Graham Corp (GHM) 2007 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Graham Corporation second-quarter 2007 conference call.

During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in a question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this call is being recorded.

I would now like to turn the conference over to Deborah Pawlowski, Investor Relations for Graham Corporation. Please go ahead.

Good afternoon, everyone. We appreciate your time with us here today.

You should have a copy of the news release that we put out Friday morning. If not, you can obtain it at the Web site, Graham-mfg.com.

I have here with me today Graham's President and Chief Operating Officer, Jim Lines, and its Chief Financial Officer Ron Hansen. Jim and Ron are going to provide their planned comments and then we will open it up for questions.

I do want to comment that I apologize actually for putting the release out Friday morning instead of just this morning. I show that we could have responded more quickly with information to the marketplace, but we had conflicted interests regarding setting the information out, because obviously the information was different than what was expected, and with timing of our availability, etc.

So with that, let me turn it over to Jim to begin the review and discussion.

Thank you, Debbie, and thank you, everyone, for taking the time to join us today. I am disappointed in the results for the quarter, just as I am certain you are. Let me review with you the events in order that resulted in lower-than-expected revenue.

Core profitability had led us to lower our expected revenue for the year to 65 to 70 million. First, the Batavia operation is running at full capacity. Even as we are expanding capacity, we remain at full capacity.

Second, we had to pull back into our Batavia operations a significant project planned to be built in Asia. Some of the work is being built in Asia. However, the majority of production hours were pulled into our plant. That was due to the ultimate customer wanting certain equipment built in our plant. Previously, planned Batavia production hours could not get outsourced quickly enough to offset this added work.

Third, as we began to mobilize our North American outsourcing strategy, there were execution problems due to two reasons. One was sourcing quickly North American manufacturing capacity to counter pulling in approximately 10 to 15% of one quarter's production capability due to the Asian project just mentioned. The second was certain customers, refining customers in particular, were resistant to having equipment outsourced. They wanted Graham-built equipment and were prepared to push out delivery schedules to wait for it.

Fourth, the (technical difficulty) only contracts that we discussed last quarter were set to be completed in the quarter. The they were changed to full production contracts as these customers became concerned and placed orders early to ensure they had manufacturing capacity lined up for their projects. These contracts were about $500,000 in planned revenue for the quarter. We did not lose the revenue but because the customers ended up booking whole manufacturing orders, revenue will be recognized on a percentage-of-completion basis. The total bookings we gained from these contracts was about $4.5 million. Someone asked, on the last conference call, about our degree of comfort in getting the manufacturing piece of the order. Well, I can confirm they have come through.

Fifth, we encountered production inefficiencies that came from overloading Batavia operations when work was pulled in and it wasn't possible to off-load the plan quickly via outsourcing. The overloaded created strain in plant operations that led to a reduction in productivity.

That gives a high-level review of why the quarter performance was below expectation. I now want to discuss why the full-year guidance is lowered from 75 to 80 million, down to 65 to $70 million. Customers in China and elsewhere in Asia are not placing equipment orders as initially planned. The delay has been three months in most cases and longer in others. The anticipated China orders in particular were planned to involve mostly local manufacturing and not create production loading for our Batavia operations. With Batavia running at full capacity, it is impossible to put more work into our plant until capacity is expanded. Going forward, North American outsourcing is gearing up, we believe, and its benefits begin in the latter part of the third quarter and into the fourth quarter.

We feel revenue in the second half will be up approximately 20% compared to the first half. About half of this gain will come from outsourcing in North America. The other 10% capacity gain is through expanding the production workforce and productivity improvement that follows from leveling the production load in our plant. We have a plan in place to outsource approximately 10% of the production hours in the second half. One-third of the orders for outsourcing are now placed, and we're sitting up the remaining two-thirds. We believe we will hit the outsourcing target, having now established the team, and work through the executional problems experienced with rapidly mobilizing our North American outsourcing plan in the second quarter.

