Description

Unusual for a VIC selection, GHM’s business--selling capital equipment to refineries for capacity expansion and to remove sulfur from crude oil and oil products--is lately the focus of many favorable news articles. It is becoming common knowledge that the high price of oil is not entirely a matter of a shortage of crude oil, or rising demand from China and India, but is also caused by a worldwide shortage of refining capacity, in particular the inability of most refineries to process any crude other than the light, sweet (low sulfur) variety. The world needs many more refineries, and it also needs to upgrade existing refineries so they can make use of lower grade, high sulfur crude, which is in much more ample supply and therefore much cheaper.

Since 2003 GHM stock has been creeping up steadily, but nowhere as much as it might have as a relatively pure play on refinery expansion and desulphurization. But as a microcap trading on the ASE, with confusing one time adjustments to its recent numbers, it hasn’t attracted much attention. With a new and very sharp CEO making major changes in critical aspects of the company’s operations, and EPS plausibly in the $3.50-4.00 range by next FY ending 3/07, there is still a potential double, or more, left in the stock, IMO. If that happens, it is most likely to occur over the next year, as the company’s connection to what is almost daily front page news becomes better known.

I previously recommended the company here in late 2003 at $9. Ordinarily, the stock wouldn’t seem as good a value at $23.85. But the company’s external environment, which then looked promising but still quite uncertain, is shaping up to be even better than one could have imagined two years ago. And the internal changes GHM is making should let it do significantly more business, earn higher margins on that business, and be better positioned to expand into other markets with different cycles some years from now, when this refinery capital investment cycle loses steam. This makes GHM more deserving of a higher valuation than under the previous management, as a “growth cyclical” rather than just a pure cyclical.

In other words, at $9 two years ago the stock may have seemed cheaper, but, like many value stocks, there was a big risk it would stay that way. Now GHM is more expensive, but there is no longer any question of industry conditions. Moreover, there is an immediate catalyst, namely, the recognition on the part of investors of a big problem to be solved (a worldwide shortage of heavy crude refining capacity), without, as yet, the recognition that GHM is the nearest thing to being a pure play solution for that problem. With the new CEO doing such things as holding the company’s first conference call in its 37 years as a public company, I think GHM could attract a lot of attention before the year is out, magnified by the fact that there are a minuscule 1.7M shares outstanding.

A quick summary of the company’s business (for more details, see my previous report, or better yet, GHM’s website at www.graham-mfg.com): Founded in the 1930s, GHM is a maker of heat transfer and vacuum equipment used in the process industries. Its products include steam jet ejectors, surface condensers, and various heat exchanger products. These very, very big metal things, shipped by train and boat, are used in refineries, chemical plants, electrical power generation, paper, fertilizer, and similar process industries, and are all made in GHM’s plant in Batavia NY. Most of GHM’s products involve lots of custom engineering, designed for a specific role in a specific plant. GHM’s customers are the engineering firms (Fluor, Bechtel, Jacobs, etc.) that design the new facilities, as well as their oil, chemical and utility company customers.

In its product lines, GHM claims a substantial market share, although that is very much a function of how one defines the market—there are big markets for similar products with less or no customized engineering, at much lower price points, in which GHM doesn’t try to compete. Fortunately, those more standard products don’t interest GHM’s traditional customers; multibillion dollar refineries need custom designed process equipment, and the savings from using standard equipment from no-name producers are trivial compared to the cost of lower efficiency or unreliability.

GHM’s biggest market is refineries and petrochemical plants. There has been underinvestment in refineries for decades. No new refinery has gone up in the US since 1976. Refineries in Asia were set up to process sweet crude for industrial uses, and not so much of the transportation fuels that are now in short supply for their cars and planes. In recent years the composition of crude oil available in the world to be refined has changed, as older sweet (low sulfur) fields have hit their peak production, while newer finds have had a much higher sulfur content. For example, the Saudis have announced increased production of oil to help keep the price down, but all their additional production is lower grade, that most refineries can’t use.

The price differential between the two has widened considerably of late. For example, according to Bloomberg, West Texas Intermediate, a sweet crude, was selling yesterday for $58.20/barrel. Maya crude from Mexico, with a much higher sulfur content, was going for $44.22/barrel. The differential between them bounces around, but throughout the 1990s was rarely more than $6/barrel. With the current differential, a lot of refineries wish they had done what Valero did, and invest in GHM type desulphurization equipment so they could use the cheap stuff and have a raw material cost advantage.

