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Executives

Deborah Pawlowski - Investor Relations

Jim Lines - President and CEO

Jennifer Condame - Chief Accounting Officer and Controller

Analysts

James Bank - Sidoti & Company

Graham Corp. (GHM) F2Q09 (Qtr End 9/30/08) Earnings Call November 4, 2008 8:30 AM ET

Operator

Greetings and welcome to the Graham Corporation second quarter 2009 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Deborah Pawlowski, Investor Relations for Graham Corporation. Thank you, Ms. Pawlowski, you may begin.

Deborah Pawlowski

Thank you, and good morning everyone. We appreciate your joining us today on Graham Corporation's second quarter fiscal 2009 financial results call. On the call I have with me today Jim Lines, President and CEO of Graham Corporation and Jennifer Condame, Chief Accounting Officer. They will be reviewing the results of the second quarter and progress on the company's strategy. You should have a copy of the earnings release that was released yesterday, and if not, you can access it at the company website www.graham-mfg.com.

As you are all aware, we may make some forward-looking statements during the formal discussion, as well as during the Q&A. These statements apply to future events and are subject to risks and uncertainties, as well as other factors that could cause actual results to differ from what is stated here today. These risks and uncertainties and other factors are provided in the earnings release, as well as other documents filed by the company with the Securities and Exchange Commission. These documents can be found at the company's website or also at www.sec.gov.

With that, let me turn it over to Jim.

Jim Lines

Thank you, Debbie, and good morning everyone. I will talk briefly about our progress year-to-date, the current economic environment and its immediate effects, and the longer-term outlook for our markets, then turn it over to Jennifer Condame, our Chief Accounting Officer to provide greater detail on the quarter and year-to-date financial information.

I am pleased that at mid-year revenues are up 20% to $51.6 million, net income is up 42.6% and earnings per diluted share are $0.99. Gross margin is 44.1% for the first half and our backlog is healthy $69.7 million. There has been movement in sales by product or by geographic location; however, that is routine. We did expect our second quarter to have a lower growth rate, which was indicated during our January conference call. Revenue was a solid $23.9 million. Gross margin held at an elevated level of 43.9% and net income came in at $4.4 million, or 18.5% return on sales.

The productivity gains from our capital investments and new equipment for production, along with ongoing investment in information technology, workflow improvements, and the commitment of our employees to become a faster company, are expanding both our capacity and our margins. There is more work to be done in these areas and our employees continue to adhere to our timelines.

Turning to the markets, and the current economic environment, I can indicate that quotation activity remains high, our sales and application engineering areas are busy and we see a lot of opportunity in the pipeline. Our engineering contractors and turbomachinery OEMs are indicating their quotation activity is robust as well. However, they are affected by what is occurring in the financial markets and the price of oil, along with metal commodity prices.

We have seen a slowing or hesitation by our customers to commit to new orders. Bookings this past quarter were down considerably and totaled $17.5 million.

We believe the third quarter bookings may be light as well. We acted proactively when the markets began to change and sales management had close contacts with our customers, the end users, engineering contractors and key OEMs. We gain an understanding of how they are affected and responding to the current market conditions.

The general feedback is, it is too early to fully understand the impact of the change in the credit markets. We believe the long-term outlook remains unchanged. Energy demand is increasing globally and investments have to be made for new capacity, the upgrading of existing facilities, or due to changing environmental regulations. We believe the energy markets will be robust long-term, but will show a pull back in the short-term. Major integrator refiners and nationalized oil companies are affected differently by the credit markets.

This customer segment has self financed projects due to the financial strength and strong operating cash flows. Independent refiners and non integrated petrochemical companies are directly affected by the credit pull back. We began to see project slow downs from this customer segment and the suspension or cancellation of projects that were in the bookings pipeline a while back. Independent refiners are important to us however, they have represented in the past, 5% to 10% of revenues annually.

