Graham Corp - Record Backlog, Similar Margins - Could This Time Be Different?

Graham Corporation has seen significant price appreciation ever since the first round of tariffs were announced this year. I see it now as perhaps one of the most interesting plays on US defense spending hikes. Next year the budget might exceed $1 trillion if approved and Trump has made it clear he wants to invest in US shipbuilding capacity. This is directly aligned with GHM. We've already seen the DoD make strategic investments in US based companies operating in an essential industry like minerals. It's purely speculative, but I wouldn't be surprised if the same happens with GHM. If it doesn't materialize its strong financial position and long runway of growth makes it an interesting opportunity in today's markets.

Revenue growth and margin results are mixed for GHM

Revenue growth has been impressive the past 3 years, outperforming the industry average and sitting in the upper percentile right now. Last quarter's highlights included 11% YoY revenue growth, logging $55.5 million. This is a slowdown from the 17.6% it has compounded in the past 3 years. The view I have is mixed because on one hand you have record backlogs of $482.9 million but slowing top line growth. Going by the past quarters sales results GHM has nearly 9 quarters of backlog still. From 2 years ago its an increase of 49.6%, which during the same period the US defense military budget has grown by 9.8% (if the 2025 budget gets approved).

During Q1 FY2026 however it added $126 million which should incentivize GHM to invest in expanding its capacity so as to not stagger up too much backlog, at least that's what I'd like to see. I don't see the point in having a massive backlog if you can only go through a small bit each quarter. This isn't enough to discredit my buy case. I still think that GHM is a solid buy here, but seeing the backlog converted into sales at a faster pace would be a big plus here. Currently GHM expects 35 - 40% to be converted in the next 12 months and 25 - 30% the following year.

In terms of gross margins the company still has a way to go if it wants to reach the upper end of the industry average. It currently sits in the middle of the pack at 25.63%. In the shareholder letter CEO Matthew Malone pointed to more margin growth in the next few quarters though, on the back of in-house investments.

We remain focused on high-return initiatives that drive long-term value creation, including numerous in-process capital investments expected to generate returns above 20%. These initiatives include automated welding, enhanced radiographic testing technologies, and our new cryogenic testing facility in Florida, which we expect will improve margins and create new revenue opportunities.

With gross margins improvements came subsequently also operating and net margin growth too, both increasing 240 bps each YoY to 8.9% and 8.3% respectively.

I think this time it will be different in terms of margin impact from the backlog growth. I think it's fair to consider the new backlog as "qualitative" seeing as much of it is from the US government, which often has fixed costs - mostly in engineering and manufacturing. The margin recovery GHM posted since 2023 is mostly the result of global supply chains and operations normalizing after the pandemic. My argument is that the new backlog is mostly fixed, adding incremental revenues without the addition of "on the move" costs like other contracts may have. This should improve operating leverage and lend GHM able to grow gross margins beyond the 30% mark. The accelerated US defense budget suggests also that GHM might see more order-flows in the future, adding fixed revenue growth.

"a large percentage of our contracts are fixed-price in nature. To help mitigate this risk, we place orders for raw materials when the purchase orders are received from the customer to lock-in raw material pricing and manufacture a large portion of our international sales in-country which helps isolate us from the impacts of tariffs." Source: 2024 Annual Report

From the last 10-K GHM states explicitly that much of the COGS are tied to the cost of raw materials, materials such as stainless steel, carbon steel or specialty alloy. Looking at steel specifically it is now below pandemic levels when the world basically stopped production for a period and many commodities dropped in price. At the same time the US production of steel has remained relatively stable at 7 -7.5 thousand tonnes per month. The combination of lower raw material prices, slowing inflation, and an increase in fixed contracts makes the case that GHM could realize higher gross margins. Noting tariffs, I see them as transitory and likely to disappear in the coming years, which should add downward pressure on domestic steel prices. This supports a long runway of margin expansion for the company. Saying that "this time it's different" carries some weight when you consider these things.

But the biggest news had to be the 54% and 55% increase in operating income and net income. I can only attribute this to the fact GHM had conservative cost of revenue increases which directly improved gross profits. This coupled with operating expenses which stayed relatively flat YoY considering the increase in revenues had noticeable impacts on profitability.

These operational improvements is what supports a buy case now. GHM has been able to scale without necessarily having to increase OPEX the same way. During the last quarter the gap between gross profits and OPEX widened which created the large increase. The rise in orders speaks to GHM experiencing increased demand. Much of this comes from the USs efforts on rebuilding its shipbuilding capacity, which has gone down much from its historical levels.

The U.S. now produces 0.2% of the world's cargo tonnage, while approximately 90% is produced in China, Korea, and Japan. America ceased to be a significant contributor to global cargo ship production long ago.

