GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Argan Inc. Could Not Really Distribute Its Cash

December 20, 2010 | About:
guruyt

Saj Karsan

21 followers
Value investors love companies with large cash balances. These companies are the least likely to flirt with financial trouble and are in a position to pay dividends and/or buy back shares. As such, when valuing companies, investors will often add a company's cash balance to the company's earnings power valuation in order to determine the company's intrinsic value. Sometimes, however, this practice can get the investor in trouble.

Consider Argan (AGX), a company primarily engaged in the production of a range of power plants. The company trades for $125 million, and generates about $10 million per year in operating income. This may not look like a steal, until one takes into account that Argan also has $76 million in cash. As such, it looks very attractive at first glance!

Unfortunately, however, the company actually needs the cash. As such, it does not appear as though that cash will be distributed to shareholders, as the nature of Argan's business requires that it maintain a ton of cash on hand, for a couple of reasons.

First, the company is paid by customers in advance for some of its construction work. But because the timing of future sales is uncertain (the company's backlog is largely composed of just 2 or 3 projects at a time), that cash is required to pay for the work the company has been contracted to complete. Dell (DELL) is an example of another company that is paid before it has to deliver its products, but Dell can more safely distribute that cash as the stream of future orders constantly replenishes its cash balance. Argan's situation is more uncertain, as it cannot distribute cash on the expectation that it will win future production contracts that replenish reserves.

In other cases, the company must perform work before it is paid. It is not uncommon to see the company's accounts receivable balance jump by tens of millions of dollars over the course of a single quarter. This again requires the company to hold ample cash reserves in order to fund construction until such time as the customer is obligated to pay.

Management's actions are consistent with the idea that the company needs strong cash reserves to operate successfully. In 2008, despite a cash balance of $70 million, the company raised $25 million of cash in a private placement. Since then, the company continues to hoard cash, having not paid a dividend or bought back shares.

Investors interested in valuing this company should therefore consider the company's cash balance as part of its operating assets, and not as excess cash. For those interested in another example of this type of situation, this is an issue that has come up before with another company.

Disclosure: None

Rating: 4.8/5 (8 votes)

Voters:

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK