Graham Corp (GHM) 2009 Q2 法說會逐字稿

Greetings and welcome to the Graham Corporation second-quarter 2009 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Deborah Pawlowski, Investor Relations for Graham Corporation. Thank you, Ms. Pawlowski. You may begin.

Thank you and good morning, everyone. We appreciate you joining us today on Graham Corporation's second-quarter fiscal 2009 financial results call. On the call, I have with me today Jim Lines, President and CEO of Graham Corporation and Jennifer Condame, Chief Accounting Officer. They will be reviewing the results of the second quarter and progress on the Company's strategy.

You should have a copy of the earnings release that was released yesterday and if not, you can access it at the company website, www.graham-mfg.com.

As you are aware, we may make some forward-looking statements during the formal discussion, as well as during the Q&A. These statements apply to future events and are subject to risks and uncertainties, as well as other factors that could cause actual results to differ from what is stated here today. These risks and uncertainties and other factors are provided in the earnings release, as well as other documents filed by the Company with the Securities and Exchange Commission. These documents can be found at the Company's website or also at www.SEC.gov. With that, let me turn it over to Jim.

Thank you, Debbie. And good morning, everyone. I will talk briefly about our progress year-to-date, the current economic environment and its immediate effects and the longer-term outlook for our markets, then turn it over to Jennifer Condame, our Chief Accounting Officer, to provide greater detail on the quarter and year-to-date financial information.

I am pleased that, at mid-year, revenues are up 20% to $51.6 million. Net income is up 42.6% and earnings per diluted share are $0.99. Gross margin is 44.1% for the first half and our backlog is a healthy $69.7 million. There has been movement in sales by product or by geographic location; however, that is routine. We did expect our second quarter to have a lower growth rate, which was indicated during our January conference call. Revenue was a solid $23.9 million. Gross margin held at an elevated level of 43.9% and net income came in at $4.4 million, or 18.5% return on sales.

The productivity gains from our capital investments in new equipment for production, along with the ongoing investment in information technology, workflow improvements and the commitment of our employees to become a faster company are expanding both our capacity and our margins. There is more work to be done in these areas and our employees continue to adhere to our timelines.

Turning to the markets and the current economic environment. I can indicate that quotation activity remains high. Our sales and application engineering areas are busy and they see a lot of opportunity in the pipeline. Our engineering contractors and turbomachinery OEMs are indicating their quotation activity is robust as well. However, we are affected by what is occurring in the financial markets and the price of oil, along with metal commodity prices.

We have seen a slowing or hesitation by our customers to commit to new orders. Bookings this past quarter were down considerably and totaled $17.5 million. We believe the third-quarter bookings may be light as well. We acted proactively when the markets began to change and sales management had close contact with our customers -- the end-users, engineering contractors and key OEMs -- to gain an understanding of how they are affected and responding to the current market conditions.

The general feedback is it is too early to fully understand the impact of the change in the credit markets. We believe the long-term outlook remains unchanged. Energy demand is increasing globally and investments have to be made for new capacity, the upgrading of existing facilities or due to changing environmental regulations. We believe the energy markets will be robust long term, but will show a pullback in the short term.

Major integrated refiners and nationalized oil companies are affected differently by the credit markets. This customer segment has self-financed projects due to their financial strengths and strong operating cash flows. Independent refiners and non-integrated petrochemical companies are directly affected by the credit pullback. We began to see project slowdowns from this customer segment and the suspension or cancellation of projects that were in the bookings pipelined a while back. Independent refiners are important to us; however, they have represented in the past 5% to 10% of revenues annually.

Project management and credit groups acted quickly to evaluate each major contract in our backlog to gain a clear understanding of our current cash position, how much money has been spent by the Company versus what has been received as customer advanced payments, to determine the amount of outstanding receivables and payables, to carefully review contract language for cancellation provisions in each contract and talk to our customers to understand the project pace, the risks and if there will be delays. We believe our backlog is secure and of high quality based on the analysis that was done. A couple projects have slowed and delivery schedules pushed out. In all cases, the customers have indicated the projects will be completed. We will, however, continue to monitor this closely.

We are seeing, as I previously noted, a slowing in our markets. Long-term fundamentals remain unchanged and confirming prior full-year guidance that the revenues will expand 15% to 20% from last year. I do caution that we expect now to be nearer to the end of the range.

