Karen Howard - IR Jim Lines - President and CEO Jeff Glajch - CFO.

Joe Mondillo - Sidoti & Company Chase Jacobson - William Blair John Bair - Ascend Wealth Advisors John Karla - Oppenheimer & Close.

Greetings, and welcome to the Graham Corporation Second Quarter Fiscal Year 2016 Financial Results. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host Karen Howard, Investor Relations for Graham Corporation. Thank you Ms. Howard, you may begin..

Thank you, Tim and good morning everyone. Thank you for joining us to discuss our results for our second quarter and the first half of fiscal 2016. We certainly appreciate your time today. You should have a copy of the news release across the wire this morning detailing Graham's results.

We also have slides associated with the commentary that we're providing here today. If you do not have the release or the slides, you can find them at the Company's website at www.graham-mfg.com. On the call with me today are Jim Lines, our President and Chief Executive Officer; and Jeff Glajch, our Chief Financial Officer.

Jim and Jeff will review the results for the quarter and the first half of the fiscal year as well as our outlook. We will then open up the lines for Q&A. As you are aware, we may make some forward-looking statements during this discussion as well as during the Q&A.

These statements apply to future events and are subject to risks and uncertainties as well as other factors which could cause actual results to differ materially from what is stated on the call.

These risks and uncertainties and other factors are provided in the earnings release and in the slide deck, as well as with other documents filed by the Company with the Securities and Exchange Commission. These documents can be found on our website or at www.sec.gov. And with that, I'm going to turn the call over to Jim to begin.

Jim?.

Thank you, Karen. Good morning and welcome to our second quarter conference call. Jeff and I will update you on performance in the quarter and on our outlook. Please refer to slide 3.

Revenue in second quarter was $22.8 million, this reflected timing of backlog conversion associated with weakened fundamentals in our refining and chemical markets that were particularly challenging starting in our third fiscal quarter 2015. Revenue declined 36% on a comparable basis from $35.6 million a year earlier.

Backlog at quarter-end of $108 million continued to be strong. Gross margin in the quarter at 31% was above what it is expected to have been at $22.8 million of revenue. We have a higher cost -- we have a higher basis in cost of goods sold and 31% gross margin would infer.

In the quarter, gross margin was positively impacted by a vendor back charged settlement and productivity gains as we near completion of the CVN-79 U.S. Navy order. Gross margin in the mid-to-upper 20% range is what should be expected at that revenue level. Income in the quarter was $2 million or $0.20 per share.

This is down from $4.2 million a year earlier. 187,000 shares were purchased or $3.4 million as of the end of September. We've continued to repurchase shares in October. I'm now referring to slide 4, weakening in refining and chemical market tied to reduced crude oil pricing that took hold about one year ago has affected order pattern and revenue.

As the top of our chart indicates there has been a downward trend from fiscal 2015 quarterly sales, two quarters of fiscal 2016. Sales to refining industry were $7.2 million and that compares to $12.3 million a year earlier. We experienced the same for chemical industry sales that were $7.3 million in the quarter versus $12.9 million last year.

Power industry sales were $3 million and sales to our other markets including U.S. naval market were $5.3 million. The lower part of our chart provides detail for annual sales levels and you'll note that the fiscal 2016 revenue guidance remains between $95 million and $105 million.

Jeff let me turn it over to you for a more detailed review of results in the quarter..

Thank you Jim, and good morning everyone. On slide 6 please. Q2 sales were $22.8 million, down 36% compared with $35.6 million in the second quarter last year.

Sales in the quarter were 67% domestic and 33% international and represented a balance between petrochem and refining orders which occurred in the first half of last year as well as the near completion of the CVN-79 Navy project. And last year's second quarter sales were split 61% domestic 39% international.

Domestic sales decreased 30% to $15.2 million, while international sales decreased 45% to $7.6 million. Gross profit increased to $7.1 million from $11 million last year due to the lower volume. Gross margins were normally flat, up 40 basis points to 31.3%.

This year's margin was favorably impacted as Jim mentioned previously by both productivity improvements as we near completion of CVN-79 as well as a vendor settlement. EBITDA margins decreased to 15% in the quarter, down from 19% last year’s second quarter, driven by the lower volume and therefore less absorption of fixed cost.

