Overview of Investment in Argan Inc. (AGX)

Investment Thesis

Argan Inc. (AGX) is a holding company that owns four operating units including an engineering, procurement, and construction (EPC) company known as Gemma Power Systems (GPS).  GPS specializes in building natural gas power plants for customers throughout the continental US.  It is Argan’s most significant operating company and the driver of overall financial performance.  Argan also owns three other operating units (The Roberts Company-TRC, Atlantic Projects Company-APC, and SMC Infrastructure Solutions-SMC) that generate revenues and profits that are substantially less than GPS. Argan’s shareholder presentation dated September 2020 (here) provides a clear overview of the structure.

I believe Argan's valuation at the recent prices of $35-40 provides investors the opportunity to benefit from the company's lagging price appreciation and current, historically high project backlog.  Investors with a time horizon of 1-2 years could see their investment grow 30-80% in that same time period with downside protection provided by a growing cash reserve that currently stands at over $25 per share.  

Argan is a small-cap company and GPS's size is significanly smaller than other EPC companies normally associated with powerplant infrastructure.  Despite their size, they have built a healthy niche in the area of natural gas-fired plants with a favorable history of execution on these complex projects.  The result as been the ability to produce large amounts of free cash flow at the high point of this profitable and somewhat cyclical business.  As recently as 2017/2018 Argan's TTM FCF reached levels of $800-900M, mostly on the strength of GPS.

However, in late 2017, a growing concern for a dwindling backlog at GPS sent investors running to the exits, driving the price down to the mid $40's after touching a high of $75 earlier in the year.  While the backlog drought was short-lived, the market did not reward investors with a price rebound as the backlog was restored (to all-time highs.)  Additionally, recent losses at APC on a project in the UK seemed to further push investors away at a time when price recovery would be expected. As a consequence, the share price has remained essentially flat for the past three years as the overall markets have moved higher.

Adding to concerns of backlog and execution at APC is a lack of clarity surrounding the performance at all of Argan's three "other" operating units.  Argan does not hold conference calls or provide much in the way of company promotion.  Very little has been communicated regarding plans to ensure these units contribute positively to overall results.  The lack of communication from management on this topic leaves investors uncertain.  Argan’s most recent 10K (fiscal year ending Jan 31st, 2020) contains language that clearly exhibits concern over the performance of The Roberts Company in the years following its 2015 acquisition. 

"...With the reengagement and leadership of TRC’s founder, our financial support and the substantial completion of these loss contracts, we acquired TRC with the belief that it was positioned to succeed in the future with a return to profitable operations. Significant efforts have been expended since the acquisition to sustain a financial turnaround with growing revenues and profitable operating results. Although actual results for Fiscal 2019 were encouraging, results of operations sagged in Fiscal 2020. There can be no assurances that TRC will re-establish the positive trend in revenues or improve profitability in the future..,"

Unsurprisingly, both TRC and APC recorded impairment charges last year. 

TRC and APC’s poor overall performance and the small size of SMC leave GPS as the operating unit that drives Argan’s performance. Unfortunately, even though GPS generally performs very well, Argan’s SG&A costs have gone up substantially post TRC and APC acquisition. It is clear that Argan must deal with their acquisition issues if longer-term shareholder value is to be increased.  There is a possibility that both APC and TRC will be deemed complete acquisition failures and be dealt with accordingly.  Without resolution of these issues, any future discussion from management about acquisitions would likely be met with scorn from shareholders. 

My Position

AGX is my largest position at approximately 15% of my portfolio. I purchased approximately 1/3 of the position in mid-2018 and the rest in late 2019 and early 2020. With the GPS backlog fully restored to $1.2B (additional projects in the queue totally over $3B that are not all bookable), the downside is well protected absent major execution or contract issues with ongoing or future projects.    

As I am now retired with over 1/2 of my living expenses covered by my IRA, downside protection is a major concern for any investment, particularly ones exceeding 5% of my portfolio. AGX provides this protection with the opportunity for good or very good returns and limited downside exposure due to a cash position that has now reached over $400M.  Evidence for the downside support can be seen in Argan's price in response to the market reaction to the Coronavirus.  While the price briefly touched $32 during the depths of the selloff, the share price has now fully recovered as many other industrial companies lag the market.

Future Outlook 

Analyst estimates for 2021, 2022 and 2023 are $0.65, $4.00+ and $5.00+ respectively. There are only 2 analysts currently covering the company and no public research is available. Assuming GPS performs as it has in the past, the share price is expected to rise as the backlog is converted to cash.  However, investors expecting outsized returns from near-term share price jumps are likely to be disappointed. The factors discussed in the investment thesis, high institutional/insider ownership, and the market’s current assessment of value stocks like AGX are all factors holding the price down even though the current fundamentals and future outlook are positive. 

