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GHM > SEC Filings for GHM > Form 10-Q on 4-Feb-2014All Recent SEC Filings

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Form 10-Q for GRAHAM CORP


4-Feb-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

(Dollar amounts in thousands, except per share data)

Overview

We are a global business that designs, manufactures and sells equipment that is critical to the energy industry, which includes the oil refining, petrochemical, cogeneration, nuclear and alternative power markets. With world-renowned engineering expertise in vacuum and heat transfer technology and extensive nuclear code accredited fabrication and specialty machining experience, we design and manufacture custom-engineered ejectors, pumps, surface condensers and vacuum systems as well as supplies and components for utilization both inside the reactor vessel and outside the containment vessel of nuclear power facilities. Our equipment is also used in nuclear propulsion power systems for the defense industry and can be found in other diverse applications such as metal refining, pulp and paper processing, water heating, refrigeration, desalination, food processing, pharmaceutical, heating, ventilating and air conditioning.

Our corporate headquarters is located in Batavia, New York and we have production facilities in both Batavia, New York and at our wholly-owned subsidiary, Energy Steel & Supply Co. ("Energy Steel"), located in Lapeer, Michigan. We also have a wholly-owned foreign subsidiary, Graham Vacuum and Heat Transfer Technology (Suzhou) Co., Ltd. ("GVHTT"), located in Suzhou, China, which supports sales orders from China and provides engineering support and supervision of subcontracted fabrication.

Highlights

Highlights for the three and nine months ended December 31, 2013 (the fiscal year ending March 31, 2014 is referred to as "fiscal 2014") include:

Net sales for the third quarter of fiscal 2014 were $23,385, a decrease of 9% compared with $25,633 for the third quarter of the fiscal year ended March 31, 2013, referred to as "fiscal 2013." Net sales for the first nine months of fiscal 2014 were $76,131, up 3% compared with net sales of $74,068 for the first nine months of fiscal 2013.

Net income and income per diluted share for the third quarter of fiscal 2014 were $1,431 and $0.14, respectively, compared with net income of $3,047 and income per diluted share of $0.30 for the third quarter of fiscal 2013. Net income and income per diluted share for the first nine months of fiscal 2014 were $7,828 and $0.78, respectively, compared with net income of $7,052 and income per diluted share of $0.70 for the first nine months of fiscal 2013. The three and nine-month periods ended December 31, 2012, fiscal 2013, included the reversal of a $975 reserve related to the expected value of the earn out from the Energy Steel acquisition. Excluding this reversal, net income and net income per diluted share for the third quarter of fiscal 2013 were $2,072 and $0.21, respectively, and net income and income per diluted share for the first nine months of fiscal 2013 were $6,077 and $0.61, respectively.

Orders booked in the third quarter of fiscal 2014 were $23,450, down 5% compared with the third quarter of fiscal 2013, when orders were $24,579. Orders booked in the first nine months of fiscal 2014 were $104,658, up 50% compared with the first nine months of fiscal 2013, when orders were $69,919.


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Backlog was a record high of $114,594 on December 31, 2013, compared with $114,392 on September 30, 2013 and $85,768 on March 31, 2013.

Gross profit margin and operating margin for the third quarter of fiscal 2014 were 26% and 9%, compared with 28% and 15%, respectively, for the third quarter of fiscal 2013. Gross profit margin and operating margin for the first nine months of fiscal 2014 were 32% and 15% compared with 29% and 13%, respectively, for the first nine months of fiscal 2013.

Cash and cash equivalents and investments at December 31, 2013 were $63,905, compared with $54,861 on September 30, 2013 and $51,692 at March 31, 2013.

Forward-Looking Statements

This report and other documents we file with the Securities and Exchange Commission include "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.

These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any future results implied by the forward-looking statements. Such factors include, but are not limited to, the risks and uncertainties identified by us under the heading "Risk Factors" in Item 1A of our Annual Report on Form 10-K for fiscal 2013.

