Description

Argan, Inc. (“AGX”) is a small, under followed power EPC business with a $1.5bn war chest of high quality backlog secured by five new projects including two booked in the last month.  Recognition of this backlog over the next 9 quarters generates $120mn of free cash flow or roughly $8/share of cash and dramatic EBITDA growth of 60%+.  The stock unfairly traded down by 25% after its last earnings announcement because of an ill-received acquisition of an unprofitable business, which our channel checks indicate has now been fixed.  Execution on its existing backlog and the profitability of this acquisition will show up in the next few quarters, illuminating the underlying business strength.  We believe the stock is worth $59/share, earning a 38% IRR over the next two years.

Business Description

Note: see Woolly18’s write-up on May 10, 2015 for additional background on the Company.

AGX is a holding company comprised of Gemma Power (“Gemma”) and a Telecom business.  Gemma Power is an engineering, procurement and construction (“EPC”) business with a particular competency in building natural gas power plants in the United States.  Power plant developers hire Gemma to engineer the design of, procure labor for and construct power plants as part of a turnkey service.  Gemma is currently completing two large scale natural gas power plants worth $770mn for Panda Power in the next two quarters and has five new projects worth a combined c. $1.5bn in its backlog. 

AGX made two acquisitions in 2015.  They acquired the Atlantic Projects Company (“Atlantic”), a small international power sub-contractor, and the more controversial Roberts Company (“Roberts”), an industrial fabrication business.  These back-to-back acquisitions after years of M&A inactivity combined with Roberts’ questionable business quality confused investors.  Pro forma for these acquisitions (on a normalized basis), Gemma contributes 87% of EBITDA, Roberts 10%, Atlantic 2% and Telecom 1%. 

Why it is Mispriced

There are three reasons for which we believe AGX is mispriced:

1. Overreaction to the Roberts Acquisition
2. Misunderstood Business Fundamentals
3. Near-term Natural Gas Growth Concerns 

1.       Overreaction to the Roberts Acquisition

AGX traded down by 17% over a 6-day period following the announcement of the Roberts acquisition.  AGX bought Roberts for $26.5mn, which included a $500k cash payment, $16mn of debt repayment and a $10mn working capital injection.  AGX’s Q3 disclosure implies that Roberts lost $12mn on about $200mn of revenue in 2015.  The optics of this deal aren’t good but we believe the underlying business is strong and Roberts will return to profitability in the next few quarters.

Multiple conversations with a variety of parties indicate that under the direction of a private equity buyout group, Roberts embarked on an aggressive growth strategy and doubled revenue in a year and a half.  The growth was poorly executed.  Roberts over hired senior managers, underpriced contracts to win business with new clients and took on too much work outside of their core competency.  As AGX CEO Rainer Bosselmann put it “they took jobs at 5% [margins] which was suicide”.

We understand that the majority of the losses in 2015 were the result of a single contract with Resolute Forest Products.  According to a former Roberts’ employee, the Resolute project was behind schedule because Roberts took on way too much work and every project got squeezed.  The Resolute project ended up having severe liquidated damages due to late delivery.

We understand that Roberts started having covenant issues with its banks in 2015, essentially making them a forced seller.  AGX was very familiar with Roberts and was quick to act.  In addition to AGX conducting due diligence on Roberts as an M&A target in the past, AGX CEO Rainer sat on the Roberts board from 2008 through the acquisition. Despite the surprising headlines, this was a well thought out and well timed deal. 

In mid-2015, the Company began to refocus its strategy.  The previous management team was fired and the founder, John Roberts, returned to run the Company.  According to Rainer, they have already scaled down from 1,400 to 500 employees and all of the money losing contracts, including the Resolute contract, have been written off.  We have verified that the Resolute project has ended and will no longer be contributing negatively to the bottom line.  We have also had multiple conversations with folks that say the direction the company is currently taking will lead it to profitability by year-end 2016.  

Based on AGX’s reported financials for the 9 months ended October 2015, Roberts’ implied full year revenue went from c.$132 in 2014 to c.$207 in 2015.  Correspondingly, their net profit went from a positive $1mn in 2014 to a negative $12mn in 2015.   Rainer is guiding the market to a normalized business running at $100mn in revenue and a 10% EBITDA margin by mid-2016.  While multiple stakeholders and former employees have confirmed this operating level for Roberts, we assume normalized revenue of $100mn per year at a 10% gross margin to remain conservative.  Using our normalized net earnings and a purchase price of $26.5mn, which includes the working capital loan, the purchase multiple is reasonable at around 5.3x.  However, using Rainer’s normalized business assumptions, the purchase multiple is closer to 2.7x.

