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Graham Corp. (NYSE:GHM)

F3Q10 (Qtr End 12/31/09) Earnings Call Transcript

January 29, 2010 11:00 am ET

Executives

Deborah Pawlowski – IR

Jim Lines – President and CEO

Jeff Glajch – VP, Finance & Administration and CFO

Analysts

Rick Hoss – Roth Capital Partners

Chris McCampbell – Stifel Nicolaus

Dick Ryan – Dougherty

James Bank – Sidoti & Company

Operator

Greetings and welcome to the Graham Corporation third quarter 2010 quarterly results 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.

Deborah Pawlowski

Thank you, and good morning, everyone. We appreciate your joining us today on Graham’s fiscal 2010 third quarter financial results call.

On the call with me today are Jim Lines, President and CEO of Graham, and Jeff Glajch, Chief Financial Officer. Jim will briefly review the third quarter’s performance and will discuss the Company strategy and the outlook as well as his perspective on the state of the industry’s we serve, while Jeff will be reviewing the Company’s performance in the recent quarter and first nine months of the fiscal year.

You should have a copy of the earnings release that was put out this morning, and if not, you can access at its Company’s Web site, which is www.graham-mfg.com. In addition, we have posted supplemental slides on the Web site to provide a visual overview of our results.

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 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 both at the Company’s Web site and at sec.gov.

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

Jim Lines

Thank you, Debbie. And good morning, everyone. I will review highlights for the quarter, touch on full fiscal year 2010 expectations, discuss current market environment and our outlook. Although it is early year to frame up fiscal 2011 we will also provide a few remarks about what we expect. Jeff will provide details on the quarter and for the full year.

The third quarter surpassed my expectations for profitability. We cannot say not about the fine work our team did to control costs, operated a high level of productivity and to execute. We continue to experience a dismal environment in our markets. And for the sales standpoint our third quarter and we believe the next three quarters represent the bottom of this downturn for the company.

Despite a 50% reduction in sales compared to one year ago we continue to meet our commitment of remaining profitable and generating operating cash flow each quarter. We achieved $0.08 per share or $12.2 million in revenue. And all things considered it represented good control over costs and excellent execution.

Our full-year guidance for fiscal 2010 is revenue between $60 million and $63 million. Gross margin in the range of 34% to 36%. And SG&A around $12 million.

To achieve the upper range for revenue and gross margin a few things will have to work in our favor to include some assistance from our customers to release engineering during the quarter so we can begin production. And no slippage on delivery dates for orders in production.

It has been a struggle since the downturn took hold to finalize engineering with our customer for major orders and then release the work into production. Secondly, we need to book $2 million to $2.5 million of small orders that convert the shipments in the quarter. We have seen a drop-off in the segment of our business during the past year. However, January is off to a good start and our sales group is working hard to win this type of work.

Also, we need to continue to control expenses as we have since this abrupt change occurred in our markets. Lastly, we must sustain strong execution in all aspects of our business. Given the commitment that we have from our employees and the keen focus on execution of our managers I have little doubt this will occur.

We did excellent bookings in this past two quarters with the third quarter in excess of $50 million and the second quarter is just under $30 million. Sales and application engineering continually assess the opportunities in the pipeline and with aggressive focus they are active and are top of opportunities that are closing.

Importantly, our capture rate during the past two quarters was exceptionally high; as a result a backlog is a record $89.8 million and is a multiyear backlog. The backlog has planned to convert the sales in this way. 50% over the next 12 months, another 10% to 15% converts by the end of fiscal 2011, remaining 35% to 40% is divided fairly evenly across fiscal years 2012 and 2013.

There has been a renewed vitality in our markets of late. Specifically, the emerging economies in Asia, the Middle East and in South America. We are not expecting the North American markets to be covered for several more quarters. As a result our sales mix for refining and petrochemical markets will continue to be weighted more heavily towards international markets.

There is intense competition for works that’s available and the combination of the competitive environment in a geographic base of the projects are beginning to put pressure on pricing. Of course, the impact in margins of geographic mix was not unexpected. And increased competition is expected during a cyclical contraction as we’re seeing.

We believe we have established strong defenses to hold our leading market position support our value-based selling proposition and respond to margin pressure. Over the last three years the Company has improved productivity through capital investments in IT and production flow in operations, to meet the company-wide to continuous improvement, error reduction and in becoming faster and leaner.

We’ve increased and approved our capability to outsource fabrication when necessary and even doing a cycle contraction we expanded the sales management team in order to stay close to the customer.

