LICY - Argan Is A Deep Value Stock With Positive Long-Term Potential

2023-03-16 17:07:33 ET

Summary

• Argan, Inc. is trading at a deep discount compared to its peers.
• The recently passed IRA will open the door for EPC projects across the Midwest and East Coast.
• AGX may experience some near-term volatility in share price, and any pullback is a buying opportunity.
• Renewables will require fossil fuels and batteries for backup capacity for grid integrity, adding a greater long-term potential for AGX.

Argan, Inc. ( AGX ) is in an interesting position to take advantage of the current drive for energy security across the US, EU, and UK. With their expertise in power transmission across most fossil fuels and renewable resources, AGX has the ability to take advantage of grid modernization in the US and the need for energy security in the EU & UK. As of Q3'23, AGX has a backlog of $800mm and a RUPO (remaining unsatisfied performance obligations) of $328.1mm. 30% of GUPO, or $100mm, is to be used for the remainder of FY23, with the remaining $228mm in FY24. Despite FY23 being a relatively lackluster year for growth, I believe the long-term outlook for EPC projects will be very prosperous for AGX in power transmission. AGX currently trades at a deep discount to its peers at 5.25x EV/EBITDA. Using average comps from their peers, we can come up with a multiple of 15.88x for a share price of $69.97. For a long-term strategy, I give AGX a buy rating.

Operations

AGX has experienced some growth challenges throughout FY23 given the global power transmission market. With industrial services driving nearly 80% of revenue and the last three quarters experiencing contraction, it is apparent as to why the market prices AGX at a discount to its peers. One major challenge to overcome is the completion of the Guernsey Power Station, which accounted for 57% of their power industrial services segment for FY22. As this project rolls off in early CY23, much of their revenue stream will need to be replaced.

Despite these recent drawbacks, AGX has successfully managed their costs and maintained gross margins to a certain degree. Because of their limited press releases and omittance of conference calls, it is challenging to speculate on a quarterly basis. Given what I know about their GUPO of $100mm and recent trends in Industrial Services and Telecom, I believe AGX may experience a -9% decline in revenues of ~$461mm with EBITDA of $41.5mm, assuming a slight margin contraction.

Their two industrial services subsidiaries, GPS & APC, have deep backlogs that include the Maple Hill Solar facility in Pennsylvania and a natural gas-fired power plant for PEUKI in Belfast, Northern Ireland, both of which are expected to be completed by this time next year (FY2H24). Their ATX unit was also awarded a construction services contract and has received full notice to commence in May 2022 to construct three 65MW natural gas-fired power plants across Ireland. GPS also received full notice to begin EPC services for a 950MW natural gas-fired power plant in Lordstown, OH with an expected completion in CY26.

Presented below are the average incremental costs per kW for constructing a new plant for 2020, as presented by the EIA . These costs may not be accurate for today's pricing; however, they should help paint a picture for future development.

The below figures combine the figures from the above chart and what we know about the capacity of the power plants in AGX's backlog. These figures are rough estimates of the total construction costs and may significantly vary depending on the region. The EIA will publish 2021 figures in July 2023.

Major costs that AGX will need to be mindful of in bidding for new contracts include the price of steel, copper, concrete, and fuel. Given that copper, steel, and fuel prices have all averaged up over the last three years, and that AGX does not hedge their commodity exposure, we can discern higher revenue growth with cost flow through to build these facilities. Based on their outlay of fixed-price contracts, this may hurt margins in the near term; however, management has outlined in their 10-K that the industry is beginning to avoid these types of contracts in the industrial services space in favor of time-and-materials contracts.

Looking ahead, I expect the recently passed Inflation Reduction Act to spark new projects across the US for AGX's industrial service and fabrication businesses. Given the key expansions in clean power generation, minerals mining, refining, and semiconductor production, and nuclear, as well as the recent public sympathy towards natural gas and nuclear in the EU, I believe AGX will see a significant amount of growth opportunity over the next 5-7 years. The first loan for $375mm has already been granted to Li-Cycle ( LICY ) to develop a battery materials recycling plant in Western New York.