2.       Misunderstood Business Fundamentals

The latest quarter showed a sequential EBITDA margin decline from 18% in Q2 2015 to 15% in Q3 2015 and a slight drop in absolute EBITDA from $18mn in Q2 2015 to $17mn in Q3 2015.  These declines reflect the fact that two large, high margin projects are rolling off the books (Panda Liberty and Patriot) and new lower margin projects are just breaking ground.  Declining EBITDA and EBITDA margins are generally not well received by shareholders, but the underlying fundamentals of the business are extremely strong. 

Revenue:

Gemma has the strongest backlog in its history, double the prior high:

In the past month, Gemma has won two large contracts with NTE in Kings Mountain, NC and CPV in Towantic, MA.  These two projects add $685mn to Gemma’s backlog, bringing the total, including the remaining work on the Panda projects to more than $1.5bn or twice its historical high.

We recognize that backlog for different businesses can mean different levels of certainty of revenue.  The backlog for many companies is relatively meaningless.  For Gemma this is not the case.  Once a project is put into backlog and a formal “Full-Notice-To-Proceed” is given, the likelihood of recognizing that revenue is extremely high. A project finance lawyer very familiar with this space described the extremely unlikely scenario in which a power plant wouldn’t get built after funding was received, and something very very bad would have to happen for the loans to stop funding.  Natural gas price changes do not fall into this category, nor do changes in interest rates, regulation and other basic business issues.  The same project finance expert explained that it is much more likely that in the case of something bad happening, the lenders would make the equity sponsors restructure the deal to reduce their risk as opposed to stopping funding.

A different project finance expert characterized these deals as being as close to a sure thing as you can get.  He said these deals don’t get financed unless the project has a hedge or revenue put in place. This means everyone involved has visibility for 4-5 years after the plant is built, so the EPC has a very low risk of project cancellation after the project receives financing.  If there are delays or cost overruns, the banks have a right to call a default and take the sponsor out at which point the contractor is at risk to get paid.  Practically speaking this doesn’t happen.  In fact, the project finance experts we have spoken with have never seen it happen. 

In short, AGX over the next 3 years is poised to generate the most revenue in its history.

Margins:

Margins on the 5 new projects in backlog will undoubtedly be lower than those achieved on the soon-to-be-completed Patriot and Liberty projects.  In contrast to the five upcoming projects, the Liberty and Panda project margins reflect Gemma’s role as a developer where they funded the initial, high-risk costs of securing all permits and approvals in return for better EPC contract terms.  They did not do this for the five new projects in backlog.  A former Gemma project manager confirmed the Gemma cannot duplicate the high returns they realized on the Panda projects unless they participate on the development side again.   

Furthermore, the Liberty and Panda projects were executed in a less competitive environment; they were somewhat groundbreaking as the first two natural gas fired power plants specifically built to take advantage of their proximity to gas in the Marcellus Shale region.  According to a project finance expert close to the deals, Liberty and Patriot were two of the earliest projects to get attractive gas prices tied to the Marcellus Shale region.  They really lit the market on fire and the early players had outstanding economics on their projects (we have heard that Panda has hit a home run on these deals).  Liberty and Patriot were unusually attractive deals.  Today’s environment is much more competitive as more EPCs are bidding on projects, and EPC’s are facing a tighter labor market forcing them into lower margins.

Margin declines aside, the sheer size of backlog still supports significant EBITDA growth:

In addition, it is worth noting that Gemma manages to earn better than average margins versus its competition.  A former Gemma project manager explained that EPC contracts are typically priced at a 12-13% gross margin with a 10% contingency buffer in case something goes wrong.  Most EPCs accept the 12-13% margin but Gemma really works to control costs and minimize change orders to get that extra 10%; earning a potential 23% gross margin.  We estimate a blended gross margin closer to 16-18% in our model to be conservative despite multiple indications that Gemma will earn above and beyond that level.

Our expectation is that EBITDA will grow from a current TTM level of $58m to $94m over our forecast period, representing 61% growth.  Over the next few quarters, EBITDA margin levels will continue to decline somewhat as the higher margin Panda and Liberty projects are completed but regardless, absolute dollar EBITDA levels grow significantly over time.

