Welcome to the Graham Corporation fourth quarter 2010 quarterly results conference call. (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 your joining us today on Graham’s fiscal 2010 fourth 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 fourth quarter’s performance and will discuss the Company’s 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 full 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 website which is www.graham-mfg.com. In addition, we have posted supplemental slides on the website 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 www.sec.gov.
So with that let me turn it over to Jim to begin the discussion.
Thank you, Debbie, and good morning everyone. The fourth quarter closed a challenging and remarkable year. Challenging and dealing with the effect of the global financial crisis that led to a rapid collapse in our markets that we saw in our order book in fiscal 2009 that played itself out through our record decline in fiscal 2010.
On the other hand, the year was remarkable in many positive ways. We demonstrated the company could not only outperform during periods of strong demand, but also deliver solid financial results in a steep downturn. The attention we provide to our customers is a critical component for our success as we set a new record for orders in the year. Our company-wide commitment to improving Graham each day drove tangible gains in operational excellence, safety and error reduction that ultimately was reflected in our ability to protect margin despite significantly lower revenue.
This market downturn has been particularly sharp and I am pleased with how our managers and employees have navigated the company through this period. We aren’t completely through the downturn and still have a couple of quarters to contend with. We believe the concluded fourth quarter and the next two quarters should represent the bottom of the cycle for us.
During the fourth quarter we had a good level of bookings considering market conditions. Bookings were $18.3 million. Notable orders in the quarter were a large order for South American crude oil refining project, two orders for geothermal power generation; one for Africa and the other for a U.S. installation, a $5 million for an ethylene producing facility in Asia. While market conditions appear to be improving we expect quarterly order levels to remain erratic and unpredictable.
Although as you can see from these orders the drivers of demand for our products as we move forward as we have discussed before will be emerging economies in Asia, the Middle East and South America for oil refining and petrochemical applications. We expect the North American market will not pick up any time soon. Specifically, from U.S. oil refining and Canadian oil sands markets.
However, we are noticing a pickup in bidding activity for U.S. alternative energy projects such as biomass to energy, municipal waste energy and geothermal power generation. The margin potential can be quite a bit lower for these projects and we are facing different competitors from those in the traditional refining and petrochemical markets.
Our near-term view remains positive based on the activity in the pipeline. Our sales and engineering team is busy developing proposals for early stage project work that could materialize into orders of several quarters out. While order levels will vary greatly by quarter we are expecting backlog to expand by year-end based on planned 5-15% year-over-year sales growth.
Sales in the quarter were $13.8 million and were in line with our expectations. Gross and operating margin were 31% and 8.6% respectively with a level of factory utilization and the amount of subcontracting in the quarter I am quite pleased with our profitability. There was exceptionally strong cash flow from operations for the fourth quarter and consequently for the full-year. $17.5 million in cash from operations was generated in the fourth quarter and $30.3 million for the full-year. Both were driven principally by unusually strong customer deposits that will translate into purchases of materials in fiscal 2011. Jeff will elaborate in greater detail on this.
We have structured the company to remain profitable at this level of utilization while permitting ongoing investment in internal development and continuous improvement. As we mentioned last quarter we expect similar sales and profit levels in the first and second quarters of fiscal 2011. The latter half of fiscal 2011 sales are planned to expand as should profitability. We plan to continue to invest in internal development and process improvement in order to strengthen the company and be in a solid position to capitalize to a greater degree than the last cycle on a market recovery.
We expect this market recovery will be different from prior recoveries. It will be led by developing and emerging economies rather than led by developed economies. This will present new challenges and exciting opportunities. Our prior and ongoing investments in people, processes, IT and production equipment ready the company for the upcoming recovery. Moreover, our acquisition program is advancing well. Our focus is clear. We are looking at companies that provide engineer to order, long sales cycle products, serve the energy markets, have a strong customer and quality minded culture, current revenue in the $20-60 million range, provide opportunities for geographic operations and market expansion and will yield a return in excess of our cost of capital.
We have had a number of conversations with various companies and I am encouraged by the strategic fit several targets see as becoming part of Graham. We will continue to remain disciplined in our identification, analysis, confirmation and ultimately integration of acquisitions.
Let me turn it over to Jeff for a detailed review of the quarter and highlights on the year. Jeff?
