ARGAN INC AGX
May 20, 2013 - 7:56pm EST by
archer610
2013 2014
Price: 16.19 EPS $1.67 $1.98
Shares Out. (in M): 14 P/E 9.7x 8.2x
Market Cap (in M): 227 P/FCF 9.7x 8.2x
Net Debt (in M): -175 EBIT 37 45
TEV: 52 TEV/EBIT 1.4x 1.1x

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  • Utilities
  • Contractor
  • Natural gas
  • excess cash
  • Revenue Growth
  • Insider Ownership
 

Description

 Argan (AGX, $16.19) is a high quality, well managed power plant contractor that trades at 1.6x EV/ LTM EBITDA. AGX has a debt free balance sheet and $175M of cash and an enterprise value of $60M. The thesis is:

(1)    AGX is cheap on an absolute basis, and on a relative basis; given its $13 per share in net cash, AGX has significant downside protection.

(2)    Catalyst: construction backlog is set to grow to over $900M on the addition of the two Moxie gas-fired plants in Pennsylvania to AGX’s backlog; AGX’s historically lumpy revenues become more consistent over the next three years as the Moxie plants provide clear sight to significant, high margin, low risk revenues.

(3)    Strong secular trends position AGX well over the next 5 years: natural gas-fueled power plants should continue to grow as coal fired power plant capacity comes off line due to new EPA regulations (MATS), continued economic growth shrinking power reserve margins in key US electricity interconnection markets (e.g. ERCOT, PJM).

(4)    Excellent owner-oriented management/board that owns 11% of the stock and has been returning cash in the form of special dividends for the last two years.

Business Description

-          Current management arrived at AGX in late 2006 (stock price was ~$6) and purchased Gemma Power Systems (“GPS” its current primary subsidiary for $33M in December 2006. GPS designs and constructs natural gas fired power plants as well as renewable energy power plants (wind, solar, biomass). Since current management bought GPS for $33M in 2006, GPS has generated ~$90M of cumulative EBIT.

-          Most of GPS’s current business is conducted on a fixed price contract basis, so there is some risk if they misestimate their costs.

-          We have conducted customer research among GPS’s large customers on recent projects and generally GPS gets high marks for finishing on time and on schedule. While some customers complained that GPS is a bit “change order happy,” most customers were highly satisfied. We were surprised to hear so many positive customer references, as we have researched other construction/contractor businesses in the past and found significantly more customer complaints.

Valuation

-          AGX trades for a forward unlevered FCF Yield of 45% and a forward EV/EBITDA on 2013E of 1.1x

  • To put this in context, AGX’s peer set trades for 5.9x-13.5x EV/LTM EBITDA with a median multiple of 8.8x; the peer set includes EME, FLR, FWLT, CBI, SKAB.SS, WG.LN, URS, GVA à AGX is extremely cheap on a relative basis

-          AGX has a debt free balance sheet and cash accounts for approximately 75% of its equity market capitalization.

-          While part of its cash is not truly excess given that it is the result of getting paid by customers faster than it has to pay its suppliers (net billings), we note that large well managed retailers, such as COST and WMT as well as various financial services firms have a similar phenomenon and as long as the business continues as a growing concern, that negative working capital balance should actually grow over time; we believe about $120M of its cash balance is truly excess

  • We would also note that to a strategic acquirer, the cash balance would be, in effect, excess cash since a larger acquirer would have its own bonding program

 

 

Catalyst

-          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

-          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

-          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

  • (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
  • (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

-          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.

 

Secular trends

-          At current and forward natural gas prices, natural gas is a cheaper and cleaner energy source when compared with coal, which will cause natural gas-fired power generation capacity to grow significantly in the US over the next 10 years. We think the CAGR for natural gas-fired capacity should grow mid to high single digits for the foreseeable future as coal-fired capacity comes offline. AGX has significant expertise in natural gas power plant construction and is positioned well to benefit from this trend.

-          In PJM (the regional transmission organization that coordinates the wholesale electricity markets in 13 states, including Pennsylvania), where the two Moxie plants have been permitted, new EPA regulations (Mercury Air Toxic Standards or MATS) will make coal-fired generation capacity even more expensive to maintain. Industry research reveals that 10,000MW of coal-fired capacity will be forced offline in the next two years alone, which will put pressure on PJM’s reserve margin (the capacity buffer for electrical generation) as the population and electricity demand continue to grow.

 

Management

-          Rainer Bosselman, Chairman and CEO of AGX, runs the company as an owner as he and the Board own 11% of the shares.

-          Bill Griffin, the CEO of their primary subsidiary GPS, owns over 5% of the company and is on the Board.