Without getting too technical, any expanding refinery would need the types of equipment made by GHM, but a refinery processing sour crude (or creating crude out of oil sands) needs lots more. The discount for higher sulfur crude is so large, and likely to stay that way, that nearly every refinery in the world has to be at least considering making alterations to handle that raw material. But it isn’t as if one can just buy a piece of equipment or two, patch it into the line, and switch crude sources. This involves a substantial investment, and time to design it, as well as the usual permitting and construction delays. Between the need for new refineries, especially in Asia where the growth in demand is strongest, and the financial benefit to refineries everywhere from processing cheaper crude, demand for the type of equipment GHM makes is likely to be very strong for at least the next several years, and probably much longer than that.

Besides demand dictated by economics, environmental regulations are helping out GHM. The EPA recognized that diesel powered vehicles are more efficient than those running on gasoline, but they give off much more pollution. To help solve this problem, the EPA several years ago required a drastic reduction in the sulfur content of diesel fuel, from the current limit of 500 ppm, to 15 ppm starting in mid 2006. This adds to the refinery’s costs, so none have been in a rush to install the necessary equipment, of which GHM is a supplier, before the deadline. But the orders must be placed soon so the equipment gets made and installed in time.

This up cycle would be occurring regardless of who was CEO of GHM. But toward the end of 2004 the board replaced the CEO, who had been at the company 35 years, with a new one from the outside with a strong manufacturing background, Bill Johnson, age 42. GHM has had an extremely insular culture, and Johnson brings a fresh eye to its business and processes. In addition to some personnel changes, he is significantly altering how GHM operates.

As Johnson analyzes it, GHM has the potential to do a lot more business at much higher margins. The big bottleneck was engineering. GHM’s engineers are excellent, but were hampered by decades of low investment in information technology, which limited their ability to design things quickly, calculate costs, and prepare bids. In good times, business would in effect be turned away once the engineers’ plates were full. In good and bad times, the long lead times exposed the company to risk from rising material prices. GHM’s manufacturing plant has always operated well below capacity because the engineers were limited in how much they could design. That said, the plant was pretty inefficient as well, with workers using old, slow machine tools when modern ones would pay for themselves in very short order.

Accordingly, GHM has a capital spending budget of about $2M this fiscal year, versus a few hundred thousand annually in previous years. It has already installed a 3D CAD system and other engineering software that it expects can reduce the lead time on some larger products to 3 months from as much as 9 months in the past. Besides letting it take on more business, this helps it become a much more valuable supplier to its customers. Remember that a refinery, or any process plant, has numerous components that must be balanced with each other. Changing the design or characteristics of one piece of equipment has implications for many other pieces of equipment as well. As the Fluors of the world strive to optimize the complete system, the longer they can work on tweaking things prior to placing a firm order, the better the result. By offering much shorter lead times, GHM is helping its customers, and will be repaid in market share, margins, or both.

One of the goals of GHM’s new engineering automation project is to standardize as much of the design process as possible, so the engineers can spend their time only on those aspects of a condenser or ejector that must be customized, and not designing everything from scratch. This obviously helps costs and capacity, but it also opens up the possibility of new and much bigger markets, in industries that have different cycles than GHM’s existing ones, and need products similar to what GHM already makes, but less customized ones at a lower price points. GHM’s history as a custom job shop makes one wonder how smoothly it could add that type of product, but it isn’t a current issue, since GHM should have its hands full with orders from existing customers for the next several years at least. And some of its existing products, such as its Heliflow line of heat exchangers, have a lower custom engineering aspect, and are being switched to a cellular manufacturing system to cut costs.

Those readers wanting numbers and projections have had a long wait, so here goes: For the FY ending 3/05, GHM reported sales of $41.3M, adjusted for the closure of a British pump maker that it owned. Hurt by rising steel prices and the weak ordering environment, gross margins were only about 10% for the first half of the year, recovering to 24% in the second half. There were three major non-recurring items that bollixed up the earnings for the year: the writeoff of British operations, severance pay to the ex-CEO, and the settlement of an old contract dispute. Adjusting for that, the company was slightly in the red, nothing worth noticing.

Rather than give a projection for the fiscal year ending next March, let me skip that for a second and move on to the following year, ending 3/07,which I think will be representative of GHM hitting on all cylinders. A lot of the refinery projects which are in the planning stages now, will be buying GHM equipment that will be shipped in 2006 and 2007. Based upon the $49.9M order rate in the 3/05 year, and assuming I am correct that it rises nicely this fiscal year, shipments of $60M look reasonable, probably very conservative, for the 3/07 FY. Gross margins in past strong markets, with GHM’s traditional inefficiencies, have usually reached 28-32%. I believe the internal changes the new CEO has introduced will add quite a bit to that, so let’s say they get to 34%. That gives us $20.4M in gross profit. SG&A was $7.9M last year, I’ll assume that it rises to $9.2M, reflecting higher sales, raises, etc. Interest expense should be negligible, and the tax rate 35%, giving us $7.3M in after tax earnings. Although there are less than 1.7M shares outstanding at the moment, there are close to 200K options, and the company has said it is considering selling 99K treasury shares to pay for its capital spending program. So rounding up everything to 2M shares fully diluted, we get about $3.60 in EPS. Actually, I think that GHM might be doing closer to $70M that year, with perhaps 36% in gross margins, producing FD EPS of over $5.00, but that isn’t really necessary to the case.