Project management and the credit groups added quickly to evaluate each major contract in our backlog. We get a clear understanding of our current cash position, how much money has been spent by the company versus what has been received as customer advance payments, to determine the amount of outstanding receivables and payables, we carefully review contract language for cancellation provisions in each contract and talk to our customers to understand the project pace, the risks, and if there will be delays.

We believe our backlog is secure and of high quality based on the analysis that was done. A couple of projects have slowed and deliveries schedules pushed out. In all cases, the customers have indicated the projects will be completed, we will however continue to monitor this closely.

We are seeing, as I previously noted, a slowing in our markets. Long term fundamentals remain unchanged and confirming prior full year guidance that the revenues will expand 15% to 20% from last year, a new caution that we expect now to be near to the end of the range.

Gross margin guidance remains in the 39% to 42% range for the full year. It is too early to comment on fiscal 2010 other than to indicate, we are seeing a slowdown for new order rates, however, quotation activity is robust and at high level.

That many projects were in the pipeline that we are now coding and tracking. I will now turn it over to Jennifer.

Jennifer Condame

Thank you, Jim. For the second quarter of fiscal 2009, which ended September 30th, 2008, we reported net sales of $23.9 million compared with $23.1 million in the second quarter of fiscal 2008. Strong sales of our condensers, heat exchanger, pump package and after market product lines were mostly offset by a decline in sales of our ejector systems.

Condensers sales increased 24.1% in the second quarter of fiscal 2009 to $5.1 million and were 21.4% of total sales. While heat exchanger sales increased to $3.1 million, a 35.5% year-over-year increases to contribute 13% of total net sales. Both pump packages and after market sales increased due to three large refinery projects.

Pump package sales increased to $2.6 million in the second quarter of fiscal 2009 or 11% of total sales, compared with $0.5 million in the second quarter of fiscal 2008. After market sales were 17.6% of total sales or $4.2 million in the second quarter of fiscal 2009, compared with $3.9 million in the same period the prior fiscal year.

Ejector systems sales declined to $8.9 million in the second quarter of fiscal 2009, down from $12.3 million in the second quarter last fiscal year. As a reminder, due to the large magnitude of the orders we received and the timing of the shipments, quarter-to-quarter fluctuations are common.

By industry, sales for the refining sector were $11.1 million or 47% of total sales in the second quarter of fiscal 2009 compared with $12 million or 52% of sales in the same period the prior fiscal year.

Sales were 27% for the chemical and the petrochemical markets, 8% for the power sector and 18% to other industrial applications in the second quarter of fiscal 2009. The portion of sales coming from international markets increased in the second quarter of fiscal 2009 to 37% compared with 33% in the same period the prior year.

We believe international sales will continue to grow and comprise a greater percentage of our total sales through the remainder of fiscal 2009, and into 2010. As a pre six months review, sales for the first half of fiscal 2009 increased 20% year-over-year to $51.6 million. Product trends in the first half were similar to the second quarter. The ejector systems sales were down while condenser, heat exchanger, pump package, and after market sales all increased in the first six months of fiscal 2009 compared with the first half of fiscal 2008.

We received $17.5 million of orders in the second quarter of fiscal 2009 down from $20.5 million in the same period the prior fiscal year. In the quarter, orders for ejector systems increased $2.1 million year-over-year. However, this increase does not upset the decline in condenser and pump package orders.

International orders grew larger comprising 48% of total orders in the quarter, up from 42% in the second quarter of last fiscal year with the increase primarily coming from Asia. For the first six months of fiscal 2009, orders were $45.3 million compared with $45.4 million in the first six months of fiscal 2008.

Significantly higher condenser and heat exchangers orders were offset by relatively flat ejector orders and decreases in pump package and after market orders. International orders were strong in the first half of fiscal 2009 increasing to 59% of total orders to $26.5 million compared with 29% or $13.2 million in the first half of fiscal 2008.

