Argan: Hitting On All Cylinders

| About: Argan, Inc. (AGX)

Summary

AGX has appreciated 115% YTD and over 160% from its low of $28.03 to $73.90. This is up from $40 and $45 at the time of my previous reports respectively.

At the end of Q2 AGX achieved substantial completion of their two largest EPC contracts to date. The ability to sign contracts of similar or larger size will profoundly increase.

Q3 results were on target with gross margins of 21% and EPS of $1.16. These results are evidence that AGX will substantially complete their $1.2B backlog by calendar 2018.

Q3 cash, after deducting billing in excess of costs and estimated earnings, increased from $262M to $284M, which is $18.20 per share. AGX current market capitalization is $1.13B.

AGX has proved why it deserves to trade at a premium. Yet, at 18x my $4.00 calendar 2017 and 2018 estimate AGX must increase their backlog for additional appreciation.

Note: On 6/10/16 (Report 1) I published on SA a complete review of Argan, Inc. (NYSE: AGX) and also a follow up on 7/13/16 (Report 2), which had an earnings model projecting AGX's earnings for 2017F and 2018F. In this review I will assume the reader is familiar with these reports.

Second Quarter Results

As reported, Q2 results were outstanding with earnings up 72%, but there were several non-recurring factors that impacted the quarter and that need to be understood before considering Q3 results. These non-recurring items occurred in the Power Services segment and included a $12.9MM settlement with a major customer that resulted in a reduction in cost of goods sold (COGS), a $2.0MM reduction of goodwill, and an estimated $2.5MM pre-tax payment to non-controlling interest.

Firstly, let's consider the settlement for "potential unscheduled damages", which resulted in the reduction of COGS. During the quarter AGX finalized the completion of two major EPC contracts with its customer, Panda Power. According to AGX, at the end of large contracts AGX and the customer may negotiate a final settlement as the contracts are closed out. Most EPC companies, especially AGX, attempt to maintain reserves sufficient to ensure that these final negotiations do not result in write-offs in past reported earnings. Remember, AGX uses percentage of completion accounting, so past earnings are estimates until a contract is completed and actual costs are known. With the contracts completion AGX reached an agreement with its customer and was able to reverse reserves for cost of goods sold by a substantial portion of these costs although the ultimate settlement has not been disclosed. Assuming that Power Services Q2 gross margin for adjusted earnings was 21%, one can see the COGS was decreased by an amount very close to the $12.9MM settlement. Thus, in Q3 Power Services earnings were in line with my projections.

In addition APC, a small company acquired in 2015, had significant opportunities in the UK, but its major customer basically shut down operations as a result of "Brexit". Given this, AGX decided to take a $2MM charge for a reduction in good will from the acquisition of APC. I estimate that in Q2 APC had revenues of about $3MM and a small loss so its not an important factor for AGX.

Lastly, AGX reported a $3.6MM pre-tax charge for "non-controlling interests". In AGX's previous major EPC contracts the company signed joint venture agreements with partners primarily because the company was much smaller, less well known, and these agreements allowed them to take on larger contracts. I had thought these contracts ended in Q2 2016. I estimate that the settlement discussed above resulted in $2.5MM being paid to these partners and shows up on AGX's income statement as earnings for non-controlling interests. The main point is that the five major EPC contracts in the current backlog do no have joint venture agreements and in Q3 these payments were only $1.1MM or 4% of pre-tax profits. These charges will be minimal in Q4 and should not occur in future earnings. Adjusted for the settlement, the $2.5MM of higher earnings for non-controlling interests and the good will charge, I consider the adjusted earnings in line with my projections.

Third Quarter Results

Fortunately, Q3 results did not have any unusual factors and results were on target. AGX increased consolidated revenues by 54% and Power Services revenue by 35% vs. a year ago. The greater growth for AGX consolidated revenue was due to two small acquisitions made in 2015. Importantly, gross margins for Power Services came in at 21.6%, an excellent result and above the 20% in my earnings model. Earnings for the quarter were $1.16. Remember my model estimated $1.00 EPS, but this is only for Power Services as it is the dominant earnings segment accounting for 94% of revenues and 100% of pre-tax earnings in 2016F. Thus, Power Systems earned about $0.94 vs. the $1.00 in my model. I believe this implies that the projections of the earnings model are basically sound, but as stressed many times, using percentage completion accounting can lead to significant earnings fluctuations, especially in quarterly results, and such variations should be expected by investors. Please see Table 1 for the Q3 income statement and the model's quarterly projections. AGX generated approximately $15MM in cash for the quarter, in line with projections.

Table 1

Argan, Inc.

Power Systems Segment

(MM USD except EPS)

Q2 Reported

Q2 Adjusted

Q3

6/10/16 Earnings Model

Revenue

143.4

143.4

151.1

150.0

Gross Profit

43.4

30.5

32.7

30.0

Gross Margin

30.3%

21.3%

21.6%

20.0%

SG&A

4.1

4.1

6.4

4.5

SG&A %

2.9%

2.9%

4.2%

3.0%

Corporate SG&A

1.7

1.7

1.7

2.0

Corporate SG&A %

1.2%

1.2%

1.1%

1.3%

Other Income

0.5

0.5

0.6

-

Impairment Loss

2.0

-

-

-

Pre-Tax Income

36.1

25.2

25.2

23.5

Non-Controlling Interests

3.6

1.1

1.2

-

Pre-tax Income to AGX

32.5

24.1

24.0

23.5

Taxes

11.8

8.7

9.4

8.7

Tax Rate

36.3%

36.1%

39

37.0%

Net Income to AGX

20.7

15.4

14.6

14.8

FD EPS

1.36

1.00

0.94

0.99

FD Shares

15.3

15.3

15.6

15.0

Created by Joe Duncan

Notes For Table 1

1. Remember that all numbers are for Power Services alone. Earnings for the Industrial Fabrications and Telecommunications divisions are either a small profit, loss, or break even depending on how one allocates corporate overhead and the tax rate for each division. This results in a slight difference between my results and AGX's consolidated results. I allocated all corporate overhead to the Power Services Division and also used the corporate tax rate in computing its results.