Obviously, the next question is what is beyond this 20%? We will continue to expand North American outsourcing due to the unclear order timing in the Asian markets. During this robust market, quoting North American outsourcing to 10% of Batavia production hours is what we feel is achievable. In addition, we continue to increase Batavia plant personnel and invest capital in the operations that will increase throughput. Our capital plan this year involves investment that is planned to expand production capacity 4 to 6% during the next fiscal year. In addition, process improvement and facility layout will provide added throughput. The order rate is strong. We believe our markets will continue to be robust beyond next year. Clearly, with bookings going to 20 million per quarter, we have to ramp up our growth to meet demand without creating an infrastructure that we will have to pay for in a less-robust cycle.

Topline growth and volume growth are not the same. We grew 10 to 15% in volume in both fiscals '05 and '06. Our unit of measure is labor hours or production. Our topline expanded an additional 10 to 20% over the volume increase due to material cost increases primarily, as well as due to pricing.

Backlog was at 45 million. There has been no indication of slowing in demand. In fact, as mentioned before, what we are seeing are customers putting in orders earlier in their process. Our limits right now are the throughput in Batavia, the extent we are committed to outsource in North America, and the pace of Asia work where local fabrication applies.

I continue to address Batavia throughput with staffing, capital investment, process improvement and workflow. We had a slow gearing-up for North American outsourcing. However, that is corrected, and the benefits will be demonstrated in our third quarter and certainly in the fourth. The Asia plan is solid, even though project pace and order placement is unpredictable in China. Asia remains an important element of our growth platform.

You're probably wondering about engineering capacity, how we're doing there. As the release mentioned, we have added additional capacity through contract engineers and continue to try to find a partner for outsourced engineering that could meet the demands of our very particular customers. We continue to seek the right partner that can assist with our type of equipment and our customer requirements. However, we have not identified a suitable partner that would not create an unacceptable drain on our engineering resources.

Our investing and automating the engineering process continues. We are making progress and in a previous call, I noted the project schedule has completion set for January 2008. We are advancing this where possible and adhering to the timeline.

Looking below the top line, we had a gross profit margin of 20% on 15.9 million in sales. Yes, we've done better on that level of sales, so let me help you understand what happened and what it means going forward. There were material cost increases plus higher engineering costs and production inefficiencies that had an impact of around 4% or so. We also had an expected loss on a job that had to be recognized in the quarter of $329,000. Only the loss has been reserved. The remained of the job, that will be sales and equivalent costs, will continue to flow through the income statement on a percentage-of-completion basis at 0 gross profit. There's no intention to win that type of order again. We did review the quality of the backlog and believe this is the only order that will require a loss provision.

Recognizing that total sales for the year were going to be lower as a result of the quarter and the extent of outsourced Asian fabrication now possible, we immediately took measures to cut SG&A. Previously, we have said that we expect SG&A to be in the $12 million area. By our cuts, we anticipate spending to be somewhere in the 10 to $10.5 million range. Operating margin for the full year should be in the range of 9 to 11%.

When a trend in the second quarter is disappointing, we have addressed it. We see no reoccurrence in coming quarters. The second-half performance is planned to be markedly above the first half. We are optimistic about next year.

Ron, you are up.

Thanks, Jim.

Sales for the quarter were up 13% to $15.9 million over last year's second quarter and up from sales of $14.6 million in the first quarter of this fiscal year. For the first half, we are at $30.5 million in sales, an increase of 18% over last year. Our gross profit percentage for the quarter was 20%, compared with 33% for the quarter ended one year ago.

Material cost are the single greatest component of the cost of goods sold; it has the most variability. Material costs have been running at about 42% of sales year-to-date. Material cost vary and have been in the 35 to 47% range within the past 12 months. A large job with 45% material cost produces a lower contribution margin percentage but can contribute greater gross profit dollars, thus increasing our operating leverage. We deal with material costs by monitoring the pricing trends when bidding on new business and placing material orders as quickly as possible after winning the bid. But keep in mind, our proposals could have been on the table for three to four months before we actually win the order and in backlog awhile before detailed engineering is completed and all material specifications are known.

