GRAHAM CORP (GHM) FY 2022 MD&A

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

(Amounts in thousands, except per share data)

Overview

We are a global leader in the design and manufacture of mission critical fluid, power, heat transfer and vacuum technologies for the defense, space, energy and process industries. For the defense industry, our equipment is used in nuclear and non-nuclear propulsion, power, fluid transfer, and thermal management systems. For the space industry our equipment is used in propulsion, power and energy management systems and for life support systems. Our energy and new energy markets include oil refining, cogeneration, and multiple alternative and clean power applications including hydrogen. For the chemical and petrochemical industries, our equipment is used in fertilizer, ethylene, methanol and downstream chemical facilities.

Our brands are built upon engineering expertise and close customer collaboration to design, develop, and produce mission critical equipment and systems that enable our customers to meet their economic and operational objectives. Continual improvement of our processes and systems to ensure qualified and compliant equipment are hallmarks of our brand. Our early engagement with customers and support until the end of service life are values upon which our brands are built.

Our corporate headquarters are located in Batavia, New York. We have production facilities co-located with our headquarters in Batavia. Our wholly-owned subsidiary, Barber-Nichols, LLC ("BN"), based in Arvada, Colorado, designs, develops, manufactures and sells specialty turbomachinery products for the aerospace, cryogenic, defense and energy markets (see "Acquisition" below). We also have wholly-owned foreign subsidiaries, Graham Vacuum and Heat Transfer Technology (Suzhou) Co., Ltd. ("GVHTT"), located in Suzhou, China and Graham India Private Limited ("GIPL"), located in Ahmedabad, India. GVHTT provides sales and engineering support for us in the People's Republic of China and management oversight throughout Southeast Asia. GIPL serves as a sales and market development office focusing on the refining, petrochemical and fertilizer markets in India.

This management's discussion and analysis of financial condition and results of operations for the fiscal year ended March 31, 2022 omits a comparative discussion regarding the fiscal year ended March 31, 2021 versus the fiscal year ended March 31, 2020. Such information is located in Item 7 – Management's Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the fiscal year ended March 31, 2021.

Acquisition

We completed the acquisition of BN on June 1, 2021. Founded as a specialty turbomachinery engineering company in 1966, BN has grown rapidly from programs that involve complex production and systems integration. By integrating knowledge in rotating equipment, power generation cycles, and electrical management systems, BN has successfully won the design and development of different power, fluid transfer, and propulsion systems used in underwater vehicles among many other accomplishments.

The acquisition of BN has changed the composition of the Company’s end market mix. For fiscal 2022, sales to the defense industry were 51% of our business compared with just 25% of sales to the defense industry for fiscal 2021. Additionally, space industry sales represent 5% of fiscal 2022 business, compared with 0% for fiscal 2021. The remaining 44% of our fiscal 2022 sales came from the refining, chemical/petrochemical and other commercial markets. These markets represented 75% of our fiscal 2021 sales. BN has outperformed expectations since being acquired.

The BN transaction was accounted for as a business combination, which requires that assets acquired and liabilities assumed be recognized at their fair value as of the acquisition date. The purchase price of $72,014 was comprised of 610 shares of the Company’s common stock, representing a value of $8,964 at $14.69 per share, and cash consideration of $61,150, subject to certain potential adjustments, including a customary working capital adjustment. The cash consideration was funded through cash on-hand and debt proceeds (See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K). The purchase agreement with respect to the acquisition also included a contingent earn-out dependent upon certain financial measures of BN post-acquisition, pursuant to which the sellers were eligible to receive up to $14,000 in additional cash consideration. At June 30, 2021, a liability of $1,900 was recorded for the contingent earn-out. Subsequent to the acquisition, the earn-out agreement was terminated and the contingent liability was reversed into Other operating income, net, on the Company's Consolidated Statement of Operations. Acquisition and integration related costs of $562 were expensed in fiscal 2022 and are included in selling, general and administrative expenses. As of October 26, 2021, the Company entered into a Performance Bonus Agreement (the "Bonus Agreement") to provide certain employees of BN with performance-based awards considering the BN business results on a stand-alone basis. The purpose of the bonus arrangement is to align a broader number of the BN leadership team with the achievement of BN performance objectives. The Bonus Agreement provides for payments to be made for certain performance-based results of BN for fiscal years ending March 31, 2024, 2025, and 2026.

