GRAHAM CORP - Quarter Report: 2008 September (Form 10-Q)

which our products are used are, to varying degrees, cyclical and have historically experienced severe downturns. Although we believe we are in a long-term expansion of demand for our products in the petrochemical, petroleum refining and power generating industries, a downturn in one or more of these industries could occur at any time. We have no way to predict or control the length or severity of any such downturn. A sustained deterioration in any of the cyclical industries we serve would materially harm our business and operating results because our customers would not likely have the resources necessary to purchase our products nor would they likely have the need to build additional facilities or improve existing facilities.

Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Dollar amounts in thousands, except per share data)

Overview

     We are a global designer and manufacturer of custom-engineered ejectors, liquid ring pump packages, condensers and heat exchangers. Our equipment is for critical applications in the petrochemical, oil refinery and electric power generation industries, including cogeneration and geothermal plants. Our equipment can also be found in diverse applications such as metal refining, pulp and paper processing, shipbuilding, water heating, refrigeration, desalination, food processing, pharmaceuticals, heating, ventilating and air conditioning.

     Our corporate offices and production facilities are located in Batavia, New York. Additionally, we have a wholly-owned foreign subsidiary in China. Our Chinese subsidiary supports sales orders from Asia and provides engineering support and supervision of subcontracted fabrication.

     Highlights for the three and six months ended September 30, 2008 are set forth below. Our current fiscal year, which we refer to as “fiscal 2009,” ends March 31, 2009.

	•		Net income and income per diluted share for the current quarter were $4,412 and $0.43, compared with net income of $4,422 and income per diluted share of $0.44 for the quarter ended September 30, 2007. Net income and income per diluted share for the six months ended September 30, 2008 were $10,096 and $0.99, compared with net income and income per diluted share for the six-month period ended September 30, 2007 of $7,080 and $0.71.
	•		Net sales for the second quarter of $23,915 were up 4% compared with the second quarter of the fiscal year ended March 31, 2008, referred to as “fiscal 2008,” when sales were $23,060. Net sales for the first six months of fiscal 2009 were $51,562, an increase of 20%, compared with $43,047 for the six months ended September 30, 2007.
	•		Orders placed with us in the three and six-month periods of fiscal 2009 were $17,451 and $45,251, respectively, compared with the three and six-month periods of fiscal 2008 of $20,528 and $45,371, respectively. We believe orders for the current quarter were down 15% compared with the same period of the prior fiscal year as a result of a hesitation in the capital construction markets caused by the current global economic crises. For the comparative six month-periods, orders were level.
	•		Backlog grew to $69,673 at September 30, 2008, representing a 23% increase compared with September 30, 2007, when backlog was $56,839. However, as a result of the second quarter decline in new orders, backlog was down from $75,971 at the end of the first quarter of fiscal 2009.
	•		Gross profit margin was 44% for both the three and six-month periods ended September 30, 2008 compared with 43% and 39% for the three and six-month periods ended September 30, 2007, respectively.
	•		Operating margins for the quarter and six-month periods ended September 30, 2008 were 27% and 29%, respectively, compared with 28% and 23%, respectively, for the quarter and six-month periods ended September 30, 2007.

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Cash and short-term investments at September 30, 2008 were $42,855, up 16% as compared with $36,793 at March 31, 2008.

     We expect that the current global economic crisis has caused a slow-down in spending by our customers as they evaluate the current and future economic impact to their project plans. However, we believe the principal market drivers that have driven our growth over the last two years are unchanged and that ultimately they will continue to drive long-term growth.

     We believe the principal market drivers that have led to increased capital spending by our customers and that are contributing to our sales growth include:

	•		Global consumption of crude oil is estimated to expand over the next decade.
	•		There is a shortage of global oil refining capacity, which is being addressed through refinery upgrades, revamps, new builds and expansions.
	•		There is a differential in raw material prices for higher quality sweet and lower quality sour crude oil. To lower production costs, many refineries are upgrading facilities in order to be able to process sour crude oil, which requires an upgrade of vacuum and heat transfer equipment of the types we design and manufacture.
	•		The expansion of the middle class in Asia is driving increasing demand for power, refinery and petrochemical products.
	•		The high cost of natural gas in North America and Europe is leading to the construction of new petrochemical plants in the Middle East, where natural gas is plentiful and less expensive.
	•		There is an increased demand for geothermal electrical power plants to meet increased electricity demand.
	•		Refineries in the United States are being upgraded to process synthetic crude oil from oil sands located in Alberta, Canada.

