Argan (AGX, $16.19) is a high quality, well managed power plant contractor that trades at 1.6x EV/ LTM EBITDA. AGX has a debt free balance sheet and $175M of cash and an enterprise value of $60M. The thesis is:

(1)    AGX is cheap on an absolute basis, and on a relative basis; given its $13 per share in net cash, AGX has significant downside protection.

(2)    Catalyst: construction backlog is set to grow to over $900M on the addition of the two Moxie gas-fired plants in Pennsylvania to AGX’s backlog; AGX’s historically lumpy revenues become more consistent over the next three years as the Moxie plants provide clear sight to significant, high margin, low risk revenues.

(3)    Strong secular trends position AGX well over the next 5 years: natural gas-fueled power plants should continue to grow as coal fired power plant capacity comes off line due to new EPA regulations (MATS), continued economic growth shrinking power reserve margins in key US electricity interconnection markets (e.g. ERCOT, PJM).

(4)    Excellent owner-oriented management/board that owns 11% of the stock and has been returning cash in the form of special dividends for the last two years.

Business Description

-          Current management arrived at AGX in late 2006 (stock price was ~$6) and purchased Gemma Power Systems (“GPS” its current primary subsidiary for $33M in December 2006. GPS designs and constructs natural gas fired power plants as well as renewable energy power plants (wind, solar, biomass). Since current management bought GPS for $33M in 2006, GPS has generated ~$90M of cumulative EBIT.

-          Most of GPS’s current business is conducted on a fixed price contract basis, so there is some risk if they misestimate their costs.

-          We have conducted customer research among GPS’s large customers on recent projects and generally GPS gets high marks for finishing on time and on schedule. While some customers complained that GPS is a bit “change order happy,” most customers were highly satisfied. We were surprised to hear so many positive customer references, as we have researched other construction/contractor businesses in the past and found significantly more customer complaints.

Valuation

-          AGX trades for a forward unlevered FCF Yield of 45% and a forward EV/EBITDA on 2013E of 1.1x

• To put this in context, AGX’s peer set trades for 5.9x-13.5x EV/LTM EBITDA with a median multiple of 8.8x; the peer set includes EME, FLR, FWLT, CBI, SKAB.SS, WG.LN, URS, GVA à AGX is extremely cheap on a relative basis

-          AGX has a debt free balance sheet and cash accounts for approximately 75% of its equity market capitalization.

-          While part of its cash is not truly excess given that it is the result of getting paid by customers faster than it has to pay its suppliers (net billings), we note that large well managed retailers, such as COST and WMT as well as various financial services firms have a similar phenomenon and as long as the business continues as a growing concern, that negative working capital balance should actually grow over time; we believe about $120M of its cash balance is truly excess

• We would also note that to a strategic acquirer, the cash balance would be, in effect, excess cash since a larger acquirer would have its own bonding program

Catalyst

-          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

-          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

-          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

• (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
• (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

-          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.

Secular trends

-          At current and forward natural gas prices, natural gas is a cheaper and cleaner energy source when compared with coal, which will cause natural gas-fired power generation capacity to grow significantly in the US over the next 10 years. We think the CAGR for natural gas-fired capacity should grow mid to high single digits for the foreseeable future as coal-fired capacity comes offline. AGX has significant expertise in natural gas power plant construction and is positioned well to benefit from this trend.

-          In PJM (the regional transmission organization that coordinates the wholesale electricity markets in 13 states, including Pennsylvania), where the two Moxie plants have been permitted, new EPA regulations (Mercury Air Toxic Standards or MATS) will make coal-fired generation capacity even more expensive to maintain. Industry research reveals that 10,000MW of coal-fired capacity will be forced offline in the next two years alone, which will put pressure on PJM’s reserve margin (the capacity buffer for electrical generation) as the population and electricity demand continue to grow.

Management

-          Rainer Bosselman, Chairman and CEO of AGX, runs the company as an owner as he and the Board own 11% of the shares.

-          Bill Griffin, the CEO of their primary subsidiary GPS, owns over 5% of the company and is on the Board.

-          The management has consistently focused on risk management, acknowledging that their fixed price contracts expose them to the risk of losses if not properly estimated and managed.

• Rainer has repeatedly walked away from project work due to excessive risk and inadequate margins; given that he is willing to forego revenues when they are not priced properly,  cash flows have been lumpy.
• He has focused his efforts on minimizing the risk of losses from the naturally asymmetric risk/reward inherent in fixed price contracts.

-          Management has been returning cash via special dividends for the last two years and have signaled their intent on continuing that trend this year. Assuming the trend continues, AGX will pay out $.70 per share this year, or about 4.25% of the current share price.

Why is AGX so cheap?

-          Virtually no sellside analyst coverage.

-          Size and insider holdings make AGX illiquid.

-          Management does not do quarterly earnings calls.

-          Lumpy/volatile annual results due to project nature of the business.

Risks

-          Project work is lumpy

• Moxie plants should give us visibility in terms of revenues over the next three years

-          Earnings / margin risk due to fixed price contracts

• Management has historically walked away from low margin business and GPS has done an excellent job estimating its costs as evidenced by its performance over the last 6+ years.
• Moxie plants allow GPS to control margin risk since they are specified as the sole possible contractor in the EPC contract, so effectively there was no competition on these deals.

-          Cash balance is not as high as it seems due to negative net customer billings of ~$72M

• This negative working capital is effectively AGX’s float and is a natural feature of their business, so assuming the business is not being liquidated, it should remain an attractive feature of their business and if interest rates are ever higher, it should be a nice source of interest income earnings.

-          Macro risk

• Protected to some degree by the safe balance sheet and large cash holdings

-          AGX’s Gemma Power Systems Division’s Moxie JV has permitted two new power plants in the Marcellus Shale region of Pennsylvania, and GPS is specified as the sole EPC contractor on these construction projects. Each 800 megawatt plant will produce ~$400M of revenues for AGX’s GPS subsidiary.  In addition the company will receive up to $35M of development success fees and the repayment of short term loans if and when the projects commence. This would put AGX’s adjusted cash balance over $200M

-          The Moxie plants (Liberty and Patriot) are in the process of securing financing and it has been reported in an industry trade magazine that Panda Power Funds is the potential owner/buyer of the two Moxie plants and is in the process of securing financing. The market for power plant financings is strong and Panda is the premier private equity player in this space, having successfully financed two nearly identical natural gas fired plants in Texas (Panda Temple and Panda Sherman in July 2012) in a more difficult financing market/environment.

-          Importantly, the margin/risk profile of the Moxie deals is more attractive than a typical contract since AGX funded the development of the projects, which has two important implications:

• (1) GPS /AGX is the sole contractor allowed to bid on the deal and guarantees an attractive margin to GPS/AGX
• (2) GPS/AGX could receive up to $35M of development success fees and loan repayments when construction commences

-          We believe that GPS/AGX will receive the final notice to proceed on both Moxie Liberty and Moxie Patriot sometime this year, as management has outlined in its most recent 10-K filing.