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Edited Transcript of GHM earnings conference call or presentation 3-Aug-18 3:00pm GMT

Q1 2019 Graham Corp Earnings Call

BATAVIA Aug 16, 2018 (Thomson StreetEvents) -- Edited Transcript of Graham Corp earnings conference call or presentation Friday, August 3, 2018 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James R. Lines

Graham Corporation - President, CEO & Executive Director

* Jeffrey F. Glajch

Graham Corporation - VP of Finance & Administration, CFO & Corporate Secretary

* Karen Howard

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Conference Call Participants

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* James Patrick McIlree

Chardan Capital Markets, LLC, Research Division - Senior Research Analyst of Industrial and Consumer Technology

* John Bair

* John Sturges

* Joseph Logan Mondillo

Sidoti & Company, LLC - Research Analyst

* Samantha Doxie

* William Lewis Baldwin

Baldwin Anthony Securities, Inc. - Principal and Co-founder

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Presentation

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Operator [1]

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Greetings, and welcome to the Graham Corporation First Quarter Fiscal Year 2019 Financial Results. (Operator Instructions) As a reminder, this conference is being recorded.

I'd now like to turn the conference over to your host, Karen Howard, Investor Relations for Graham Corporation.

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Karen Howard, [2]

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Thank you, Dana, and good morning, everyone. We appreciate you joining us today to discuss the results of Graham's Fiscal 2019 First Quarter results. You should have a copy of the news release that was distributed across the wires this morning. We also have slides associated with the commentary that we're providing here today.

If you don't have the release or the slides, you can find them on 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 as well as our outlook. We will then open 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.

I also want to point out that during today's call, we will discuss some non-GAAP financial measures, which we believe are 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 reconciliations of comparable GAAP to non-GAAP measures in the tables accompanying today's earnings release.

And with that, it is my pleasure to turn the call over to Jeff to begin. Jeff?

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Jeffrey F. Glajch, Graham Corporation - VP of Finance & Administration, CFO & Corporate Secretary [3]

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Thank you, Karen, and good morning, everyone. If you can turn to Slide 4 of the deck, first quarter was -- had revenue of $29.6 million, which was up 42% compared with the first quarter of last year. However, a portion of that, approximately $3 million of the revenue increase was due to the adoption of the new revenue recognition standard. So excluding that, our sales were up 27%. While we will not speak in much detail about the revenue recognition standard update, I would suggest that if anyone is interested, there is a very well written detailed analysis of it in the 10-Q, which we will be filing early next week and I want to complement our internal team led by Jennifer Condame, our Chief Accounting Officer, who complied all of that work and did all the work internally and did the write-up you will see in the 10-Q.

Net income in the quarter was $2.3 million or $0.24 a share. The impact of the revenue recognition was only $0.01 a share of that $0.24, had a very minor impact on the profitability in the quarter. Orders in the quarter were $22 million and our backlog remains strong at nearly $115 million.

We turn to Slide 5 to talk a little more detail about the quarter. As I mentioned earlier, sales were $29.6 million, up from $20.9 million last year. The split of sales domestic versus international over the past couple of years has been 2/3 to 3/4 domestic sales. However, in this quarter, domestic sales were only 46%. This was driven by one very large project in Canada which represented more than 1/3 of the revenue in the quarter. We would not expect this shift to be permanent but rather 1 or 2 quarter impact due to that particular order.

Gross profit was up $7.1 million, up from $4.8 million in the previous year. Our gross profit margin was up 130 basis points. If we adjusted out the revenue recognition adjustments, the gross profit margin actually would have been closer to 26% in the quarter because the $3 million of incremental revenue was at a very low gross profit margin.

EBITDA margin was 11.1% versus 8.3%, driven by the stronger gross profit margin. And as I mentioned earlier, earnings per share were $0.24, up from $0.10 last year.

On to Slide 6. From a cash position standpoint, our cash decreased slightly in the quarter, down $1.2 million. This is just due to timing of some working capital and nothing beyond that. We did pay out $900,000 in dividends in the quarter. As you may have noted last night, we announced that we are increasing our dividend from $0.09 to $0.10 a quarter. So our quarterly dividend will be approximately $1 million per quarter going forward.

