Greetings. Welcome to Graham Corporation's Second Quarter Fiscal Year 2023 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note that this conference is being recorded.

At this time, I'll turn the conference over to Deborah Pawlowski, Investor Relations. Ms. Pawlowski, you may now begin..

Thank you, Rob, and good morning, everyone. We certainly appreciate your time today and your interest in Graham Corporation. Joining me here today are Dan Thoren, our President and CEO; and Chris Thome, our Chief Financial Officer.

You should have a copy of the second quarter fiscal year 2023 financial results, which we released this morning before the market.

Also for your information and posted on our website are slides that will accompany today's conversation, as well as supplemental information that provides greater detail regarding sales, bookings and backlog by industry and geography on our website. Those can be found at ir.grahamcorp.com.

I will first have Dan and Chris do a formal presentation, after which we will then open the lines for Q&A So if you'll turn to slide two in the deck that I mentioned, I'll review the safe harbor statement. You should be aware that we may make some forward-looking statements during the formal discussions, as well as during the Q&A session.

These statements apply to future events that are subject to risks and uncertainties, as well as other factors that could cause actual results to differ materially from what is stated here today.

These risks and uncertainties and other factors are provided in the earnings release, as well as with other documents filed with the Securities and Exchange Commission. These documents can be found on our website ir.grahamcorp.com or at sec.gov. During today's call, we will also make some non-GAAP financial measure disclosures.

We believe these measures will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP.

We have provided the reconciliation of non-GAAP measures with comparable GAAP measures in the tables that accompany today's release and the slides. So with that, if you would please advance to slide three, I'll turn the call over to Dan to begin.

Dan?.

Thank you, Debbie, and good morning, everyone. I am pleased to report that we are tracking to plan. Our results are as we expected, and we are on track to achieve our fiscal year guidance. Our second quarter was a big bookings quarter, with over $90 million in new orders.

Approximately $70 million was attributed to our defense market and another $20 million to space and refinery petrochem. All of these newly booked orders have better margins than in the past. We were able to increase pricing on both our Navy and energy jobs. We are seeing continued strong demand in our refinery petrochem aftermarket business.

We have not seen an increase in commercial capital equipment orders yet, but our customers tell us they expect those orders to come in calendar 2023. Execution is improving through continual improvement in the short term and with capital investments for the long term.

Both business units are working hard to improve manufacturing processes and seeing improved cost and yield because of the effort. This quarter, our Board approved the acquisition of an automated welding machine, a new mill turn machining tool, a pump test rig and a facility expansion.

The automated welding machine will reduce cost and rework on some of our heat exchanges we are making in Batavia. The new mill turn machine tool will significantly reduce manufacturing time on production torpedo programs, while the facility expansion will enable a higher production delivery rate for these programs.

The pump test rig will be used to demonstrate life cycle for high compliance production pumps that we are making in Arvada. As we clear the low-margin jobs through the year, we expect profitability to continue improvement. For the quarter, given the product mix, GAAP loss was about $200,000 and EBITDA was $1.5 million.

With that, I'd like to hand it over to Chris Thome for a discussion of our financial performance..

Thank you, Dan, and good morning, everyone. I will begin my presentation on Slide 4. As Dan mentioned, our second quarter performance was in line with our expectations. Sales were $38.1 million, up 12% over last year's second quarter and 6% over the trailing first quarter.

I would like to point out that this growth was all organic as both periods included a full quarter from Barber-Nichols. Year-over-year growth included $3 million from the space industry, where we are building relationships with many of the key commercial players.

In fact, during the quarter, we were recognized by Virgin Orbit as one of the critical suppliers, which we believe is a testament to the value our solutions and engineering services bring to that industry. During the quarter, we continued to see strong growth in the refining and petrochemical commercial aftermarket, which was up 36%.

This is significant in that we view aftermarket sales as a leading indicator of future capital investments by our customers. As Dan mentioned, we expect the next capital investment cycle to begin in calendar year 2023.

Offsetting these increases were sales to the defense market, which were down $5 million compared with the second quarter of last year, which is a record quarter for this business. The change was all about project timing, reflecting the significant level of defense industry business we have in our backlog.

As noted in our release today, we delivered an additional first article unit for a critical US Navy program and are on schedule to ship the remaining first article units by the end of the first quarter in fiscal 2024.