Forward-Looking Statements

     This report and other documents we file with the Securities and Exchange Commission include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.

     These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any future results implied by the forward-looking statements. Such factors include, but are not limited to, the risks and uncertainties identified by us under the heading “Risk Factors” in Item 1A of our Annual Report on Form 10-K for fiscal 2008 and in Item 1A of this Report. Forward-looking statements may also include, but are not limited to, statements about:

	•		the current and future economic environments affecting us and the markets we serve;
	•		sources of revenue and anticipated revenue, including the contribution from the growth of new products, services and markets;

	•		plans for future products and services and for enhancements to existing products and services;
	•		estimates regarding our liquidity and capital requirements;
	•		our ability to attract or retain customers;
	•		the outcome of any existing or future litigation; and
	•		our ability to increase our productivity and capacity.

     Forward-looking statements are usually accompanied by words such as “anticipate,” “believe,” “estimate,” “may,” “intend,” “project,” “expect” and similar expressions. Actual results could differ materially from historical results or those implied by the forward-looking statements contained in this report.

     Undue reliance should not be placed on these forward-looking statements. Except as required by law, we undertake no obligation to update or announce any revisions to forward-looking statements contained in this report, whether as a result of new information, future events or otherwise.

Results of Operations

     For an understanding of the significant factors that influenced our performance, the following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and the notes to our condensed consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q.

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

		Three Months Ended								Six Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net sales		$	23,915			$	23,060			$	51,562			$	43,047
Net income			4,412				4,422				10,096				7,080
Diluted income per share			0.43				0.44				0.99				0.71
Identifiable assets			83,318				54,878				83,318				54,878

The Second Quarter of Fiscal 2009 Compared With the Second Quarter of Fiscal 2008

     Sales for the second quarter of fiscal 2009 were $23,915, a 4% increase as compared with sales of $23,060 for the second quarter of fiscal 2008. A $2,058 increase in sales of pumps combined with a $996 and $806 increase in sales of condensers and heat exchangers, respectively, more than offset the $3,314 decline in sales of ejectors. The second quarter of fiscal 2008 included two large ejector orders for the refinery market. Aftermarket sales were up $309 in the current quarter compared with the same period last year.

     Sales for the six-month period ended September 30, 2008 were $51,562, up 20%, compared with $43,047 for the first six months of fiscal 2008. Heat exchanger sales increased $1,484, condenser sales increased $2,957, pump package sales increased $3,410 and aftermarket sales increased $6,335 for the first half of fiscal 2009. The increases in pump package and aftermarket sales were due to three large refinery projects. These increases more than offset the $5,671 decrease in ejector sales in the six month-period ended September 30, 2008 compared with the first half of our prior fiscal year.

     International sales accounted for 37% and 33% of total sales for the second quarters of fiscal 2009 and fiscal 2008, respectively. International sales increased $1,450 in the current quarter compared with the three-month period ended September 30, 2007 with increases of $2,498 and $1,242 from the Middle East and Western Europe, respectively, more than offsetting declines in Asia, South America and other areas. We believe this trend of international sales comprising a larger percentage of our total sales will continue into fiscal 2010. For the six months ended September 30, 2008, international orders were 35% of total sales compared with 43% for the six-month period ended September 30, 2007. International sales dollars of $18,026 for the current six-month period compared with the six months ended September 30, 2007 were relatively unchanged.

     Fluctuations in sales among products and geographic locations can vary measurably from period to period based on timing and magnitude of projects. Sales in the three months ended September 30, 2008 were 47% to the refining industry, 27% to the chemical and petrochemical industries, 8% to the power industry and 18% to other industrial applications. Sales in the three months ended September 30, 2007 were 52% to the refining industry, 28% to the chemical and petrochemical industries, 2% to the power industry and 18% to other industrial applications. Increased sales to the power industry included applications for fossil fuels while other industrial applications included heating, ventilation and air conditioning requirements and sales to the pulp and paper industry. For the six-month periods ended September 30, 2008 and 2007, sales were, respectively, 50% and 50% to the refinery industry, 23% and 26% to the chemical and petrochemical industries, 6% and 3% to the power industry and 21% and 21% to other industrial applications. For additional information on future sales and our markets, see “Orders and Backlog” below.