Cash on hand at the end of the quarter is $75 million or $7.66 per share. We continue to look to utilize this cash to find an appropriate acquisition candidate or candidates. We continue to be working very hard in that regard. However, we are also keeping our discipline in place and will not make an acquisition for acquisition sake, but rather we want to make an acquisition which will add to earnings and the cash flow for our shareholders.

Capital (sic) [capital expenditures] in the quarter was very low at $200,000, relative to our expected capital for the year of $2 million to $2.5 million. Again, this is simply timing and there should be nothing to read beyond that.

With that, I'd like to pass the phone over to Jim Lines to talk more about the outlook for the rest of the year.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [4]

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Thank you, Jeff, and good morning, everyone. Please turn your attention to Slide 8. Quarterly revenue continues to reflect improved fundamentals in our oil refining markets. And our first quarter revenue from refining markets was 2/3 of total revenue or just under $20 million.

It's important to qualify the refining revenue. There are 2 factors that boosted revenue during the quarter. First, as you may recall from our prior conference calls, an order with specialized high-cost material was secured in our third fiscal quarter of 2018 that now is in its revenue cycle. Due to the high material cost, it, of course, elevates revenue. If materials were more standard, revenue would have been several million dollars lower in the quarter.

Secondly, our operations team developed for that particular order welding methods and took other actions that resulted in markedly greater productivity, enabling the production process to require less hours, which allowed revenue previously planned for the second quarter to be realized in our first quarter. The benefit realized in the first quarter will lower somewhat what had been previously planned revenue for the second quarter. All in all, a terrific job by our operations team.

Revenue from our other markets was down. However, I view that more of a timing issue, as backlog for those end markets has increased. Revenue in the quarter at $29.6 million or $3 million less if we exclude, as Jeff has outlined, revenue caused by an accounting standard change is a terrific start to the year. It sets fiscal 2019 up well for appreciable growth compared to fiscal 2018.

As Jeff said, domestic sales were 46% of total. Again, that is somewhat distorted by the high material cost order that was for Canadian oil sands operator service.

We are currently projecting full year revenues between $95 million and $105 million.

And now we'll reference Slide 9. There is an easy comparison to order level one year earlier. Nonetheless, orders are up across all key industries. There was good order activity in the quarter for U.S. petrochemicals second wave expansion, having won orders for an ethylene plant revamp and for downstream new petrochemical capacity. We also had improvement in order levels from our commercial nuclear market.

Bookings were $22 million, off compared to $40 million in the previous 2 quarters, however, there was a healthy level of high-quality orders. Our trailing 12-month order trend is encouraging with it at $123 million as of June 30. As we drop off $17.1 million from the second quarter of fiscal 2018 and add in new orders across this current quarter we now are in, we should anticipate the trailing 12-month order trend will continue to increase.

On to Slide 10. Consolidated backlog remains healthy at $115 million. Our work for the U.S. Navy continues to represent a sizable percentage of the total. On June 30, Navy backlog was 56% of total. It is important to compare and contrast backlog one year earlier to that of today to illustrate how Graham has accelerated from the bottom of a very severe downturn. On June 30, 2017, backlog was $73 million with non-Navy backlog being approximately $26 million. On June 30, 2018, backlog is up $42 million overall from one year earlier and with non-Navy backlog at approximately $50 million, it has nearly doubled compared to last year.

Importantly, order quality has improved as well, resulting in greater backlog with stronger margins. We continue to benefit from an extended backlog where 55% to 60% will convert within the next 12 months. The remainder provides a production base loading for 2 or 3 years onward.

On to slide 11. The positive developments on the order front enabled us to modify upward full year guidance. I'm pleased to provide the following improved guidance: revenue is expected to be between $95 million and $105 million, gross margin will range between 24% to 26%, SG&A spend will be between $18 million and $18.75 million, full year effective tax rate is projected to be 20% to 22%.