For the quarter, sales in the US increased 16% to $30.3 million and represented 80% of our sales, while international sales of $7.8 million, accounted for 20% of total sales and were consistent with the prior year.

The mix of US to international sales has shifted over the last couple of years given the growth in our Navy business as well as the addition of Barber-Nichols, which sells primarily into the US.

Gross profit and margin improved over the prior year period on a better mix of higher-margin projects namely space, commercial aftermarket and new energy as well as better execution and pricing.

The decline sequentially was as expected and was due to pivots on projects made in the first quarter to keep production moving that resulted in that quarter benefiting from a better mix of business. SG&A expense for the second quarter was $5.3 million, consistent with the prior year.

However, as a percentage of sales, SG&A expense improved to 14% compared to 15% in the prior year as we maintain strong cost discipline, while growing our topline. The net result was near breakeven net income for the quarter, adjusted earnings per share of $0.03, and adjusted EBITDA of $1.5 million.

Turning to slide five, you could see our capitalization. Net debt at quarter end was $5 million, up slightly from $4.2 million at the end of the trailing first quarter due to the timing of milestone payments.

We have instituted strong cash management discipline throughout the organization, which includes actively managing working capital and operating expenses, while increasing oversight of capital expenditures to ensure proper returns.

As a result, capital expenditures in the quarter were $0.9 million and we have reduced our guidance for CapEx spend for fiscal 2023 to be approximately $3 million to $4 million.

The investments that we are making that Dan highlighted earlier totaled approximately $4 million and will occur over the next four quarters with each project having a greater than 20% IRR. Turning to slide six. As previously announced, we had record orders during the quarter of $91.5 million, driven by repeat orders for critical US Navy programs.

We believe these repeat orders validate the investments we made over the last year and our customers' confidence in our execution. We also expect these repeat orders will be at higher margins through increased pricing and better execution.

In addition to strong defense sales, we had $13 million in refining and petrochemical orders, which related to continued strong commercial aftermarket demand and $4 million of orders each from space and other commercial, which is comprised primarily of new energy.

The orders for the quarter resulted in a book-to-bill ratio of 2.4 times and reflects the breadth and diversity of our customer base. If you turn to slide seven, you can see that these orders drove a 20% increase in backlog from the sequential first quarter and now sits at a record $313 million.

We believe 40% to 45% of this backlog will convert within the next 12 months. Most of the backlog expected to convert beyond 12 months is for the defense industry, primarily to the US Navy. Defense now comprises 79% of our backlog and is significant in that it provides greater visibility and stability to our business.

Slide eight provides our guidance for fiscal 2023. Our first half results were in line with our expectations and gives us confidence we will be able to achieve our full year guidance. As such, we are reaffirming our expectations of revenue and adjusted EBITDA growth for the year.

Revenue is expected to be between $135 million to $150 million, which implies topline growth at the midpoint of 16%. From a margin perspective, we are looking for a gross margin of 16% to 17% and expect SG&A to be 15% to 16% of sales.

The net result is that we expect adjusted EBITDA to be in the range of $6.5 million to $9.5 million, which equates to an adjusted EBITDA margin of 5% to 6%. As discussed, year-to-date fiscal 2023 results were impacted by our larger lower margin first article US Navy projects.

We believe this negative impact will continue through the first quarter of 2024 when the last of these larger first article projects are expected to be completed. I should also point out that the company's third quarter is typically impacted by lower labor hours due to the holidays.

With that, operator, please open the phone lines, and Dan and I will be happy to take your questions..

Thank you. We'll now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Theodore O'Neill with Litchfield Hills Research. Please proceed with your question..

Thank you and congratulations on beating the estimates for the quarter..

Thanks, Theo..

Thanks, Theo..

Yes. So in your opening remarks, you talked about some new equipment that you're ordering.

What kind of lead times are you looking at for that, or is it already on its way in?.

Yes. Lead times for those machine tools typically are around a year. And so as Chris had mentioned, we're kind of expecting that capital expenditure to go over the next four years. So we put money down fourth quarters. Thank you. So we put money down at the beginning to get the order going and then pay for it when it's delivered.

So yes, there are some things that are relatively quick and then most of that capital equipment ends up being kind of a year long..

Right.

Can you talk about whether or not -- what you're seeing in terms of the inflation or supply chain issues in your business?.

