Description

Thesis: Graham Corporation is consistent double digit cash flow return on capital earner with the highest EBITDA margins in the industry; book value compounder, at 16% last 10 years; trading at its historical lows (1.4x BV); with incredibly strong balance sheet at over 1/3 of market value in cash with zero debt.  With a significant pull back on capex by refiners running at 100% capacity, the company is due for a significant order uptick in the next 12-18 months.  In the meantime the company is increasing the recurring revenue portion of its business and has a long term contract with the Navy to supply components for the nuclear submarine fleet. Continued strong growth in book value and EPS even through the cyclical lows and the return to the 10-, 20-, 30- year book value median highs of 3.6x should provide a 180% upside within the next 3 to 5 years.

*I’m including a number of quotes from the CFO and CEO over the last year in this write up. I’ve spoken with the CFO and his public and private stance is very similar so I thought including transcript quotes gives pretty good color on the business and company.

Business Description

Graham Corporation, together with its subsidiaries, engages in the design, manufacture, and sale of heat transfer and vacuum equipment for the chemical, petrochemical, refining, energy, defense, and electric power generating industries worldwide. The company offers heat transfer equipment, including surface condensers, Heliflows, water heaters, and various types of heat exchangers; and vacuum equipment consisting of steam jet ejector vacuum systems and liquid ring vacuum pumps. It also services and sells spare parts for its equipment; and supplies components used inside reactor vessels and outside containment vessels of nuclear power facilities. The company sells its products directly, as well as through independent sales representatives. Graham Corporation was founded in 1936 and is headquartered in Batavia, New York.

For FY 2015 (3/30/15) the company’s $135mm in revenues were broken down by the following:

Chemical/Petrochemical: 35%

Refining: 32%

Navy/Other: 18%

Power (Nuclear): 15%

United States: 67%

Asia: 8%

Middle East: 8%

Other: 20%

Backlog ($108mm 9/30/15):

Navy/Other: 52%

Chemical/Petrochemical: 12%

Refining: 24%

Power: 12%

SWOT Analysis (the best way to describe the company)

Strengths:

·       Refining Market Leadership – GHM is the leading supplier of vacuum systems and surface condensers, an annual ~$200mm market. The company has a ~30% market share and an exceptional reputation having supplied the market for almost 80 years.  Additionally, the company has a 50% to 66% bid to win ratio historically.  GHM also has a nice mid-teens market share in the petrochemical market as well.

·       Critical Component Products/Low Capital Costs – The company’s products are both of critical importance and have a high cost of failure, thus reputation for high quality is important. Additionally, the products are an extremely low part of the overall capital budget creating low price sensitivity to the customers.

“Our equipment is critical to the process in the operation of our customers’ facilities. It has, what we like to call, a high cost of failure. If it doesn’t work, our customers have a big problem, because we believe we are very good in what we do; that’s what we believe our customers come to us for. They have a low tolerance, if it’s not meeting its performance specifications that our customers expect. When we quote them, our product is going to work to that quoted level, and in most cases it does. It’s very difficult to replace or adjust the equipment. Finally, our product has a low relative capital cost. And what I mean by that, if you’re building a large refinery that perhaps may cost $5 billion, our equipment maybe is $5 million of that or $10 million of that, which is one or two-tenths of 1% of the total capital cost of their facility. So our equipment is a very small piece. They are more focused on, is it operationally going to work? Is it going to work to specifications? Is it going to start up on time? Are they going to get the right support? And while cost is always important, it’s not usually one or two on their list of factors to consider.” – Jeff Glajch, CFO, 8/11/15

·      High Cash Flow Returns On Capital and Industry High Margins – Graham has some of the highest cash flow returns on capital in the industry, with the median 10 year annual return of 16% and average of 26%.  The lowest return it’s ever had in the last 10 years has was been 11%.  The company has a median EBITDA margin of 17% (15% to 19% range) compared to the Industrials Industry median of 8%.  This is achieved by having one low capital cost facility in cheap-to-hire upstate NY and relatively low SG&A expense of 15-16% (down cycle guidance of 17-18%) and an efficient use of working capital at 10% of revenues on average. Maintenance CapEx has been minimal at $2-$3mm per year at 1-2% of revenues.  As a result the company has been able to convert 90% to 100% of its net income to free cash flows historically

      Strong Balance Sheet – As a result of its high CFROA GHM company has built up ~62.5mm of cash on its balance sheet, with zero net debt despite paying a consistently growing dividend.  While there is an $18 million stock buy back in place (or 11% of market cap, $3.4 bought at 9/30/15 with more purchases in October), the company is actively looking for acquisitions.  With a recent increase in capacity at the Batavia facility (at a $6.5mm expansion) the company is well positioned to consolidate smaller competitors or ancillary services.  For example, the new facility expansion allowed the company to win the long term Navy contract.  