Actually SG&A spending was down by $500,000 or 11% primarily due to the benefit of the restructuring activity that we took in Q4 of last year. Net income decreased to $2 million from $4.2 million or $0.20 per share, down from $0.41 per share.

Onto slide 7, results for the first half of fiscal 2016 were impacted by sales and productivity reductions in Q2. If you recall, Q1 of fiscal 16 was fairly comparable to Q1 of last year.

Sales in the first half of fiscal 2016 were $50.4 million, down 21% when compared with $64.1 million from the first half o last year with almost all the shortfall coming in this quarter. Year-to-date sales of 65% domestic and 35% international compared to 69% and 31% respectively last year.

Domestic sales decreased to $32.8 million compared with $44.1 million last year, while international sales were $17.6 million this year compared to $20 million last day. Year-to-date gross profit decreased to $15.2 million, down from $18.9 million last year.

As with Q2, the decrease was driven by lower volume, partly offset by 60 basis point increase in gross margins, again due primarily to one-time items in Q2. Year-to-date EBITDA margins were 15%, down from 17% in the first half last year. And net income decreased to $4.3 million from $6.6 million or $0.43 per share, down from $0.65 per share.

So on to slide six, we had strong operating cash flow in the first half of the year at $7.7 million, which was a mix of earnings and some unwinding of working capital, which we discussed on previous calls.

We returned $5 million of this to shareholders, $3.4 million in share repurchases as Jim mentioned as well as another $1.6 million in dividend payments. Our cash balance is up approximately $2 million from the end of fiscal year 2015 at $62.4 million.

And we expect some further working capital gains in the second half of the fiscal year, most likely in the third quarter as we further unwind our working capital which was at an elevated level at the end of fiscal 2015. Jim will complete our presentation by discussing the market outlook and full-year guidance.

Jim?.

Thank you Jeff. Please review now slide 10. Order pattern from refining and chemical markets as I noted in earlier remarks changed dramatically starting in our third quarter of fiscal 2015.

During this most recent quarter, gross orders were $24.5 million and $20.6 million net of a $3.9 million order secured in our first quarter of 2015 that went into delayed conversation shortly thereafter and that now has been canceled.

Refining and chemical industry orders are expected to remain volatile due to median industry reaction to dramatically reduced crude oil prices. This we believe is a short-term impact on orders.

Longer term, the global demand drivers that ultimately affect orders from these markets such as expanding population and increasing standards of living and thus corresponding increased global energy consumption will spur investment in new oil refining and chemical industry capacity along with spurring investment that keeps current capacity operating efficiently.

We have higher waiting for domestic orders or orders for U.S. end users represented 59% of total orders in the quarter. Our sales personnel are quite active as there was currently a significant amount of bidding work ongoing. On to slide 11, we have built a terrific backlog of work that stood at $108 million on September 30th.

Due to strength of our naval strategy coupled with weakened refining and chemical markets, the percentage of backlog planned to convert during the next 12 months is 45% to 50% of total backlog. 55% of backlog is from the markets or customer not served by the company five years earlier.

Action taken to diversify market served has dramatically improved backlog and long-term outlook for revenue and profitability. 47% of backlog is for the US Navy, 27% is for the refining market. Power and chemical industries each represent 10% of backlog. Our backlog composition has a different conversion schedule than historically.

45% to 50% converts within 12 months, 5% to 10% converts 12 to 24 months and the remainder which is 40% to 45% beyond two years from now. I’ll now refer to the guidance slide. Current guidance for revenue is unchanged at a range of $95 million to $105 million. We have narrowed gross margin to a range of 27% to 28%. SG&A holds at 17% to 18% of sales.

Full year effective tax rate is anticipated to be between 32% and 33%. Our vision and strategies to expand Graham’s revenue base haven't changed as we implement and execute strategies intended to drive top line to $200 million or greater.

And it is important to point out that we are carrying now $1.5 million to $2 million of pre-tax personnel expense necessary to support longer-term growth initiatives such as our naval and nuclear market strategies. Such expense is included in our guidance and is primarily in cost of goods sold.

