Graham Corporation

Greetings and welcome to the Graham Corporation second quarter fiscal year 2021 financial results conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Gordon, Investor Relations for Graham Corporation. Thank you, sir. You may begin.

Thank you, Christine, and good morning, everyone. We appreciate you joining us today to discuss Graham's fiscal 2021 second quarter results. You should have a copy of the news release that was distributed across the wire this morning. We also have slides associated with the commentary that we are providing here today. If you do not have the release or the slides, you can find them on the company's website at www. On the call with me today are Jim Lines, our President and Chief Executive Officer, Jeff Gleick, our Chief Financial Officer, and Alan Smith, Vice President and General Manager of our Batavia, New York facility. Jeff will start with the financial overview of the period. Alan will then provide an overview of our operations. and Jim will wrap up the prepared remarks with a strategic overview of our business and provide our outlook for the rest of fiscal year 2021. We will then open the lines for Q&A. 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 the risks and uncertainties, as well as other factors which could cause actual results to differ materially from what is stated in the calls. These risks and uncertainties and other factors are provided in the earnings release and in the slide deck, as well as other documents filed by the company with the Securities and Exchange Commission. These documents can be found on our website or at www.sec.gov. I also want to point out that during today's call, we will discuss some non-GAAP financial measures which we believe are useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for the results prepared in accordance with GAAP. We have provided reconciliations of our comparable GAAP to non-GAAP measures in the tables accompanying today's earnings release. If you will turn to slide four, I will hand the call over to Jeff Gleick.

Thank you, Chris. As Chris mentioned, if we're starting on slide four, It was very nice to operate in Q2 in normal capacity after running at approximately 50% capacity in Q1 due to COVID-19. Q2 sales were $28 million, up from $21.6 million in Q2 of last year. Sales in the defense, the Navy market, were $9.4 million in the quarter. In the quarter, we had a quick-turn material order, which made up approximately a little over half of the revenue. in the Navy, we expected this to occur in the quarter. While it is not a repeatable type sale, it was not a surprise. Year-to-date defense sales were 12.9 million or 29% of sales. This is slightly higher than we expect for the full year. We would expect around 25% of our sales to be for the Navy for the full fiscal year. The quarter also benefited from an acceleration of some work at one of our Asian subcontractors They had available capacity and pulled some work from Q3 into Q2. Q2 net income was $2.7 million or 27 cents per share, up from $1.2 million or 12 cents per share last year. Stronger revenue and margins drove the improvement. Cash is still good at nearly $68 million. Finally, orders in the quarter were $35 million, driven by strong international refining and awards in Asia and defense in the United States. Our backlog improved to $114.9 million. The conversion of a portion of our backlog provides the foundation for our improved guidance for the fiscal year. Moving on to slide five, I discussed the sales detail on the last slide with the quarter at $28 million. Sales in the second quarter was 62% domestic, 38% international. Last year's second quarter was 73% domestic, 27% international. Gross profit in the quarter was increased to $7.7 million, up from $4.9 million last year, primarily due to volume. Gross margins were at 27.5%, up from 22.9%. EBITDA margins were 14.2%, up from 7.8% in last year's second quarter. And finally, net income was $2.7 million, up from 1.2 million last year. On to slide six. For the first half of fiscal 2021, sales were 44.7 million compared with 42.2 million in the first half of last year. This increase was despite the challenging Q1 when our production capacity was at 50% due to COVID-19. Unit 8 sales are 60% domestic, 40% international, compared with 71% domestic and 29% international last year. Gross profit was $9.3 million, slightly off the $9.7 million last year, and gross margins were down at $20.7 versus $22.9 last year, again impacted by COVID-19 in the first quarter. Unit 8 EBITDA margins were 4.9% versus 4.5% in the first half of last year. and net income is $900,000, or $0.09 per share, down from $1.3 million, or $0.13 per share last year. Again, the first quarter loss due to COVID-19 was substantial, but we have more than recovered that in the second quarter. Finally, moving on to slide seven, cash is at $67.9 million, down from $73 million at the end of fiscal 2021. but this is simply timing of working capital, namely accounts receivable and accounts payable. We are expecting this to come back in the third quarter. Our quarterly dividend remains firm at $0.11 a share. Capital spending has been light in the first half of the year at $800,000 compared to $700,000 last year. As we have seen in the last few years, our capital spending will increase in the second half of the year, and we still expect The total spend for the year to be between $2 and $2.5 million. Finally, as we continue to work on our acquisition pipeline and activities, COVID has not had an adverse effect on our efforts as we have built some very good relationships over time, and these conversations continue, however many of them are remote as opposed to in person. But they are still occurring and still very active. Alan will provide a presentation by providing more depth on our operations in Q2, and then Jim will provide a market update as well as our updated guidance for the rest of the fiscal 2021.

