Defense Reliance And Space Demand Shifts Will Pressure Margins And Future Earnings

Catalysts

About Graham

Graham Corporation provides engineered vacuum, heat transfer and turbomachinery solutions for defense, energy and commercial space markets.

What are the underlying business or industry changes driving this perspective?

• As commercial launch providers and government agencies normalize launch cadences and rationalize orbital infrastructure spending, Graham's recent surge of space turbomachinery and test facility orders could prove front loaded. This could leave utilization of new capacity and the Florida cryogenic site structurally below expectations and weigh on revenue growth and return on invested capital.
• Reliance on long cycle U.S. Navy programs and torpedo platforms concentrates risk in a defense budget environment that is prioritizing cheaper unmanned and defensive systems. A shift in procurement priorities or program delays could reduce backlog conversion and compress earnings from the predominantly defense driven mix.
• The push into small modular nuclear reactors depends on a currently uncertain regulatory, financing and deployment pathway. If customer projects slip or are canceled, engineering heavy development work may not scale into meaningful production volumes, which could pressure net margins and limit longer term revenue diversification.
• Layering advanced manufacturing, automated welding, x ray inspection and specialized cryogenic stands onto a relatively modest revenue base increases fixed costs. If end market growth for high speed rotating equipment and foil bearing applications moderates, operating leverage could turn negative and erode adjusted EBITDA margins.
• Ongoing tariffs, higher material content in large defense contracts and a mix shift toward lower margin material receipts risk structurally capping gross margin expansion. Even if headline revenue grows from the record backlog, earnings per share could lag as pricing power fails to fully offset cost and mix headwinds.

Assumptions

This narrative explores a more pessimistic perspective on Graham compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Graham's revenue will grow by 8.4% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 6.0% today to 10.9% in 3 years time.
• The bearish analysts expect earnings to reach $31.6 million (and earnings per share of $2.78) by about December 2028, up from $13.7 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $36.3 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 23.5x on those 2028 earnings, down from 51.9x today. This future PE is lower than the current PE for the US Machinery industry at 25.7x.
• The bearish analysts expect the number of shares outstanding to grow by 0.78% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.29%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The record backlog of 500.1 million and a year to date book to bill ratio of 1.7 times, with 35% to 40% of backlog expected to convert to revenue over the next 12 months, provides multi year visibility that could support sustained top line growth and stability in revenue and earnings.
• Strong secular tailwinds in naval defense, including long standing U.S. Navy modernization programs and follow on MK48 Mod 7 Heavyweight Torpedo orders, combined with new torpedo platform development, could underpin durable demand that supports recurring projects, pricing power and resilient net margins.
• Growth investments in advanced manufacturing, automated welding, x ray inspection and high return projects with expected returns above 20% return on invested capital, along with the phase out of the Barber Nichols earnout bonus, may structurally lift efficiency and operating leverage, driving higher adjusted EBITDA margins and net income over time.
• Secular expansion in commercial space launch, cryogenics and small modular nuclear reactors, supported by new Barber Nichols orders totaling 22 million and early stage SMR development programs, could evolve into scaled production that diversifies end markets and accelerates long term revenue growth and earnings.
• The accretive acquisition of Xdot Bearing Technologies, with patented foil bearing technology that enhances high speed rotating machinery across aerospace, defense, energy transition and industrial applications, may unlock higher value engineered solutions and adjacent markets, supporting premium pricing, higher gross margin mix and stronger earnings growth.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Graham is $52.0, which represents up to two standard deviations below the consensus price target of $69.25. This valuation is based on what can be assumed as the expectations of Graham's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $80.0, and the most bearish reporting a price target of just $52.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be $290.2 million, earnings will come to $31.6 million, and it would be trading on a PE ratio of 23.5x, assuming you use a discount rate of 8.3%.
  
• Given the current share price of $64.53, the analyst price target of $52.0 is 24.1% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.