Forward-looking statements may also include, but are not limited to, statements about:

the current and future economic environments affecting us and the markets we serve;

expectations regarding investments in new projects by our customers;

sources of revenue and anticipated revenue, including the contribution from the growth of new products, services and markets;

expectations regarding achievement of revenue and profitability expectations;

plans for future products and services and for enhancements to existing products and services;

our operations in foreign countries;

our ability to continue to pursue our acquisition and growth strategy;

our ability to expand nuclear power work, including into new markets;

our ability to successfully execute our existing contracts;

estimates regarding our liquidity and capital requirements;

timing of conversion of backlog to sales;

our ability to attract or retain customers;

the outcome of any existing or future litigation; and

our ability to increase our productivity and capacity.

Forward-looking statements are usually accompanied by words such as "anticipate," "believe," "estimate," "may," "might," "intend," "interest," "appear," "expect," "suggest," "plan," "encourage," "potential," and similar expressions. Actual results could differ materially from historical results or those implied by the forward-looking statements contained in this report.


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Undue reliance should not be placed on our forward-looking statements. Except as required by law, we undertake no obligation to update or announce any revisions to forward-looking statements contained in this report, whether as a result of new information, future events or otherwise.

Current Market Conditions

We continued to see strong bidding activity from our customers during the third quarter of fiscal 2014. We believe that bidding activity is a leading indicator of the direction and health of our markets. We believe the business environment is continuing to improve and that our customers are becoming more inclined to procure the equipment needed for their projects. This supports our belief that the oil refining, petrochemical and related markets we serve are continuing to move toward a stronger part of the business cycle.

We believe the following demand trends that are influencing our customers' investments include:

Lower natural gas cost resulting from a significant increase in supply has been driven by technology advancements in drilling. The dramatic change in natural gas costs and expectation of steady supply in the U.S. has led to a revival in the U.S. petrochemical market and recent movements toward potential major investment. There are numerous projects in planning, initial engineering, or construction phases for the new petrochemical producing facilities, including ethylene, methanol, ammonia and urea facilities. In addition, existing petrochemical facilities are evaluating restarting idled process units or debottlenecking existing operations to increase throughput. We currently have a number of these projects in our pipeline and have begun to add new orders into backlog associated with the North American petrochemical/chemical markets. We historically have had strong market share within U.S. petrochemical facilities. Lower natural gas cost has also made the U.S. production of ethane, which is a by-product of natural gas production, favorably competitive with naphtha, which is a by-product of crude oil refining, as a feedstock for ethylene production. Proposed ethylene capacity expansion and re-opening of mothballed facilities in the U.S., as well as downstream products, are being discussed by petrochemical producers for the first time in well over a decade. We believe investment in U.S. petrochemical markets could be significant over the next several years.

The U.S. refining market has exhibited improvement throughout fiscal 2014. We do not expect this market to return to the order levels experienced during the last upcycle, but anticipate that this market will improve compared with its order levels over the past few years. We expect that the U.S. refining markets will continue to be an important aspect of our business.

We are beginning to see renewed signs of planned investments in the U.S. to convert greater percentages of crude oil to transportation fuels, such as revamping distillation columns to extract residual higher-value components from the low-value waste stream. We are also seeing renewed investment to expand the flexibility of facilities to allow them to utilize multiple feed stocks. Moreover, a trend to upgrade existing equipment in order to extend on-stream operation duration between planned shutdowns has emerged which has resulted in an increase in demand for our equipment.


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Investments, including foreign investments, in North American oil sands extraction projects have occurred over the past few years. These investments suggest that downstream spending involving our equipment might increase in the next several years.

The expansion of the economies of oil-producing Middle Eastern countries, their desire to extract greater value from their oil and gas resources, and the continued global growth in demand for oil and refined products has renewed investment activity in that region. Moreover, the planned investment schedule of refinery and petrochemical projects in the major oil-producing Middle Eastern countries is encouraging.

Emerging economies, especially in Asia, continue to have relatively strong economic growth. We believe that this expansion is driving growing energy requirements and the need for more energy and energy related products. In many emerging countries, such as India for example, renewed demand for energy products such as transportation fuel and consumer products derived from petrochemicals is driving increased investment in petrochemical and refining capacity.