Value estimates from KORR Acquisitions, a fund that holds a substantial position in the stock, range from $75 to north of $90. KORR has recently been active in pushing management to improve shareholder value. The open letter (here) details their view of where value needs to be created. Based on previous FCF with similar revenue in the past, these estimates seem fair or even a bit conservative. Much will depend on GPS’s ability to maintain or grow their backlog as they complete projects. This will continue to be a key indicator that I will be watching in addition to project execution/margins. 

My personal, conservative estimate of fair value (as of Sept ‘20) is $67-$75. I will consider, but may not necessarily, sell 1/3 to 1/2 of my total position within this range. Depending on the outlook at the time and management’s ability to mitigate the company cyclicality issues and improve performance at APC and TRC, I may either hold on to 2/3 of my current position or possibly sell the entire position. I expect to update this write-up when/if the price climb to the $67-$75 range is realized. 

Risks and Drivers Away from Estimated Value 

As with all EPC companies, many of the major risks involve contract and project execution. Generally, this explains much of their low multiples alongside their inherent cyclical nature. AGX and more specifically GPS has a good reputation within the industry for execution. However, Argan has sited in their 10K that a move toward ever greater numbers of fixed price-contracts continues to increase the risk posed by project execution issues. They contend that this has been the driver of some companies’ choice to exit the business of building power plants. A development that is viewed as positive by Argan. With high institutional and insider ownership and considering the backlog and performance issue discussed, the price action of the stock has been focused on current performance rather then any future prospects.  Additional project starts and subsequent revenue improvement is likely to be the key driver of price improvement. 

To the Downside

Argan’s most recent failure in the area of project execution has been with APC who suffered significant losses at the TessRep Project located in The UK. Schedule delays and cost overruns have resulted in major project losses. Management has reportedly put these issues behind them by realizing all of the losses and converting the remaining contract work to time and material. Additional clarity on this project should come over the next 1-2 quarters as the project is completed. However, a similar experience at any other active projects withing APC or GPS could tank the stock price. AGX reports in their July 30th, 2020 10Q that management changes have taken place at APC in response to the issues and losses.

As already mentioned, a repeat of backlog depletion would be cause for divergence from the expected value of $67-75. As this has already occurred recently, any significant backlog reduction over the period of the next 2-4 quarters, could quickly cause the price to fall back to the mid $30’s or possibly lower. 

Although less likely, margin compression on the current book of projects could cause misses to the EPS estimates that are currently in play. 

Lastly, any near-term discussion from management about acquisition targets or similar discussion would almost certainly send the stock tumbling given their recent lack of integration success. No discernible benefit has come from the 2016 acquisitions and any hint of a repeat would be a cause for many investors to consider exiting the stock (including me.) 

To the Upside

The recent announcement of stock repurchases and a special dividend of $1.00/share suggests that AGX management is aware that they need to be more proactive in the promotion of shareholder value as a driver for the stock price. However, the somewhat modest nature of both of these actions has done little to lift sentiment and price beyond their direct calculated values.

Argan has noted in their 10K that the trend toward natural gas-fired power plants and a reduced number of competitors should favor them in the coming years. If Argan can further their competitive advantage in these facilities while standardizing and reducing the risks, upside to the stock estimate could be achieved. However, the growing trend toward renewables in the developed countries could stem the demand for natural gas-fired power plants should policy in the US, UK, and other countries where Argan does business opt to move more aggressively away from fossil fuels. These two trends may very well be offsetting and causing natural gas-fired plants to still be built, but at a reduced rate and with increased public opposition. 

Another upside advantage could come from improving the operating performance and contributions from both APC and TRC. While I have not studied the acquisition case for these units at length, it is hopeful from their statements concerning performance of both of these companies will be converted into actions to improve their relative contribution. Without the benefit of conference calls to probe such issues, investors are left to filing statements to understand actions for the underperforming units.

Last, is the chance that AGX pursues a sale of GPS or the entire company to a larger firm. KORR has been pushing for this route. But without any comment from management, it is difficult to assess this possibility or the premium that such a move would bring. AGX has been silent on any acquisition or divestiture strategy, but the latter seems counterintuitive to their stated position and perceived actions. The ever-increasing cash and cash equivalents that AGX has on the balance sheet makes the possibility of a deal to gain access to unlock that reserve real, if not somewhat remote. A 15-30% upside to the prevailing price might be expected should such an event occur.

sej, sept 2020