Capacity replacement will be a major catalyst for AGX. The EIA estimates that 28% of the US-based coal-fired power plants will be retired through 2035. This equates to 59GW of capacity. Though we cannot speculate which energy source will be chosen to replace this capacity, we can discern some details based on public consensus and regional challenges presented from extreme weather. With the assumption that wind and solar energy will be expanded, governments have made it clear that gas-fired power plants will be utilized as backup capacity. We can also expect that battery storage capacity will need to be built out for backup generation for nights and tame winds. This poses an opportunity for the EPC space on multiple fronts and can potentially lead to some massive expansion.

PJM projects roughly 40GW of capacity to retire through 2030, 25GW of which is driven by policy. This represents 21% of the current installed capacity.

One of the benefits of PJM's data is that it mostly pertains to geographies that AGX does business in; much of their construction projects reside in the Midwest and East Coast regions. Considering the vast amounts of retirements set throughout the next 10-12 years, we can expect a strong long-term outlook for the EPC services space as new capacity is built out and brought online.

Risks

There are many risks to be mindful of when considering AGX as an investment. There have been multiple projects cancelled in recent years, including a 650MW natural gas-fired power plant in Connecticut and a 1,740MW natural gas-fired power plant in Virginia. AGX accounts for these projects utilizing VIEs and provides financing through Argan Holding Co. and had to write off these charges. The potential for project termination adds challenges to the predictability of future cash flows, even after notice to proceed has been granted.

Other challenges include commodity prices in relation to quoting fixed-price contracts. Given that AGX does not hedge their commodity exposure, this may lead to uneven margins when estimating performance on a short-term basis.

Financing future projects may also pose a significant risk for AGX. As the Fed increases rates, taking out loans can add additional costs to the end-client and projects may inevitably be delayed or cancelled. The Wall Street Journal recently published a report on the challenges faced in developing offshore wind farms given the current macroeconomic outlay. Avangrid, a subsidiary of Iberdrola, has recently requested termination of a 1.2GW project off the coast of Massachusetts due to higher financing costs. Though the IRA was passed to provide financing to these types of projects, these guaranteed loans are tied to the 10-year treasury and may only offer slightly better pricing over investment grade debt. Also, given recent events in the banking sector, receiving long-duration loans may be delayed until these liquidity challenges are resolved. Despite major projects like this being delayed or terminated, this can have a potential benefit to promote natural gas-fired power plants.

Other risks involved include transportation costs, sourcing labor, labor costs, and public policy and geopolitical risks.

One risk I will note is a potential cut to their dividend. Argan utilized cash to pay out their dividend in FY20 and FY21 due to disruptions in the global market. Though their current payout ratio sits at 42%, future fluctuations in earnings may add further stress to their cash position. It is unlikely that this measure will be taken, but it is important to be mindful of it.

Shareholder Benefits, Valuation, & Conclusion

Argan does hold some significant shareholder benefits, including share buybacks and a stable dividend. Argan has recently increased their share buyback program from $100mm to $125mm. They also offer a flat $0.25/share quarterly dividend, with a forward yield of 2.82%. The downside of their dividend is that it is a flat rate without any indication of growth. They have, however, paid out two special dividends in 2020. Though we cannot expect special dividends to be paid out regularly, we can potentially expect that management will grant special dividends upon the completion of major projects that add a significant amount of cash to the balance sheet.

On a valuation basis, I used an average EV/EBITDA multiple of AGX's peers to come up with a $70 price target. Given their long-term growth potential as the power transmission landscape modernizes, I expect AGX to experience a strong decade of performance. I give AGX a strong long-term buy rating and suggest dollar cost averaging throughout the next few quarters.

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