Alan? Thank you, Jeff. Good morning, everyone. I'd ask that you refer to slide 9. Sales for the second quarter were $28 million. As Jeff has mentioned in his remarks, the company completed a large material-only order for a defense customer, which required very little conversion resources. Sales to the defense industry were up 6.8 million year-on-year due to the prior mentioned materials order and greater defense conversion as we continue to grow our naval workforce. Lastly and importantly, due to the strength of our backlog, annual guidance has been increased from 90 to 95 million 93 to 97 million. Please move on to slide 10. While COVID-19 has impacted demand for our product, there are several actions that are being implemented to ensure that we maximize the margin of the work that is expected to convert during this financial year. During the first quarter conference call, I outlined several initiatives that the company was pursuing in order to maximize the realized margins. In particular, we are focused on reducing our material costs, hiring and quickly onboarding welders, differentiating our company from our competitors in the defense industry through superior execution, and leveraging IT tools to increase the productivity of our team. On the material procurement front, the team has had success in reducing our costs. Graham is a relatively small buyer of carbon steel and stainless steel plates. Therefore, we typically procure our plates from distributors. However, we are finding in this time of low demand, the mills are willing to sell directly to us, thus reducing our costs. We are also focused on growing our workforce in order to increase production volume. To this end, we have recently completed an expansion of our weld school. We now have the capacity to train up to ten welders, up from five. The work for the Navy has higher welder content than does our network. Welding is a critical skill set for the company, and we must expand our capacity. The weld school on our campus is a terrific addition for workforce development. Currently, we are prioritizing improving our productivity in the Navy production areas now that the company has completed many of the first-time operations. Productivity enhancements will stem from improved build flows, employee training, creation of jigs and fixtures, and lastly, applying lessons learned. Our IT department continues to develop tools which will improve our ability to manage our global fabrication partners. A management dashboard is being developed to track all aspects of our outsourced projects. The dashboard will aggregate information that is stored on several IT platforms and will improve the productivity of our project managers. With that, I'll turn the presentation over to Jim.

