Value Line Institutional Services

 

December 2016

Our digital Institutional Small & Mid-Cap Bulletin for professional subscribers offers powerful content featuring a pair of companies not often covered by sell-side analysts. Two stock highlights, one geared toward momentum investors and the other for buy-and-hold accounts, offer readers current, unbiased recommendations with in-depth analysis. These monthly featured stocks are among the approximately 1,800 that appear in The Value Line Investment Survey® — Small & Mid-Cap. Tap into Value Line's equity coverage, where you'll have access to complete content, and the ability to create watchlists and alerts based on the featured companies offered in this exclusive bulletin.


Momentum Investment

Argan Inc. (AGX)

By Jeremy Butler, Editorial Analyst

Argan Inc. provides an array of services to the power generation and renewable energy markets, including engineering, procurement, construction, commissioning, maintenance, development, and consulting services. It provides these services to independent power companies, public utilities, municipalities, public institutions, and private industry. Its main lines of work are building power plants and signing service contracts with existing plants for maintenance, repair, and related work. The company was incorporated in Delaware in May, 1961, has about 1,200 employees, and is headquartered in Rockville, Maryland.

An Interesting Momentum Pick
Since the Presidential election in the United States, shares of Argan have moved notably higher in value. This appeared to stem from the possibility that greater national infrastructure projects and a renewed focus on creating manufacturing jobs, policy proposals put forth by President-elect Donald J. Trump on the campaign trail, will spur a need for more low-cost power. Argan is in the business of providing services (including construction) to companies that operate gas-fired power plants and renewable energy facilities. These companies would likely be vital to providing the low-cost power necessary to drive this long-term activity. In fact, according to the American Society of Civil Engineers, infrastructure funding required through 2020 tallies $736 billion for electricity (power grids, etc.) and $1.72 trillion for surface transportation needs. While competition is stiff (the company’s rivals include Bechtel, Fluor, the SNC-Lavalin Group, and Chicago Bridge & Iron, to name a few), Argan has been capturing market share from its larger-cap peers in recent years thanks to its speedy turnaround times, very competitive fee structure, and comprehensive range of services. All told, while the equity’s recent price increase does add an element of risk, we believe that its gains have not run their course, and we view Argan as one of the faster-growing entities in the infrastructure repair/renewal space.

In addition, Argan’s management team has stated its intent to accelerate its acquisition strategy and purchase bolt-on businesses that have the potential for rapid growth. The company expects to do this prior to a more meaningful rise in interest rates, which have been moving higher since the Presidential election. The company’s debt-free balance sheet, ample cash flow, and large amount of cash on hand give it significant financial latitude in this regard.

Solid Second-Quarter Results
Argan delivered very strong results in its fiscal second quarter (ended July 31st.). They were driven by the completion of two large service projects, as well as the favorable settlement of a $12.9 million liability suit. Revenues of $163 million were well ahead of Wall Street’s consensus forecast of $149 million and 67% above the year-earlier tally of $97.4 million. Share earnings (on a diluted basis) were up a prodigious 72%, to $1.29. This was thanks to higher sales, lower expenses, and the aforementioned legal settlement, which should also result in lower costs for Argan over the next few quarters. Project backlog doubled to $1.32 billion, from $660 million in the second quarter of last year. This was thanks to an increased number of service contracts. On a side note, the company’s Ireland-based subsidiary, Atlantic Projects Company (APC), suffered from the United Kingdom’s vote to leave the European Union, which contributed to the suspension of work on APC’s largest project. Specifically, the $20 million Mayo renewable biomass project in Ireland was canceled after the developer wasn’t able to secure financing due to anxieties resulting from the Brexit vote.

The Project Pipeline Is Expanding
Argan’s second-quarter results were the best in the company’s history, and they are liable to get even better. This is because the company has a record number of engineering, procurement, and construction (EPC) projects in its pipeline (five). Four of these are moving along as expected. The exception is the Medway power plant project, as final approval by Medway’s board of directors has yet to be received. We do, however, anticipate approval within the next few months. All five of these EPC projects are expected to be completed over the span to 2018, and we look for the company to bid on, and win, further projects over that time frame. In fact, the number of gas-fired power plants being built is expected to climb over that span, giving Argan ample opportunity to capture more service and/or EPC contracts.

Of note, Argan’s five-largest customers account for 77% of total service revenues. Since these customers consist mainly of public utilities and public institutions, the risk of cancelation is low, although the concentration does add an element of risk. Future contracts are likely to be with similar types of clients. All told, we expect Argan to earn $3.70 a share on sales of $670 million in fiscal 2016. We look for these tallies to rise to $3.80 and $710 million, respectively, in fiscal 2017.

Conclusion
Argan’s relatively small size enables it to operate on a more nimble basis than its larger-cap peers. This is thanks to more personal service, which speeds up turnaround times. In addition, it has a favorable track record at executing its services in a high-quality manner and on schedule. Furthermore Argan’s fees are highly competitive. Despite Mr. Trump’s call to bring back more coal mining, we believe cleaner-burning, lower-cost natural gas will remain the go-to choice for many power generation operators in the public and private spheres.

Despite this stock’s recent price rise, we think the likelihood of increasing sales and earnings over the next few quarters, helped by a rising number of service projects, will keep the stock headed on an upward trajectory. We also note the company’s ample financial flexibility to acquire bolt-on businesses that would complement its existing enterprises. This would likely expand its earnings potential beyond our estimates. Momentum investors are encouraged to take a look at this stock.


At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.


