December 2016 update – Single Names

It’s been a while since I last wrote. Here I will just give a quick update then sketch out a couple stock ideas I’m still in. I will leave the forward looking macro view for the next post.

It’s been a good month for all investors and I’m no exception. Post the Trump win I loaded up on financials (SLM and WFC), and tripled my holdings in Sterling Constructions (STRL). These are concentrated 7%-12% positions. I also went long the US dollar against yen and euro, riding USD/JPY from 105 to 115. A week ago I cut back on STRL, exited WFC completely, then went long Russian rubles.

This series of frantic trading and macro maneuvers paid off. In the last month I did better than the S&P index even with all my large cash holdings/shorts/hedges. I started taking chips off the table as the market looks extended again.

Single Names I'm still Bullish On

I’m still very bullish on Salle Mae and Sterling Constructions over the next 3 years. FNF is another that can double. Below are a just some bullet points.

Sallie Mae (SLM)

So the stock trades at $10.8 at the time of writing. Downside is $10-$10.5. Upside could be $15+ and a highly probable one.

This is a company that was doing well even before the election – strong growth, strong ROE, and solid capital levels. Management is also trying to improving cost efficiency. The only thing that held back the stock was Democrats’ various attempts to undermine the private student loan market (free college, student loan forgiveness, and general hostility toward lenders…etc).

After November, all the sudden we have 1) decline in regulatory risk, 2) potential market size expansion as Republicans might scale back government funded student loans, 3) higher rates and steeper yield curve driving higher net interest margins, 4) a big tax cut (SLM pays a high 35-40% and their preferred dividend further leverages EPS to tax cuts). The last point alone could juice their earnings by 30%+.

Here’s how I roughly think about floor value and upside. The stock was trading in the $7-$7.5 range before election. Republican president and congress removes an existential threat to the business and should make this worth $8-$8.5. Tax cut improves earnings by 30%+, so add another $2/share and we’re already at $10-$10.5 as floor value – not far from where the stock trades now.

And that’s before factoring in better net interest margin and market size expansion! All together, there’s a high probability that SLM earns $1.5/share within 3 years. At a fair 10x multiple SLM could easily be worth $15/share.

We have a nice bet here. SLM represents 7-8% of my portfolio and I will look to add on weakness.

Sterling Construction (STRL)

Although a construction/infrastructure stock, this is not really a “Trump Trade”, as I wrote about Sterling Construction back in July here. The thesis has not changed much, but the emphasis has shifted from company specific factors to the industry and macro pictures, which has gotten much better.

The company is highly leveraged to gross margins, which was already improving back in July, but now will likely go higher due to 3 factors. First, management has stated their intention to go after higher margin, non-highway projects (commercial, airports…etc), and have in fact started to win them. Second, the local projects passed during November 9th will be supportive for industry competitive landscape and margins.

Finally, Trump’s $1 trillion infrastructure plan threatens to take margins, and by extension STRL’s stock, to a whole new level.

So both the probability and magnitude of a win are much higher now. Right before the November election, I would say STRL’s floor value is about $6.5 and ceiling about $8.5. Now I would say the floor is ~$7.5 and the upside is uncapped until the teens’ or even $20’s.

The key is to not get ahead of ourselves too much though. I’m looking for improved quarterly results, new contract wins, or legislative progress on Trump’s plan to add to my positions.

Fidelity National Financial (FNF)

This is the largest title company and the most profitable one. The company operates in an oligopoly with captive customers - title insurance is mandatory purchase. At $34 per share, the stock is acting incredibly bearish right now. But a catalyst has surfaced.

Currently there are 2 negatives holding back the stock in my opinion. First is structural complexity. FNF consist of the core FNF title insurance company, a publicly traded subsidiary Black Knight Financial (BKFS) and the FNFV tracking stock (which represent a portfolio of side bets like restaurants). The second problem is commercial title revenues are slowing down.

There's a catalyst coming next Fall. Management announced they will address the structural complexity issue by cleanly splitting out core FNF title division, BKFS, and FNFV. This would allow the core FNF business be included in indices.

The core FNF title business then has a path to double once commercial revenue stabilizes. Here's what could happen with some back of the envelope math:

• Home sales picks up. Perhaps because millenials are reaching the 30-40 age zone for peak home buying, or because Trumponomics puts more money in peoples pocket. Say home sales up 5% and housing price up 5%, that's a 10% revenue gain. With operating leverage you get to 15% gain pretax.
• 3 years from now pretax grew by 1.15^3-1 or 50%.