Gross margin guidance remains in the 39% to 42% range for the full year. It is too early to comment on fiscal 2010, other than to indicate we are seeing a slowdown for new order rates. However, quotation activity is robust and at a high level and that many projects are in the pipeline that we are now quoting and tracking. I will now turn it over to Jennifer.

Thank you, Jim. For the second quarter of fiscal 2009, which ended September 30, 2008, we reported net sales of $23.9 million compared with $23.1 million in the second quarter of fiscal 2008. Strong sales of our condenser, heat exchanger, pump package and aftermarket productlines were mostly offset by a decline in sales of our ejector systems. Condenser sales increased 24.1% in the second quarter of fiscal 2009 to $5.1 million and were 21.4% of total sales, while heat exchanger sales increased to $3.1 million, a 35.5% year-over-year increase that contributes 13% of total net sales.

Both pump packages and aftermarket sales increased due to three large refinery projects. Pump package sales increased to $2.6 million in the second quarter of fiscal 2009 or 11% of total sales compared with $0.5 million in the second quarter of fiscal 2008. Aftermarket sales were 17.6% of total sales or $4.2 million in the second quarter of fiscal 2009 compared with $3.9 million in the same period the prior fiscal year.

Ejector system sales declined to $8.9 million in the second quarter of fiscal 2009, down from $12.3 million in the second quarter last fiscal year. As a reminder, due to the large magnitude of the orders we receive and the timing of shipments, quarter-to-quarter fluctuations are common.

By industry, sales for the refining sector were $11.1 million, or 47% of total sales in the second quarter of fiscal 2009 compared with $12 million, or 52% of sales in the same period the prior fiscal year. Sales were 27% to the chemical and petrochemical markets, 8% to the power sector and 18% to other industrial applications in the second quarter of fiscal 2009. The portion of sales coming from international markets increased in the second quarter of fiscal 2009 to 37% compared with 33% in the same period the prior year. We believe international sales will continue to grow and comprise a greater percentage of our total sales through the remainder of fiscal 2009 and into 2010.

As a brief six-month review, sales for the first half of fiscal 2009 increased 20% year-over-year to $51.6 million. Product trends in the first half were similar to the second quarter. Ejector system sales were down while condenser, heat exchanger, pump package and aftermarket sales all increased in the first six months of fiscal 2009 compared with the first half of fiscal 2008.

We received $17.5 million of orders in the second quarter of fiscal 2009, down from $20.5 million in the same period the prior fiscal year. In the quarter, orders for ejector systems increased $2.1 million year-over-year. However, this increase did not offset the decline in condenser and pump package orders.

International orders grew larger, comprising 48% of total orders in the quarter, up from 42% in the second quarter last fiscal year with the increase primarily coming from Asia. For the first six months of fiscal 2009, orders were $45.3 million compared with $45.4 million in the first six months of fiscal 2008. Significantly higher condenser and heat exchanger orders were offset by relatively flat ejector orders and decreases in pump package and aftermarket orders. International orders were strong in the first half of fiscal 2009, increasing to 59% of total orders, to $26.5 million compared with 29% or $13.2 million in the first half of fiscal 2008.

At the end of the second quarter, backlog was $69.7 million, up 23% compared with $56.8 million at the end of the second quarter of fiscal 2008. We believe that virtually all of the backlog will be converted to sales within the next 12 months.

With that, I will now review the operating performance for the quarter and six-month periods. Gross margin was again strong in the second quarter at 43.9% compared with 42.9% in the second quarter last fiscal year and higher than the guidance we have previously disclosed due to the mix of higher-margin projects and continued gains in operating leverage.

For the first six months, gross margin was 44.1% in fiscal 2009 and 38.5% in fiscal 2008 with higher aftermarket sales in the first quarter contributing to the favorable product mix. We expect gross margin to moderate in the second half of the fiscal year and the full fiscal year margin to be in the range of 39% to 42%, reflecting the orders in the backlog and declining material prices.

SG&A expenses were $3.9 million, or 16.4% of sales, in the second quarter of fiscal 2009, up from $3.4 million, or 14.9% of sales in the same period last fiscal year. Although flat compared with expenses of $3.8 million in the first quarter of fiscal 2009.