-          The management has consistently focused on risk management, acknowledging that their fixed price contracts expose them to the risk of losses if not properly estimated and managed.

  • Rainer has repeatedly walked away from project work due to excessive risk and inadequate margins; given that he is willing to forego revenues when they are not priced properly,  cash flows have been lumpy.
  • He has focused his efforts on minimizing the risk of losses from the naturally asymmetric risk/reward inherent in fixed price contracts.

-          Management has been returning cash via special dividends for the last two years and have signaled their intent on continuing that trend this year. Assuming the trend continues, AGX will pay out $.70 per share this year, or about 4.25% of the current share price.

 

Why is AGX so cheap?

-          Virtually no sellside analyst coverage.

-          Size and insider holdings make AGX illiquid.

-          Management does not do quarterly earnings calls.

-          Lumpy/volatile annual results due to project nature of the business.

 

Risks

-          Project work is lumpy

  • Moxie plants should give us visibility in terms of revenues over the next three years

-          Earnings / margin risk due to fixed price contracts

  • Management has historically walked away from low margin business and GPS has done an excellent job estimating its costs as evidenced by its performance over the last 6+ years.
  • Moxie plants allow GPS to control margin risk since they are specified as the sole possible contractor in the EPC contract, so effectively there was no competition on these deals.

-          Cash balance is not as high as it seems due to negative net customer billings of ~$72M

  • This negative working capital is effectively AGX’s float and is a natural feature of their business, so assuming the business is not being liquidated, it should remain an attractive feature of their business and if interest rates are ever higher, it should be a nice source of interest income earnings.

-          Macro risk

  • Protected to some degree by the safe balance sheet and large cash holdings

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

-          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

-          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

-          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

  • (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
  • (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

-          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.

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    Description

     Argan (AGX, $16.19) is a high quality, well managed power plant contractor that trades at 1.6x EV/ LTM EBITDA. AGX has a debt free balance sheet and $175M of cash and an enterprise value of $60M. The thesis is:

    (1)    AGX is cheap on an absolute basis, and on a relative basis; given its $13 per share in net cash, AGX has significant downside protection.

    (2)    Catalyst: construction backlog is set to grow to over $900M on the addition of the two Moxie gas-fired plants in Pennsylvania to AGX’s backlog; AGX’s historically lumpy revenues become more consistent over the next three years as the Moxie plants provide clear sight to significant, high margin, low risk revenues.

    (3)    Strong secular trends position AGX well over the next 5 years: natural gas-fueled power plants should continue to grow as coal fired power plant capacity comes off line due to new EPA regulations (MATS), continued economic growth shrinking power reserve margins in key US electricity interconnection markets (e.g. ERCOT, PJM).

    (4)    Excellent owner-oriented management/board that owns 11% of the stock and has been returning cash in the form of special dividends for the last two years.

    Business Description

    -          Current management arrived at AGX in late 2006 (stock price was ~$6) and purchased Gemma Power Systems (“GPS” its current primary subsidiary for $33M in December 2006. GPS designs and constructs natural gas fired power plants as well as renewable energy power plants (wind, solar, biomass). Since current management bought GPS for $33M in 2006, GPS has generated ~$90M of cumulative EBIT.

    -          Most of GPS’s current business is conducted on a fixed price contract basis, so there is some risk if they misestimate their costs.

    -          We have conducted customer research among GPS’s large customers on recent projects and generally GPS gets high marks for finishing on time and on schedule. While some customers complained that GPS is a bit “change order happy,” most customers were highly satisfied. We were surprised to hear so many positive customer references, as we have researched other construction/contractor businesses in the past and found significantly more customer complaints.

    Valuation

    -          AGX trades for a forward unlevered FCF Yield of 45% and a forward EV/EBITDA on 2013E of 1.1x

    • To put this in context, AGX’s peer set trades for 5.9x-13.5x EV/LTM EBITDA with a median multiple of 8.8x; the peer set includes EME, FLR, FWLT, CBI, SKAB.SS, WG.LN, URS, GVA à AGX is extremely cheap on a relative basis

    -          AGX has a debt free balance sheet and cash accounts for approximately 75% of its equity market capitalization.

    -          While part of its cash is not truly excess given that it is the result of getting paid by customers faster than it has to pay its suppliers (net billings), we note that large well managed retailers, such as COST and WMT as well as various financial services firms have a similar phenomenon and as long as the business continues as a growing concern, that negative working capital balance should actually grow over time; we believe about $120M of its cash balance is truly excess

    • We would also note that to a strategic acquirer, the cash balance would be, in effect, excess cash since a larger acquirer would have its own bonding program

     

     

    Catalyst

    -          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

    -          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

    -          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

    • (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
    • (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

    -          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.

