GRAHAM CORP - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED MARCH 31, 2004

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO .

COMMISSION FILE NUMBER 1-8462

GRAHAM CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 16-1194720
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

20 FLORENCE AVENUE, BATAVIA, NEW YORK 14020
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

Registrant's telephone number, including area code -- 585-343-2216

Securities registered pursuant to Section 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

TITLE OF CLASS

COMMON STOCK PURCHASE RIGHTS

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 (the "Act") during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X]

The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of September 30, 2003, the last business day of the Company's
most recently completed second fiscal quarter, was $13,323,620.

As of May 15, 2004, there were outstanding 1,658,327 shares of common
stock, $.10 par value. As of May 15, 2004, there were outstanding 1,658,327
common stock purchase rights.

DOCUMENTS INCORPORATED BY REFERENCE

(1) Notice of Meeting and Proxy Statement for the 2004 Annual Meeting of
Stockholders is incorporated by reference into Part III of this filing.

An Exhibit Index is located at page 44 of this filing under the sequential
numbering system prescribed by Rule 0-3(b) of the Act.
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GRAHAM CORPORATION

FORM 10-K INDEX

PART I

(Dollar amounts in thousands except per share data).

ITEM 1. BUSINESS

(a) GENERAL DEVELOPMENT OF BUSINESS

Graham Corporation (the "Company" or the "Registrant") is a Delaware
company incorporated in 1983. It is the successor to Graham Manufacturing Co.,
Inc., which was incorporated in 1936. The Company's business consists of two
segments, one operated by the Company in the United States and one operated by
its indirectly wholly-owned subsidiary in the United Kingdom.

UNITED STATES OPERATIONS

During the Fiscal Year ended March 31, 2004 ("FYE 2004") the Company's U.S.
operations consisted of its engineering and manufacturing business in Batavia,
NY.

The Company is a well-recognized supplier of steam jet ejector vacuum
systems, surface condensers for steam turbines, liquid ring vacuum pumps and
compressors, dry pumps and various types of heat exchangers such as Heliflow and
plate and frame exchangers. It possesses expertise in combining these various
products into packaged systems for sale to its customers in a variety of
industrial markets, including oil refining, chemical, petrochemical, power, pulp
and paper, other process applications, and shipbuilding.

FYE 2004 U.S. sales were $38 million, a decrease of 14% from the previous
fiscal year. The decrease in sales versus the previous year principally reflects
a significant decline in sales of surface condensers, due to over-capacity in
the U.S. domestic power-generating industry and in the chemical processing
industry worldwide.

Orders in FYE 2004 were $33.9 million, down 4% from the previous fiscal
year. Backlog stood at $19.2 million on March 31, 2004, compared to $22.9
million on March 31, 2003 and $31.5 million on March 31, 2002.

The Company recognized a $522 gain due to curtailment of a medical benefit
plan for retired employees. This gain is reported as "Other Income" in the
Consolidated Statement of Operations.

The Company's main markets appear to be emerging from their most prolonged
recession in decades, with improvement in the refinery market, the chemical
market and the domestic power industry. These markets remain highly competitive.

The Company broadened its market coverage of instantaneous water heaters in
FYE 2004 with the introduction of the MicroMax water heater.

The Company's U.S. export sales represented 54% of U.S. sales in FYE 2004,
compared to 29.5% of U.S. sales in the previous year. Export sales reflected a
prolonged recession in Asia and Latin America. However, the Asian markets for
the Company's products have demonstrated early signs of recovery. The consensus
in the industry is that opportunities in the refinery markets are expected to
increase.

The Company had 252 employees in the United States as of March 31, 2004.

UNITED KINGDOM OPERATIONS

During FYE 2004, the Company's U.K. operations were conducted by its
indirectly wholly-owned subsidiary, Graham Precision Pumps Limited (GPPL) in
Congleton, Cheshire, England. GPPL is wholly-owned by Graham Vacuum & Heat
Transfer Limited, which in turn is wholly-owned by the Company. Graham Vacuum
and Heat Transfer Limited has no employees.

GPPL manufactures liquid ring vacuum pumps, rotary piston pumps, oil sealed
rotary vane pumps, atmospheric air operated ejectors and complete vacuum pump
systems that are factory assembled with self-supporting structure.

Sales for FYE 2004 were $8.1 million, an increase of 18% compared with the
previous year.

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Orders for GPPL in FYE 2004 were $9.5 million, up 31% from the previous
fiscal year. Year end backlog stood at $3.2 million, compared to $1.3 million on
March 31, 2003 and $1.2 million on March 31, 2002.

This reflects several large export orders for the petrochemical industry
and continued strong activity in offshore oil operations. GPPL's markets
generally show strong signs of recovery, with particularly robust activity in
the chemical industry. Demand for products involved in petrochemical
applications remains strong and during the fiscal year GPPL saw significant
improvement in inquiries for liquid ring vacuum pumps.

GPPL employed 57 people on March 31, 2004.

CAPITAL EXPENDITURES

The Company's capital expenditures for FYE 2004 amounted to $284. Of this
amount, $249 was for the U.S. business and $35 was for the U.K. business.

(b) FINANCIAL INFORMATION ABOUT SEGMENTS

(1) Segments and (2) Information as to Lines of Business

Graham Corporation operates in only one industry segment which is the
design and manufacture of vacuum and heat transfer equipment. Further
geographical segment information is set forth in Note 14 to the Consolidated
Financial Statements on pages 34-37 of the Annual Report on Form 10-K.

(c) NARRATIVE DESCRIPTION OF BUSINESS

(1) Business Done and Intended to be Done

Principal Products and Markets

The Company designs and manufactures vacuum and heat transfer equipment,
primarily custom built. Its products include steam jet ejector vacuum systems,
surface condensers for steam turbines, liquid ring vacuum pumps and compressors,
dry vacuum pumps and various types of heat exchangers including helical coil
exchangers marketed under the registered name "Heliflow" and plate and frame
exchangers. These products function to produce a vacuum or to condense steam or
otherwise transfer heat, or any combination of these tasks. All of the products
named, other than the pumps, accomplish these results without involving any
moving parts. Graham's products are available in all metals and in many
non-metallic and corrosion resistant materials as well.