2. In the Q2 column, for adjusted earnings, the cost of goods sold was reduced by the $12.9MM settlement, net income to non-controlling interests was reduced by $2.5MM, and the impairment charge for the reduction is good will for APC was eliminated.

3. Note that the "earnings for non-controlling interests" is a pre-tax payment to AGX's joint venture partners, which reduces AGX's pre-tax income for tax purposes and consequently increases their tax rate.

4. In Q3 AGX received a $2MM tax credit due to stock option activity. Without this credit the tax rate would have been 39%. Since this factor cannot be estimated for future quarters I consider it non-recurring and used a 39% tax rate for Q3 in Table 1.

5. The earnings model from my second report was for 2.5 years or 10 quarters. The model used here is that model with all figures divided by 10 to compute the earnings power for one quarter. Also, note that the line that was supposed to be for pre-tax income was mistakenly labeled EBITDA instead of pre-tax income.

Future Opportunities

It is clear that AGX is a unique, superbly managed growth company. Past results have been spectacular. The past five-year annualized growth (see most recent investor relations presentation) in Revenue, EBITDA, Book Value and EPS were 30%, 45%, 22%, and 27% respectively. However, as good as AGX has been, one must ask what comes after calendar 2018? Only a single smaller contract is set for completion in 2019 and no significant additional contracts have been announced in the last two quarters. Given the massive increase in the backlog in 2015F and Q1'16, only the most hard-nosed critic could ask the company "what have you done for me lately?" However, even given the uniqueness of the company, its profitability and cash generating abilities, I think it is necessary for investors to examine what is likely to come next. With AGX now selling for 18x my calendar '17 and '18 estimates, I believe additional appreciation is likely to require growth in the backlog over the next two years.

Two very significant EPC contracts were recently awarded to competitors, one to Kiewit Construction and a second to a joint venture between Bechtel and Siemens. Management does not believe that this is significant, the beginning of a trend or a sign that contacts are becoming more competitive. Management estimates that its market share of the gas power plant business is 15-20% leaving much room to grow. AGX has increased its sales staff recently and is aggressively bidding on new contracts. The company has said that at this time there are about 15 to 25 opportunities for natural gas plants and that the company has "a lot of irons in the fire". Management's goal and guidance is to enter 2018F with a higher backlog and to grow revenues over the next two years noting, as always, that the EPC industry is lumpy and that precise predictions are not possible.

I believe management's goals are reasonable and that in the future AGX will increase its market share. I think it is highly likely that within a few quarters the backlog will begin to increase and that significant new contracts will be awarded to AGX, but the only thing I or any investment analyst can base such a projections on is the quality of the management and its past record. However, if one thinks about it that is true for almost all companies.

A major part of any investment thesis for AGX, again especially with the inflated stock price, has to be what AGX will do with its current cash and its future positive cash flow. AGX had $285MM in cash at the end of Q3 or $18/share and I estimate it will generate an additional $374MM in free cash flow (after paying a $1.00 annual dividend) or an additional $24/share as it works off its current backlog over the next 7-8 quarters. The total is about $650MM and is huge for a company the size of AGX (about $1B market cap).

AGX could pursue a stock buyback, but I consider that very unlikely. It could increase its current $0.70 dividend. Take note that AGX declared a special dividend in 2016, which made the total dividend $1.00. Management states that a "special dividend" will be paid when the board feels the current earnings level warrants it. AGX's management believes it operates in a cyclical industry with fixed cost contracts and that it is essential to have a very conservative attitude to managing its cash and balance sheet. This is especially true as it expects to be bidding for large EPC contracts in the near future. In my opinion that philosophy should give investors great confidence in AGX, but also implies that only moderate increases in the $1.00 payout are likely until the company is able to achieve a level of earnings power significantly above the current $4.00 level.

Acquisitions are another possibility to achieve growth, but AGX made two small acquisitions in 2015. Both have performed significantly below management's expectations. In response to my question as to whether these poor results have made AGX more cautious with respect to future acquisitions, the answer seemed to be a decided yes. However, the company did point out that once the giant companies like Kiewit, Bechtel and Chicago Bridge & Iron are excluded, the EPC industry is highly fragmented. Clearly there are many possible acquisition targets available, but I got the impression that management will be extremely cautions in making acquisitions in the foreseeable future.

Conclusions and Recommendations

As noted in this and the previous reports, I consider AGX an extremely good company and the class act of the EPC industry. Yet, having appreciated over 100% in 2016, high expectations are almost certainly priced into the stock. 18x future earnings is a high multiple for the EPC industry and AGX will need to sustain their current profitability and cash generation in 2019 and beyond to justify that valuation. With the vast majority of growth expected to come from Power Services AGX is primed to take advantage of their industry leading profitability and cost structure.

At $73.90 (12/19/16 close) AGX does not look like a bargain and it certainly is not the bargain it was earlier in 2016, but I would remind readers that great companies, after they have been discovered by the market and having achieved wide exposure, institutional following and ownership, as has happened to AGX this year, almost always seem too expensive to buy and I doubt AGX will prove to be an exception to that. AGX is recommended as a strong hold and an aggressive buy on any pull back to the mid to low $60s or on announcements of new EPC contracts that raise the backlog significantly.

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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