Revenue we recognized in this quarter were for orders won about six to nine months ago and constructed with materials that were purchased anywhere from four to five months back, up to a couple of weeks before final fabrication. It all depends on the job and its requirements.

Another component of our cost of sales is engineering costs, which makes up about 7% of our cost of sales. These costs remained at about 5.6% of sales year-to-date over year-to-date last year but up 20%, or $294,000 in absolute terms, as a result of needing contract workers to process our exceptionally large backlog, which stood at $45 million as of September 30. These items, together with some plant inefficiencies and a $329,000 loss provision on one job in-process, resulted in a 24% first-half gross margin percentage, compared with 31% for the first half last year.

SG&A for the quarter was $2.4 million or about 15% of sales. For the first half, SG&A was about $4.8 million or 16% of sales. We expect SG&A to remain in the 15% range for the second half of the year, which is down about 18% for the year from our budget due to cost savings programs enacted.

The effective tax rate year-to-date was 37%. We expect the annual rate to be in the same range. In the current quarter, we adjust the year-to-date rate to reflect our annual expectations.

Net income was $563,000 for the quarter compared to $1.35 million last year. The lower earnings this quarter are due to lower margins. For the first half, net income was $1.7 million, down $374,000 or 18% due to the second-quarter results.

Cash used by operations (indiscernible) $10.4 million to cash provided to cash used year-to-date, compared with the six-month period ended September 30, 2005. The swing was primarily due to greater working capital relating to increased Accounts Receivables and unbilled revenue. These balance sheet items increased largely due to negotiated sales terms. Additionally, we used $2 million in cash to fund our defined benefit pension plan. We believe cash from operations will be positive for the year.

Capital expenditures year-to-date were $668,000. We believe CapEx will be in the range of 1.4 to $1.8 million for the year. CapEx will be focused on office and plant capacity expansions through greater IT automation and additions to our manufacturing equipment.

Jim, back to you.

Thanks, Ron. Operator, I will open it up now for questions.

Thank you. (OPERATOR INSTRUCTIONS) [Paul Carpenter], [Samafour] Management.

I'm curious about why you are concerned about cost-cutting in SG&A; that's typically not something I would expect of a company that is growth-constrained. Can you comment on that?

Paul, we took a look at our SG&A and the discretionary spending in that area itself. We needed to lower it as we looked at a reduction in our topline. We weren't spending, in the SG&A area, at this point to develop sales and Asia, which is for the funding was going to the extent that we had planned because the orders just aren't materializing as quickly as they were planned. The China were slowing down; the Asia work in general is slowing down. And we felt it was appropriate at this time, in light of that slowdown, to back off somewhat in our SG&A area.

So, it would be fair to say the reduction in SG&A is all, has all to do with marketing expenditure and such in China?

It has to do with marketing, advertising in general, China, Asia to a certain extent.

To domestic, the domestic reduction would be because you just don't have the capacity to take those additional orders?

Correct.

Okay. Could you talk a bit more about the job where you took the loss, the loss provision?

Sure, absolutely.

What kind of job it was, why you were unable to get the kind of returns on the job that you expected?

Okay, Paul. That was an order, to be quite candid, that we didn't need to take. It was poor-margin major order. We needed to be more selective and adhere to our normal margin decision policies. That wasn't done, and now we have to work a poor job through our backlog and get it through to shipment in the fourth quarter. We took the loss provision of around 329,000 in the second quarter. As we described, the remainder of the year, the job will be processed on revenue recognition, percent-of-completion at 0 gross profit. What occurred is we chased our Italian and Korean competitors to a low price. We won the order. It was at a premium versus the Italians, but still it was a poor decision. We don't routinely take orders like that. This was the first I've experienced in 22 years with the Company. And Paul, I have no intention to take another in this current marketplace.

Was it an order to try to win business in Asia?

It was an order with (indiscernible) machinery OEM for an ethylene plant that is or will be in Saudi Arabia.

Okay. Was that business you were anticipating for thawing out at your Asian operations?

No.

It's the Batavia business?

