Graham Corp. GHM
November 30, 2003 - 1:56pm EST by
bibicif87
2003 2004
Price: 9.03 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 15 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

GHM is an unknown micro cap, for good reason. Its stock price is net unchanged in the 35 years it has been public. It is a cyclical capital goods company whose most recent quarter showed the lowest new order input in years. The ASE listed stock sometimes goes several days in a row without trading. Due to excessively fearful lawyers on its Board, management is unforthcoming about the company, and its competitors are all private, making useful information scarce. GHM’s Yahoo message board hasn’t had a post, even a spam, in nearly half a year. Exciting, eh?

Nevertheless, about once every seven or eight years, new orders, backlog, the stock price, and then earnings explode, and it seems plausible that another such period may again be approaching. Given the stock’s thinness, one has to start accumulating well in advance, so that when excellent earnings do show up and the stock runs, perhaps in 2005, one has at least some position, and can take long term gains. Fortunately, the company has a decent balance sheet, limited capital needs, a modest dividend, and is near breakeven even in the current business trough, so if the upturn doesn’t arrive on schedule, the most likely risk is boredom.

GHM is a maker of heat transfer and vacuum equipment, used in the process industries worldwide. Its products include such things as steam jet ejectors, liquid ring pumps and compressors, dry vacuum pumps, steam surface condensers, and various heat exchanger products. Most of these are very, very big metal things, shipped by train and boat, and are used in chemical plants, refining, electrical power generation, paper, fertilizer, and similar process industries. GHM’s products are mostly bought for capacity expansion, but there is some replacement and upgrade market as well. With the exception of a small pump operation in the UK, GHM’s products are made in its plant in Batavia, NY and, because of their specialty nature, are competitive in markets throughout the world.

The way this business works is that someone planning, say, a new oil refinery in Asia, typically hires a major engineering firm, such as Bechtel or Fluor, to design it and specify the equipment. Early in the design process the engineering company checks with GHM, among others, for quotes on its participation, which typically includes some mix of standard and custom products, plus design and engineering work to integrate these into the complete project.

As the overall design takes shape, the engineering company selects GHM and/or competitors for various aspects of the project, and through some combination of bidding and negotiation will make a selection and issue a contract, which might call for the delivery six months to a year or more later. So an inquiry that GHM gets today might result in a contract next summer or fall, and delivery in 2005. The revenues from most of GHM’s contracts are recognized only when the contract is completed, although a few very large ones use the percentage of completion method. This leads to wildly variable numbers in any given quarter, depending on what got shipped when.

At GHM’s first ever presentation to an investment conference, in Buffalo ten days ago, management reported that inquiries have been picking up considerably in the last few months. If this continues, it should result in a jump in new orders and backlog in 2004 and in sales and earnings in 2005. That is far from certain, but is plausible, because when one looks at the years when GHM’s sales and earnings have been the highest, they have typically followed years in which the world economy was rising, and especially after oil and chemical prices were high. With oil prices now hovering above $30, natural gas at $5 (twice its 1990’s price), and most chemicals and plastics retaining most of their price spikes of the last year, it is rational for the companies making these products to expand.

China in particular is a promising market area. Automobile demand there is taking off, and China needs more refineries, and upgrades to its approximately 60 existing refineries, many of which were badly built and inefficient. Also, China’s own crude is sweet, and GHM is particularly strong in engineering and equipment for processing high sulfur sour crude, which China will have to import in greater quantities. GHM has done big jobs for Syncrude Canada, the Venezuelan state oil company, and others processing difficult crudes.

Other industries that use lots of GHM type equipment and have favorable long term growth characteristics include electrical generation, geothermal, desalinization, and pharmaceuticals, although all industries have their own investment cycles that usually don’t coincide. That is why most years GHM’s numbers blob around randomly at modest levels, as strength in one area is offset by weakness in another, and GHM and its competitors’ excess capacity keeps pressure on margins.

