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GHM > SEC Filings for GHM > Form 10-K on 4-Jun-2014All Recent SEC Filings

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Form 10-K for GRAHAM CORP


4-Jun-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

(Amounts in thousands, except per share data)

Overview

We are a global business that designs, manufactures and sells critical equipment for the energy industry which includes the oil refining, petrochemical, as well as cogeneration, nuclear and alternative power markets. With world-renowned engineering expertise in vacuum and heat transfer technology and a leading nuclear code accredited fabrication and specialty machining company, we design and manufacture custom-engineered ejectors, vacuum pumping systems, surface condensers and vacuum systems as well as supplies and components for 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 are 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 our fiscal year ended March 31, 2014, which we refer to as "fiscal 2014" include:

Net income and income per diluted share for fiscal 2014, were $10,145 and $1.00 compared with net income and income per diluted share of $11,148 and $1.11, respectively, for the fiscal year ended March 31, 2013, which we refer to as "fiscal 2013."

Net sales for fiscal 2014 were $102,218, down 3% compared with $104,973 for fiscal 2013.

Operating cash flow for fiscal 2014 was $15,230, up from $12,432 in fiscal 2013.

Orders received in fiscal 2014 were a record $128,152, up 34% compared with fiscal 2013, when orders were $95,828.

Backlog on March 31, 2014 was a fiscal year end record at $112,108, up 31% from backlog of $85,768 on March 31, 2013.

Gross profit and operating margins for fiscal 2014 were 31.1% and 14.3% compared with 30.3% and 14.5%, respectively, for fiscal 2013.

Cash and short-term investments at March 31, 2014 were $61,146 compared with $51,692 as of March 31, 2013, up 18%.

At fiscal year end, we had a solid balance sheet that was free of bank debt and which we believe provides us with financial flexibility to pursue our business strategy.

Forward-Looking Statements

This report and other documents we file with the Securities and Exchange Commission ("SEC") 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 Part I and elsewhere in this Annual Report on Form 10-K.


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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;

political instability in regions in which our customers are located;

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

our ability to expand nuclear power work 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.

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.

Fiscal 2014 and Current Market Conditions

During fiscal 2014, we began to see the benefit of the improving market environment. Orders increased 34% to a record $128,152, 18% higher than our previous fiscal year record. Bidding activity continued to be strong throughout the year. We believe bidding activity is a leading indicator for the direction and health of our markets. We believe the business environment has improved and that we are seeing a market expansion in our key end markets of oil refining, petrochemical and other related energy markets. We believe the current activity level within our pipeline continues to be more robust than in past cycles.

We believe that the demand trends affecting our customers' investments include:

Natural gas serves as both an energy source and feedstock to chemical industries. Low cost and the plentiful supply of North American natural gas has led to a revival in the U.S. petrochemical market. This is evident as we witness a significant increase in the planned construction of new petrochemical producing facilities, including ethylene, ammonia, methanol, propane dehydrogenation (PDH) and urea facilities. In addition, existing petrochemical facilities are restarting idled process units or debottlenecking existing operations to increase throughput. We currently have a number of these projects in our backlog and many more in our pipeline. We historically have had strong market share within U.S. petrochemical facilities. This has continued to date in the current expansion. We believe this is the first wave of major investment by petrochemical producers since the 1990's. Lower natural gas cost is a relatively recent phenomena, having occurred over the past five years and is driven by technology advancements in drilling, which in turn has created a significant increase in supply. This has made the U.S. production of the raw material for ethylene, ethane (which is a side product of natural gas production), globally competitive with naphtha


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(the alternative feedstock for ethylene used in most of the world). We believe investment in U.S. petrochemical markets could be significant over the next decade, although such investment could occur in multiple phases.

The U.S. refining market exhibited some improvement in fiscal 2014. We do not expect the U.S. refining markets to return to the levels experienced during the last upcycle, but that such markets will continue to improve. We expect that the U.S. refining markets will continue to be an important aspect of our business.

We are seeing 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 feedstocks. Moreover, a trend to upgrade existing equipment in order to extend on-stream operation duration between planned shutdowns has emerged that has resulted in an increase in demand for our equipment.