At the end of the second quarter, backlog was $69.7 million up 23% compared with $56.8 million at the end of the second quarter of fiscal 2008. We believe that virtually all of the backlog will be converted to sales within the next 12 months.

With that I will now review the operating performance for the quarter and six month period. Gross margin was again strong in the second quarter at 43.9%, compared with 42.9% in the second quarter last fiscal year and higher than the guidance we have previously disclosed, due to the mix of higher margin projects and continued gains in operating leverage.

For the first six month gross margin was 44.1% in fiscal 2009, and 38.5% in fiscal 2008 with higher after-market sales in the first quarter contributing to the favorable product mix. We expect gross margin to moderate in the second half of the fiscal year and the full fiscal year margin to be in the range of 39% to 42%, reflecting the orders into the backlog and declining material prices.

SG&A expenses were $3.9 million or 16.4% of sales in the second quarter of fiscal 2009, up $23.4 million or 14.9% of sales in the same period last fiscal year, although flat compared with expenses of $3.8 million in the first quarter of fiscal 2009.

Consulting costs were incurred in the second quarter, which are expected to contribute to greater efficiencies in IT, engineering and manufacturing. For the six month period, SG&A was $7.8 million or 15% of sales in fiscal 2009 and $6.5 million or 15% of sales in fiscal 2008.

Higher sales commissions and variable compensation contributed to the six months increase in expenses. We expect SG&A expenses to be 15% to 16% of sales for the full fiscal year. Interest income was a $172,000 in the second quarter down from $264,000 in the second quarter last year, due to the falling interest rates and a change in our internal investment policy to invest exclusively on US treasury securities rather than both treasury securities and US sponsored agency notes.

For the six months period, interest income was $303,000 in fiscal 2009 and $494,000 in fiscal 2008. The effective tax rate was 34.5% in the second quarter of fiscal 2009 and 34% for the first six months. The rate is projected to be 33.5% for the full fiscal year.

Net income in the second quarter of fiscal 2009 was $4.4 million or $0.43 per diluted share, compared with $4.4 million or $0.44 per diluted share in the same period in the prior year. For the six months period, net income was $10.1 million or $0.99 per diluted share for fiscal 2009 and $7.1 million or $0.71 per diluted share for fiscal 2008.

The per share data reflects the two-for-one stock split that was effected on October [6th] for stockholders of record on September 5th. At their meeting yesterday, the Board of Directors declared a quarterly cash dividend of $0.02 per common share. The dividend will be payable on January 5th, to stockholders of record on December 1st.

Cash, cash equivalent and investments were $42.9 million at the end of the second quarter of fiscal 2009, up from $36.8 million at March 31, 2008. There were no borrowings on $30 million revolving line of credit at the end of the second quarter and $8.8 million of outstanding and letters of credit.

Net cash provided by operating activities was $4.4 million in the first half of fiscal 2009, down from $9 million in the same period last fiscal year, due to higher working capital requirements from an increase in accounts receivable, due to timing of customer billings, higher inventory and a $3.5 million contribution to the pension plan.

Capital expenditures were $576,000 in the second quarter and $795,000 for the six month period of fiscal 2009, up from $284,000 and $447,000 in fiscal 2008 respectively.

We expect capital spending to be in the range of $1.8 million to $2.2 million for the full fiscal year.

That concludes my remarks. Jim I will turn it back to you.

Jim Lines

Thank you, Jennifer. Operator, you may open the line now for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Thank you. Our first question is coming from the line of James Bank with Sidoti & Company. Please go ahead with your question.

James Bank - Sidoti & Company

Hi, good morning.

Jim Lines

Hi James.

James Bank - Sidoti & Company

My first question is on SG&A. I think that was for the biggest alarm to me and biggest disappointment in the quarter. Why was the expense so much materially higher than it was in the first quarter on a percentage of sales basis?

Jim Lines

The SG&A has a component that is tied to the profitability of our orders, which is commissioned in variable compensation and that is the biggest effect that caused the increase, that is been the profitability of our work, linking the margins that is 44.4% and we had some resulting expenses as well.