It is Batavia business; that's right. That particular customer base, the ethylene market or the Middle Eastern petrochemical customer base, they will not permit Asian manufacture. They want a Graham-built product, Graham USA-built product.

Okay, thank you. I just have one final question. It has to do with your balance sheet. Your capital expenditure requirements are very, very limited, given your liquidity in the balance sheet and your ongoing anticipated cash flow. It's for quite some time now. I realize the industry is very cyclical and you've been through some significant ups and downs over the years but you have a large amount of cash on your balance sheet, a stock that is down significantly, at least from where you last did the equity offering. What is your intent for that cash? How can you add value for the shareholders, given that the stock has been hit pretty hard but yet you expect good things going forward and the backlog seems to be increasing?

Okay, that's a great question. What we historically had done, with respect to CapEx, was kept it around depreciation. As we are in this growth period, last year, this year and going forward while we are growing, our plan is to spend more, to invest capital in Batavia, balance our competing need for the capital interests of Batavia with capital that might be needed in our Asian operation. Right now, our plan, as I mentioned in the conference call earlier, was between 1.4 and 1.8. Our capital plan actually is 1.84 for this year, which is roughly two times depreciation. It is our intent, Paul, to put capital into the business, to expand our capacity to enable us to push the top line as well as improve our cost basis, but right now, it is to gain capacity.

Fair enough, but that would still leave you with an ample excess cash position on the balance sheet for the foreseeable future.

Yes.

Any, has there been any discussions amongst yourselves or with the Board as to how you could improve the returns to shareholders by using that cash for a stock buyback or ways to return the value to shareholders through other means?

We have had discussions at our Board meetings to that effect. We are continuing to look at opportunities to increase shareholder value. There are a variety of ways to do that, but that is a discussion that we have had and we've talked through a number of facets surrounding that. We are continuing to have those discussions. I am not at Liberty to go into detail about any one in particular, but we're having those discussions.

Fair enough. Thank you.

[Philip Richter], Ingalls.

Hi, Jim. Just a quick question on a comment you had regarding the refining customers who were resistant to non-Graham-built equipment. Could you further elaborate on that? And could you indicate whether this could be a problem going forward with the outsourcing strategy, as much of your revenue is dependent on the refining sector? Thank you.

Sure, Philip. It's very interesting. We hadn't seen this before. We've been selling to the refining sector for a long time, and we've also outsourced in certain times, in the mid '90s when it was very busy. We've seen a change in attitude with our refining customers, particularly in North America, where it's good news and bad news. They want a product built by Graham, and what we're going through right now is we are having discussions with these different refiners. The contract terms may allow that, but they are really leaning on us hard saying, we want you to build it; just tell us when you can ship it. If we need to delay delivery six months, that's fine. We want your product. That's a change that we hadn't seen before, where schedule was paramount and they allowed subcontracting. So we are seeing a little change here with respect to we mentioned that the projects are being released earlier to the manufacturers, which gives them more liberty to take receipt of the equipment. But what's really that makes us proud is they want our product. They don't want anyone else's product, even though it would be built to our design, under our quality surveillance. They want the Graham product, and we hadn't seen that in the past.

Again, I would just characterize that as a North American refining problem that we've just begun to see. We are not seeing it in Asia, per se with our Chinese customers, but it's unique to the North American refiners such as ExxonMobile or shell or Chevron. They are our very good customers, so we're listening to them; we're trying to negotiate with them. But when they are indicating we will take it when you can get it done, we just want you to build it; that's a change that we hadn't seen in the last up cycle of the mid '90s.

Thank you.

Michael [Hiebert], Axiom Asset Management.

Yes, Jim, just so I'm clear, when you refer to North American outsourcing, I assume that you're referring to business that is to be delivered into North America and is outsourced to a partner who is also located in North America.

To a large extent, Michael, that is correct. We have, for the Asian work, work for China, that was to be built, for example, in Asia or in China for delivery to the Asian customer. That work hasn't materialized as initially planned. We have ample demand for our products here and in the Western Hemisphere, so it's more of a Western Hemisphere-type strategy, a North American-type strategy, where we are going to North American fabricators for those projects where we can and have them subcontract for delivery, largely, Michael, to North America.

