Argan Inc. Is A Red Hot Growth Story

| About: Argan, Inc. (AGX)

Summary

AGX is a small fast growing company in the heavy construction industry, specializing in engineering and construction of natural gas power plants.

AGX has a $1.5B project backlog that includes projects contracted through 2019 compared to LTM revenue of $460MM.

Gemma Power Systems is able to grow significantly with extremely low capital expenditures.

The continuing shift in energy share from coal-fired to natural gas-fired plants will increase demand for AGX’s primary subsidiary, Gemma Power Systems sequentially for many years.

AGX has a superb balance sheet: zero debt and $319MM in cash & short-term investments, which is about 50% of the market value of equity ($615MM Market Cap).

Considerations

There are a couple things to consider before reading my analysis of Argan, Inc. (NYSE: AGX). Firstly, AGX has a January fiscal year meaning that their 2016 results ended January 31st and their 2017 fiscal year started February 1st. Secondly, AGX is comprised of four subsidiaries, but only one is significant for this analysis. Gemma Power Systems (GPS) represents 96% of AGX's trailing twelve months (TTM) revenue from January 30th 2016 results. GPS will be the topic of this report and I will not discuss the other subsidiaries.

Investment Action & Thesis

I am recommending Argan, Inc. as a strong buy with a 30% upside from the 6/8/16 closing price of $39.39. My 12-month price target is $51.0 and is supported by a ttm and ntm P/E discount to competitors. I believe AGX to be worth at least a 15% premium if not more. Please see Table 3 for this reasoning. Over the last 5 years AGX's EPS and EBITDA have grown at a 28.6% CAGR. The company's financial health is outstanding with $319.0MM in cash and short-term investments along with zero long-term debt. AGX has a 24.1% gross margin, which is nearly twice the nearest competitor's margin and earned an 18% return on equity. Its large backlog makes AGX extremely attractive and provides great visibility on the next three years' revenues and earnings.

Background

Argan, Inc. conducts the majority of its operations through its wholly owned subsidiary Gemma Power Systems, LLC . Through GPS, which is about 96% of its revenues, it provides a full range of development, consulting, engineering, procurement, construction, commissioning, operations, and maintenance services to the power generation and renewable energy markets for a wide range of customers including public utilities, independent power project owners, municipalities, and private industry (Value Line). GPS has installed and is under contract for more than 14,000 megawatts of capacity (1 megawatt equals 1 million watts). Power experience includes: combined and simple-cycle natural gas-fired, combustion turbines, coal/wood fueled projects, wind plants, solar facilities, and waste recovery facilities (Investor Relations presentation).

Backlog and Current Projects:

AGX's backlog is a measure of future project revenue. As projects are started the liability account, "billings in excess of revenue", increases. As contracts are signed by GPS their backlog increases. Concurrently, as projects progress and are completed that backlog decreases and is realized as revenue. Gemma's backlog as of 1/31/15, 7/31/15, 10/31/15, and now 4/30/16 was $423MM, $660MM, $1,235MM, and $1,500MM respectfully. With seven current projects underway, GPS and thus AGX should see very strong future revenue and earnings growth.

GPS has a robust portfolio of current projects as exhibited in Table 1. The entire process of designing, building, and completing these power-generating facilities takes approximately three years. This figure is consistent with past results and also forward projections. While the majority of their contracts are natural gas-fired plants GPS has and will continue to build solar, wind, and biomass facilities. GPS builds both combined cycle and simple cycle plants where combined cycle has a higher thermal efficiency and is therefore preferred. GPS has also completed projects in pollution control and biodiesel and ethanol processing facilities. The overall portfolio is geographically diverse with contracts across the eastern, mid-west, and western United States. With extensive contracts through 2018 and the ability to take on additional projects thereafter, forecasting revenues and earnings for GPS is straightforward as long as margins are maintained

Table 1

Project

Output

Type

Contract Value (MM)

Estimated Completion

Panda Liberty

829 MW

Natural Gas-Fired

$390

Spring 2016

Panda Patriot

829 MW

Natural Gas-Fired

$390

Mid-2016

Caithness Moxie Freedom

1040 MW

Natural Gas-Fired

$400

2018

NTE Middletown

475 MW

Natural Gas-Fired

$290

2018

NTE Kings Mountain

475 MW

Natural Gas-Fired

$275

2019

Exelon West Medway II

200 MW

Dual Fuel

$100

2018

East Texas Electric Cooperative

50 MW

Biomass-Fired

$25

Dec-2017

CPV Towantic Energy Center

785 MW

Dual Fuel

≈ $400

2018

Source: AGX Investor Relations, created by Joseph Duncan

Shifting Energy and Regulatory Environment:

The energy and regulatory environment in the United States will be favorable for GPS for the foreseeable future. With the constant threat of additional EPA regulations and the new standards under the Clean Power Plan, the demand for Gemma's services should increase. Natural gas, renewable, and alternative energy plants are leading a transition away from traditional coal-fired plants.

In 2015 about 5% of the total coal-fired power plant fleet in the U.S. was retired bringing down coal's total power share from 50% in 2008 to about 33% today (WSJ). Additionally, natural gas-fired plant power share reached 32% and renewable, primarily solar and wind, reached 7% (WSJ). Both former statistics are all-time high power shares and this trend will continue to gain momentum. New gas-powered plants will be needed to replace the older plants that undergo decommissioning. This factor will be the single greatest driving force for GPS. The power share shift will take years and will likely continue for decades, which demonstrates sustained demand for GPS.

