Graham (GHM)

GHM is one of those stocks that can drive you crazy. The company is involved in a hot industry (oil refining), backlog is increasing by over 50% (see below), the valuation is cheap, but the company is a micro-cap and hence its shares are extremely volatile and subject to manipulation (especially it seems by a completely unscrupulous specialist). I´ve been buying GHM since June, and have recently taken a huge hit on some of my recent purchases (wiping out all of my recent stock market gains in 2005), but I still feel this stock is an excellent buy and hold for the next year, especially after the recent dip.

What does GHM do?

From the company´s latest S-2: "We design, manufacture and sell custom-built vacuum and heat transfer equipment. Our products include steam jet ejector vacuum systems, surface condensers for steam turbines, vacuum pumps and compressors, various types of heat exchangers, including helical coil heat exchangers marketed under the Heliflow® name, and plate and frame exchangers. Our products produce a vacuum, condense steam or transfer heat, or perform a combination of these tasks. Our products are available in a variety of metals and non-metallic corrosion resistant materials. Our products are used in a wide range of industrial process applications, including: petroleum refineries; power generation facilities, such as fossil fuel, nuclear, cogeneration and geothermal power plants; liquefied natural gas production facilities."

The short take: GHM sells specialized manufactured products (see more detail below) which are primarily sold to  oil refineries, petrochemical plants and power generation  facilities.

Why buy GHM now?

• Unbelievable Industry Fundamentals and Macro-Trends that will last for quite some time

It´s actually quite simple why GHM makes for an excellent invesment. This company supplies vital products to one of the hottest industries today: oil refineries. For anyone following the current oil boom, it is common knowledge (reiterated daily in almost every newspaper) that one of the major issues with oil capacity worldwide is a lack of investment in upgrading old oil refineries and building new ones. Prodded by governments worldwide, and due to extremely large recent profit gains made by oil refiners, it seems quite obvious that there will soon be a huge and sustained boom in refinery captial expenditures worldwide. GHM will benefit greatly from this boom.

From the company´s 10Q:

"The current level of inquiries for Graham’s products gives the Company reason to believe that it has entered an up cycle for capital spending, which it believes should continue to positively impact its business for the immediate future. Global growth and expansion in oil refineries, petrochemical plants and power generation are driving current demand for Graham products."

"Approximately 36% of the backlog can be attributed to equipment for refinery project work, 38% to petrochemical projects, and 18% to equipment sold to the power sector. Refinery project work is on the increase due to the need for more refinery capacity. This need is being driven by the shortages of refinery capacity resulting from rising oil demand from China and India, the need to upgrade existing refineries so that they can make use of lower grade, high sulfur crude, and the need to revamp refineries to meet environmental regulations pertaining to diesel fuel sulfur content requirements. Most refineries today can only process light, sweet (low sulfur) crude, which is in less supply and more expensive than the high sulfur crude variety. Orders from the petrochemical and power markets are mainly for overseas capacity expansion projects. These orders reflect the improved Asian economy. In recent years there has been minimal capital investments by these sectors."

Also note that: These refineries projects are complex and take a long time to complete (so this is not a one quarter phenomenon and GHM´s earnings will increase for many years), No new refinery has gone up in the US since 1976, the composition of crude oil available in the world to  be refined has changed, as older sweet (low sulfur) fields have hit their peak production, while newer finds have had a much higher sulfur content (even the Saudis production is lower grade, that most refineries can’t use without GHM´s desulphurization equipment).

• New Management Team

At the end of 2004, Graham hired a  new CEO. I have usually done extremely well when buying stocks in companies that hire a new CEO to revitalize a once sleepy company. And GHM has been a sleeper. In fact, the stock had barely moved for a decade until this year. It is still  too early to judge the new CEO, as  I think that anyone with a modicum of intelligence would be able to increase GHM´s profits in this sort of environment, but so far (with the exception of a ludicrous private equity offering , see below), the new CEO at GHM has done some positive things for the company, including increasing PR, holding conference calls with investors etc.

• Low Valuation

GHM is no hype stock. The company pays a dividend, has no debt, and also has started to report strong profits. In the first quarter of fiscal year 2006, ended June 2005 (GHM has a non-traditional fiscal year),  GHM reported $0.20 per share in earnings on a 42% increase in sales. Margins also increased substantially (GHM is a manufacturer, so higher sales on a fixed capital base will lead to increased margins) with Gross margins at 28% vs. 9% last year.  Most importantly, backlog was $31,145 at June 30, 2005, as compared to $18,776 at June 30, 2004, representing a 66% increase.

Management at GHM is guiding total fiscal 2006 sales of $55 - $60 million and gross margins of over 30%. Plugging these numbers into a spreadsheet, I have come up with potential earnings for GHM of between $1.15 - $1.25 per share for fiscal 2006. The big question is what multiple should be placed on GHM´s earnings. Bears will point out that GHM is in a cyclical industry and as such the multiple should be low. I would counter that by stating that the macro-trends that are currently favoring GHM will likely continue for at least another 3 years, and GHM´s earnings could grow so substantially by the time peak hits, that the company does not deserve a cyclical-like multiple. This is a once in a lifetime super-cycle for oil refinery cap-ex. When you consider that Graham can grown earnings (looking at the backlog and the industry trends) to at least $1.60 per share by next year (actual numbers could be substantially higher, maybe as high as $2.50 per share), it should seem quite clear that GHM´s stock is not in the least bit expensive at less than 15X 2006 estimates, and it could get a huge multiple expansion as soon as more people realize how favorably this company is positioned over the next several years. It may sound crazy, but this stock can go to $50, under the best case scenario (20X 2007 earnings of $2.50). In the worst case, it probably just hangs around where it is. So this is definately a low risk/high reward situation.

• Stock is being artificially pressured 

In what I consider to be a completely bonehead move on the part of management (their first fault to date), GHM recently filed to sell about 200,000 common shares in privately negotiated transactions. Why is this stupid? Because the company has no need to raise money via equity  transactions, which only serve to dilute shareholders and place shares into the hands of individuals and companies whose sole desire is to manipulate GHM´s stock price for short-term gains. GHM states that they need this money for cap-ex expenditures, but last I looked GHM has no debt, a solid cash position, and excellent cash-flow prospects. In short, they don´t need to raise any money. They could pay for all of their cap-ex needs via existing cash and/or bank loans. As a shareholder, I´d much rather see this underleveraged company borrow funds from a bank (the amount is so negligible), than sell stock in privately negotiated transactions. There is absoutely no risk at this point in GHM taking on $3 million in debt.

So why is GHM doing this? In short, this was a mistake of judgement on the part of management, which I hope they will reverse soon. In the meantime (for reasons which are beyond the scope of this post), GHM´s stock is being manipulated downward, so as to force an equity sale of shares at low prices. At the same time, many shareholders are getting scared and bailing, leading to an oversupply of shares, while others like myself, am overbought the shares, leading to a lack of demand. The end result, is that the private sale of shares is creating a short-term situation whereby the supply/demand situation for GHM has lead to a downward spiral in the stock price, and the stock has therefore become a very attractive investment.

Holding Period?

If you buy GHM, you need to hold this stock for at least a year, to participate in the large earnings increases that will surely be reported. I suspect that as more and more people see GHM´s stellar results and begin to understand the earnings potential here, the stock will make new highs. I´ve never seen a stock where the company has 50%+ backlog growth, 30-50%+ earnings growth, and an amazing 3 year business environment, not outperform the stock market.