Description

Argan (AGX) has 50% upside over the next 6-months as the company is on the cusp of booking $1.4 billion in new business, a significant value for a company that generated LTM revenues and EPS of $378 million and $2.00, respectively.  The new awards should generate roughly $210 million of EBITDA over a 3+ year period, or roughly 70% of Argan’s enterprise value. When coupled with existing backlog, Argan should generate $3/share of annualized earnings over a multi-year period, which we expect will produce a $50/share stock. Despite industry leading fundamentals ($12/share of net cash, 50% earnings growth and 3.5x book-to-bill), AGX still trades at a 40% discount to peers.

While we provide a brief background below, this write-up will focus primarily on the company’s current situation. Those seeking a more detailed overview of Argan should refer to Archer610’s VIC write-up posted in May 2013 and the Sum Zero write-up posted September 2013.

Background

We initially became investors in AGX in July 2013 when the stock was $16/share. The thesis was predicated on the “Moxie Award” – two natural gas fired power plants worth $800 million that would transition Argan’s financial profile from low visibility, volatile earnings to high visibility, growing earnings. Argan won the award and executed above plan on construction, driving the stock to as high as $41/share.

Despite earnings growth that has consistently beat market expectations, the stock drifts lower as Argan has yet to replace the high margin Moxie backlog. The key investment controversy: can AGX replace the high margin backlog that has steadily depleted over the last 18-months and if not, will FY15 (last year) mark peak earnings?

Key Investment Points

1. We are tracking $2 billion of near-term awards of which we believe Argan could book $1.4 billion, providing visibility into $3/share of normalized earnings over a multi-year period. Similar to the Moxie award in 2013, Argan would once again have industry leading fundamentals (3.5x book-to-bill and 50% earnings growth) at a 40% valuation discount to peers.

2. Increased bonding capacity should increase Argan’s earnings power by 100%.

3. Net cash of $172 million ($12/share) could yield an additional $5-10/share of upside to our estimates if partially deployed.

Key Investment Point #1: Bookings Should Drive Normalized EPS to $3/Share Through FY18

Our channel checks suggest Argan is bidding on $2 billion of projects. We believe the company is likely to book at least $1.4 billion in the next year -- $450 million could be booked in the next month.  In total, Argan would generate $210mm of EBITDA on these contracts, or roughly 70% of its enterprise value. In conjunction with the $423mm current backlog, Argan should generate $3/share of annualized earnings over a multi-year period.

We summarize the larger bidding opportunities below:

1. NTE Energy ($550 million opportunity for AGX): NTE Energy is in the process of developing three electric generation facilities. Two of the facilities – Kings Mountain and Middletown – should be awarded in the near term and we believe Argan could secure these. From a project level standpoint, NTE Energy has 1) already secured equity financing (Capital Dynamics and Guggenheim), 2) lined up Power Purchasing Agreements, and 3) received the necessary regulatory permits. For Argan to be a beneficiary, NTE needs to obtain debt financing and sign an EPC agreement. Our research indicates Argan may have already signed a letter of intent for both facilities, and we note the company’s strong relationship with NTE management (several are former Argan employees) and experience with like projects (essentially in AGX’s sweet spot).  We analyze each opportunity below:

    

   1. Kings Mountain Energy: a 475MW natural gas electric generating facility in Cleveland County, NC. Debt financing was recently launched by MUFG Union Bank and ING Capital. Upon closing of the financing, we would expect an EPC agreement and Formal Notice to Proceed. We expect this to occur in the coming weeks with work to begin in June. We estimate the value to Argan at $275mm.

       

   2. Middletown Energy: a 525MW natural gas electric generating facility in Middletown, OH. Debt financing was recently launched by BNP Paribas and Credit Agricole. Upon closing of the financing, we would expect an EPC agreement and Formal Notice to Proceed. We expect this to occur in the coming weeks with work to begin in June. We estimate the value to Argan at $275mm.

       

2. Moxie Freedom ($425mm opportunity for AGX): In addition to Moxie Liberty and Moxie Patriot, Moxie Energy LLC is proposing to develop “Moxie Freedom,” a 900MW gas fired facility located in Salem Township, PA. Moxie Energy has already lined up an equity partner and received most of the necessary permits.  Argan has provided pre-development financing for Freedom, giving them first right of refusal for the EPC contract. Similar to Liberty/Patriot, this provides us a high degree of conviction that should financing be obtained (which we believe it will), Argan will receive the EPC contract. Upon signing, Argan would also receive a $4mm success fee. We expect a contract in 4Q15/1Q16 with construction ramping in 2H16. We estimate the value to Argan at $425mm.