With these and many other improvements implemented I believe we can continue to achieve acceptable margin levels while sales mix becomes more international. Although we have been encouraged with the recent activity in our markets and we are seeing early indications of recovery we believe the recovery is gradual and order levels will remain erratic while the North American markets remain down for some time.

We will continue to defend aggressively our leading market position. We are disciplined in our pricing and we act quickly to opportunities along with changes in our markets. We are constantly evaluating growth opportunities from acquisitions or other forms of business combinations and although there have been a few interesting prospects we are still too pricy for our liking.

The criteria remains expanding sales of engineer to order products to the energy markets, the additional products, accessing new markets and/or expanding our manufacturing footprint geographically.

Regarding fiscal 2011 the next few quarters will be tough and that they like this past quarter represents what we believe to be the bottom of this downturn. First half of fiscal 2011 will be comparable to the second half of fiscal 2010 in terms of revenue and profitability. It is the result of light bookings three quarters to five quarters back.

As we work through those quarters we anticipate revenue growth and profit improvement commencing the second half of fiscal 2011. We need a little more time to gain traction on the large projects won recently to understand better how we will convert to revenue.

Customer engineering releases have been slow and that directly affects when we can begin production and start to recognize revenue. I will be in a better position to comment or thoroughly on fiscal 2011 during the May conference call.

Our challenge over the next three quarters is surgically expanding as needed to address the growth we expect in the beginning of the second half of fiscal 2011 while operating in a weak revenue environment and maintaining profitability.

The front end of our business is extremely busy. Engineering, design, CAD, purchasing are all very busy. And while we are working with customers to try and get early releases majority of projects are on elongated time schedules. And customers are watching their own cash flow. As a result they are not interested in moving projects forward until it’s necessary.

Another example of our near-term challenge is, is the Navy project. Although we do not expect to recognize revenue on this project until fiscal 2012 it is an engineering attempts of project and we will be consuming engineering man hours over the next year.

However, our method of revenue recognition is percentage of completion and that is our production hours only, not engineering time. We expect that we could find the proper balance and despite having to drive through this currently dismal market environment. We are very encouraged as we look beyond fiscal 2011. Let me turn the call over to Jeff for his remarks.

Jeff Glajch

Thank you, Jim, and good morning, everyone. I will start with a review of sales and operations activity before moving on to orders and backlog. As you saw in the release net sales in the third quarter of fiscal 2010 were $12.2 million, a $12.5 million decline compared with the last year’s third quarter and down $3.9 million from the trailing second quarter of this fiscal year.

As expected Graham sales have continued to shift toward international and away from the U.S. market. Third quarter fiscal 2010 sales were 42% domestic and 58% international, completely inverted from last year’s third quarter although first half of this year’s sales had been equally split between the U.S. and international markets.

U.S. sales declined $9.3 million or approximately 65% to $5.1 million in the quarter while international sales declined $3.2 million or just 32% to $7.1 million.

Sales to all major international regions were lower compared with last year’s third quarter with the exception of Africa.

For the first three quarters of fiscal 2010 net sales were down 37% below last year’s comparable period. In this period U.S. sales made up 48% of total sales and international sales accounted for the remaining 52%. The percentages for the same period last year were weighted more heavily toward the U.S. which had 63% versus 37% international.

Sales in the first nine months of this fiscal year to Asia had nearly doubled to $14.9 million from $7.8 million in the first nine months of fiscal 2009. This combined with slower U.S. market sales accounted for the majority of the shift toward international weighting.

While the current quarter’s order levels was heavily weighted toward the U.S. if you were to exclude the large North African U.S. Navy project orders would have been more weighted toward international as we have seen in the first half of the fiscal year. Looking forward to the next few quarters we continue to expect see our sales and order mix shifting toward Asia and the Middle East and away from the United States.

By industry, sales dollars have declined across all segments. The most pronounced decline was in refining, especially in the U.S. as would be expected. Sales to refiners were down to 36% of total sales in the third quarter of this fiscal year compared with 46% in the same period last year. 44% were to the petrochemical industry, up from 27% and 20% were to the power industry and other industrial applications, down from 27% last year.

For the nine months of fiscal 2010, refining industry sales accounted for 43% of total sales, down from 48% total sales in last year’s first nine months. Petrochemical sales for this period increased to 32%, up from 24% last year, while sales for power and other industrial applications decreased to 25% from 28% of total revenue last year.