James Bank - Sidoti & Company

Okay. So, given the fact that the gross margins are relatively similar, despite the fact the sales were down, the profit share will still remains static, more or less?

Jim Lines

More or less.

James Bank - Sidoti & Company

Okay. Fair enough. Thank you.

Jim Lines

You are welcome, James.

James Bank - Sidoti & Company

Jim, if you would quantify the hesitation of the larger order placement?

Jim Lines

Sure. We began to see some slowing a few months back from our customers. We have commented on several conference calls, going back over last several quarters the difficulty we had in predicting when orders would be placed by our customers. We commented in the past that some orders that we thought would be booked in a particular quarter, actually still are open to be won several quarters later, or were we booked two or three quarters after we thought that should be booked.

We have noticed that there has been a slowdown as our customers are taking – a certain segment of our customers are taking a wait-and-see attitude. Other customers, I would say, the independent refiners have had to change their capital spending plan in light of what is occurring in the credit markets. I commented in the prerecording that the previous independent refiners they are important to us, for they have in the past represented between 5% and 10% of sales to our integrated customers or the nationalised oil refiners. They really have not seen the credit market affecting their long-term spending plan. Although, I would say we have seen a pause or I believe a temporary delay in order placement.

James Bank - Sidoti & Company

Okay. So, if I had to quantify it, probably in the ballpark of $1 million to $2 million then, is that fair to say for these independent refiners?

Jim Lines

You are trying to quantify the delay within the quarter for the bookings?

James Bank - Sidoti & Company

Yes.

Jim Lines

Well, we are a lumpy business and we talked about that in the past. We were expecting a couple of larger orders to be placed in this quarter, I am sorry, the quarter that just ended. However, they have carried into a subsequent quarter, the quarter that we are in now. We expect to book them in our third quarter. So, some of it is timing James…

James Bank - Sidoti & Company

Okay.

Jim Lines

As we have talked about before.

James Bank - Sidoti & Company

Okay. The aftermarket orders, certainly very good in the second quarter again like the first, and what is the driver behind this if there is one?

Jim Lines

A driver that we have been made aware of is just the strong compelling argument to keep a refinery running. We have seen our refining customers make purchase decisions for capital spares that we hadn’t seen them make in the past. The rationalization they were giving to us is, what is most important to them is assuring on-stream performance from a turnaround for the next five years.

They can not afford an unscheduled turnaround, because of the financial implications of that. So they have had a different purchasing pattern then we have seen in the past, favorably affecting us. That is just due to the strength and the importance of keeping the refinery on-stream.

James Bank - Sidoti & Company

Okay. You know Jim, I am sorry, I actually had just another question on the orders.

Jim Lines

That is fine.

James Bank - Sidoti & Company

When I went back and looked at it historically and what you have done since your fiscal 2000 year, when I looked at the year-end order number and then looked at the subsequent year end sales, it is pretty much identical. I think there is just one year there where your year-end sales were a little bit lower than what you had started with in terms of orders.

If we go to the lower end of your top line guidance range, that number will be now I believe lower than what your year end orders were, when you finished fiscal ’08. Is this just a cautious tone we need to take in this type of environment given what we have seen, or is there something really underpinning that, that you are not targeting that lower end of your top line guidance range?

Jim Lines

You are right. Looking back there was almost a correlation of one between bookings of the prior year, sales of subsequent year. This year however, we are seeing projects extended by our customers. The delivery cycle in the past had been 8 months to 12 months from order to shipment for a major contract. Today and as we have talked about in prior conference calls the schedules are nearer to 12, 15 or in some cases 18 months. I do not view this as a capacity constraint for our business; it is a pacing of project execution by our customers.