Long-Term Investment

Energy Recovery, Inc. (ERII)

By Kevin Downing, Editorial Analyst

Background

Energy Recovery’s (ERII) products are utilized in applications such as water desalination and oil and gas drilling to make industrial fluid flow processes more efficient. Most of the company’s revenue is currently generated from water desalination customers ranging in size from facilities on cruise ships and in resorts to large-scale plants. The primary water technology, PX Pressure Exchanger, saves desalinization facilities up to 60% of their electricity costs by capturing energy that would otherwise be wasted. It also lowers capital expenditures by reducing water pump size requirements. Currently deployed PX products save customers in excess of $1.4 billion in energy costs per year and significantly reduce plant carbon dioxide emissions.

In an effort to diversify product offerings and expand its addressable market, the company has adapted the same fluid dynamics principals used in its water technology for applications in the oil and gas sector. Specifically, the VorTeq system is used in hydraulic fracturing, a well-stimulation technique where rock is fractured by the injection of a highly abrasive pressurized fluid into a wellbore to create cracks in deep-rock formations, thereby permitting oil and gas extraction. Conventionally, the abrasive fracking fluid passes through pumps that pressurize it. This process puts a lot of wear and tear on the pumps, resulting in excessive downtime for repairs and maintenance. The VorTeq solution instead has water pass through the pumps, transferring hydraulic energy to the fracking fluid to pressurize it. Since water is nonabrasive, the lifespan of the pumps is extended, saving customers significant capital and operating costs.

Schlumberger Deal

On October 19, 2015, the company reached a deal with Schlumberger Technology Corp. (the world’s largest oilfield services provider) for exclusive rights to the VorTeq hydraulic pumping system. The agreement stipulated that Schlumberger pay a $75 million exclusivity fee immediately, which is being amortized over the course of the 15-year agreement. Separately, Energy Recovery is set to receive two $25 million payments that are subject to the completion of two testing milestones. Most importantly, the deal is expected to yield continuing annual royalties of $80 million-$200 million, or approximately 2x to 4x the current annual revenues of the core Water business.

In the months following the announcement, the shares appreciated from $2.46 to the current 52-week high of $15.98. Since that peak, however, the stock has depreciated over 30%, owing largely to news that the two milestone payments will likely be pushed out to 2017. Specifically, the company initiated testing for the first milestone and discovered that under full flowing pressure conditions, reliability concerns had arisen. Simply put, the piping and routing apparatus—a.k.a. the “missile”—is vibrating too much to pass the initial commercialization requirements. Fixing the problem is a collaborative effort, as the company is now relying heavily on Schlumberger’s engineers for their missile design expertise. A complete redesign was not ruled out. While management certainly appears to have the shortest route to approval and commercialization in mind, it revealed that it “will not trade short-term gains for longer-term uncertainty.” When pressed for a time frame if a complete redesign is in fact necessary, Energy Recovery said this could exceed 16-20 months. Encouragingly, however, Schlumberger’s comments on the matter suggest it has confidence in the technology’s ultimate potential for commercialization.

Growth Drivers

Population and economic growth in emerging markets, such as India and China, are driving water demand for human, agricultural, and industrial use. Meanwhile, the company anticipates that markets traditionally not associated with water desalination, including parts of the United States, will inevitably develop a need for the technology as current resources become strained. 

On the oil and gas front, recent oil price trends are a bit of a double-edged sword. When oil prices are low, as they are now, exploration activity tends to decline. At the same time, that environment makes customers more inclined to seek a cost advantage and, thus, more willing to implement nascent, innovate technologies such as VorTeq.

Assuming VorTeq passes muster and becomes commercialized (as we think it will), it may well enjoy a demand environment that’s significantly improved from recent conditions. Indeed, President-elect Donald J. Trump has expressed aspirations to make America energy independent and to create jobs. This might entail opening up more federal lands to drilling and/or easing regulations on fracking.

Finally, additional applications for the company’s core pumping technology are certainly possible, albeit ill defined. Energy Recovery aspires to identify and develop another oil and gas application for its technology as early as 2017. If such a situation played out, management would likely use the same strategy it used with VorTeq, i.e., partnering with larger companies to achieve economies of scale.

Recent Results

Energy Recovery posted mixed results in the third quarter. The top line rose only 1% year over year, as a drop in product revenue was offset by initial amortization of the $75 million Schlumberger exclusivity fee. The weaker core results were due to a difficult comparison and the timing of water product sales to original equipment manufacturer and aftermarket customers, which can vary significantly quarter to quarter. On the bright side, a favorable product mix shift, price increases, lower manufacturing overhead, and the royalty fees helped the gross margin rise 900 basis points, the third-consecutive quarter of record results. Still, operating expenses grew 21%, owing to a rise in engineering staff tasked with expanding the product pipeline and finalizing the VorTeq technology. Efforts to maintain market share in the Water business and other employee and infrastructure expenses also contributed. In general, the company plans to increase R&D spending by 30% per year for at least the next three years as the product suite is built out. All told, the net loss per share of $0.01 matched the prior-year tally. Notably, Wall Street’s consensus 2016 loss-per-share estimate is currently $0.01, while next year’s average profit estimate stands at $0.63.

Conclusion

Management refers to its technology as “disruptive,” and we tend to agree, as the benefits to customers’ cost bases appear to be substantial. And despite some bumps in the road, most notably with Schlumberger, the likelihood of a successful commercialization of VorTeq appears solid, in our view, and we like the potential for new oil and gas applications. However, the shares are prone to severe price swings, and any negative progress reports will likely result in significant price depreciation. Overall, we are recommending these shares to patient, long-term investors.

 

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

 

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