Once or twice a decade, though, enough cycles do line up favorably, and this boosts GHM’s margins as well as sales. Years of low demand weed out the weak competitors, so when orders snap back, GHM and the other survivors can raise prices and cherry pick which orders they want, bringing peak gross margins to 30% or more, compared to the high teens when business is slow. The combination of rising sales and margins in the up cycle leads to an explosion in earnings over a three or so year period, before the cycle reverses. Up cycles that I know of (I’ve been following the stock on and off for thirty years) include the late 1960’s when GHM went public, the mid-1970’s and early 1980’s (both after big increases in oil prices), the late 1980’s and 1990’s.

One other reason for the big swings in pricing power is limited worldwide capacity of certain specialized production equipment. For example, GHM has two huge 37 spindle CNC controlled Moline drills, capable of drilling precise holes in stainless steel plates more than twelve feet wide, up to six inches think, and weighing up to 30,000 pounds. There are only so many of these machines in the world, and when they are all busy, those who have them can price that scarcity into whatever product that requires them.

To the extent that what GHM is selling when it bids on a job is really its engineering skills, in theory it could be vulnerable to competition from India or other places where engineers come cheap. So far that hasn’t been a big problem, because of the specialized nature of GHM’s skills, and the willingness of customers to pay up for quality, since the cost of shutting down an entire refinery or process plant because of equipment failure is so huge compared to any possible savings to be had by using cheaper equipment from an unknown source. Over time, though, it could be an issue if companies in India and elsewhere build a reputation for quality. To the extent that what GHM is selling when it bids on a job is really access to its specialized equipment and skilled labor force, then that helps keep up margins when demand in general is strong.

A matter that GHM is wrestling with is how to grow the segment of its business which consists of standard products. This category includes various lower priced products, especially vacuum pumps and heat exchangers, that can be fit into a customer’s operation with little or no engineering assistance or customization on GHM’s part. GHM’s existing marketing model of direct contact with major end users and engineering firms, and independent reps serving others, works fine for a job shop making physically large custom items, and has given it 50+% market share in many of its major product areas, but is not ideal for a lower priced standard product line. GHM knows this, and expects to make some marketing changes, as well as introduce more standard products at lower price points to reach a broader market and increase the attractiveness to dealers of carrying the GHM line. It remains to be seen whether this effort will succeed, but with a tiny market share in this area GHM has little to lose.

Executive compensation is actually reasonable, with the CEO at $250K and the next highest officer at around $160K. There are about 226K options outstanding, which at 13.8% of shares outstanding is more than I would like, but with 198K of them having a weighted average strike price of $12.78, they aren’t exactly a giveaway. Ignoring the options, insiders own about 15% of the stock.

In terms of numbers, GHM at about $9 is selling at a discount to its $11.55 book. With 1.63M shares outstanding, it has a market cap of about $15M, and with cash a couple million greater than debt, an EV of about $12M. Sales have been roughly in the $40M-$50M area for the last five years. Operating income has been slightly in the red in the last two years, although profitable after one time gains, and the company cut costs with a downsizing last winter. Dividends, at a nickel a quarter, were resumed last year after a ten year hiatus.

At the next peak, perhaps in 2005-6, one could reasonably expect to see sales of $60-70M, gross margin percent closer to 30%, and EPS well north of $2. If the world is going into a stagflation environment like the 1970’s, as some expect, with continued upward pressure on energy and other raw material prices, then GHM’s numbers could hold at high levels for some time, as it did in the 1970’s, rather than fall off quickly post peak, as it did in the deflationary 1980’s and ‘90s.

While it makes more sense with a stock like this to buy when inquiries start rising, and sell when they turn into reported profits at the peak, the public usually does the opposite. Since GHM stock is so thin, one gets some interesting runs. In mid 1989 GHM rose to $27 from $4 a year earlier, and in 1997 it rose to four times its low two years earlier.

No one knows with any certainty what kind of economic environment the world will face over the next several years, and predicting the timing of capital goods expenditures in a wide variety of industries is also impossible. It may well be that GHM’s numbers continue to blob along at an unremarkable level for years to come. But the sustained rise in certain commodity prices suggests that the recent rise in inquiries to GHM about potential jobs may well turn into real orders within the year.

For more background, I recommend the company’s website, at

http://www.graham-mfg.com/

Catalyst

Rising inquiries, and the growing profitability of its customers, suggests that GHM will see rising orders in 2004, and increased profits in 2005.
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