Yes, certainly. In inflation, we are seeing increased prices from our suppliers, and we're able to build those into our bids fairly well. Suppliers are continuing to kind of hold short validity dates for the material, and we're just passing those on to our customers.

I'm thinking that pretty much all customers know exactly where we are with supply chain, and we haven't got any pushback for needing to revisit material pricing, for instance, when we accept orders. So maybe a little bit better, but supply chain is still a little bit challenged..

Okay. And I noticed that under the product line sales, the space segment was up strongly this year over last.

Is there -- is that a market share gain, or is the pie just getting bigger?.

Probably a little bit of both. We're seeing some activity continuing in launch type activities. And then we're also seeing some more orders in the thermal management systems for communication satellites. Both of those continue to grow as a market and we're able to participate in those..

Okay. Thanks very much..

Yes..

Thank you. Our next question is from the line of Andrew Shapiro with Lawndale Capital. Please proceed with your questions..

Hi, thank you. So a few questions here regarding right now the low profitability or breakeven first article units.

These are the units for the sub programs, right?.

Correct. We have one for the sub program and then one for the carrier program. Yes..

And are both of those suffering presently from low margins because these are the first article units?.

Yes. Yes. They are..

And when you refer to the first article units will be done in their delivery through Q1 fiscal 2024, I think that's – correct me if I'm wrong, is the June 2023 quarter.

Is that right?.

Yes, that's correct, Andrew..

Okay.

And there -- and the -- and this is first article for both the carriers and the subs in terms of that kind of quarterly completion?.

Yes, exactly..

Okay. Now the low margin on those, remind me, I think I asked this one or two quarters ago when I first got interested in the company.

These are fixed fee contracts and that you bid on and of course, you learn from experience, and that's why there'll be better margins for next time -- or were these some type of R&D with cost plus in them?.

No. They are firm fixed price contracts that are bid competitively upfront. Then you go through all of the learning. And then when you bid them again, you basically get to bid what your actual hours were expended in the first article. And so your pricing actually improves for the second one..

Got it. And then the automated welding equipment to be installed and activated in Batavia, which I think is where you're doing much of the first article work and the second article work.

When is that equipment expected to be installed and activated?.

That has like a year lead time to get it in, get it installed and get it operational. So we would expect probably fall of next year is the time frame that we'll be able to bring that online in our production process..

Okay.

So when you bid out that we'll call it the second articles or the second wave of contracts that have now gone into the backlog, was that on any assumption of the productivity enhancement this new equipment would provide or that will be an added benefit and bonus?.

Yes. If we're successful with the implementation of the automated welding equipment, it will reduce both labor hours that we put into the jobs as well as rework hours that we would have with a manual process. So it should improve margins from that -- from where we bid those jobs..

Awesome. All right. Thank you..

Yes. Thanks, Andrew..

Our next question is from the line of Brett Kearney with Gabelli Funds. Please proceed with your questions..

Hi, guys. Good morning, thanks for taking my question. And Congrats on the continued execution..

Thanks, Brett..

Thanks, Brett..

Thanks, Brett..

Two quick ones. Great to see growth, I mean, really all areas of the business, but particularly on the new energy side, curious, there's so much happening in some of these spaces, the opportunities you're seeing and Graham and Barber-Nichols are best suited for.

Do those primarily fall kind of within the US geographically, or how are you thinking about kind of the global opportunity set across some of those areas?.

Yes, very much right now, they're all domestic. So we're seeing biodiesel applications, both new and existing. There's some good activity on the hydrogen side in the hydrogen production, transportation, distribution, fueling type of area. And then there's continued to be some good activity on the small modular nuclear side.

So, that ends up being very much R&D, where the other two are more on the production side. But yes, some pretty interesting opportunities and again, all domestic at this point..

Great. And then, it sounds like you've identified some really attractive internal investment opportunities that are moving forward.

I was wondering, just as part of kind of the process overhauls you put in place at the organization, if you could talk about how these investments kind of bubbled up and kind of how you guys are looking at identifying and going after some of these attractive internal investment opportunities in the future?.

Yes. Pretty much all the really good ideas come from the floor. So, people that are struggling with a particular process or challenged with a piece of equipment that they can see that there's a better way. We get some really good ideas from folks that are on the production floor, just kind of dealing with it every day.