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

The continued expansion of the economies of many of the 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. We do not believe that the ongoing political unrest in the Middle East has impacted our business to date. Moreover, the planned timeline of refinery and petrochemical projects in the major Middle Eastern countries is encouraging.

Emerging economies, especially in Asia, continue to have relatively strong economic growth compared with other regions, however this growth appears to be more moderate than in our prior business cycle. Asian countries, specifically China and India, are experiencing sustained demand for energy products such as transportation fuel and consumer products derived from petrochemicals. We believe that Chinese and Indian investments in refining, petrochemical and energy facilities continue to be planned. This renewed demand is driving increased investment in petrochemical and refining capacity.

China has also seen a near-term slowdown in spending in the refining and petrochemical markets as the government is moderating its near term investments in an attempt to control inflation. It appears political issues in China have also delayed the investment decision process, however, we believe this is a delay rather than a cancellation of project activity.

South America, specifically Brazil, Venezuela and Colombia, is seeing increased refining and petrochemical investments that are driven by its expanding economy, and increased local demand for transportation fuels and other products that are made from oil as the feedstock. Countries in this region also desire 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.

Investment in new nuclear power capacity in the U.S. and internationally may become subject to increased uncertainty due to political and social pressures, which were augmented by the tragic earthquake and tsunami that occurred in Japan in March 2011. 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 will occur. However, the low cost of natural gas does not lead us to believe that additional near-term new capacity is likely.

The need for additional safety and back up redundancies at existing domestic nuclear plants could increase demand for our products in the near-term.

Investments in existing U.S. nuclear plants to extend their operating life and add incremental capacity are expected to continue. 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 expect that the outcome of these trends will provide growth opportunities for our business. The investments in new petrochemical capacity built in North America, while providing significant volume, are not likely to provide the margin opportunity that the North American refining market yielded in the last upcycle. Less favorable product mix may limit the potential upside in gross margin. In addition, the projected expansion in petrochemical and oil refining outside of North America, primarily in the growing Asian and South American markets, will continue to result in pressure on our pricing and gross margins, as these markets historically generated lower margins than North American refining markets.

Because of continued global economic and financial uncertainty and the risk associated with growth in emerging economies, we also expect that we will have continued 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 orders 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 fiscal 2014, fiscal 2013 and fiscal 2012, respectively, are set forth in the table below.

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Expected Domestic Growth in Chemical Processing Coupled with International Growth in Refining and Chemical Processing Combined with Expanded Market Opportunities in Nuclear Power and U.S. Navy Projects

We expect incremental investments in the domestic market for the refining market and renewed investment in the chemical processing market in North America. We also expect growth in the refining and chemical processing capacity to be driven by emerging markets. We have expanded our addressable markets with expansion of our business capabilities in the power market and our focus on U.S. Navy nuclear propulsion projects. We believe our revenue opportunities during the near term will be more heavily weighted in the domestic


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market. However, over the longer term, we believe the opportunities will be equivalent between the domestic and international markets.

We believe the long-term trends remain strong and that the drivers of future growth include:

Natural gas in the U.S. is globally competitive with oil. As such, lower costs and plentiful 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.

An expansion of the petrochemical market in the U.S., which has begun, is expected to continue over the next several years, given the plentiful supply and globally competitive price of natural gas. In fiscal 2014, we saw nearly $40,000 in new orders in the domestic petrochemical market.

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 North America and 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.

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

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 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.

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

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

Long-term growth potential in alternative energy markets, such as geothermal, coal-to-liquids, gas-to-liquids and other emerging technologies, such as biodiesel, and waste-to-energy are expected to provide additional sales opportunities.

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

Long-term increased project development of international nuclear facilities is expected.

We believe that 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.

Domestic sales in fiscal 2014 were 62% of total sales. While we see annual fluctuations between domestic and international sales, we had seen a trend toward more international sales. Domestic sales as a percent of total sales had been declining in previous years, from a peak of 63% in our fiscal year ended March 31, 2009 (fiscal 2009) to 53% in fiscal 2013. The recent shift toward more U.S. sales has been driven primarily by mix of our end market sales, with higher domestic chemical and petrochemical sales as well as continued sales to the U.S. Navy and our penetration of the domestic nuclear market.