As to the present FY ending next March, I am less sure. We know the backlog is up, and the company has stated that gross margins in backlog are up, but it is hard as an outsider to determine the impact of the wholesale internal changes on this year’s operating margins. So I’ll just pick numbers out of thin air and say sales of $50M and EPS of $2. I think the focus should be more on new orders and backlog that reported earnings.

Two timing issues worth mentioning: Traditionally GHM reports a huge Q4 ending March, and then sharply lower results in the next two quarters. This is purely an artifact of previous management practices, paying workers overtime to jam everything out the door at the end of the fiscal year to hit various targets, leaving little to do in the new year. The new CEO has vowed to change this, but he was still new to the company in the March quarter, and I believe it happened again. So sequentially, I expect the June quarter, although still well up from last year, to be well below the $13.2M in sales and $0.42 in EPS from continuing operations reported in the March quarter. Will that bother anyone? It shouldn’t, but it might.

Also, the stock, like most microcaps, especially those trading on the ASE, can’t be bought or sold in any quantity without having a big impact on the price. The company has stated, though, that it is considering selling 99K shares of stock it has in its treasury, to pay for the substantially increased capital spending that it is doing this year, as discussed above. With the 10-K filed last week, a filing on that offering might be made soon. How and when exactly it will get offered, and whether an interested investor might get his or her hands on a big chunk, or all of it, I can’t say. Given my own very large holdings in GHM, built up over the last two years, I don’t expect to participate in the block.

Finally, let me elaborate on a thought touched on earlier that is such a stretch on the very concept of value investing as might induce some VIC members to suggest I be kicked out of the club for even mentioning it, or at least doom this idea to a low rating:

When public investors are in a speculative mood, companies are often valued based upon the size of the problem they are attempting to solve, without the kind of sophisticated analysis of their potential returns over the complete cycle, and what that implies for correct valuation, that we normally do here at VIC. So an orthodox VIC analysis of GHM would recognize that its earnings over the next several years ought to be strong based upon the capital investment cycle in the industries it serves, plus the internal changes that seem likely to expand margins and opportunities. However, until proven otherwise, one should place little value in GHM’s long term goal of expanding its markets to other industries with different cycles. Accordingly, the “correct” VIC response is to say that if GHM’s peak EPS in this cycle is projected to be, let’s say, $5.00 in FY 3/08, then the stock ought not sell for more than $35-40 then, as investors start to anticipate the next down cycle. That doesn’t make the idea particularly compelling in the $20s now.

But don’t forget that from all the news articles the public is aware of the worldwide refinery shortage, and the inability of most refineries to process the lower grade crudes available at such big discounts. Yet there are very few ways for an investor to play that concept. One can buy VLO, but if over time other refineries invest in desulphurization, it will lose its edge. One can buy the engineering companies like FLR, JEC, SGW and others, who are hired by the oil companies to design these projects, and many institutions will, but these already have market caps in the billions and little operating leverage, and do work for so many other industries that they are hardly pure plays.

But clear cut, direct beneficiaries of the need to solve this problem other than GHM? I can’t say there are many. Combine that with a minuscule share count, and strong Y/Y sales and earnings comparisons likely for many quarters, and there is the potential for GHM to be priced much, much higher than what orthodox VIC analysis would dictate. Were this stock to run to $100, its market cap would still be under $200M, a very modest amount when investors are excited by a concept. It hasn’t happened yet with GHM, but the company has been so insular and secretive, despite being public for decades, that few know of its existence. With the company recently hiring an investor relations firm and holding its first ever earnings report conference call, plus the fertile field created by the constant news stories, I believe the word will get out.

I don’t think it is crazy to think there is some probability of that happening in this environment. Most VIC ideas, especially those which sell at the biggest discounts to intrinsic value, lack that potential. So whatever one thinks GHM is worth from a pure value point of view, one might consider adding to that some amount, your choice, quantifying the present value of the stock’s potential to get ridiculously overpriced.

Catalyst

1. Strong growth in orders and backlog; and
2. Investor recognition of company's position in the hot field of refinery capital goods, and desulphurization.