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Thesis

Graham Corporation (GHM) is a high quality business run by top notch managers trading for an average price. The business has long term tailwinds, and the company has a sizeable cash balance that can be used to make an acquisition. I believe investors today are buying all of the company’s future growth opportunities for free.

What Do They Do?

Graham makes engineered-to-order products for the energy markets, including ejector systems, surface condensers, and small specialty heat exchangers and pumps. What do these do? Basically, the ejector systems lowers the pressure within a column, which allows liquids to boil at much lower temperatures. They sell mainly into the refining, petrochemical, and power markets.

Do They Have a Moat?

Yes, an extremely large one.

Graham has a moat in two areas. First, the products they sell are a very small cost of the total system (when they sell to a refiner, their product normally costs $4 to $6 million, while the total refinery costs $2 to $5 billion), but their products are “systems critical.” When the product is such a small portion of cost and critical to the entire project, the customer is not going to go with an unknown company just to save $50,000. Instead, they are going to go with proven leaders who will be there to provide support if anything goes wrong and have proven product reliability. Graham is by far the most trusted and biggest player in this niche, so most people chose them.

Second, Graham mentions that most of the systems that they are contracted for have 5-year lead times. Graham’s products aren’t needed until the 3 to 3.5 year mark, and they are normally contracted to build their products at the 2 year mark. Graham, however, sends their engineers to work with and design systems with the project leads from the start of the project. They provide their technical advice to the customers for free. In return, the customer grows to trust Graham. While this investment does not always lead to sales, Graham notes they are almost always invited to bid on the project and have extremely high success rates in the bidding process.

Also, this business calls for very little capital investment. Graham execs note that normalized capex should run between $1 to $2 million per year. For a company that earned over $15 million in both fiscal year 2008 and 2009, you can see that they can generate lots of excess capital and cash.

Operational Risk

Graham’s business is very cyclical and highly dependent on the energy markets. Note, however, that while they currently are very integrated in oil refineries and other petrochemical powered projects, they are relatively energy agnostic- Graham’s products work just as well with geothermal, natural gas, biofuels, etc. Still, a prolonged contraction in demand for all energy would hurt Graham.

The biggest risk to an investor today, however, is that Graham has a large cash war chest (over $55 million of excess cash), and they are determined to make an acquisition. If they make a poor acquisition, it will really hurt shareholder value. However, while I’m normally terrified of acquisitions, I’m soothed by how the company is going about the process. They have continually said they will not rush into an acquisition and that they will only make the right acquisition at the right cost, and they have backed their words up. They announced their desire to make an acquisition at least two years ago and still have not made any moves - they have not found the right acquisition at the right price. Further, look at this quote from the CFO:

Once we’ve identified the right opportunity, we want to make sure that we’re going to generate cash with the cash that we are spending cash with the cash that we are spending. We’re not looking just to improve our earnings-per-share. Given that the $58 million is currently invested in treasury bills making 10, 15, 20 basis points it would be very easy to improve our earnings-per-share and make a sub-optimal acquisition. That’s not our intent. Our intent is to make an acquisition that will generate on a cash basis a return that exceeds our cost of capital.

Valuation

Graham’s current value ratios don’t like a typical value play. Their P/E, for example, is just under 20. However, this is because Graham’s markets tend to bottom 18 months after the bottom of a recession. Indeed, Graham has forecasted that the next two quarters will mark the bottom in their market. I believe this, however, is an opportunity for today’s investor. Investors are seeing other companies earnings and sales rapidly increasing and wondering why Graham’s are lagging behind, perhaps questioning the viability of Graham’s markets. However, Graham has consistently stated they believe in the long term strength of their markets, and we are beginning to see that in increased orders and backlogs.

Anyway, for a cyclical business, I think the most appropriate valuation is to take a multiple of their average earnings over a full cycle. Graham’s most recent cycle started in fiscal 2005 and ended in fiscal 2009. EBITDA over that time averaged 12.63 million. Graham has stated average cap ex should run between $1 to $2 million per year. Let’s say it runs at the high end of that, $1.6. That puts average EBIT at $11 million, and earnings of about $7.7 million assuming a 30% tax rate. Applying a multiple of 10 to EBIT, or a multiple of 15 to earnings, yield values of 110 to 115 million. Adding back the $56 million in cash gives a value of about 170 million, equivalent to today’s price.

The problem with that, however, is it ignores the moat of the business. After stripping out excess cash, I find the company averaged ROE of over 30% over the past cycle. Management has also made significant investments in IT which has allowed the business to expand into new areas that diversify the company and cushion them in down cycles. Margins are also vastly improving- the EBITDA margin in the current down cycle will be higher than the margins were at the very beginning of the last up cycle.

Catalyst

No strong catalyst, though if management can make that strong acquisition they have been talking about, it will drastically improve earnings.

Price Target

At today’s prices, I think you are buying the company and getting all of its growth prospects for free. While it’s difficult to assign a specific value to that growth, I have a price target of $22.4 on GHM. This would put an EV of about $165 million on the stock, about 15 times EBIT over the last cycle. I think this nicely balances out the company’s growth prospects and the fact the company is a much stronger company now than it was during the last cycle with a conservative valuation.

Note: I originally stumbled upon the idea through the magic formula screen at magicformulainvesting.com, and I got really interested in them after reading the transcripts of one of their presentations. This is an extremely shareholder friendly company, and you can find transcripts of all of their presentations here, as well as transcripts of all their earnings conference calls here. I encourage you to read them, they’re exciting and an excellent example of how I like management to approach their business.

Disclosure: Author long GHM

Source: Graham Corp.: High Quality Business With Free Growth Kicker