     

    Secular trends

    -          At current and forward natural gas prices, natural gas is a cheaper and cleaner energy source when compared with coal, which will cause natural gas-fired power generation capacity to grow significantly in the US over the next 10 years. We think the CAGR for natural gas-fired capacity should grow mid to high single digits for the foreseeable future as coal-fired capacity comes offline. AGX has significant expertise in natural gas power plant construction and is positioned well to benefit from this trend.

    -          In PJM (the regional transmission organization that coordinates the wholesale electricity markets in 13 states, including Pennsylvania), where the two Moxie plants have been permitted, new EPA regulations (Mercury Air Toxic Standards or MATS) will make coal-fired generation capacity even more expensive to maintain. Industry research reveals that 10,000MW of coal-fired capacity will be forced offline in the next two years alone, which will put pressure on PJM’s reserve margin (the capacity buffer for electrical generation) as the population and electricity demand continue to grow.

     

    Management

    -          Rainer Bosselman, Chairman and CEO of AGX, runs the company as an owner as he and the Board own 11% of the shares.

    -          Bill Griffin, the CEO of their primary subsidiary GPS, owns over 5% of the company and is on the Board.

    -          The management has consistently focused on risk management, acknowledging that their fixed price contracts expose them to the risk of losses if not properly estimated and managed.

    • Rainer has repeatedly walked away from project work due to excessive risk and inadequate margins; given that he is willing to forego revenues when they are not priced properly,  cash flows have been lumpy.
    • He has focused his efforts on minimizing the risk of losses from the naturally asymmetric risk/reward inherent in fixed price contracts.

    -          Management has been returning cash via special dividends for the last two years and have signaled their intent on continuing that trend this year. Assuming the trend continues, AGX will pay out $.70 per share this year, or about 4.25% of the current share price.

     

    Why is AGX so cheap?

    -          Virtually no sellside analyst coverage.

    -          Size and insider holdings make AGX illiquid.

    -          Management does not do quarterly earnings calls.

    -          Lumpy/volatile annual results due to project nature of the business.

     

    Risks

    -          Project work is lumpy

    • Moxie plants should give us visibility in terms of revenues over the next three years

    -          Earnings / margin risk due to fixed price contracts

    • Management has historically walked away from low margin business and GPS has done an excellent job estimating its costs as evidenced by its performance over the last 6+ years.
    • Moxie plants allow GPS to control margin risk since they are specified as the sole possible contractor in the EPC contract, so effectively there was no competition on these deals.

    -          Cash balance is not as high as it seems due to negative net customer billings of ~$72M

    • This negative working capital is effectively AGX’s float and is a natural feature of their business, so assuming the business is not being liquidated, it should remain an attractive feature of their business and if interest rates are ever higher, it should be a nice source of interest income earnings.

    -          Macro risk

    • Protected to some degree by the safe balance sheet and large cash holdings

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    Neither I nor others I advise hold a material investment in the issuer's securities.

    Catalyst

    -          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

    -          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

    -          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

    • (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
    • (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

    -          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.

    Messages


    SubjectRE: a couple questions
    Entry05/21/2013 03:19 PM
    Memberarcher610

    1.       The current backlog is about $200M, so the addition of these plants would add $400M each, so a total backlog of call it $1B, but assume that it happens half way through this year in which case they will have completed one of the major projects (CPV Sentinel Energy in Desert Hot Springs, CA) in their backlog and burned about $100M, so the ending backlog would then be at Q213 about $900M. These projects (Moxie) will likely take about 1.5 to 2 years to build, these should take about two years, which would suggest $200M of revenue per Moxie plant per year, or about $400M of revenues for each of the next two years, plus the remaining $100M of backlog primarily related to the Texas ETEC Woodville Renewable Project. So I think it would be safe to imagine that each of the next two years would be $400M+ of revenues. And these margins would be higher than normal projects due to the exclusivity feature on the Moxie deals.

    2.       If you go to AGX’s Gemma division’s website you will see that Gemma has already received limited notice to proceed in April and is expecting final notice to proceed in July of this year, see the following link: http://arganinc.com/pdf_files/gemma_marketing_brochure_20132.pdf. I think Moxie Patriot based on the timing of the recent press releases and commentary in the 10-K would be about 2 months after, so maybe September 2013 we would see final notice to proceed for Moxie Patriot. The article in Power Intelligence suggests that the project equity owner (Panda Power Funds) is going to market shortly to raise the debt financing component, so we should see the results of that capital raise in the next month or so. Based on all this I would expect that AGX would add the projects to backlog by Q213.