It is our intention to stay committed to long-term growth initiatives that require between $1.5 million and $2.5 million of pretax investment, expense and personnel and corresponding revenue or offsetting profit while managing across challenging quarters during the short-term. Investment expense will be added prudently.

However, we are more focused on long-term earnings than maximizing short term quarterly profit. Tim, please open the line for questions. Thank you..

Excellent. [Operator Instructions] Our first question comes from the line of Joe Mondillo at Sidoti & Company. Please proceed with your question. .

First question regarding gross margin, how much did that vendor settlement amount to in the quarter?.

It was a couple of hundred thousand dollars. .

Okay.

And in terms of the increased guidance or I guess narrowing it to the high end of the gross margin guidance, was that mostly related to that or was there – was it something else?.

Well, as we got the midpoint of the year and taking into consideration the benefit of the stronger gross margin in the second quarter tied to the things that we had mentioned, we did feel it was necessary to tighten the guidance to reflect where we think the second half will be.

Absolutely our narrowing was correlated to strong performance in the second quarter..

But I mean was it – so I guess if take out 200,000 in the second quarter related to that vendor settlement, it’s about almost 100 basis points it looks like.

I mean, was the narrowing largely to do with that or was it a combination of that as well as determining sort of how the backlog was going to fall in the back half of the year and how that gross margin will look?.

Joe, our view of the second half of the year margin isn’t changing from what's it’s been, but if you look at the first half between the vendor settlement and the productivity improvements that we saw in CVN 79, our margin through the first half of the year is 30%.

And so our range of 27% to 28% obviously would suggest margins will be lower in the second half of the year to get down to the 27% to 28% range, but we felt if we kept the range to 26% to 28% that would look suggest a really low potential margin in the second half of the year.

And while it’s going to be lower than the first half, it won't bring our overall margins down south of 27%..

Okay, perfect. Thank you for that. Next, in terms of the orders, I was wondering if you could just sort of walk me through the several different end markets and sort of just give a little more color on sort of what you are seeing or feeling.

Oil refining actually was the strongest quarter of orders in four quarters now, but chemical and petrochemical was probably the worst in over 18 months or so. So if you could just maybe walk through the four different sort of categories and sort just give us your take on sort of how you are feeling about those markets. That would be helpful..

Sure. As it relates to the refining market, you are correct, we did have strong order intakes in the quarter and that was encouraging. We do remain long term optimistic about the refining sector, although we have to respect the short-term challenges that market is going through.

If we separate the refining market into new capacity and investment in keeping existing facilities running, we do expect to see stronger quarterly orders on the latter segment of the refining business which is keeping the existing facilities running and investments in, as we call them, Brownfield investments.

For new capacity that’s a little more difficult to predict. We have fairly substantial pipeline of bidding activity. We've had a fairly substantial pipeline of bidding activities for new capacity for a couple of years now. And one of those orders fell into the quarter fortunately. Our team did a great job to be in a position to pull that in.

It is difficult to predict it, Joe, will that be repetitive or is that signaling a change in refining market, we don't think so at this point in time, but overall we are getting about the immediacy of what’s going on in our markets, refining market we are very positive about the direction more term in the refining space.

The chemical sector, we are beginning to see this as a North American comment. We have begun to see the second wave of new petrochemical capacity enter into the big pipeline. The first wave we secured a fair amount of work in the summer of 2014 for that work. I'm sorry, summer of 2013, got that right, 2013.

But the second wave is starting to setup now and secondarily and also importantly we’ve begun to see some of the downstream investments that follow the first wave of new capacity enter into our big pipeline, so we are beginning to see that segment show some signs of activity, which we hadn’t seen for about the last four to five quarters quite honestly.

And so that is encouraging. I do want to couch that optimism with the remark that is important to bear in mind. The first wave of new chemical capacity in North America was predominantly from domestic end users.

This next wave has an international aspect to it where either it is an international end user or an international EPC is being involved in the projects. And that does have the tendency to put pressure on margins and also change the competitive landscape for who we might be competing against.

