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Chuck Royce, who added to his position in Graham Corporation (GHM) at the end of 2012 after divesting about half of his position in late 2011 and early 2012, will likely attract 'guru followers' and value investors to revisit this world leader in the design and manufacture of Engineered-To-Order products for the energy markets whose earliest roots extend back to 1936. The market is anticipating news or announcements of new builds for Submarine Programs by GHM, which will validate GHM's ambition to be a consistent supplier to the Navy and build a $20-30 million per year revenue base for itself. Since fiscal 2006, GHM has delivered 7 consecutive years of profitability and grown its revenue and EPS by a respectable ten year CAGR of 8.1% and 14.4% respectively. GHM also has a rock-solid balance sheet with no debt and net cash representing approximately one-fifth of its current market capitalization.

Company Background

GHM is a global designer, manufacturer, and supplier of custom engineered ejectors, pumps, condensers, vacuum systems, and heat exchangers, with world-renowned engineering expertise in vacuum and heat transfer technology. GHM's subsidiary Energy Steel & Supply Co. is a leading code fabrication and specialty machining company dedicated exclusively to the nuclear power industry. Sold either as components or complete system solutions, the principle markets for the company's equipment include oil and gas refining, chemical/petrochemical, nuclear power generation and other power generation.

Business Quality

GHM has strong brand recognition in the industry, by virtue of a strong reputation for top quality, reliable products and high standards of customer service built over the past 75 years. Futhermore, its wholly-owned subsidiary, Energy Steel, has a 30-year history of providing products and support to its customers, especially the U.S. nuclear power industry. The recognition of the Graham and Energy Steel brands allows GHM to capitalize on market opportunities in both existing and potential markets.

GHM's key markets, both old and new, are growing. Its traditional markets in oil refining and petrochemical are benefiting from aging infrastructure in developed markets, middle class expansion and consequently accelerated demand in emerging markets. Major refining projects are slated for Middle East countries such as Saudi Arabia, Kuwait, Iraq, UAE; while favorable natural gas prices are expected to drive investments in petrochemical and fertilizer plants. GHM's new markets in power generation and power for defense industry have strong growth potential. Its power generation business is expanding as a result of aging nuclear power infrastructure and new power plants on the back on international nuclear power expansion. Besides a strong pipeline for replacing and upgrading equipment at existing plants, GHM secured first orders for US-based Westinghouse AP1000 new facilities. Investment in new U.S. nuclear reactor projects planned for the Summer (South Carolina) and Vogtle (Georgia) facilities are positive signs of continued growth in the domestic nuclear market.

GHM creates a competitive advantage for itself by getting involved in the early sales/product lifecycle. By getting its feet wet in concept and front end engineering design in the first two years prior to the bid, GHM has an edge over competing bidders by understanding pipeline, developing design options, and identifying key decision makers in the bidding process.

Catalysts

Chuck Royce added to his position in GHM by buying 128,123 shares at an average price of $19.50 in the fourth quarter of 2012. Royce & Associates currently holds 1,121,785 shares or 11.23% of total shares outstanding in GHM, with an estimated average cost of approximately $12 per share. Chuck Royce, who added to his position in GHM at the end of 2012 after divesting about half of his position in late 2011 and early 2012, will attract 'guru followers' and value investors to revisit the stock.

At the Western New York Investors Conference in September 2012, management provided guidance on the profit potential for the Naval Nuclear Propulsion Program: $35 million to $40 million addressable opportunity per carrier under the Aircraft Carrier program; and $20 million to $25 million addressable opportunity per Ohio Replacement class submarine and $15 million to $20 million addressable opportunity per Virginia-class submarine under the Submarine program. During the second quarter fiscal 2013 Results Teleconference, GHM revealed that it had already secured $2.3 million in orders for the Naval Nuclear Propulsion Program replacement parts for equipment that it provided quite some time ago for carriers, and a couple of orders for sub work, still in the engineering aspect of those programs. While these particular orders are not for build, management views them as important stepping stones to eventually building equipment for Submarine Programs. Any news or announcements of new builds for Submarine Programs will be a huge step in GHM's ambition to be a consistent supplier to the Navy and build a $20-30 million per year revenue base.

Valuation and Financial Analysis

GHM currently trades at a trailing twelve months P/E of 37.2 and a trailing twelve months EV/EBITDA of 14.9. GHM has achieved a trailing twelve months ROE of 7.2% and a five year average ROE of 17.9%

Since fiscal 2006, GHM has delivered 7 consecutive years of profitability with positive operating cash flow in six out of the seven years. Management has grown GHM's revenue and EPS by a respectable ten year CAGR of 8.1% and 14.4% respectively. GHM is debt-free and has a strong balance sheet with net cash of $46.9 million representing approximately 20% of its current market capitalization. Its defined benefit pension plan obligations are fully funded. GHM has paid out dividends in every single year since 2002 and currently sports a dividend yield of 0.36%.

Investment Risks

Most of GHM's products are purchased in connection with oil refinery construction, revamps and upgrades and customers may defer or cancel orders in the event of huge volatility in the price of oil and natural gas. In addition, GHM faces considerable customer concentration risk, with top ten customers accounting for 43% and 46% of its consolidated sales in fiscal 2012 and 2011 respectively.

GHM's business strategy revolves around pursuing defense-related projects as well as projects for end users in the alternative energy markets in the U.S. Government cutbacks in defense spending or reduced incentives for alternative energy projects, as part of efforts to reduce large U.S. federal budget deficits, could potentially reduce demand for its products.

GHM derives a substantial portion of its sales from fixed-price contracts. Its profitability will suffer if the original cost estimates in contracts prove to be inaccurate, its subcontractors fail to perform, or contract counterparties successfully assert claims against GHM.

Source: Graham Corporation: Chuck Royce Buying Again And Potential Submarine Win Will Be Key Catalysts