With that, Dana, please open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Joe Mondillo from Sidoti & Company.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [2]

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So I was wondering -- I went back and looked at when was the last time you saw this kind of revenue and even if you exclude sort of that $3 million of low margin, last time was around 2013 and 2014, and we were at around 30% gross margins. And I don't even think refining was as big of a percentage as the total as it was this quarter. So I'm just wondering how you would characterize, I guess, maybe the pricing that you saw within the work that you did and you shipped in this quarter relative to the past? And sort of how you're thinking about your orders and your market going forward regarding, I guess, pricing and gross margins?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [3]

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Sure. Joe, it's a great question, and thank you for bringing it up because it does require some clarification. What has pulled down margin in the quarter was the high cost material order, which was rather appreciable. As Jeff had mentioned, it was maybe about 1/3 of the revenue in the quarter was from that specialized high material content order. That will have a tendency of pulling down gross margin on average and that's what occurred. If we normalized the material content to more traditional types of equipment materials, the margin would have been more reflective of typical margins. But importantly -- so that was dealing with the order that we got some time back and is running through the revenue cycle. What I can say more qualitatively is what's coming into backlog, what's building for future revenue, is of a superior quality, superior margin to what has been running through revenue. That's not necessarily in the immediate next quarter, but more looking out a few quarters forward. With the bookings that we've been able to secure and the quality of those bookings, we should begin to see margins move up to a higher level. So I would say Joe, what you saw in this quarter while that revenue level was comparable to the revenue level of 2 or 3 years back, the margins were not, it was because of material content and you don't get the same margin bounce on high material content.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [4]

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All right Great. And then just sort of thinking about the cycle in general. You sort of peak, I think, around 30 -- low 30% range in gross margins in the last peak. Just wondering sort of how you're seeing differences play out with this cycle? And how you think about where your gross margins can go? I know, Navy is a little below average even though operating margin there at the Navy is sort of similar. But -- let's just take maybe Navy out of the equation, looking at your core business, do you think you can surpass the last peak? Or the last 2 peaks, we've seen sort of a downtrend from 40% 2 peaks ago, 30% last peak. Just wondering sort of how you think about the cycle and the kind of work that you're getting and pricing and where you think your gross margins can grow in this cycle?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [5]

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There's a lot in that question. So let me try to parse it apart. The 2015 fiscal year at $135 million with 31% gross margin plus or minus, by no means were we in full stride of a cycle peak. That was initial pick up coming off of a fairly flat 3 years in a row. We did not project at that point in time that we were into a strong pricing environment. But it was more mid-level pricing environment. So the gross margins reflected that. Even though we had high volume, we didn't have strong pricing power at that point in time. We had strong pricing power in the fiscal years 2008 and fiscal '09, where gross margins eclipsed 41% in both those years. '15 was nowhere near that, nor are we near that today. However, if we look at our business going forward and as you cited the Navy, we can't extract that as a consolidated result because it does, and we said this consistently, it will pull down gross margin, the Navy work, because of its material content, the type of contract it is. However, it averages in at the op margin line fine. We would anticipate as we get to the next peak with some strong pricing fundamentals that gross margin on a consolidated basis should be in the low to mid-30%, including Navy. Our core work would be stronger, of course.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [6]

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Okay, great. And then just I wondered if you could sort of comment on a couple of your end markets, specifically the orders in chemical processing. I know we saw that press release that you put out, so obviously things are starting to sort of heat up there. Just wondering if you could comment on that and how you're seeing sort of the pipeline of projects. Do you think orders continue to ramp up going forward? And then, also power gen has been really a weak area of your business, but it seems like we're starting to see some light there; a little bit anyways. I'm wondering if you could sort of provide some color on that?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [7]