This equipment is used in a wide range of industrial process applications:
power generation facilities, including fossil fuel plants and nuclear plants as
well as cogeneration plants and geothermal power plants that harness naturally
occurring thermal energy; petroleum refineries; chemical plants; pharmaceutical
plants; plastics plants; fertilizer plants; breweries; titanium plants;
liquefied natural gas production; soap manufacturing; air conditioning systems;
food processing plants and other process industries. Among these the principal
markets for the Company's products are the chemical, petrochemical, petroleum
refining, and electric power generating industries. The Company's equipment is
sold by a combination of direct company sales engineers and independent sales
representatives located in over 40 major cities in the United States and abroad.

Status of Publicly Announced New Products or Segments

The Company has no plans for new products or for entry into new industry
segments that would require the investment of a material amount of the Company's
assets or that otherwise is material.

Sources and Availability of Raw Materials

Certain material shortages have affected the Company's ability to meet
delivery requirements for certain orders. The Company is identifying alternative
vendors in such cases and seeks to negotiate escalation provisions in its
contracts in the event that costs of materials increase.

2

Material Patents, Trademarks

The Company holds no material patents, trademarks, licenses, franchises or
concessions, the loss of which would have a materially adverse effect upon the
business of the Company.

Seasonal Variations

No material part of the Company's business is seasonal.

Working Capital Practices

The Company's business does not require it to carry significant amounts of
inventory, or of materials beyond what is needed for work in progress. The
Company does not provide rights to return goods, or payment terms to customers
that would be considered extended in the context of the practices of its
industries.

Principal Customers

The Company's principal customers include the large chemical, petroleum and
power companies, which are end users of the Company's equipment in their
manufacturing and refining processes, as well as large engineering contractors
who build installations for such companies and others.

No material part of the Company's business is dependent upon a single
customer or on a few customers, the loss of any one or more of whom would have a
materially adverse effect on the Company's business. No customer of the Company
or group of related customers regularly accounts for as much as 10% of the
Company's consolidated annual revenue.

Order Backlog

Backlog of unfilled orders at March 31, 2004 was $21,988 compared to
$23,497 at March 31, 2003 and $32,299 at March 31, 2002. The backlog contains
$5,484 in orders that will likely not be shipped in the next twelve months.

Government Contracts

No material portion of the Company's business is subject to renegotiation
of profits or termination of contract or subcontracts at the election of the
government.

Competition

The Company's business is highly competitive and a substantial number of
companies having greater financial resources are engaged in manufacturing
similar products. However, the Company believes it is one of the leading
manufacturers of steam jet ejectors.

Research Activities

During the fiscal years ended March 31, 2004, 2003, and 2002 the Company
spent approximately $138, $187 and $248, respectively, on research activities
relating to the development of new products or the improvement of existing
products.

Environmental Matters

The Company does not anticipate that compliance with federal, state and
local provisions, which have been enacted or adopted regulating the discharge of
material in the environment or otherwise pertaining to the protection of the
environment, will have a material effect upon the capital expenditures, earnings
and competitive position of the Company and its subsidiaries.

(d) FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS

The information called for under this Item is set forth in Note 14 to
Consolidated Financial Statements, on pages 34-37 of this Annual Report on Form
10-K.

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ITEM 2. PROPERTIES

United States: The Company's corporate headquarters is located at 20
Florence Avenue, Batavia, New York, consisting of a 45,000 square foot building.
The Company's manufacturing facilities are also located in Batavia, consisting
of approximately thirty-three acres and containing about 204,000 square feet in
several connected buildings, including 162,000 square feet in manufacturing
facilities, 48,000 square feet for warehousing and a 6,000 square-foot building
for product research and development.

Additionally the Company leases U.S. sales offices in Los Angeles and
Houston.

United Kingdom: The Company's U.K. subsidiary, Graham Precision Pumps
Limited, owns a 41,000 square-foot manufacturing facility located on 15 acres in
Congleton, Cheshire, England.

Assets of the Company with a book value of $26,005 have been pledged to
secure certain domestic long-term borrowings. Short and long-term borrowings of
the Company's United Kingdom subsidiary are secured by assets of the subsidiary,
which have a book value of $786.

ITEM 3. LEGAL PROCEEDINGS

This information is set forth in Note 15 to the Consolidated Financial
Statements on page 37 of the Annual Report on Form 10-K.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the fourth quarter of the fiscal year
covered by this report to a vote of the Company's security holders.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.

(a) The Company sold no equity securities that were not registered during
the period covered by this Annual Report on Form 10-K.

(b) Not applicable.

(c) Not applicable.

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ITEM 6. SELECTED FINANCIAL DATA

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(1) The financial data presented for 2004-1998 is for the respective twelve
months ended March 31. The financial data presented for 1997 is for the
three-month transition period ended March 31, 1997. The financial data
presented for 1996-1994 is for the respective twelve months ended December
31.

NET SALES $ in Thousands

04 43321.00
03 49378.00
02 47396.00
01 44433.00
00 38728.00
99 52978.00
98 56206.00
96 51487.00
95 50501.00
94 46467.00

WORKING CAPITAL $ in Thousands

04 11700.00
03 12779.00
02 13812.00
01 11162.00
00 12397.00
99 11989.00
98 12459.00
96 8239.00
95 7093.00
94 6819.00

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(2) Per share data has been adjusted to reflect a three-for-two stock split on
July 25, 1996.

LONG-TERM DEBT $ in Thousands

04 93.00
03 127.00
02 150.00
01 682.00
00 1948.00
99 505.00
98 859.00
96 1442.00
95 3303.00
94 5161.00

SHAREHOLDERS' EQUITY $ in Thousands

04 18150.00
03 18793.00
02 19636.00
01 17137.00
00 17092.00
99 16712.00
98 17775.00
96 11915.00
95 8426.00
94 7045.00

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

(Dollar amounts in thousands except per share data).

OVERVIEW

Graham Corporation consists of two operating segments as determined by
geographic areas (USA: Graham Corporation, UK: Graham Vacuum and Heat Transfer
Limited and its wholly-owned subsidiary, Graham Precision Pumps Limited).

Graham Corporation designs and builds vacuum and heat transfer equipment
for the process industries throughout the world. It is a worldwide leader in
vacuum technology. The principal markets for our equipment are the chemical,
petrochemical, petroleum refining and electric power generating industries,
including cogeneration and geothermal plants. Other markets served include metal
refining, pulp and paper, shipbuilding, water heating, refrigeration,
desalination, food processing, drugs, heating, ventilating and air conditioning.