Orders received in the third quarter of fiscal 2010 were a record $51.6 million. The previous record was $35.1 million which was realized in the fourth quarter of fiscal 2008. Domestic orders totaled $37 million and accounted for 72% of orders.

The domestic orders were largely driven by the North African orders to support the U.S. Navy aircraft carrier which was in excess of $25 million. Please note as we have mentioned in the past we expect quarterly orders during this disruptive period in the cycle to be quite erratic and we suggest using trailing 12 month information to understand our order trends.

At the end of December 2009, backlog was a record $89.8 million, a $39.3 million improvement from the backlog of $50.5 million at the end of September 2009 and $13.8 million above our previous record of $76 million which was achieved in June 2008.

As Jim mentioned it is important to note that we expect only 50% of this backlog to ship in the next 12 months and 60% to 65% is expected to convert the sales in the next 15 months which will take us to the end of fiscal 2011.

Our historical 12-month shipment expectation is usually 85% to 90% of backlog; however, the U.S. Navy project is not expected to begin to convert the sales until the start of fiscal 2012. In addition, a significant portion of a pair of large Middle East refinery orders which we discussed on last quarter’s conference call will only partly convert before the end of fiscal 2011.

Our backlog is split as follows; 40% in refining, 20% in chemical and petrochemical and 40% for power and other markets. As a side note the U.S. Navy project falls into and makes up the majority of the ladder category. Our equipment is part of the nuclear power compulsion system for this year.

We still have $7 million of orders in our backlog that if projects currently on hold. This number has not changed in the past quarter. Given our backlog in general business conditions we are narrowing our guidance for the full fiscal year 2010 revenue to be in the range of $60 million to $63 million.

Our gross margin continued relatively strong in the third quarter given our level of sales and better than previously anticipated. Our restructuring efforts over the last year stuck extremely well without any significant cost increases during the quarter.

Gross profit was $3.8 million, or 31.4% of sales, compared with $9.4 million, or 37.9% of sales in last year’s third quarter. For the three quarters of fiscal 2010 our gross profit was $18.0 million, or 37% of sales, compared with $32.1 million, or 42.1% of sales, in last year’s first nine months.

Based on the strength of our gross margin in the third quarter, we have increased our full-year gross margin guidance as a percentage of sales to be in the range of 34% to 36%. When you do the math you will find that our fourth quarter gross margins will be lower than the third quarter in the mid-to-high 20s although planned level of revenue was expected to be similar to the third quarter the mix contains lower margin projects.

For the third quarter of fiscal 2010 SG&A expenses were $2.7 million or 22.3% of sales compared with $3.6 million or 14.4% of sales in the third quarter last year. SG&A was also down about 11% from the trailing second quarter.

For the nine month period SG&A expenses were $9.0 million or 18.6% of sales compared with $11.3 million or 14.8% of sales in last year’s comparable period.

The restructuring initiatives we undertook, both at the end of fiscal 2009 and

more recently in the second quarter of fiscal 2010, combined with lower commission costs, related to the decline in sales, account for the reduction in SG&A dollars in the current fiscal year.

We were also able to delay certain spending in the third quarter. We have lowered our expected SG&A spending for the full fiscal 2010 to approximately $12 million. We expected sequential increase in SG&A is related to the weighting of projects based in China and selling expenses associated with them as well as the need to execute some activities that were delayed during our third quarter.

Interest income in the third quarter of fiscal 2010 declined to $11,000 compared with $83,000 in the same period last year as a result of the significant decline in U.S. Treasury yield. Our investments are in U.S. Treasury securities with maturities up to 180 days. Our effective tax rate for the Q3 was just above 31%, our year-to-date effective tax rate for fiscal 2010 is approximately 35% though excluding the tax charge we discussed during the last quarter’s call the effective rate is just above 30%. We expect the full-year rate will be between 30% and 31% when you exclude that charge

Net income in the third quarter of fiscal 2010 was $800,000, down nearly 80% below last year’s third quarter. On a per diluted share basis earnings were $0.08 per share compared with 37% last year.

For the nine-month period net income was $5.8 million for the first three quarters compared with $13.9 million last year. We believe that we have had good results given the significant effect de-leveraging has on our business with lower volume. We have structured the business to weather the trough but we would be quite happy when we get to the other side and achieve our growth goals.

Graham’s balance sheet remains strong with cash, cash equivalents and investments totaling $57.7 million at the end of December, up from $54.7 million at the end of September and $46.2 million at the end of fiscal 2009.