When the company won a $136.5 million contract from the US Navy for the Virginia Class Submarine back in May the stock was already on an upwards trajectory but this only added to that momentum. It was significant seeing as the contract now makes up over 20% of the total backlogs. We've seen several efforts from the US government to invest in domestic production and reduce reliance on foreign companies and production sites. The most notable one in the past weeks has been the government investments made into rare earth miner MP Materials (MP) and lithium miner Lithium Americas (LAC).

My suggestion that the same will happen with GHM is purely speculative and should be interpreted as such. It's not the central thesis as GHM could in my opinion do very well if it continues to win government contracts without it having a considerable stake.

If the administration wants to improve its ship building capacity faster, investing in GHM might be one solution. But again, this is still speculation. In special cases the US will most likely outsource building, like icebreakers now order from Finland. But for US defense ships I think it's logical this will come from its own production in order to maintain the integrity of the ships and not leak vital information. Since GHM has a market cap of just $604 million now, taking a 10% stake wouldn't require a lot of capital. It already spent way more than this on the LAC purchase. If GHM also gets more government contracts I can see margins going up as the current administration has been known to allocate substantial capital to US based production companies.

Moving over to outlooks GHM expects net sales to grow 12.4% on the high-end. Gross margins will stay much the same YoY and so will SG&A expenses in relation to net sales. This seems to indicate that a direct 12.4% top line growth rate will be reflected in both operating income and net income too. Capital expenditures will continue to stay high compared to 2024 and 2023, which had $9.2 and 3.7 million respectively.

Segment products & end markets

In GHM there is only one reportable segment but it covers several products, applications and end markets.

The Company and its operating subsidiaries design and manufacture mission critical fluid, power, heat transfer and vacuum technologies for the Defense, Energy & Process, and Space industries. The Company also services and sells spare parts for its equipment.

Defense sales are the majority of GHM's revenues. But since last year energy & process has grown at a considerable rate, now making up 40.6% of sales, up from 33.8%. Nearly all of its sales is done in the US with other parts being Canada and Asia.

Defense sales are largely made up of:

Power plant systems, torpedo ejection, propulsion and power systems and thermal management systems.

Energy sales are largely made up of:

Heat transfer and vacuum systems, power generation systems, turbines and compressors.

Space sales are largely made up of:

Rocket propulsion systems, cooling systems, fans and pumps. Currently 87% of the order backlog is in defense related orders, 11% in energy and the remaining part in space. Seeing as virtually all of its revenues comes from the US a worthwhile comparison would be to see how US defensive spendings are likely to shape up over the next decade. The DoD has requested a record setting $1 trillion in military budget for next year, which by a wide margin makes it the largest in the world. $113 billion is mandatory spending with $843 billion in discretionary spendings. Nearly a third of the budget will go towards the US Navy which is beneficial to GHM seeing as this is the main government customer it has. It specifically mentioned funding for 19 new US Navy battle force ships and maintaining 287 in total. This increase I think marks the current administration's ambitions to continue investing in the navy and have the most advanced navy on the planet and complete control of the oceans.

In 2024 GHM signed a contract with a nonprofit called BlueForge Alliance which is government backed. It was an effort to expand the US welder workforce and improve US naval ship production. Then in May this year GHM announced that it had gotten $2.2 million in contributions from one of its customers to:

enhance the Company's capabilities in evaluating critical welds in support of the Columbia and Virginia class submarine programs.

So GHM has already gotten an indirect contract and support from the US government and now this year a customer, likely one of the larger contractors like General Dynamics Electric Boat or Huntington Ingalls Industries. I'm making the case here that GHM is not that far off from getting a bigger contract from the DoD and there is already precedent now for the government to take a stake in vital US based companies, a box I think GHM ticks off.

Fortress balance sheet

GHM is virtually debt-free as of the last report and has been like this ever since 2023 after paying down the $9.7 million it held then. Thanks to moderate sales growth which has been accompanied by margin growth GHM doesn't need to issue debt in order to grow right now.

Because of the low debt it has one of the best debt/EBITDA in the industry right now at 0.29. This supports my statement that GHM has a fortress balance sheet, further strengthened by its $10.8 million cash pile.

In times of needing finance GHM has resorted to equity financing but the rate has been incredibly low. Shares have grown from 10 million to 10.9 million in 4 years, roughly 2.5% per year is not something to be worried about I think.

As per the SEC filing GHM also has access to a $50 million credit facility set up in 2023 with Wells Fargo. This coupled with a net cash position I believe gives GHM flexibility should it want to support ongoing operations or further increase its Capex and target growth initiatives. For a small cap like GHM this is a major positive when many similarly sized companies might struggle to stay at a reasonable leverage ratio. Even if interest rates are coming down next year I don't see GHM needing to resort to this. If it receives a major contract or investment from the DoD this would come with a very favorable loan with a coupon rate below market rates to encourage GHM to expand domestic production.

