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 for the quarter and also provide a review of the company strategy and outlook.
On our website at www.graham-mfg.com, you will find those press releases 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, Debbie, and good morning, everyone. We are pleased with the results of the third quarter and with our acquisition of Energy Steel in the quarter. I would like you to refer to slide five 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 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's 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 have partnered with an Indian company to fabricate the condensers locally in India with the Indian fertilizer facility, further advancing our local manufacturing strategies.
We also had Energy Steel add about $800,000 of new orders since we owned them mid month 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 2010 to the first quarter of 2011. 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're through the trough, and we should begin to have a sequential revenue growth again in our fourth quarter. Comparing year over year is going to be relatively easy because we're comparing 12-year periods to the trough 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's really tied to the pricing environment where orders won 12 to 18 months ago. Those have to be moved through the backlog. We're 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, it 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. The facility that's there now has ample capacity for greater throughput. I remain very optimistic about Energy Steel and its contribution through Graham's future earnings.
Turning to slide five, 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. Our ability to hit the $72 million and 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've said for a number of quarters, the international market will become more important and will lead to 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 others. If we look going forward into '12 and beyond, we should see the power segment begin to expand with the addition of Energy Steel. We feel more positive about the outlook long-term 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, have done a terrific job to ensure there's been minimal disruption with the integration of Energy Steel with Graham.
It has 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 objective and profit improvement objectives for the business.
I am very pleased with the first 1.5 months 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's been very little carry-over into the fourth quarter. It was expensed almost fully in the third quarter.
Looking at growth opportunities as it relates to Energy Steel or our nuclear power market strategy, we believe there's 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, and we feel there's just tremendous upside with this strategy and the acquisition of Energy Steel.
Now on slide seven, I just wanted 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'll play in with our focus on the Naval Nuclear Propulsion Program. We've 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's 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. We have a focus on renewable energies. That's one market that's 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. 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 that 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 a few 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. We have to address demand in a way that we have a flexible cost model. I believe we've advanced that flexible cost model with our focus on subcontracting to allow us to expand when there's strong demand but yet have a fixed cost structure that's 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've committed to and we are achieving shorter lead times across our company. Error reduction has really taken hold. We've seen the improvement in quality, the reduction in re-work come down quite a bit over the last year.
We've implemented a number of IT improvements, both in operations and in the office and our production area as well. 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.
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's a more forward-looking comment as we have identified where the growth is that we need to invest in the business to capitalize on those opportunities.
With that, I'd like to turn it over to Jeff for a more detailed review on the quarter.
Thank you, Jim. As you can see on slide nine, 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 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 in 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; the remaining 6% from the Energy Steel acquisition.
What we're 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're clearly out of the fourth 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 about 10% from last year's number. But that includes the acquisition cost. When you strip out those acquisitions-related costs to 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 a 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 it improved, it was still slightly below 1.0. Again, we expect to continue to see that, a 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 had mentioned, we're working through some lower-margin projects that came in house about a year or so ago. If you look 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 trough in the second and 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 expectations. The decrease in SG&A as a percent of sales has continued as we've, 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 base load.
Looking at the next slide, our outlook for updating our fiscal 2011 full-year guidance; as Jim mentioned, we expect the revenue range of $69 million to $72 million, inclusive of Energy Steel. We expect full-year gross margins to be 28% to 30%. At 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-upper-30 range -- I'm sorry, gross margins to be at the peak of the next cycle to be in the mid-upper-30 range and SG&A to be in the mid teens, though we believe we're still a couple of 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 phase of] 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 and have an acceptable EBITDA margins at the bottom of the cycle, as we've 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've seen $8 million of our excess customer deposits come down. With all of 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 the $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. We will certainly be looking at that.
We definitely want to make sure that we get the Energy Steel acquisition fully integrated and we're very comfortable with that. Subsequent to that, we will continue to look for acquisition opportunities in the long term.
With that, I would like to turn the floor over to questions. Thank you very much for your time.
Ladies and gentlemen, we'll now be conducting the question-and-answer session. (Operator Instructions). Your first question comes from the line of Rick Hoss - Roth Capital Partners.
Rick Hoss - Roth Capital Partners
Jim, remind me. What's your win rate in China? Pick a period; five years, four years or whatever you think can demonstrate the success you're having there on larger, more significant refining or petrochemical fertilizer projects.
Up until 2006 we did not have an installation in China for a vacuum distillation service in the refinery. That's the very (inaudible) system that we sell 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 the refining sector because we knew they would be expanding. Over that period of time from really 2007, calendar 2007, to end of calendar 2010 there was about 3 million barrels per day of additional distillation capacity added and we had won about two-thirds of that. We have one 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. We've done well. We think we have a very strong market condition, certainly about 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's with the Graham brand and executing extremely well on the orders that we won to move ahead of our European competition and the local competitor that we see from time to time on smaller projects. So I've been very pleased and I think we dominate the 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 necessarily entered that market?
That's correct. The first couple of years we were still finding our way, perfecting our model. The last two years our capture ratio actually has been much higher.
Can you give us an expectation for how orders are tracking so far in the fourth quarter? Do you feel that there is a potential to have fourth quarter orders higher than the third quarter or is it too early to tell?
I think there's a really good pipeline with Energy Steel. We're hoping to have a strong bookings quarter with them. They have a number of large projects that they're tracking. Our sense is they will close in the quarter and, should they do so, we'll 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're focused on. To be above the $17.8 million, I think that's 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 teams are advising, that there's a rich pipeline of opportunities expected to close in the quarter and I feel we're in pretty good position on most of them.
So I guess a more appropriate question would be your six month outlook is certainly above the top six months from a booking perspective.