Ejectors, liquid ring and dry vacuum pumps, condensers, heat exchangers and
other products we sell, sold either as components or as complete systems, are
used by our customers to produce synthetic fibers, chemicals, petroleum products
(including gasoline), electric power, processed food (including canned, frozen
and dairy products), pharmaceutical products, paper, steel, fertilizers and
numerous other products used everyday by people throughout the world.

The mission of Graham Corporation is to enhance our position, in existing
and new markets, as a worldwide leader in the engineering and manufacturing of
high quality vacuum and heat transfer products and services. We strive for
continuous growth of revenues and profits and to produce a good return on
investment for our shareholders. We will continue to be known for high integrity
and concern for our customers, employees and community.

Graham is coming off the deepest and most prolonged recession in its
markets in its 68-year history. This recession has been caused by over capacity
in the principal industries served and a general global recession.

The Company emerges from FYE 2004 in a sound position with respect to cash
and short-term investments and with its core competencies intact.

FORWARD-LOOKING STATEMENTS

Certain statements contained in this document, including within this
Management's Discussion and Analysis of Financial Condition and Results of
Operations, that are not historical facts, constitute "Forward-Looking
Statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. Forward-looking statements, in general, predict, forecast, indicate or
imply future results, performance or achievements and generally use words so
indicative. The Company wishes to caution the reader that numerous important
factors which involve risks and uncertainties, including but not limited to
economic, competitive, governmental and technological factors affecting the
Company's operations, markets, products, services and prices, and other factors
discussed in the Company's filings with the Securities and Exchange Commission,
in the future, could affect the Company's actual results and could cause its
actual consolidated results to differ materially from those expressed in any
forward-looking statement made by, or on behalf of, the Company.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS

The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America ("GAAP").

Critical accounting policies are defined as those that are reflective of
significant judgments and uncertainties, and could potentially result in
materially different results under different assumptions and conditions.
Management has discussed each of these critical accounting policies and
estimates with the Audit Committee of the Board of Directors.

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Revenue Recognition -- The Corporation recognizes revenue and all related
costs on contracts with a duration in excess of three months and with revenue of
at least $1,000 and 500 pounds sterling, in the USA and UK operating segments,
respectively, using the percentage-of-completion method. The
percentage-of-completion method is determined by relating actual labor incurred
to-date to management's estimate of total labor to be incurred on each contract.
Contracts in progress are reviewed monthly, and sales and earnings are adjusted
in current accounting periods based on revisions in the contract value and
estimated costs at completion.

Revenue not accounted for using the percentage-of-completion method is
accounted for on the completed contract method because of the large number of
contracts and the fact that the effects of the use of such method do not vary
materially from the use of the percentage-of-completion method. The Company
recognizes revenue and all related costs on the completed contract method upon
substantial completion or shipment to the customer. Substantial completion is
consistently defined as at least 95% complete with regard to direct labor hours.
Customer acceptance is generally required throughout the construction process
and the Company has no further obligations under the contract after the revenue
is recognized.

Pension and Postretirement Benefits -- The Company's defined benefit
pension and other postretirement benefit costs and obligations are dependent on
actuarial assumptions used in calculating such amounts. These assumptions, which
are reviewed annually by the Company, include the discount rate, long-term
expected rate of return on plan assets, salary growth, healthcare cost trend
rate and other economic and demographic factors. The Company bases the discount
rate assumption for its plans on the AA-rated corporate long-term bond yield
rate. The long-term expected rate of return on plan assets is based on the
plan's asset allocation, historical returns and management's expectation as to
future returns that are expected to be realized over the estimated remaining
life of the plan liabilities that will be funded with the plan assets. The
salary growth assumptions are determined based on the Company's long-term actual
experience and future and near-term outlook. The healthcare cost trend rate
assumptions are based on historical cost and payment data, the near-term
outlook, and an assessment of the likely long-term trends.

To the extent that actual results differ from our assumptions, the
differences are reflected as unrecognized gains and losses and are amortized to
earnings over the estimated future service period of the plan participants to
the extent such total net recognized gains and losses exceed 10% of the greater
of the plan's projected benefit obligation or the market-related value of
assets. Significant differences in actual experience or significant changes in
future assumptions would affect the Company's pension and postretirement benefit
costs and obligations.

Use of Estimates -- The preparation of these financial statements requires
us to make estimates and judgments that affect the reported amounts of assets
and liabilities, revenues and expenses and related disclosure of contingent
assets and liabilities at the date of our financial statements. Actual results
may differ from these estimates under different assumptions or conditions. Use
of estimates include the recording of revenue, pension obligations, and the
underlying assumptions and valuation reserves for uncollectible accounts,
inventory obsolescence, deferred taxes, warranty and liquidated damages.

8

RESULTS OF OPERATIONS

For an understanding of the significant factors that influenced the
Company's performance during the past three fiscal years, the following
discussion should be read in conjunction with the consolidated financial
statements and the notes to consolidated financial statements presented in this
annual report.

Amounts above are inclusive of intercompany amounts.

2004 COMPARED TO 2003

Consolidated sales (net of intercompany sales) were $43,321 for the fiscal
year ended March 31, 2004. This represents a 12% decrease as compared to FYE
2003. Sales from USA operations were down 14% from last year. The decrease in
sales resulted from significantly fewer surface condenser sales. Surface
condenser sales to the domestic power industry and worldwide chemical industry
were down due to a capacity-to-demand imbalance in these industries.

The three principal markets Graham serves are now in varying stages of
recovery. The refinery market for Graham's products is picking up due to clean
fuel standards regulatory requirements. The chemical market is coming back due
to the strength of the general global economic recovery. The domestic power
industry for plants of about 200 mega-watts in size is in a moderate recovery
mode due to the need for more efficient plants and ones that are more
environmentally friendly. We expect these markets to continue to be active for
several years. The most significant threats our Company faces in its markets
today are the effects of terrorist acts on economic activity in Graham's markets
and metal shortages (i.e., the ability to obtain materials timely and pass
potentially higher costs through to the customer). Either of these threats, or
others, could dampen or stop the market recoveries now occurring. Although order
opportunities are increasing, pricing remains very competitive and may continue
to hold gross profit margins below historical levels for orders booked through
at least the first half of FYE 2005.

Sales from UK operations increased 18% for the year. The increased sales
are attributed to several large orders shipped to China for the petrochemical
industry, and continued strong activity in offshore oil operations. Like USA
operations, the markets, in general, and, in particular, the chemical industry,
show signs of recovery. While offshore oil activity remains strong, significant
improvement in inquiries for GPPL's traditional products (e.g., liquid ring
pumps) is evident.