And that could affect our capture rate and/or the margins which will win that work. However, all in all, it’s good to see the second wave of new capacity entering into the bid pipeline as well as the downstream activity from the first wave.

On the nuclear market side, we're very encouraged there with the work our team and who is leading our nuclear strategy is doing to build our pipeline.

We bought in a new general manager into that business, nuclear market engineering and project management specialist as well as a new sales manager and we are beginning to see the pipeline start to diversify and expand and we expect that to translate into stronger bookings and then correspondingly stronger revenue some quarters out from now.

So that's very encouraging as we look at what that team has done. And then on the naval side, that work has an intermittency to it. We think over the next 12 to 15 months there will be – this is a broad range, but there will be $30 million to $50 million worth of activity that should close that’s in our addressable product scope.

For the smaller segment of our business that we call short cycle, that's actually fairly steady. We haven't seen much erosion in that level of business there, so I think I'll walk through everything. .

Great. Thanks a lot, Jim that was really helpful.

Just lastly, I’m just wondering if you could comment on the M&A market to give in sort of now that we’re word 15 months into sort of the downturn in oil prices and just the weakness that we are seeing overall in the industrial sector worldwide, just wondering how confident are you to maybe put the balance sheet to work or any comments on that would be great?.

Joe, we are continuing to look at the opportunities, the market is still a little pricier than one would think it would thus far into what would be clearly a downturn, but we are continuing to look at opportunities and certainly are active there.

But I can’t say I'm encouraged that the prices are coming down, so we must take that into account as we continue to move forward..

Okay.

And does that change your way of thinking about capital allocation at all? I noticed that you did buy back some stocks in the quarter, does that sort of imply that if you’re not able to get something done, you'll be participating in that?.

Not at all. We're still very encouraged at the opportunities that are out there from the acquisition standpoint, you just have to find the right one. And our buyback is a separate activity and our buyback, we are not intending to increase it or decrease it relative to our need for capital for acquisitions.

When we laid the buyback out upfront, we said, we – If we execute on the buyback, we have more than enough dry powder to also go through our acquisition program as we plan to, so there – while they are obviously related, in reality their distinct uses capital.

Clearly the acquisition is at the top of that list and the buyback is second on the list, but we believe we can do both without impacting either one or the other one. .

Okay, great. Thanks a lot. .

Our next question comes from the line of Chase Jacobson of William Blair. Mr. Jacobson, please proceed with your question..

Hi good morning. So I guess, keeping around this acquisition topic, so I understand that you’ve had a lot going on internally and that the prices are still – we’re obviously – the weakness in the market is known by all the players and the seller expectations have stayed high.

So I guess my question is what gives you the confidence or the feeling that eventually those prices are going to come down?.

Chase, this is – couple of things. First off, this is a bit similar to what we saw back in 2009, 2010 where prices stayed elevated a little longer than one would have thought that would have stayed elevated, and they did eventually come down.

But secondly, we're looking for one transaction and if we can find that one transaction that perhaps has a little more reasonable expectations, we'll proceed down that path.

So this is a process that does require a little bit of patience on our part, but we're willing to have that patience and we do believe that we will find an acquisition opportunity going forward..

Okay. I guess, we’ll have to be patient then too. On the gross margin, understanding where your revenue is and that you have some under absorption as you’re positioned for the longer term. I know we're not going to get back to the levels that we're in a fiscal ’09 and ’10, right.

But just going back over a year, you were pushing 31, to 30 – maybe going to 32, do you think that – is there a structural change in the market that's going to keep you from getting the margins back over – the gross margin back over 30% as we go forward or is it going to be a situation where it’s going to stay highly competitive? And just because the global market is not as strong, you have pockets of strength here and there, you kind of get stuck in the high 20s range..

Chase, let me start answering this question, and then I'll pass it over to Jim because I think he can give you more color on it.

If you look at this year’s gross margin, the range of 27 to 28, if you recall early in Jim’s prepared remarks, he mentioned the additional costs that we are incurring to drive some of our gross initiatives – growth initiatives.