The company’s acquisition strategy seeks to diversify products, markets, and/or geographic presence. The company’s acquisition criteria are:

·        Engineered-to-order products for energy industry

·        Strong management team with customer and quality focus

·        $20 million – $60 million in annual revenue

·        Cash return exceeds equity cost of capital

·        Strong pricing discipline 

o   Example/Case: The company recently bought Energy Steel, for $18.5mm, a small scale supplier to the nuclear power market.  Adding GHM’s scale to Energy Steel has allowed the company to compete and expand in markets and businesses they haven’t before.

“When we bought Energy Steel few years back, what were their limitations and how did we help them? I’ll talk to Energy Steel specifically. It was a very well-run company, can’t be more complimentary of the management team that came with the business. They had run into a couple of barriers, one is that they were reticent to go after large projects. So they had challenging projects in the past, that had led them to not go after multimillion dollar projects, we are now going go after those big projects. We brought project management capabilities to them so, subsequent to the acquisition for example, about the year or two in, we won a pair of projects to provide equipment to the new build nuclear plant in the Summer facility in South Carolina and the Vogtle facility in Georgia through our customer who is Westinghouse. Those two projects in aggregate were approximately $15 million; they are not complete yet, they are almost complete, but there are long-life projects like that. Those are projects that Energy Steel would not have been comfortable betting on in the past and perhaps Westinghouse would not have been comfortable awarding to them should Energy Steel have a bid on them, because they did not have lot of experience in project managing projects of that size, that’s one example.

Another example would be international risk. So Energy Steel again, a very good team, were exclusively domestically focused. Because Graham has such an international presence, 40% to 50% of our business historically is international, we are very comfortable operating outside the United States where the legal structure may be different. The project managers also may be different than they would be in North America. And so we’ve had some opportunities which again, through Energy Steel or within the nuclear market though Graham, we’ve been able to win, because of that risk tolerance and that international knowledge that perhaps Energy Steel didn’t feel as comfortable with yet.” - – Jeff Glajch, CFO, 8/11/15

Finally, the company entered into a $25mm (expandable up to $50mm) credit agreement with JPM, allowing it to have “dry acquisition powder” for up to $112mm.

·      Business diversification – GHM has an active strategy to diversify away from the cyclical and oil price dependent refining and petrochemical spaces while leveraging their high quality engineering and welding infrastructure into power and defense spaces such as the Navy contracts and nuclear power.  Currently its chemical and refining businesses account for 67% with a near term goal of a reduction down to below 50% via growth of Navy and Power segments and small tuck-in acquisitions.  Additionally, operating on multiple fronts has allowed the company to bid on close to $1 billion projects over the last 12 months.

·        Recurring Revenue Base – Over the last cycle the company has picked up a nice recurring revenue component which was $50mm (of $135mm) of revenue with a near term forecast of up to $60mm.  The aftermarket revenue serves the installed refining and petrochemical Graham installations, replacement equipment for over 100 nuclear plants in the US as well as short cycle (3 to 9 month) business orders.  Once the Navy contract kicks in the next 12-24 months, which is about 65% of the current backlog ($110mm) the recurring component should go up to 60-70% of revenues.

·        Properly Incentivized Management - Management compensation is aligned with investors with short term compensation based on Net Income and Order Bookings, while longer term stock compensation is based on EBIT and EBITDA margin relative to the Baird Industrial Index.  I would say for a change the board does not set easy lay ups for management with respect to achieving targets (example 2015 target bookings were $135mm).  Additionally the company requires each officer to hold 3.0x (CEO) to 1.0x (other officers) of base salary in company stock.  The company insiders own 4% of the company stock or approximately $7mm at depressed levels, excluding some options.  Getting the company stock to my price target level (see Valuation) i.e. over $20mm in value, is a great incentive in my opinion.

