Description

Thesis: Revenue for this specialized gas power plant EPC should inflect 3x in the next two years. The company’s backlog has reached $1.4 billion and will likely rise to $2.5 billion as more projects will be won over the next 12 months. As these projects are executed at close to historical mid double digit margins, AGX should generate record levels of EBITDA and earnings for the next several years, starting in FY21 (CY20). The stock should inflect higher as results improve materially starting two quarters from now (Q3.20). AGX is trading at 3x forward EV/E and 7x forward P/E and has 45% of market cap in net cash. 

Investment Summary: 

Argan’s largest subsidiary, Gemma, saw its backlog fall to $365m at the end of last year as it completed four power plants. Since then, it has quickly grown to $1.4B with another $1-1.5B in potential project wins within the next 12 months. This should allow for revenue to ramp from its current $200m run rate to over $1B. After speaking with management and industry insiders, we are confident that Gemma will be able to execute on these plants with at least mid double-digit operating margins as a proven best in class operator. This should lead to over $5 of EPS next year and over $6 in the out years. With roughly $19 in net cash per share (the best proxy is current assets - current liabilities) and the stock at $40, that roughly 4x P/E ex-’cash’. That is far too cheap, especially considering that Argan is likely to generate an additional cumulative $20 per share in free cash flow over the next 3 years. In essence, you are getting the business for free 3 years out.

Company Background

Argan has been written up several times before, most recently as 2016 at around $33 a share, with the stock proceeding to go past $70 less than a year later. The company has not changed much since then so this section will remain brief. This is a holding company with 4 companies split into 3 reporting segments. Gemma Power Systems (GPS) and Atlantic Projects Community (APC) make up the Power Services division, which is typically 90% of revenue and essentially all of the operating profit. GPS is the only subsidiary that matters. The last two projects for APC are in their final stages in the UK, the contracts of which were only worth $100m total combined. One of the UK projects ran into trouble this year but we believe the company took an appropriately large write-off last quarter to bracket the loss. This was likely the reason for the recent drop from $50 to $40. It is important to remember that APC’s is basically a non-core UK asset and performance there does not reflect on GPS’s stellar decade long track record in the US.

The Roberts Company (TRC) was acquired at the end of 2015 and is the entirety of the Industrial Fabrication and Field Services segment. This company probably can have annual revenues of $100m and while the target operating margin is likely mid single digits, last year it was only 2%. The market was not keen on this acquisition when it happened and the potential from it has yet to be realized, but is not core to the thesis.

Finally, there is Southern Maryland Cable (SMC) which is the Telecom Services Segment of Argan. It is even smaller than TRC with revenues around $10m per year since 2013 and is unlikely to move the needle in either direction going forward.

Therefore, the future value of this business rests entirely upon Gemma, the EPC contractor that specializes in large (> 100MW) natural gas power plants. This is where all of the large projects have been won and where the inflection in revenue trajectory will come from. The CEO of this subsidiary (Bill Griffin) is a founder of Gemma, best in class operators, and the highest paid person at Argan and for good reason. Management will be discussed in greater depth below.

Industry

Natural gas power plants currently make up around only 16% of power generation in the United States, which just surpassed coal in the past few years. This has more to do with the latter’s rapid decline than an increase in demand for gas plants. However, as coal plants continue to be retired, their power contribution needs to be replaced and often times, renewable options are not sufficient, particularly in the Northeast region of the country. It is hard to make a very long term (20 year) case for growth in natural gas plants but it seems reasonable to assume that they will continue to be built during the next decade as the final 15% of coal contribution is phased out with the historically steady pace of 1% share loss per annum.