So that is depressing margins in the neighborhood of 150 to 200 basis points, so excluding that, we would be kind of touching up pretty close to the 30% gross margin level even in this down cycle, so with that as a basis point as startup, I’ll let Jim give you more color around his view of where the markets are longer term and where the margins perhaps are..

Certainly at this particular point in time, there is pressure on margins and the order environment is, I guess, hyper competitive for what's available to go after and that has the tendency of compressing margins. We're also seeing more flexibility to allow other suppliers into that bid process.

I can speak more from a historical point of view and then I’ll give you my theory. We see this every down cycle, we see pressure on project cost, more focused on price and we see in the near term some new entrants come in and take some business.

And we're very judicious, and we are very disciplined in how we protect our turf and our pricing decisions and we expect the extent of the immense value that we provide to this marketplace and we expect to be paid for that.

And as we watch some of these price leaders take work, it’s tough, but those decisions sometimes manifest themselves in wrong decisions to the end-user three or four years out and that gets recognized. That happened in 1997, 1998 showed up in 2000, that happened again in the last downturn in 2010 and 2011 and it goes away a couple of years later.

So speaking historically, we deal with this every time and it has a duration, do I think it's irreparable, do I think it’s changed the structure of our markets, that's not immediately evident to me, but we're planning on a new landscape and Graham needs to change its value proposition on those cost basis.

I don’t believe that to be the case at this point in time. .

Okay, that's extremely helpful. And last quarter – last question Jeff. I noticed an increase in receivables in the quarter, I think it’s timing, I think it moved from unbilled revenue.

Does that convert in the second half of the year and is that – can you give any color if that's just a couple of big projects there or it’s just kind of a coincidence of timing on a lot of small things?.

Chase, you are correct, it moved from unbilled revenue to accounts receivable. And in fact if you were to go back to a couple of quarters, end of March, you would see our unbilled revenue has dropped from $18.5 million to about $8.5 million, so down by $10 million. Receivables have gone up by 5 and that’s exactly what’s occurring.

It’s a number of orders, but there are certainly a couple of big ones in there. Our expectation is that receivable number come down pretty meaningfully over the next quarter or two. I think a good portion of it will probably come down in the quarter ending in December..

Perfect, thank you..

Our next question comes from the line of John Bair of Ascend Wealth Advisors. Please proceed with your question..

Thank you, good morning. Couple of questions.

In the acquisition outlook, would you consider using – would you probably use a full cash or would you consider some stock as part of those – as part of that?.

John, our expectation in order is to use cash first. If by some scenario, there was a large enough acquisition that it absorbed all of our cash, we would likely use a prudent amount of debt second, and prudent amount would be no more than 1 to 1.5 times EBITDA. And then stock would be the third.

So it would have to be a pretty darn big acquisition for us to get to that stock, given the fact that we have over $16 million of cash? Don’t want to use equity I guess is the short answer..

I’m sorry. Say again..

The short answer is we do not want to use equity..

Right, okay. Very good. The other question I have is I saw an announcement of a large Kuwaiti refining award, I think it was 600 plus thousand barrels a day.

When those kind of awards are made, where do you -- how long of a timeline is it before you folks might be involved in the build out process of that?.

Sure. You're referring to the Kuwait National Petroleum Corporation Al Zour Refinery..

Yes..

We’ve been chasing that refinery project, we’ve been involved in the bidding process and the concept and feed projects and EPC work since 2006. We’ve been on the hunt for this, it’s still off the table at the end of the last cycle in 2009. It's been reactivated. There are four or five EPC modules that have been awarded.

This has been on our radar screen for quite some time and we've invested a great deal of energy to be participating in it..

Okay.

So are you saying then that you’re going to be part of that project or you’re still in the award process or how does that work?.

Yeah. We're still bidding it. The EPCs have just been selected and the awards with the five models to the EPCs has occurred over the last two to three quarters. We would expect the active bidding for purchase to begin in the next 6 to 12 months..

Okay. Very good..

Our next question comes from the line of John Karla of Oppenheimer & Close. Please proceed with your question..

Good morning, gentlemen.

How are you?.

Doing very well..

Great.