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Key Results

Key results for our fiscal year ended March 31, 2022, which we refer to as "fiscal 2022," include:

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Net sales for fiscal 2022 were $122,814, up 26% compared with $97,489 for the fiscal year ended March 31, 2021, which we refer to as "fiscal 2021." BN contributed $47,865 of sales for fiscal 2022, which more than offset the $22,540 decline in our legacy business. BN has outperformed our expectations during the first ten months of ownership.

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Net loss and loss per diluted share for fiscal 2022 were $8,773 and $0.83, respectively, compared with net income and income per diluted share of $2,374 and $0.24, respectively, for fiscal 2021. The net losses incurred in fiscal 2022 were primarily due to our strategic decision to take on additional costs in order to meet our customers delivery schedules. We estimate that these strategic decisions, as well as material cost increases for first article projects impacted our results by over $10,000. The losses at our Batavia facility were partly offset by income from BN and higher energy and chemical aftermarket sales.

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We recently shipped a first article condenser for a critical navy submarine application and are on schedule to ship the remaining first article projects throughout fiscal 2023.

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Gross profit and operating margins for fiscal 2022 were 7.4% and (9.2%), respectively, compared with 21.0% and 3.1%, respectively, for fiscal 2021.

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Orders booked in fiscal 2022 of $143,877 increased 18% compared with $121,619 of orders booked in fiscal 2021. BN contributed $67,914 of bookings in fiscal 2022. For more information on this performance indicator see "Orders and Backlog" below.

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Backlog at March 31, 2022 was $256,536 compared with $137,567 at March 31, 2021, and included $117,769 from BN. For more information on this performance indicator see "Orders and Backlog" below.

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Cash and cash equivalents and short-term investments at March 31, 2022 were $14,741 compared with $65,032 as of March 31, 2021, a decrease of $50,291 primarily due to cash invested in the acquisition of BN in fiscal 2022. Cash used in operations for fiscal 2022 was $2,219, compared to cash used of $1,722 in fiscal 2021.

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In fiscal 2022, $3,523 was returned to shareholders as dividends compared with $4,391 in fiscal 2021. In fiscal 2022, we suspended our dividend in accordance with the terms of our credit agreement with Bank of America. There can be no guarantee that we will pay dividends in the future and will depend on a variety of factors, including our future financial performance, organic growth opportunities, general economic conditions and other factors, many of which are beyond our control.

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At March 31, 2022, we had $0 outstanding on our line of credit. We believe this, along with our cash balances, provide us adequate financial flexibility to meet our obligations.

Current Market Conditions

Demand for our equipment and systems for the defense industry is expected to remain strong and continue to expand, based on the planned procurement of submarines, aircraft carriers and undersea propulsion and power systems. Based on defense budget plans and the solutions we provide, we anticipate demand for our equipment and systems will continue to increase in coming years. With the addition of revenue from the BN acquisition, consolidated sales to the U.S. Navy for fiscal 2022 was $62,189, or 51% of total sales. In addition to U.S. Navy applications, we also provide specialty pumps, turbines, compressors and controllers for various fluid and thermal management systems used in Department of Defense radar, laser, electronics and power systems. We have built a leading position, and in some instances, a sole source position, for certain systems and equipment for the defense/space industry and others.

Our traditional energy markets are undergoing significant transition. While we expect that fossil fuels will continue to be an important component in the energy industry for many years to come, there are significant changes in the priorities for capital investments by our customers and the regions in which those investments are being made. We expect that the systemic changes in the energy markets, which are influenced by the increasing use by consumers of alternative fuels, will lead to demand growth for fossil-based fuels that is less than the global growth rate. We also anticipate that future investment by refiners in renewable fuels (e.g., renewable diesel), in existing refineries (e.g., to expand feedstock processing flexibility and to improve conversion of oil to refined products) to gain greater throughput, or to build new capacity (e.g., integrated refineries with petrochemical products capabilities), will continue to drive demand for our products and services. The timing and catalyst for a recovery in these markets (crude oil refining and chemical/petrochemical) remains uncertain. Accordingly, we believe that in the near term the quantity of projects available for us to compete for will remain low and that new project pricing will remain challenging.

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Of note, we have experienced a noticeable increase in our energy and chemical aftermarket orders in fiscal 2022, primarily from the domestic market. Aftermarket orders have historically been a leading indicator of future capital investment by our customers in their facilities for upgrades and expansions. As such we believe there is the possibility of a cyclical upturn in the next twelve to eighteen months following several years of reduced capital spending in a low oil price environment, although not as robust as years past due to the factors discussed above.

The alternative and clean energy opportunities for our heat transfer, power production and fluid transfer systems are expected to continue to grow. We assist in designing, developing and producing equipment for hydrogen production, distribution and fueling systems, concentrated solar power and storage, and small modular nuclear systems. We are positioning the Company to be a more significant contributor as these markets continue to develop.