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Joe, we do see the chemical industry, primarily in North America, moving into a second wave of investment. That's not necessarily always going to be new capacity because we are seeing brownfield investments or revamp, debottlenecking, starting up idle facilities. So we did have a fairly large order in this last quarter that we would call a revamp that was coming from our installed base. And then we also had some new capacity orders that came in, in this last quarter for new petrochemical capacity. We have a pretty good batch of opportunities in front of us for North American petchem and also, some international petchem that should break over the next couple of quarters. We're seeing directionally an improvement in the petchem market, where we expect to see a stronger order environment. It will come down to our ability to capture those orders. We feel strong about some and we feel some are more risky. But in general, directionally, the petchem market is stronger today than we would say it was 12 months ago. Regarding the power market and I think your question related to the nuclear market or the power market as a whole The nuclear market we've seen our backlog expand somewhat for the nuclear market. It was -- I don't want to diminish the great work that our team had done, but it's coming off of a trough type of backlog level in the nuclear market. But our backlog for the nuclear market compared to about a year ago was up about 50%. So the team has done a good job to turn that around and get that backlog to a healthier level for the nuclear market. Our power generation market outside of nuclear, we simply serve principally the renewables market. And I would characterize our positioning there as we're more opportunistic. When we see an opportunity for the right order, we'll go after it aggressively and tuck that into our backlog. We're not a strong player there across the power market, primarily because that has inferior margin potential to the rest of our work. And also, the commercial terms can be onerous. So therefore, we look at those opportunities situationally and opportunistically and grab that work when it makes sense.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [8]

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Okay. A couple more questions. Just I wanted to ask about the tariffs and just all this inflation that we're seeing on the material side of things. I know directly I don't think you're that exposed to it just given how your business model works or whatnot. But I was wondering what you're hearing in terms of your customers and specifically sort of projects that you're looking at selling into? Are you concerned at all? Is there any risk of any sort of slowdown in demand as people sort of maybe put a pause on certain projects or certain CapEx spending, just given the uncertainty now and then sort of just waiting until they sort of have a little more uncertainty? Or are you not really hearing anything like that?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [9]

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Well, it has elevated the cost basis for us. And therefore, the purchase price that our customers pay for goods like ours and everyone is experiencing the same type of issue. Once the tariff was tweeted, our input costs for certain commodities went up in one day 18% to 20%. And that was true across the supply chain to our end markets. So it is causing an impact to the cost of the projects for our customers. Having said that though, we haven't seen that affect at this point the pace of these projects, where we can correlate it to a tariff impact. What we are hearing is the procurement functions of our customers saying, "Too bad, deal with it, get your costs down, we're not paying for it." So we'll deal with that as we can. Where it really has an impact, Joe, I would say, more meaningfully, is in the international markets, where to a similar degree, our international competitors haven't had a step up in cost because they use an international supply chain. We use a domestic supply chain or if we're using an international supply chain, it has a tariff put on it. So therefore, the input costs our competition see for international work is lower. And that's having an effect on our margin potential with international work. That's where I see the biggest issue. And actually, we've met with our congressman recently and we talked about the impact this was having on industrial companies and Graham in particular and he just asked us to put on our national hat, think about the nation and don't think about ourselves. And it is impacting us. But I think long term, this will get righted over time, but it's having a short-term impact.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [10]

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So just to follow on that last sort of commentary. Do you think that gross margin could either see a pause in the expansion that you're seeing in terms of the orders? Or even a downturn considering not only I would imagine currency is also a competitive disadvantage just with the dollar sort of increasing. So dollar increasing, your competitors' costs decreasing. Do you think you could see maybe a pause in gross margin expansion within the order books?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [11]

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I think where this has an impact in our business is in the chemicals sector -- petrochemical sector, primarily internationally. But for our refining markets, I'm not judging where this will have a large impact on us. And in the petchem market, it's actually a nice geographic swing back toward investment in North America, where we will see some international competition in North America, but not of course, in every project. So I think through our order selection process and the discernment that we exercise on the type of orders to take and the margins that we'll take those orders at, I think we'll be okay on balance.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [12]

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Okay. And then last question that I wanted to ask was the SG&A. I understand what's going on this year with your SG&A budgets. Just wondering sort of as we look -- just thinking theoretically sort of going into 2020, how are you thinking about that budget? Do you think you potentially put a complete pause on sort of the hiring, at least in the sales department and you potentially see some attrition to some extent and so maybe we don't see a whole lot of SG&A expansion in 2020? Or how are you sort of thinking about that coming off of, not 2019 year that we already know is up pretty significantly year-over-year?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [13]