 Opportunities:

·      Rebound of refining expenditures – Due to the significant pullback in oil prices the refining industry, led by multinationals such as Exxon or Total, have initiated spending cuts across the board, in upstream, midstream and downstream, with the same dynamic occurring with the national/government owned customers such as Saudi Aramco who need to support social spending programs.  This has caused the company to guide to ~$100mm revenue number for 2015, down from $135mm last year. In the mean time the refining industry has been running at over a 100% capacity, led by refining product demand such as low gas prices and high spreads, while barely spending any money on upkeep.  This dynamic should reverse itself in the near term.  

“We have the view that they can’t run that hard forever. That just doesn’t make sense. If you look more long-term, the utilization levels in the refining market have been nearer to 85% to 90%. At times like this when they have a chance to maximize cash generation from the refining assets, they do that and they harvest, but they can’t do that continually, because ongoing investment has to be made to keep these facilities running, and then secondarily, there is global energy demand growth. There’s also capacity destruction that has to be replaced.

There’s been 5 million barrels per day taken out of capacity. While holding refining capacity constant, that means it was replaced by 5 million barrels of new capacity, and that doesn’t necessarily get mentioned in any of the industry statistics. To us, that’s incredibly meaningful, and there’s another plan, 3 million to 4 million of refining capacity to be taken offline this decade, that will be replaced just to hold the line, just to hold the refining capacity*. Again, those aren’t reported in industry statistics, but they benefit Graham very much. I think new capacity in one form or another, either replacing capacity destruction or just pure new capacity, is coming. They can’t run this asset base at this utilization level continuously.”

*For context every 1mmbd capacity addition equals a $45 to $60mm bidding opportunity for GHM

“We feel that our aftermarket-type orders for existing refining capacity should begin to pick up. Those come out of the maintenance budgets and it’s imperative to keep those facilities running well. Discretionary decisions to not invest in that manner for a couple of quarters is possible, but it can’t be done for a long period of time and so we think that will be stepping up over the next several quarters.

In terms of investment in new capacity, those are very significant sums of money for the end-users. We would expect these companies to first get through their board meetings in January with the year-end results. If you recall, what happened when there was the dramatic change in the markets in November and December of last year, the real direction wasn’t set until January, when the board meetings were held with the Boards of Directors, and they decided how to deploy their capital, and what projects were going to proceed. I anticipate the same to be true as we get through this upcoming first calendar quarter.”

“For new capacity, that’s a little more difficult to predict. We have a fairly substantial pipeline of bidding activity. We’ve had a fairly substantial pipeline of bidding activity for new capacity for a couple of years now. Fortunately, one of those orders fell into the quarter. Our team did a great job to be in a position to pull that in. It’s difficult to predict it, Joe, if that will be repetitive or if it is signaling a change in the refining market, and we don’t think it is at this point in time. But overall, forgetting about the immediacy of what’s going on in our refining market, we’re very positive about the long-term direction in the refining space.

In the North American chemical sector, we have begun to see the second wave of new petrochemical capacity enter into the bid pipeline. The first wave was the summer of 2013, in which we secured a fair amount of work.

But the second wave is starting to set up now, and secondarily, and also importantly, we’ve begun to see some of the downstream investments that follow the first wave of new capacity enter into our bid pipeline. We’re beginning to see that segment show some signs of activity, which we hadn’t seen for about the last four quarters to five quarters, quite honestly.

That is encouraging, but I do want to couch that optimism with the remark that is important to bear in mind that the first wave of new chemical capacity in North America was predominantly from domestic end users. This next wave has an international aspect to it, whether it is an international end user or an international EPC being involved in the projects.

