2023-03-17 10:04:06 ET
Summary
- Graham Corporation's revenue in the near term should benefit from the strong order rate and healthy backlog levels.
- In the long term, the company should benefit from the U.S. navy ship procurement programs, which span decades.
- Based on my DCF calculations, GHM stock is currently overvalued.
Investment Thesis
Graham Corporation ( GHM ) is experiencing a healthy order rate and strong order backlog due to the healthy demand from the defense market. This should benefit the company's near-term revenue growth. In the long term, the company should benefit from the U.S. Navy ship procurement programs, which span decades. GHM has a pipeline of opportunities worth $1 bn to $1.3 bn over the next 30 years from these planned projects with the Navy. The company is improving its profitability, which allows it to pay off its debt and become a debt-free company again. Despite these healthy growth prospects, I have a hold rating on the stock due to its expensive valuation.
Orders & Backlog
The orders in Q3 FY23 declined Y/Y as well as sequentially due to the timing of the projects. The orders in the nine-month period were $151.9 mn, up 26% Y/Y with a book-to-bill ratio of 1.33x. This includes a 47% increase in defense orders, a 141% increase in space orders, and a 33% increase in chemical and energy aftermarket orders. The increased orders reflect repeat orders for critical U.S. Navy programs. The order backlog in Q3 FY23 increased by 8% to $294 mn.
GHM's Backlog order chart (Created by DzD Analysis by taking data from GHM)
Looking ahead, management anticipates that 40% to 50% of the backlog will be converted within the next 12 months, with the remaining 20% to 30% converted in the following 12 months. The majority of the backlog to be converted is for the defense industry, which now comprises 80% of the backlog following the acquisition of Barber-Nichols. The company is receiving a large number of repeat orders from the U.S. Navy, which continued in the month of January 2023. This should benefit the company's revenue in the coming quarters. Given the healthy order rate and backlog level, GHM's Board of Directors approved the acquisition of an automated welding machine, a new mill turning machine, a pump test rig, and facility expansion. These acquisitions and facility expansions should reduce production times and enable higher production delivery rates.
In the long term, the company should benefit from the navy ship procurement program, which spans decades. The company has a pipeline of opportunities worth $1 bn to $1.3 bn over the next 30 years from these planned projects with the Navy. The first project is the CBN Ford-class carrier, with two carriers under construction and eight remaining builds planned with a timeline of one every four years. The revenue per ship is in the range of $40 mn to $50 mn and with the remaining life of the program, the company has $400 mn in revenue potential. The second project is the SSN Virginia class submarines, with eight submarines under construction and 36 remaining builds that are planned at two submarines per year and expected to be completed by 2050. The revenue potential from this project is approximately $300 mn. The last project is the SSBN Columbia Class submarines, with one submarine under construction and 11 planned builds. The Navy is planning to build one Columbia class per year through 2023, and GHM's one sub revenue is ~$40 mn with a total future revenue potential of $400 mn.
I believe the long-term U.S. Navy contracts provide GHM with long-term visibility on revenue, and the repeat build process drives a solid recurring revenue stream for the company.
In the refining market, GHM has an installed base of approximately $1 bn and it appears it has not been proactive in going back to its customers and following up with the prior customers on how the equipment is operating. The company has now started working on this by building an aftermarket team and using its database of installed bases to understand how the equipment is running and make recommendations to its operators regarding maintenance and replacement. This should benefit the company by generating recurring revenue from MRO activities.
Overall, I believe the company has good near-term and long-term revenue growth prospects given its healthy backlog and increased exposure to the defense market. Given the strong results in Q3 FY23, management has increased its revenue guidance range to $145 mn to $155 mn and is working toward its fiscal year 2027 target of $200 million.
Improving profitability
GHM's Gross margin and Adjusted EBITDA margin (Created by DzD Analysis by taking data from GHM)
GHM's margins have been steadily improving since the acquisition of Barber-Nichols in June 2021. However, in Q3 FY21, the margins were negatively impacted due to the lower-margin first article projects received from the U.S. Navy. These projects are usually less profitable, resulting in a temporary dip in gross margin and adjusted EBITDA margin. However, in Q3 FY23, GHM's gross margin and adjusted EBITDA margin both showed significant improvement, reaching 15.6% and 5.6%, respectively. This improvement was driven by the company's continued efforts to improve execution, better pricing and mix, and higher volumes.
Looking ahead, GHM is focused on stabilizing its business and further improving execution to drive productivity and improve margins. The company also has higher-margin projects in its backlog, which should benefit the margins going forward. Overall, I believe GHM's margins should gradually increase in Q4 FY23 and beyond, driven by the company's productivity improvement initiatives and higher-margin projects in its backlog.
Balance Sheet & Cash Flow
During Q3 FY23, the company successfully paid off a significant portion of its debt, amounting to approximately $5 million, which brought the total debt down to $14.2 million from $19.1 million in the previous quarter. This debt repayment was funded by the company's strong cash flow from operations, which amounted to $9.3 million in the quarter. As a result of the stronger EBITDA and debt payments, the net leverage ratio improved and was brought down to 2.5x by the end of the quarter, which is in compliance with the bank's credit agreement. This is a positive development for the company, as it demonstrates its commitment to reducing debt and improving its financial position.
The company is focusing on generating cash to further reduce its debt and invest in organic growth opportunities. In the first nine months of the fiscal year, the company's capital expenditure was $2.4 million, and management anticipates this to be between $3 million and $4 million for the full fiscal year 2023. Overall, the company's debt reduction efforts and focus on generating cash for growth opportunities are positive developments that should help to strengthen its financial position and support its long-term growth prospects.
Risks to my thesis
I am anticipating a gradual improvement in the company's margins due to the improvement in productivity and higher-margin projects. However, it is important to note that the execution of these projects is crucial, and any missteps could impact both margins and cash flow. If cash flows are negatively impacted, the company may struggle to meet its debt obligations, leading to an increase in its net leverage ratio and a potential breach of its credit agreement.
Valuation
WACC Calculation (Created by DzD Analysis using DiscoverCI calculator)
I arrived at the conclusion that Graham Corporation is currently overvalued by conducting a DCF analysis. In my DCF analysis, I assumed revenue would grow in the high teens in FY23 given the healthy demand and strong order rate experienced in the first three quarters of the fiscal year. Beyond FY23, the revenue growth should be between high single-digit and low double-digit due to the healthy order backlog. Additionally, I factored in the company's capital expenditure of approximately $3 million in 2023, reflecting its investments in facilities and new equipment. This would likely impact the company's operating margins, which I expect to improve gradually due to the company's productivity improvements and higher-margin projects in its backlog. I used a discount rate of 8.06% by using the cost of equity of 8.56% and a cost of debt of 4.29%, which is below the industry level , and arrived at a fair value of $6.55 for GHM.
Conclusion
GHM has a positive outlook in both the near and long term. With a strong order rate and healthy backlog levels, the company's revenue should continue to grow in the short term. The company's acquisition of Barber-Nichols has significantly increased its exposure in the defense market, positioning it well for the planned U.S. Navy programs. GHM's profitability should continue to improve due to higher margin projects in the backlog and the company's continued focus on improving productivity. Despite these positive growth prospects, investors should exercise caution, as the stock's valuation has increased significantly in recent months. I believe a hold rating is more appropriate until the company's valuation becomes more reasonable.
For further details see:
Graham Corporation: Not A Buy After The Recent Bull Run