Okay, thank you.

(OPERATOR INSTRUCTIONS). George Walsh, Gilford Securities.

Just a question, in terms of the capacity and meeting the demand, you know you've made the technology investments in the IT. Is it a question of the engineering productivity hours involved, and, or is it more on the actual manufacturing side with the products? How much of this is actual added man power versus further developments or deals to be gotten out of technology investments you've made or will make in the future?

Okay. Well, we still have those two key issues, George. One is expanding our engineering capacity, and we are attacking that on multiple fronts. One is, I think as you mentioned, the automation piece. That is progressing more slowly than we had initially envisioned, but at the last conference call, I indicated to you we accelerated that schedule, and our plan is to have the automation piece providing benefit by no later than January 2008. To augment that, we've had to bring in additional staff to support the increased demand as well as run the teams harder with overtime.

Then the fourth aspect that, which was not yet provided benefit, is outsourcing engineering to low-cost areas. We have added, to our China team, three engineers. We did that in the second quarter. Our plan is to increase that to six engineers and put them through training and get them ready to help offload us. But that will take a bit of time; that's not immediate; that's not a third-quarter solution. But we are growing our China team to have technical assets there to help offload our Batavia engineers.

Then on the production side, where the present constraint is the fabrication side, is Batavia is running at full capacity. As I mentioned, we had to pull in a fairly large job that was planned for full fabrication in Asia, in Korea. And here too a North American joint venture partner came to us and said, we want these particular items built by you, by Graham. They were very insistent, so we had to make a decision of should we fight this or respect the wishes of one of our number one customers. So we pulled that work into Batavia, which wasn't scheduled, and that gave us an overload.

Our response to that was how do we get Batavia unloaded? That was our North American or that is our North American outsourcing strategy, which we are rolling out now. It was difficult to ramp that up quickly in the second quarter. We did have execution issues there with how quickly we were trying to do it, but it is moving along now. And it is our intent, George, to be at around 8 to 10% of our Batavia production is being outsourced in North America, excuse me.

Okay. Now, just moving through the -- you mentioned the Asian markets. One of the things you said in the release is the potential there versus some of the tighter gross margins. Is that something that is just going to be -- and then the benefits to be had from the outweighed by the potential in those markets versus the margins? Is that something that's just going to continue? And are you saying that the volumes will make up for any margin issues, or is it that you're going to be able to address margin issues in the future in the Asian market?

Well, the margin issue, we're going to have to address with costs of processing that type of project, and where the project will be built. The sales price, we won't have much leverage on driving that sales price higher. Those are highly competitive situations, more so than in North America. So carving out our costs to process that work, that's key. That speaks to having an Asian fabrication strategy in place, which that we are fairly comfortable with, and then supporting that with low-cost engineering, to work within the sales price available in that marketplace.

All right. Is there a certain ramp up and confidence in the Asian capabilities you have that's needed here so you can meet (indiscernible) cycle?

Well, we need to, as we spoke about, expand our engineering capacity in China. We have three onboard now; we want to grow that to six. Get them comfortable and capable of processing our type of work to unload our Batavia engineering team. And then work through the initial linearity side of a fabricated building our equipment. We have two contracts right now where some fabrication will be done by a Chinese fabricator. We've used Korean fabricators before, we've used Indonesian fabricators before. It's not something we're uncomfortable with; it's necessary, though, to work within the margin in the Asian market --to have that in place and running well. And that's what we're working towards now.

I was referring a bit more to your client themselves, your customers, their confidence level. I mean, you've had a bit of an issue with that here like you've mentioned this quarter. Is that something that -- you address that obviously while you are taking in some of the work, but you also need to -- your strategy is to do more of this than they do. You want to build up the confidence that your clients had in the work you're doing there.

Right, one of the aspects -- let's talk in particular about China -- is we are working off the China end-user approved manufacturers' list. We are going to the fabricators that they want us to use.

Okay.

