I heard about this company when Tobias Carlisle piteched it on Investor’s podcasts episode 188 Tobie is the founder of Carbon Beach Asset Management and an author of Deep Value. I admire him for his thoughtful picks and good research. I decided to look into this when I found similarities with Argan and ideas mentioned in Mohnish Pabrai’s book, ‘Dhandho investor’ which advocates investing in low risk; high uncertainty businesses.
Complete report – Download – Argan Inc (AGX)
Argan Inc is a holding company established since 1961. It earns 90% of its revenue from Gemma Power Systems (GPS) which provides Engineering, Procurement and Construction (EPC) services to build natural gas-fired as well as renewable energy power plants. GPS has installed 15,000 MW of power plants and completed 40 turnkey projects in the last 20 years. Argan has a strong debt-free balance sheet and a cash worth of $434 Million. Their operating margins are around 13%. Return on equity is at 22% whereas sector median is 11%. Book value has been growing at 20% CAGR for the last 10 years. Currently, Gemma has a backlog of $600 Million which is likely to complete by 2019. The other 3 subsidiaries provide industrial shed, equipment installations, and telecommunication services.
Historically, coal has been the major source of energy and most of the plants in the U.S were built in the 1970s with 30-40 years of efficient lifespan. Recent technological advances gave birth to new and inexpensive means of recovering natural gas from shale rock formations. Thus, made available an abundant supply of cheap, less carbon-intense and higher efficiency natural gas. This has resulted in an increase of gas power plants from 21% to 32% since 2008. Natural gas power plants are 16% less expensive in operation than coal power which thus becomes an obvious choice. Moreover, energy code compliance (MATS) has forced owners to shutdown/replace old coal-based power plants with more environmentally friendly natural (clean) gas power plants. Overall, there is a moderate demand for construction of new natural gas power plants as old plants retire.
Gemma power is a comparatively small but very well managed player among big corporations such as Fluor & Kiewit. Being small is actually their competitive advantage since customers can always expect an A team from Gemma whereas their competitors could provide B or C teams depending on the size of the project. CEO of Gemma, William Griffin is an excellent executor and has shown an ability to convert large backlog worth 1.5 Billion into revenue. However, management has not been diligent about their recent acquisitions which is a cause for concern.
Historically, Argan’s top line has grown at 15% and had a free cash flow of $34 Million on an average for last 10 years growing from $19 Million (Avg of 2009-13) to $66 Million (Avg of 2014 to 2018). That’s around 13% CAGR. Assuming the company grows its free cash flows at 10% a year for the next 10 years and we sell the business at 10 to 15 times its 10th-year free cash flow. That gives us a market cap of $1,101 Million (70$ per share). The current market cap of $620 Million ($39 per share) assumes only $20 Million of cash flows that do not grow at all. Thus, the company looks undervalued with an intrinsic value being in the range of $50 to $70. That’s 44% margin of safety to the current price. (Detailed DCF analysis in the complete report)
It’s clear that there is much uncertainty about how this might play out. Markets hate uncertainty and that’s exactly the case for Argan Inc. Argan has no future work. The last couple of poor acquisitions have made Mr.market trust less on Argan’s management. However, the company has a strong balance sheet and Gemma power has shown consistent ability to deliver and generate revenue from its backlog in the past. Thus, I think this is low-risk; high uncertainty bet. Wall Street cannot always distinguish between risk and uncertainty. Savvy investors like Mohnish Pabrai and Warren Buffet have been taking advantage of such situations in the past. However, I do not think this is a high-quality business with a sustainable moat around it. One of the basic questions I ask myself after all the analysis is if I am willing to put 25% of my net worth to buy this business. If the answer is no, I don’t buy a share. If the answer is yes – I invest 5 to 10% position. Argan is definitely a bargain in the highly overvalued market at the moment. I would be very interested to see how this plays out in the future.
Disclaimer: This is not a stock tip. These are my personal opinions for educational purposes only. Anyone who invests in any company needs to do their own due diligence and are themselves fully responsible for the outcome.