Results of Operations

For an understanding of the significant factors that influenced our performance, the following discussion should be read in conjunction with our consolidated financial statements and the notes to our consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K.


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

                                                Year Ended March 31,
                                          2014          2013          2012
             Net sales                  $ 102,218     $ 104,973     $ 103,186
             Net income                 $  10,145     $  11,148     $  10,553
             Diluted income per share   $    1.00     $    1.11     $    1.06
             Total assets               $ 141,634     $ 126,733     $ 114,977

Fiscal 2014 Compared with Fiscal 2013

Sales for fiscal 2014 were $102,218, down $2,755 or 3%, as compared with sales of $104,973 for fiscal 2013. Domestic sales were $63,850 or 62% of total sales, up from $55,695 or 53% of total sales in fiscal 2013. Domestic sales increased $8,155, or 15% compared with fiscal 2013. International sales accounted for $38,368 or 38% of total sales for fiscal 2014, down from $49,278 or 47% of total sales in fiscal 2013. International sales decreased $10,910 or 22% compared with fiscal 2013. By market, sales for fiscal 2014 were 35% to the refining industry, up from 34% in fiscal 2013, 24% to the chemical and petrochemical industries, the same as in fiscal 2013, 23% to the power markets, up from 22% in fiscal 2013, and 18% to other industrial applications, including the U.S. Navy, down from 20% in fiscal 2013.

Our gross margin for fiscal 2014 was 31.1% compared with 30.3% for fiscal 2013. Gross margins in fiscal 2014 increased compared with fiscal 2013, primarily due to an increase in higher margin, short cycle sales in the first half of fiscal 2014. Gross profit for fiscal 2014 decreased $10, compared with fiscal 2013 due to lower revenue offsetting the higher gross margin rate.

Selling, general and administrative, or SG&A, expense for fiscal 2014 was $17,195, up 4% or $635, compared with $16,560 in fiscal 2013. However, fiscal 2013 SG&A included the benefit of a $975 reversal of a reserve for the potential earn-out for year two following the Energy Steel acquisition. The earn-out for the second year, calendar year 2012, had been partly reserved for at the time of acquisition with the remaining charges added subsequent to the acquisition. However, due to lower order volume levels experienced in calendar year 2012 and project timing, the 2012 Energy Steel earn out criteria was not achieved. As a result, the reserve of $975 was adjusted to $0, and $975 was recorded as a reduction of SG&A expenses in the third quarter of fiscal 2013. Excluding the reserve adjustment, SG&A in fiscal 2013 would have been $17,535. Comparing fiscal 2014 SG&A to the adjusted number, SG&A in fiscal 2014 was down $340, or 2%.

SG&A as a percentage of sales in fiscal 2014 was 16.8% of sales compared with 15.8% of sales (and 16.7% of sales excluding the $975 reserve reversal noted above) in fiscal 2013.

Interest income for fiscal 2014 was $94, up from $51 in fiscal 2013.

Interest expense was $1 compared with a credit of $264 in fiscal 2013. The credit in fiscal 2013 was due to the interest charges being reversed for a research and development tax credit audit resolution reached with the Internal Revenue Service (the "IRS"). It is our policy to recognize any interest related to uncertain tax positions in interest expense. In fiscal 2013, due to lower than expected assessments by the IRS, we reversed provisions that had been made in earlier periods for interest related to previously uncertain tax positions. The IRS audit tax resolution is discussed in more detail in Note 10 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.

Our effective tax rate in fiscal 2014 was 31% compared with an effective tax rate of 28% for fiscal 2013. The tax rate in fiscal 2013 was favorably impacted by the reversal of the earn-out reserve noted above in the SG&A discussion which was not tax affected. Excluding the reversal of the earn-out reserve, the effective tax rate in fiscal 2013 was 30%.

Net income for fiscal 2014 and fiscal 2013 was $10,145 and $11,148, respectively. Income per diluted share was $1.00 and $1.11 for the respective periods.