So there, we are fairly confident, or we are very confident that the relationship that the fabricator already has with the end-user will support that sales effort. When we move outside China, where we've had Korea work or Indonesian work or business built elsewhere, that we have to work through. We're not uncomfortable with that; that's more common and more typical in the Asian market -- Asian markets.

Okay. Could you address the material costs a bit? It seems like they were also a large bulk of the change in your gross margins? Could you just kind of go into that in a little more detail what was going on there, and have there been any changes even since the end of the quarter?

Sure. Well, let me just first state that materials have been volatile, but with respect to our operating budget for the first six months, we are spot-on with what our material spend was planned to be -- within 2%. I think we are 2% under, 0.2% under the materials spend.

But what we are comparing to is a more costly materials environment versus 12 months ago. If we look at the roughly the $5 million increase in sales between the first half of '06 and the present first half, $3.8 million of that roughly $5 million is materials. Now, we've passed that material into the marketplace. We knew that is what it was going to cost us, so it was in line with our budget. But that does have a tendency to drive down your operating margins, your gross margin percentage and your operating margin percentage. And that depends upon the markup you're able to get on the incremental material costs.

You can't always get that at 27% or 28% or 30%; the marketplace doesn't permit that. So it does have a tendency to lower the margin percentages.

Okay, is there any one specific material that was a particular problem?

Sure, there are two. The copper bearing alloys has really been brutal. If you follow copper at all, it has been quite volatile. It jumped up in the span of a month, in April through May, maybe through the beginning of June, up 30% -- just rapidly increasing. Then it dropped about 25%, jumped back up 20% by the end of July. And now it's sort of stable at around 15% above where it was in April. But it's fairly stable right now. So copper bearing alloys, which George, that is our largest material item in our material mix would be copper bearing alloys.

The other area is stainless steel. And in particular, the nickel content in stainless steel. If anyone has been watching nickel, that has been on quite a continual rise. That has been more steady for the increase. But I would say our one that we watch, the one that we have greatest concern about is copper bearing alloy. It would be copper bearing alloys.

Okay, great. All right, I will get back in queue, but thanks a lot, Jim.

(OPERATOR INSTRUCTIONS) Gary Schwab with Ryan Beck.

About this issue of the North American refiners, Exxon Mobil, Shell, Chevron wanting you to fabricate, are you able to put any special pricing in because you're having to pull product back into your plant when you really don't have the space to do it?

Well, that particular order where we had to do that, we weren't able to make a selling price adjustment. The contract has already been negotiated. The customer had come back to us and simply said look, Graham, we want you to build this item. We may have been able to fight it, but it wasn't a fight that I felt had the right long-term outcome, so we pulled it into our plant. But in general when we are dealing with North American refiners, we have good pricing power.

Okay, because now you know going forward this is what they are expecting, so I would think that you should be able to say, okay, we were planning on outsourcing this, but if you need it built in the plant it's going to cost more, because we are tight.

Right, right. I do feel in general as a company we are matching price very well. When we had to pull this job back it, it was a difficult on for us, but in my opinion it was the decision at the time with respect to that customer and the long-term buying potential of that customer. But going forward in the refining sector we're doing a very good job managing price.

Is your capacity still on the engineering side, is that the bottleneck, or are you also fabricating constrained?

Well, we have both, as we have covered earlier with George. We still have the engineering capacity expansion project, and we are tracking that with five facets that I reviewed at the last conference call. Then we also have the production issues that we're facing right now, as we've not had the Asian work materialize, and we're trying to offset that with greater capacity and outsourcing capacity in North America.

So what is your in-house capacity right now on the fabricating side? On the fabricating side, can it be looked at that way?

Sure, sure. On the fabricating side, I will walk you through where we've been, and then where we're going. On the fabricating side, we've increased Batavia's capacity between '05 and '06 around 10%. And then we've increased between '06 and '07 -- '07 being our present year -- we have increased resources around 14%.

And as we go forward, augmenting that with North American outsourcing and then continuing to add staff, that will further increase our topline capability, while in addition to that, we are investing capital into the operations to allow greater throughput as well.