Risks to Outlook

To succeed GPS must complete projects on time and on budget. GPS must also maintain or continue to increase their backlog, as they grow. This seems highly probable given their track record and the changing power generation environment.

GPS must continue to maintain margins on future projects and to increase its backlog over time. Two major projects are scheduled for completion in fiscal 2017 and GPS is experiencing higher than average margins and profitability at the present time. As long as average margins are maintained, as expected by management, that is fine. Finally, in large construction projects cost overruns can be disastrous. Since AGX operated with fixed cost contracts it is essential that GPS continue to project costs accurately as they have in the past. The fact that the backlog is comprised of generating plants very similar to those recently completed gives one confidence that margins can be maintained.

Catalysts for Growth

· Increasingly favorable regulatory environment.

· Well-defined transition from coal-fired power plants to natural gas-fired and renewable energy plants.

· Very strong capital structure positions them to make accretive acquisitions, although historically acquisitions, other than GPS, have not played an important part in its growth.

· Capacity additions: As you can see Table 2, GPS requires almost no capital to grow. AGX has spent only $7.1 million on capital expenditures in total over the last three years with depreciation at $2.9 million total for the past 3 years while earning $106.0 million in net income.

· Growth of natural gas extraction and production in the Marcellus, PA basin.

· Project backlog additions.

Table 2

Net Income

Capital Expenditures

Depreciation

2013

$23.0

$7.3

$0.8

2014

$40.0

$1.1

$0.8

2015

$30.0

$2.9

$0.8

2016

$36.0

$3.1

$1.3

Source: Capital IQ, created by Joseph Duncan

Valuation

I used a blend of two traditional valuation techniques for AGX: comparable companies analysis (compco) and a relative EV/EBITDA multiple. A DCF was not possible due to high levels of net working capital.

I compared Argan to other industry competitors from Capital IQ and the most recent shareholders' presentation slides (see Table 3). The following companies were included: Chicago Bridge & Iron Company N.V. (NYSE:CBI), Fluor Corporation (NYSE:FLR), Primoris Services Corporation (NASDAQ:PRIM), and Jacobs Engineering Group Inc. (NYSE:JEC).

Argan is trading at a ttm P/E ratio of 14.6x and ntm P/E ratio of 12.6x, compared to their competitor's average of 20.6x and 13.2x, respectfully (as of 6/8/16 close). I calculated a per share value of $51.00 by taking forward P/E average of competitors x AGX ntm EPS x 1.15. I believe Argan is worth at least a 15% premium to its competitors, yet it currently is trading at a significant discount. I believe my price target to be conservative. Additionally, I considered a 20% and 25% premium in my compco analysis. I will have an update after the high volume trading stops in the coming days.

Table 3

COMPCO (Industry= Constuction and Engineering)
Company (as of 6/8/16 close) EV/EBITDA P/E Dividend Projected PEG Ratio Growth Estimate
LTM NTM Yield 5 year gwth Source
Fluor Corporation 6.83 15.2 1.55% 7.5% 2.0 Value Line Estimates
Chicago Bridge and Iron 5.12 7.6 0.72% 8.5% 0.9 Value Line Estimates
Primoris Services Corporation 9.18 14.1 0.97% 18.5% 0.8 Value Line Estimates
Jacobs Engineering Group Inc. 9.32 15.9 N/A 7.0% 2.3 Value Line Estimates
Average 7.6 13.2 1.08% 10.4% 1.5
Argan Inc 3.36 12.6 1.75% 25.0% 0.5 Avondale Partners
Argan Valuation = worth a P/E premium of 15% to the industry average
= 13.2X 1.15 X $3.35 (2017 EPS)
$50.85 (15% PREMIUM)
$53.06 (20% PREMIUM)
$55.28 (25% PREMIUM)

Source: Capital IQ, Value Line, and Avondale Parters. Created by Joseph Duncan

My relative valuation is based on an EV/EBITDA multiple consistent with estimates from Capital IQ and Avondale Partners. AGX currently trades at 3.36x LTM estimated EV/EBITDA and the industry competitors currently trade at 7x LTM EV/EBITDA. AGX should trade between 5 and 7x EV/EBITDA, which is in line with competitors and well above where it is today.

Investment Conclusion

AGX will make a great addition for investors looking for small cap exposure. The stock is relatively volatile and trades in relatively small volume. Average daily volume over the last three months is about 100,000 shares per day. At the time of my analysis AGX was trading below its 52 week high and I did not believe all the good news, current backlog value, and higher earnings in fiscal 2017 are reflected in the current price. After a couple strong days of trading since their Q1 earnings release the stock has surged, breaking $40. AGX reported progress on current projects, consistent margins, and the start of their newest project (bottom of table1). Their largest project now represents only 18% revenue concentration per any one quarter, which adds diversity and hedging. The 33% earnings growth projected for 2017 should draw investor attention to this stock. AGX is strongly recommended for purchase.

The timing of this report is poor, because of the earnings release, yet I believe the valuation for AGX will still be attractive in the coming weeks. I am long AGX.

Disclosure: I am/we are long AGX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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