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We're thinking about it this way, we're expecting at this point in time a multiyear expansion across our markets. And we intend to capitalize on that and we need strong channel management to be able to that. We don't anticipate, Joe, that SG&A will increase in proportion to the revenue expansion we're expecting, in particular from '19 to '20. But in absolute terms, it is likely -- highly likely that the SG&A spend, the S spend, will go up as we ready our organization to capitalize on the opportunities. And then secondarily, we have a richness of long-tenured employees and we need to ready the organization for their eventual departure to do something different. And we're bringing in some new talent to ready the organization and to have sales continuity 5 years forward as an example. And there is a fair amount of time that's necessary to ready an individual to have he or she ready to go in and sell to our customers with the methods and the strategies that we deploy. So therefore, we need to bring these individuals in early. And we haven't found anyone that we've been able to hire away from a competitor or a type of industrial peer that's a plug and play. That takes a fair amount of time to get these individuals ready to sell the way we sell and how we optimize price. So therefore, I would anticipate the absolute spend to go up, but not in proportion to the revenue expansion, at least across '20 relative to '19.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [14]

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Okay. If I could squeeze in just one last one also. Your backlog declined a little bit in the first quarter and I know just given with all the press releases that you've put out in terms of some of these orders, you have a lot of project work in fiscal '19 that's going to fall off the backlog. Just wondering sort of what your thoughts are on landing more orders this year? And what you're sort of thinking year-end backlog could look like relative to the strong backlog that we saw entering this fiscal year? Do you think you could at least regain enough orders to sustain where the backlog was entering this year? Do you think there potentially could be some growth? Or do you think there is a risk that backlog is down year-over-year at the end of this year?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [15]

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It's a fair question, and I will give you my judgment. Right now to land at the midyear -- mid-level of our guidance, which is $100 million, we see a robust pipeline of opportunities in our bidding pipeline that we're expecting to close in the next 1, 2 or 3 quarters. My judgment is, we'll continue to build a great backlog and expand our backlog and we're building on our organization accordingly on that premise. So that's the conviction that I have. We're readying for multiyear growth. Multiyear growth would suggest a strong order environment with building backlog.

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Jeffrey F. Glajch, Graham Corporation - VP of Finance & Administration, CFO & Corporate Secretary [16]

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Joe, this is Jeff, if I could just add one more comment. Jim talked in his prepared remarks about how our commercial backlog has doubled over the past 12 months. Our expectation, as Jim has talked about the backlog growing, is that we will see continued growth on our commercial backlog.

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Operator [17]

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Our next question comes from the line of John Sturges from Oppenheimer & Company.

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John Sturges, [18]

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It's been a bit of a slog, but it looks like the cycle has turned. I'm curious about a couple of years ago, you had your own welder training program in order to -- because you had some difficulty finding trained personnel to meet the demand at that point. It looks likely you're going to see similar rise in demand. So I'm just curious how you're handling labor because it's certainly not gotten easier to hire people these days.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [19]

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Thank you, John. We are seeing a shortage of qualified skilled tradespeople. However, that cannot deter our ability to grow. Therefore, we've actually -- and we are investing to expand our welding training lab. We're roughly doubling its capacity from what it had been. We're going to build our own workforce. So we'll be bringing in entry-level people. We'll train them the Graham way. We'll get them ready. And even if we hire from the outside, it's very common that a welder, an ASME welder from the outside, is not accustomed to the type of welding in the out of position and the geometries that we weld with our large fabrication of large weldments. So therefore, there is a long training period as well with a trained person to enter the Graham production organization. So we've looked at this quite simply. We have an ability to grow. There is a strong demand in front of us. We have to build our own workforce. We'll look at both a combination of hiring talent and the skilled talent that's already and also building our own workforce through our training programs, our educational programs. And as I just cited, we're doubling -- we intend to double the size of our welding training lab. So we can put closer to 10 people through our training program at a time.

