Value Investing

Cashflow King Argan Well Placed For Continued Growth

One of the cheapest stocks in our All InvestableDeep Value Stock Screener is Argan, Inc. (NYSE:AGX).

Argan provides a full range of engineering, procurement, construction, commissioning, operations management, maintenance, development, technical and consulting services to the power generation and renewable energy markets for a wide range of customers including independent power project owners, public utilities, power plant equipment suppliers and global energy plant construction firms.

A quick look at the company’s share price history over the past twelve months shows that its share price has risen 126% to $73.30 from $29.95 in December 2015, but I believe Argan still provides good value and has lots more growth to come.

(Source: Google Finance)

To better understand the potential growth for Argan it’s important to first understand what’s happening in the power industry in the United States.

According to data released by the U.S. Energy Information Administration, natural gas was the source of 33.5% of the electrical power generated in the United States in the first half of 2016; coal was 28.1%. For the comparable period one year ago, 30.5% of the nation’s electrical power was produced with natural gas.

Over the last 10 years, total power generation has increased by less than 1% and coal has remained the largest energy source for electricity generation. However, during this period, the amount of electricity generated by natural gas-fired power sources increased by 75%, and the amount of electric power generated by coal-fired plants declined by 33%. The amount of electricity provided by nuclear power plants increased over the last 10 years by only 2%. Electrical power generated by renewable energy sources (excluding hydroelectric sources) more than tripled over the last ten years, but represents only 7% of total generation.

Argan is well placed to capitalize on the growth in the natural gas-fired power market with its growing reputation as an accomplished and cost-effective provider of engineering, procurement and construction (EPC) contracting services and its proven track record to deliver completed power facilities, particularly combined-cycle, gas-fired power plants. The EPC approach preferred by Argan was once considered an alternative delivery method for power plant construction, but now it’s an accepted industry practice in the United States as a strategy that gives project owners an end-to-end solution by putting most aspects and phases of a project under a single contract.

Growing Revenues, Margins & Net Income

As you can see from the diagram below the majority of the company’s consolidated revenues (2017 YTD) comes from its subsidiaries, Gemma Power Systems (“GPS”) 83.3%, The Roberts Company (“TRC”) 12.7%, Atlantic Projects Company Limited (“APC”) 2.6%, and Southern Maryland Cable, Inc. (“SMC”) 1.4%.

(Source: Company presentation, January 2017)

Argan has been successfully growing its revenues, margins and net income. A quick look at the company’s income statements below shows the company has increased revenues by 50% in the past twelve months. What’s also noticeable is that the company’s gross profits, operating income and net income have all significantly increased, up 56%, 85% and 200% respectively. Moreover, the company is maintaining healthy gross margins around 20%, operating margins around 15% and net margins of 18% in its latest quarter, Q3 2016.

Quarterly Income Statement (Amounts in 000’s)
Quarter: 3rd 2nd 1st 4th
Quarter Ending: 10/31/2016 7/31/2016 4/30/2016 1/31/2016
Total Revenue $175,444 $162,495 $130,348 $116,387
Cost of Revenue $138,866 $118,483 $102,046 $92,844
Gross Profit $36,578 $44,012 $28,302 $23,543
Operating Income $26,730 $34,499 $21,255 $14,460
Net Income $18,073 $19,674 $12,230 $6,728

(Source: Company reports)

Argan has been able to achieve these outstanding results due to its successful ramping up four new EPC projects and completion of both of its Panda Liberty and Panda Patriot combined cycle power projects in Pennsylvania.

The twin 829 MW projects located in Bradford and Lycoming County, Pennsylvania, are state-of-the-art natural gas-fired facilities that provide clean, reliable electric power to more than two million homes. These facilities were the first projects to be designed and cited specifically to capitalize on the Marcellus Shale natural gas formation in Pennsylvania. Panda Liberty achieved substantial completion in April 2016 and Panda Patriot achieved substantial completion in June 2016. These completions were achieved through a joint venture with The Lane Construction Corporation, who was the Engineering-Procurement-Construction contractor for the projects.

It’s important to remember that Argan has a great track record when it comes to growth. A quick look at the graph below shows the company has consistently grown its CAGR by 33% over the past 5 years.

(Source: Company presentation, 2017)

Recent Acquisitions

While the company’s power industry services business is delivering great results the same can’t be said for its two recent acquisitions, APC and TRC.

In May, 2015, Argan acquired Atlantic Projects Company Limited (APC), which provides turbine, boiler and large rotating equipment installation, commissioning and outage services. APC operates under its own name and with its own management team as a member of the Argan group of companies.

In July 2016, work was suspended on APC’s largest project, which represented over 90% of its backlog. This was in addition to issues in APC’s primary market, the United Kingdom, which voted to leave the European Union in June, 2016. The result meant a drop in the sterling pound currency, financial market uncertainty and recessionary pressures which will likely impact the availability of financing for its future power plant developments. APC’s second largest market, the Middle East, has also been experienced decreased project activity due to capital constraints, resulting from decreased oil revenues. Argan expects further losses from APC for the remainder of the fiscal year. 