We believe in the near and medium-term that chemical and petrochemical capital investment will continue to decouple from energy investment. Over the long term, we expect that population growth, an expanding global middle class and an increasing desire for improved quality of life and access to consumer products will drive increased demand for industrial goods within the plastics and resins value chain along with fertilizers or related products. Consequently, when global economies return to stable growth, we expect investment in new global chemical and petrochemical capacity will resume and that such investments will in turn drive growth in demand for our products and services.

BN products and market access provide revenue and growth potential in the commercial space/aerospace markets. The commercial space market has grown and evolved rapidly, and BN has provided rocket engine turbo pump systems and components for many of the launch providers. We expect that in the long term extended space exploration will become more prevalent, and we anticipate that our thermal/fluid management and environmental control and life support system turbomachinery will play important roles. BN is also participating in future aerospace power and propulsion system development through supply of fluid and thermal management systems components. Small power dense systems are imperative for these applications and we believe our technology and expertise will enable us to achieve sales growth in this market as well.

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The chart below illustrates our strategy to increase our participation in the defense market. The defense market comprised 76% of our total backlog at March 31, 2022. We believe this diversification is especially beneficial when our commercial markets are weak, as is presently the case.

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Results of Operations

For an understanding of the significant factors that influenced our performance, the following discussion should be read in conjunction with our consolidated financial statements and the notes to our consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K.

The following table summarizes our results of operations for the periods indicated:

(1)
Selling, general and administrative expense is referred to as "SG&A."

Fiscal 2022 Compared with Fiscal 2021

Sales for fiscal 2022 were $122,814, up 26% as compared with sales of $97,489 for fiscal 2021. Domestic sales were $97,639 or 80% of total sales, up from $52,724 or 54% of total sales in fiscal 2021. Domestic sales increased $44,915, or 85%, compared with fiscal 2021. International sales accounted for $25,175, or 20% of total sales, for fiscal 2022, down from $44,765 or 46% of total sales in fiscal 2021. International sales decreased $19,590, or 44% compared with fiscal 2021. By market, sales for fiscal 2022 were 20% to the refining industry (down from 41% in fiscal 2021), 13% to the chemical and petrochemical industries (down from 25% in fiscal 2021), 51% to the defense industry (U.S. Navy) (up from 24% in fiscal 2021), and 18% to space and other commercial and industrial markets (up from 10% in fiscal 2021). Fluctuation in sales among markets, products and geographic locations varies, sometimes significantly, from quarter-to-quarter based on timing and magnitude of projects. The significant shift towards domestic sales in the defense industry is primarily due to the BN acquisition in June 2021 and the strategic decision by management to diversify its revenue stream away from the refining industry. See also "Current Market Conditions," above. For additional information on anticipated future sales and our markets, see "Orders and Backlog" below.

Our gross margin for fiscal 2022 was 7.4% compared with 21.0% for fiscal 2021. Gross profit for fiscal 2022 decreased $11,340, or 55%, compared with fiscal 2021. The decline in gross profit and margin was the result of cost and schedule issues and COVID-19 related delays related to our first article defense projects at our Batavia operation. We have chosen, in the near term, to over-resource certain critical defense orders to ensure we meet the delivery expectations of our customers. We have continued to be challenged by labor shortages in our local market and made the strategic decision to increase our use of external contract welders, at a much higher cost, in order to meet our customers' delivery schedules and help secure future orders. Redirecting resources to defense contracts at our Batavia operation has also impacted our commercial market orders which had to be outsourced. We estimate that the impact of all these factors, along with material cost increases for first article projects, was over $10,000 in fiscal 2022. These losses were partially offset by the positive contribution from the BN acquisition and strong energy and chemical aftermarket sales in fiscal 2022. We expect that we will be able to reduce the use of contract welders and our contract losses in fiscal 2023. As we make further progress on our production schedule and grow our welding staff, we will be able to reduce our reliance on contract welders. This is expected to help with margin improvement over the coming quarters. We recently shipped a first article condenser for a critical navy submarine application and are on schedule to ship the remaining first article projects throughout fiscal 2023.

SG&A expense for fiscal 2022 was $21,299, up 22%, or $3,828, compared with $17,471 in fiscal 2021. SG&A expenses included intangible amortization of $913 in fiscal 2022. Approximately $4,800 of this increase was from ten months of BN being added in fiscal 2022. Additionally, fiscal 2022 results include $840 of costs incurred in connection with the BN acquisition, and bank waiver and amendment fees. SG&A expense as a percentage of sales in fiscal 2022 was 17.3% of sales compared with 17.9% of sales in fiscal 2021. The SG&A expense increases discussed above were partially offset by decreased variable compensation and outside sales agent commissions.