Consulting costs were incurred in the second quarter, which are expected to contribute to greater efficiencies in IT, engineering and manufacturing. For the six-month period, SG&A was $7.8 million, or 15% of sales, in fiscal 2009 and $6.5 million, or 15% of sales, in fiscal 2008. Higher sales commissions and variable compensation contributed to the six-month increase in expenses. We expect SG&A expenses to be 15% to 16% of sales for the full fiscal year.

Interest income was $172,000 in the second quarter, down from $264,000 in the second quarter last year due to the fall in interest rates and a change in our internal investment policy to invest exclusively in US Treasury securities rather than both Treasury securities and US-sponsored agency notes. For the six-month period, interest income was $303,000 in fiscal 2009 and $494,000 in fiscal 2008.

The effective tax rate was 34.5% in the second quarter of fiscal 2009 and 34% for the first six months. The rate is projected to be 33.5% for the full fiscal year.

Net income in the second quarter of fiscal 2009 was $4.4 million, or $0.43 per diluted share compared with $4.4 million, or $0.44 per diluted share in the same period the prior year. For the six-month period, net income was $10.1 million, or $0.99 per diluted share for fiscal 2009 and $7.1 million, or $0.71 per diluted share for fiscal 2008. The per share data reflects the two-for-one stock split that was effected on October 6 for stockholders of record on September 5. At their meeting yesterday, the Board of Directors declared a quarterly cash dividend of $0.02 per common share. The dividend will be payable on January 5 to stockholders of record on December 1.

Cash, cash equivalents and investments were $42.9 million at the end of the second quarter of fiscal 2009, up from $36.8 million at March 31, 2008. There were no borrowings on our $30 million revolving line of credit at the end of the second quarter and $8.8 million of outstanding in letters of credit.

Net cash provided by operating activities was $4.4 million in the first half of fiscal 2009, down from $9 million in the same period last fiscal year, due to higher working capital requirements from an increase in accounts receivable, due to timing of customer billings, higher inventory and a $3.5 million contribution to the pension plan.

Capital expenditures were $576,000 in the second quarter and $795,000 for the six-month period of fiscal 2009, up from $284,000 and $447,000 in fiscal 2008 respectively. We expect capital spending to be in the range of $1.8 million to $2.2 million for the full fiscal year. That concludes my remarks. Jim, I will pass it back to you.

Thank you, Jennifer. Operator, you may open the line now for questions.

(Operator Instructions). James Bank, Sidoti & Co.

Hi, good morning. My first question is on SG&A. I think that was the biggest alarm to me and I guess the biggest disappointment in the quarter. Why was the expense so much materially higher than it was in the second quarter -- excuse me -- first quarter on a percentage-of-sales basis?

The SG&A has a component that is tied to the profitability of our orders, which is commission and variable compensation and that is the biggest effect that caused the increase has been the profitability of our work, maintaining the margins at 44.4% and we had some consulting expenses as well.

Okay. So I guess given the fact that the gross margins were relatively similar, despite the fact that sales were down, that profit sharing still will remains static more or less?

More or less.

Okay. Okay. Fair enough. Thank you. Jim, if you could just quantify the hesitation of the large order placement.

Sure. We began to see some slowing a few months back from our customers. We have commented on several conference calls going back over the last several quarters the difficulty we had in predicting when orders would be placed by our customers. We commented in the past that some orders that we thought would be booked in a particular quarter actually still are open to be won several quarters later or were booked two or three quarters after we thought they should be booked.

We have noticed that there has been a slowdown as our customers are taking -- a certain segment of the customers are taking a wait-and-see attitude. Other customers, I would say the independent refiners, have had to change their capital spending plans in light of what is occurring in the credit markets.

I commented in the pre-recording that the independent refiners, they are important to us, but they have in the past represented between 5% and 10% of sales to our integrated customers or the nationalized oil refiners. They really haven't seen the credit market affecting their long-term spending plans. Although, I would say we have seen a pause or I would believe a temporary delay in order placement.

Okay. So if I had to quantify it, it would probably be in the ballpark of $1 million to $3 million then? Is that fair to say for these independent refiners?

Oh, for -- you are trying to quantify the delay within the quarter for the bookings?

Yes.

Well, we are a lumpy business and we have talked about that in the past. We were expecting a couple larger orders to be placed in this quarter's -- I'm sorry -- the quarter that just ended. However, they have carried into a subsequent quarter, the quarter that we are in now. We expect to book them in our third quarter. So some of it is timing, James, like we have talked about before.