Although China has many of the characteristics of other Asian countries, there has been a near-term slowdown in spending in the refining and petrochemical markets as the government is moderating its near-term investment to attempt to control inflation. A number of projects, which were expected to move forward in the first nine months of fiscal 2014, have been pushed out six to twelve months. This appears to be a delay in projects moving forward rather than project cancellations. Moreover, the Chinese government's most recent five year plan calls for ongoing investment in the energy markets.

South America, specifically Brazil, Venezuela and Colombia, is seeing increased refining and petrochemical investments that are driven by expanding economies, and increased local demand for transportation fuels and other products that are made from oil as the feedstock. South American countries are also working to extract more value from their natural resources by supplying energy products into the global markets. However, the South American market can be unpredictable and has historically been slower to invest than other emerging markets.

The continued progress at the new U.S. nuclear reactor projects planned for the Summer (South Carolina) and Vogtle (Georgia) facilities suggest some growth in the domestic nuclear market. However, investment in new nuclear power capacity in the U.S. and internationally remains uncertain due to political and social pressures, which were augmented by the tragic earthquake and tsunami that occurred in Japan in March 2011. In addition, the low cost of domestic natural gas may shift investment away from the nuclear market in North America.

The need for additional safety and back-up redundancies at existing domestic nuclear plants driven by new regulatory requirements could increase demand for our products.

The desire to extend the life of the existing nuclear plants including new operating licenses and expanded output (re-rating) of the facilities will require investment and could increase demand for our products.


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We believe that the consequences of the trends described above will drive revenue growth. As we look at margin potential in the current business cycle compared with the previous cycle, we expect growth in emerging markets to result in continued pressure on our pricing and gross margins, as these markets historically provided lower margins than North American refining markets. While we believe the investments in new petrochemical capacity expected to be built in North America will provide revenue growth, we do not expect the gross margins from that market will be as strong as other domestic markets. The mix of international customers who are investing in domestic petrochemical projects will likely temper the margin expectations of this market. Therefore, we believe peak margins in the current business cycle will be lower than the previous cycle, which was primarily driven by the domestic refining market.

Because of continued global economic and financial uncertainty and the risk associated with growth in emerging economies, we also expect that we will continue to experience volatility in our order pattern. We continue to expect our new order levels to remain volatile, resulting in both relatively strong and weak quarters. As the chart below indicates, quarterly order levels can vary significantly.

We believe that looking at our order level in any one quarter does not provide an accurate indication of our future expectations or performance. Rather, we believe that looking at our orders and backlog over a trailing twelve-month period provides a better measure of our business.

Our quarterly order levels and trailing twelve-month order levels for the first three quarters of fiscal 2014, and the four quarters of fiscal 2013 and fiscal year ended March 31, 2012 (which we refer to as "fiscal 2012"), respectively, are set forth in the chart below.

[[Image Removed: LOGO]]


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Expected International Growth in Refining and Chemical Processing and Domestic Growth in Chemical Processing, Nuclear Power and U.S. Navy Projects

We expect growth in refining capacity to be driven by emerging markets. We also expect incremental investments in the domestic market for existing refining facilities. Investment in the chemical and petrochemical processing markets is expected to be split between North America and the international market. Accordingly, we believe our revenue opportunities in chemicals and petrochemicals will be balanced between the domestic and international markets. This differs with the previous cycle, which was almost exclusively driven by the international markets. We have also expanded our addressable markets with the expansion of our capabilities in the power market and our focus on the U.S. Navy nuclear propulsion projects.

Over the long-term, we expect our customers' markets to regain their strength and, while remaining cyclical, continue to grow. We believe the long-term growth trend remains strong and that the drivers of future growth include:

Global consumption of crude oil is estimated to expand significantly over the next two decades, primarily in emerging markets. This is expected to offset estimated flat to slightly declining demand in North America and Europe. In addition, an increased trend toward export supply of finished product from the Middle East to Europe is expected.

Global oil refining capacity is projected to increase, and is expected to be addressed through new facilities, refinery upgrades, revamps and expansions.

Increased demand is expected for power, refinery and petrochemical products, stimulated by an expanding middle class in Asia and the Middle East.

More domestic refineries are expected to convert their facilities to use heavier, more readily available and lower cost crude oil as a feedstock.

