Graham Corp (GHM) 2011 Q3 法說會逐字稿

Greetings and welcome to the Graham Corporation third-quarter 2011 quarterly results conference call. At this time all participants are in a listen-only mode. A 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, Deborah Pawlowski, Investor Relations for Graham Corporation. Thank you, Ms. Pawlowski, you may begin.

Thank you, Claudia, and good morning, everyone. We appreciate your joining us today on Graham's fiscal 2011 third-quarter conference call. On the call I have with me today Jim Lines, President and CEO of the Company, and Jeff Glajch, Chief Financial Officer. Jim and Jeff will be reviewing the results of the quarter and also provide a review of the Company's strategy and outlook.

On our website at www.Graham-mfg.com you will find both the press release as well as supplemental slides that are posted there. Jim and Jeff will be referring to the slides during the formal part of their discussion.

As you are aware, we may make some forward-looking statements during this 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 materially from what was 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 at SEC.gov.

So with that, let me turn it over to Jim to begin the discussion. Jim?

Thank you, Debby, and good morning, everyone. We are pleased with the results in the third quarter and with our acquisition of Energy Steel in the quarter. I would like you to refer to slide 5, where I will review highlights for the quarter.

Orders were strong in the quarter at $17.8 million. We won some very key orders during the quarter.

A project for an oil sands extraction facility in Alberta, which is the first of that type of order for us. We see a good opportunity in the coming years for this type of sale. We also won another project for a China refining facility; that is our ninth order in the last four years. Again, we continue to progress well with our China strategy focused on the refining market.

We also won a nice order for a very large fertilizer project that will be built in India. It will be the largest fertilizer facility in the world. What's different about this one is we had partnered with an Indian company to fabricate the condensers locally in India for the Indian fertilizer facility, further advancing our local manufacturing strategies.

We also had Energy Steel at about $800,000 of new orders since we owned them midmonth in December.

On the sales side I thought we had a strong quarter for sales at $19.2 million. If we compare to a few quarters back, we had fairly similar sales from the third quarter of 2002 to the first quarter of 2011, and then we began to have sales expand in our second quarter and then in the third quarter. We're at a point now where we think we are through the trough, and we should begin to have sequential revenue growth again in our fourth quarter.

Comparing year-over-year is going to be relatively easy because we are comparing 12-year periods to the troughs to the current quarters. But we did have a 58% expansion in sales compared to the prior-year period.

Gross margins, they came in line with our expectation at 25.3%. That is really tied to the pricing environment for orders won 12 to 18 months ago. Those have to be moved through the backlog; they are going through the backlog now. We have higher-quality orders in the backlog that will begin to convert as we're into fiscal 2012.

Operating margin, if we remove the acquisition-related expenses, was again in line with our expectations at about 10%. We're very pleased with the acquisition of Energy Steel. It's an excellent strategic fit.

The business has a similar sales and execution model to Graham's core business. We find the company has a terrific management team.

We've identified very clear avenues for growth, and the facility that is there now has ample capacity for greater throughput. I remain very optimistic about Energy Steel and its contribution to Graham's future earnings.

Turning to slide 5, revenue. Our guidance has been tightened to $69 million to $72 million. For the first three quarters, revenue year-to-date is $48.3 million. If we take the midpoint of the guidance that would suggest the fourth quarter comes in at $22.2 million.

To get to the upside of the guidance, that will require getting some traction on some more profitable, larger orders that are in our backlog. We have capacity; we have strategies to pull those into the fourth quarter. And our ability to hit the $72 million or maybe push a little bit beyond that will be tied to our traction on those projects, which have higher revenue and profitability per production hour.

From a sales mix point of view, as we have said for a number of quarters, the international market will become more important and will lead the recovery. Year-to-date international sales are about two-thirds of our sales, primarily from the Middle East, Asia.

End-use markets. Refining remains important at about one-third of our sales mix; chemical processing; power generation; and other. If we look going forward into '12 and beyond we should see the power segment begin to expand with the addition of Energy Steel.

And we feel more positive about the outlook long-term for oil refining and petrochemical markets as well. So we would expect sales in those segments to expand as well.