Okay. The aftermarket orders, certainly very good in the second quarter again like the first and what is the driver behind this, if there is one?

A driver that we have been made aware of is just the strong, compelling argument to keep a refinery running. We have seen our refining customers make purchase decisions for capital spares that we hadn't seen them make in the past. The rationalization they were giving to us is what's most important to them is assuring onstream performance from a turnaround for the next five years. They can't afford an unscheduled turnaround because of the financial implications of that. So they have had a different purchasing pattern than we have seen in the past. Favorably affecting us. That is just due to the strength and the importance of keeping the refinery onstream.

Okay, Jim, I'm sorry, I actually had just another question on the orders. When I went back and looked at it historically and what you guys have done since your fiscal 2000 year, when I looked at the year-end order number and then looked at the subsequent year-end sales, it was pretty much identical. I think there was just one year there where your year-end sales was a little bit lower than what that year started with in terms of orders. If we go to the lower end of your top-line guidance range, that number will be now, I believe, lower than what your year-end orders were when you finished fiscal '08.

Is this something just to be -- is this sort of just a cautious tone we need to take in this type of environment given what we have seen or is there something really underpinning that that you are now targeting that lower end of your top-line guidance range?

You are right. In looking back, there was almost a correlation of one between bookings the prior-year sales to the subsequent year. This year, however, we are seeing projects extended by our customers. The delivery cycle in the past had been 8 to 12 months from order to shipment for a major contract. Today, and as we have talked about in prior conference calls, the schedules are nearer to 12, 15, in some cases, 18 months. I don't view this as a capacity constraint for our business. It is a pacing of project execution by our customers.

Okay. Very helpful. Lastly, the inventory, and I apologize if this was covered in the prepared remarks. Not a considerable amount, but certainly higher than where it has been in the past and I kind of took a double take also because the commodity prices have come down so considerably. So what is in that inventory right now?

With what was happening with our customers and again, going back to delays, we are (inaudible) order business and there are starts, there are stops, there are engineering change orders that come into play. We felt we were coming into an environment where we would have more of that, so we actually proactively increased our inventory to give us production continuity and flexibility and that showed up in our WIP and that showed up in our inventory number. That will work itself out, but that was a proactive decision by management to maintain production continuity.

Okay. Fair enough. Thank you, Jim. I will jump back in line.

(Operator Instructions). George Walsh, Gilford Securities.

Thank you. Jim, I was just wondering, with the pullback and the price of oil, how has that affected certain projects, like I know you were looking -- more things were happening up in the oil sands in Canada? Anything on the outlook there in terms of near-term impact with pricing and then long-term demand outlook?

Okay. That's a great question. I would say we are in our second year of project delay that we are seeing in the Alberta oil sands area. Not so much tied initially to the price of oil, more to the ability to execute the contracts. The contractors, the EPCs in that region, the construction, the availability of human capital to execute the contracts was in short supply, so they have had to slow down those projects. At the same time that the cost of the projects was escalating very quickly.

But I just want to put this in context. We look at the oil sands as an area that we will continue to invest and when we look at the first one million barrels per day of oil that was brought onstream, that was occurring between 1996 and 2006. And if you think in terms of what oil was then, it was between $15 a barrel in the early -- in the mid '90s up to $50 to $60 a barrel in 2005 and '06.

We know the refiners today, because of the cost of the projects, are using somewhere between $70 and $85 per barrel for the economic analysis of their project viability because the cost of the projects have doubled. But we still see the oil sands as an area where investments will be made and if you look at the investments that are going on in the Petroleum Administrative District 2 in the US, they are making significant revamps to US refineries in preparation to be able to process [better] crude oil that is going to be produced in Alberta coming from future investments. We see this as a timing issue. We think the breakeven for those projects is below where the price of oil is to date. We believe, however, there is a timing issue and we are looking at a second year of delays.

Okay. What do you think that breakeven point is?

Well, as I mentioned, we know they are looking at somewhere between -- $70 and $85 a barrel is what we are being told in their economic analysis, primarily because the cost of the projects have doubled. When we think in terms of what occurred in '95 through 2004, those projects were in the ballpark of $5 billion to $8 billion. Today, we are hearing numbers that are between $12 billion and $18 billion for the cost of the project, including the mining and the upgrading. So they are using a higher price for the price of oil in their economic analyses to take some of the risk away.