Shale gas development and the resulting availability and abundance of affordable natural gas as feedstock to U.S.-based chemical/petrochemical facilities is expected to lead to renewed investment in chemical/petrochemical facilities in the U.S.

Lower costs and increased supply are expected to drive increased domestic use of natural gas in the U.S., as well as the ability to export liquefied natural gas to serve other regions.

Construction of new petrochemical plants in the Middle East is expected to meet local demand.

Continued investment in new and replacement nuclear aircraft carriers and submarines by the U.S. Navy is expected to ensure its fleet of vessels is up to date and utilizes current technology.

Increased investments in new power generation projects are expected in Asia and South America to meet projected consumer demand increases.


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Long-term growth potential is expected in alternative energy markets, such as geothermal, coal-to-liquids, gas-to-liquids and other emerging technologies, such as biodiesel, and waste-to-energy. Increased development of geothermal electrical power plants in certain regions is also expected to address projected growth in demand for electrical power.

Increased regulation worldwide, impacting the refining, petrochemical and nuclear power industries is expected to continue to drive capital investments.

Increased focus on safety and redundancy is anticipated in existing nuclear power facilities.

Long-term increased development of nuclear facilities may occur internationally.

We believe that all of the above factors offer us long-term growth opportunities to meet our customers' expected capital project needs. In addition, we believe we can continue to grow our less cyclical smaller product lines and aftermarket businesses.

Our domestic sales, as a percentage of aggregate product sales, were 62% in the third quarter of fiscal 2014 and 57% in the first nine months of fiscal 2014. This is compared with 44% and 53%, respectively, in the comparable periods of fiscal 2013. In fiscal 2012 and fiscal 2013, domestic sales were 54% and 53%, respectively. We expect the percentage of domestic business should continue to be higher when compared with the prior two fiscal years due to the strong domestic orders for the remainder of fiscal 2014.

Results of Operations

For an understanding of the significant factors that influenced our performance, the following discussion should be read in conjunction with our condensed consolidated financial statements and the notes to our condensed consolidated financial statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q.

The following table summarizes our results of operations for the periods indicated:

                                         Three Months Ended                       Nine Months Ended
                                             December 31,                            December 31,

                                       2013                 2012               2013                 2012

Net sales                              $23,385            $25,633                $76,131            $74,068
Net income                              $1,431             $3,047                 $7,828             $7,052
Diluted income per share                 $0.14              $0.30                  $0.78              $0.70
Total assets                          $135,569           $123,338               $135,569           $123,338


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The Third Quarter and First Nine Months of Fiscal 2014 Compared With the Third Quarter and First Nine Months of Fiscal 2013

Sales for the third quarter of fiscal 2014 were $23,385, a 9% decrease as compared with sales of $25,633 for the third quarter of fiscal 2013. The lower sales were a result of the relatively low order levels seen in fiscal 2013. Domestic sales increased $3,140, or 28%, in the third quarter of fiscal 2014 compared with the third quarter of fiscal 2013. International sales year-over-year decreased $5,388, or 38%, driven by lower sales in the Middle East and Asia, partly offset by higher sales in Canada. Sales in the three months ended December 31, 2013 were 31% to the refining industry, 23% to the chemical and petrochemical industries, 23% to the power industry, including the nuclear market and 23% to other commercial and industrial applications. Sales in the three months ended December 31, 2012 were 43% to the refining industry, 25% to the chemical and petrochemical industries, 16% to the power industry, including the nuclear market, and 16% to other commercial and industrial applications. Fluctuations in sales among markets, products and geographic locations can vary measurably from quarter-to-quarter based on timing and magnitude of projects. See "Current Market Conditions," above. For additional information on future sales and our markets, see "Orders and Backlog" below.

Sales for the first nine months of fiscal 2014 were $76,131, an increase of 3% compared with sales of $74,068 for the first nine months of fiscal 2013. The increase in current year sales was due to higher domestic and Canadian sales, partly offset by lower sales in the Middle East. Domestic sales increased $4,371, or 11%, in the nine months ended December 31, 2013 compared with the nine months ended December 31, 2012. International sales accounted for 43% and 47% of total sales for the first nine months of fiscal 2014 and fiscal 2013, respectively. International sales in the year-over-year nine month periods decreased $2,308, or 7%, driven by lower sales in the Middle East, partly offset by higher sales in Canada. Sales in the first nine months of fiscal 2014 were 40% to the refining industry, 18% to the chemical and petrochemical industries, 25% to the power industry, including the nuclear market, and 17% to other commercial and industrial applications. Sales in the first nine months of fiscal 2013 were 30% to the refining industry, 28% to the chemical and petrochemical industries, 21% to the power industry, including the nuclear market, and 21% to other commercial and industrial applications.

