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AS Merko Ehitus (TAL: MRK1T), the largest listed construction company and residential real estate developer in the Baltics, earns a Very Attractive rating based on my stock rating methodology. An accompanying spreadsheet with my accounting adjustments and reverse discounted cash flow (DCF) scenarios is available. Merko Ehitus presents a rare deep-value opportunity with asymmetric upside. Despite its dominant market position, ability to earn and grow attractive profits, and superior capital allocation, the stock remains significantly undervalued. A confluence of factors -cyclical fears, Baltic market inefficiencies, and a lack of international investor coverage- has created a mispricing that offers an attractive entry point for long-term investors. With strong secular tailwinds in infrastructure and defence spending, scale economies, favourable supply-side constraints, a fortress balance sheet, and deep undervaluation, Merko is well-positioned to deliver outsized returns.
A Vertically Integrated Business
Merko Ehitus operates a two-pronged business model comprising general construction services, which accounted for about 88% of revenue in 2024, and real estate development, which accounted for 12%. The business model is vertically integrated, so that a client can contract Merko Ehitus to execute the entire construction and real estate development process -preparation, design, construction, fittings and warranty-period service, in construction services, and planning, design development, construction, sales, and service during the warranty period in real estate development-. Whereas many construction firms are heavily reliant on subcontracting, Merko Ehitus leverages a vertically integrated model that minimises transaction costs, enhances execution efficiency, and improves quality control. This structure enables Merko Ehitus to capture higher margins across the value chain while reducing reliance on volatile external contractors.
Offerings and Geographic Diversification Lower Risk to Investors
Construction services and real estate development are inherently cyclical industries, tied to economic growth, interest rates, and government spending. However, Merko’s geographic diversification and wide range of offerings, reduce the risks inherent in being in the business.
Merko Ehitus operates in Estonia, Latvia, and Lithuania, with a nascent presence in Norway. In terms of client location, Lithuania, with 52.6% of revenues, is the largest geographic segment, followed by Estonia with 41.7%, Latvia with 5.7% and Norway with 0.05%. In Lithuania, the firm engages in real estate development, building and infrastructure construction, and public-private partnerships (PPP) projects; while in Estonia, it engages in real estate development, building, infrastructure and road construction, and concrete works; in Latvia, in engages in real estate development and building and infrastructure construction; and in Norway, it engages in real estate development and building construction. Merko Ehitus’ geographic diversification reduces its exposure to any single country’s economic cycle and provides it with multiple pathways for growth as economic conditions change across the region. For example, while transaction volumes for apartment development have largely not recovered from the effects of Russia’s invasion of Ukraine, the rebound in the Lithuanian markets has cushioned the firm from the less robust Estonian and Latvian markets. In an environment of stabilising prices for new residential projects, Merko Ehitus has been able to grow profits, in large part thanks to Lithuania.
The wide range of construction services and products and comprehensive solutions offered by the company reduces operating risk, allowing it to respond to shifts in demand. For instance, in the 2023 annual report, the company’s chief executive officer (CEO), Ivo Volkov, noted that,
Since the real estate market will remain unstable in the near future and the pace of apartment sales is low, we are steering our developments at a pace and volume that corresponds to the new market situation.
In the near future, we will again focus more on construction service. Our portfolio of work is in about as good condition as can be in today’s turbulent world, counterbalancing the negative impact on our construction volumes and sales from the apartment market slump.
Merko Ehitus’ Scale Advantage
Although Merko Ehitus competes with firms such as Nordecon (TAL: NCN1T) in Estonia, as well as regional Nordic construction firms in select segments, as the largest listed builder and developer in the Baltics, Merko Ehitus can leverage its relationships with its suppliers and contractors to get discounts on the volumes of business it brings. In addition, the company can scale its operating costs and expenses across the region. As the chart below shows, Merko Ehitus has been able to reduce the cost-burden its revenues bear, measured as operating costs divided by revenue, from nearly 95% in 2019 to almost 88% in 2024.
The company’s scale reduces its operational risk and further enhances the de-risking that occurs from the wide range of offerings that the firm has.
Moreover its scale allows it to compete for long-term contracts and execute or be involved in complex, large-scale projects, such as Rail Baltica. Indeed, for the sixth year in a row, a survey by Kantar Emor found that Merko Ehitus was the most well-known and trusted brand in Estonia. The company’s buildings have earned prizes across the region. For instance, the Merks Viesturdārzs residential project earned the first place in the New Homes category at the Best Building of the Year awards in Latvia 2022, and Vilneles Skverai was declared Lithuania’s best residential project at the Sustainable Development 23. With recognition, comes the opportunity to be involved in more large-scale, and highly profitable projects.