In December, 2015, Argan also acquired The Roberts Company (“TRC”), which is an industrial fabricator and constructor. The company paid $0.5 million to acquire the member interests of TRC, and assumed approximately $15.6 million in debt obligations which it paid off on the acquisition date. Argan had to advance an additional $22.5 million in cash to TRC in order to fund the completion of the work on its loss contracts.

TRC has had a mixed performance since acquisition. The subsidiary had a positive first quarter in 2016, due in part to approved change orders and revisions of estimates to complete certain of its legacy loss contracts (which existed prior to its acquisition). In its second quarter, TRC had a $1.3 million pre-tax loss resulting primarily from a reduction in total revenues. In its latest quarter things were more positive driven in part by new customer projects and the completion of some of its legacy loss contracts.  TRC earned $2.3 million in pre-tax income in Q3 2016, and has finally been able to shift its focus from its legacy loss contracts and company restructuring to improving its business and generating new growth.

Contract Backlog

As you can see below the future looks bright for Argan with a very healthy contract backlog. In October, 2016 the company reported its total contract backlog was approximately $1.2 billion ensuring the company can maintain solid growth in both future revenues and earnings. This table summarizes the company’s largest EPC power plant projects:

(Source: Company presentation, 2017)

Strong Balance Sheet

Argan is financially robust and continues to have a very strong balance sheet. A quick look at the company’s quarterly balance sheet for the trailing months shows the company had cash and cash equivalents of $446 million and zero debt at the end of Q3, 2016. With its current market cap of $1.12 billion, when we subtract its cash and cash equivalents that leaves Argan with an Enterprise Value of $676 million.

Quarterly Balance Sheet (Amounts in 000’s)
Quarter: 3rd 2nd 1st 4th
Quarter Ending: 10/31/2016 7/31/2016 4/30/2016 1/31/2016
Current Assets
Cash and Cash Equivalents $170,775 $162,855 $191,430 $160,909
Short-Term Investments $275,545 $220,297 $128,225 $114,098
Short-Term Debt / Current Portion of Long-Term Debt $0 $0 $0 $0
Long-Term Debt $0 $0 $0 $0

(Source: Company reports)

We prefer the use of Enterprise Value (EV) as it’s a better indication of the total cost to buy a company in its entirety. EV is calculated as follows:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–that must be taken on by a buyer of the entire company.

With an Enterprise Value of $676 million and adjusted operating earnings* of $99 million (ttm), that means Argan is trading on an Acquirer’s Multiple of 6.83 or, 6.83 times adjusted operating earnings*, and still represents good value.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Income*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

Strong Free Cash Flow

Argan is a well run company that is operationally efficient. A quick look at the company’s cashflow statements over the trailing twelve months below shows the real strength of the company. Argan generated $198 million in operating cash flow (ttm) and had capex of just $2.98 million in capex (ttm). That means the company generated $195 million in free cash flow (ttm) for a FCF/EV yield of 28% (ttm).

Quarterly Cashflow Statement (Amounts in 000’s)
Quarter: 3rd 2nd 1st 4th
Quarter Ending: 10/31/2016 7/31/2016 4/30/2016 1/31/2016
Net Income $18,073 $19,674 $12,230 $6,728
Net Cash Flow-Operating $72,604 $68,981 $43,726 $12,791
Capital Expenditures -$869 -$1,367 -$245 -$447

(Source: Company reports)

With that amount of free cash the company has a number of options in terms of its capital allocation. It’s free to explore other assets for acquisition, repurchase shares, or pay out dividends. In September the company declared a regular cash dividend in the amount of $0.70 per share of common stock and a special cash dividend in the amount of $0.30 per share of common stock, for a total cash dividend of $1.00 per share of common stock, paid on October 28, 2016.

Rainer Bosselmann, Chairman and Chief Executive Officer, commented, “Argan is pleased to announce the payment of a regular cash dividend of $0.70 per share of common stock for the fiscal year ending 2017. In addition, our success in finishing the Panda power plant projects in Pennsylvania over the last couple of quarters prompted the Board to declare an additional special dividend of $0.30 per share. We appreciate the continued support from our stockholders.”

Joel Greenblatt Bullish on Argan

One last thing I like to do when I’m analyzing stocks is take a quick look at their institutional ownership. One name that popped up during my analysis of Argan was Gotham Asset Management LLC. Joel Greenblatt is the Managing Principal and Co-Chief Investment Officer of Gotham Asset Management and one of my favorite investors to follow. It seems Joel Greenblatt is also bullish on Argan with new three new additions to his portfolio in 2016:

Date Action Shares
2016-09-30 Add 115,843
2016-06-30 Add 27,595
2016-03-31 Add 18,203

(Source: NASDAQ.com)

Summary

Argan is a very well run company that is operationally efficient. The company is well placed to capitalize on the growth in the natural gas-fired power market. With its strong balance sheet, healthy contract backlog and free cash flow Argan is set to grow organically and free to explore other assets for acquisition. In terms of its valuation, Argan is good value with an Acquirer’s Multiple of 6.83 or, 6.83 times adjusted operating earnings and a free cash flow yield of 28%. The only risks that I see for Argan are in its latest acquisitions. The two most recent acquisitions have had their issues so we will have to wait and see how they progress.