Certainly, there's some manufacturing, engineering and design engineering type ideas that come through to, but yes, we're pretty excited, and that's really kind of why I wanted to highlight those in my opening statement in that we're able to see some of those opportunities, start investing in them today, don't expect immediate return.

But pretty quick return in the next couple of years that really will improve our efficiency and throughput and enable us to accelerate on the revenue side, so pretty excited about all of them. And it's just that continual improvement mindset that both businesses have that's starting to come through..

I think I would add to that, Brett is that, one of the projects is capacity expansion as well. One of our defense programs, which is seeing some really nice growth, we needed to take on additional space and purchase some new equipment as well to accommodate their request for volume..

Terrific. Thanks, so much guys..

Yes. Thank you, Brett..

Thank you. The next question is from the line of John Bair with Ascend Wealth Advisors. Please proceed with your question..

Thanks. Good morning..

Hey John..

Good morning, John..

It appears that your cost of goods sold rate of change is starting to slow down.

Am I reading that right? And is that something that you think is going to continue?.

So if you recall from last quarter, John, we expected -- we had -- the first quarter benefited from a really good mix. And we did expect that gross profit percentage to come down in the current quarter. So I would say the margin for this quarter was in line with our expectation.

We still continue to see some impact from these first article jobs in the second half of the year. But as those jobs make their way through our backlog, we would expect our margin to improve after that..

Okay.

One another question was, so as you move through these projects and get into the second tier, if you will, going forward or looking out over a couple of years, what do you think the mix could be on winning new project orders as a winning first bid to where the order backlog as it grows, becomes more of mix of repeat business, if you will for existing projects that as opposed to maybe getting new bid wins that would require this first article learning curve?.

Sure. So if we focus on the defense for now, we are building up some nice backlog of repeat work. And so necessarily, we would expect that that repeat work is a higher percentage of any new first articles. We will be bidding additional new first article jobs in the future, because that's where the growth in out years really comes.

But as a percentage of our overall business, it should be a smaller percentage going forward..

Okay. Very good. Thank you very much..

Yeah. Thanks, John..

Thank you. [Operator Instructions] The next question is from the line of Gary Schwab with Valley Forge Capital Management. Please proceed with your question..

Yeah, hi. Thanks for taking my question. Nice defense orders.

Was there any first article new business included in this big defense order that you just got this quarter?.

No, it was all repeat..

Okay. And as far as cutting back on CapEx, for the year you said 3% to 4%. I think last quarter you were saying 4% to 5.5%.

What in your plan is being deferred if anything?.

Yeah. So I would say, at this point, it was just the discretionary spend. We've been trying to be prudent as we work our way through these projects. We are trying to be prudent with the spend given the cash flow that we were generating, but we expect the CapEx to pick up as our cash flow expense.

So basically, we're only spending what we're generating from a cash flow perspective. But certainly not putting these projects behind in any way.

These are little bit larger projects that had to go through a full financial evaluation, and I think we said at the beginning of the year that we thought they would be in the second half, more towards the second half of the year. So those are right on schedule..

Okay.

So your planned expansion at Barber-Nichols, and the new equipment that you mentioned, that's all in this 3% to 4%, or that hasn't even been paid for yet?.

So a portion of it, because as we said, it's going to go through the next four quarters, but a portion of it is built into that 3% to 4%, yes..

Okay.

Can you give us an update on Arc & Flame? I think you said that for November, you're going to have a big graduation month and what about your next class? And have you been able to attract any more experienced well there is since the last call?.

Yeah. So you have it right on there, Gary. Our next graduating class is in November, we have been seeing an uptick with some experienced hires. But it is a continual battle for sure. We're not out of the woods yet. We've made some good progress. We're able to kind of maintain a level workforce right now.

And we do expect to bump up once that that class graduates in November. But it still remains a daily battle..

And then the next Arc & Flame class will start in January, if I remember right..

Okay.

Are you graduating the full class, or are you getting dropouts or – what's happened?.

You know, I would say through the normal, we've had a few dropouts, but that's -- we go through some rigorous testing, some don't quite make it through, unfortunately. But we've retained -- I think we started with 11 and we're down to 10 now. So, we -- not too bad..

Okay. So you're keeping the bulk anyway. In June, you were running a full first shift. But only a small second shift.

Has that improved much? And do you have any idea when the second shift would fill?.