Risks

The main risks to GHM right now include rising costs of sales. It has shown it can directly translate revenue growth down to earnings growth. Since GHM works with a lot of raw material the implementation of tariff rates might raise domestic prices causing GHM to be stuck selling at pre-determined prices seeing as most of it is based on the order backlog. There might be some flexibility here, but I'd be hesitant to suggest that GHM could suddenly increase its sales price by 20% just because it has to pay 20% more for raw materials or products.

Small cap trading at a discount to peers, even after rising over 80% YTD

In a peer group comparison consisting of:BAE Systems (BAEBY), Lockheed Martin (LMT), Hexcel Corporation (HXL), RTX Corporation (RTX) and Northrop Grumman (NOC) GHM has been a top performer this year, sitting at the highest price return by a decent bit.

Based on YoY revenue growth it has been the fastest growing over a 5 year span. It was surpassed by both BAE Systems and Hexcel but was able to retake its number one spot. This speaks to the momentum still in the stock and why it has performed so well YTD compared to the rest. If more DoD contracts come its way I suspect this trend will only continue.

In terms of net margin GHM is in the middle of the pack with 6.43%. But it's the one that has made the biggest improvement over the past 3 years, growing negative 0.38% in 2022 to 6.43% and surpassing far larger companies like Lockheed Martin and Hexcel.

I think I've laid out a good case as to why GHM is not necessarily valued the way it should be considering how well it performed to larger peers. Based on P/S it sits just above Hexcel at 2.78x TTM. I think a more justified FWD P/S would be 3x given the momentum it has and how much it's growing its backlog right now. Paying 3x sales is worth it if there is growth present and the company has a strong growth path forward, but importantly no financial issues that might slow down its expansion right now.

Seeing as GHM is a high growth stock still I've decided to also go with a PEG model to substantiate my claim that it's fairly valued. Current FWD P/E is 38. I see GHM growing revenues at 15% CAGR the next 3 years, slightly below its historical rate. But I see net income growing faster as margin improves. We've already seen how a direct revenue boost translates into a similar net income increase since GHM pays little in OPEX and no real interest expense either. By saying this net income should grow at 17% CAGR the next 3 years at least. This gets me a PEG ratio of 2.23 based on FWD P/E of 38.

LMT - 3 Year EPS growth rate - 6.33% & FWD P/E - 23

HXL - 3 Year EPS growth rate - 17.6% & FWD P/E - 33

Compared to peers like LMT or HXL which both have PEG ratios of 3.65 and 1.8 I don't really see GHM as overvalued here now. It has shown it has more momentum in both revenues and net margin growth. HXL is valued lower but GHM comes out ahead since it has outperformed HXL in net margins and YoY revenue growth.

By looking at the revenue recognition of backlogs I can estimate the conversion pace of GHM compared to peers such as CW, BWXT and HWM. Out of all I think GHM seems to be the strongest. In 2 years 70% of the backlogs could be recognized as revenues. None of the other companies come close to this. CW perhaps as it says 90% will be recorded over the next 3 years, which I've decided do distribute equally. HWM doesn't implicitly state when backlogs will be recognize as revenues, nor do they report any insightful figure to their actual amount when going over the last 10-Q SEC filing.

With a better backlog conversion rate gives investors a better growth visiblity. Backlog growth only really matters at the end if it turns into revenues at a rapid pace. The market is often short-sighted, which I don't want this analysis to come as. I intended on highlighting its superior conversion rate as a quality it can carry on long-term. By the US military budget growing GHM is better fit to convert this into actual top line growth then is closest peers.

Out of the Gurus who are buying shares in GHM it's mostly First Eagle Investment (Trades, Portfolio) and Brandes Investment Partners. Notably has been a change in the number of sales by between Q3 and Q2 this year. Q2 saw only sales, a likely effect of the share price rising so quickly and investors taking profits. Now after consolidating the selling has gone down. Perhaps I am early by suggesting the price is undervalued right now. But being early is not always a bad thing here.

Management guided for $235 million in net sales next year. Based on my fair value of 3x FWD sales this gets me $705 million. GHM has a market cap of $604 million now which gives me a 16.7% upside still for the stock. Its price is attractive and the premium in areas like EV/EBITDA and P/E compared to peers because of its lack of debt. Sales growth goes directly to the earnings. It has better financial flexibility than most of its peers and greater backlog conversion. The case that it might see part of its ownership go to the US government is both speculative but rather interesting. It's a well run company with an attractive upside if US defense spendings continue and it can secure more contracts.