Turning to the next slide, the integration of Energy Steel has gone very well. Lisa Rice, the other managers at Energy Steel, Jeff, they have done a terrific job to ensure there has been minimal disruption with the integration of Energy Steel into Graham.

It's gone quite smoothly. We plan to be 404 compliant by the end of fiscal year 2012. We had a strategy session with the managers of Energy Steel to define our growth objectives and profit improvement objectives for the business, and I am very pleased with the first month and a half of our ownership of Energy Steel.

The acquisition-related costs, which were expensed in the third quarter, affected net income by about $0.05 per share. We believe there is very little carryover into the fourth quarter. It was expensed almost fully in the third quarter.

Looking at growth opportunities as they relates to Energy Steel or our nuclear power market strategy, we believe there is greater penetration available to us in the existing nuclear power plants. We also feel that we can broaden our supply of products to the nuclear market by bringing engineering and process know-how that the Graham team has to complement the strengths of Energy Steel.

Also there will be, we believe, a number of new power plants in the US to be built over the coming decade. Four to six are expected to be underway by 2018. We feel there is just tremendous upside with this strategy and the acquisition of Energy Steel.

On slide 7, just wanting to recap a bit about the strategic actions we took over the last two years to position our Company and to drive growth in coming years. I believe we have enlarged our sandbox that we will play in.

With our focus on the Naval Nuclear Propulsion Program we have made a clear commitment to the Navy that we will be a consistent supplier to their nuclear propulsion program. The carrier order was a very significant win for us. Our team dedicated to the nuclear program with the Navy is focused on additional opportunities, and we feel that is going to be a very important leg of our business in the coming years.

The nuclear power market, we have a clear, directed approach to expand our sales into that market space with the acquisition of Energy Steel. The Batavia Operations is currently undergoing a certification process to produce nuclear quality products as well.

And we have a focus on renewable energies. That is one market that is pretty active in the US market right now.

If we look at Graham more historically we would say we were driven off of two markets, oil refining and chemical processing; and then we served a variety of other end-use markets. Projecting forward with the actions that we took over the last 12 to 18 months, we see four strong market segments, plus the additional markets that Graham serves -- oil refining; chemical processing; defense, with the Navy program; and power generation. This provides us with a larger addressable market and greater avenues for growth.

We've also taken the downturn to expand our subcontractor network. This provides greater flexibility. It shortens the supply chain.

In the last year we've added three more subcontractors in North America. We now have in our international areas three contractors in South Korea, two in China, and two in India. Currently we have work in our backlog being produced now in China, in India, and in South Korea.

What this does for us -- our markets will be cyclical and we have to address demand in a way that we have a flexible cost model. I believe we have advanced that flexible cost model with our focus on subcontracting to allow us to expand when there is strong demand, but yet have a fixed cost structure that is suited for the downturn. I think that was evident in how we performed through the last two years during the trough.

We also focused during the downturn on the core business -- to hold our margins, to improve our margins in the face of international sales mix and lower margin potential. We have committed to and we are achieving shorter lead times across our Company.

Error reduction has really taken hold. We have seen the improvement in quality and the reduction in rework come down quite a bit over the last year.

We have implemented a number of IT improvements both in operations and in the office, in our production area as well. And we have a strong commitment to continuous improvement, all of which is allowing us to hold our margins and improve our margins as we go forward.

We're also, with the strong opportunities for growth across the four market segments that I defined earlier, we will be making investments in personnel to expand our capability and capacity. That is a more forward-looking comment, as we have identified where the growth is and we need to invest in the business to capitalize on these opportunities.

With that I would like to turn it over to Jeff for a more detailed review on the quarter.

Thank you, Jim. As you can see on slide 9, as Jim has mentioned, we have had a fairly stagnant revenue period from Q3 of fiscal 2010 to the beginning of fiscal 2011. That obviously followed a downturn in late -- in the first half of fiscal 2010. However, over the last three quarters we've really seen a pickup.

Q3 revenue was $19.2 million, up sequentially 22% from the prior quarter. 18% of that 22% was organic growth; the other 4% was for the couple of weeks that we owned Energy Steel in December. This follows a 17% sequential increase from Q1 to Q2 in fiscal 2011.