The consolidated gross profit percentage was 17% for the current year as
compared to 19% for FYE 2003. USA operations' gross profit margin remained
unchanged as compared to FYE 2003 at 16%, as overall production overhead costs
were managed in proportion to lower sales. Cost actions initiated in prior years
helped to reduce production costs in FYE 2004 as compared to FYE 2003. For
example, in February 2003, postretirement medical benefits for employees of the
USA operation employed as of April 1, 2003 were terminated. Additionally, real
estate taxes were reduced as a result of a legal proceeding settlement entered
in September 2003 and workers' compensation costs were reduced by back-to-work
programs. The Company was also able to reduce its warranty reserve because
certain claims of significant value were settled. The gross profit margin from
UK operations decreased from 30% last year to 22% for the current year due to
quality problems pertaining to faulty and incorrect materials supplied by
vendors. This led to high re-work costs. A second problem causing the decrease
in gross profit margins in the UK was downward pressure on selling prices.

Selling, general and administrative (SG&A) expenses for FYE 2004 were 23%
of sales as compared to 21% for the prior year. This percentage increase is due
to reduced sales in FYE 2004. Total SG&A costs for the

9

current year were down 4%. The decrease was due to lower employment costs
resulting from a major staff downsizing in FYE 2003.

Interest expense increased 36% in the current year. The increased expense
came from UK operations and follows higher short-term bank debt. Short-term debt
increased significantly in the fourth quarter due to low shipping activity in
January and February. Product shipments were delayed to March due to technical
specification matters that needed to be addressed.

Other income for FYE 2004 was $522 as compared to $1,801 for FYE 2003. The
current year's income represents a curtailment gain resulting from the
discontinuation of postretirement medical benefits discussed above. Other income
of $1,801 recognized in FYE 2003 was a result of a contract cancellation fee on
an order from a customer in the electric power generating industry.

Other expense for the current year is zero as compared to $658 in FYE 2003
for severance costs.

The benefit for income taxes was 42% of the loss before income tax benefit
amount for the current year as compared to a provision for income taxes equal to
31% of the income before income taxes amount in FYE 2003. The FYE 2004 effective
rate increased due to an income tax benefit gained in terminating split-dollar
life insurance policies and distributing the proceeds to the respective
employees in October 2003.

The net loss for FYE 2004 was $1,070 or $0.65 per fully diluted share. The
Company recognized a net income of $133 or $0.08 per fully diluted share for FYE
2003.

2003 COMPARED TO 2002

Consolidated sales (net of intercompany sales) were $49,378 for the fiscal
year ended March 31, 2003. This represents a 4% increase over FYE 2002. Sales
from USA operations were greater than the prior year by 7%, primarily due to
maintaining domestic market share comparable to the prior year while increasing
export sales about 30% over FYE 2002. The increased sales were due to specific
refining and electric power generating projects and not a general recovery in
foreign markets.

Sales from UK operations decreased 8% as compared to FYE 2002. In
particular, significant reductions came in sales of pump package systems and
spare parts. The reduction in spare part sales was due to fewer replacements
purchased by traditional customers. This was due to significant buying in recent
prior years. The decline in pump package sales was due to the absence of orders
for large sales values. UK sales of pumps for offshore oil facilities for FYE
2003 were up 50% as compared to FYE 2002. This increase was due to the high cost
of oil, which in-turn makes the higher operating costs of offshore production
feasible.

The consolidated gross profit percentage was 19% as compared to 21% for FYE
2002. In the USA, the gross profit percentage was 16% as compared to 18% for the
prior year. This decline was due to the colder winter causing higher comfort
heating charges, greater defined benefit pension costs due to the three-year
decline in the stock market and higher product warranty costs.

The gross profit percent in the UK dropped from 38% in FYE 2002 to 30% in
FYE 2003. This was attributed to reduced sales volume and fewer sales in
offshore spare parts. Spare part sales generate greater profit margins than new
unit sales. It is believed fewer replacement parts were sold because new pumps
were purchased instead. In addition to sales, the gross profit margin in the UK
declined due to greater production overhead costs caused by temporary staffing
needs. As a percent of sales, production costs were 27% of sales in FYE 2003 as
compared to 21% in FYE 2002.

Selling, general and administrative expenses for FYE 2003 were down 2% from
FYE 2002. SG&A expenses represented 21% of FYE 2003 sales as compared to 22% for
FYE 2002. The decrease in costs was due to lower variable compensation costs.

For FYE 2003, interest expense decreased 34% due to reduced interest rates
and maintaining a low debt level.

10

The provision for income taxes was 31% for FYE 2003 as compared to 34% for
the year ended March 31, 2002. The lower effective rate was due to the impact of
the extra territorial income exclusion benefit from foreign shipments.

Consolidated net income for FYE 2003 was $133 or $.08 per diluted share as
compared to $2,305 or $1.38 per diluted share in FYE 2002.

SHAREHOLDERS' EQUITY

2004 COMPARED TO 2003

Shareholders' Equity decreased $643 or 3% from March 31, 2003. Decreases
were caused by the net loss, an increase to the minimum pension liability
adjustment and the corporate dividend. These charges were partially offset by a
favorable foreign currency translation adjustment, issuance of common stock
resulting from the exercise of stock options and Director and Officer repayment
of notes due for the purchase of Graham's common stock under the Long-Term Stock
Ownership Plan. For further information, see Consolidated Statements of Changes
In Shareholders' Equity.

2003 COMPARED TO 2002

Shareholders' Equity decreased $843 or 4% in FYE 2003. The Company
recognized a minimum pension liability adjustment net of an income tax benefit,
which reduced equity by $1,090. This adjustment will be reversed if and to the
extent the USA defined benefit pension plan investments in stocks and bonds
recover.

LIQUIDITY AND CAPITAL RESOURCES

11

CONTRACTUAL AND COMMERCIAL OBLIGATIONS

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(1) For additional information, see Notes 5 and 6 to the Consolidated Financial
Statements.

(2) Amounts represent anticipated contributions to the defined benefit pension
plan and postretirement medical benefit plan for FYE 2005. The Company
expects to be required to make cash contributions beyond one year.

