Argan: Bright Past, Murky Future

On almost all valuation metrics, Argan, Inc. (AGX) looks to be obscenely cheap. Furthermore, when looking in the rear-view mirror, it looks to be a decently high-quality company for the industries it operates in. When presented with such an opportunity, investors should pause and ask why the market is being so nice to give them this sort of opportunity in the first place. As I will show, while the past looks great, the future is far too unclear to make any sort of conviction investment in Argan. Instead, taking a smaller position as part of a larger basket of similar stocks that the market seems to be overly pessimistic on seems like the way to go.

Company Description

Argan is a holding company with four wholly owned subsidiaries: Gemma Power Systems (GPS), the Roberts Company (TRC), Atlantic Projects Company (APC), and Southern Maryland Cable (SMC). For reporting purposes, Argan segments these subsidiaries into three segments: Power Services (GPS, APC), Industrial Services (TRC), and Telecom Services (SMC). The vast majority (i.e., ~90%) of AGX’s revenue comes from the Power Services segment, with Gemma Power Systems providing the overwhelming majority therein.

Source: Argan Investor Presentation

As such, an investment in AGX is primarily an investment in the future outlook of Gemma, and that’s what this article will mainly focus on. Gemma is engaged in the engineering, procuring, and construction (EPC) business. Over the last several years, Gemma has largely driven revenues for Argan through the design and construction of natural gas-fired power plants. Thus, conceptually, it is helpful to think of Argan as a turnkey service provider to developers to help them design and build power plants. As a service provider, per its balance sheet, most of Argan’s assets are current assets, with no PP&E to fall back on as any sort of valuation bulwark. Thus, Argan’s business value will come essentially solely on the basis of the cash flows it can be expected to generate into the future.

Recent History

The last several years have been very good for Argan. Revenues and EPS have been growing at a nice clip:

Source: Argan Investor Presentation

This has translated into great numbers regarding measures of the quality of the company, like ROE (28.68% ttm), FCF margins (20.28% ttm), Gross margins (19.01% ttm), all of which are fantastic numbers, especially relative to competitors in their industry. Moreover, Argan has no debt, and officers and directors of the company (12 persons) hold a significant percentage of outstanding stock (7.64%, per the May 2017 proxy statement).

Future Outlook

So why can you currently buy AGX’s shares for a seemingly bargain basement price of roughly 8x ttm earnings, or an even much lower number if you look at it on an EBITDA basis (i.e., management’s preferred metric)? Prospective investors could be na茂ve and extrapolate the above revenue and net income charts indefinitely into the future (which, obviously, was almost certainly the intent of their inclusion in the investor presentation). But one should ask oneself what reason there would be to do this.

As a service company, as mentioned previously, we need to have an idea of Argan’s prospective cash flows into the future. In the extreme, if Argan has no expected cash flows into the future, its value must be something like its liquidation value, which, using Ben Graham’s old Net-Current-Asset-Value model equates out to roughly $18-$19/share – i.e., greater than 50% downside from current levels. Presumably, Argan will have cash flows into the future. So what can a prospective investor estimate those cash flows will be? Per their most recent 10-Q, Argan’s backlog is as follows:

Source: Argan 10-Q for period ending 10/31/17

I have been able to find no insight from management (beyond vague promises and intentions which can serve as no basis for a conviction investment) about what’s to come after these projects are completed. Furthermore, remembering that Gemma’s construction of natural gas-fired power plants has been the main revenue driver for Argan over the last several years, management interestingly says the following in the same 10-Q (emphasis added):

In summary, the development of natural gas-fired and renewable power generation facilities in the United States should continue to provide construction opportunities for us, although the pace of new opportunities emerging may decrease in the near term.

This is consistent with the following chart from the EIA:

Source: U.S. Energy Information Administration

The main import of this chart is that the EIA projects very little in the way of natural gas capacity additions during the period of 2019-2023 with the vast majority of capacity additions going to wind and solar during that time. This is precisely the important time frame for Argan for which we have no information from management (or elsewhere as far as I can see) about its winning of new contracts and replenishing of its rapidly depleting backlog – this winning of new contracts being precisely the sort of thing needed to generate the same sorts of revenues into the future which it has generated in the recent past primarily from natural gas-fired power plant constructions.

One might be suspicious of the EIA’s projections due to, for instance, the economics surrounding wind and solar power facility construction versus natural gas-fired plant construction. In fact, I’ve seen other-end-of-the-spectrum estimates which suggest there might be something like 150 new natural gas power plants coming online by 2020. If this latter were to come to pass and Argan could get a small piece of it (which would be the only reasonable expectation), that would be a tremendous boon to the business and the stock. If something like the EIA’s projections come to pass, that could be an unmitigated disaster for the business and the stock. The point is that there is just too much variance of potential outcomes here to make heads or tails of it.

The Upshot

Because of this wide variance in potential outcomes, for me, Argan entails too much uncertainty to take a sizable position, in percentage terms, as part of a portfolio. However, I do believe that it would serve well as a small position in a basket approach which attempts to buy statistically cheap stocks in the hopes that the market is overly discounting said stocks relative to their future prospects. In fact, this is what I am doing with Argan. Riding alongside insiders who have a significant stake in the company’s success together with the existence of a debt-free balance sheet which offers the prospect to navigate through tough times – this to me justifies taking exposure in what looks to be a possibly obscenely cheap opportunity, even if the opportunity doesn’t merit taking a large position due to the risk and uncertainty.

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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