James Bank - Sidoti & Company

Okay, that is very helpful. Lastly the inventory and I apologize if this is covered in the prepared remarks. Not a considerable amount, but certainly higher than what I would spend in the past, and that took a double tick also because the commodity prices have come down, so considerably. So what is in that inventory right now?

Jim Lines

With what was happening with our customers and again going back to delays (inaudible).

James Bank - Sidoti & Company

Okay.

Jim Lines

To order business, and there is starts, there is stops, there is engineering change orders that are coming deploy. We felt we were coming into an environment where we would have more of that, so we actually proactively increased our inventory to give us production continuity and flexibility, and that showed up in our [wip] and that showed up in our inventory number. That will work itself out, but that was a proactive decision by management to maintain production continuity.

James Bank - Sidoti & Company

Okay, fair enough. Thank you, Jim. I will jump back in line.

Jim Lines

You are welcome, James.

Operator

(Operator Instructions). Our next question will be coming from the line of (inaudible) with Gilford Securities. Please proceed with your question.

Unidentified Analyst

Thank you. Jim I was just wondering with the pullback in the price of oil, how has that affected certain projects? Like I know you are looking more things were happening up the oil sand in Canada, any thing on the outlook in terms of near term impact with pricing and then long term demand outlook?

Jim Lines

Okay, that was a great question. I would say we are in our second year of project delay that we are seeing in the Alberta oil sands area. Not so much tied initially to the price of oil, more to the ability to execute the contracts.

The contractors, the EPCs in that region, the construction, the availability of human capital to execute the contracts were in short supply. So they have had to slow down those projects at the same time that the costs of the project were escalating very quickly.

I just want to put this in context. We look at the oil sands as a scenario that we will continue to invest, and when we look at the first 1 million barrels per day of oil that was brought on stream, that was a turn between 1996 and 2006. If you think in terms of what oil was then, it was between $15 a barrel in the mid-90s up to $50 to $60 a barrel in 2005 and '06.

We know the refiners today because of the cost of the projects, I hear its somewhere between $70 and $85 per barrel for the economic analysis of the project viability, because the cost of the projects have doubled. We still see the oil sands as an area where investments will be made.

If you look a the investments that are going on in the petroleum administrative district too in the US, they are making significant revamps to US refineries, in preparation to be able to process and (inaudible) its going to be produced in Alberta. Coming from future investments, we see this as a timing issue, we think the breakeven for those projects is below where the price of oil is today. We believe however that there is a timing issue and we are looking at a second year of delays.

Unidentified Analyst

Okay, what you think that breakeven point is?

Jim Lines

Well as I mentioned, we know they are looking at somewhere between [$70], $85 a barrel, that is what we are being told in the economic analysis, primarily because the cost of the projects have doubled. When we think in terms of what occurred in '95 through 2004, those projects were in the ballpark of $5 billion to $8 billion. Today we are hearing numbers that are between $12 billion and $18 billion for the cost of the project including the mining and upgrading. So they are using higher price or the price of oil and their economic analysis to take some of the risk away.

Unidentified Analyst

Okay. Jim another question on another topic. You have used this cycle to beef up the balance sheet, you got more cash than you have ever had in your history, you have more share outstanding and actually you have more liquidity than you have had.

You have mentioned M&A possibilities for the company, and you have had a certain pullback here in the economy and then the price of oil. Has that created an opportunities for what is your strategic thinking and what is the landscape in terms of potential acquisitions or any type of M&A activity for you.

Jim Lines

To be (inaudible) my strategy for the business has not changed. Our plan is to double the size of our company over the next three to four years, three to five years was our initial timeline, during that [throughput] organic growth as well as acquisition growth. I see what is happening in the marketplace as painful as it is as an opportunity. We are going to continue to do what we do well, which is improve our current company and use the strength of our balance sheet, the strength of our brand to look at external growth options as well.

Unidentified Analyst

Okay. I am just pushing a little bit, just being a little more specific in terms of the type of opportunity that you are seeing there that you could take advantage of.