2004 COMPARED TO 2003

Consolidated cash flow from operations was negative $1,044 for FYE 2004 as
compared to a positive cash flow of $1,897 for FYE 2003. The negative cash flow
was largely a result of the net loss, fewer customer progress payments due to
fewer major orders (e.g., surface condensers) and a significant defined benefit
pension contribution due to the decrease in the value of the investments held by
the defined benefit pension plan as a result of the 2001-2002 stock market
decline.

The Company expects to continue to consume cash in excess of amounts
generated from operations over the first several months of fiscal year 2005 to
cover operating losses, dividends, and to fund a build-up of work-in-process
inventory for increased shipments in the second half of FYE 2005.

Graham's primary source of liquidity is cash flow from operations,
investments in short-term US Treasury bills, and secured credit agreements. Cash
sources in 2004 and 2003 have been sufficient to meet our liquidity needs, and
we believe our cash sources will be sufficient to meet our projected future cash
requirements.

Capital expenditures are estimated to be $637 next year. Depreciation is
estimated to be $1,017.

2003 COMPARED TO 2002

Consolidated cash flow from operations was $1,897 for FYE 2003 as compared
to $4,464 for FYE 2002. Cash flow for FYE 2003 was greatly enhanced by
collection of the unusually large trade accounts receivable balance as of March
2002. Receivables were substantially greater than normal due to fourth quarter
FYE 2002 significant customer cancellation fees and progress billings.
Offsetting the change in the accounts receivable balance of $9,758 between March
31, 2002 and 2003 were (1) an increase in inventory, (2) a special payment to
the defined benefit pension plan and (3) fewer customer deposits. Inventory
increased due to the manufacturing stage of USA customer orders, and UK
operations increased inventories (and short-term debt) acquiring dry pump
gearboxes from a supplier who manufactured them under a "make and hold" program.
Customer deposits decreased $4,572 this year as compared to FYE 2002 due to the
reduction of large projects currently in the manufacturing system. To ensure
compliance with a bank loan covenant, the Company made an additional $1,600
payment to the defined benefit pension fund in FYE 2003. A fourth item, which
reduced working capital in FYE 2003, was the recognition of $702 in accruals
relating to terminations and retirements.

12

ORDERS AND BACKLOG

USA orders for the current year were down 4% or $1,313 from last year. UK
orders were up 31% over FYE 2003. Bookings for USA operations were down due to
the decline of orders placed for surface condensers. Orders placed with the UK
operation were up due to the increased activity in offshore oil projects and
orders for the petrochemical industry. Orders placed with USA operations are
expected to be greater in FYE 2005 due to the recovering global economy and
specific markets supplied by Graham. Orders placed with UK operations are
expected to be slightly greater than FYE 2004.

At March 31, 2004, the consolidated backlog was $21,988, down 6% from March
31, 2003. All orders represent orders from traditional markets in the Company's
established product lines. The backlog contains approximately $5,484 in orders
that will likely not be shipped in the next twelve months.

In April 2004, Graham filed a complaint for breach of contract in the
United States District Court, asking the Court to find a contract, valued at
$5,144 and included in the $5,484 noted above, cancelled and award cancellation
fees as specified in the contract.

MARKET RISK (QUANTITATIVE AND QUALITATIVE DISCLOSURES)

The principal market risks (i.e., the risk of loss arising from changes in
market rates and prices) to which Graham is exposed are:

- interest rates

- foreign exchange rates

- equity price risk

The assumptions applied in preparing quantitative disclosures regarding
interest rate, foreign exchange rate and equity price risk are based upon
volatility ranges experienced in relevant historical periods, management's
current knowledge of the business and market place, and management's judgment of
the probability of future volatility based upon the historical trends and
economic conditions of the business.

The Company is exposed to interest rate risk primarily through its
borrowing activities. Management's strategy for managing risks associated with
interest rate fluctuations is to hold interest-bearing debt to the absolute
minimum and carefully assess the risks and rewards for incurring long-term debt.
Assuming year ended 2004 and 2003 variable rate debt, a 1% change in interest
rates would impact annual interest expense by $19 and $15, respectively.

Graham's international consolidated sales exposure for the current year
approximated 59% of annual sales as compared to 37% for the year 2003. Operating
in world markets involves exposure to movements in currency exchange rates.
Currency movements can affect sales in several ways, the foremost being the
ability to competitively compete for orders against competition having a
relatively weaker currency. Business lost due to this cannot be quantified.
Secondly, cash can be adversely impacted by the conversion of sales in foreign
currency

13

to USA dollars. The substantial portion of Graham's sales is collected in the
local currency (USA -- dollars; UK -- pounds sterling). In FYE 2004 and 2003,
sales in foreign currencies were 3% and 1.5% of sales, respectively. At certain
times, the Company may enter into forward foreign exchange agreements to hedge
its exposure against unfavorable changes in foreign currency values on
significant sales contracts negotiated in foreign currencies.

Graham has limited exposure to foreign currency purchases. In FYE 2004 and
2003, purchases in foreign currencies were 9% and 4% of cost of goods sold,
respectively. At certain times, forward foreign exchange contracts may be
utilized to limit currency exposure.

Foreign operations resulted in a current year net loss of $276 as compared
to a net loss of $96 for FYE 2003. As currency exchange rates change,
translations of the income statements of the UK business into US dollars affect
year-over-year comparability of operating results. The increase in the foreign
currency translation rate to convert pounds sterling to US dollars increased all
UK income statement items and order amounts by 10% and all UK balance sheet and
backlog amounts by 16% in FYE 2004 over 2003. The Company does not hedge
translation risks because cash flows from UK operations are mostly reinvested in
the UK. A 10% change in foreign exchange rates would have impacted the UK
reported net loss by approximately $28 for FYE 2004 and $10 for the previous
year.

The Company has a Long-Term Incentive Plan, which provides for awards of
share equivalent units (SEUs) for outside directors based upon the Company's
performance. The outstanding SEUs are recorded at fair market value thereby
exposing the Company to equity price risk. Gains and losses recognized due to
market price changes are included in the Company's results of operations. Based
upon the SEUs outstanding at March 31, 2004 and 2003, and a $12 per share price,
a 50-75% change in the respective year-end market price of the Company's common
stock would positively or negatively impact the Company's operating results by
$100 to $151 for FYE 2004 and $99 to $148 in FYE 2003. Assuming required net
income of $500 is met, and based upon a market price of the Company's stock of
$12 per share, a 50-75% change in the stock price would positively or negatively
impact the Company's operating results by $142 to $213 in 2005, $162 to $242 in
2006, $182 to $273 in 2007, $196 to $295 in 2008 and $211 to $317 in 2009.