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John Sturges, [20]

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Excellent. And I'm curious you had made a -- capacity you would create -- I'm going to say finalized capacity build several years ago. Is there additional capital spending required, say, in the next couple of years? Or can you meet it with your current capacity ability?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [21]

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As we look at the rooflines, our Batavia roofline, we think is suitable for normally $150 million, $160 million of run rate. And then our Lapeer roofline for the nuclear market, that's suitable for $40 million or $50 million of nuclear work. So put that in that context, we think we have ample roofline for some growth for some time. However, I did want to put a caveat out there, we are looking at and having some discussions with the primes to the U.S. Navy. And if we're able to expand our product offering there, it may require a facility expansion for those specialized items that we would build there. But that would only be, should we secure that incremental type of work, with the U.S. Navy. All very positive, but that would be the reason why we'd have to have a facility CapEx if we take on incrementally more naval work that wasn't modeled into our facility expansion plan.

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John Sturges, [22]

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I'm curious would that expansion in the Graham? Or would it be in Michigan, -- I mean Batavia or in the Michigan?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [23]

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That would be in Batavia.

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Operator [24]

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Our next question comes from the line of Jim McIlree from Chardan Capital.

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James Patrick McIlree, Chardan Capital Markets, LLC, Research Division - Senior Research Analyst of Industrial and Consumer Technology [25]

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Can you talk about your operating cash flow expectations for the rest of this year, particularly regarding working capital? I noticed there was a fairly large investment in working capital this quarter. I'm trying to understand how that flows through for the rest of the year.

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Jeffrey F. Glajch, Graham Corporation - VP of Finance & Administration, CFO & Corporate Secretary [26]

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Sure, Jim. This is Jeff. We expect our operating cash flow to be positive for the year; to be quite strong, actually. We will, obviously, be paying a dividend off of that. And we have our capital investment, but we expect it to be positive. As we grow, we will see some increase in working capital. If you look at our net working capital as a percentage of sales at the end of the last fiscal year, it was a little over 2%. If I look at it today versus our trailing 12-month sales, it's at about 4%, which is still a very, very low level and the type of level that we typically target. We're typically between 0 and 10% and timing of specific projects can move that in a quarter. But we expect to stay at that low level. So will we see some increase in absolute working capital dollars as we move towards -- through this early part of this expansion? Yes. Do we think it will dramatically impact our cash position relative to where it's at? And the answer to that is, we do not.

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James Patrick McIlree, Chardan Capital Markets, LLC, Research Division - Senior Research Analyst of Industrial and Consumer Technology [27]

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Okay. And can you talk about your expectations for Navy bookings for the next 12 to 24 months?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [28]

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We would expect over the next 12 to 24 months, not the next 1 or 2 quarters, but in that longer time frame. While we're actually going to convert a fair amount of our backlog, our vision and expectation over the 24-month period is that we will add in absolute terms to our naval backlog and have a higher naval backlog at the end of fiscal '20 compared to where it is today.

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James Patrick McIlree, Chardan Capital Markets, LLC, Research Division - Senior Research Analyst of Industrial and Consumer Technology [29]

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But it sounds like that there is going to be ebbs and flows in that just based on the timing of the deliveries and the timing of the quarters.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [30]

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Sure.

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Operator [31]

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Our next question comes from the line of Samantha Doxie from Walthausen & Company.

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Samantha Doxie, [32]

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My first question is, is there any seasonality to help the bookings come in?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [33]

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Not really. There can be some seasonality to our aftermarket, which is a lower segment of our business in terms of the amount of dollars that are booked. We don't really view ourselves as a seasonal business from a revenue or order intake perspective, although there is some seasonality around when our customers place aftermarket orders.

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Samantha Doxie, [34]

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Okay. And then my next question is, could you please tell us what the core competencies are of Graham and then relate those to what you guys are looking for? And how you're going about looking for a way to put all the capital to use?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [35]