• Tax rate cut from 35% to 20-25%. That means EPS could be 70%+ higher in 3 years
• Just making up some numbers - right now $1 pretax get you 0.65. In 3 years you have $1.5 pretax at 25% tax rates. That results in an 70% higher EPS.

• P/E multiple of core title business re-rates from 12-15x because revenue outlook reverted to growth. Removal of structural complexity in the FNF complex also helps. That's another 25% gain.

Compounding these effects get you a double. I already have a solid position on this. But I could really go big (thinking like 20% position) if I see commercial title revenue to stabilize.

Sterling Construction Will Enjoy Higher Margins For Years to Come

Sterling Construction Company (STRL) works on transportation and water infrastructure projects (more of the former, particularly highways). It’s a microcap that few analysts cover. The stock trades at $5/share and I think it could be worth $8.

The company has all sorts of not-so-obvious positives: turnaround play with operating momentum, low margin legacy contracts fading away, big net operating losses (NOLs) to monetize, understated book value due to off-balance sheet asset. On top of all that, management incentives are aligned with shareholders.

The political/economic climate also favors Sterling. Monetary policy is running out of bullets and politicians have to start pulling fiscal levers. Highway construction is one area that enjoys bipartisan support – even Republican candidate Trump talks about using constructions to provide jobs.

The next few paragraphs will give a brief industry background before getting into company specifics.

Cyclical business, But Right Part of the Cycle

Coming out of the Great Recession, federal and state governments tightened their construction budgets. For the past few years, companies competed intensely for limited work and margins fell as a result.

That picture is reversing. At the federal level, Obama signed a $300+bn Fixing America’s Surface Transportation Act (“FAST Act”) in December 2015, which provides certainty over the next 5 years. At the state and local government level, politicians have also been working to boost construction budgets.

Texas and California are Sterling’s two biggest markets. Texas is already seeing a spike in highway construction budget. Not only that, the recently passed Proposition 7 will provide billions more in funding starting late 2017. California is also in the works - although transportation needs were not addressed in the June budget, it remains high on the agenda. Multiple stakeholders are united in their push for increased funding. Here’s a taste of what's happening from Granite Construction’s latest transcript.

"We are helping lead the charge in California where construction industry and labor leaders are working shoulder to shoulder to build legislative support for a long-term incremental commitment for transportation investment of at least an additional $40 billion over the next 10 years."

In the coming years, I expect even better legislative support for infrastructure projects as politicians turn to fiscal stimulus. With a bigger and more visible budget, competition will be more rational and that should lead to better margins.

Gross Margin Turnaround and Other Good Stuff

In fact, Sterling Construction is already seeing improving margins. Gross margin is by far the largest driver of net income and cash flows, and here’s how that’s looking:

The momentum is clear. Gross margin troughed during 2013-2014 and has been going up since. Also note that margins have plenty of upside before returning to historical norm of 10%+.

Backlog margins are improving as well. Gross margins in the backlog for the past 4 quarters (starting 1Q’15) are 6.0%, 6.5%, 7.0%, 7.7%. Management expects 8.5%-9% by year end.

Part of the margin improvement will come from better mix. Sterling has been held back by legacy low margin projects from 2013, but it is quickly working them down. Here’s what CEO Paul Varello have to say:

“…we have to complete approximately $70 million worth of legacy jobs that will finish over the next couple of quarters and will generate small to zero margins. We believe that we will start to see the higher margin projects generate stronger earnings in Q3 and beyond…In addition, by year-end we anticipate that our overall backlog margin will be in the range of 8.5% to 9%.”

Those higher margins come at a great time as Sterling had accumulated a big NOL. With the cycle turning, it will basically pay no taxes the next few years.

There are more goodies and I will quickly outline them here:

• Sterling bought $40mm of life insurance policies. The policies are to cover Sterling’s commitment to buy out minority interests upon death of key executives. That commitment is booked as a liability on balance sheet, but the insurance policies are off balance sheet. So book value is understated by a material amount. 
• The company just did an equity raise to deleverage the balance sheet. 
• CEO Varello took an $1 salary and restricted stock when he took over last year. 

Put it all together

Backlogs have been increasing and will likely increase over the next five years. Margins have gone up with lots of room to go. But at $5/share the stock is trading like a normal cyclical. It certainly does not reflect the extended growth runway I described above.

2017 P/E is a modest ~9x. The real question is how does 2018+ look? I think the answer is higher revenue, higher margin, and no taxes will translate to explosive free cash flows growth and multiples expansion.



Note: Competitor Primoris was also bullish about Texas in its 1Q’16 call.

“We continue to expect substantial growth in the Texas heavy civil market, especially once Prop 7 money starts to flow. Which should be sometime late next year.”