Our gross profit margin for the third quarter of fiscal 2014 was 26% compared with 28% for the third quarter of fiscal 2013. Gross profit for the third quarter of fiscal 2014 decreased to $6,090 from $7,128, or 15%, compared with the same period in fiscal 2013. Gross profit margin and dollars decreased primarily due to product mix in the current year's third quarter.

Our gross profit margin for the first nine months of fiscal 2014 was 32% compared with 29% for the first nine months of fiscal 2013. Gross profit dollars for the first nine months of fiscal 2014 increased 15% to $24,394, compared with the same period in fiscal 2013, which had gross profit of $21,277. The increase in gross profit was due to a greater level of sales driven by both short cycle sales, which had stronger pricing levels, and the conversion of projects, primarily during the first two quarters of fiscal 2014, which had more favorable pricing compared with the projects converted in the same period of fiscal 2013.

Selling, general and administrative ("SG&A") expense in the three and nine-month periods ended December 31, 2013 increased $914, or 29%, and $1,246, or 11%, respectively, compared with the same periods of the prior year. The increase in SG&A expenses for the three and nine-month periods was primarily due to the reversal, in the third quarter of fiscal 2013, of the $975 reserve related to the expected value of the earn-out from the Energy Steel acquisition.

SG&A expense as a percent of sales for the three and nine-month periods ended December 31, 2013 was 18% and 17%, respectively. This compared with 12% and 16%, respectively for the same periods of the prior year. As noted above, the $975 reserve reversal occurred in the third quarter of fiscal 2013. Excluding the reserve reversal, SG&A expense as a percent of sales for the three and nine-month periods ending December 31, 2012 would have been 16% and 17%.


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Interest income was $10 and $31 for the three and nine-month periods ended December 31, 2013, compared with $13 and $38 for the same periods ended December 31, 2012. The low level of interest income relative to the amount of cash invested reflects the persistent low level of interest rates on short term U.S. government securities.

Interest expense was ($11) and ($2) for the three and nine-month periods ended December 31, 2013, compared with $19 and $(271) for the same periods ended December 31, 2012. It is our policy to recognize any interest related to uncertain tax positions in interest expense. In the third quarter of fiscal 2014 and the second quarter of the prior year, fiscal 2013, we reversed provisions that had been made in earlier periods for interest related to uncertain tax positions, due to lower than expected assessments by the IRS. See Note 12 to our Unaudited Condensed Consolidated Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q.

Our effective tax rate in fiscal 2014 is projected to be between 33% and 34%. The tax rate used to reflect income tax expense in the current quarter was 29%, and the tax rate for the first nine months of fiscal 2014 was 32%. Included in the current quarter was a reversal of $134 liability for unrecognized tax benefits. Excluding this reversal, the effective tax rate in the three and nine-months ended December 31, 2013 were 35% and 33%, respectively. The tax rate for the comparable three and six month periods of fiscal 2013 was 23% and 29%, respectively. The lower tax rate realized in the third quarter of fiscal 2013 was related to the reversal of the Energy Steel earn-out reserve discussed above, which was not tax affected. Excluding this reversal, the effective tax rate in each of the three and nine-month periods ended December 31, 2012 would have been 32%.

Net income for the three and nine months ended December 31, 2013 was $1,431 and $7,828, respectively, compared with $3,047 and $7,052, respectively, for the same periods in the prior fiscal year. Income per diluted share in fiscal 2014 was $0.14 and $0.78 for the three and nine-month periods, compared with $0.30 and $0.70 for the same three and nine-month periods of fiscal 2013. Excluding the earn-out reversal which occurred in the third quarter of fiscal 2013, net income and income per diluted share for the third quarter of fiscal 2013 were . . .

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