Thank you Jim and good morning everyone. I will start with a review of sales and operations activity before moving on to orders, backlog and our outlook for fiscal 2011.
As you saw in our press release, net sales in the fourth quarter of fiscal 2010 were $13.8 million, an $11 million decline compared with last year’s fourth quarter but a $1.6 million increase from the trailing third quarter of this fiscal year. As expected, Graham sales have continued to shift towards international and away from the U.S. market. Fourth quarter fiscal 2010 sales were 67% international and 33% domestic, practically the inverse of the 36% international and 64% domestic in last year’s fourth quarter and expanding this year’s year-to-date trend of 52% international and 48% domestic in the first three quarters of fiscal 2010.
Compared with last year’s fourth quarter international sales increased to $9.3 million up $300,000 while U.S. sales declined to $4.5 million, down $11.3 million. For fiscal 2010 net sales were $62.2 million, down 38.5% from fiscal 2009. International sales made up 55% of the total while U.S. sales made up the remaining 45%. International sales in fiscal 2010 decreased by 8% to $34.3 million. Within the international markets Asia sales were $20.3 million, up 53% from $13.3 million last year while sales to all other international markets were $14 million, down 42% from $24.1 million last year.
We have made great strides continuing to penetrate the Asian market especially since we opened an office in China in 2006. We believe our brand in Asia is strong and there remains significant growth potential for Graham in this important growing market. U.S. sales declined to $27.9 million, off 56% from last year’s total of $63.7 million more reflecting the shift where capital is being invested in the refining and petrochemical markets.
By industry, sales dollars declined across all segments in the fourth quarter. The most pronounced decrease in dollars was in refining especially in the U.S. Sales to refiners were down to 34% of total sales in the fourth quarter of this fiscal year compared with 37% in the same period last year. 45% of sales went to the petrochemical industry, up from 35%. 21% of sales were to the power industry and other industrial applications, down from 28% last year.
For fiscal 2010 refining industry sales accounted for 41% of total sales, down from 46% last year. Petrochemical sales for this period increased to 35%, up from 27% last year while sales for power and other industrial applications decreased to 24% from 27% last year.
Before I discuss orders I want to reiterate what we have mentioned in the past; that we expect quarterly orders during this and most periods to be erratic and we suggest using trailing 12-month information to best understand our order trends. Orders in the fourth quarter of fiscal 2010 were $18.3 million, down 11% from the fourth quarter of fiscal 2009. Full-year orders were a record $108.3 million, up 47% from $73.9 million in fiscal 2009. Backlog on March 31, 2010 of $94.3 million was also a record, up from $89.8 million on December 31, 2009 and nearly double the March 31, 2009 level of $48.3 million.
Backlog has increased from its low point in fiscal 2010 of $37 million on June 30, 2009 as we have seen three consecutive quarters of book-to-bill ratios above 1.0. Orders in the fourth quarter were 61% international and 39% domestic. For the full-year orders were split evenly between international and domestic. International orders grew in fiscal 2010 to $54 million, up $11.6 million or 27% from fiscal 2009. Domestic orders were $54.3 million, up $22.9 million or 73% from last fiscal year.
The domestic increase was primarily due to a large order in excess of $25 million from Northrop Grumman to support the U.S. Navy. Excluding this project, international orders would have been in excess of 65% of total orders. Looking forward to the next few quarters we continue to see our sales and order mix shifting towards Asia, the Middle East and South America and away from the United States. It is important to note we expect only 50-60% of our current $94.3 million backlog to ship over the next 12 months.
Historically our 12 month conversion of backlog is usually 85-90%. However, the U.S. Navy project and a couple of large Middle East refinery project have a longer conversion period than normal. The U.S. Navy project alone, which makes up approximately 30% of our backlog, is not expected to begin to convert to sales until the beginning of fiscal 2012. Our backlog is split as follows; 37% in refining, 15% in chemical and petrochemical and 48% for power and other projects. Included in the latter category is the aforementioned Navy project.
At the end of fiscal 2010 we still had $7 million worth of orders in our backlog for projects currently on hold. While this number has not changed in the fourth quarter of fiscal 2010 we did receive a notice of cancellation of one project within the past couple of weeks which will reduce our backlog by $1.5 million.