The other cause for concern about this space is the difficulty with which power plants are actually built. In less than 2 years, the field of competing EPCs for such projects has shrunk from 6 to 3. Skanska, Aecom, and Fluor all exited the space and Jacobs Engineering sold off its business. This has left Kiewet and Gemma as the two prominent players left. This shrinkage has happened as the number of projects declined and competitors overbid for plants. Fluor’s management team even came out and said the entire space is unprofitable and EPC’s working on these power plants aim to break even. These competitors exiting has allowed Gemma to build it largest backlog ever during this resurgence in the number of projects being planned. However, if competitors claim these new projects are unprofitable, how can Gemma hope to create value? This became a key question to determining the outlook for Argan.

Value Proposition / Competitive Advantage

Gemma has survived the trough in the power plant cycle and is poised to succeed on these future projects due several advantages developed over time: 

• Management discipline: they walk if cannot meet mid double digits margin projections. Turnover in core staff is low. Their average Power Services EBIT margin is stable and confirms the discipline: 17% last five years, 19% last 7 years, 16% last 10 years. There are a few low project years like FY20 (now) and FY10 as they cannot control the timing of ground breaking on projects. Management is keenly aware of rising labor costs and have bid on projects as such. To be conservative we assumed EBIT margins in power peak at 15% not the prior Panda highs of over 20%.

• Great project execution through specialization: only does gas power plants and builds the simplest and most efficient plant that matches the specs; “lead with the construction in mind and not let the engineers run wild”. 

• A recurring customer base which prefers to work with this proven operator: competitors that left the business were working with public utilities for the most part. Gemma is willing to work with such customers, but often prefers power merchants due to better aligned incentives and faster decision-making. 

• Development-stage financial involvement in the project: leads to success fees and higher margins.

• Lean operations: Gemma hires or subs out construction staff for each project. They have recurring labor pools in each geography they work with repeatedly. They mostly work with non-union labor. They furlough staff with some pay between projects to keep them available. 

We spoke with their biggest competitor Kiewit. One executive said that any time they find themselves bidding against Gemma, they expect to lose. Gemma is very selective with the projects it chooses to bid for, but when they do, they typically win the contract. Now with so much competition gone, more projects are viable, leading to the growing backlog. 

Projects

Currently, only 3 projects make up the majority of the $1.4B+ backlog (Reidsville NC $250m, Guernsey OH $900m, Harrison WV $325m). As previously mentioned, the two UK plants that are being finished contribute very little to this number. Channel checks indicate that Argan should receive the full notice to proceed (and break ground) on the large Guernsey project in the coming weeks and will start to contribute a meaningful amount of revenue in the 3rd quarter. This should be followed shortly after by a full notice to proceed for the smaller Harrison WV plant. 

Furthermore, there are over $3B or so in potential projects planned to start in the next 18 months that have yet to announce an EPC. Given past relationships with various owners and developers, Gemma has a good chance to win at least $1B of that. We are tracking the following projects as likely additions to the backlog:

• Chickahominy project, which Argan has already won, but has yet to receive the limited notice to proceed and therefore cannot add to its backlog. This is a massive project with $800m in value to the EPC (may be more with turbines) that just received final permitting and can close on the final step of financing. 

• Brooke County WV: $400m project

• Harrison County OH: $525m project

There are multiple other projects we track that are further out 2020+ timeline. As Gemma starts to work through the existing book, we believe the backlog can surpass $2B later in 2019 and likely go in the mid $2B next year.

Management 

Gemma is not the only lean operation in this conglomerate, and all of Argan aims to keep its overhead as low as possible. There are only 4 people that work in the corporate office. This includes its longtime CEO, Rainer Bosselmann (76), who owns over 3% of the company. He is a deal maker that owned companies in the technology and textile spaces before this shift to construction decades ago. Rainer knows his businesses intimately, but allows the management teams of subsidiaries run their companies as they see fit, especially with Gemma. We think eventually Rainer will sell the company.

As mentioned before, Gemma’s founder and CEO, Bill Griffin (64), is the highest paid person in the company with a roughly $5m salary in good years. He owns about 2% of the company. He is the anchor to Gemma strong culture and has navigated the business through countless cycles. 