So the nine months of fiscal 2010 we generated $12.7 million from operating activities and increased our cash and investments position by $11.5 million. The cash generation in the first nine months of fiscal 2010 resulted from a combination of strong operating income despite the market downturn and continued improvements in working capital. Excluding cash, cash equivalents and investments the net of our current asset less current liabilities is negative $2.5 million.

We have no borrowings on our $30 million bank line and are utilizing it solely for outstanding letters of credit which totaled $8.8 million at the end of the second quarter.

Capital expenditures were $220,000 in the third quarter of fiscal 2010 and $502,000 in the first nine months of this fiscal year. We continue to pursue our capital plan, which is an important part of our internal development activities and estimate the total capital expenditures for fiscal 2010 will be between $800,000 and $1 million with half of that investment being used for productivity improvements.

We do expect our capital spending in fiscal 2011 to be around $3 million in total as we will need to make a major investment in spending for specific manufacturing equipment for the Navy project. That investment alone would be approximately $1.5 million.

In closing, we expect the fourth quarter of fiscal 2010 and the first two quarters of fiscal 2011 to have similar depressed sales levels as we achieved in the third quarter fiscal 2010.

Despite the lower sales levels we expect to continue to remain profitable in each quarter and to generate positive cash flow. We expect sales to begin to increase in the second half of fiscal 2011.

That concludes my remarks. Jim, I turn it back to you.

Jim Lines

Thank you, Jeff. Operator, please open the line for questions.

Question and Answer Session

Operator

Thank you. (Operator instructions). Our first question is from the line of Rick Hoss with Roth Capital Partners. Please proceed with your question sir.

Rick Hoss – Roth Capital Partners

Hi good morning, Jim, Jeff, Debbie?

Jeff Glajch

Hi, Rick.

Jim Lines

Good morning, Rick.

Deborah Pawlowski

Hi Rick.

Rick Hoss – Roth Capital Partners

For this quarter and you've given your expectations for comparable types of revenue level that’s taking sequentially would you view this quarter as probably the weakest from a revenue standpoint?

Jim Lines

We view that the next three quarters will have revenue in the range that actually similar to the third quarter that just ended, however, there can be some upside to that based on releases from our customers and being able to get engineering into production and then revenue recognition. Risk on the downside is delays from our customer in doing that and the level of small orders that are one that typically can convert within a quarter. So we see the right ways to think about over the next few quarters is comparable to the third quarter, understanding there could be some upside and there is some risk or little downside.

Rick Hoss – Roth Capital Partners

Okay. And then earlier, Jim, you talked about types of product that you could sell in the $2 million to $2.5 million range, what products are those?

Jim Lines

That comment was for our smaller products and that we to meet the upper end of the full year guidance required an additional level of bookings in this quarter that would convert to sales in the quarter of $2 million to $2.5 million we have after market, small heat transfer products, small ejector systems and vacuum pumps that, that stood that category that have an ordered to shift cycle between one week and six weeks.

Rick Hoss – Roth Capital Partners

Okay. And then you comment that January looked pretty good so far that would be related to those types of smaller (inaudible) type product?

Jim Lines

That’s correct.

Rick Hoss – Roth Capital Partners

Okay. And then on the productivity improvements that you mentioned in your release can you give us an appreciation to what type of benefit we could see to say take a revenue level and just again in 2008 year you’re on $85 million, your SG&A was $13 million can you tell us an approximate level that given the new structure that you’re operating under, what for SG&A you would expect?

Jim Lines

For the productivity improvements they relate more to in the costs.

Rick Hoss – Roth Capital Partners

The gross margin?

Jim Lines

In the gross margin.

Rick Hoss – Roth Capital Partners

Right.

Jim Lines

Although we have business improvement that goes into the SG&A side much of our capital plan really related to leveraging the operations side of the business.

Rick Hoss – Roth Capital Partners

Okay. So it would be pretty difficult to nail down as the profitability of future products probably be lower than you experienced in 2008 however that would be partially offset by these improvements that you made in the organization?

Jim Lines

That’s a great way to look at it. That’s how we thought about it. When we embarked on the capital plan recognizing over a period of time we will be facing margin pressure in the marketplace because of the business becoming more weighted toward international sales and the type of orders that we thought we would win in the comings years. To combat that we had an aggressive capital plan to improve the performance of the business.

So we do think generally we will have margin pressure and we’ve done a number of things to have a defense against that, but we’ve also commented if you’re comparing us to 2008 or 2009 fiscal year performance the gross margin was 40% plus or minus a little bit we would expect in a comparable period of peak market conditions that we would be a little bit below that in the mid-to-upper 30% gross margin range of a modeling ramp.