Okay. And one last thing. When you outsource, how much lower on margins when you outsource?

The margin will come down -- the gross margin will come down around 10 points. If it was 30, it will be 20.

Okay.

If it was 25, it will be 15.

Okay. So, you're trying to keep your outsourcing to a minimum, if possible, but you also need to increase your fabrication capability and engineering capability in-house.

Right, right. What's happening now is, you might be wondering, why is it such a big penalty? Most businesses that can fabricate for the process industries in North America or the refining industries quickly, they are at full capacity, or near to full capacity. They are managing prices well. So if we compare what we were able to procure subcontracting for two or three years ago to what we are paying for it now, costs are quite a bit higher.

Okay. One last thing. Do you have any confidence that you can give any kind of guidance on this call for anything -- for the (multiple speakers) --?

Other than the guidance that we gave (multiple speakers)?

Other then the guidance you gave, do you have anything going forward other than --?

Well, the guidance, Gary, that we have is $65 million to $70 million for topline for the full year, an operating margin of 9% to 11%, and gross margin down about 2 points due to the job we took, which will put us in the 26% range.

Right, but as far as giving guidance for 2008, you're not ready to go there at all on a revenue number?

Not at this point. I can speak qualitatively about where we are. The backlog has good quality sales in the backlog. I would qualitatively say, it's a better-looking backlog than what we're working through right now on our sales. And the sales pipeline going forward still looks very strong, and we are managing pricing very well. So I would qualitatively say going forward next year we feel will be better than the year we are leaving March 31st, '07.

And everything that you have in the backlog has a scheduled date for when it's going to go through the plant, and everything is budgeted for in the backlog? In other words, you can handle all the backlog?

We can handle the backlog, but we are supporting that with North American outsourcing as well.

Okay.

And then, we are still planning to win some Asian work of course. We are going after that aggressively.

[Suni Okashie] with Passport Capital.

I think my question was just asked and answered, but I will ask it again. It seems you should be able to charge a premium for Graham-manufactured goods if the customer really wants it. And it sounded as though you were afraid to ask your customer to do that. It seems like such a reasonable request, or a reasonable demand after the fact if they come back and say we want it manufactured by you, to say well, we're going to have to charge you more. What was the concern about making that request to the customer?

The concern was we had agreed to a negotiated set of terms and conditions and a price for that project. They permitted in the end partial fabrication in their plant. So we have roughly 40% of the hours been done -- I'm sorry, in their plant -- in an Asian fabrication location, and then the other 60% they wanted pulled into our plant.

So the initial contract specified that it would be done in your plant is what it sounds like.

No, no. We did not commit to where it would be built. When we sold the job, except for the 40%, it was understood that it would be built in an Asian fabricators' plant. The other 60% we intended to put in that same fabricators' plant because they had capacity, they had the quality, they had the capability of doing the project. But then our customer came back around -- the joint venture partner and said, we want you to do it. Pull it out and do it in your plant. And it was not subject to renegotiation.

Okay. One other small question. With regards to the material costs, is it possible in the future to put a variable material component in the bid? Is that not typically done in this business or --?

It depends on the buyer's attitude. We can try for an -- it's called an escalation provision. And as I mentioned to you, through the operating period of the first half we've been right in line with our material forecast. It's comparing the percentage of material relative to the sales price, a quarter 12 months ago to the quarter that just closed. That's why the margin percentages have trended down to a certain extent.

But we feel we are able to manage the volatility of materials fairly well, as demonstrated by being able to stay in line with our material plan. The customers right now have not been accepting escalation.

Okay.

We've done it. We've tried it a few times, to be quite candid, but in general the buyers want a fixed-price. They will pay a premium, somewhat of a premium, to take that risk away from them and put it into our lap, and we do build in some protection in our selling price for that.

Understood. Thank you very much. One additional question. With regards to our competition, are they -- when we go up against them, they seem to be pretty aggressive on price. Are they not as capacity constrained as we are? Is there a way of knowing that or is the entire industry capacity constrained right now? It sounds like our partner fabricators are capacity constrained and that tend to boost prices, but at the same time our competition seems to be aggressive with respect to pricing somehow.