That does have a tendency to put pressure on margins, and changes the competitive landscape for who we might be competing against. And that could affect our capture rate and/or the margins which will win that work. However, all-in-all, it’s good to see the second wave of new capacity entering into the bid pipeline, as well as the downstream activity from the first wave.” – James Lines, CEO, 10/28/2015

·       Growth in NAVY program – In what I consider a more exciting development for the company (relative to its history) is the participation in the Naval Nuclear Propulsion Program where the company supplies components to US NAVY’s aircraft carriers and submarines.  While the company currently has over $50mm in its $108mm backlog related to long term projects the opportunities to expand this business are great.

o   The US Navy currently has 10 Aircraft Carriers in service, with 3 more commissioned to take service in the next 10 years. Each new Aircraft carrier presents a  potential $40mm opportunity.

o   For each Virginia Class Submarine, being built at about 1 per year, the company can get ~$20mm with Ohio Class, scheduled to begin building in 2021 getting up $25mm in component costs per sub.

Weaknesses/Threats/Risks:

·        Cyclical, Cyclical, Cyclical – Graham is a great industrial, but at the end of the day, the markets that it serves are very cyclical and very much so tied to oil prices as a boom or bust business.  As I discuss in the valuation section, I believe the company is priced at the bottom and it still earns good returns/cash flows even in down cycles, but big cycle swings certainly impact results. This years’ earnings guidance of $95-$105mm in revenues is down $30 to $40mm from last year and this year’s EPS is likely to be around $1.00, down from $1.57 last year.

·      Microcap/Size – Much like Energy Steel was too small to participate in some deals, there’s no doubt that GHM’s size precludes it from getting a bigger piece of the refinery CapEx/MRO pie.  It would probably be in better hands of a bigger industrial firm. 

 Despite a 30+ year trading history GHM is still a $100mm EV value company with a $700,000 daily trading volume putting into squarely into “illiquid microcap” category.

·        Oil prices – The company’s results and, to a decently high correlation extent, stock price are tied to oil prices movements (see 2008/2009).  More importantly the results are tied to the volatility of oil as high volatility gives refiners low visibility on input costs and makes them loathe to invest in high cap ex projects.   I would say the company’s profitability and performance has a lower correlation with oil, especially relative to oil service firms, as it remains highly profitable throughout the cycle, nonetheless, continued uncertainy with oil prices will probably effect its results in the near term.  Additionally, oil currently has the 3^rd highest historical short position built up at 300mm barrels by a number of hedge funds leaving a high possibility of a short squeeze and more volatility on the near term horizon.

·        Large Customers - Additionally, the company has stated that they tend to have a higher piece of the pie on the state-owned and multinational integrateds that are building increasingly bigger refineries but also are having the most difficulty dealing with oil prices.

“I think this is important for investors to understand, we have three sets of customers in the refining market. I will speak to them from the smallest to the largest as a portion of our overall refining business. The smallest of the three are the independent refiners, those who are less impacted by the lower oil prices and more focused on the spread from what comes in to what goes out for them, and they actually are doing quite well right now. And that’s an area you would continue to expect to see investment in, we’re certainly seeing some activity there now, but again, that’s the smallest of the three pieces.

The second largest piece for us would be the multinational integrated refiners, someone like an Exxon, Shell or British Petroleum. They are impacted more so because they’ve got upstream opportunities, as well as downstream opportunities and their upstream opportunities are being dramatically impacted by the lower cost of oil. And with that, the capital investment across their business is at a depressed level compared to where it was a year or so ago.

Finally, the third piece of our customer base, which is larger than the multinationals, would be the state-owned refiners, someone like Saudi Aramco or Pemex or Petrobras, they have the same issues as multinationals, but they also have governmental issues, where they use their cash flow, not only to reinvest, but also use that cash flow to support their country social programs. So they have even more of an impact on their capital spending in the near term.

So those last two groups have certainly been impacted by lower oil prices. We expect in the near term they will continue to be. What they are looking for, quite frankly, is stabilization of oil prices. It is less important where the absolute oil price is, but more important that it’s stabilized. They can work to a stable oil price.” - – Jeff Glajch, CFO, 8/11/15

Valuation:

Graham Corp is a solid industrial company with a leading position in a niche market, a solid balance sheet and high consistent returns on capital.  The company has a number of competitive advantages including a multi decade reputation for high quality, a large installed recurring revenue base within its refining, petrochemical and defense customers and a solid balance sheet to withstand any significant downturns.

I don’t have the foresight to predict an exact timing of the market up turn, and when the oil price volatility will subside. However, what I see in Graham Corp is solid long term investment with low downside and a very high upside.