OTHER MATTERS

The Company broadened its market coverage of instantaneous water heaters in
FYE 2004 with the introduction of MicroMax. This new standard product meets a
market need for users who do not have available steam as a utility for the water
heater.

Increases in material and labor costs traditionally have been offset by
cost cutting measures and selling price increases. Obtaining price increases is
largely a factor of supply and demand for Graham's products, whereas inflation
factors can originate from influences outside of the Company's direct global
competition. Graham will continue to monitor the impact of inflation in order to
minimize its effects in future years through sales growth, pricing, product mix
strategies, purchasing advantageously, productivity improvements, and cost
reductions.

The Company's USA operations are governed by federal environmental laws,
principally the Resource Conservation and Recovery Act, the Comprehensive
Environmental Response, Compensation and Liability Act (CERCLA), the Clean Air
Act, and the Clean Water Act, as well as state counterparts ("Environmental
Laws"). Environmental Laws require that certain parties fund remedial actions
regardless of fault, legality or original disposal or ownership of the site.
Graham is not involved in any environmental remediation projects.

NEW ACCOUNTING PRONOUNCEMENTS

In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness to Others." FIN 45
expands disclosure requirements and requires that a guarantor recognize, at fair
value, a liability for its obligation under a guarantee. The recognition and
measurement requirements are effective on a prospective basis for guarantees
issued or modified after December 31, 2002. Adoption of this standard did

14

not have a material impact on the Company's financial position, results of
operations or cash flows. The Company has complied with the expanded disclosure
requirements.

In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51." FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity if
the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 is effective immediately for certain
requirements and was amended in December 2003 to defer implementation of other
requirements until March 2004. Adoption of this standard had no effect on the
Company's financial position, results of operations or cash flows.

In December 2003, the FASB revised SFAS No. 132 ("SFAS 132-R"), which deals
with employers' disclosures about pensions and other postretirement benefits,
and amended certain other related FASB statements. This statement requires
additional disclosures about assets, obligations, cash flows, and net periodic
benefit cost of defined benefit pension plans and other postretirement benefit
plans. It does not change the measurement or recognition of those plans. Graham
will adopt the provisions of SFAS 132-R as they become effective. See Note 9 of
Notes to Consolidated Financial Statements for pertinent disclosures for this
reporting period.

15

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

(Financial Statements, Notes to Financial Statements, Quarterly Financial
Data)

(Dollar amounts in thousands except per share data).

CONSOLIDATED STATEMENTS OF OPERATIONS

See Notes to Consolidated Financial Statements.

16

CONSOLIDATED BALANCE SHEETS

See Notes to Consolidated Financial Statements.

17

CONSOLIDATED STATEMENTS OF CASH FLOWS

See Notes to Consolidated Financial Statements.

18

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

See Notes to Consolidated Financial Statements.
19

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 -- THE COMPANY AND ITS ACCOUNTING POLICIES:

Graham Corporation and its subsidiaries are primarily engaged in the design
and manufacture of vacuum and heat transfer equipment used in the chemical,
petrochemical, petroleum refining, and electric power generating industries and
sell to customers throughout the world. The Company's significant accounting
policies follow.

Principles of consolidation and use of estimates in the preparation of
financial statements

The consolidated financial statements include the accounts of the Company
and its wholly-owned domestic and foreign subsidiaries. All significant
intercompany balances, transactions and profits are eliminated in consolidation.

The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements, as well as the related
revenues and expenses during the reporting period. Actual amounts could differ
from those estimated.

Translation of foreign currencies

Assets and liabilities of foreign subsidiaries are translated into U.S.
dollars at currency exchange rates in effect at year-end and revenues and
expenses are translated at average exchange rates in effect for the year. Gains
and losses resulting from foreign currency transactions are included in results
of operations. The Company's sales and purchases in foreign currencies are
minimal, therefore, foreign currency transaction gains and losses are not
significant. Gains and losses resulting from translation of foreign subsidiary
balance sheets are included in a separate component of shareholders' equity.
Translation adjustments are not adjusted for income taxes since they relate to
an investment which is permanent in nature.

Revenue recognition

Percentage-of-Completion

The USA Company recognizes revenue and all related costs on contracts with
a duration in excess of three months and with revenues of $1,000 and greater
using the percentage-of-completion method. The UK Company applies the
percentage-of-completion method of accounting for revenue recognition and all
related costs on contracts with a duration in excess of three months and with
revenues of 500 pounds sterling and greater. The Company has established the
systems and procedures essential to developing the estimates required to account
for a contract using the percentage-of-completion method. At the USA and UK
companies, the percentage-of-completion is determined by relating actual labor
incurred to-date to management's estimate of total labor to be incurred on each
contract. Contracts in progress are reviewed monthly, and sales and earnings are
adjusted in current accounting periods based on revisions in contract value and
estimated costs at completion.

Completed Contract

All contracts with a duration of less than three months and with revenue of
less than $1,000 in the USA and 500 pounds sterling in the UK are accounted for
using the completed contract method. The Company recognizes revenue and all
related costs on these contracts upon substantial completion or shipment to the
customer. Substantial completion is consistently defined as at least 95%
complete with regard to direct labor hours. Customer acceptance is generally
required throughout the construction process and the Company has no further
obligations under the contract after the revenue is recognized. The effect of
applying the completed contract method does not vary materially from the results
of applying the percentage-of-completion method.

Shipping and handling fees and costs

Shipping and handling fees billed to the customer are classified as revenue
and the related costs incurred for shipping and handling are included in cost of
goods sold.

20

Investments

Investments consist primarily of fixed-income debt securities with original
maturities of beyond three months. All investments are classified as
held-to-maturity as the Company has the positive intent and ability to hold the
securities to maturity. The investments are stated at amortized cost which
approximates fair value. All the investments mature within one year.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined
on the first-in, first-out method. Progress payments for orders are netted
against inventory to the extent the payment is less than the inventory balance
relating to the applicable contract. Progress payments that are in excess of the
corresponding inventory balance are presented as customer deposits in the
Consolidated Balance Sheets.