     Our gross profit percentage for the second quarter of fiscal 2009 was 44% compared with 43% for the second quarter of fiscal 2008. Gross profit percentage for the six-month periods ended September 30, 2008 and 2007 was 44% and 39%, respectively. Gross profit dollars for the first half of fiscal 2009 increased 37% compared with fiscal 2008, primarily as a result of a 20% increase in sales. The higher gross profit percentage and dollars were due mostly to improved product mix achieved by increased selectivity on orders accepted and higher volume. We were able to increase our sales volume through productivity improvements made in engineering and manufacturing by process improvements, technology and new equipment. The efficiencies we have gained have enabled us to control our fixed cost structure on higher sales volumes.

     Selling, general and administrative (“SG&A”) expenses, expressed as a percent of sales, for the three-month periods ended September 30, 2008 and 2007 were 16% and 15%, respectively. SG&A expense, expressed as a percent of sales, was 15% for both the six-month periods ended September 30, 2008 and 2007. Actual costs for fiscal 2009 for the three and six-month periods ended September 30, 2008, compared with the same respective periods in fiscal 2008, increased $493, or 14%, and $1,237, or 19%, respectively. Higher SG&A expenses were due to increased sales commissions related to higher sales and to increased variable compensation as a result of a 43% increase in net income for the six-month period. In addition, we incurred consulting costs for information technology, engineering and manufacturing projects which we believe will lead to reduced cycle time, greater efficiencies and capacity expansion.

     Interest income for the three month-periods ended September 30, 2008 and 2007 was $172 and $264, respectively. For the six-month periods ended September 30, 2008 and 2007, interest income was $303 and $494, respectively. Decreased interest income was due to lower interest rates and investing in lower risk and yield instruments. Our investments at September 30, 2008 consisted solely of fixed income debt securities issued by the United States Treasury.

     Interest expense was $2 for each of the quarters ended September 30, 2008 and 2007. For the six-month periods ended September 30, 2008 and 2007, respectively, interest expense was $3 and $8. The decrease was due to lower interest rates and a decline in capital lease obligations outstanding.

     Our effective income tax rate in fiscal 2009 is projected to be 33%. However, for the six months ended September 30, 2008, our actual effective income tax rate was 34% due to our Chinese subsidiary’s taxable loss at September 30, 2008 for which the related tax benefit was recognized at the lower foreign statutory rate. Our effective tax rate for fiscal 2008 was 33%.

     Net income for the fiscal 2009 second quarter was $4,412, relatively unchanged from $4,422 for the fiscal 2008 second quarter as increased expenses offset the effect of higher sales. For the six-month period of fiscal 2009, net income was up 43% to $10,096 compared with $7,080 for the six month-period of fiscal 2008. Income per diluted share was $0.43 and $0.99 for the three and six month-periods ended September 30, 2008, respectively, compared with $0.44 and $0.71 for the three and six-month periods ended September 30, 2007, respectively. The increase in the weighted average shares outstanding in the fiscal 2009 second quarter resulted in slightly lower diluted earnings per share.

Liquidity and Capital Resources

     The following discussion should be read in conjunction with our Condensed Consolidated Statements of Cash Flows:

		September 30,
		2008				2007
Cash and investments		$	42,855			$	24,137
Working capital		$	46,906			$	30,425
Working capital ratio(1)			3.4				3.0
Long-term debt (capital leases)		$	46			$	45
Long-term debt/capitalization(2)			0	%			0.1	%
Long-term liabilities/capitalization(3)			4.7	%			4.5	%

     Net cash provided by operating activities for the first six months of fiscal 2009 was $4,402, compared with $8,997 for the six months ended September 30, 2007. The decrease was due to an increase in working capital, decreases in net operating losses and research and development credits available to reduce current taxes payable, and a contribution we made to our pension plan. The contribution to the pension plan in the current six-month period was $3,500 compared with $0 for the six months ended September 30, 2007. Expressed as a percent of income before taxes, the current income tax provision for the first half of fiscal 2009 was 26% compared with 4% for the first half of fiscal 2008. Our working capital rose due to an increase in our accounts receivable balance. The higher accounts receivable balance at September 30, 2008 does not represent a change in collection terms, but was due to the timing of billings to customers.