For the quarter, sales were up 58% versus the similar quarter last year. 52% of that growth again was organic and the remaining 6% from the Energy Steel acquisition.

What we are seeing is revenue growth being driven by the international markets, which we expected, with the growth occurring in our key markets in Asia, the Middle East, South America, and in Canada. We believe we are clearly out of the four-quarter cycle bottom that we had been in earlier this year and late last year, and are looking to continue to see growth in the next quarter also, as Jim has talked about.

Earnings per share in the quarter were $0.08 a share, up above 10% from last year's number; but that included the acquisition cost. When you strip out those acquisition-related costs and the transaction cost, our earnings were up very dramatically at $0.13 a share.

Looking at the next slide, orders have rebounded in the third quarter to $17.8 million from the low levels of the first half of this year. In fact, the third-quarter order level was very close to the combination of the first and second quarter.

Included in that $17.8 million was about $800,000 worth of orders from Energy Steel. Although the $17.8 million is a significant growth over the last couple of quarters, it is down pretty significantly from the third quarter of last year. But recall, the third quarter of last year included the very large order from the US Navy.

Our backlog remains strong, just 4% off its record high at $90.5 million. Included in the $90.5 million is $8.6 million related to Energy Steel; so just under 10% of our backlog is related to Energy Steel.

Within the third quarter our book-to-bill ratio, while improved, was still slightly below 1.0. Again, we expect to continue to see that stronger level of orders going forward.

Flipping to the next slide, looking at the gross margins and looking at profitability in general, as expected the gross margin in the third quarter was lower than it had been recently. It was really driven by a mix of projects in production.

As Jim has mentioned, we are working through some lower margin projects that came in-house about a year or so ago. If you looked at the second quarter, we had a couple of higher margin projects move into the second quarter and then lower margin ones move out to the third quarter. So that really identified the drop from the second to the third quarter.

The operating margins also had declined commensurate with the gross margin change.

Looking at SG&A spending, it remains under tight control and at the lower end of our expectation. The decrease in SG&A as a percent of sales has continued to date as we have kept SG&A dollars fairly flat despite the recent increase in sales.

We do, however, expect SG&A dollars to rise as we invest in resources to support our future growth, as Jim had mentioned. As well, we will be adding the Energy Steel SG&A dollars onto our baseload.

Looking at the next slide, our outlook for updating our fiscal 2011 full-year guidance. As Jim mentioned we expect a revenue range of $69 million to $72 million inclusive of Energy Steel. We expect full-year gross margins to be 28% to 30%; on a year-to-date basis they are 29%.

SG&A we expect to be between $12.4 million and $12.8 million, which would suggest a Q4 SG&A between $3.9 million and $4.3 million. Much of that increase versus our year-to-date run rate is the addition of Energy Steel.

We continue to expect SG&A at the peak of the next cycle to be in the mid to upper 30 range -- I'm sorry, gross margins at the peak of the next cycle to be in the mid to upper 30% range and SG&A to be in the mid teens, though we believe we are still a couple years away from seeing that peak level.

If you look at the next slide, and this is a slide that we have shared before, which really shows how Graham has changed from its past cycles to our current business and financial model in this most recent cycle. While we don't enjoy down markets, you can see in this most recent down market we were pleased to see that our performance in that down market, at an EBITDA level of over 12%, was actually above what our previous peak EBITDA margins were in earlier cycles. So we continue to have the focus to maximize our EBITDA margins at the top of cycles, but also look at have acceptable EBITDA margins at the bottom of the cycle, as we have seen in this last performance.

Finally, looking at our balance sheet, we utilized $18 million to purchase Energy Steel in the third quarter. As well, over the last three quarters we have seen $8 million of our excess customer deposits come down. With all that occurring, we still have $48 million in cash and no bank debt.

With the year-to-date reductions in the excess customer deposits, we think that is probably now -- instead of at $14 million to $16 million, where it had been at the beginning of the quarter -- probably $6 million to $8 million above a more normalized level. So subtracting that out from the $48 million of cash, we believe we have around $40 million to $42 million of free cash to invest to grow the Company in the future, and we will certainly be looking at that.