Other operating income for fiscal 2022 was $827 compared to $0 for fiscal 2021 and includes $1,900 of income related to the change in fair value of the BN contingent earn-out, which was terminated in fiscal 2022, partially offset by $1,073 of severance and transition expense recognized in connection with the departure of our former CEO and CFO.

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Net interest expense for fiscal 2022 was $400 compared to income of $156 in fiscal 2021 primarily due to increased borrowings related to the BN acquisition.

Our effective tax rate in fiscal 2022 was 22% compared with 27% in fiscal 2021. The decrease in tax rate was primarily due to the mix of earnings by geography, which were in lower tax rate jurisdictions as compared with the prior year.

Net loss and loss per diluted share for fiscal 2022, were $8,773 and $0.83, respectively, compared with net income and income per diluted share of $2,374 and $0.24, respectively, for fiscal 2021.

Non-GAAP Measures

Adjusted earnings before net interest expense, income taxes, depreciation and amortization ("EBITDA"), adjusted net income, and adjusted diluted earnings per share are provided for information purposes only and are not measures of financial performance under accounting principles generally accepted in the U.S. ("GAAP"). Management believes the presentation of these financial measures reflecting non-GAAP adjustments provides important supplemental information to investors and other users of our financial statements in evaluating the operating results of the Company. In particular, those charges and credits that are not directly related to operating performance, and that are not a helpful measure of the performance of our underlying business particularly in light of their unpredictable nature. These non-GAAP disclosures have limitations as analytical tools, should not be viewed as a substitute for net income determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies. In addition, supplemental presentation should not be construed as an inference that our future results will be unaffected by similar adjustments to net income determined in accordance with GAAP. Adjusted EBITDA and adjusted net income is a key metric used by management and our board of directors and is the basis for a portion of management's performance-based compensation.

We believe adjusted EBITDA is often a useful measure of a company’s operating performance and is used by management to measure the operating performance of our business. Adjusted EBITDA excludes charges for depreciation, amortization, interest expense, taxes, other acquisition related expenses (income), and other unusual/nonrecurring expenses. Adjusted EBITDA does not represent and should not be considered as an alternative to net income, operating income, net cash provided by operating activities or any other measure for determining operating performance or liquidity that is calculated in accordance with GAAP.

Management uses adjusted net income and adjusted diluted earnings per share to assess the Company’s consolidated financial and operating performance. Adjusted net income and adjusted diluted earnings per share are provided for informational purposes only and are not a measure of financial performance under GAAP. These measures help management make decisions that are expected to facilitate meeting current financial goals as well as achieving optimal financial performance. Adjusted net income provides management with a measure of financial performance of the Company based on operational factors as it removes the impact of certain unusual/nonrecurring items from the Company’s operating results. Adjusted diluted earnings per share provides management with an indication of how adjusted net income would be reflected on a per share basis for comparison to the GAAP diluted earnings per share measure.

A reconciliation of adjusted EBITDA, adjusted net income, and adjusted diluted earnings per share to net income (loss) in accordance with GAAP is as follows:

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(1) Applies a normalized tax rate of 20% to non-GAAP adjustments above, which are each pre-tax.

Liquidity and Capital Resources

The following discussion should be read in conjunction with our consolidated statements of cash flows and consolidated balance sheets appearing in Item 8 of Part II of this Annual Report on Form 10-K:

(1)
Working capital equals current assets minus current liabilities.

(2)
Working capital ratio equals current assets divided by current liabilities.

We use the above ratios to assess our liquidity and overall financial strength.

Net cash used by operating activities for fiscal 2022 was $2,219, compared with $1,722 for fiscal 2021. This $497 increase was primarily due to lower cash net income of $12,353 partially offset by $11,856 generated from lower working capital levels (primarily customer deposits) due to the timing of payments on these contracts versus when revenue is earned/billed.

Capital spending in fiscal 2022 was $2,324, compared with $2,158 in fiscal 2021. Capital expenditures in each of fiscal 2022 and fiscal 2021 were approximately 90% and 80% for facilities along with machinery and equipment, respectively, and the remaining for all other items.