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Sure. We look at ourselves as having a number of key core differentiators and we look for partners and acquisition targets with similar capabilities. One is the way we go to market, the way we sell, the way we create value for our customer and the opportunity management. We provide an immense amount of engineering support to our customers while they're evaluating how do you build their new facilities or revamp their existing facilities and integrate our type of products into their projects. There is a knowledge gap that we've built with the way our sales personnel and application personnel come in and provide technical expertise on how to integrate our products into the process. That's a unique capability. There is a fair amount of S expense in our business to be able to do that. However, we create a lot of value, and we think we extract a lot of value. So that's a key differentiator on our customer-facing platform. A second key differentiator, and a very unique capability that we have, is large project management. We take on very large, very complicated projects with a fixed price. And there are always issues that arise in executing those contracts, the design is not frozen, there's engineering churn, there's engineering iteration. We have a model that we are very adept at being able to do that complex contract management with engineering change, even when projects are in production. So we are not a high-volume, low-mix business. We're a low-volume, high-mix business and that's a particular operating model, that's a particular operations function in the office that we would look for businesses with similar capabilities. And not all industrials possess that capability. A third differentiator is, we build incredibly complicated equipment to watch like tolerances, very large fabrications that can be the size of a small home, where we're held to thousands of 1-inch tolerances on critical dimensions. The capabilities of Graham's production personnel and manufacturing experts to construct these large weldments to high-quality requirements, a lot of interaction with our customer, that's a very unique capability. We excel at that, and we look for businesses that have similar characteristics of specialized custom fabrication to very exacting tolerances. And value is not an option because the cost of failure is severe for the user. And we'd look for again a business with that type of capability. And the fourth is a cultural sensibility of a cradle-to-grave support to the customer for what we sell. We have an aftermarket team that provides a great deal of technical support once the equipment is in operation to understand how to improve performance, how to mitigate operational risk and how to ensure the customers meet their operating objectives and maximize their resources to produce the products they're trying to produce. So there's 4 key differentiators that are the value drivers for Graham in how we serve our customers, and we look for complementary cultures and capabilities within the targets that we're looking at.

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Operator [36]

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Our next question comes from the line of Bill Baldwin from Baldwin Anthony Securities.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [37]

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Jim, looking out at your business longer term and if you deem that to be competitive in the international arena, if you come to that conclusion, does it make sense to focus M&A activity on trying to identify some capabilities overseas that would allow you to be able to offer the same value added proposition there that you do here based upon your specialized welding, et cetera, et cetera?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [38]

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Sure. We have had that in our business planning analysis. And I can just share with you where our sensibilities are right now. There's a very large cycle dynamic, as you know, in the energy markets, where there is a strong demand and then there is a steep drop-off. What occurs when you have bricks-and-mortars in international operations is you have a higher fixed cost and a higher breakeven that you have to deal with, with a very severe cyclical downturn coming at some point in time. What we've elected to do is use a shared margin model, where we find fabrication partners, where we don't own the bricks-and-mortar, but we work with high-caliber, high-quality fabrication partners that when the need arises, we put work into their operations for our orders, and therefore, we don't have that fixed cost. And then secondarily, what we found through our analysis here is we'd have to have an operation solution that's suitable for China, which is different than what's suitable for India, which would be different from what's suitable for Southeast Asia. So therefore, we've chosen not to have an operating footprint that's global, simply because it elevates our breakeven and our fixed cost and we can't endure that in any type of cycle dynamics that the energy markets go through. So we've chosen to share the margin and have a variable cost model.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [39]

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So if you do -- so what you're saying is you can find qualified welders and trained craftspeople outside United States to be able to fabricate your equipment to the tolerances required by utilizing kind of that shared model?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [40]

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We have been able to do that. And the way we do that is we actually put our personnel -- here we're a little bit different as well from our peers, our competitive peers, who might place an order with a fabricator and don't have the same level of surveillance that we impart. When we put an order into a Chinese company or an Indian company, as an example, or an Asian company, our fabrication and quality specialists are in that facility regularly and we own, it's our badge, it's our quality. It has to be built to our standards. And that's been something that the end users have noticed. When we do a shared margin model, it is very comparable to a Graham product is being built because we make sure our fabrication specialists are there and they're building to are exacting quality standards. We don't produce a product that's of a quality standard in a low-cost region that's more customary. We produce it to our quality standards.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [41]

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Very good. And then once the product -- once your equipment is installed and up and operating, do you service and support that equipment from your United States base?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [42]

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We typically do. We haven't built out a localized performance improvement organization in the international markets. But we do have a fairly large team here at our headquarters in Batavia that will go into Thailand, go into Southeast Asia, go into China, go into India, go into South America and provide performance improvement analysis for a refiner petrochemical user from Batavia. We send them over and they do it there. Long term, we might localize that capability, but that's in our long-range planning, not the next 1 or 2 years forward.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [43]

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Right now you find that works effectively for you, then you can support that equipment from the U.S. and...