    

3. CPV Towantic ($350mm opportunity for AGX): An 805MW natural gas electric facility in Oxford, CT. The project is led by CPV, who has a successful history working with Argan. While the project has been around for some time, we believe it could get accelerated given Global Infrastructure Partners recently acquired Warburg Pincus’ majority equity stake in CPV, providing additional growth capital. We believe a contract will be awarded in Q3 with work to start in Q4. We estimate the value to Argan at $350mm.

    

4. Panda Hummel ($500mm opportunity for AGX): Panda Power Funds (owners of Moxie Liberty and Patriot) are developing a 1GW natural gas facility in Snyder County, PA. Construction could potentially start late this year. Panda typically reserves these jobs for Bechtel, but specifically asked Argan to bid given their strong performance on Moxie. This is excluded from our estimates and would represent upside.

Key Investment Point #2: Increased Bonding Capacity Increases Earnings Power by 100%

The largest constraint to Argan’s activity in the last 2+ years has been its bonding capacity, a key requirement to signing EPC contracts. Until recently, Argan’s bonding capacity was around $400-500 million. When the company was awarded $800 million of work for the Panda Projects, they were required to find a JV partner (in this case Lane Construction) purely for added bonding capacity. As seen in the Moxie Projects, this was costly to the tune of 25% of profits. Given the size and scope of projects Argan has recently completed, its bonding agent has increased capacity to $1 billion, thereby eliminating the need for a JV partner. This essentially doubles the earnings power of Argan.

Key Investment Point #3: Free Optionality on Cash Balances

Argan currently has $12/share of net cash on the balance sheet and we estimate this will grow to $15/share by the end of the year. The company has used its cash to pay special dividends for the last three years and we believe it will do so again in September. Argan has been reticent to use its cash so as to avoid straining its bonding capacity. However, now that there is additional flexibility in that regard, we believe the company will increasingly look towards acquisitions. While the Gemma acquisition would be nearly impossible to replicate, we believe management is looking for a similar structure – namely, a tightly controlled business that could be acquired for less than 5x EBITDA and use Argan as a public vehicle. We believe the company could close an acquisition this year. If Argan acquires an $80mm company for 5x EBITDA, it will be roughly $0.70/share accretive. A 10x EPS multiple would add 20% to the stock price.

Conclusion / What Happens If We Are Wrong?

Predicting bookings for E&C companies is typically a futile exercise. There are usually too many dynamics at play to not only determine a project’s success and timing, but also to determine the contractor. That being said, our prior success investing in the sector rests on a few laurels: First, our interest is only peaked when development projects reach maturity and are near construction. Hence, we mitigate pre-development risks such as securing working capital financing, a Power Purchasing Agreement (PPA) and regulatory permits. Second, we only like to become involved at the time of project financing. At this point, the uncertainties that remain – securing financing and an EPC contract – are (somewhat) analyzable. Finally, we need to have some level of conviction that the investment prospect is going to be selected as the builder and the margin profile compensates for the risk.

We believe these criteria have been met. Specifically, an increase in bonding capacity, all-time high bidding pipeline, and conviction on winning new business leads us to believe we are entering a period of increased normalized EBITDA and EPS of $70mm and $3.00, respectively.  At 7x FY16 EBITDA and 12x EPS, the stock would be valued at $50/share (50% upside from the current price). Valuation would be in line with peers despite Argan’s superior fundamentals.

Let’s assume we are wrong and Argan does not book the new business as we anticipate. At this point, the company has roughly 1.2 years of backlog before it needs to book new business. In this case, we expect Argan to revert to “old” normalized EBITDA and EPS of $30mm and $1.50, respectively. At 6x FY16 EBITDA and 8x EPS, the stock would be valued at $27/share (18% downside from the current price). This does not include any accretion from capital deployment.

Catalyst

1. $1.4 billion of new bookings -- $450 million could be booked in the next month.

2. Deployment of excess cash.

3. Special dividend.