We definitely want to make sure that we get the Energy Steel acquisition fully integrated, and we are very comfortable with that. And subsequent to that we will continue to look for acquisition opportunities in the long term. With that I'd like to turn the floor over to questions, and thank you very much for your time.

(Operator Instructions) Rick Hoss, ROTH Capital Partners.

Good morning. Jim, remind me. What is your win rate in China? And pick a period, five years, four years, or whatever you think can demonstrate the success you are having there on larger, more significant refining or petrochem fertilizer projects.

Up until 2006 we did not have an installation in China for a vacuum distillation service in a refinery. That is the very large ejector system that we saw routinely throughout the world.

So we hadn't had an installation in China up to that point. We entered China at about that time with a focus on refining sector, because we knew they would be expanding.

Over that period of time, from really calendar 2007 to end of calendar 2010 there was about 3 million barrels per day of additional distillation capacity added. We had won about two-thirds of that. We have won nine of the -- actually of the installations we have won nine of about 17.

But we have the majority of the distillation capacity defined as barrels per day. It's a higher capture ratio than the number of wins.

Okay.

We have done well. We think we have a very strong market position, certainly above 50% market share if we look at that period of time, 2007 through 2010, when we entered the market. And our team focused on positioning our brand, demonstrating the value that is with the Graham brand, and executing extremely well on the orders that we won, to move ahead of our European competition and a local competitor that we see from time to time on smaller projects. So I have been very pleased and I think we dominate that market right now.

Would you say in the latter years you have a greater share versus the earlier years? In other words, are you taking share today versus when you initially entered that market?

That's correct. The first couple years we were still finding our way, perfecting our model. The last two years our capture ratio actually has been much higher.

Okay. That makes sense. Then can you give us an expectation for how orders are tracking so far in the fourth quarter? Do you feel that there is the potential to have fourth-quarter orders higher than the third quarter? Or is it too early to tell?

I think there is a really good pipeline with Energy Steel. We are hoping to have a strong bookings quarter with them.

They have a number of large projects that they are tracking. Our sense is they will close in the quarter. And should they do so, they will have a very nice level of bookings.

For the core business, the pipeline is really just incredible with the amount of work that we have, that we are focused on. To be above the $17.8 million, I think that is very probable. But there is a chance based on timing that the orders in the pipeline don't move to procurement and we could come in below that.

But I firmly believe based on what our sales team is advising that there is a rich pipeline of opportunities expected to close in the quarter. And I feel we are in pretty good position on most of them.

Okay. So I guess a more fair question would be -- your six-month outlook is certainly above the past six months from a booking perspective?

Absolutely. I feel quite confident that we will beat the first half of fiscal '11 because we pretty much did in the third quarter.

Okay, okay. Then remind me. Does Energy Steel, does it have a quicker conversion of backlog to revenue?

That's interesting. Because like the core business of Graham they have some short-cycle business that comes in and out in a month to one quarter; and then they have longer cycle sales, like Graham, that may be in backlog for six to 15 months.

It's a similar split, maybe one-third, two-thirds. One-third short cycle, two-thirds long cycle. So it's pretty similar.

Okay. Then last question from me. What are you doing to mitigate raw material? I know that you typically built it in the contracts, due to the length of your contracts. But what are you seeing? What is your outlook, etc.?

The outlook is for rising material costs. We are staying ahead of it, I believe, with how we are pricing our products. We are staying current for our major contracts, getting up-to-date pricing right up to the day we get the order so we know what our material costs are.

And then as we have shared with everyone before, our policy after we have an order is to procure very shortly after we have won the order the volatile materials. So we lock in any cost creep exposure.

We have done very well over the last three or four years. It's been a very volatile metals market, and our team has done well to stay in front of it. Our procurement policy is such that we do well to retain margin, if not improve our margin, through procurement strategy; and I don't see that changing.

Okay, and I know a couple quarters back you were able to -- you had a pretty decent benefit to EPS based on that strategy. Does it work better in an inflationary environment or it really doesn't matter?

It worked better at that point in time because the demand in the supply chain just wasn't there, so the suppliers were incredibly hungry. Our procurement team took advantage of that to find the hungriest suppliers to negotiate the best prices.