Our gross margin continued to be relatively strong in the fourth quarter given our level of sales. Gross profit was $4.3 million or 31.1% of sales compared with $9.6 million or 38.8% of sales in last year’s fourth quarter. For fiscal 2010 our gross profit was $22.2 million or 35.7% of sales compared with $41.7 million or 41.3% of sales in fiscal 2009. Clearly for the year the impact of lower sales volumes adversely impacted the gross profit dollar level as well as the under-loading of our production facility which negatively impacted our gross margin percentage.
For the fourth quarter of fiscal 2010 SG&A expenses were $3.1 million or 22.5% of sales compared with $3.5 million or 14.1% of sales in the fourth quarter of last year. In last year’s fourth quarter, fiscal 2009 that is, we also incurred $600,000 of nonrecurring costs related to restructuring expenses. For fiscal 2010 SG&A and other expenses were $12.2 million or 19.6% of sales compared with $15.4 million or 15.2% of sales in fiscal 2009.
The restructuring initiatives we undertook both at the end of fiscal 2009 and in the second quarter of fiscal 2010 combined with lower costs related to the decline in sales accounted for the reduction in SG&A dollars in the current fiscal year. Interest income in the fourth quarter of fiscal 2010 declined to $11,000 compared with $30,000 in the same period last year as a result of the continuing decline in U.S. Treasury yields.
Our investments are in U.S. Treasury securities with maturities up to 180 days. For fiscal 2010 interest income was $55,000 compared with $416,000 in fiscal 2009 despite a significantly higher cash and investments balance. Our effective tax rate in the fourth quarter was almost 49%. However, this included a $311,000 charge to reduce a historical deferred tax benefit for the New York State tax credits which we do not believe we will be able to utilize. Excluding this charge the effective tax rate was below 23%.
For fiscal 2010 our year-to-date tax rate is 36.8% though excluding the tax charges adjusted in the second and fourth quarter the current year effective rate was just about 29%.
Net income in the fourth quarter fiscal 2010 was $600,000, down 83% below last year’s fourth quarter. On a per diluted share basis earnings were $0.06 compared with $0.35 last year. Adjusting out the one-time state tax charge mentioned previously net income was $900,000 or $0.09 per diluted share. For fiscal 2010 net income was $6.4 million compared with $17.5 million in fiscal 2009. We believe we had a good financial result given the significant effect de-leveraging had on our business with lower volume. We have structured the business to work through the trough in our markets and we will be quite happy to get through the next couple of quarters and to begin to see growth in the second half of fiscal 2011.
Graham’s balance sheet remains strong with cash, cash equivalents and investments totaling $74.6 million at the end of March, up from $57.7 million at the end of December and $46.2 million at the end of fiscal 2009. While we are very pleased with this increase it is important to note the vast majority of our cash and investment improvement in the fourth quarter came from a large increase in customer advances which grew to $22 million up from $6 million at the end of December. This increase came from a handful of customers who provided higher up front and near-term projects payments to lock in raw material costs.
The $6 million level from December is in line with a normal cash advance balance from our customers. We expect the customer deposit level to remain higher than normal throughout fiscal 2011 though we do expect it to generally reduce over that period hence using rather than generating cash in this category.
For fiscal 2010 we generated $30.3 million from operating activities, approximately half of which came from the customer deposit increase just discussed. Excluding the customer deposit increase we still generated $14.1 million which given our weak end markets is a significant accomplishment. The cash generation in fiscal 2010 resulted from a combination of strong operating income despite the market downturn and continued improvements in working capital.
We have no borrowings on our $30 million bank line and are utilizing it solely for outstanding letters of credit which totaled $9.6 million on March 31, 2010. Capital expenditures were $500,000 in the fourth quarter of fiscal 2010 and $1 million for the full-year. In fiscal 2009 our capital expenditures were just below $300,000 in the fourth quarter and $1.5 million for the full-year.
As we look ahead to fiscal 2011 we see it as a tale of two halves. The first half of fiscal 2011 will look a lot like the last two quarters; namely sales levels of $12-14 million per quarter and gross margins in the mid to upper 20’s. In the second half of fiscal 2011 we expect to see significant improvement in sales and growth in margins versus the first half of the year. For the full-year fiscal 2011 we expect to see sales 5-15% above fiscal 2010 or $65-72 million with gross profit margins of 27-31%.
