Seeking Alpha
, Barel Karsan (436 clicks)
Long only, deep value, contrarian
Profile| Send Message|
( followers)  

Value investors love companies with large cash balances. These companies are the least likely to flirt with financial trouble and are in a position to pay dividends and/or buy back shares. As such, when valuing companies, investors will often add a company's cash balance to the company's earnings power valuation in order to determine the company's intrinsic value. Sometimes, however, this practice can get the investor in trouble.

Consider Argan (NYSE:AGX), a company primarily engaged in the production of a range of power plants. The company trades for $125 million, and generates about $10 million per year in operating income. This may not look like a steal, until one takes into account that Argan also has $76 million in cash. As such, it looks very attractive at first glance.

Unfortunately, however, the company actually needs the cash. As such, it does not appear as though that cash will be distributed to shareholders as the nature of Argan's business requires that it maintain a ton of cash on hand for a couple of reasons.

First, the company is paid by customers in advance for some of its construction work. But because the timing of future sales is uncertain (the company's backlog is largely composed of just two or three projects at a time), that cash is required to pay for the work the company has been contracted to complete. Dell (NASDAQ:DELL) is an example of another company that is paid before it has to deliver its products but Dell can more safely distribute that cash as the stream of future orders constantly replenishes its cash balance. Argan's situation is more uncertain as it cannot distribute cash on the expectation that it will win future production contracts that replenish reserves.

In other cases, the company must perform work before it is paid. It is not uncommon to see the company's accounts receivable balance jump by tens of millions of dollars over the course of a single quarter. This again requires the company to hold ample cash reserves in order to fund construction until such time as the customer is obligated to pay.

Management's actions are consistent with the idea that the company needs strong cash reserves to operate successfully. In 2008, despite a cash balance of $70 million, the company raised $25 million of cash in a private placement. Since then, the company continues to hoard cash, having not paid a dividend or bought back shares.

Investors interested in valuing this company should therefore consider the company's cash balance as part of its operating assets and not as excess cash. For those interested in another example of this type of situation, this is an issue that has come up before with another company, KHG Humboldt (OTCQB:KHDHF).

Disclosure: No position

Source: Argan: Don't Be Deceived by Cash Balances