Dividend payments were $3,524 in fiscal 2022, compared with $4,391 in fiscal 2021. In fiscal 2022, we suspended our dividend in accordance with the terms of our credit agreement with Bank of America. There can be no guarantee that we will pay dividends in the future and will depend on a variety of factors, including our future financial performance, organic growth opportunities, general economic conditions and other factors, many of which are beyond our control.

Cash and investments were $14,741 at March 31, 2022, compared with $65,032 at March 31, 2021, down $50,291 or 77% primarily due to the $60,282 used to fund the BN acquisition.

We invest net cash generated from operations in excess of cash held for near-term needs in short-term, less than 365 days, certificates of deposit, money market accounts or U.S. government instruments, generally with maturity periods of up to 180 days. Our certificates of deposit are used to securitize our outstanding letters of credit, which reduces our cost on those letters of credit. Approximately 90% of our cash and investments are held in the U.S. The remaining 10% is invested in our China operations.

Capital expenditures for the fiscal year ending March 31, 2023, which we refer to as "fiscal 2023," are expected to be between approximately $4,500 and $5,500. Approximately 35% of our fiscal 2023 capital expenditures are expected to be for machinery and equipment, and 50% for buildings and leasehold improvements to fund our growth initiatives with the remaining amounts expected to be used for other items. The majority of our planned capital expenditures are discretionary.

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On June 1, 2021, we entered into a $20,000 five-year loan with Bank of America. The term loan requires monthly principal payments of $167 through June 1, 2026, with the remaining principal amount plus all interest due on the maturity date. The interest rate on the term loan is the applicable Bloomberg Short-Term Bank Yield Index ("BSBY"), plus 1.50%, subject to a 0.00% floor.

On June 1, 2021, we entered into a five-year revolving credit facility with Bank of America that provides a $30,000 line of credit, including letters of credit and bank guarantees, expandable at our option and the bank's approval at any time up to $40,000. As of March 31, 2022, there was no amount outstanding on the line of credit. Amounts outstanding under the facility agreement bear interest at a rate equal to BSBY plus 1.50%, subject to a 0.00% floor. As of March 31, 2022, the BSBY rate was 0.130830%. Outstanding letters of credit under this agreement are subject to a fee of 1.50% per annum of the outstanding undrawn amount of each letter of credit that is not secured by cash and 0.60% of each letter of credit that is secured by cash. Amounts available for borrowing under the revolving credit facility are subject to an unused commitment fee of 0.25%. As of March 31, 2022, there was $4,750 letters of credit outstanding with Bank of America.

Under the original term loan agreement and revolving credit facility, the Company covenants to maintain a maximum total leverage ratio, as defined in such agreements, of 3.0 to 1.0, with an allowable increase to 3.25 to 1.0 following an acquisition for a period of twelve months following the closing of the acquisition. In addition, the Company covenanted to maintain a minimum fixed charge coverage ratio, as defined in such agreements, of 1.2 to 1.0 and minimum margined assets, as defined in such agreements, of 100% of total amounts outstanding on the revolving credit facility, including letters of credit. At December 31, 2021, the Company was out of compliance with its bank agreement covenants and was granted a waiver for noncompliance by Bank of America. At March 31, 2022, the amount available under the revolving credit facility was $10,250.

On March 31, 2022 and June 7, 2022, we entered into amendment agreements with Bank of America. Under the amended agreement, the Company is not required to comply with the maximum total leverage ratio and the minimum fixed charge coverage ratio covenants contained in the original term loan agreement for the periods ending December 31, 2021 and March 31, June 30 and September 30, 2022. The principal balance outstanding on the line of credit may not exceed $15,000, unless letters of credit exceed $11,500, in which case the limit is $17,000, until the compliance date. The compliance date is defined as the date on which Bank of America has received all required financial information for the fiscal year ending March 31, 2023 and no event of default exists. In addition, on or before September 1, 2022 and at all times thereafter, all of our deposit accounts, except certain foreign subsidiary accounts, will be either subject to a deposit account control agreement or maintained with Bank of America. The Company covenants to maintain EBITDA, as defined in such amendment, of at least ($700) for the twelve-month period ending June 30, 2022 and $1,800 for the twelve-month period ending September 30, 2022; maintain a total maximum leverage ratio of 4.0 to 1.0 for the twelve-month period ending December 31, 2022 and 3.0 to 1.0 for the period ending March 31, 2023; and maintain liquidity, as defined in such amendment, of at least $10,000 prior to the occurrence of the compliance date and $20,000 from and after the occurrence of the compliance date.

In connection with the waiver and amendments discussed above, we are required to pay a back-end fee of $725 to Bank of America payable upon the earliest to occur of (i) any default or event of default, (ii) the last date of availability under the revolving credit facility, and (iii) repayment in full of all principal, interest, fees and other obligations, which may be waived or cancelled if certain criteria are met.