Okay. Now Jim, another question on another topic. You have used this cycle to beef up the balance sheet. You have got more cash than you have ever had in your history. You have more shares outstanding and actually you have more liquidity than you have had and you have mentioned M&A possibilities for the Company and you have had a certain pullback here in the economy and in the price of oil and has that created any opportunities or what is your strategic thinking and what is the landscape in terms of potential acquisitions or any type of M&A activity for you?

To be succinct, my strategy for the business hasn't changed. Our plan is to double the size of our Company over the next three to four years. Three to five years was our initial timeline. Doing that through both organic growth, as well as acquisition growth. I see what is happening in the marketplace, as painful as it is, as an opportunity. We are going to continue to do what we do well, which is to improve our current company and use the strength of our balance sheet, the strength of our brand to look at external growth options as well.

Okay. Can you just -- I am pushing a little bit, just anything a little more specific in terms of the type opportunities you are seeing there that you could take advantage of?

Well, I think it is still a little early. The valuation we believe for the businesses that are selling into the energy sector still are high. Give it a couple quarters depending upon the severity of the pullback. I think there will be some opportunities in front of us in subsequent quarters, but to give you an idea of what our thoughts are regarding acquisition criteria, the acquisition size would be below $100 million. It would be engineered-to-order products that fit our brand, that are in the energy sector.

Now in the energy sector, we are not just talking about oil refining and petrochemical; we are talking about power generation, alternate energy, waste-to-energy, geothermal, areas where the Graham brand is exceptionally strong, where a differentiated solution can be sold at a premium and that is what we do well. And we will look to expand our geographic market presence, perhaps our geographic footprint and diversify our products.

Okay, very good. Thank you, Jim.

(Operator Instructions). James Bank, Sidoti & Co.

What was the percentage of subcontract work in the quarter?

It was around 6%.

Oh, just 6%?

Yes.

Okay. Are you going to revise -- is it going to be sort of the 12% to 13% for the full year still or is it maybe down from there?

In our earnings release, we guided to a number in the range of 8% to 10%.

Oh, I'm sorry. I missed that.

That's okay. We had -- actually entering the quarter, we had forecasted a higher level of subcontracting, but as is the nature of our business, within a quarter, things happen that cause projects to be delayed. We have a large project that was going to be built -- that will be built in China where it was to commence in the quarter that just closed. However, due to delays, it has been pushed out to be commenced in the quarter we are in now. So we are expecting a higher level of subcontracting, but due to the timeline of that project, there were some changes.

And in addition, we have had a slowdown caused by engineering change orders for a US-based refiner, two very large vacuum pump packages that haven't been able to kick off because of the engineering flux between us and the contractors. So we were anticipating a higher level of subcontracting, but due to the nature of our business, we came in at 6%.

Okay. So what I did catch in the press release is the SG&A as a percentage of sales guidance of 15% to 16%. So I guess with that, I can assume higher profitability in the back half, especially if you have less subcontracted work. So can we then assume that maybe your gross margin will be on the higher end of the 39% to 42% range?

I would maintain that we will be between 39% and 42%. However, remember what I just said. Our Chinese project will have subcontracting in Q3 and Q4. There was also other subcontracting in our work as well to bring us to between 8% to 10% for an average for the whole year. I would caution that will be around the midpoint to the lower end.

Even with the assumed profit sharing in the back half of the year?

Yes.

Okay. Thank you. That's all I have.

(Operator Instructions). There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Thank you. I would just like to reiterate that our backlog is strong at a near record level. We have taken steps to evaluate the quality of our backlog and any execution risks that there might be. Our quotation pipeline is robust and is still at a very high level. Our research and discussion with the end-users and the contractors has concluded that the long-term growth prospects for the energy sector are unchanged.

I am confirming our prior guidance of revenue growth between 15% to 20% and gross margin between 39% and 42%. Our managers and employees are continuing to execute our business improvement initiatives and they are having a positive effect on our operating results. The Company's balance sheet is excellent. We are carrying no debt. Our pension assets are in good shape. Cash utilization efficiency is excellent and our cash and investments on hand are just under $43 million. Thanks to the hard work of our managers and employees, Graham is in excellent shape. And I look forward to updating you on our progress during the January conference call. Thank you.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.