Merko Ehitus’ recent expansion into high-margin infrastructure projects, such as wind energy and national defense facilities, positions it well for structural growth. An example of this is the large wind farm infrastructure project in Lithuania, which the company has been seized with for the last two years. In its 2024 unaudited interim report, management revealed that its Lithuanian team was,
…able to tap into the economy of scale effect and build a record 87 turbine foundations using what was effectively an industrial production process, at a consistent pace and record speed. In addition, risks were avoided, and all of it together yielded significant savings on expenses. Expenses were also reduced by the fact that work on a national defence site in Lithuania are executed ahead of schedule.
These scale advantages have really come to the fore during Estonia’s recession, and an era of interest rate growth in the Baltics and the Eurozone at large: Merko Ehitus has been able to grow despite weakening demand in construction and real estate development, because it can build cheaper than competitors, and win attractive contracts.
Supply-Side Constraints Favour Incumbents
Barriers to entry are the friend of the investor and the economics of construction and real estate development in the Baltics provide incumbents such as Merko Ehitus with a number of benefits. The region has a skilled labour shortage and has faced subsequent, though easing wage growth -except in Lithuania, where it continues to grow-. Not only are skilled labourers more likely to favour working for Merko Ehitus over its rivals, the rising hiring costs place limits on competition from both new entrants and smaller rivals. In 2023, the company ranked as the most attractive employer in Estonia, cementing this view.
Across the Baltics, housing affordability has declined sharply since 2022, although there is some recovery. While this will and has continued to impact the company negatively, it is cushioned by the fact that, again, given its scale and brand strength, it will be able to close new contracts, and secure order books, at a faster rate than its rivals, improving its competitive position.
A History of Profitable Growth
Merko Ehitus is a highly efficient operator, combining both scale and profitability. Since 2019, Merko Ehitus has compounded revenue and net operating profit after-tax (NOPAT) by 10.5% and 31.6% a year, respectively. A key question for any construction firm is the durability of its margins. Historically, the industry has been plagued by low returns on capital due to aggressive bidding and thin margins. Merko Ehitus, however, has consistently bucked this trend, with NOPAT margin improving from 4.7% in 2019 to 11.3% in 2024, highlighting its ability to extract economic rents despite a challenging economic environment. Key to this has been the firm’s long standing reputation, which ensures it secures premium contracts with both private and public sector clients; the firm’s vertical integration and superior cost controls; a strong balance sheet position that insulates the firm from rising financing costs, providing a competitive edge over leveraged peers; and the benefits from the Baltic governments’ multi-billion-euro investments in renewable energy, infrastructure, and defense projects. From a game-theoretic perspective, Merko’s repeated interactions with public sector clients create a “reputation effect,” where reliability and execution quality lead to a reinforcing cycle of contract wins. Smaller competitors face a prisoner’s dilemma: either compete aggressively on price and risk financial distress or concede market share to Merko.
Merko Ehitus’ invested capital turns remaining unchanged, at 0.86, in that time. Rising NOPAT margins and flat invested capital turns have led to an expansion of return on invested capital (ROIC) from 4.1% in 2020 to 9.7% in 2024.
Attractive Dividends are Supported by Free Cash Flow
Merko Ehitus has increased its annual dividends from €1.00 per share in 2019 to €1.30 per share in 2024. In 2025, the annual dividend will increase to €1.90 per share, and has a yield of 7.48%. Since 2019, the firm has earned nearly €133 million in free cash flow (FCF), some 33% of enterprise value, and paid out almost €94 million in dividends, showing that the firm’s dividend payments have been supported by earned FCF.
Strong Balance Sheet and Credit Rating
Merko Ehitus’ ability to maintain its competitive position is, in part, a function of its strong balance. Merko Ehitus earns a Very Attractive credit rating, with all five criteria of my credit rating framework also scoring as Very Attractive. In the event of adverse economic conditions unfolding, Merko Ehitus’ robust financial health strengthens its ability to navigate through that.
Moreover, with €91.9 million in cash and cash equivalents as of the end of 2024, Merko Ehitus is in a strong cash position to navigate the current epoch of economic uncertainty, and invest counter-cyclically and capture distressed assets at attractive valuations. The company also has overdraft contracts with banks amounting to €51.1 million, of which €44.0 million was unused as of the end of 2024. This gives the company €135.9 million in liquidity, with just €21.3 million debt due in 2025.
In Merko Ehitus’ fourth quarter results, it spent €8.5 million in marketing, general and administrative expenses, or €2.1 million per month. In a worst-case scenario in which Merko Ehitus pays down its current debt, earns no revenue, and covers its full marketing, general and administrative expenses, Merko Ehitus could operate for 55 months without requiring any additional capital. It is, of course, unlikely in the extreme that Merko Ehitus’ revenue would be driven down to zero. Additionally, in this catastrophic scenario, Merko Ehitus would be able to pare down its marketing, general and administrative expenses.
Defense Spending Could Benefit Merko Ehitus
President Donald Trump’s urgings for the United States’ partners in the North Atlantic Treaty Organisation (NATO) to spend more of its gross domestic product (GDP) on defense, have been favourably in the Baltics, where the spectre of Russian aggression looms large. Estonia and Lithuania have both agreed to spend 5% of their GDPs on defence, with Estonia’s prime minister, Kristen Michal, remarking that,
These kind of signals probably are messages from Trump that you should take your defense very seriously — so for me it’s quite understandable. …If you are probably the wealthiest and most free region in the world, you should protect it and invest in your own defense.
This surge in defence spending would make Estonia and Lithuania the highest percentage defense spenders in NATO, ahead of Poland. This rapid escalation in military investment is expected to drive large-scale infrastructure projects, including military bases, logistics hubs, and critical defense infrastructure. Merko Ehitus is well-positioned to secure these contracts due to its proven track record in government-funded infrastructure projects; established relationships with Baltic defense ministries; and expertise in large-scale, high-security construction. This spending spree creates a multi-year tailwind for the company, boosting revenue growth and strengthening its competitive position in public-sector contracting.
Merko Ehitus’ Current Price Implies NOPAT Falls 58%
Throughout this discussion, the macroeconomic headwinds facing the Baltics have cast a shadow. The company’s stock seems, however, to have priced in a catastrophic decline in profits. At its current price of €26 per share, Merko Ehitus has a price-to-economic book value (PEBV) ratio of 0.42, implying that the market expects the company’s NOPAT to permanently decline by 58%. This seems a rather catastrophist view of the company’s prospects. In this catastrophist scenario, The company’s EBV per share is €58, a 123% upside to the present price.
The current price implies a scenario worse than the 2008 Housing Crisis. Using my reverse DCF model, I quantified the cash flow expectations implied by the current price.
Scenario 1
I used the historical revenue declines and NOPAT margins for the housing crisis from 2007 to 2011 to model the catastrophist scenario implied by Merko Ehitus’ current stock price. In this scenario, NOPAT falls by 37% in 2025, and by 5.8% compounded annually for the next five years, at which point it equals the current stock price. This scenario implies that Merko Ehitus’ 2030 NOPAT will be 65% below its 2024 NOPAT, a return to its 2020 NOPAT levels.
Scenario 2: Giveaway Valuation Gives Significant Upside
If one assumes that the Baltics will grow modestly in 2025, and that the wave of defense spending will create, in the least, a floor for Merko Ehitus’ revenue, then the company appears quite clearly undervalued. In this scenario, NOPAT falls by nearly 36% in 2025 and grows by just 0.5% till 2030, for a shareholder value per share of nearly €48, an upside of 83% from the current price. By way of comparison, as aforementioned, Merko Ehitus’ NOPAT has compounded by 31.6% a year over the last five years.
Impact of Footnotes Adjustments and Forensic Accounting
Here below are details of adjustments made to Merko Ehitus’ 2024 unaudited interim report:
Income Statement: I made $4.3 million in adjustments to calculate NOPAT, with the net effect of deducting $3.71 million in non-operating income. The adjustments are equal to 6.7% of Merko Ehitus’ IFRS net income.
Balance Sheet: I made €617 million in adjustments to calculate invested capital with a net increase of €188 million. The largest of these adjustments was €402 in accumulated asset write-downs, an adjustment which, on its own, is worth 90% of reported assets.
Valuation: I made €121 million in adjustments with a net effect of increasing shareholder value by €58 million. The largest of these adjustments was €65 million in excess cash, representing just over 14% of Merko Ehitus’ market cap.