Absolutely, I feel quite confident that we'll be at the first half of fiscal '11 what we pretty much did in the third quarter.
Then remind me. Does Energy Steel -- do they 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 that's pretty similar.
Last question for me -- what are you doing to mitigate raw material? I know that you typically build it into the contract due to the length of your contracts. But what are you seeing? What's your outlook, et cetera?
The outlook is for rising material costs. We're staying ahead of it, I believe, with our pricing our products. We're 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.
Then, as we've shared with everyone before, our policy after we have an order is to procure very shortly after we've won the order the volatile materials so we lock in any cost creep exposure. We've 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 and our procurement policy is such that we do well to retain margin if not improve our margin through procurement strategy. I don't see that changing.
I know that a couple quarters back 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 and our procurement team took advantage of that to define 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, 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.
Your next question comes from the line of Dick Ryan - Dougherty & Company.
Dick Ryan - Dougherty & Company
Jim, the contract you mentioned in backlog that's 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's a refinery in Africa. We're 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 deliveries sometime 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's released. But our sense is, based on the feedback we're having from our customer, it's coming off hold.
Dick Ryan - Dougherty & Company
You mentioned seeing some margin improvement or placing improvement on contracts. Are you seeing that in Energy Steel as well or is that more descriptive of your core business?
I would see that's more descriptive of our core business and I'll be better able to comment on that probably in the May, June call after we've had more time with Energy Steel.
Dick Ryan - Dougherty & Company
What sort of feedback have you gotten to date from either their customers or others in the industry now that you own them?
We've gotten very positive feedback of smart acquisition, a good decision and the customer base likes the long-term potential they see with 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.
Dick Ryan - Dougherty & Company
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're getting concerned of pricing as well [to get] in the queue of further increases?
We haven't seen that. That is something we clearly did see in the 2007, 2008 timeframe. I think it's 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.
Your next question comes from the line of Chris McCampbell - Stifel Nicolaus.
Chris McCampbell - Stifel Nicolaus
Could you give a little color on what's 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 just made one, but maybe if you could talk about where you are in the process of finding other opportunities.
Oil sands -- we're very optimistic about oil sands and where it is today. We see investment happening in the extraction side and that's 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 in extraction capacity, therefore, new bitumen capacity and there's demand there for our products now with the solution that we provided with the recent order.
Then downstream of that for the upgraders, we're seeing -- there really was a stop to investment and upgrading activity about three years ago. But we now are seeing a couple of projects move back onto the table where we're doing early design work, some engineering studies and it's 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're tracking towards that. What's important is we're 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.
Chris McCampbell - Stifel Nicolaus
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.
Well, these are -- 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 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 4 million per upgrader.
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're 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. So all those things came in line and we're very pleased with that.
We are continuing to look. We're going to make sure that we fully integrate Energy Steel within the Graham family and then we'll continue to look while we're doing that. I'm not expecting anything in the immediate term but certainly if the right opportunity comes up we'll pursue it.
So I can't really give you a timeframe other than to say we want to make sure we get this one integrated cleanly first and then we'll move on. We obviously have a 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 don't -- 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've acquired Energy Steel, our acquisition program is still active and we're still looking.
Yes, we still are looking routinely at what's out there and if something comes up we'll pursue it. But we want to make sure we get this one in-house and clean first.
(Operator Instructions). Your next question comes from the line of Scott Blumenthal - Emerald Advisers.
Scott Blumenthal - Emerald Advisers
Jim, I think it was last quarter, possibly the previous quarter, 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 and what your feelings are with regard to that?
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. As we look on average at the margin in the backlog, it's higher than what's being converted to revenue.
The suggestion there is as we get through that lower margin backlog we'll have margin lift as we get to the higher margin work and we'll also have the benefit of leverage because the revenue run rate, pressure 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. We need to push through the business and they're pushing through really a little bit in Q3, a lot in Q4 and somewhat into Q1. We get this behind us -- it's pretty much behind us, I think, in Q4. The average margin of the backlog is superior to what we're producing now and that will provide a nice lift to the margin.
Scott Blumenthal - Emerald Advisers
Jeff, with regard to the quarter that we're talking about now, I saw that you had a sequential increase in backlog even though book to bill was, as you mentioned, below one, which would suggest that your short cycle businesses are doing really pretty well. Can you talk about specifically the short cycle businesses and what you saw during this quarter and how you've seen that maybe accelerate into the current quarter?
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 was really what pushed it up. With regard to short cycle businesses, they have been a little stronger, I'd say in the last quarter or two than they have been previous to that. But really the big jump in the -- the $7.2 million jump in the backlog was due to adding over $8 million of Energy Steel backlog onto our existing backlog.
(Operator Instructions). Your next question comes from the line of Walter Lang - Avondale Partners.
Walter Lang - Avondale Partners
I was curious if you're seeing any increase in activity in US refiners given the improvement [Kraxberg] in the recent past.
We're seeing some early inquiry activity. To be candid, though, we think it's not near-term purchase opportunities that we're working on. We don't see much of the pipeline really tied to the US refining market, 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.
Your next question comes from the line of Scott Blumenthal - Emerald Advisers.
Scott Blumenthal - Emerald Advisers
Jim, do you -- 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 or fuels. There will be some process applications that require vacuum and heat transfer equipment and that's where we fit in. Yes, but not on the extraction.
Scott Blumenthal - Emerald Advisers
So you would be then a beneficiary, I guess, as the opportunity evolved towards the mid and late part of the cycle.
Gentlemen, it appears we have no further questions. I'll 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 to the expansionary period that we believe we're in the early stages of.
I feel we've done the right things in the downturn to provide different and additional avenues for growth. We focused on improving the core business and we've added Energy Steel to Graham and we're 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'll 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.
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