    SubjectRE: RE: a couple questions
    Entry05/21/2013 03:41 PM
    Memberotto695
    two follow-up questions:
     
    1) what is lead-time from final approval to beginning of revenue recognition (other than the $35m development fee you mentioned)?  in other words, given the timing of these awards (assuming they are finalized), does it appear to you that revenues will likely be down for F14 (ending january, 2014) given that current backlog is only 200m and last year's reveneus were $276M?
     
    2)  The $400M+ sounds great for the next couple years as it sounds like a baseline amount (assuming the two plants are awarded) with potential for more if awarded additional projects.  But, what can you say about their capacity to handle additional projects and also any further information on pipeline?  In other words, after they are awarded the two projects, will they be in a bit of a quiet period for a while because such a large jump in business would require all of their attention (and they want to make sure to some in on budget) or will they be actively seeking additional project awards to add further to revenues in F15 & F16 (january year-ends)?
     
    thanks!

    SubjectRE: RE: RE: a couple questions
    Entry05/21/2013 05:12 PM
    Memberarcher610

    1.       The remaining projects in the current backlog are: ETEC Woodville, TX (expected completion December 2014), CPV Sentinel (expected completion July 2013), Ravenbrook Landfill (June 2013). ETEC is the bulk of the current backlog and probably accounts for about 50% of the backlog or about $100M (it was originally a $200M deal according to the customer/project owner who we have spoken with, and about half of the work was done on that project as of January 2013 so far with no hitches). Therefore I would expect that GPS will book the other half of the project or about $100M from Jan 13 until Dec 14. Using that assumption gives us $50M this fiscal year for ETEC, plus $80M from CPV Sentinel and Ravenbrook, or about $130M plus whatever they book in terms of Moxie (see below comments). If you assume they break ground on the Moxie plants this year, we should have an up year on revenues this year, but if Moxie gets delayed then it certainly could be lower yoy revenues this year. That being said, I obviously believe that they will get full notice to proceed on both Moxie plants this year (see the Gemma link below).

    2.       Based on management’s commentary, we believe that Moxie Liberty and Moxie Patriot will consumer most of Gemma Power System’s bandwidth over the next 2 or so years. Importantly, however, Gemma’s resume has suddenly improved dramatically as they are now known as a major player in the construction of natural gas combined cycle power plants. Heretofore, larger players like Bechtel were only invited to these deals (see the previous Panda plants in Texas which were both constructed by Bechtel), but now Gemma is a real player. I believe that given their improved resume, plus the longer term secular growth in natural gas combined cycle which is replacing coal fired capacity as I stated in the thesis, we are at the relatively early stages of many more gas plants. The key is always making sure that management does not select high risk projects that create margin risk, therefore I believe that Gemma will continue to grow but will do so thoughtfully and my sense is they are likely quite busy with Moxie, but also thoughtfully using their improved resume to build a pipeline for FY ending Jan 16 and beyond. So, in short, I would expect and management has said that Gemma will be busy with Moxie for two years but now has entrée into a likely rapidly growing pipeline of natural gas plant deals, and given gas prices and EPA regulations (MATS), there should be a good runway for growth and hopefully AGX/Gemma will remain cautious in how they manage the risks of growing.


    SubjectRE: Margins
    Entry05/23/2013 07:52 PM
    Memberarcher610

    There are two main reasons: (1) AGX, today, largely operates on a fixed price basis, so to the extent they are able to manage costs below their original bid estimates, their margins have benefited as the cost delta is captured by them. To be clear though, the opposite is also true, meaning that AGX will bear cost underestimation in their margins too. Recently, they have performed better in terms of estimating and managing costs and therefore enjoyed higher margins. (2) The other driver of higher margins relative to peers is that AGX has a lower overhead cost structure than its competitors, including the large competitors you mentioned. AGX runs SG&A/sales at under 5%, about 200bps lower than peers that are ~7% SG&A/sales . This lower overhead translates into higher profit margins.

     

    My sense is that 9-11% EBITDA margins are the longer term average unless the business returns to more cost plus contracts, which would reduce margins but also reduce margin risk.

     

    So while we are enjoying higher margins today, we should be mindful that there is risk to margins given the current fixed price nature of the contracts.

     

    That being said, the Moxie plants will be higher margin because there was no competition on the bids, and therefore for the next 2+ years I do believe that margins should be in the 11-12%+ range with less risk . Beyond that a good margin to use is probably 9-11% unless the composition of contract type changes dramatically.

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