     We invest net cash generated from operations in excess of cash held for near-term needs in marketable securities. Investments are United States government instruments, generally with maturity periods of 91 to 120 days. Investments at September 30, 2008 and March 31, 2008 were

$37,811 and $34,681, respectively. Other investing activities in the first six months of fiscal 2009 included capital expenditures of $795.

     Sources of cash from financing activities for the six months ended September 30, 2008 included the issuance of common stock for stock options exercised, which raised $695, compared with $273 in the first six months of fiscal 2008. In the six-month period ended September 30, 2008, we also recognized a $1,696 increase in capital in excess of par value for the income tax benefit realized upon exercise of stock options in excess of the tax benefit amount recognized pertaining to the fair value of stock option awards treated as compensation expense.

     Uses of cash for financing activities for the six months ended September 30, 2008 included dividend payments of $354 compared with $196 for the six-month period ended September 30, 2007. In the first half of fiscal 2009, we borrowed and repaid $14 to finance working capital needs compared with $19 for the first half of fiscal 2008.

     We have a credit facility with Bank of America, N.A. that provides a line of credit up to $30,000, including letters of credit and bank guarantees. Borrowings under our credit facility are secured by all of our assets. Borrowings and standby letters of credit outstanding under our credit facility on September 30, 2008 were $0 and $8,796, respectively. Our borrowing rate as of September 30, 2008 was the bank’s prime rate minus 125 basis points, or 3.75%. We believe that cash generated from operations, combined with our investment and available financing capacity under our credit facility will be adequate to meet our cash needs in the foreseeable future.

     Capital expenditures for fiscal 2009 are projected to be approximately $1,800 to $2,200. Planned investment is expected to be about 33% in machinery and equipment, 53% for information technology and 14% for all other capital expenditures. We estimate 68% of our capital expenditure budget for fiscal 2009 will support productivity improvements, while the balance will be primarily used for capitalized maintenance projects. Capital expenditures in fiscal 2008 were 60% for plant machinery and equipment and 40% for all other capital expenditures. Fifty-six percent of our capital spending was for productivity improvements, while the balance was primarily for capitalized maintenance.

Orders and Backlog

     Orders for the three and six-month periods ended September 30, 2008 were $17,451 and $45,251, respectively. Orders for the three and six-month periods ended September 30, 2007 were $20,528 and $45,371, respectively. Orders represent communications received from customers requesting us to supply products and services and can fluctuate significantly quarter to quarter by industry and product lines and, therefore, we do not believe quarter to quarter comparisons reflect business trends. Orders in the second quarter of fiscal 2009 were down $3,077 from the prior year’s second quarter. A $2,076 increase in ejector orders in the fiscal 2009 second quarter did not offset a $3,013 decline in pump package orders and a $1,618 decline in condenser orders compared with the fiscal 2008 second quarter.

     We experienced a significant increase in orders for surface condensers in the first half of fiscal 2009 of $3,488, or 33%, compared with the first half of fiscal 2008. Surface condenser orders represented 31% of our orders in the six-month period ended September 30, 2008 compared with 24% in the six-month period ended September 30, 2007. Condenser orders were for refinery, petrochemical and electric power applications. Offsetting the increase in condenser orders for the first half of fiscal 2009 was a decrease in pump package orders for the six-month period ended September 30, 2008 compared with the six months ended September 30, 2007 of $4,843. The large pump package orders received last fiscal year were for refinery projects and approximately half of the total order value was converted to sales in the first six months of fiscal 2009. We

believe any of our product categories in any given period could constitute a significant percentage of the orders for that period and do not necessarily represent business trends.

     Domestic orders for the fiscal 2009 second quarter were 52% of total orders, or $9,104. They were down $2,732, or 23%, compared with domestic orders of $11,836, or 58% of total orders, in the second quarter of fiscal 2008. International orders were 48% of total orders, or $8,347, in the second quarter of fiscal 2009 compared with the second quarter of fiscal 2008, when international orders were 42%, or $8,692. Declines by industry were in the refining and power markets.