Thank you, Alan, and good morning, everyone. I begin my remarks starting with slide 12. Order level in the quarter was strong, especially given the state of crude oil refining and petrochemical markets. The strong order level in the quarter is the result of implementing effectively diversification strategy. We discussed during the past couple years actions taken to be successful in the more price-conscious segment of refining chemical markets. Both participation and market share were low, which afforded an opportunity to address this segment differently. Opportunity generation and bid management structure were modified, and also execution strategy changed. Replicating the success in China, a subsidiary structure was established in India. It is necessary within India, as an example, to localize selling certain technical resources and quality control personnel. We have the best chance to secure large project orders when they are supported and followed for a long time. A local presence permits that. This then allows for pulling a customer toward Graham rather than Graham having to move toward its competition. Also, fabricating certain components locally within India is important. As a result of this strategy, $10 million of new orders for India were secured in the quarter. These orders were for both customers and end users that had not used Grab before. I am pleased with our success in India. We plan to pursue principally large project work, and as of today, the company has secured two of the three most recent large projects. I commend the team that initiated and drove the strategy and those now executing the orders. Excuse me. Another highlight was securing additional work for the US Navy. This strategy is about 10 years old and a large order in the quarter confirms the shipyards and the US Navy find value in our engineering and fabrication capabilities program management strengths, willingness to listen to feedback and implement improvements, our quality program, and also that we will invest in facilities, modern machine tools, personnel, and employee development. General conditions in our crude oil refining and petrochemical markets is weak, while the pipeline for the US Navy is strong. This is noted by orders for crude oil refining and petrochemicals being down compared with last year. Let's move on to slide 13. I want to discuss briefly market outlook and what we are seeing in our key markets. I plan to go clockwise, beginning in the upper left quadrant. The sales team did well to secure a significant amount of work that is for Asia. The Indian work mentioned a moment ago, plus approximately $10 million in additional orders fiscal year to date that are for Asia. The pipeline must rebuild and move from early stage activity to procurement stage. We expect the next few quarters to be about building the pipeline. We are seeing COVID having an impact in Asia. as one large project in the bid pipeline that was teed up to be placed, in order to be placed, had to be postponed due to workforce impact from the disease. We believe it will be activated again once the country has the spread of the disease back under control. Our team in India, our team in China, and those overseeing Southeast Asia point to COVID as on the rise again. resulting in slowing of activity along with heightened uncertainty. In the Americas, it is quite slow for both revamped retrofit and also routine spare parts. Refiners, they are focused on preserving cash right now and are postponing MRO or capital projects. We don't see this picking up until demand recovers following having COVID under control. Those projects that may proceed, we are carefully following. On a positive note, an engineering-only order for a large crude oil refinery revamp was secured that we hope proceeds within the next 12 months. For that case, the refiner could fund only upfront engineering at this stage so that detailed layout is done, enabling the project to proceed quickly once it is ultimately released for fabrication. If and when it proceeds into fabrication, we anticipate that a change order will exceed $5 million. Crude oil below $40 a barrel and pandemic-driven global disruption have resulted in activity being pulled in by most national, integrated, and independent oil refiners. Moving over to U.S. Navy, Navy in particular and defense overall is active. We have a solid pipeline of activity. Some of it is for new components that we have not done before, while others are repeat components for upcoming vessels. Submarine programs are vital for national defense and other strategic missions for our country. There is terrific visibility into multiple year new vessel requirements that underpin this segment continuing to be strong. We have identified and are pursuing $40 to $60 million of opportunities for the Navy, and they should be placed with a selected vendor over the next nine months. We have M&A target identification and development concentrated in the defense segment due to its strong long-term fundamentals. As Jeff noted, relationships in certain cases were established prior to COVID, and we continue to nurture them with a combination of remote interactions along with selective visits. Short cycle work is off 20 to 30%. Crude oil refining and petrochemical markets are where the majority of spare parts revenue is derived. These markets, as I mentioned, are in cash preservation mode until the global economy is back on its feet. and demand subsequently recovers. On an upbeat note, there is step-up in short-cycle inquiries. However, that is not translated into an improved order level just yet. Chemicals and petrochemicals are also down. Projects have been shelved or delayed. The pandemic sent a demand shock that is not yet fully abated. Getting COVID behind in most regions throughout the world is the catalyst for demand returning. Let's now move on to slide 14. Backlog is a healthy $115 million split evenly between commercial and defense. The staging of backlog, or work in process already, provides an ability to state guidance at this extraordinary time when many companies cannot. 60 to 65% of backlog is planned to convert during the next four quarters, with approaching 40% of backlog planned to convert during the next two fiscal quarters. Please go on to the next page. As Jeff and Alan mentioned, we are updating our guidance. We've increased the revenue range to between 93 and $97 million. implying the second half should be between $48 and $52 million for revenue. Gross margin is expected to be between 21 and 23%. SG&A spend between $17 and $17.5 million. And we're projecting the effective tax rate is approximately 22%. With that, Christine, I would ask that you open the line for questions. Thank you.

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing star keys. Once again, if you would like to ask a question, press star one on your telephone keypad at this time. One moment, please, while we poll for questions. Thank you. Our first question comes from the line of Joe Mondillo with Sidoti. Please proceed with your question.

Hi, guys. Good morning. Morning, Joe. Hi, Joe. So I was wondering if you could let us know what the gross margins for the quarter looked like if you exclude that defense material order.

It would have been comparable because that was a materials-only order. So it wasn't appreciably different. Comparable to what period are you?

Quarter overall. Oh, okay. So the 27.5% excluding that order, it would have been 27.5% or around there? If not materially different from that, correct. Okay. And then just as far as sort of what you can see in terms of work and sort of the bookings pipeline over the next, I guess, for maybe the rest of the fiscal year, it sounds like things are relatively slow in the past or in this past quarter. You saw some strength in the orders and some of that was Asia related, but you sort of mentioned that Asia. is maybe you're expecting a rebuild of the pipeline. And so, um, does that indicate that that Asia strength that you saw in the quarter, you know, will be lighter than, you know, lighter than what we saw in the second quarter. Um, and it sounds like America's is pretty weak. So just overall, it seems like from my vantage point that bookings may be, um, may be comparable to the four-quarter trailing average? Or could you just talk about sort of what you're seeing in the pipeline?