GHM has a 30+ year trading history and a very consistent P/B relationship which how I am choosing to value this investment using a 3 to 5 year timeline.

Downside Case: Price Target $14.50 to $17.00

-       In the next 3 years the company muddles through on a $100mm in revenues earning $1.00 per share a year, making no acquisitions, buying back 10% of its shares at $16/$17 and paying out ~$1.00 in dividends (~$0.32-$0.33 per year).  The current book value of $116 is reduced to $101mm by the buy back, earns about $27mm in earnings with the new book value of $128mm and the new share count is 9mm, down from 10mm.  This equals a book value of~ $14.00ish.

In the last 30 years, the company has traded below 1.2x B/V 3 times, and never below 1.06x.  The 5-,10-,20-- year P/B median lows are all at 1.75x (30-year is at 1.98x). At the current $16.70 price the company is trading 1.4x P/B.  I believe in a downside case where the company’s long term growth prospects are impaired a 1.2x P/B is a decent estimate for a downside value.

This means from today’s $11.70 book value per share a potential downside for this investment is 15% down to $14.50 and longer term at a $14.00 book value per share the downside price is $16.80 for a 0% loss. This doesn’t include dividends, the possibility of a takeover or using the rest of the cash on the balance sheet plus $5mm to $15mm in FCF a year to buy back more stock.

The key point I am trying to make here is a long term investment in this company is unlikely to lose money and the key risk is dead money risk.

*calculating the multiple lows and highs involves taking the 52-week highs and lows and dividing them by book value (or EPS or EBITDA). Taking a median of that number over X years establishes a decent base for historical highs and lows.  This “mean reversion” valuation method works pretty well with companies with long term trading histories and consistent earnings and book value growth.

Base Case: $37.00 to $48.00

-       In the next 3 to 5 years the company reaches is near term $200mm revenue goal (organically and through acquisitions).  At 17% EBITDA margins, a $2.5mm depreciation expense and 33% tax rate that gets you $2.35 in EPS.  

The book value is reduced to $100mm on a $15mm share buyback at $20.00 by .8mm shares to 9.1mm and adds $45mm in retained earnings for 3 years. New book value per share is $16.00.

Over the last 30 years GHM has traded over 3.0x book value 25 times.  Over the last 10 years, the company has traded over 3.0x book value 9 out of 10 times. The 10^th was 2.7x.  The 5-,10-,20-- year P/B median highs range between 3.2x to 3.65x.  I think using 3.0x book is not a heroic assumption consideration the historic precedent returning a 3+ year price target of $48.00 or a 180% + upside.

Other considerations:  Using the same median method but understanding the EPS median lows are actually on peak earnings, GHM has a pretty consistent low P/E median of 16.0x on peak earnings. Graham’s direct competitor Gardner Denver was acquired for ~15.0x TTM peakish earnings (and 2.65x Book Value and 8.0x EBITDA) in 2013 by a financial acquirer, KKR.  Using 16x on $2.35 in EPS estimates gets you a ~$38.00 price target, however, that would surely need to be ex-cash which will still likely be $5 to $6 per share for approximately $44.00.

I don’t have a good sense of historical EBITDA multiples but a 3 year EBITDA estimate of $35mm and 8.0x deal multiple gets you a $280mm EV plus $50mm in estimated cash (assuming some acquisitions get you to the $200mm revenue number). A $330mm market value gets you to ~$37.00 per share.  I would also like to think that a strategic acquirer (a defense contractor, any one of the major industrial firms) would pay a higher multiple than a purely financial acquirer’s 8.0x.

Again, I don’t have a magic crystal ball to forecast things correctly but I think a trough to cycle peak upside of 180%+ from today’s price is not a stretch of assumptions or imagination especially since the company reached $41.94 in late 2013.

Upside Case: $60.00+

-        I could do one in more detail but at the last market peak in 2008, the company traded at insane price of up $109.00.  Not sure we could repeat this but I think an upside case of anywhere above $60.00, 20x+ EPS and 5.0x book value has happened more than a few times during the companies trading history so not out of the realm of possibilities.   

Catalyst

- The company makes a cycle trough acqusition with its $60mm cash balance buying someone on the cheap

- Continued strong stock buy back

- Rebound of refining cap ex market and growth in order book

- Potentially being acquired by a larger competitor