We did not have any off-balance sheet arrangements as of March 31, 2022 and 2021, other than letters of credit incurred in the ordinary course of business.

We believe that cash generated from operations, combined with the liquidity provided by available financing capacity under our credit facility, will be adequate to meet our cash needs for the immediate future.

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Stockholders' Equity

The following discussion should be read in conjunction with our consolidated statements of changes in stockholders' equity that can be found in Item 8 of Part II of this Annual Report on Form 10-K. The following table shows the balance of stockholders' equity on the dates indicated:

Fiscal 2022 Compared with Fiscal 2021

Stockholders' equity decreased $1,435 or 1%, at March 31, 2022 compared with March 31, 2021.

On March 31, 2022, our net book value per share was $9.07, down from $9.83 at March 31, 2021.

Orders and Backlog

Management uses orders and backlog as measures of our current and future business and financial performance. Orders in fiscal 2022 increased 18% to $143,877 from $121,619 in fiscal 2021. Orders represent communications received from customers requesting us to supply products and services. Revenue is recognized on orders received in accordance with our revenue recognition policy described in Notes 1 and 3 to the consolidated financial statements contained in Item 8 of Part II of this Annual Report on Form 10-K.

Domestic orders were 81%, or $117,106, and international orders were 19%, or $26,772, of our total orders in fiscal 2022. This compared with domestic orders of $89,283, or 73% of total orders, and international orders of $32,336, or 27% of our total orders in fiscal 2021. Domestic orders increased by $27,823, or 31%. This increase was due to the BN acquisition, which added $66,149 to domestic orders, as well as higher aftermarket orders, partly offset by lower energy and petrochemical orders and a decrease in defense (U.S. Navy) orders, which are lumpy in nature. Net international orders decreased by $5,564, or 17% in fiscal 2022.

Backlog was $256,536 at March 31, 2022, up 86% compared with $137,567 at March 31, 2021. Backlog is defined by us as the total dollar value of orders received for which revenue has not yet been recognized. All orders in backlog represent orders from our traditional markets in established product lines. Included in backlog at March 31, 2022 was $117,769 from BN. Approximately 40% to 50% of orders currently in our backlog are expected to be converted to sales within one year. At March 31, 2022, approximately 76% of our backlog was attributable to defense (U.S. Navy) projects, 10% for refinery project work, 5% for chemical and petrochemical projects, 4% for space projects and 5% for other industrial applications.

Outlook

Our defense business continues to be strong. With the acquisition of BN, 76% of our $256,536 backlog is in defense. Because much of the defense backlog includes projects with order to shipment timeframes of up to five years, we expect 45% to 50% of our sales in fiscal 2023 to be from the defense market. Defense spending, specifically for the U.S. Navy, is expected to remain steady over the foreseeable future.

Near term opportunities in the global energy and petrochemical markets have slowed significantly due to the combined impact of the COVID-19 pandemic and increasing use by consumers of alternative fuels. However, the recent improvement in our aftermarket and short cycle business in North America is encouraging. As such we believe there is the possibility of a cyclical upturn in the next twelve to eighteen months following several years of reduced capital spending in a low oil price environment, although not as robust as in years past. Strategically, we are implementing efforts to capture more aftermarket opportunity less oriented to capital projects.

Our objective is to leverage our engineering knowhow and depth of application experience to identify more opportunities for our products and technologies in our targeted markets.

Our expectations for sales and profitability assume that we are able to operate our production facilities in Batavia, New York and Arvada, Colorado at or above "normal" (pre-COVID-19 pandemic) capacity throughout fiscal 2023. We project that approximately 40% to 50% of backlog will convert to sales over the next 12 months. We expect the remaining backlog will convert beyond fiscal 2023, which includes a combination of U.S. Navy orders that have a long conversion cycle (up to six years) as well as certain commercial orders, the conversion of which has been extended by our customers.

Sales in fiscal 2023 is expected to be $135,000 to $150,000. We expect gross profit margins to recover to 16% to 17% of sales as the U.S. Navy project cost overruns at our Batavia facility in fiscal 2022 are not expected to reoccur and we expect to begin work on the more profitable Navy projects in the second half of fiscal 2023. We expect SG&A to be 15% to 16% of sales and our effective tax

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rate to be 21% to 22% for fiscal 2023. Adjusted EBITDA is expected to be $6,500 to $9,500 for fiscal 2023. We have not reconciled non-GAAP forward-looking Adjusted EBITDA to its most directly comparable GAAP measure, as permitted by Item 10(e)(1)(i)(B) of Regulation S-K. Such reconciliation would require unreasonable efforts to estimate and quantify various necessary GAAP components largely because forecasting or predicting our future operating results is subject to many factors out of our control or not readily predictable.