At a qualitative level, I think your assessment, as you take the information that we've shared with you today into account, is generally correct. There is an overall slowness, notwithstanding the region, in refining and petrochemicals. We did have some large project work get secured by us in the quarter. Those aren't always repeatable, and it can make our order patterns lumpy or quite variable when those orders are $5 million, $6 million, and a quarterly order level might be $20 to $25 million as an example. So those can have a material impact. But as we look at the quarter, the upcoming quarters from an order level, We see some softness, indeed, for large project work. We don't necessarily feel it. It traces back to how Q4 and Q1 were. And also, on a more positive note, aggregating all of our end markets, we are anticipating a book-to-bill to be above 1.

And that would be for the year?

For the year, I apologize.

For the full year, yes, Joe. Okay. And then just relative to gross margins and looking at that backlog, your gross margins have been sort of all over the place the last three or four quarters. Could you help us maybe understand what that gross margin profile looks like in the backlog? Sure. it looks like you're expecting some pretty decent gross margin actually in the back half of the year just relative to your guidance. I guess maybe you can comment on that and then sort of beyond that, beyond fiscal 21.

I'm going to dissect it a little bit. The margin quality for the naval work, as we project forward, we believe begins to average up. And there's reasons that we had cited previously for that. As Alan and his team have executed extraordinarily well on that strategy over the last decade, we've been able to move from what was principally 100% of the backlog at a point in time five years or so ago was all competitively bid To today, maybe 20-ish percent of the backlog is competitive, I'm sorry, 80% is competitively bid, 20% is under sole source contracting. Projecting forward and how we're seeing the evolution of our relationship with the shipyards, we think in a few more years, our backlog should be closer to 50% for the Navy under sole source versus competitively bidding. And that has a different margin potential than what's been running through backlog right now. So we would expect that backlog quality to continue to improve as we move through the next several quarters, the next several years. And then of course that translates into an improvement we believe in our overall financial performance as a result. As we look at our Americas or Western Hemisphere work. We haven't really seen appreciable margin variation with what's going on in those end markets today. We've been able to win what was available at satisfactory margins, probably equal to or averaging up. And then as we move into these previously underserved or under-participated markets, You may have caught that we referred to the expression of price sensitive or price conscious segment of the market. That can have and does have a lower gross margin than most of our other work. However, the drop down to op profit is satisfactory. So therefore, we're not necessarily fixated on where gross margin is going to go. We're fixated on where net profit goes.

Okay, and it looks like the guidance is implying gross margins in the back half of the year of 23%, 24% roughly. What is driving that because you've seen other than the second quarter, and I guess you can't really count the first quarter because you were operating at low operating rates, but looking at the back half of last year, you're implying some good, very good improvements. What would be driving that in the back half?

Hey, Joe, this is Jeff. You know, we've been communicating for probably the last three or four quarters that our backlog, the margin in our backlog was improving. Obviously, Q1 was impacted by the fact that we were at half capacity. But I think if we went back to the middle of last year and forward, we talked about our backlog was improving, and we were seeing some improvement in the margins there. So that's really what's driving it.

Okay. And then just last question, and I'll hop in queue. Relative to COVID, could you just address sort of what you're seeing in your Buffalo market and, you know, Anything that you have to say regarding the ramp up that we're seeing in cases in the country and just anything that you're anticipating potentially as we get into the winter months?

Sure. I think in the local markets, we've seen a little bit of an uptick, but not a dramatic uptick. We've put in some very good processes here at Graham to minimize the risk to our employees. We are not allowing visitors on site with very minimal exceptions. We've got cleanliness procedures across the company that we put in during the time period that we primarily shut down in late March, early April, and those have been very effective for us. So we're pleased at the fact that we've not... Our employee base has not been impacted by COVID, but obviously we continue to be very wary of what's going on in the community, what's going on outside of our community, because some of the COVID issues can be local and some of them can travel their way in. But we're not seeing a huge uptick locally, though, as I think with a lot of places there is a bit of an uptick that are occurring. We're going to stay vigilant. Our employees are doing a great job, and our leadership team around COVID has stayed focused on making sure that we don't take our eye off the ball.

Okay, thanks. I'll hop back in queue. Thanks, guys. Thanks, Joe.

As a reminder, if you would like to ask a question, press star 1 on your telephone keypad. Our next question comes from the line of Theodore O'Neill with Litchfield Hills. Please proceed with your question.

Thank you. Congratulations on a great quarter. Thanks, Theo. Thank you, Theo. Yeah. So my first question is for Alan. Last quarter, Alan, you talked about expanding the welding school to up to eight welders, and now you're saying it's going up to ten. What's driving that, and how's it going?