I found that to be more unique to bottom of the cycle, light demand, and our procurement strategy to get at it and take advantage of it. As demand starts to increase in the supply chain, some of that capability goes away because there is such strong demand.

Okay, fair enough. Thank you.

Dick Ryan, Dougherty & Company.

Say, Jim, the contract you mentioned in backlog that is on hold, I believe it was around $1 million. Any sense whether that, given the better environment out there, does that come off hold?

Our sense with that one, Dick -- it is a refinery in Africa. We are having conversations with our customer now, that our sense is it's going to be coming off of hold and will be released into production, with delivery sometime in the latter half of calendar '12. So we feel very positive that should get released.

We may do a change to the engineering which could delay when it is released. But our sense is, based on the feedback we are having from our customer, it is coming off hold.

Okay. You mentioned seeing some margin improvement or pricing improvement on contracts. Are you seeing that in Energy Steel as well? Or is that more descriptive of your core business?

I would say that is more descriptive of our core business, and I will be better able to comment on that probably in the May/June call after we have had more time with Energy Steel.

What sort of feedback have you gotten to date from either their customers or others in the industry now that you own them?

We have gotten very positive feedback of -- smart acquisition, a good decision, and the customer base likes the long-term potential to see what the combination of what Graham brought to the table and the strength that Energy Steel had. So it's been a very favorable response across the customer base and those serving the nuclear market.

Okay. One last one, you talked briefly on the rising material costs. In your conversations with customers, is that a factor that they might start moving some of these projects to the left a little bit if they are getting concerned on pricing as well? Trying to get in the queue ahead of further increases?

We haven't seen that. That was something we clearly did see in the 2007/2008 time frame. I think it is too early in the market recovery to expect that type of behavior by our customers.

They are aware of rising material costs. We are in conversations with them with respect to how it affects the price. But we haven't seen a move to the left.

Okay, great. Thanks, guys.

[Chris McCampbell], Stifel Nicolaus.

Good morning, guys. Could you give a little color on what is going on with the oil sands business, maybe in comparison to the last cycle, as far as Graham is concerned?

Also, I hate to ask about other acquisitions now that you have just made one, but maybe if you could talk about where you are in the process of finding other opportunities. Thanks.

Okay, I will take the first section of that question. Oil sands. We are very optimistic about oil sands and where it is today. We see investment happening in the extraction side, and that is the order that we won recently, which was a new type of application for Graham on the extraction side. We hadn't really participated there before.

But there is a lot of investment going on, extraction capacity, therefore new bitumen capacity. And there is demand there for our products now, with the solution that we provided with the release of the recent order.

And then downstream of that for the upgraders we are seeing -- there really was a stop to investment in upgrading activity about three years ago. But we now are seeing a couple of projects move back on to the table, where we are doing early design work, some engineering studies, and it is beginning to feel positive again that investment will be made. It was our sense about a year ago that we didn't think upgrading investment would take place until calendar '12, and I still think we are tracking toward that.

Okay.

But what's important is we are now serving two ends of the oil sands sector, the extraction side and the upgrading side. So again, we have enlarged our addressable market with some strategies that we undertook during the downturn to get at another piece of the business that we hadn't served before.

Jim, how does that compare to the last cycle? I don't recall how much business you all actually got out of that last time.

On the upgrader side these are massive projects. It's been our experience -- and if history repeats itself -- we didn't really see more than two go in a 24-month period, the way the projects pace and the resources that are required for these massive projects.

But for us it's great business. It is great incremental business. It's an area that we have a strong brand and a good market share.

But it's not as though we would expect five or six projects to come together in a 12-month period. We would expect one or two. The ASP on that could be $3 million to $8 million per upgrader.

Okay.

Chris, this is Jeff. On your second question, we took a good amount of time to make sure we found the right acquisition the first time. We are very happy with Energy Steel.

They met our market criteria. They met our business criteria. They met our management criteria with having a strong management team and a quality focus. All of those things came in line, and we are very pleased with that.

We are continuing to look. We are going to make sure that we fully integrate Energy Steel within the Graham family. And then we will continue to look while we are doing that.