Property, plant and depreciation

Property, plant and equipment are stated at cost net of accumulated
depreciation and amortization. Major additions and improvements are capitalized,
while maintenance and repairs are charged to expense as incurred. Depreciation
and amortization are provided based upon the estimated useful lives under the
straight line method. Estimated useful lives range from approximately five to
twenty-five years for office and manufacturing equipment and forty years for
buildings and improvements. Upon sale or retirement of assets, the cost and
related accumulated depreciation are removed from the accounts and any resulting
gain or loss is included in the results of operations. The Company regularly
assesses all of its long-lived assets for impairment. When the carrying value of
an asset exceeds its undiscounted cash flows, the Company recognizes an
impairment loss if the asset's fair value is less than its carrying value. The
impairment is then calculated as the difference between the carrying value and
the fair value of the asset. No such impairment losses were recorded in 2004,
2003 or 2002.

Product warranties

The Company estimates the costs that may be incurred under its product
warranties and records a liability in the amount of such costs at the time
revenue is recognized. The reserve for product warranties is based upon past
claims experience and ongoing evaluations of any specific probable claims from
customers. A reconciliation of the changes in the product warranty liability is
presented in Note 4 of the Notes to Consolidated Financial Statements.

Income Taxes

The Company recognizes deferred income tax assets and liabilities for the
expected future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. Deferred income tax assets and
liabilities are determined based on the difference between the financial
statement and tax bases of assets and liabilities using currently enacted tax
rates. The Company evaluates the available evidence about future taxable income
and other possible sources of realization of deferred income tax assets and
records a valuation allowance to reduce deferred income tax assets to an amount
that represents the Company's best estimate of the amount of such deferred
income tax assets that more likely than not will be realized.

Stock-based compensation

The Company accounts for stock-based compensation in accordance with SFAS
No. 123, "Accounting for Stock-Based Compensation". As permitted by SFAS No.
123, the Company continues to measure compensation for such plans using the
intrinsic value based method of accounting, prescribed by Accounting Principles
Board (APB), Opinion No. 25, "Accounting for Stock Issued to Employees".
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's stock at the date of grant over
the amount an employee must pay to acquire the stock. Compensation cost for
share equivalent units is recorded based on the quoted market price of the
Company's stock at the end of the period.

Under the intrinsic value method, no compensation expense has been
recognized for its stock option plans. Had compensation cost for the Company's
two stock option plans been determined based on the fair value at the grant date
for

21

awards under those plans in accordance with the optional methodology prescribed
under SFAS No. 123, the Company's net income and net income per share would have
been the pro forma amounts indicated below:

The weighted average fair value of the options granted during 2004, 2003,
and 2002 is estimated as $3.27, $2.88, and $5.85, respectively, using the Black
Scholes option pricing model with the following weighted average assumptions:

Per share data

Basic (loss) earnings per share is computed by dividing net (loss) income
by the weighted average number of common shares outstanding for the period.
Common shares outstanding include share equivalent units which are contingently
issuable shares. Diluted (loss) earnings per share is calculated by dividing net
(loss) income by the weighted average number of common and, when applicable,
potential common shares outstanding during the period. A reconciliation of the
numerators and denominators of basic and diluted (loss) earnings per share is
presented below.

22

Options to purchase shares of common stock, which totaled 211,695, 136,000
and 138,350 in 2004, 2003 and 2002, respectively, were not included in the
computation of diluted (loss) earnings per share as the effect would be
anti-dilutive.

Cash flow statement

The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.

Interest paid was $137 in 2004, $97 in 2003, and $161 in 2002. In addition,
income taxes (refunded) paid were $(274) in 2004, $1,194 in 2003, and $(521) in
2002.

Non cash activities during 2004, 2003, and 2002 included capital
expenditures totaling $11, $76 and $112, respectively, which were financed
through the issuance of capital leases. In 2004 and 2003, minimum pension
liability adjustments, net of income tax benefits, were recognized totaling $448
and $1,090, respectively. In addition, dividends of $83 and $82 were recorded
but not paid in 2004 and 2003, respectively.

Accumulated other comprehensive (loss) income

Comprehensive (loss) income is comprised of net (loss) income and other
comprehensive income or loss items, which are reflected as a separate component
of equity. For the Company, other comprehensive income or loss items include a
foreign currency translation adjustment and a minimum pension liability
adjustment.

Accounting and Reporting Changes

In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness to Others." FIN 45
expands disclosure requirements and requires that a guarantor recognize, at fair
value, a liability for its obligation under a guarantee. The recognition and
measurement requirements are effective on a prospective basis for guarantees
issued or modified after December 31, 2002. Adoption of this standard did not
have a material impact on the Company's financial position, results of
operations or cash flows.

In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest
Entities, an Interpretation of ARB No. 51." FIN 46 requires certain variable
interest entities to be consolidated by the primary beneficiary of the entity if
the equity investors in the entity do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated financial
support from other parties. FIN 46 is effective immediately for certain
requirements and was amended in December 2003 to defer implementation of other
requirements until March 2004. Adoption of this standard had no effect on the
Company's financial position, results of operations or cash flows.

In December 2003, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting Standards ("SFAS") No. 132, "Employers'
Disclosures About Pensions and Other Postretirement Benefits", an amendment of
SFAS Nos. 87, 88, and 106 (SFAS 132R). SFAS 132R requires expanded disclosures
about defined benefit pension plans and other postretirement benefit plan
assets, obligations, cash flows, and net costs, and retains the disclosures
required by SFAS 132. The expanded benefit payment disclosure requirements of
SFAS 132R are effective for fiscal years ending after June 15, 2004. The
remaining expanded disclosures required by SFAS 132R are effective for fiscal
years ending on or after December 15, 2003, and for the first interim period
following adoption of the standard. The Company has complied with all expanded
disclosures required for fiscal years ending on or after December 15, 2003.

23

NOTE 2 -- INVENTORIES:

Major classifications of inventories are as follows:

NOTE 3 -- PROPERTY, PLANT AND EQUIPMENT:

Major classifications of property, plant and equipment are as follows:

Depreciation expense in 2004, 2003, and 2002 was $1,035, $1,004, and $955,
respectively.

NOTE 4 -- PRODUCT WARRANTY LIABILITY:

The reconciliation of the changes in the product warranty liability is as
follows:

The decrease in expense for product warranties resulted from the reversal
of provisions made in 2003 for specific claims that were settled during 2004 for
less than the amounts reserved.

NOTE 5 -- LEASES:

The Company leases equipment and office space under various operating
leases. Rent expense applicable to operating leases was $150, $159 and $123 in
2004, 2003, and 2002, respectively.