What's driving that is as we completed the project, It appeared that we had more room than we thought, so we were able to locate two more well booths. The project's going very well. Where the teaching and training portion of the building is, that's complete. We're finishing up a canteen and restrooms. The restrooms and canteens should be completed by the end of November, and we'll be ready to accept all 10 new students.

Great. And, Jim, on slide 13, I'm not sure I understand this bullet point here. Under the U.S. Navy, certain bids are new components. What are those components that you're talking about there?

That terminology, Theo, is it's a new fabrication for us that we have not done before. And we wanted to cite that because it confirms our ability to continue to grow the three programs that we're involved in organically by winning new equipment, new components.

I see. Okay, thanks very much. Great. Thank you. You're welcome.

Thank you. Our next question comes from the line of Joe Mondillo with Sedoti. Please proceed with your question.

Hi, guys. Just a couple follow-up questions, so thanks. On that same slide, slide 13, in the bottom left quadrant, talking about the petrochemical market, you cited about the next wave of ethylene capacity in the Middle East and Asia. Could you give us a sense of sort of more what's going on there and what kind of timing of where some of these projects that you're seeing are at right now and maybe when they would maybe start to convert into orders for you guys? Is this a multi-year type of thing or next year?

I would say it's more of a multi-year type of thing, Joe. And the perspective today is different than I would have had six to nine months ago pre-COVID. The Middle East projects we would contend need... stability in the global markets, and also likely some improvement in the price of oil. These are typically integrated refining projects where they're coupling crude oil refining with petrochemical production. So we think that's a couple years out. However, this is quite a clear mission by several countries, Saudi Arabia in particular, about diversifying into petrochemicals and doing that via integrated refineries. In Asia, China in particular, they'll probably be ahead of other regions with the investment in new petrochemical capacity. There too, they're building integrated refineries that couple petrochemical production with crude oil refining. Massive opportunities for us. We're going through the execution of one of those orders right now for China, wherein, as before, we would have thought of a China incremental new capacity in China might be a $3 to $5 million opportunity for us. We are now running through backlog $13 million for an integrated refinery. It's work that we've secured. It's going through the execution phase right now. And we anticipate China in particular and also other regions around the world will be moving toward crude oil to chemicals as they transition from less of a barrel for fuels to more of a barrel toward petrochemicals.

Okay. And as far as your short cycle business, is that mainly... North America, given your installed base is so big, or is that beyond that? And, you know, based on your answer, I'm just wondering, you mentioned inquiries are up. I was just really specifically wondering where, specifically what markets or geographies says those inquiries are up?

We tend to think of our short cycle work as 80-20, 80% domestic market. Some of it's international, but the vast majority is domestic.

And so those inquiries are then mainly domestic then?

That's correct. I'm sorry.

Yes. Okay. And then lastly, wondering if you could just sort of update us, sort of, you know, typical quarterly updates on your balance sheet and M&A and any updates there.

Sure. Joe, this is Jeff again. On the balance sheet, I mentioned our cash is around $68 million, which is fairly consistent to where it was the last quarter. I would expect in this quarter we should see that improving. We've got quite a bit in receivables right now that should be coming in in the next couple of months, and so I would expect our cash position will step up during this quarter. And then the rest of the balance sheet, nothing out of the ordinary. Everything else is in a good place. With regard to M&A, as both Jim and I mentioned, we continue to remain active. We're primarily focused on the defense sector and the Navy sector. And the fact that our process is such that we reach out, we start to build relationships over time. A lot of those relationships have been in place. um, for, uh, for, for a while. And so they, they're, they predate COVID. So we've been able to continue those, uh, primarily remotely, though we've had a couple of, uh, in-person visits over the last quarter. Um, so those, those will continue. And, and, uh, the pipeline on the acquisition side continues to be strong. Um, and, you know, even with some of the challenges with doing this through the, the, uh, virtual environment, uh, because we have those relationships, um, it's been, uh, It hasn't had to slow down at all. So we're pretty pleased about where the pipeline's at right now, and hopefully we can continue to move things forward.

Okay, great. All right, thanks a lot.

Thank you, Joe.

We have no further questions at this time. Mr. Lyons, I would now like to turn the floor back over to you for closing comments.

Thank you, Christine, and thank you, Joe and Theo, for your questions this morning. We appreciate everyone listening in to our conference call, and we look forward to updating everyone again in January. Have a great day. Stay safe. Bye.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.