Small Cap Stocks

This is an update to our last post on GHM, based on the company’s earnings today. Good report, but dismal guidance, a typical trend for many companies nowadays.

With the company admitting a peak in the cycle in 2009, it’s clearly way too early to bet a turnaround. But, GHM will surely emerge from this cycle intact, given the company’s significant cash position (50% of market cap), low cap-ex needs, and ultimately large end markets (i.e. refineries and chemical plants can only put off cap-ex for so long).

As we don’t expect the company to lose money in the downturn (it didn’t lose much money last time around), at a certain price the shares will clearly offer an incredible investment opportunity, even considering a long and severe downturn. If other micro caps are any indication, however, the shares may get ridiculously cheap as the downturn accelerates. In fact, it’s conceivable that the shares trade to cash levels, which though absurd, is happening quite frequently in this market. That’s fine by us as the downturn sows the seeds of significant capital gains, when the cycle eventually turns, as it always does.

Update: Just listened to the GHM conference call. The CEO mentioned that in a downturn, as he has experienced in the past, sales could drop 35% year over year. However, he still expects GHM to be profitable even with this sales drop. Ultimately, if GHM’s sales drop to $60 million in 2010 and the company remains profitable, the stock should not have big downside. Interestingly, the stock market, in its typical irrational manner, has reacted well to the coming guaranteed downturn. Seemingly, dismal economic conditions were already priced in. However, I would have a little more patience before investing in GHM. A few bad quarters of earnings will hopefully provide a better entry price.

A brief comment on the Jacobs Engineering Conference Call implies some positives for Graham (GHM), one of the stocks we have followed for several years already.

Note: GHM reports earnings this Friday.

By way of introduction, for those who no longer follow GHM: GHM has fallen to under $10 from over $50 in the last few months. The company has over $4 per share in cash and no debt. Enterprise value is therefore about $50 million. Backlog, the vast majority which will convert to sales over the next twelve months is about $70 million. GHM operates in the beleaguered energy sector, mainly in refineries and chemical plants, i.e. downstream projects.

Despite a low valuation for GHM, I’ve been reluctant to get into it for a trade, since it was unclear how bad business could get because of the crisis. But hidden in the Jacobs conference call (Jacobs is one of Graham’s biggest clients), was the following quote from the Chairman:

“So big companies in Saudi are looking at the project they got in hand. They are obviously going to get some of these re-bid in terms of current commodity pricing and that type of thing. But… and of course, because your prices drop some of the upstream things that slowed down, but the down stream projects refineries the chemical plants, that type of thing; all appear to be live and well right now.”

My conclusion: GHM will not see a significant slow down in its business. And so at 2X EV/EBITDA, the stock may get a good bounce if earnings are not as dismal as The Market seems to be pricing in.