3.       Near-term Natural Gas Growth Concerns

In recent years, the power market has trended away from coal production towards natural gas production.  This trend has been triggered by lower gas prices and supported by more attractive economics in building and maintaining natural gas plants compared to coal plants.  Regulation, as an added tailwind, has made coal power emissions compliance prohibitively expensive and has forced a wave of early coal retirements.  In 2015 alone, 14GW of coal, or 4.6% of total U.S. capacity, was retired.  We believe the natural gas power market will continue to steadily grow but there are fears that natural gas prices have troughed, gas fired power plants are being overbuilt, and essentially this is as good as it gets for AGX.

First of all, the natural gas market strength is helpful but not required for our thesis.  Our base case underwrites successful execution of Gemma’s current backlog rather than a plethora of new growth opportunities from a booming natural gas market.  Gemma is at full capacity and will not add any additional projects to backlog for quite some time.  As discussed, once a project has been financed and work has commenced, these contracts are basically revenue in-the-bag.

In addition, Gemma’s size shields it somewhat from changes in the overall power industry. Gemma needs a few good projects a year to feed the beast compared to its larger competitors who are more reliant on a booming energy market to reach the 20-30 projects they might be working on at a given time.  Gemma has secured its existing backlog for the next few years.  If in fact we are at peak levels for natural gas power development, in 3 years, Gemma can rely on its expertise in developing other types of power plants in order to replenish its backlog, including wind, solar, biomass and biofuel.  In other words, Gemma is not a one-trick pony. 

Financial Overview and Valuation

Our base case scenario assumes that Panda Liberty and Patriot roll off in the next two quarters and realize a higher gross margin from a contingency release.  We also assume the 5 new projects roll into revenue at a cadence similar to that experienced for the Panda projects.  We estimate lower blended gross margins for the new projects compared to the Panda projects, which benefited from Gemma's contribution of development equity and a more benign competitive environment. We think the margins we’ve assumed for the new projects are conservative for the life of the project. We assume Roberts is normalized at $100mn in revenue and a 10% gross margin by 2017FY.

Assuming no multiple expansion, the 2015 actual EV/EBITDA multiple of 6.6x implies a price target of $59.48 by year-end 2018. Note that we have adjusted the billings in excess of costs out of the cash balance for the purposes of calculating enterprise value as we consider it restricted cash. Other adjustments to free cash flow include the minority interest Gemma pays out to its JV bonding partner on the Panda projects which will not continue after the projects close this year.

Risks

·      Execution.  Given Gemma’s size, our biggest concern is Gemma’s ability to execute on such a large number of projects.  The 5 project, $1.5bn backlog level is by far Gemma’s largest undertaking.  Multiple reference checks confirm that Gemma has a stellar track record of exceptional performance.  We have spoken with customers, competitors and suppliers that vouch for Gemma’s work quality.  We have also spoken with a bonding agent that explained the 3 key metrics, or “3Cs”, used to underwrite a company for bonding purposes are character, capital and capacity.  Within capacity, a bonding agent assesses relevant experience and the man power.  He said they ask themselves, ‘can they company fill the job with current employees’. It gives us additional assurance that Gemma’s bonding agent, a conservative third party that focuses on the down-side, doubled Gemma’s bonding capacity in 2015 based on, in part, their ability to perform this level of work.  Nevertheless, this remains a concern.

·      The Supreme Court rules against the EPA’s Clean Power Plan.  In February 2016, the Supreme Court issued a stay on the EPA’s Clean Power Plan, questioning the EPA’s jurisdiction in imposing a rule over the states.  Regardless of the outcome, most states have imposed their own, similar emission rules and are moving ahead with implementation. 

·      Natural gas prices spike, slowing the pace of coal retirements.  We have a good level of clarity on the coal retirement schedule.  The EIA estimates that 18-23GW of coal will be retired in the U.S. through 2040.  Conversely, natural gas capacity is expected to grow 2.8% annually during the same time period.  While Gemma has a niche capability in the complicated natural gas combined cycle technology, they have experience building all types of power plants.  Gemma is not dependent on a natural gas boom in particular but on a slow and steady power market.  As an added upside, the Atlantic platform gives AGX an option to expand internationally if the U.S. power market slows.  Atlantic is based in Dublin with recent projects in Kuwait, Singapore, Ireland and Iceland.    

Catalyst

·         Backlog flows into revenue and profit

·         Roberts turnaround