Graham (GHM) Update

I just finished listening to Graham's (GHM) quarterly conference call.

Basically the major reason for the miss on earnings here was because of a substantial decline in gross margins from the 2nd quarter. I, for one, had expected gross margin of at least 30% or higher (second quarter margins were nearly 33%), but the company had gross margins of only 27%. Management has explained the shortfall as related to the materials used in certain products. I'm not quite sure I fully understand or accept the explanation. In any case, clearly Graham (GHM) does not have much pricing power and more importantly I believe they will not see much gross margin improvement any time soon. They even mentioned that gross margins in China will be lower than current margins. The reason: Competition.

I am firmly believe that high gross margins are the lifeblood of a business. I was very bullish on Graham (GHM), because they appeared to entering an upcycle of increasing sales, and increasing gross margins, two key ingredients for stock price appreciation (higher gross margins businesses receive higher price to earnings/cash flow mutliples). However, now that I know that gross margins have peaked, and may even decline, there does not seem to be a reason why the stock deserves a high multiple off of earnings. So even if you assume that Graham grows substantially to lets say $90 million in sales (unlikely, but a possibility), and earns $1.50-$1.75 per share (depending on margins), what multiple does that deserve? 10X at most is my answer. So the stock should not trade much above $15.

The one very bullish aspect to the story is that earnings in the 4th quarter should be blockbuster, but I suspect that the market will discount those huge earnings, given the high variability in earnings that this quarter proved could be the case with Graham (GHM) moving forward.

Bottom-line, I've sold all my shares and booked a nice profit. The tremendous opportunities available to Graham (GHM) worldwide are still a reason to keep an eye on the stock, should it continue to sell off, but it is not clear the company will capitalize in time to support a significantly higher stock price to compensate for the risk at this point.

Comments

[Old guy]

I've followed GHM for many years. I don't disagree that the quarter was disappointing, and see nothing wrong with your selling the stock. I do disagree, though, with your "high gross margins are the lifeblood of a business" concept, as it applies to GHM. I'll explain why, so you know in case you get back into GHM someday.

The amount of business that GHM can do is limited at this point by its engineering capacity. If it had more engineers, it could take more orders--they are definitely out there. GHM is generally taking only the highest margin orders now. There are tons of lower margin business available that would be very lucrative, but GHM can't take that business. If it solves its engineering capacity issue, it could do so--gross margin percentage would then be lower, but because of the much higher revenues, EPS would be much higher.

The part you said you didn't understand about the effect of materials on margins can be explained with this hypothetical example: Order X, made of standard steel, costs GHM $700K to design and make, and they sell it for $1M. Order Y is an identical product, except made of fancy alloys; the engineering cost to GHM is the same, the alloys cost an extra $250K, but GHM charges an extra $300K for the product. So Product X has a gross profit of $300K, which is a 30% gross margin. Product Y has a profit of $350K, but its gross margin percent is only 26.9% of the $1.3M selling price. GHM would obviously be happier with an order for Product Y than X, because it results in higher dollar profits, even at a lower gross margin percentage.

[hawaiiretiro]

Old Guy,

You haven't explained Ned why high gross margins are not the life blood of the business. Financial metrics such as margins of any type are the lifeblood of any business. If the cannot be sustained at the maximum level then a company will be discounted accordingly. That is the point he is making.

Lastly,

If you read GHM's last 10q you will see that they are specifically expecting lower margins as a result of low margin business in Asia, higher materials and energy cost, and benefit costs.

This may be a bull sector in the macro sense, but the likelihood of GHM significantly capitalizing on it is slim. Flour looks better positioned

[hawaiiretiro]

Wow....spelling...get rid of "ned" in my message. Also I meant to type Fluor not flour. I'm certain there isn;t much to be made in refining flour!

[Old guy]

"You haven't explained Ned why high gross margins are not the life blood of the business."

What counts is EPS, not gross margins. The markets in which GHM competes consist of work available at various margin levels. With its limited engineering capacity, GHM has been focusing on getting primarily the highest margin jobs. Yet there is a much bigger market of jobs out there that, because of various factors, have somewhat smaller margins. That includes a lot of work in China, but elsewhere as well.

As GHM reduces the engineering bottleneck it will bid on more of those jobs. They are potentially very profitable, despite having lower margins. For example, Toyota has much bigger gross margins on its Lexus line than its Camry line. Should Toyota be unhappy everytime it sells another Camry, because that will lower its gross margin? Should Toyota stop selling Camrys so as to increase its gross margin?

There remains an "execution risk" with GHM. It may screw up and not accomplish what it hopes. But the goal is not a bad one--a much bigger and more profitable company than if it sat around and turned its nose up at all except the highest gross margin jobs.

[hawaiiretiro]

YF,

You first responce I could not have said better myself. I can't add anything to what you have already outlined.

Good discussion and good luck to you old man

[Old guy]

YF, I agree, my Camry/Lexus analogy is not a perfect one, because that is a mass production business, in which volume in Camrys helps lower the cost to make a Lexus. My point was merely that skimming just the highest gross margin jobs, as in effect you recommend, may be a decent strategy for GHM only if it wants to maximize current earnings and stay a $50M/year business.

But if it wants to participate in this supercycle that will involve huge projects, mostly in Asia, for the rest of this decade and beyond, as well as leverage its production capabilities which even now can turn out $100M/year or more, then it has to 1) eliminate its engineering bottleneck and 2) as engineering capability expands, be willing to go after slightly less wide margined business. The first item involves some sacrifice of current earnings to get new people up to speed. The second item means going after the massive Asian market--it does NOT mean custom projects with 10% gross margins as you suggest.

There is certainly execution risk, but the goal of GHM having sales of $100M and EPS north of $2 in two years is neither unworthy nor unachievable. Moreover, the discipline of trying to grow, rather than sitting back and only plucking the ripest fruit, will help lower costs and expand margins on GHM's traditional business. This will come from lower factory overhead per unit on the higher volume, and the lower cost of engineers in China and India (where non-critical engineering is being outsourced).

I'm not disagreeing with your thoughts on the stock. GHM could easily go lower before any worthwhile rally ensues. I just think you underestimate the CEO, whose strategy strikes me as correct.