Jim Lines

Well, I think it is still a little early. The valuation, we believe for the businesses that are selling into the energy sector still are high. Given a couple of quarters depending on the severity of the pullback, I think there will be some opportunities in front of us in subsequent quarters. To give you an idea of what our thoughts are regarding acquisition criteria, the acquisition size would be below $100 million, it would be engineered to order products that fit our brand, that are in the energy sector.

Now in the energy sector, we are not just talking about oil refining and petrochemical. We are talking about power generation, alternate energy, [waste] energy, geothermal, areas where the Graham brand is exceptionally strong, where differentiated solution can be sold at a premium and that is what we do well. We will look to expand our geographic market presence, perhaps a geographic footprint and diversify our products.

Unidentified Analyst

Okay, very good. Thank you, Jim.

Jim Lines

Welcome.

Operator

Thank you. (Operator Instructions). Our next question is a follow-up from the line of James Bank with Sidoti & Company. Please go ahead with your questions sir.

James Bank - Sidoti & Company

Hi. What was the percentage of subcontract work in the quarter?

Jim Lines

It was around 6%.

James Bank - Sidoti & Company

Just 6.

Jim Lines

Yes.

James Bank - Sidoti & Company

Okay. Are you going to revise, is it going to be the 12 to 13% for the full year still or is it maybe down from there?

Jim Lines

In our earnings release we have guided to a number in the range of 8 to 10% .

James Bank - Sidoti & Company

I am sorry, missed that.

Jim Lines

That is okay. We had actually entering the quarter we had forecasted a higher level of subcontracting, but as is the nature of our business, within a quarter, things happened that caused projects to be delayed. We had a large projects that was going to be built, that will be built in China, was to commence in the quarter that just closed.

However, due to delays, it is been pushed out to be commenced in the quarter we are in now. So we are expecting a higher level of sub-contracting, but due to the timeline of that project there were some changes, and in addition, we have had a slowdown caused by engineering change orders for a US based refiners, two very large vacuum pump packages that have not been able to kick off because of the engineering flux between us and the contractors. So we were anticipating a higher level of subcontracting, but due to the nature of our business, we came in at 6%.

James Bank - Sidoti & Company

Okay. So if they would, I did catch in the press releases, the SG&A as a percentage of sales guidance of 15 to 16%, so with that I can assume higher profitability in the back half, especially if you have less subcontracted work. So, can we than assume that maybe your gross margin will be on the higher end of the 39% to 42% range?

Jim Lines

I would maintain that would be between 39% and 42%. However, remember what I just said, our Chinese project will have subcontracting in Q3 and Q4…

James Bank - Sidoti & Company

Right.

Jim Lines

So also, other subcontracting in our work as well to bring us between 8% to 10% for an average for the whole year, I would caution that will be around the midpoint to the lower end.

James Bank - Sidoti & Company

Even with the assumed profit sharing in the back half of the year?

Jim Lines

Yes.

James Bank - Sidoti & Company

Okay. All right, thank you, that is all I have.

Operator

Thank you. (Operator Instructions). Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Jim Lines

Thank you. I would just like to reiterate that our backlog is strong, at a near record level. We have taken steps to evaluate the quality of our backlog and any execution risks that there might be. Our quotation pipeline is robust, and is still at a very high level. Our research and discussions with the end-users and the contractors has concluded that the long-term growth prospects for the energy sector are unchanged.

I am confirming that our prior guidance of revenue growth between 15% to 20% and gross margin between 39% and 42%. Our managers and employees are continuing to execute our business improvement initiatives, and they are having a positive effect on our operating results.

The company’s balance sheet is excellent. We are carrying no debt, our pension assets are in good shape, cash utilization efficiency is excellent, and our cash and investments on hand are just under $43 million. Thanks to the hard work of our managers and employees, Graham is in excellent shape.

I look forward to updating you on our progress during the January conference call. Thank you.

Operator

Ladies and gentlemen this concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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