Well, let me just break that down geographically. If we look at the North American situation, which still is very, very active for the refining sector, that's where our competitors, as well as the North American subcontractors, have fairly deep backlogs, and everyone is managing price per well. We don't see foreign competition in our home market, we see local competition.

When we moved to Asia, and in some cases to the Middle East or elsewhere, there we are competing more globally. And there appears to be greater manufacturing capacity globally than there is in North America. And also, a cost basis with our Asian competitors is lower than our North American competitors, due to the inherent cost of doing business in Malaysia or the Philippines or Korea versus in North America. But fortunately, we don't see them in our home market.

Is there any threat of that, do you think, or are buyers just not going to go there in our homeland?

I can speak to the immediate aspect of that. We don't see it as an immediate threat. Long-term of course we keep our eye on that, but right now just because we spoke of earlier, the refiners want our product. They want a Graham product. They don't want a Korean-built product.

I think that's just wonderful, really.

They look at life-cycle costs in the long run of running a refinery for 20, 30, 40, 50 years, and they are prepared to pay for that quality -- the North American refinery.

That makes a lot of sense. Well, thank you very much. That was very clear. I appreciate it.

You are very welcome.

A follow-up from Gary Schwab with Ryan Beck.

Just one other thing, you guys have a large overhead, I assume for heating, with a large open space for fabricating. Natural gas prices are way down this year compared to where they were last year. How much is this going to help you?

We've looked at that. We've factored that into our second half plan. We are coming down roughly $150,000 in utility spend for the second half. And we've put that into our plan going forward. It has come down, fortunately. And we've done some things as well to mitigate utility usage, so we will have a savings versus last year. It will still be up versus 2005 though, because we are comparing a vastly different cost environment.

At this time it appears there are no further questions. I'd like to turn the program back over to Mr. Jim Lines for any additional or closing comments.

Well, thank you very much for listening in today, spending time with us to go over the second quarter outlook for next year. Hopefully we've answered your questions. I did want to review with you, and make sure you understand that when we look at next year and going beyond, we are in the right markets at the right time. I believe there is run left in the refining and petrochemical markets. The last conference call I noted we felt we are approaching the midpoint for the petrochemical cycle. The refining market we believe will remain strong through our fiscal 2010.

There are six areas we're focused on to expand our top line and grow profits. We are managing price very hard. We are very aggressive on price. It's a target-rich environment, you have to be aggressive and also selective, so we don't take the type of order that we had to discuss for the second quarter. We will be more selective than the prior 12 months.

The orders can be lumpy. They do come in without a particular rhythm. However, we will be disciplined to win the right orders.

In addition, we are expanding engineering capacity. We talked about that with the engineering automation, the addition of staff, trying to find the right partner for low-cost engineering outsourcing. That's key. We are adding capacity to our China team. We want to double that over the next six months. We have added three, and want to add three more.

I plan to invest capital in Batavia to increase production capacity. We're doing that now with welding equipment, plate-burning equipment, as well as machining equipment. That will increase our capacity going forward. I will balance the capital need for the Batavia-based operation based on our near-term view against the competing needs of capital in Asia.

We will continue to drive Asian fabrication outsourcing. This is primarily for Asian end-users. The North American customers won't accept it right now.

We are also looking at North American outsourcing as to how we can expand capacity. We can't ramp up Batavia quick enough to meet the demand for our products. That's good from one point of view where we can maximize pricing, but I find it unacceptable to turn away the opportunities that are available in the marketplace.

In this other area, the sixth area is, we must look to diversify product and markets. We are too concentrated in the refining and petrochemical sector, and we have to address our cyclicality. I feel we are in the right spot. We had a tough second quarter; that's behind us. We understood the execution issues that we faced there. We've made the corrections. And going forward I see the Company as very strong with a very promising future.

And thank you again.

That does conclude today's program. You may disconnect your line at any time.