is because construction is an inherently cyclical business. Since it's reliant on big tech businesses continuing to ramp up data center and other specialty property development, Sterling could be just one bad year away from losing its high-flying construction stock status. Such is life for highly cyclical companies.
As an alternative for investors who are upbeat on infrastructure development, an index fund like the Invesco Building & Construction ETF (PKB 1.33%) might be worthy of consideration. It includes Sterling Infrastructure in its portfolio of stock holdings.
For now, it's interesting to see Sterling's E-Infrastructure acquisition efforts start to pay off. But the stock price rocketing higher in the last year isn't a reason to buy. Investing in small-cap stocks requires discipline, so tread lightly with this one.