Property, plant and equipment include the following amounts for leases
which have been capitalized.

24

Amortization of machinery and equipment under capital lease amounted to
$43, $167 and $149 in 2004, 2003, and 2002, respectively, and is included in
depreciation expense.

As of March 31, 2004, future minimum payments required under non-cancelable
leases are:

NOTE 6 -- DEBT:

Short-Term Debt Due Banks

The Company and its subsidiaries had short-term borrowings outstanding as
follows:

The United Kingdom subsidiary has a revolving credit facility agreement,
which provides a line of credit of 1,220 pounds sterling ($2,245 at the March
31, 2004 exchange rate) including letters of credit through May 31, 2004. The
interest rate is the bank's rate plus 1 1/2%. The bank's base rate was 4% and
3.75% at March 31, 2004 and 2003, respectively. The United Kingdom operations
had available unused lines of credit of $269 at March 31, 2004. The United
Kingdom short-term bank borrowings are collateralized by assets of the United
Kingdom subsidiary, which have a book value of $786 at March 31, 2004. The
United States operation does not provide a corporate guarantee or any security
for the United Kingdom revolving credit facility.

During 2004, the Company amended its United States revolving credit
facility agreement. The amended facility agreement provides a line of credit of
up to $8,000 including letters of credit through October 31, 2005. Under the
terms of the agreement, the Company was able to borrow at a rate of prime at
March 31, 2004 and prime minus 75 basis points at March 31, 2003. The bank's
prime rate was 4% and 4.25% at March 31, 2004 and 2003, respectively. The United
States operations had available unused lines of credit of $6,540 at March 31,
2004.

The weighted average interest rate on short-term borrowings in 2004 and
2003 was 4.6% and 3.5%, respectively.

Long-Term Debt

The Company and its subsidiaries had long-term borrowings outstanding as
follows:

With the exception of capital leases, there are no long-term debt payment
requirements over the next five years.

The Company is required to pay commitment fees of 1/2% on the unused
portion of the domestic revolving credit facility. No other financing
arrangements require compensating balances or commitment fees.

The loan agreements contain provisions pertaining to the maintenance of
minimum working capital balances, tangible net worth and financial ratios as
well as restrictions on the payment of cash dividends to shareholders and
incurrence of

25

additional long-term debt. In addition, the United States operations cannot make
any loans or advances exceeding $500 to any affiliates without prior consent of
the bank.

NOTE 7 -- FINANCIAL INSTRUMENTS AND DERIVATIVE FINANCIAL INSTRUMENTS:

Concentrations of Credit Risk:

Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash, cash equivalents,
investments, and trade accounts receivable. The Company places its cash, cash
equivalents, and investments with high credit quality financial institutions,
and actively evaluates the credit worthiness of these financial institutions.
Concentrations of credit risk with respect to trade accounts receivable are
limited due to the large number of customers comprising the Company's customer
base and their geographic dispersion. At March 31, 2004 and 2003, the Company
had no significant concentrations of credit risk.

Letters of Credit:

The Company has entered into standby letter of credit agreements with
financial institutions relating to the guarantee of future performance on
certain contracts. At March 31, 2004 and 2003, the Company was contingently
liable on outstanding standby letters of credit aggregating $1,511 and $1,394,
respectively.

Foreign Exchange Risk Management:

The Company, as a result of its global operating and financial activities,
is exposed to market risks from changes in foreign exchange rates. In seeking to
minimize the risks and/or costs associated with such activities, the Company may
utilize foreign exchange forward contracts with fixed dates of maturity and
exchange rates. The Company does not hold or issue financial instruments for
trading or other speculative purposes and only contracts with high quality
financial institutions. If the counter-parties to the exchange contracts do not
fulfill their obligations to deliver the contracted foreign currencies, the
Company could be at risk for fluctuations, if any, required to settle the
obligation. At March 31, 2004 and 2003, there were no foreign exchange forward
contracts held by the Company.

Fair Value of Financial Instruments:

The estimates of the fair value of financial instruments are summarized as
follows:

INVESTMENTS -- The fair value of investments at March 31, 2004 and
2003 approximated the carrying value.

SHORT-TERM DEBT -- The carrying value of short-term debt approximates
fair value due to the short-term maturity of this instrument.

LONG-TERM DEBT -- The carrying values of credit facilities with
variable rates of interest approximate fair values.

NOTE 8 -- INCOME TAXES:

An analysis of the components of pre-tax (loss) income is presented below:

26

The (benefit) provision for income taxes consists of:

The reconciliation of the (benefit) provision calculated using the United
States federal tax rate with the provision for income taxes presented in the
financial statements is as follows:

27

The deferred income tax asset (liability) recorded in the Consolidated
Balance Sheets results from differences between financial statement and tax
reporting of income and deductions. A summary of the composition of the deferred
income tax asset follows:

Deferred income taxes include the impact of foreign net operating loss
carryforwards and the federal AMT credit, which may be carried forward
indefinitely, federal and state operating loss carryforwards, which expire in
2024, and investment tax credits, which expire from 2009 to 2019. A valuation
allowance of $376 at March 31, 2004 is deemed adequate to reserve for the
foreign net loss carryforwards, which have not met the criteria for realization.

The Company does not provide for additional U.S. income taxes on
undistributed earnings considered permanently invested in its United Kingdom
subsidiary. At March 31, 2004, such undistributed earnings totaled $945. It is
not practicable to determine the amount of income taxes that would be payable
upon the remittance of assets that represent those earnings.

NOTE 9 -- EMPLOYEE BENEFIT PLANS:

Retirement Plans

The Company has a qualified defined benefit plan covering employees in the
United States hired prior to January 1, 2003, which is non-contributory.
Benefits are based on the employee's years of service and average earnings for
the five highest consecutive calendar years of compensation in the ten year
period preceding retirement. The Company's funding policy for the plan is to
contribute the amount required by the Employee Retirement Income Security Act of
1974. The measurement date for the plan is December 31.

28

The components of pension cost are:

The weighted average actuarial assumptions used to determine net pension
cost are:

Discount rate............................................... 6 3/4% 7 1/4% 7 1/4%
Rate of increase in compensation levels..................... 3% 3% 3%
Long-term rate of return on plan assets..................... 9% 9% 9%

The expected long-term rate of return is based on the plan's asset
allocation using forward-looking assumptions in the context of historical