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James R. Lines, Graham Corporation - President, CEO & Executive Director [44]

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We have. Yes. And it's typically paid for. It's typically a fee-based opportunity for us, so therefore, we've actually built out our organization. If I thought about where it was 5 years ago, we probably now have 2.5x the capacity to provide service in the market than we had 5 years ago because we have added to that workforce.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [45]

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Very good. So it looks like then, if need be, you can be competitive on some international projects through the shared model, it just might not financially pass through to Graham like it would on a domestic order, but you can still protect your market share over there and protect your brand internationally.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [46]

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Indeed, and let me just cite some success. If I thought of -- if we look at China in particular, we had 0 market share in the China refining market for ejector systems up until 2006. We put a strategy in place to penetrate, participate and expand market share in the China refining market for ejector systems. And from 2007 through today, for the key application, crude-backing distillation, we have somewhere between we believe 40% and 50% market share with a shared margin model.

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William Lewis Baldwin, Baldwin Anthony Securities, Inc. - Principal and Co-founder [47]

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Outstanding. And that's utilizing your experienced sale force in it to capture that business and then execute it through the shared model?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [48]

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In this particular case, we did localize and have a subsidiary structure set up in Suzhou, China to actually do the technical selling and the customer-facing side of order management supported by our technocrats here in the home office, but we have localized a team in China that has about 7 or 8 personnel there to serve the China market. That was a clear directional strategy that we wanted to go in and take that beachhead and we've been successful. We're now turning our attention to other international markets and are evaluating deploying of similar concepts in other high-growth industry -- high-growth regions.

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Operator [49]

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Our next question comes from the line of John Bair from Ascend Wealth Advisors.

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John Bair, [50]

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The domestic refining market seems to be running at near full capacity. And I was wondering if you've seen any meaningful uptick in expansion, bidding opportunities there. In other words, are these markets operators starting to look to expand their capacity, either add-ons or perhaps even some new greenfield-type expansion?

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James R. Lines, Graham Corporation - President, CEO & Executive Director [51]

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We've had a batch of work that's secured or running through our revenue cycle now that I would characterize as those types of debottlenecking capacity increase projects for the North American refining market. And we have others in our bid pipeline that are potentially going to break over the next year or so. So we have begun to see that as they look to leverage their asset base, get more out of it, but rather than add incremental greenfield capacity, the industry, of course, is trying to figure out how to get more with what they have and they will do incremental strategic investments around bottom-of-the-barrel conversion, feedstock flexibility, and those are investments that we've lived on for the last 2 decades, 3 decades in the North American refining space because there hasn't been any new capacity to speak of. That's our home turf. They continue to invest and get more out of these assets and we will be there to help them do that.

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John Bair, [52]

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Okay. And on the last call, I asked about this, but I'll reask it again with the little more attention being brought about with the IMO low-sulfur diesel for the tanker market or boat market, whatever. Just wondering if now there is more attention being paid to that. I've seen some reports that say anywhere from 0.5 million to 1.5 million barrels a day may not be capable of being refined to meet those standards. So wondering if you're seeing any more -- seeing any increase in your customers or potential customers to address that.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [53]

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I'll be honest with you. Jeff and I get this question quite regularly. And we haven't had much, if any commentary from our end markets about needing to do anything, with the exception of I heard it for the first time within the last 2 weeks of a refiner doing an investment correlated to MARPOL standards or IMO standards. So we haven't really noticed an uptick that we would correlate to the lower pollution standards for bunker fuels with marine vessels. However, I have heard the remark finally once from one of our refiners for a project that we're working on.

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Operator [54]

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Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to management for closing remarks.

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James R. Lines, Graham Corporation - President, CEO & Executive Director [55]

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Thank you, Dana, and thank you, everyone, for your time on the call this morning. We're pleased to update you on the progress as we enter into fiscal 2019 and also to update our guidance to reflect a stronger outlook that we have for the year, and Jeff and I look forward to updating you on the next conference call in one more quarter. Thanks, again. Have a good weekend.

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Operator [56]

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