Contingencies and Commitments

We have been named as a defendant in lawsuits alleging personal injury from exposure to asbestos allegedly contained in or accompanying our products. We are a co-defendant with numerous other defendants in these lawsuits and intend to vigorously defend ourselves against these claims. The claims in our current lawsuits are similar to those made in previous asbestos lawsuits that named us as a defendant. Such previous lawsuits either were dismissed when it was shown that we had not supplied products to the plaintiffs’ places of work, or were settled by us for immaterial amounts.

As of March 31, 2022, we are subject to the claims noted above, as well as other legal proceedings and potential claims that have arisen in the ordinary course of business. Although the outcome of the lawsuits, legal proceedings or potential claims to which we are or may become a party cannot be determined and an estimate of the reasonably possible loss or range of loss cannot be made for the majority of the claims, we do not believe that the outcomes, either individually or in the aggregate, will have a material adverse effect on our results of operations, financial position or cash flows.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements and the notes to consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K, which have been prepared in accordance with GAAP.

Critical accounting policies are defined as those that reflect significant judgments and uncertainties and could potentially result in materially different results under different assumptions and conditions.

Revenue Recognition. The Company accounts for revenue in accordance with Accounting Standard Codification 606, "Revenue from Contracts with Customers" ("ASC 606").

We recognize revenue on all contracts when control of the product is transferred to the customer. Control is generally transferred when products are shipped, title is transferred, significant risks of ownership have transferred, we have rights to payment, and rewards of ownership pass to the customer. Customer acceptance may also be a factor in determining whether control of the product has transferred. Although revenue on the majority of our contracts, as measured by number of contracts, is recognized upon shipment to the customer, revenue on larger contracts, which are fewer in number but generally represent the majority of revenue, is recognized over time as these contracts meet specific criteria in ASC 606. Revenue from contracts that is recognized upon shipment accounted for approximately 25% of revenue in fiscal 2022. Revenue from contracts that is recognized over time accounted for approximately 75% of revenue in fiscal 2022. We recognize revenue over time when contract performance results in the creation of a product for which we do not have an alternative use and the contract includes an enforceable right to payment in an amount that corresponds directly with the value of the performance completed. To measure progress towards completion on performance obligations for which revenue is recognized over time the Company utilizes an input method based upon a ratio of direct labor hours incurred to date to management’s estimate of the total labor hours to be incurred on each contract, or cost incurred to date to management's estimate of the total cost to be incurred on each contract, or an output method based upon completion of operational milestones, depending upon the nature of the contract.

Business Combinations and Intangible Assets. Assets and liabilities acquired in a business combination are recorded at their estimated fair values at the acquisition date. The fair value of identifiable intangible assets is based upon detailed valuations that use various assumptions made by management. Goodwill is recorded when the purchase price exceeds the estimated fair value of the net identifiable tangible and intangible assets acquired. Definite lived intangible assets are amortized over their estimated useful lives and are assessed for impairment if certain indicators are present. Goodwill and intangible assets deemed to have indefinite lives are not amortized but are subject to impairment testing annually or earlier if an event or change in circumstances indicates that the fair value of a reporting unit or the indefinite lived asset may have been reduced below its carrying value.

Pension and Postretirement Benefits. Defined benefit pension and other postretirement benefit costs and obligations are dependent on actuarial assumptions used in calculating such amounts. These assumptions are reviewed annually and include the discount rate, long-term expected rate of return on plan assets, salary growth, healthcare cost trend rate and other economic and demographic factors. We base the discount rate assumption for our plans on the FTSE Pension Liability Above-Median AA-Index. The long-term

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expected rate of return on plan assets is based on the plan’s asset allocation, historical returns and expectations as to future returns that are expected to be realized over the estimated remaining life of the plan liabilities that will be funded with the plan assets. The salary growth assumptions are determined based on long-term actual experience and future and near-term outlook. The healthcare cost trend rate assumptions are based on historical cost and payment data, the near-term outlook, and an assessment of likely long-term trends.

Critical Accounting Estimates and Judgments

We have evaluated the accounting policies used in the preparation of the consolidated financial statements and the notes to consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K and believe those policies to be reasonable and appropriate.