Rick Hoss – Roth Capital Partners

Okay, thanks for your insight.

Jim Lines

You’re welcome.

Operator

Thank you. Our next question is from the line of Chris McCampbell of Stifel Nicolaus. Please go ahead with your question sir.

Chris McCampbell – Stifel Nicolaus

Good morning, guys. Just had a quick question. Can you remind me if we still have an active stock buyback program or did that end I guess last year?

Jeff Glajch

This is Jeff, Bell. We do still have an active buyback program that is in place until July of this year. We have not repurchased any shares under that buyback program since the first quarter of this fiscal year however.

Chris McCampbell – Stifel Nicolaus

Okay, great, thanks.

Operator

Thank you. (Operator instructions). Our next question is from the line Dick Ryan with Dougherty. Please proceed with your question sir.

Dick Ryan – Dougherty

Hi, good morning, guys. Jim, you talked about an environment where you are seeing increased competition, pricing pressures but then your comment of exceptionally high capture rate. Can you kind of walk through what you know, what you are saying there and what’s causing that high batting average if you will?

Jim Lines

Sure. What we’re seeing right now compared to one year or two years back is the number of opportunities at any given point in time are far fewer where orders that are closing, therefore, the same number of suppliers are chasing fewer orders and that increases the competitive pressure. And then you add to that far less of the available opportunities are for the North American market, which had in the past a much higher margin potential.

So we have those things going on, but to our credit, our sales team, our application team has had a very close focus on those orders that we felt would be closing and our interaction with the customer, our managing of the sales pipeline really have led to an increase in our capture ratio with an aggressive for those projects that are closing. In some cases admittedly we took a defensive posture to maintain our dominant position in a particular market, in other cases the margins have been customary, but in general, and I would say the competitive pressure is greater than it had been one year to two years ago.

Dick Ryan – Dougherty

Okay. On the international side, I think you mentioned you’re seeing for the strength in Africa and then South America was mentioned earlier can you give us a little color on what you’re seeing in some of those regions?

Jim Lines

Sure, yes, the recovery appears to be in early stages in the Asian market, in particular, in China, also the Middle East has had some activity and we’ve had prior announcements regarding orders that we have won for the Middle East and we felt and we had indicated that Asia and the Middle East would lead the recovery in our markets followed by South America.

The opportunity pipeline that we’re looking at there’s a number of projects on the horizon in South America for the state-owned refiners expanding the refining capacity or adding new petrochemical plants and we see those materializing over the next one year to five years, the Middle East has had a couple of projects move ahead and China has been pretty steady. Africa was that was an isolated case of fertilizer project in Northern Africa that we had won.

Dick Ryan – Dougherty

Okay. Great. Thank you.

Jim Lines

You’re welcome.

Operator

(Operator instructions). Our next question is from the line of James Bank of Sidoti & Company. Please go ahead with your question, sir.

James Bank – Sidoti & Company

Hi, good morning.

Jeff Glajch

Good morning, James.

James Bank – Sidoti & Company

Hi, joining very late to the call here. I just wanted to quickly ask if there were any new words mentioned on your prepared remarks, Jim, for the month of January.

Jim Lines

We did not mention any (inaudible).

James Bank – Sidoti & Company

Okay, great. And again if you’ve already covered this I’m sorry, but certainly a big noticeable increase in your power orders in this recent quarter I was wondering if there was something specific in there or this is the type of trend we should see going forward given the fact that refining is especially in the U.S. is slow?

Jeff Glajch

James, this is Jeff. Is it really powers [ph] the power in other category related to the U.S. Navy project that we (inaudible) that we announced in December that falls into that category (inaudible) but that’s the big driver there.

James Bank – Sidoti & Company

Okay. And lastly I guess for the U.S. any good news to report from maybe some renewable fuel works, any of these alternative areas that you guys otherwise didn’t participate really historically I think given this environmental shift?

Jim Lines

Looking at the U.S. market there is a lot of activity in small power plants, cogeneration, waste to energy, municipal solid waste to energy, combined cycle power plants, those historically going back to the 80s a little bit in 90s when it was active was an area that grounded very well in and we have our eye on that.

James Bank – Sidoti & Company

Okay. Great. Thank you.

Jeff Glajch

Welcome.

Jim Lines

Welcome.

Operator

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

Jim Lines

Well, thank you, everyone, and we look forward to updating everyone again on our May call. Thank you.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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