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Fiscal 2013 Compared with Fiscal 2012

Sales for fiscal 2013 were $104,973, up $1,787 or 2%, as compared with sales of $103,186 for fiscal 2012. Domestic sales were $55,695 or 53% of total sales, down from 54% of total sales in fiscal 2012. Domestic sales increased by $263 in fiscal 2013. International sales accounted for $49,278 or 47% of total sales for fiscal 2013, up from 46% of total sales in fiscal 2012. International sales increased $1,524 or 3% compared with fiscal 2012. By market, sales for fiscal 2013 were 34% to the refining industry, down from 35% in fiscal 2012, 22% to the power markets, down from 28% in fiscal 2012, 24% to the chemical and petrochemical industries, up from 17% in fiscal 2012, and 20% to other industrial applications, including the U.S. Navy, the same as in fiscal 2012.

Our gross margin for fiscal 2013 was 30.3% compared with 31.6% for fiscal 2012. Gross margins in fiscal 2013 decreased compared with fiscal 2012 due to a few high margin projects which converted to sales in the first half of fiscal 2012, which were won with pricing in line with the peak of the last upcycle. Gross profit for fiscal 2013 decreased $813, compared with fiscal 2012.

SG&A expense for fiscal 2013 was $16,560, up 7% or $1,020, compared with $15,540 in fiscal 2012. However, this also included the $975 reversal of a reserve for the potential earn out for year two of the Energy Steel acquisition. The Energy Steel acquisition provided for a potential earn out to the seller of up to $1,000 per year for each of the first two full calendar years (calendar years 2011 and 2012) that we owned Energy Steel. The first year, calendar year 2011, the earn-out was achieved and paid to the seller in January 2012. The earn out for the second year, calendar year 2012, had been partly reserved for at the time of acquisition with the remaining charges added subsequent to the acquisition. However, due to lower order volume levels experienced in calendar year 2012 and project timing, the 2012 Energy Steel earn out criteria was not achieved. As a result, the reserve of $975 was adjusted to $0, and $975 was recorded as a reduction of selling, general and administrative expenses in the third quarter of fiscal 2013.

SG&A expense increased due to higher selling and commission cost and an increase in headcount, as we prepared for the anticipated continued recovery in our markets. SG&A as a percentage of sales increased in fiscal 2013 to 15.8% of sales (16.7% of sales excluding the $975 reserve reversal noted above) compared with 15.1% of sales in fiscal 2012.

Interest income for fiscal 2013 was $51, down from $58 in fiscal 2012.

Interest expense was a credit of $264 in fiscal 2013, down from $476 in fiscal 2012. The decrease was due to the interest charges being reversed for a research and development tax credit audit resolution reached with the IRS. In the second quarter of fiscal 2013, due to lower than expected assessments by the IRS, we reversed provisions that had been made in earlier periods for interest related to previously uncertain tax positions. The IRS audit tax resolution is discussed in more detail in Note 10 to the Consolidated Financial Statements in Item 8 of

Part II of this Annual Report on Form 10-K.

Our effective tax rate in fiscal 2013 was 28% compared with an effective tax rate of 37% for fiscal 2012. The tax rate in fiscal 2013 was favorably impacted by the reversal of the earn out reserve noted above in the SG&A discussion which was not tax affected. Excluding this charge, the effective tax rate in fiscal 2013 was 30%. The higher effective tax rate in fiscal 2012 was due to a charge of $374 related to the resolution of an IRS audit related to research and development tax credits taken in tax years 2006 through 2008. Excluding this charge, the effective tax rate in fiscal 2012 was 34%. The comparison of the adjusted tax rates, decreasing to 30% from 34% was due to the renewal of the R&D tax credit, which was only applicable for a portion of fiscal 2012 and an increase in tax deductions claimed for domestic production activities.

Net income for fiscal 2013 and fiscal 2012 was $11,148 and $10,553, respectively. Income per diluted share was $1.11 and $1.06 for the respective periods.


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Stockholders' Equity

The following discussion should be read in conjunction with our consolidated statements of changes in stockholders' equity that can be found in Item 8 of Part II of this Annual Report on Form 10-K. The following table shows the balance of stockholders' equity on the dates indicated:

March 31, 2014 March 31, 2013 March 31, 2012 $105,908 $92,995 $81,620

Fiscal 2014 Compared with Fiscal 2013

Stockholders' equity increased $12,913 or 14%, at March 31, 2014 compared with March 31, 2013. This increase was primarily due to net income earned in fiscal 2014.

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