We believe that the most critical accounting estimates used in the preparation of our consolidated financial statements relate to labor hour estimates, total cost, and establishment of operational milestones which are used to recognize revenue over time, accounting for contingencies, under which we accrue a loss when it is probable that a liability has been incurred and the amount can be reasonably estimated, accounting for business combinations and intangible assets, and accounting for pensions and other postretirement benefits.

As discussed above under the heading "Critical Accounting Policies", we recognize a majority of our revenue using an over-time recognition method. The key estimate for the over-time recognition model is total labor, total cost and operational milestones to be incurred on each contract and to the extent that these estimates changes, it may significantly impact revenue recognized in each period.

Contingencies, by their nature, relate to uncertainties that require us to exercise judgment both in assessing the likelihood that a liability has been incurred as well as in estimating the amount of potential loss. For more information on these matters, see the notes to consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K.

As discussed above under the heading "Critical Accounting Policies", we allocate the purchase price of an acquired company, including when applicable, the acquisition date fair value of contingent consideration between tangible and intangible assets acquired and liabilities assumed from the acquired business based on their estimated fair values, with the residual of the purchase price recorded as goodwill. Third party appraisal firms and other consultants are engaged to assist management in determining the fair values of certain assets acquired and liabilities assumed. Estimating fair values requires significant judgments, estimates and assumptions, including but not limited to: discount rates, future cash flows and the economic lives of trade names, technology, customer relationships, and property, plant and equipment. These estimates are based on historical experience and information obtained from the management of the acquired company and are inherently uncertain.

During fiscal 2022, we completed the acquisition of BN for an aggregate purchase price of $72,014. We identified and assigned value to identifiable intangible assets of customer relationships, technology and technical know-how, backlog and trade name, and estimated the useful lives over which these intangible assets would be amortized. The estimates of fair values of these identifiable intangible assets were based upon discounted cash flow models, which include assumptions such as forecasted cash flows, customer attrition rates, discount rates, and royalty rates. The fair value estimates resulted in identifiable intangible assets, in the aggregate, of $32,500. The resulting goodwill, in the aggregate, from this acquisition was $23,523. For more information on these matters, see the notes to consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K.

Accounting for pensions and other postretirement benefits involves estimating the cost of benefits to be provided well into the future and attributing that cost over the time period each employee works. To accomplish this, assumptions are made about inflation, investment returns, mortality, turnover, medical costs and discount rates. These assumptions are reviewed annually.

The discount rate used in accounting for pensions and other postretirement benefits expense (income) is determined in conjunction with our actuary by reference to a current yield curve and by considering the timing and amount of projected future benefit payments. The discount rate assumption for fiscal 2022 was 3.21% for our defined benefit pension plans and 2.34% for our other postretirement benefit plan. A reduction in the discount rate of 50 basis points, with all other assumptions held constant, would have increased fiscal 2022 net periodic benefit expense for our defined benefit pension plans and other postretirement benefit plan by approximately $351 and $0.1, respectively.

The expected return on plan assets assumption of 5.5% used in accounting for our pension plan is determined by evaluating the mix of investments that comprise plan assets and external forecasts of future long-term investment returns. A reduction in the rate of return of 50 basis points, with other assumptions held constant, would have increased fiscal 2022 net periodic pension expense by approximately $210.

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During fiscal 2022 and fiscal 2021, the pension plan released liabilities for vested benefits of certain participants through the purchase of nonparticipating annuity contracts with a third-party insurance company. As a result of these transactions, in fiscal 2022 and fiscal 2021, the projected benefit obligation and plan assets each decreased $1,279 and $1,477, respectively.

As part of our ongoing financial reporting process, a collaborative effort is undertaken involving our managers with functional responsibilities for financial, credit, tax, engineering, manufacturing and benefit matters, and outside advisors such as lawyers, consultants and actuaries. We believe that the results of this effort provide management with the necessary information on which to base their judgments and to develop the estimates and assumptions used to prepare the financial statements.

We believe that the amounts recorded in the consolidated financial statements included in Item 8 of Part II of this Annual Report on Form 10-K related to revenue, contingencies, pensions, other postretirement benefits and other matters requiring the use of estimates and judgments are reasonable, although actual outcomes could differ materially from our estimates.

New Accounting Pronouncements

In the normal course of business, management evaluates all new accounting pronouncements issued by the Financial Accounting Standards Board, the SEC, the Emerging Issues Task Force, the American Institute of Certified Public Accountants or any other authoritative accounting body to determine the potential impact they may have on our consolidated financial statements. For discussion of the newly issued accounting pronouncements see ''Accounting and reporting changes'' in Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K.