Despite higher revenue and the improved utilization which comes with it the margins are expected to be below fiscal 2010 due to the competitiveness in the market for orders over the past few quarters and the shift of our business towards emerging markets and power generation arena as Jim mentioned earlier. We also do not expect to repeat the raw material savings we achieved in the first half of fiscal 2010.
SG&A for fiscal 2011 should be in a range of $12.5-13 million and we expect an effective tax rate of 30-33%. From a cash standpoint we expect our operating cash flow may likely be negative in some periods primarily due to the unwinding of a significant portion of the $16 million in customer deposits I mentioned earlier. Beyond that our operating cash flow will continue to be strong as it has in the depth of this downturn.
We expect our capital spending in fiscal 2011 to be between $2.8-3.3 million. We need to make a major investment in specific manufacturing equipment for the Navy project. That investment alone will be approximately $1.5 million, around half of the total capital for fiscal 2011.
We expect order levels over the upcoming quarters to continue to be erratic and while we generally expect the book-to-bill ratio to exceed and our backlog to grow we are likely to see some quarters where the book-to-bill is below 1.0.
In closing, we believe the fourth quarter was successful despite the depressed level of sales as we continue to remain profitable, generate cash, increase our record backlog, stay close to our customers, focus on internal improvements and positive ourselves well for the beginning of the improvements in our markets particularly in the international arena. We do not believe we are completely out of the woods yet but we have seen strong orders over the past few quarters.
We expect to remain profitable in the first half of 2011 as we did in the latter half of 2010 despite the low sales level and expect to see a noticeable sequential improvement in sales and earnings in the second half of fiscal 2011.
That concludes my remarks. Jim back to you.
Thank you, Jeff. Operator, please open the line for questions at this time.
Question and Answer Session
(Operator Instructions) The first question comes from the line of George Walsh – Gilford Securities.
George Walsh – Gilford Securities
I wonder if you could give just a little more detail about the deposits you are getting from customers. It seems a little different from what I have seen over the years. Is there something special going on there that you are getting more of this money up front? Is it a matter of you are negotiating that you are getting that or conditions in the commodities markets? Or something or any other factor that you may see there?
In general we don’t see a change going forward in how we historically have been able to negotiate progress payments. What we did have was a handful of contracts where we were able to negotiate more forward progress payments as we negotiated with our customers to try and lock in our material costs and they helped participate in that locking in of our costs by advancing us money through negotiations. They were supportive of that. They understood the situation and we negotiated that with a handful of customers. However, I don’t see a pattern change going forward in general.
George Walsh – Gilford Securities
Were those most of the international customers you got that from?
Some were international and one in particular was U.S. based.
George Walsh – Gilford Securities
Maybe a broader question, very broad, but anything in the accident with BP in the Gulf that you see has any potential impact on you in terms of your refining business?
That is a pretty significant even that is happening right now. If I think about it and apply it in a broad sense I think it will support perhaps further investment in the oil sands which is beneficial to us as there could be fear in deep water drilling in the Gulf of Mexico. I don’t think in general it is going to change the long-term demand pattern we project for oil based products and then demand for our equipment. However, I do think there will be a short-term reaction to what has occurred and hopefully foster investment in the oil sands.
George Walsh – Gilford Securities
Any new trends there in the oil sands that you are seeing in terms of momentum of investment there in projects?
One of the things we like about the oil sands activity now is we are seeing investment occur now in the extraction side, developing the sites for the production of oil sand that ultimately then must be upgraded. Where Graham’s equipment is required is in the upgrading section. The investment going on now in the production side has to translate at some point to investments being made in upgrading capacity which is where our large ejector systems and steam surface condensers are required. We are encouraged by what is happening now.
George Walsh – Gilford Securities
On a quantitative basis between getting these deposits up front, you have a record backlog, the cash position is strong so that seems very good but you do say qualitatively you feel the recovery is somewhat tentative. Is that just a standard caution or are there other elements in there you may want to expand on versus some of the quantitative elements that are setting up pretty well for fiscal year 2011?