Finally, there is David Watson, who joined in 2015 after Rainer’s CFO and partner of 20 years retired. He joined from a business development company and came on right before the TRC acquisition. David also runs a bare bones investor relations effort. Argan does not host earnings calls, put out investor presentations or entertain much sellside coverage. This management team is entirely focused on running its businesses and creating value. 

Overall the management team owns over 8% of the company. Dimensional owns 8% and Wellington 8%. 

What Happens Next

Due to a -65% decline in revenue in Q1 and an almost $30m writedown from issues with APC’s UK projects, AGX has given up all of its gains since it started to rebuild its backlog earlier this year. However, this is almost the exact same set up as the spring of 2016, the last time we owned the company. When the stock sold off on news of the TRC acquisition and a Q4 that saw the 3rd consecutive quarter of declining Gemma revenue. At that time, the backlog was just over $1B and cash per share was around $11. The stock was around $30. The following quarter, revenue from the backlog started to come in and Gemma grew sales 30% y/y with a 20% operating margin. From there, AGX doubled in roughly 6 months and nearly hit $75 at its peak.

This time around, the entire set up is even better with cash per share double what it was then and a backlog that could hit $2.5B. Even with more conservative margins projected, this should result in nearly twice the earnings generated from FY16-FY18. Once revenue starts to flow through the income statement, the stock should inflect.

Valuation

We view Argan as one of the best opportunities in this late cycle economy as it is at the low point before a large profit inflection and is uncorrelated with the overall market. However, valuing it is not easy given the large upcoming profit increase and the large cash balance but we think it’s conservatively worth $70-80/share. Note that the stock peaked at $70 last time (early 2017) and now we project the earning power and cash cushion to be almost double. There’s no close comp to this so we are using a wide set of STRL, TPC, PRIM, MDR, GVA, KBR, SNC:CN, FLR.

We look at valuation in multiple ways:

• Simplistically, you are getting the business for free now at $19/cash + $20/share in earnings in the next 3 years = $5.60 in FY21, $7.50 in FY22, and $7.10 in FY23 (FY20 is irrelevant and we ignore it but we project $1.75.)

• Earnings will not collapse after FY23 as we have not counted 3+ other plants that we know of right now and more will be added in three years time. The company could be making $6/share for a while. At 10x and assuming half of the current net cash is excess you get $70. Comps trade at 9-12x forward P/Es and have substantial debt.

• Applying a trough 8x multiple to $7.50 of peak earnings plus future excess cash you get to at least $80/ share.

• Applying 6.5x EV/E and current cash (which will go up) you get to $70-85/share using our EBITDA projections of $135m, $180m, $170m. Comps trade at 5-9x EV/E. 

Catalysts

1. Full Notice to Proceed on Guernsey, OH project and then Harrison, WV should cause revenue to grow massively in Q3. A very small portion may hit earlier, but we expect Q2 (ends July) to be the last low quarter before the inflection point.

2. Future very likely contract wins announced on Brooke County WV and Harrison County OH inflect revenue further in Q4. We also believe that Reidsville starts generating revenue by Q4

3. Future likely projects wins like Chickahominy (gets financing done), Anderson County SC, Windham CT start contributing next year

4. Return of some excess cash to shareholders via a special dividend once working capital needs for major projects are met (could be as early as this year).

Risks

• Project financing risk. Due to permitting and other delays multiple large projects are competing for financing this year. Our channel checks show that this is progressing as debt financing is being raised and equity follows, with turbine manufacturers pitching in as well.

• Ability to handle 6-7 large projects simultaneously. The company has done this before in FY 2016-2019 with the Panda projects. 

• Project execution risk. Cost overruns would materially harm project profitability and lead to lower margins and possible penalties. Gemma has a stellar record of execution so we think this risk is low.

• Much higher natural gas prices could make such plants uneconomic. Again we think this risk is low.

• Post coal replacement cycle natural gas will eventually give way to cleaner energy sources. We think this is 10-20 years away. 

Catalyst

See Catalyst Section Above