The vendor settlement, that 200,000, I'm going to assume that was pre-tax, so it was a reference to the expansion of gross margin?.

Correct..

Okay, great.

Can you also give any color or quantify whether your refinery orders were primarily large independents or IOCs, NOCs, any type of breakdown would be helpful?.

The large order in the quarter, I'm unable to say who the refiner is, but it was a state-owned refiner that we've got the new capacity order from. And we also have, that was the majority of the orders, but there is underlying work that crosses all sectors, state-owned, multi-national integrated as well as the smaller independent refiners.

But the large order that impacted the refining orders in the quarter materially was from a state-owned refiner..

Okay, great.

And the tenure of your customers, are they still conscious and waiting for oil to settle down, the price or facing a little more conflict into your possibly a potentially calendar Q4 budget flush?.

We feel for the more quicker turn, our aftermarket type orders into new capacity, I'm sorry existing refiner capacity, we think that should begin to pick up, those come out of the maintenance budgets and it’s on paradigm to keep those facilities running well.

Discretionary decisions to not invest in that manner for a couple of quarters is possible, but it can't be done for a long period of time. So we think that’s stepping up over the next several quarters. In terms of investment in new capacity, very significant sums of money for the end-users.

We would expect these companies up to get through their board meetings in January with the year-end results and have directions that after they get through their board meetings.

If you recall what happened when there was the dramatic change in the markets in November-December of last year, the real direction wasn’t set until January when the board meetings were held with the Boards of Directors and they decided how to deploy their capital and what projects we’re going to proceed.

I anticipate the same to be true as we get through this upcoming first calendar quarter..

Okay, great. And because I see that there is the opportunity to repurchase stock and hopefully that opportunity may be short lived. Thanks very much..

Our next question comes from the line of Joe Mondillo of Sidoti & Company. Please proceed with your question..

Hey, guys. Thanks for taking my follow-up questions. I just had two additional questions.

In terms of just going on, just hopping on the question in regard to new capacity in oil refining, do you have any sense of how we can continue at the capacity that we are at? In other words earlier this year, we were at 95%, 96% utilization rates at our refineries domestically, highest level since I think 2005.

Is that sustainable -- do you have any idea if that’s sort of sustainable and they will just continue to run at 95%, 96%, 97% utilization rates or do you get the sense that over the next couple of years that they are going to have to expand capacity to some extent?.

We have the view that they can't run that hard forever. That just doesn't make sense. If you look more long-term, the utilization levels in refining market have been nearer to 85% to 90%.

At times like this when they have a chance to maximize cash generation from the refining assets, they do that and they harvest, but they can't do that continually, because ongoing investment has to be made to keep these facilities running and then secondarily, there is global energy demand growth.

And there is also capacity destruction that has to be replaced. And there has been 5 million barrels per day taking out of capacity. So while holding refiner capacity constant, that means it was replaced by 5 million barrels of new capacity, that doesn’t necessarily get mentioned in any of the industry statistics.

To us, that’s incredibly meaningful and there is another plan, $3 million to $4 million of refining capacity to be taken off-line in this decade that will be replaced just to hold the line, just to hold the refining capacity. And again, those aren’t reported in industry statistics, but they benefit Graham very much so.

So I think new capacity in one form or another, either replacing capacity destruction or just pure new capacity is coming. They can't run this asset base at the utilization level continuously..

Okay, thanks. And then secondly the $46 million or so in backlog that’s supposed to hit 2018 and beyond. I believe that’s a three-year project, three or four years.

I was just wondering how that hits on an annual basis starting 2018, is it sort of evenly over a three or four-year period or is it going to be more lumpy over that period?.

It’s about a five-year conversion cycle and the first year and the fifth year are not as strong as years two through four..

Okay, great. Alright, thanks a lot..

You are welcome..

There are no further questions in the audio portion of this conference. I would now like to turn the conference back over to management for closing remarks..

Thank you, Tim and thank you, everyone for your attendance on our conference call and for your questions. We look forward to updating you on our progress during the January conference call and have a good week..

This concludes today's teleconference. We ask that you disconnect your lines at this time and have a wonderful rest of your day..