It is a good question. We are somewhat hesitant in that we don’t believe our markets are in full recovery and clearly we would expect some fragility in the recovery based on what is happening with currency changes and the European situation. They all could have a short-term effect. Looking beyond 2011 which is what we are doing, we are very positive in the outlook and the requirement for capital investment in new petrochemical facilities, new refining facilities, new power generating facilities, we have to get through this period of time which is unpredictable and a time to be cautious.
While we had a very strong level of bookings last year even removing the Navy project I was very pleased with the level of our bookings for fiscal 2010 but our sales team was focused on where the opportunities were and I have to admit there were small pockets of opportunities and our team did a great job capitalizing on those small pockets. In general, there are a limited number of projects. That makes the competitive environment hypersensitive to pricing and protracted negotiations all of which don’t favor necessarily the early part of 2011. But looking beyond these tough couple of quarters and looking beyond 2011 itself I am very encouraged by what we see in the pipeline and the opportunities for Graham.
The next question comes from the line of Chris McCampbell – Stifel Nicolaus.
Chris McCampbell – Stifel Nicolaus
Where would you say we are in the cycle of building the backlog? Do we still have some quarters where we may continue to be able to grow that or are we going to be quickly reaching a point where we start shipping and the backlog will kind of rollover a little bit?
As we mentioned, the first two quarters of fiscal 2011 will be comparable to the last few quarters of fiscal 2010. We have a nice backlog, a high quality backlog that gives us visibility out beyond 2011. I do feel what our view is into the pipeline we will have backlog expand by the end of the year but within the year quarter by quarter there could be quarters where the backlog drops somewhat and there could be quarters where the backlog has an appreciable gain. Nothing that is different from the past.
Chris McCampbell – Stifel Nicolaus
In terms of candidates you are looking at with acquisition possibilities would they share the same cycle or are you looking at companies that may be able to benefit from a later cycle or even earlier cycle where you are kind of diversifying the cycle?
I think the candidates we have been looking at fall into both categories. There are some that would be in a similar cycle to us but there are others that would be somewhat off-cycle and could potentially improve our cyclicality a little bit. So they really fall into both categories.
Chris McCampbell – Stifel Nicolaus
You are looking strictly at situations where you would just use cash and not stock?
Most likely but certainly there are scenarios where a seller might be interested in some stock. We would be very conservative there. We don’t want to dilute our existing shareholders by any meaningful amount.
The next question comes from the line of Dick Ryan – Dougherty.
Dick Ryan – Dougherty
When you look at the pipeline of opportunities there can you give us a feel quantitatively that the size of opportunities you are considering?
The pipeline, I will first speak to it geographically. Much of the pipeline or activity that is emanating from Asia, the Middle East and South America as we have said in the past. On the U.S. market side we are seeing our pipeline increase for opportunities in power generation applications. So going to the size of the projects for power generation applications in the U.S. market these tend to be good size orders but smaller in size compared to a refining project.
As I mentioned earlier in the call the margin potential can be dramatically different for those opportunities due to the buying criteria of the customer as well as the competitive landscape we are facing in that marketplace. When we move to our more traditional markets of refining and petrochemical into the Middle East, South America and Asia the size there for projects can vary between $1 million to $5-7 million. We have a good population of those opportunities in the pipeline over the next 12-18 months.
Dick Ryan – Dougherty
When you look at the announcement from [inaudible] had a pretty good batting average of oil refining jobs in China and the ethylene award in the most recent quarter, does that give kind of a little bit of a forward feel for what could be developing in the chemical processing environment? Is that kind of a precursor of other jobs in the pipeline?
We have won during the last two quarters two nice ethylene projects for Asia; one was for India. One was for Northern Asia. We are bidding a number of ethylene projects. My belief is those won’t materialize for 6-18 months for new orders. Remember our sales cycle is such that we wish to be involved very early. So that gives us good visibility into the pipeline and I would say petrochem lags a little bit behind what we are seeing for investment by the refining market.
There are no further questions in the queue at this time. I would now like to turn the floor back over to management for closing comments.
Thank you everyone for your time this morning. As we communicated on the call we were very pleased with our performance in fiscal 2010. We are very encouraged by how the company is positioned to get through 2011 and we are very excited about looking beyond 2011 based on what we see in the pipeline and improvements we have put into the business and our acquisition program to move Graham to a higher level of performance. We look forward to updating you during the July call. Thank you.
Ladies and gentlemen this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.
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