     For the six month-period ended September 30, 2008, international orders were 59% of total orders, or $26,491, compared with 29% of total orders, or $13,221, in the first six months of 2008. The increase in international orders for the first six months of fiscal 2009 came primarily from Asia, up $16,174, which represented 36% of our total orders for fiscal 2009 through the second quarter. Our domestic orders in both periods were comprised mostly of refinery projects. International orders were for refinery, petrochemical and power generation applications. We believe, subject to order selection, that in the future, some periods can be heavily weighted toward international orders and other periods to domestic orders, but that the emerging trend in the foreseeable future will result in a greater weighting toward international orders. By industry, the $5,170 increase in orders from the chemical and petrochemical industry and the $3,999 increase in orders from other industrial and commercial applications were not enough to offset the decline in orders from the refining industry and the power industry of $6,478 and $2,814, respectively, in the first half of fiscal 2009 when compared with the same period in fiscal 2008. We believe that the rapid decline in oil prices in the quarter ended September 30, 2008 and the current global economic crisis caused our customers to hold orders until markets become more stable.

     Backlog was $69,673 at September 30, 2008, compared with $56,839 at September 30, 2007, a 23% increase. Backlog is defined 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. Substantially all of our current backlog is expected to be converted to sales within the next twelve months, and represents orders from traditional markets in our established product lines. At September 30, 2008, approximately 51% of our backlog was attributable to equipment for refinery project work, 30% to chemical and petrochemical projects, and 19% to other industrial or commercial applications. At September 30, 2007, approximately 50% of our backlog was attributable to equipment for refinery project work, 26% to chemical and petrochemical projects, and 24% to other industrial or commercial applications, including electrical power.

Contingencies and Commitments

     We have been named as a defendant in certain lawsuits alleging personal injury from exposure to asbestos contained in our products. We are a co-defendant with numerous other defendants in these lawsuits and intend to vigorously defend against these claims. The claims are similar to 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 amounts below expected defense costs. Neither the outcome of these lawsuits nor the potential for liability can be determined at this time.

     From time to time in the ordinary course of business, we are subject to legal proceedings and potential claims. As of September 30, 2008, other than noted above, we were unaware of any pending material litigation.

Critical Accounting Policies, Estimates and Judgments

     Our unaudited condensed consolidated financial statements are based on the selection of accounting policies and the application of significant account estimates, some of which require management to make significant assumptions. We believe that the most critical accounting estimates used in the preparation of our condensed consolidated financial statements relate to labor hour estimates used to recognize revenue under the percentage-of-completion method, 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, and accounting for pensions and other postretirement benefits. For further information, refer to Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8 “Financial Statements and Supplementary Data” in our Annual Report on Form 10-K for our fiscal year ended March 31, 2008.

New Accounting Pronouncements

     In September 2006, the Financial Accounting Standard Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 was effective as of the beginning of fiscal 2009, which commenced April 1, 2008. The impact of adopting all provisions of SFAS No. 157 had no effect on our financial position, results of operations and cash flows when adopted.

     In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. In our fiscal year ended March 31, 2007, we adopted the provisions of SFAS No. 158 which were effective for that year. Effective April 1, 2008 we recognized the effects of changing our measurement dates for our defined benefit plans from a December 31 to a March 31 date. Under the approach we selected, we remeasured our plan assets and benefit obligations as of the beginning of fiscal 2009. Our adoption of SFAS No. 158 had the effect of reducing our prepaid pension asset by $801, reducing our deferred income tax liability by $260, reducing stockholders’ equity by $506 and decreasing accrued postretirement benefits by $35.

     In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits entities to choose to measure certain financial instruments and certain other items at fair value in order to mitigate volatility in reported earnings. SFAS No. 159 was effective as of April 1, 2008. We have determined not to change how we measure financial instruments and certain other items covered under SFAS No. 159.

     In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities to enhance disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We do not believe the adoption of SFAS No. 161 will have a material effect on our consolidated financial statement disclosures.

Off Balance Sheet Arrangements

     We did not have any off balance sheet arrangements as of September 30, 2008 or 2007, other than operating leases.