Yeah. It's actually improved quite a bit. And essentially, what happened is, again, listen to employees about what they want – and we floated the idea of a 410 kind of arrangement where they could get their 40 hours and four days. And then have a longer weekend. And we rolled that out on second shift. And it turns out that people really like that.

And so we've got a lot more people on to the second shift than we had before. So it's getting close to being a full second shift, and now we've got availability on first shift to hire and fill there, too. So, good progress on kind of balancing the shifts at this point..

Okay. That's good to hear.

And then finally, I just – with the recent political conflicts between the US and China, is it having any deleterious effects on your China business outlook?.

We haven't seen anything to date. That China business can run in the $5 million to $12 million range. It has been a little bit lower recently. But we haven't seen any bad effects from that conflict thus far. Certainly, keeping our eyes and ears open, and trying to understand what's going to happen there.

It ends up being a relatively small piece of our overall business and so not too concerned about it, but certainly watching it for sure..

Okay. And then, I just have one last one. You said last quarter that there was going to be some low-margin business that didn't come in, in Q1, and it was going to -- when you thought it was going to eventually come in.

Did that all come in? And did that go out in Q2?.

Yes. We had some lower-margin business that was in -- for the India market that cleared -- probably, 90% of it cleared in the second quarter. So we felt like that would be a little bit of a drag and it was for the second quarter, but that appears to have cleared. I think, the last item shipped like the first or second week of November..

Okay.

So that was the biggest reason for your lower margin in the second quarter?.

I know that I'd characterize it as the biggest, but certainly a part of --.

Not the biggest, but -- yes..

Yes. Yes..

Okay. All right. Thanks very much..

Yes. Thanks, Gary..

Our next question is from the line of John Deysher with Pinnacle. Please proceed with your questions..

Good morning, everyone..

Hey, John..

I was happy to see the backlog up significantly. I just want to make sure I understand the nature of that backlog, does that backlog, I think, you said 80% was defense-oriented, which is about $250 million.

Does any -- is any of that $250 million of defense backlog, does that include any new first article projects?.

No..

Okay.

Does it include any second article projects?.

Yes. Certainly, there's -- in our backlog, there's the first articles that we've been talking through that aren't complete that ship through June of 2023 and some second articles that also are in that time frame. So, yes, it does include lower margin stuff, and that's what we had talked about earlier in the call..

Right. That part is clear.

But what would be a rough percentage of the backlog that is going to be the higher-margin second article projects?.

So, John, we announced the $70 million in order -- or the $90 million in orders that we got, which was a record order level, of which $70 million was related to defense. That's the second article. That's all repeat orders for the Navy..

Yes. That's the higher margin, better pricing orders that are in our backlog..

And that's what caused the backlog to step up as much as it did..

Okay. All right. So backlog….

Thanks, Debbie..

Sorry, go ahead..

No, I was just thanking Debbie, I didn't understand the question and she helped me to answer it there..

Okay. Yes. Debbie is good at that.

So $70 million is the total of the second article projects embedded in the backlog?.

Now there's more than that, because there’s a carrier program also that will have better margins. So, yes, I wouldn't characterize it as just the $70 million in the backlog. It's more than that.

And then, that backlog also includes quite a bit from Barber-Nichols, right? So there's in the neighborhood of $100 million for Barber-Nichols and a big portion of that is repeat production on some of their programs also.

So -- we're actually very happy about the backlog that we've got, and we're encouraged that it's good margin and that we can continue to improve and better that going forward..

Okay, great.

And when does the second article backlog start to become produced when do you…?.

Yeah. We're actually producing in Batavia, second article equipment now. On the carrier side, we've ordered material for some of the submarine programs and then Barber-Nichols is absolutely in the production of follow-on orders that have good margins associated with them.

So right now -- so think about it as kind of clearing the lower-margin jobs through June of next year and then what we have in backlog is actually pretty good stuff..

Okay. Great. That's helpful. Thank you..

Thank you. At this time, we have reached at the end of the question-and-answer session. I'll turn the call over to Management for closing remarks..

Thank you very much. In closing, I'll just say that we're very excited about the future of Graham and I am especially grateful to the entire Graham Corporation team for their commitment, their resiliency and their contributions to delivering on the quarter and to driving our future potential. Thanks for your interest in our company.

I hope you have a great day and look forward to talking to you again..

This will conclude today's conference. You may disconnect your lines at this time. Thank you for your participation..