I am not expecting anything in the immediate term. But certainly if the right opportunity comes up, we will pursue it. So I can't really give you time frame other than to say we want to make sure we get this one integrated cleanly first, and then we will move on.

We obviously have the good balance sheet as well as with our new facility with Bank of America. We have quite a bit of flexibility on debt if we decide to go with an acquisition large enough to require some debt.

But again I wouldn't be looking for something in the immediate future. We want to make sure we integrate this one cleanly first.

The key point with that is, while we have acquired Energy Steel, our acquisition program is still active and we are still looking.

Yes, we still are looking routinely at what is out there. Again, if something comes up we will pursue it; but we want to make sure we get this one in-house and clean first.

Yes, sure. Okay. Thanks.

(Operator Instructions) Scott Blumenthal, Emerald Advisers.

Jim, I think it was last quarter, possibly the previous quarter, you talked about -- you telegraphed the lower margin composition of your backlog and how you expected that to persist probably until the end of the fiscal year here. Can you talk about the composition of what you currently have in backlog of what your feelings are with regard to that?

Sure. As you indicated, we felt Q3 and Q4 would have margin squeeze because of the margin in the backlog that was being converted to revenue at that time.

Right.

As we look on average at the margin in the backlog, it's higher than what is being converted to revenue. The suggestion there is, as we get through that lower margin backlog, we will have margin lift as we get to the higher margin work. We will also have the benefit of leverage as the throughput, the revenue run rate, production rate is going to be higher at that point in time.

We have to deal with the realities of Q1 and Q2, which were about $18 million of total bookings -- need to push through the business. They are pushing through really a little bit in Q3, a lot in Q4, and somewhat into Q1. We get this behind us -- it is pretty much behind us I think in Q4, the average margin of the backlog is superior to what we are producing now. And that will provide a nice lift to the margin.

Okay, that's really helpful. Thank you. Just with regard to the quarter that we are talking about now, I saw that you had a sequential increase in backlog even though book-to-bill was, as you mention, below 1, which would suggest that your short-cycle businesses are doing really pretty well.

So can you talk about specifically the short-cycle businesses, and what you saw during this quarter, and how you have seen that maybe accelerate into the current quarter?

Sure. Actually the growth in the backlog in the quarter was really due to the acquisition of Energy Steel. Adding Energy Steel on top of our Q2 backlog is really what pushed it up.

With regard to the short-cycle businesses, they have been a little stronger I would say in the last quarter or two than they had been previous to that. But really the big jump in the -- the $7.5 million or $7.2 million jump in the backlog was due to adding over $8 million of Energy Steel backlog on to our existing backlog.

Okay, good enough. Thank you.

(Operator Instructions) Walter Lang, Avondale Partners.

Good morning, guys. I was curious if you are seeing any increase in US refiners, given the improvement in the crack spreads in recent past.

We are seeing some early inquiry activity. To be candid, though, we think it is not near-term purchase opportunities that we are working on. We don't see much of the pipeline really tied to the US refining market pipeline, our bookings pipeline tied to the US refining market.

There are a few. It's nice to see a few, but it's not at a point where we saw it in '04, '05, '06.

Okay, thank you.

Scott Blumenthal, Emerald Advisers.

Jim, do you -- or is there any opportunity for you in shale gas as I sit here on top of the Marcellus?

There could be; not necessarily at the extraction, if you will, but conversion of the shale gas to petrochemicals or chemical fuels. There will be some process applications that require vacuum and heat transfer equipment, and that is where we fit in. Yes, but not on the extraction.

Okay, so you would be then a beneficiary, I guess, as the opportunity evolves toward the mid and late part of the cycle?

That's correct.

Okay, all right. Thank you.

Gentlemen, it appears we have no further questions. I will now turn the floor back over to Jim Lines for closing comments.

Thank you for your time this morning. We are very encouraged by our third-quarter results, our forecast for the remainder of the year, but most importantly getting through this trough and into the expansionary period that we believe we are in the early stages of.

I feel we have done the right things during the downturn to provide different and additional avenues for growth. We focused on improving the core business, and we have added Energy Steel to Graham.

We are very excited about the next many years for our business, and I look forward to updating you on the -- I guess May conference call that we will have. Thank you.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and we thank you for your participation.